ȱ
ȱȱȱȱȱ
ȱ ȱ
ȱȱȱȱ
¢ȱŘşǰȱŘŖŖşȱ
ȱȱȱ
ŝȬśŝŖŖȱ
ǯǯȱ
ŚŖŗŝřȱ
ȱȱȱ
Pr
epared for Members and Committees of Congress
ȱȱȱȱȱ
ȱ
¢ȱ
The current financial crisis began in August 2007, when financial stability replaced inflation as
the Federal Reserve’s chief concern. The roots of the crisis go back much further, and there are
various views on the fundamental causes.
It is generally accepted that credit standards in U.S. mortgage lending were relaxed in the early
2000s, and that rising rates of delinquency and foreclosures delivered a sharp shock to a range of
U.S. financial institutions. Beyond that point of agreement, however, there are many questions
that will be debated by policymakers and academics for decades.
Why did the financial shock from the housing market downturn prove so difficult to contain?
Why did the tools the Fed used successfully to limit damage to the financial system from previous
shocks (the Asian crises of 1997-1998, the stock market crashes of 1987 and 2000-2001, the junk
bond debacle in 1989, the savings and loan crisis, 9/11, and so on) fail to work this time? If we
accept that the origins are in the United States, why were so many financial systems around the
world swept up in the panic?
To what extent were long-term developments in financial markets to blame for the instability?
Derivatives markets, for example, were long described as a way to spread financial risk more
efficiently, so that market participants could bear only those risks they understood. Did
derivatives, and other risk management techniques, actually increase risk and instability under
crisis conditions? Was there too much reliance on computer models of market performance? Did
those models reflect only the post-WWII period, which may now come to be viewed not as a
typical 60-year period, suitable for use as a baseline for financial forecasts, but rather as an
unusually favorable period that may not recur?
Did government actions inadvertently create the conditions for crisis? Did regulators fail to use
their authority to prevent excessive risk-taking, or was their jurisdiction too limited and/or
compartmentalized?
While some may insist that there is a single cause, and thus a simple remedy, the sheer number of
causal factors that have been identified tends to suggest that the current financial situation is not
yet fully understood in its full complexity. This report consists of a table that summarizes very
briefly some of the arguments for particular causes, presents equally brief rejoinders, and includes
a reference or two for further reading. It will be updated as required by market developments.
ȱȱȱ
ȱȱȱȱȱ
ȱ
ȱ
The financial crisis that began in 2007 spread and gathered intensity in 2008, despite the efforts
of central banks and regulators to restore calm. By early 2009, the financial system and the global
economy appeared to be locked in a descending spiral, and the primary focus of policy became
the prevention of a prolonged downturn on the order of the Great Depression.
The volume and variety of negative financial news, and the seeming impotence of policy
responses, has raised new questions about the origins of financial crises and the market
mechanisms by which they are contained or propagated. Just as the economic impact of financial
market failures in the 1930s remains an active academic subject, it is likely that the causes of the
current crisis will be debated for decades to come.
This report sets out in tabular form a number of the factors that have been identified as causes of
the crisis. The left column of Table 1 below summarizes the causal role of each such factor. The
next column presents a brief rejoinder to that argument. The right-hand column contains a
reference for further reading. Where text is given in quotation marks, the reference in the right
column is the source, unless otherwise specified.
ȱȱȱ
ŗȱ
ȱ
Table 1. Causes of the Financial Crisis
Cause Argument
Rejoinder
Additional
Reading
Imprudent
Against a backdrop of abundant credit, low interest rates, and
Imprudent lending certainly played a role, CRS Report RL33775, Alternative
Mortgage Lending
rising house prices, lending standards were relaxed to the point
but subprime loans (about $1 – 1.5
Mortgages: Causes and Policy Implications
that many people were able to buy houses they couldn’t afford.
trillion currently outstanding) were a
of Troubled Mortgage Resets in the
When prices began to fall and loans started going bad, there was relatively small part of the overall U.S.
Subprime and Alt-A Markets, by Edward
a severe shock to the financial system.
mortgage market (about $11 trillion) and V. Murphy.
of total credit market debt outstanding
(about $50 trillion).
Housing Bubble
With its easy money policies, the Federal Reserve allowed
It is difficult to identify a bubble until it
CRS Report RL33666, Asset Bubbles:
housing prices to rise to unsustainable levels. The crisis was
bursts, and Fed actions to suppress the
Economic Effects and Policy Options for
triggered by the bubble bursting, as it was bound to do.
bubble may do more damage to the
the Federal Reserve, by Marc Labonte.
economy than waiting and responding to
the effects of the bubble bursting.
Global Imbalances
Global financial flows have been characterized in recent years by None of the adjustments that would
Lorenzo Bini Smaghi, “The financial
an unsustainable pattern: some countries (China, Japan, and
reverse the fundamental imbalances has
crisis and global imbalances – two sides
Germany) run large surpluses every year, while others (like the
yet occurred. That is, there has not been of the same coin,” Speech at the Asia
U.S and U.K.) run deficits. The U.S. external deficits have been
a sharp fall in the dollar’s exchange value, Europe Economic Forum, Beijing, Dec.
mirrored by internal deficits in the household and government
and U.S. deficits persist.
9, 2008.
sectors. U.S. borrowing cannot continue indefinitely; the
resulting stress underlies current financial disruptions.
http://www.bis.org/review/r081212d.pdf
Securitization
Securitization fostered the “originate-to-distribute” model, which Mortgage loans that were not securitized, Statement of Alan Greenspan before
reduced lenders’ incentives to be prudent, especially in the face
but kept on the originating lender’s
the House Committee on Oversight
of vast investor demand for subprime loans packaged as AAA
books, have also done poorly.
and Government Reform, October 23,
bonds. Ownership of mortgage-backed securities was widely
2008 (“The breakdown has been most
dispersed, causing repercussions throughout the global system
apparent in the securitization of home
when subprime loans went bad in 2007.
mortgages.”)
ȬŘȱ
ȱ
Cause Argument
Rejoinder
Additional
Reading
Lack of
“Throughout the housing finance value chain, many participants
Many contractual arrangements did
Statement of the Honorable John W.
Transparency and
contributed to the creation of bad mortgages and the selling of
provide recourse against sellers or
Snow before the House Committee on
Accountability in
bad securities, apparently feeling secure that they would not be
issuers of bad mortgages or related
Oversight and Government Reform,
Mortgage Finance
held accountable for their actions. A lender could sell exotic
securities. Many non-bank mortgage
October 23, 2008
mortgages to home-owners, apparently without fear of
lenders failed because they were forced
repercussions if those mortgages failed. Similarly, a trader could
to take back loans that defaulted, and
sell toxic securities to investors, apparently without fear of
many lawsuits have been filed against MBS
personal responsibility if those contracts failed. And so it was for issuers and others.
brokers, realtors, individuals in rating agencies, and other market
participants, each maximizing his or her own gain and passing
problems on down the line until the system itself collapsed.
Because of the lack of participant accountability, the originate-to-
distribute model of mortgage finance, with its once great promise
of managing risk, became itself a massive generator of risk.”
Rating Agencies
The credit rating agencies gave AAA ratings to numerous issues
All market participants underestimated
Securities and Exchange Commission,
of subprime mortgage-backed securities, many of which were
risk, not just the rating agencies.
“SEC Approves Measures to
subsequently downgraded to junk status. Critics cite poor
Purchasers of MBS were mainly
Strengthen Oversight of Credit Rating
economic models, conflicts of interest, and lack of effective
sophisticated institutional investors, who Agencies,” press release 2008-284,
regulation as reasons for the rating agencies’ failure. Another
should have done their own due diligence Dec. 3, 2008.
factor is the market’s excessive reliance on ratings, which has
investigations into the quality of the
been reinforced by numerous laws and regulations that use
instruments.
ratings as a criterion for permissible investments or as a factor in
required capital levels.
Mark-to-market
FASB standards require institutions to report the fair (or current Many view uncertainty regarding financial “Understanding the Mark-to-market
Accounting
market) value of securities they hold. Critics of the rule argue
institutions’ true condition as key to the
Meltdown,” Euromoney, Mar. 2008.
that this forces banks to recognize losses based on “fire sale”
crisis. If accounting standards—however
prices that prevail in distressed markets, prices believed to be
imperfect—are relaxed, fears that
below long-term fundamental values. Those losses undermine
published balance sheets are unreliable
market confidence and exacerbate banking system problems.
will grow.
Some propose suspending mark-to-market; EESA requires a
study of its impact.
Ȭřȱ
ȱ
Cause Argument
Rejoinder
Additional
Reading
Deregulatory
Laws such as the Gramm-Leach-Bliley Act (GLBA) and the
GLBA and CFMA did not permit the
Anthony Faiola, Ellen Nakashima, and
Legislation
Commodity Futures Modernization Act (CFMA) permitted
creation of unregulated markets and
Jill Drew, “What Went Wrong?”
financial institutions to engage in unregulated risky transactions
activities; they simply codified existing
Washington Post, Oct. 15, 2008, p. A1.
on a vast scale. The laws were driven by an excessive faith in the markets and practices. (“There is this
robustness of market discipline, or self-regulation.
idea afloat that if you had more
regulation you would have fewer
mistakes,” [Gramm] said. “I don’t see any
evidence in our history or anybody else’s
to substantiate it.” Eric Lipton and
Stephen Labaton, “The Reckoning:
Deregulator Looks Back, Unswayed,”
New York Times, Nov. 16, 2008.)
Shadow Banking
Risky financial activities once confined to regulated banks (use of Regulated banks—the recipients of most Nouriel Roubini, “The Shadow Banking
System
leverage, borrowing short-term to lend long,, etc.) migrated
of the $700 billion Treasury TARP
System is Unravelling,” Financial Times,
outside the explicit government safety net provided by deposit
program—have not really fared much
Sep. 22, 2008, p. 9.
insurance and safety and soundness regulation. Mortgage lending, better than investment banks, hedge
in particular, moved out of banks into unregulated institutions.
funds, OTC derivatives dealers, private
This unsupervised risk-taking amounted to a financial house of
equity firms, et al.
cards.
Non-Bank Runs
As institutions outside the banking system built up financial
Liquidity risk was always present, and
Krishna Guha, “Bundesbank Chief Says
positions built on borrowing short and lending long, they became recognized, but its appearance at the
Credit Crisis Has Hallmarks of Classic
vulnerable to liquidity risk in the form of non-bank runs. That is, extreme levels of the current crisis was
Bank Run,” Financial Times, Sep. 3, 2007,
they could fail if markets lost confidence and refused to extend
not foreseeable.
p. 1.
or roll over short-term credit, as happened to Bear Stearns and
others.
Off-Balance Sheet
Many banks established off-the-books special purpose entities
Beginning in the 1990s, bank supervisors Adrian Blundell-Wignall, “Structured
Finance
(including structured investment vehicles, or SIVs) to engage in
actually encouraged off-balance sheet
Products: Implications for Financial
risky speculative investments. This allowed banks to make more finance as a legitimate way to manage
Markets,” Financial Market Trends, Nov.
loans during the expansion, but also created contingent liabilities risk.
2007, p. 27.
that, with the onset of the crisis, reduced market confidence in
the banks’ creditworthiness. At the same time, they had allowed
banks to hold less capital against potential losses. Investors had
little ability to understand banks’ true financial positions.
Government-
Federal mandates to help low-income borrowers (e.g., the
The subprime mortgage boom was led by Lawrence H. White, “How Did We
Mandated Subprime Community Reinvestment Act (CRA) and Fannie Mae and
non-bank lenders (not subject to CRA)
Get into This Financial Mess?” Cato
Lending
Freddie Mac’s affordable housing goals) forced banks to engage in and securitized by private investment
Institute Briefing Paper no. 110, Nov.
imprudent mortgage lending.
banks rather than the GSEs.
18, 2008.
ȬŚȱ
ȱ
Cause Argument
Rejoinder
Additional
Reading
Failure of Risk
Some firms separated analysis of market risk and credit risk. This Senior management’s responsibility has
“Confessions of a Risk Manager; A
Management
division did not work for complex structured products, where
always been to bridge this kind of gap in
Personal View of the Crisis,” The
Systems
those risks were indistinguishable. “Collective common sense
risk assessment.
Economist, Aug. 9, 2008.
suffered as a result.”
Financial Innovation New instruments in structured finance developed so rapidly that In a global marketplace, innovation will
Joseph R. Mason, “The Summer of ‘07
market infrastructure and systems were not prepared when
continue and national regulators’
and the Shortcomings of Financial
those instruments came under stress. Some propose that
attempts to restrain it will only put their Innovation,” Journal of Applied Finance,
markets in new instruments should be given time to mature
countries’ markets at a competitive
vol. 18, Spring 2008, p. 8.
before they are permitted to attain a systemically-significant size. disadvantage. Moreover, it is hard to tell
This means giving accountants, regulators, ratings agencies, and
in advance whether innovations will
settlement systems time to catch up.
stabilize the system or the reverse.
Complexity
The complexity of certain financial instruments at the heart of
Standard economic theory assumes that
Lee Buchheit, “We Made It Too
the crisis had three effects: (1) investors were unable to make
investors act rationally in their own self-
Complicated,” International Financial Law
independent judgments on the merits of investments, (2) risks of interest, which implies that they should
Review, Mar. 2008.
market transactions were obscured, and (3) regulators were
only take risks they understand.
baffled.
Human Frailty
Behavioral finance posits that investors do not always make
Since regulators are just as human as
Cass Sunstein and Richard Thaler,
optimal choices: they suffer from “bounded rationality” and
investors, how can they consistently
“Human Frailty Caused This Crisis,”
limited self-control. Regulators ought to help people manage
recognize that behavior has become
Financial Times, Nov. 12, 2008.
complexity through better disclosure and by reinforcing financial suboptimal and that markets are headed
prudence.
for a crash?
Bad Computer
Expectations of the performance of complex structured products Blaming models and the “quants” who
James G. Rickards, “A Mountain,
Models
linked to mortgages were based on only a few decades worth of designed them mistakes a symptom for a Overlooked: How Risk Models Failed
data. In the case of subprime loans, only a few years of data were cause—“garbage in, garbage out.”
Wall St. and Washington, ”Washington
available. “[C]omplex systems are not confined to historical
Post, Oct. 2, 2008, p. A23.
experience. Events of any size are possible, and limited only by
the scale of the system itself.”
Excessive Leverage In the post-2000 period of low interest rates and abundant
Leverage is only a symptom of the
Timothy F. Geithner, “Systemic Risk
capital, fixed income yields were low. To compensate, many
underlying problem: mispricing of risk and and Financial Markets,” Testimony
investors used borrowed funds to boost the return on their
a credit bubble.
before the House Committee on
capital. Excessive leverage magnified the impact of the housing
Financial Services, July 24, 2008.
downturn, and deleveraging caused the interbank credit market
to tighten.
Ȭśȱ
ȱ
Cause Argument
Rejoinder
Additional
Reading
Relaxed Regulation The SEC liberalized its net capital rule in 2004, allowing
The net capital rule applied only to the
Stephen Labaton, “Agency‘s ‘04 Rule
of Leverage
investment bank holding companies to attain very high leverage
regulated broker/dealer unit; the SEC
Let Banks Pile Up New Debt, and
ratios. Its Consolidated Supervised Entities program, which
never had statutory authority to limit
Risk,” New York Times, Oct. 3, 2008, p.
applied to the largest investment banks, was voluntary and
leverage at the holding company level.
A1, and Testimony of SEC Chairman
ineffective.
Christopher Cox, House Oversight and
Government Reform Committee, Oct.
23, 2008. (Response to question from
Rep. Christopher Shays.)
Credit Default
“An interesting paradox arose, however, as credit derivatives
Speculation in derivatives generally makes Jongho Kim, “From Vanilla Swaps to
Swaps (CDS)
instruments, developed initially for risk management, continued
prices of the underlying commodities
Exotic Credit Derivatives,” Fordham
to grow and become more sophisticated with the help of
more stable. We do not know why this
Journal of Corporate & Financial Law, Vol.
financial engineering, the tail began wagging the dog. In becoming relationship sometimes breaks down.
13, No. 5 (2008), p. 705.
a medium for speculative transactions, credit derivatives
Even in CDS, the feared “explosion” of
increased, rather than alleviated, risk.”
defaults has not happened, albeit the
expensive rescue of AIG may have
prevented such an event.
Over-the-Counter
Because OTC derivatives (including credit swaps) are largely
The largest OTC markets—interest rate Walter Lukken, “How to Solve the
Derivatives
unregulated, limited information about risk exposures is available and currency swaps—appear to have held Derivatives Problem,” Wall Street
to regulators and market participants. This helps explain the Bear up fairly well.
Journal, Oct. 10, 2008, p. A15.
Stearns and AIG interventions: in addition to substantial losses to
counterparties, a dealer default could trigger panic because of
uncertainty about the extent and distribution of those losses.
Fragmented
U.S. financial regulation is dispersed among many agencies, each
Countries with unified regulatory
U.S. Treasury, Blueprint for a Modernized
Regulation
with responsibility for a particular class of financial institution. As structures, such as Japan and the UK,
Financial Regulatory Structure, Apr. 2008.
a result, no agency is well-positioned to monitor emerging
have not avoided the crisis.
system-wide problems.
No Systemic Risk
No regulator had comprehensive jurisdiction over all
Some question whether the problem was Henry Kaufman, “Finance’s Upper Tier
Regulator
systemically-important financial institutions. (The Fed had the
lack of authority or failure to use existing Needs Closer Scrutiny,” Financial Times,
role of systemic risk regulator by default, but lacked authority to regulatory powers effectively.
Apr. 21, 2008, p. 13.
oversee investment banks, hedge funds, nonbank derivatives
dealers, etc.)
Short-term
Since traders and managers at many financial institutions receive Shareholders already have incentives and Andrew Ross Sorkin, “Rein in Chief’s
Incentives
a large part of their compensation in the form of an annual
authority to monitor corporate
Pay? It’s Doable,” New York Times, Nov.
bonus, they lack incentives to avoid risky strategies liable to fail
compensation structures and levels.
3, 2008.
spectacularly every five or ten years. Some propose to link pay
to a rolling average of firm profits or to put bonuses into escrow
for a certain period, or to impose higher capital charges on banks
that maintain current annual bonus practices.
ȬŜȱ
ȱ
Cause Argument
Rejoinder
Additional
Reading
Tail Risk
Many investors and risk managers sought to boost their returns
Dispersal of systematic risk via financial
Raghuram Rajan, “A Tale of Two
by providing insurance or writing options against low-probability innovation was believed to make the
Liquidities,” Remarks at the University
financial events. (Credit default swaps are a good example, but by financial system more resilient to shocks. of Chicago Graduate School of
no means the only one.) These strategies generate a stream of
Business, Dec. 5, 2007, online at
small gains under normal market conditions, but cause large
http://www.chicagogsb.edu/news/12-5-
losses during crises. When market participants know that many
07_Rajan.pdf.
such potential losses are distributed throughout the system (but
do not know exactly where, or how large), uncertainty and fear
are exacerbated when markets come under stress.
Black Swan Theory This crisis is a once-in-a-century event, caused by a confluence of “Some might be tempted to see recent
Geoff Booth and Elias Mazzawi, “Black
factors so rare that it is impractical to think of erecting
events in the financial markets as just
Swan or Fat Turkey?” Business Strategy
regulatory barriers against recurrences. According to Alan
such black swans. But this would be quite Review, vol. 19, Autumn 2008, p. 34.
Greenspan, such regulation would be “so onerous as to basically wrong, in our view. Many of the flaws
Also: Michael J. Boskin, “Our Next
suppress the growth rate of the economy and ... [U.S.] standards that have led to current turbulent
President and the Perfect Economic
of living.” Testimony before the House Oversight and
conditions have not ridden on the back of Storm,” Wall Street Journal, Oct. 23,
Government Reform Committee, Oct. 23, 2008.
a black swan. Instead, they are the result 2008, p. A17.
of weaknesses and failings in the
interpretation of risk analysis and the
process of oversight.” (Booth and
Mazzawi)
Source: Table Compiled by CRS.
Note: Passages in quotation marks are from the source cited in the right-hand column, unless otherwise noted.
Ȭŝȱ
ȱȱȱȱȱ
ȱ
ȱȱ ȱ
Mark Jickling
Specialist in Financial Economics
mjickling@crs.loc.gov, 7-7784
ȱȱȱ
Şȱ