The Origins of the Financial Crisis, finansowy, kryzys finansowy
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F I X I N G F I N A N C E S E R I E S – P A P E R 3
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N O V E M B E R 2 0 0 8
The Origins
of the Financial Crisis
Martin Neil Baily, Robert E. Litan, and Matthew S. Johnson
The Initiative on Business and Public Policy provides analytical
research and constructive recommendations on public policy issues affecting
the business sector in the United States and around the world.
of the Financial Crisis
Martin Neil Baily, Robert E. Litan, and Matthew S. Johnson
The Initiative on Business and Public Policy provides analytical
research and constructive recommendations on public policy issues affecting
the business sector in the United States and around the world.
The Origins
T h E O R i g i N S O f T h E f i N a N c i a L c R i S i S
ConTenTS
Summary
7
Introduction
10
housing Demand and the Perception of Low risk in housing Investment
11
The Shifting Composition of Mortgage Lending and the erosion of
Lending Standards
1
economic Incentives in the housing and Mortgage origination Markets
20
Securitization and the Funding of the housing Boom
22
More Securitization and More Leverage—CDos, SIVs, and
Short-Term Borrowing
27
Credit Insurance and Tremendous growth in Credit Default Swaps
32
The Credit rating Agencies
3
Federal reserve Policy, Foreign Borrowing and the Search for Yield
36
regulation and Supervision
0
The Failure of Company risk Management Practices
2
The Impact of Mark to Market
3
Lessons from Studying the origins of the Crisis
references
6
About the Authors
7
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T h E O R i g i N S O f T h E f i N a N c i a L c R i S i S
SUMMArY
havoc in markets in the U.S. and across the
world since August 2007 had its origins in an
asset price bubble that interacted with new kinds of
inancial innovations that masked risk; with compa-
nies that failed to follow their own risk management
procedures; and with regulators and supervisors
that failed to restrain excessive risk taking.
ing securities backed by those packages to inves-
tors who receive pro rata payments of principal and
interest by the borrowers. The two main govern-
ment-sponsored enterprises devoted to mortgage
lending, Fannie Mae and Freddie Mac, developed
this inancing technique in the 1970s, adding their
guarantees to these “mortgage-backed securities”
(MBS) to ensure their marketability. For roughly
three decades, Fannie and Freddie conined their
guarantees to “prime” borrowers who took out
“conforming” loans, or loans with a principal below
a certain dollar threshold and to borrowers with a
credit score above a certain limit. Along the way,
the private sector developed MBS backed by non-
conforming loans that had other means of “credit
enhancement,” but this market stayed relatively
small until the late 1990s. In this fashion, Wall
Street investors effectively inanced homebuyers
on Main Street. Banks, thrifts, and a new industry
of mortgage brokers originated the loans but did
not keep them, which was the “old” way of inanc-
ing home ownership.
A bubble formed in the housing markets as home
prices across the country increased each year from
the mid 1990s to 2006, moving out of line with fun-
damentals like household income. Like traditional
asset price bubbles, expectations of future price
increases developed and were a signiicant factor
in inlating house prices. As individuals witnessed
rising prices in their neighborhood and across the
country, they began to expect those prices to con-
tinue to rise, even in the late years of the bubble
when it had nearly peaked.
The rapid rise of lending to subprime borrowers
helped inlate the housing price bubble. Before
2000, subprime lending was virtually non-existent,
but thereafter it took off exponentially. The sus-
tained rise in house prices, along with new inancial
innovations, suddenly made subprime borrowers
— previously shut out of the mortgage markets —
attractive customers for mortgage lenders. Lend-
ers devised innovative Adjustable Rate Mortgages
(ARMs) — with low “teaser rates,” no down-pay-
ments, and some even allowing the borrower to
postpone some of the interest due each month and
add it to the principal of the loan — which were
predicated on the expectation that home prices
would continue to rise.
Over the past decade, private sector commercial
and investment banks developed new ways of se-
curitizing subprime mortgages: by packaging them
into “Collateralized Debt Obligations” (sometimes
with other asset-backed securities), and then divid-
ing the cash lows into different “tranches” to ap-
peal to different classes of investors with different
tolerances for risk. By ordering the rights to the
cash lows, the developers of CDOs (and subse-
quently other securities built on this model), were
able to convince the credit rating agencies to assign
their highest ratings to the securities in the high-
est tranche, or risk class. In some cases, so-called
“monoline” bond insurers (which had previously
concentrated on insuring municipal bonds) sold
protection insurance to CDO investors that would
pay off in the event that loans went into default.
In other cases, especially more recently, insurance
companies, investment banks and other parties did
But innovation in mortgage design alone would
not have enabled so many subprime borrowers to
access credit without other innovations in the so-
called process of “securitizing” mortgages — or the
pooling of mortgages into packages and then sell-
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7
T
he inancial crisis that has been wreaking
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