ABSTRACT Banks provide a valuable but inherently unstable combination of deposit‐taking and lending functions that were successfully held together for several decades after the New Deal by tough banking rules. The weakening of the rules after the 1970s promoted the displacement of traditional relationship‐based banking with securitized, arms‐length alternatives that encouraged banks to undertake activities about which bankers lacked deep relationship‐based knowledge of the risks. Ironically, this risky behavior, encouraged by loosened regulation, was reinforced by progressively tightened securities regulation, which (...) promoted stock‐market liquidity but also deprived large banks (and other publicly traded companies) of oversight by investors with “insiders’” knowledge. Both the underregulation of banking and the overregulation of securities were underpinned by economic theories that favored blind diversification in liquid, anonymous markets, and that ignored the value of relationship‐based knowledge and case‐by‐case due diligence. (shrink)

ABSTRACT Asset‐market bubbles occur dependably in laboratory experiments and almost as reliably throughout economic history—yet they do not usually bring the global economy to its knees. The Crash of 2008 was caused by the bursting of a housing bubble of unusual size that was fed by a massive expansion of mortgage credit—facilitated, in turn, by the longest sustained expansionary monetary policy of the past half century. Much of this mortgage credit was extended to people with little net wealth who made (...) slender down payments, so that when the bubble burst and housing prices declined, their losses quickly exceeded their equity. These losses were transmitted to the financial system—including banks, investment banks, insurance companies, and the institutional and private investors who provided liquidity to the mortgage market through structured securities. It seems that many of these institutions became insolvent; it is certain that they became illiquid. Liquidity loss and solvency fears created a feedback cycle of diminished financing, reduced housing demand, falling housing prices, more borrower losses, and further damage to the financial system and eventually the stock market and the real economy. There are important parallels with the housing and financial‐market booms that led up to the Crash of 1929 and the Great Depression. (shrink)

ABSTRACT The main cause of the crisis was the behavior of the banks—largely a result of misguided incentives unrestrained by good regulation. Conservative ideology, along with unrealistic economic models of perfect information, perfect competition, and perfect markets, fostered lax regulation, and campaign contributions helped the political process along. The banks misjudged risk, wildly overleveraged, and paid their executives handsomely for being short‐sighted; lax regulation let them get away with it—putting at risk the entire economy. The mortgage brokers neglected due diligence, (...) since they would not bear the risk of default once their mortgages had been securitized and sold to others. Others can be blamed: the ratings agencies that judged subprime securities as investment grade; the Fed, which contributed low interest rates; the Bush administration, whose Iraq war and tax cuts for the rich made low interest rates necessary. But low interest rates can be a boon; it was the financial institutions that turned them into a bust. (shrink)