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The TED spread (in red), an indicator of perceived credit risk in the general economy, increased significantly during the financial crisis, reflecting an increase in perceived credit risk. The TED spread spiked up in July 2007, remained volatile for a year, then spiked even higher in September 2008, reaching a record 4.65% on October 10, 2008.
TED spread and components during 2008
World map showing real GDP growth rates for 2009 (countries in brown were in recession)
Share in GDP of U.S. financial sector since 1860[1]
The New York City headquarters of Lehman Brothers

Causes

Federal Funds Rate compared to U.S. Treasury interest rates

While the causes of the bubble are disputed, the precipitating factor for the Financial Crisis of 2007–2008 was the bursting of the United States housing bubble and the subsequent subprime mortgage crisis, which occurred due to a high default rate and resulting foreclosures of mortgage loans, particularly adjustable-rate mortgages. Some or all of the following factors contributed to the crisis:[187][63][64]

  • Lax underwriting standards and high mortgage approval rates led to an increase in the number of homebuyers, which drove up housing prices. This appreciation in value led many homeowners to borrow against the equity in their homes as an apparent windfall, leading to over-leveraging.
  • The high delinquency and default rates by homeowners, particularly those with subprime credit, led to a rapid devaluation of mortgage-backed securities including bundled loan portfolios, derivatives and credit default swaps. As the value of these assets plummeted, buyers for these securities evaporated and banks who were heavily invested in these assets began to experience a liquidity crisis.
  • Securitization allowed for shifting of risk and lax underwriting standards: Many mortgages were bundled together and formed into new financial instruments called mortgage-backed securities, in a process known as securitization. These bundles could be sold as (ostensibly) low-risk securities partly because they were often backed by credit default swaps insurance.[188] Because mortgage lenders could pass these mortgages (and the associated risks) on in this way, they could and did adopt loose underwriting criteria (due in part to outdated and lax regulation[citation needed][189]).
  • Lax regulation allowed predatory lending in the private sector,[190][191] especially after the federal government overrode anti-predatory state laws in 2004.[192]
  • The Community Reinvestment Act (CRA),[193] a 1977 U.S. federal law designed to help low- and moderate-income Americans get mortgage loans encouraged banks to grant mortgages to higher risk families.[194][195][196]
  • Reckless lending by lenders such as Bank of America's Countrywide Financial unit, caused Fannie Mae and Freddie Mac to lose market share and to respond by lowering their own standards.[197]
  • Mortgage guarantees by Fannie Mae and Freddie Mac, quasi-government agencies, which purchased many subprime loan securitizations.[198] The implicit guarantee by the U.S. federal government created a moral hazard and contributed to a glut of risky lending.
  • Government policies that encouraged home ownership, providing easier access to loans for subprime borrowers; overvaluation of bundled subprime mortgages based on the theory that housing prices would continue to escalate; questionable trading practices on behalf of both buyers and sellers; compensation structures by banks and mortgage originators that prioritize short-term deal flow over long-term value creation; and a lack of adequate capital holdings from banks and insurance companies to back the financial commitments they were making.[199][200]
  • The Wall Street and the Financial Crisis: Anatomy of a Financial Collapse (Levin–Coburn Report) by the United States Senate concluded that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street".[201]
  • In its January 2011 report, the Financial Crisis Inquiry Commission (FCIC) concluded that the financial crisis was avoidable and was caused by: [202][203][204][205][206]
    • "widespread failures in financial regulation and supervision", including the Federal Reserve's failure to stem the tide of Toxic assets;
    • "dramatic failures of corporate governance and risk management at many systemically important financial institutions" including too many financial firms acting recklessly and taking on too much risk;
    • "a combination of excessive borrowing, risky investments, and lack of transparency" by financial institutions and by households that put the financial system on a collision course with crisis;
    • ill preparation and inconsistent action by government and key policy makers lacking a full understanding of the financial system they oversaw that "added to the uncertainty and panic"
    • a "systemic breakdown in accountability and ethics" at all levels.
    • "collapsing mortgage-lending standards and the mortgage securitization pipeline"
    • deregulation of over-the-counter derivatives, especially credit default swaps
    • "the failures of credit rating agencies" to correctly price risk
  • The 1999 Gramm-Leach-Bliley Act, which partially repealed the Glass-Steagall Act effectively removed the separation between investment banks and depository banks in the United States and increased speculation on the part of depository banks.[207]
  • Credit rating agencies and investors failed to accurately price the financial risk involved with mortgage loan-related financial products, and governments did not adjust their regulatory practices to address changes in financial markets.[208][209][210]
  • Variations in the cost of borrowing.[211]
  • Fair value accounting was issued as U.S. accounting standard SFAS 157 in 2006 by the privately run Financial Accounting Standards Board (FASB)—delegated by the SEC with the task of establishing financial reporting standards.[212] This required that tradable assets such as mortgage securities be valued according to their current market value rather than their historic cost or some future expected value. When the market for such securities became volatile and collapsed, the resulting loss of value had a major financial effect upon the institutions holding them even if they had no immediate plans to sell them.[213]
  • Easy availability of credit in the US, fueled by large inflows of foreign funds after the 1998 Russian financial crisis and 1997 Asian financial crisis of the 1997–1998 period, led to a housing construction boom and facilitated debt-financed consumer spending. As banks began to give out more loans to potential home owners, housing prices began to rise. Lax lending standards and rising real estate prices also contributed to the real estate bubble. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load.[214][187][215]
  • As part of the housing and credit booms, the number of mortgage-backed securities (MBS) and collateralized debt obligations (CDO), which derived their value from mortgage payments and housing prices, greatly increased. Such financial innovation enabled institutions and investors to invest in the U.S. housing market. As housing prices declined, these investors reported significant losses.[216]
  • Falling prices also resulted in homes worth less than the mortgage loans, providing borrowers with a financial incentive to enter foreclosure. Foreclosure levels were elevated until early 2014.[217] drained significant wealth from consumers, losing up to $4.2 trillion[218] Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. Total losses were estimated in the trillions of U.S. dollars globally.[216]
  • Financialization - the increased use of leverage in the financial system.
  • U.S. government policy from the 1970s onward emphasized deregulation to encourage business, which resulted in less oversight of activities and less disclosure of information about new activities undertaken by banks and other evolving financial institutions. Thus, policymakers did not immediately recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system. Some experts believe these institutions had become as important as commercial (depository) banks in providing credit to the U.S. economy, but they were not subject to the same regulations.[219] These institutions, as well as certain regulated banks, had also assumed significant debt burdens while providing the loans described above and did not have a financial cushion sufficient to absorb large loan defaults or losses.[220] These losses affected the ability of financial institutions to lend, slowing economic activity.

Subprime lending

US subprime lending expanded dramatically 2004–2006

The relaxing of credit lending standards by investment banks and commercial banks allowed for a significant increase in subprime lending. Subprime did not become magically less risky; Wall Street just accepted this higher risk.[221]<

While the causes of the bubble are disputed, the precipitating factor for the Financial Crisis of 2007–2008 was the bursting of the United States housing bubble and the subsequent subprime mortgage crisis, which occurred due to a high default rate and resulting foreclosures of mortgage loans, particularly adjustable-rate mortgages. Some or all of the following factors contributed to the crisis:[187][63][64]

  • Lax underwriting standards and high mortgage approval rates led to an increase in the number of homebuyers, which drove up housing prices. This appreciation in value led many homeowners to borrow against the equity in their homes as an apparent windfall, leading to over-leveraging.
  • The high delinquency and default rates by homeowners, particularly those with subprime credit, led to a rapid devaluation of mortgage-backed securities including bundled loan portfolios, derivatives and credit default swaps. As the value of these assets plummeted, buyers for these securities evaporated and banks who were heavily invested in these assets began to experience a liquidity crisis.
  • Securitization allowed for shifting of risk and lax underwriting standards: Many mortgages were bundled together and formed into new financial instruments called mortgage-backed securities, in a process known as securitization. These bundles could be sold as (ostensibly) low-risk securities partly because they were often backed by credit default swaps insurance.[188] Because mortgage lenders could pass these mortgages (and the associated risks) on in this way, they could and did adopt loose underwriting criteria (due in part to outdated and lax regulation[citation needed][189]).
  • Lax regulation allowed predatory lending in t

    The relaxing of credit lending standards by investment banks and commercial banks allowed for a significant increase in subprime lending. Subprime did not become magically less risky; Wall Street just accepted this higher risk.[221]

    Due to competition between mortgage lenders for revenue and market share, and when the supply of creditworthy borrowers was limited, mortgage lenders relaxed underwriting standards and originated riskier mortgages to less creditworthy borrowers. In the view of some analysts, the relatively conservative government-sponsored enterprises (GSEs) policed mortgage originators and maintained relatively high underwriting standards prior to 2003. However, as market power shifted from securitizers to originators and as intense competition from private securitizers undermined GSE power, mortgage standards declined and risky loans proliferated. The riskiest loans were originated in 2004–2007, the years of the most intense competition between securitizers and the lowest market share for the GSEs. The GSEs eventually relaxed their standards to try to catch up with the private banks.[222][223]

    A contrarian view is that Fannie Mae and Freddie Mac led the way to relaxed underwriting standards, starting in 1995, by advocating the use of easy-to-qualify automated underwriting and appraisal systems, by designing the no-down-payment products issued by lenders, by the promotion of thousands of small mortgage brokers, and by their close relationship to subprime loan aggregators such as Countrywide.[224][225]

    Depending on how "subprime" mortgages are defined, they remained below 10% of all mortgage originations until 2004, when they rose to nearly 20% and remained there through the 2005–2006 peak of the United States housing bubble.[226]

    Role of affordable housing programs

    The majority report of the Financial Crisis Inquiry Commission, written by the six Democratic appointees, the minority report, written by three of the four Republican appointees, studies by Federal Reserve economists, and the work of several independent scholars generally contend that government affordable housing policy was not the primary cause of the financial crisis. Although they concede that governmental policies had some role in causing the crisis, they contend that GSE loans performed better than loans securitized by private investment banks, and performed better than some loans originated by institutions that held loans in their own portfolios.

    In his dissent to the majority report of the Financial Crisis Inquiry Commission, conservative American Enterprise Institute fellow Peter J. Wallison[227] stated his belief that the roots of the financial crisis can be traced directly and primarily to affordable housing policies initiated by the United States Department of Housing and Urban Development (HUD) in the 1990s and to massive risky loan purchases by government-sponsored entities Fannie Mae and Freddie Mac. Based upon information in the SEC's December 2011 securities fraud case against six former executives of Fannie and Freddie, Peter Wallison and Edward Pinto estimated that, in 2008, Fannie and Freddie held 13 million substandard loans totaling over $2 trillion.[228]

    In the early and mid-2000s, the Bush administration called numerous times for investigations into the safety and soundness of the GSEs and their swelling portfolio of subprime mortgages. On September 10, 2003, the United States House Committee on Financial Services held a hearing at the urging of the administration to assess safety and soundness issues and to review a recent report by the Office of Federal Housing Enterprise Oversight (OFHEO) that had uncovered accounting discrepancies within the two entities.[229][230] The hearings never resulted in new legislation or formal investigation of Fannie Mae and Freddie Mac, as many of the committee members refused to accept the report and instead rebuked OFHEO for their attempt at regulation.[231] Some, such as conservative Peter J. Wallison, believe this was an early warning to the systemic risk that the growing market in subprime mortgages posed to the U.S. financial system that went unheeded.[232]

    A 2000 United States Department of the Treasury study of lending trends for 305 cities from 1993 to 1998 showed that $467 billion of mortgage lending was made by Community Reinvestment Act (CRA)-covered lenders into low and mid level income (LMI) borrowers and neighborhoods, representing 10% of all U.S. mortgage lending during the period. The majority of these were prime loans. Sub-prime loans made by CRA-covered institutions constituted a 3% market share of LMI loans in 1998,[233] but in the run-up to the crisis, fully 25% of all subprime lending occurred at CRA-covered institutions and another 25% of subprime loans had some connection with CRA.[234] However, most sub-prime loans were not made to the LMI borrowers targeted by the CRA,[citation needed][235] especially in the years 2005–2006 leading up to the crisis,[citation needed][236] nor did it find any evidence that lending under the CRA rules increased delinquency rates or that the CRA indirectly influenced independent mortgage lenders to ramp up sub-prime lending.[citation needed][237]

    To other analysts the delay between CRA rule changes in 1995 and the explosion of subprime lending is not surprising, and does not exonerate the CRA. They contend that there were two, connected causes to the crisis: the relaxation of underwriting standards in 1995 and the ultra-low interest rates initiated by the Federal Reserve after the terrorist attack on September 11, 2001. Both causes had to be in place before the crisis could take place.[238] Critics also point out that publicly announced CRA loan commitments were massive, totaling $4.5 trillion in the years between 1994 and 2007.[239] They also argue that the Federal Reserve's classification of CRA loans as "prime" is based on the faulty and self-serving assumption that high-interest-rate loans (3 percentage points over average) equal "subprime" loans.[240]

    Others have pointed out that there were not enough of these loans made to cause a crisis of this magnitude. In an article in Portfolio Magazine, Michael Lewis spoke with one trader who noted that "There weren't enough Americans with [bad] credit taking out [bad loans] to satisfy investors' appetite for the end product." Essentially, investment banks and hedge funds used financial innovation to enable large wagers to be made, far beyond the actual value of the underlying mortgage loans, using derivatives called credit default swaps, collateralized debt obligations and synthetic CDOs.

    By March 2011, the FDIC had paid out $9 billion to cover losses on bad loans at 165 failed financial institutions.[241][242] The Congressional Budget Office estimated, in June 2011, that the bailout to Fannie Mae and Freddie Mac exceeds $300 billion (calculated by adding the fair value deficits of the entities to the direct bailout funds at the time).[243]

    Economist Paul Krugman argued in January 2010 that the simultaneous growth of the residential and commercial real estate pricing bubbles and the global nature of the crisis undermines the case made by those who argue that Fannie Mae, Freddie Mac, CRA, or predatory lending were primary causes of the crisis. In other words, bubbles in both markets developed even though only the residential market was affected by these potential causes.[244]

    Countering Krugman, Peter J. Wallison wrote: "It is not true that every bubble—even a large bubble—has the potential to cause a financial crisis when it deflates." Wallison notes that other developed countries had "large bubbles during the 1997–2007 period" but "the losses associated with mortgage delinquencies and defaults when these bubbles deflated were far lower than the losses suffered in the United States when the 1997–2007 [bubble] deflated." According to Wallison, the reason the U.S. residential housing bubble (as opposed to other types of bubbles) led to financial crisis was that it was supported by a huge number of substandard loans—generally with low or no downpayments.[245]

    Krugman's contention (that the growth of a commercial real estate bubble indicates that U.S. housing policy was not the cause of the crisis) is challenged by additional analysis. After researching the default of commercial loans during the financial crisis, Xudong An and Anthony B. Sanders reported (in December 2010): "We find limited evidence that substantial deterioration in CMBS [commercial mortgage-backed securities] loan underwriting occurred prior to the crisis."[246] Other analysts support the contention that the crisis in commercial real estate and related lending took place after the crisis in residential real estate. Business journalist Kimberly Amadeo reported: "The first signs of decline in residential real estate occurred in 2006. Three years later, commercial real estate started feeling the effects.[247] Denice A. Gierach, a real estate attorney and CPA, wrote:

    ... most of the commercial real estate loans were good loans destroyed by a really bad economy. In other words, the borrowers did not cause the loans to go bad-it was the economy.[248]

    Growth of the housing bubble

    Due to competition between mortgage lenders for revenue and market share, and when the supply of creditworthy borrowers was limited, mortgage lenders relaxed underwriting standards and originated riskier mortgages to less creditworthy borrowers. In the view of some analysts, the relatively conservative government-sponsored enterprises (GSEs) policed mortgage originators and maintained relatively high underwriting standards prior to 2003. However, as market power shifted from securitizers to originators and as intense competition from private securitizers undermined GSE power, mortgage standards declined and risky loans proliferated. The riskiest loans were originated in 2004–2007, the years of the most intense competition between securitizers and the lowest market share for the GSEs. The GSEs eventually relaxed their standards to try to catch up with the private banks.[222][223]

    A contrarian view is that Fannie Mae and Freddie Mac led the way to relaxed underwriting standards, starting in 1995, by advocating the use of easy-to-qualify automated underwriting and appraisal systems, by designing the no-down-payment products issued by lenders, by the promotion of thousands of small mortgage brokers, and by their close relationship to subprime loan aggregators such as Countrywide.[224][225]

    Depending on how "subprime" mortgages are defined, they remained below 10% of all mortgage originations until 2004, when they rose to nearly 20% and remained there through the 2005–2006 peak of the United States housing bubble.[226]

    The majority report of the Financial Crisis Inquiry Commission, written by the six Democratic appointees, the minority report, written by three of the four Republican appointees, studies by Federal Reserve economists, and the work of several independent scholars generally contend that government affordable housing policy was not the primary cause of the financial crisis. Although they concede that governmental policies had some role in causing the crisis, they contend that GSE loans performed better than loans securitized by private investment banks, and performed better than some loans originated by institutions that held loans in their own portfolios.

    In his dissent to the majority report of the Financial Crisis Inquiry Commission, conservative American Enterprise Institute fellow Peter J. WallisonAmerican Enterprise Institute fellow Peter J. Wallison[227] stated his belief that the roots of the financial crisis can be traced directly and primarily to affordable housing policies initiated by the United States Department of Housing and Urban Development (HUD) in the 1990s and to massive risky loan purchases by government-sponsored entities Fannie Mae and Freddie Mac. Based upon information in the SEC's December 2011 securities fraud case against six former executives of Fannie and Freddie, Peter Wallison and Edward Pinto estimated that, in 2008, Fannie and Freddie held 13 million substandard loans totaling over $2 trillion.[228]

    In the early and mid-2000s, the Bush administration called numerous times for investigations into the safety and soundness of the GSEs and their swelling portfolio of subprime mortgages. On September 10, 2003, the United States House Committee on Financial Services held a hearing at the urging of the administration to assess safety and soundness issues and to review a recent report by the Office of Federal Housing Enterprise Oversight (OFHEO) that had uncovered accounting discrepancies within the two entities.[229][230] The hearings never resulted in new legislation or formal investigation of Fannie Mae and Freddie Mac, as many of the committee members refused to accept the report and instead rebuked OFHEO for their attempt at regulation.[231] Some, such as conservative Peter J. Wallison, believe this was an early warning to the systemic risk that the growing market in subprime mortgages posed to the U.S. financial system that went unheeded.[232]

    A 2000 United States Department of the Treasury study of lending trends for 305 cities from 1993 to 1998 showed that $467 billion of mortgage lending was made by Community Reinvestment Act (CRA)-covered lenders into low and mid level income (LMI) borrowers and neighborhoods, representing 10% of all U.S. mortgage lending during the period. The majority of these were prime loans. Sub-prime loans made by CRA-covered institutions constituted a 3% market share of LMI loans in 1998,[233] but in the run-up to the crisis, fully 25% of all subprime lending occurred at CRA-covered institutions and another 25% of subprime loans had some connection with CRA.[234] However, most sub-prime loans were not made to the LMI borrowers targeted by the CRA,[citation needed][235] especially in the years 2005–2006 leading up to the crisis,[citation needed][236] nor did it find any evidence that lending under the CRA rules increased delinquency rates or that the CRA indirectly influenced independent mortgage lenders to ramp up sub-prime lending.[citation needed][237]

    To other analysts the delay between CRA rule changes in 1995 and the explosion of subprime lending is not surprising, and does not exonerate the CRA. They contend that there were two, connected causes to the crisis: the relaxation of underwriting standards in 1995 and the ultra-low interest rates initiated by the Federal Reserve after the terrorist attack on September 11, 2001. Both causes had to be in place before the crisis could take place.[238] Critics also point out that publicly announced CRA loan commitments were massive, totaling $4.5 trillion in the years between 1994 and 2007.[239] They also argue that the Federal Reserve's classification of CRA loans as "prime" is based on the faulty and self-serving assumption that high-interest-rate loans (3 percentage points over average) equal "subprime" loans.[240]

    Others have pointed out that there were not enough of these loans made to cause a crisis of this magnitude. In an article in Portfolio Magazine, Michael Lewis spoke with one trader who noted that "There weren't enough Americans with [bad] credit taking out [bad loans] to satisfy investors' appetite for the end product." Essentially, investment banks and hedge funds used financial innovation to enable large wagers to be made, far beyond the actual value of the underlying mortgage loans, using derivatives called credit default swaps, collateralized debt obligations and synthetic CDOs.

    By March 2011, the FDIC had paid out $9 billion to cover losses on bad loans at 165 failed financial institutions.[241][242] The Congressional Budget Office estimated, in June 2011, that the bailout to Fannie Mae and Freddie Mac exceeds $300 billion (calculated by adding the fair value deficits of the entities to the direct bailout funds at the time).[243]

    Economist Paul Krugman argued in January 2010 that the simultaneous growth of the residential and commercial real estate pricing bubbles and the global nature of the crisis undermines the case made by those who argue that Fannie Mae, Freddie Mac, CRA, or predatory lending were primary causes of the crisis. In other words, bubbles in both markets developed even though only the residential market was affected by these potential causes.[244]

    Countering Krugman, Peter J. Wallison wrote: "It is not true that every bubble—even a large bubble—has the potential to cause a financial crisis when it deflates." Wallison notes that other developed countries had "large bubbles during the 1997–2007 period" but "the losses associated with mortgage delinquencies and defaults when these bubbles deflated were far lower than the losses suffered in the United States when the 1997–2007 [bubble] deflated." According to Wallison, the reason the U.S. residential housing bubble (as opposed to other types of bubbles) led to financial crisis was that it was supported by a huge number of substandard loans—generally with low or no downpayments.[245]

    Krugman's contention (that the growth of a commercial real estate bubble indicates that U.S. housing policy was not the cause of the crisis) is challenged by additional analysis. After researching the default of commercial loans during the financial crisis, Xudong An and Anthony B. Sanders reported (in December 2010): "We find limited evidence that substantial deterioration in CMBS [commercial mortgage-backed securities] loan underwriting occurred prior to the crisis."[246] Other analysts support the contention that the crisis in commercial real estate and related lending took place after the crisis in residential real estate. Business journalist Kimberly Amadeo reported: "The first signs of decline in residential real estate occurred in 2006. Three years later, commercial real estate started feeling the effects.[247] Denice A. Gierach, a real estate attorney and CPA, wrote:

    ... most of the commercial real estate loans were good loans destroyed by a really bad economy. In other words, the borrowers did not cause the loans to go bad-it was the economy.[248]

    Between 1998 and 2006, the price of the typical American house increased by 124%.[249] In contrast, during the 1980s and 1990s, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio increased to 4.0 in 2004, and 4.6 in 2006.[250] This housing bubble resulted in many homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation.

    In a Peabody Award winning program, NPR correspondents argued that a "Giant Pool of Money" (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade. This pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with products such as the mortgage-backed security and the collateralized debt obligation that were assigned safe ratings by the credit rating agencies.[3]

    In effect, Wall Street connected this pool of money to the mortgage market in the US, with enormous fees accruing to those throughout the mortgage supply chain, from the mortgage broker selling the loans to small banks that funded the brokers and the large investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted, and continued strong demand began to drive down lending standards.[3]

    The collateralized debt obligation in particular enabled financial institutions to obtain investor funds to finance subprime and other lending, extending or increasing the housing bubble and generating large fees. This essentially places cash payments from multiple

    In a Peabody Award winning program, NPR correspondents argued that a "Giant Pool of Money" (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade. This pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with products such as the mortgage-backed security and the collateralized debt obligation that were assigned safe ratings by the credit rating agencies.[3]

    In effect, Wall Street connected this pool of money to the mortgage market in the US, with enormous fees accruing to those throughout the mortgage supply chain, from the mortgage broker selling the loans to small banks that funded the brokers and the large investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted, and continued strong demand began to drive down lending standards.[3]

    The collateralized debt obligation in particular enabled financial institutions to obtain investor funds to finance subprime and other lending, extending or increasing the housing bubble and generating large fees. This essentially places cash payments from multiple mortgages or other debt obligations into a single pool from which specific securities draw in a specific sequence of priority. Those securities first in line received investment-grade ratings from rating agencies. Securities with lower priority had lower credit ratings but theoretically a higher rate of return on the amount invested.[251]

    By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak.[252][253] As prices declined, borrowers with adjustable-rate mortgages could not refinance to avoid the higher payments associated with rising interest rates and began to default. During 2007, lenders began foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006.[254] This increased to 2.3 million in 2008, an 81% increase vs. 2007.[255] By August 2008, approximately 9% of all U.S. mortgages outstanding were either delinquent or in foreclosure.[256] By September 2009, this had risen to 14.4%.[257][258]

    After the bubble burst, Australian economist John Quiggin wrote, "And, unlike the Great Depression, this crisis was entirely the product of financial markets. There was nothing like the postwar turmoil of the 1920s, the struggles over gold convertibility and reparations, or the Smoot-Hawley tariff, all of which have shared the blame for the Great Depression." Instead, Quiggin lays the blame for the 2008 near-meltdown on financial markets, on political decisions to lightly regulate them, and on rating agencies which had self-interested incentives to give good ratings.[259]

    Lower interest rates encouraged borrowing. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%.[260] This was done to soften the effects of the collapse of the dot-com bubble and the September 11 attacks, as well as to combat a perceived risk of deflation.[261] As early as 2002, it was apparent that credit was fueling housing instead of business investment as some economists went so far as to advocate that the Fed "needs to create a housing bubble to replace the Nasdaq bubble".[262] Moreover, empirical studies using data from advanced countries show that excessive credit growth contributed greatly to the severity of the crisis.[263]

    current account deficit, which peaked along with the housing bubble in 2006. Federal Reserve chairman Ben Bernanke explained how trade deficits required the U.S. to borrow money from abroad, in the process bidding up bond prices and lowering interest rates.[264]

    Bernanke explained that between 1996 and 2004, the U.S. current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the country to borrow large sums from abroad, much of it from countries running trade surpluses. These were mainly the emerging economies in Asia and oil-exporting nations. The balance of payments identity requires that a country (such as the US) running a current account deficit also have a capital account (investment) surplus of the same amount. Hence large and growing amounts of foreign funds (capital) flowed into the U.S. to finance its imports.

    All of this created demand for various types of fin

    Bernanke explained that between 1996 and 2004, the U.S. current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the country to borrow large sums from abroad, much of it from countries running trade surpluses. These were mainly the emerging economies in Asia and oil-exporting nations. The balance of payments identity requires that a country (such as the US) running a current account deficit also have a capital account (investment) surplus of the same amount. Hence large and growing amounts of foreign funds (capital) flowed into the U.S. to finance its imports.

    All of this created demand for various types of financial assets, raising the prices of those assets while lowering interest rates. Foreign investors had these funds to lend either because they had very high personal savings rates (as high as 40% in China) or because of high oil prices. Ben Bernanke referred to this as a "saving glut".[265]

    A flood of funds (capital or liquidity) reached the U.S. financial markets. Foreign governments supplied funds by purchasing Treasury bonds and thus avoided much of the direct effect of the crisis. U.S. households, used funds borrowed from foreigners to finance consumption or to bid up the prices of housing and financial assets. Financial institutions invested foreign funds in mortgage-backed securities.[citation needed]

    The Fed then raised the Fed funds rate significantly between July 2004 and July 2006.[266] This contributed to an increase in 1-year and 5-year adjustable-rate mortgage (ARM) rates, making ARM interest rate resets more expensive for homeowners.[267] This may have also contributed to the deflating of the housing bubble, as asset prices generally move inversely to interest rates, and it became riskier to speculate in housing.[268][269] U.S. housing and financial assets dramatically declined in value after the housing bubble burst.[270][27]

    Subprime lending standards declined in the U.S.: in early 2000, a subprime borrower had a FICO score of 660 or less. By 2005, many lenders dropped the required FICO score to 620, making it much easier to qualify for prime loans and making subprime lending a riskier business. Proof of income and assets were de-emphasized. Loans at first required full documentation, then low documentation, then no documentation. One subprime mortgage product that gained wide acceptance was the no income, no job, no asset verification required (NINJA) mortgage. Informally, these loans were aptly referred to as "liar loans" because they encouraged borrowers to be less than honest in the loan application process.[271] Testimony given to the Financial Crisis Inquiry Commission by whistleblower Richard M. Bowen III, on events during his tenure as the Business Chief Underwriter for Correspondent Lending in the Consumer Lending Group for Citigroup, where he was responsible for over 220 professional underwriters, suggests that by 2006 and 2007, the collapse of mortgage underwriting standards was endemic. His testimony stated that by 2006, 60% of mortgages purchased by Citigroup from some 1,600 mortgage companies were "defective" (were not underwritten to policy, or did not contain all policy-required documents)—this, despite the fact that each of these 1,600 originators was contractually responsible (certified via representations and warrantees) that its mortgage originations met Citigroup standards. Moreover, during 2007, "defective mortgages (from mortgage originators contractually bound to perform underwriting to Citi's standards) increased ... to over 80% of production".[272]

    In separate testimony to the Financial Crisis Inquiry Commission, officers of Clayton Holdings, the largest residential loan due diligence and securitization surveillance company in the United States and Europe, testified that Clayton's review of over 900,000 mortgages issued from January 2006 to June 2007 revealed that scarc

    In separate testimony to the Financial Crisis Inquiry Commission, officers of Clayton Holdings, the largest residential loan due diligence and securitization surveillance company in the United States and Europe, testified that Clayton's review of over 900,000 mortgages issued from January 2006 to June 2007 revealed that scarcely 54% of the loans met their originators' underwriting standards. The analysis (conducted on behalf of 23 investment and commercial banks, including 7 "too big to fail" banks) additionally showed that 28% of the sampled loans did not meet the minimal standards of any issuer. Clayton's analysis further showed that 39% of these loans (i.e. those not meeting any issuer's minimal underwriting standards) were subsequently securitized and sold to investors.[273][274]

    Predatory lending refers to the practice of unscrupulous lenders, enticing borrowers to enter into "unsafe" or "unsound" secured loans for inappropriate purposes.[275][276][277]

    In June 2008, Countrywide Financial was sued by then California Attorney General Jerry Brown for "unfair

    In June 2008, Countrywide Financial was sued by then California Attorney General Jerry Brown for "unfair business practices" and "false advertising", alleging that Countrywide used "deceptive tactics to push homeowners into complicated, risky, and expensive loans so that the company could sell as many loans as possible to third-party investors".[278] In May 2009, Bank of America modified 64,000 Countrywide loans as a result.[279] When housing prices decreased, homeowners in ARMs then had little incentive to pay their monthly payments, since their home equity had disappeared. This caused Countrywide's financial condition to deteriorate, ultimately resulting in a decision by the Office of Thrift Supervision to seize the lender. One Countrywide employee—who would later plead guilty to two counts of wire fraud and spent 18 months in prison—stated that, "If you had a pulse, we gave you a loan."[280]

    Former employees from Ameriquest, which was United States' leading wholesale lender, described a system in which they were pushed to falsify mortgage documents and then sell the mortgages to Wall Street banks eager to make fast profits. There is growing evidence that such mortgage frauds may be a cause of the crisis.[281]

    A 2012 OECD study[282] suggest that bank regulation based on the Basel accords encourage unconventional business practices and contributed to or even reinforced the financial crisis. In other cases, laws were changed or enforcement weakened in parts of the financial system. Key examples include:

    • Jimmy Carter's Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) phased out several restrictions on banks' financial practices, broadened their lending powers, allowed credit unions and savings and loans to offer checkable

      A 2011 paper suggested that Canada's avoidance of a banking crisis in 2008 (as well as in prior eras) could be attributed to Canada possessing a single, powerful, overarching regulator, while the United States had a weak, crisis prone and fragmented banking system with multiple competing regulatory bodies.[299]

      Increased debt burden or overleveraging

      Leverage ratios of investment banks increased significantly between 2003 and 2007.
      Household debt relative to disposable income and GDP.

      Prior to the crisis, financial institutions became highly leveraged, increasing their appetite for risky investments and reducing their resilience in case of losses. Much of this leverage was achieved using complex financial instruments such as off-balance sheet securitization and derivatives, which made it difficult for creditors and regulators to monitor and try to reduce financial institution risk levels.[citation needed][300]

      U.S. households and financial institutions became increasingly indebted or overleveraged during the years preceding the crisis.[301] This increased their vulnerability to the collapse of the housing bubble and worsened the ensuing economic downturn.[302] Key statistics include:

      Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion over the period, contributing to economic growth worldwide.[13][14][15] U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.[12]

      U.S. household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990.[301] In 1981, U.S. private debt was 123% of GDP; by the third quarter of 2008, it was 290%.[303]

      From 2004 to 2007, the top five U.S. investment banks each significantly increased their financial leverage, which increased their vulnerability to a financial shock. Changes in capital requirements, intended to keep U.S. banks competitive with their European counterparts, allowed lower risk weightings for AAA-rated securities. The shift from first-loss tranches to AAA-rated tranches was seen by regulators as a risk reduction that compensated the higher leverage.[304] These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of U.S. nominal GDP for 2007. Lehman Brothers went bankrupt and was liquidated, Bear Stearns and Merrill Lynch were sold at fire-sale prices, and Goldman Sachs and Morgan Stanley became commercial banks, subjecting themselves to more stringent regulation. With the exception of Lehman, these companies required or received government support.[305]

      Fannie Mae and Freddie Mac, two U.S. government-sponsored enterprises, owned or guaranteed nearly $5trillion in mortgage obligations at the time they were placed into conservatorship by the U.S. government in September 2008.[306][307]

      These seven entities were highly leveraged and had $9 trillion in debt or guarantee obligations; yet they were not subject to the same regulation as depository banks.[290]

      Prior to the crisis, financial institutions became highly leveraged, increasing their appetite for risky investments and reducing their resilience in case of losses. Much of this leverage was achieved using complex financial instruments such as off-balance sheet securitization and derivatives, which made it difficult for creditors and regulators to monitor and try to reduce financial institution risk levels.[citation needed][300]

      U.S. households and financial institutions became increasingly indebted or overleveraged during the years preceding the crisis.[301] This increased their vulnerability to the collapse of the housing bubble and worsened the ensuing economic downturn.[302] Key statistics include:

      Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion over the period, contributing to economic growth worldwide.[13][14][15] U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.[12]

      U.S. household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990.[301] In 1981, U.S. private debt was 123% of GDP; by the third quarter of 2008, it was 290%.[303]

      From 2004 to 2007, the top five U.S. investment banks each significantly increased their financial leverage, which increased their vulnerability to a financial shock. Changes in capital requirements, intended to keep U.S. banks competitive with their European counterparts, allowed lower risk weightings for AAA-rated securities. The shift from first-loss tranches to AAA-rated tranches was seen by regulators as a risk reduction that compensated the higher leverage.[304] These five institutions reported over $4.1 trillion in debt for fisca

      U.S. households and financial institutions became increasingly indebted or overleveraged during the years preceding the crisis.[301] This increased their vulnerability to the collapse of the housing bubble and worsened the ensuing economic downturn.[302] Key statistics include:

      Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion over the period, contributing to economic growth worldwide.[13][14][15] U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.[12]

      U.S. household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990.[301] In 1981, U.S. private debt was 123% of GDP; by the third quarter of 2008, it was 290%.[303]

      From 2004 to 2007, the top five U.S. investment banks each significantly increased their financial leverage, which increased their vulnerability to a financial shock. Changes in capital requirements, intended to keep U.S. banks competitive with their European counterparts, allowed lower risk weightings for AAA-rated securities. The shift from first-loss tranches to AAA-rated tranches was seen by regulators as a risk reduction that compensated the higher leverage.[304] These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of U.S. nominal GDP for 2007. Lehman Brothers went bankrupt and was liquidated, Bear Stearns and Merrill Lynch were sold at fire-sale prices, and Goldman Sachs and Morgan Stanley became commercial banks, subjecting themselves to more stringent regulation. With the exception of Lehman, these companies required or received government support.[305]

      Fannie Mae and Freddie Mac, two U.S. government-sponsored enterprises, owned or guaranteed nearly $5trillion in mortgage obligations at the time they were placed into conservatorship by the U.S. government in September 2008.[306][307]

      These seven entities were highly leveraged and had $9 trillion in debt or guarantee obligations; yet they were not subject to the same regulation as depository banks.[290][308]

      Behavior that may be optimal for an individual such as saving more during adverse economic conditions, can be detrimental if too many individuals pursue the same behavior, as ultimately one person's consumption is another person's income. Too many consumers attempting to save or pay down debt simultaneously is called the paradox of thrift and can cause or deepen a recession. Economist Hyman Minsky also described a "paradox of deleveraging" as financial institutions that have too much leverage (debt relative to equity) cannot all de-leverage simultaneously without significant declines in the value of their assets.[302]

      In April 2009, Federal Reserve vice-chair Janet Yellen discussed these paradoxes:

      Once this massive credit crunch hit, it didn't take long before we were in a recession. The recession, in turn, deepened the credit crunch as demand and employment fell, and credit losses of financial institutions surged. Indeed, we have been in the grips of precisely this adverse feedback loop for more than a year. A process of balance sheet deleveraging has spread to nearly every corner of the economy. Consumers are pulling back on purchases, especially on durable goods, to build their savings. Businesses are cancelling planned investments and laying off workers to preserve cash. And, financial institutions are shrinking assets to bolster capital and improve their chances of weathering the current storm. Once again, Minsky understood this dynamic. He spoke of the paradox of deleveraging, in which precautions that may be smart for individuals and firms—and indeed essential to return the economy to a normal state—nevertheless magnify the distress of the economy as a whole.[302]

    The term financial innovation refers to the ongoing development of financial products designed to achieve particular client objectives, such as offsetting a particular risk exposure (such as the default of a borrower) or to assist with obtaining financing. Examples pertinent to this crisis included: the adjustable-rate mortgage; the bundling of subprime mortgages into mortgage-backed securities (MBS) or collateralized debt obligations (CDO) for sale to investors, a type of securitization; and a form of credit insurance called credit default swaps (CDS). The usage of these products expanded dramatically in the years leading up to the crisis. These products vary in complexity and the ease with which they can be valued on the books of financial institutions.[citation needed]

    CDO issuance grew from an estimated $20 billion in Q1 2004 to its peak of over $180 billion by Q1 2007, then declined back under $20 billion by Q1 2008. Further, the credit quality of CDO's declined from 2000 to 2007, as the level of subprime and other non-prime mortgage debt increased from 5% to 36% of CDO assets. As described in the section on subprime lending, the CDS and portfolio of CDS called synthetic CDO enabled a theoretically infinite amount to be wagered on the finite value of housing loans outstanding, provided that buyers and sellers of the derivatives could be found. For example, buying a CDS to insure a CDO ended up giving the seller the same risk as if they owned the CDO, when those CDO's became worthless.[309]

    CDO issuance grew from an estimated $20 billion in Q1 2004 to its peak of over $180 billion by Q1 2007, then declined back under $20 billion by Q1 2008. Further, the credit quality of CDO's declined from 2000 to 2007, as the level of subprime and other non-prime mortgage debt increased from 5% to 36% of CDO assets. As described in the section on subprime lending, the CDS and portfolio of CDS called synthetic CDO enabled a theoretically infinite amount to be wagered on the finite value of housing loans outstanding, provided that buyers and sellers of the derivatives could be found. For example, buying a CDS to insure a CDO ended up giving the seller the same risk as if they owned the CDO, when those CDO's became worthless.[309]

    This boom in innovative financial products went hand in hand with more complexity. It multiplied the number of actors connected to a single mortgage (including mortgage brokers, specialized originators, the securitizers and their due diligence firms, managing agents and trading desks, and finally investors, insurances and providers of repo funding). With increasing distance from the underlying asset these actors relied more and more on indirect information (including FICO scores on creditworthiness, appraisals and due diligence checks by third party organizations, and most importantly the computer models of rating agencies and risk management desks). Instead of spreading risk this provided the ground for fraudulent acts, misjudgments and finally market collapse.[310] Economists have studied the crisis as an instance of cascades in financial networks, where institutions' instability destabilized other institutions and led to knock-on effects.[311]

    Martin Wolf, chief economics commentator at the Financial Times, wrote in June 2009 that certain financial innovations enabled firms to circumvent regulations, such as off-balance sheet financing that affects the leverage or capital cushion reported by major banks, stating: "... an enormous part of what banks did in the early part of this decade—the off-balance-sheet vehicles, the derivatives and the 'shadow banking system' itself—was to find a way round regulation."[312]

    Incorrect pricing of risk

    Economists, particularly followers o

    Economists, particularly followers of mainstream economics, mostly failed to predict the crisis.[348] The Wharton School of the University of Pennsylvania's online business journal examined why economists failed to predict a major global financial crisis and concluded that economists used mathematical models that failed to account for the critical roles that banks and other financial institutions, as opposed to producers and consumers of goods and services, play in the economy.[349]

    Popular articles published in the mass media have led the general public to believe that the majority of economists have failed in their obligation to predict the financial crisis. For example, an article in The New York Times noted that economist Nouriel Roubini warned of

    Popular articles published in the mass media have led the general public to believe that the majority of economists have failed in their obligation to predict the financial crisis. For example, an article in The New York Times noted that economist Nouriel Roubini warned of such crisis as early as September 2006, and stated that the profession of economics is bad at predicting recessions.[350] According to The Guardian, Roubini was ridiculed for predicting a collapse of the housing market and worldwide recession, while The New York Times labelled him "Dr. Doom".[351]

    Within mainstream financial economics, most believe that financial crises are simply unpredictable,[352] following Eugene Fama's efficient-market hypothesis and the related random-walk hypothesis, which state respectively that markets contain all information about possible future movements, and that the movements of financial prices are random and unpredictable. Recent research casts doubt on the accuracy of "early warning" systems of potential crises, which must also predict their timing.[353]