Origins of the financial crisis

“The financial crisis that has been wreaking 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 financial innovations that
masked risk; with companies that failed to follow their
own risk management procedures; and with regulators and
supervisors that failed to restrain excessive taking. ....

Over the past decade, private sector commercial and
investment banks developed new ways of securitizing
subprime mortgages: by packaging them into
"Collateralized Debt Obligations" (sometimes with other
asset-backed securities), and then dividing the cash
flows into different "tranches" to appeal to different
classes of investors with different tolerances for risk.
By ordering the rights to the cash flows, the developers
of CDOs ... were able to convince the credit rating
agencies to assign their highest ratings to the
securities in the highest tranche, or risk class. ....

These new innovations ... facilitated the boom in
subprime lending that occurred after 2000. ...
[H]ouseholds previously unable to qualify for mortgage
credit became eligible for loans. This new group of
eligible borrowers increased housing demand and helped
inflate home prices.

These new financial innovations thrived in an environment
of easy monetary policy by the Federal Reserve and poor
regulatory oversight. .... [P]anic hit in 2007, however,
as sudden uncertainty over asset prices caused lenders to
abruptly refuse to rollover their debts, and over-
leveraged banks found themselves exposed to falling asset
prices with very little capital.

While ex post we can certainly say that the system-wide
increase in borrowed money was irresponsible and bound
for catastrophe, it is not shocking that consumers,
would-be homeowners, and profit-maximizing banks will
borrow more money when asset prices are rising; indeed,
it is quite intuitive. What is especially shocking,
though, is how institutions along each link of the
securitization chain failed so grossly to perform
adequate risk assessment on the mortgage-related assets
they held and traded. ... [A]t no point did any
institution stop the party or question the little-
understood computer risk models, or the blatantly
unsustainable deterioration of the loan terms of the
underlying mortgages.”

Martin Neil Baily, Robert E. Litan, and Matthew S.
Johnson, The Origins of the Financial Crisis (Brookings
Institution, Initiative on Business and Public Policy,
Washington, DC, November 2008).

http://www.brookings.edu/papers/2008/11_orgins_crisis_baily_litan.aspx

Martin Neil Baily, Robert E. Litan, and Matthew S. Johnson are all with the Brookings Institution.

The authors find that the financial crisis has its origins in a housing price bubble where too many people thought that housing prices could only go up, this led to an increased demand for housing, which in turn spurred new kinds of financial innovations that masked the risk inherent in these loans, and that all involved in marketing, packaging and managing these mortgages failed to prudently originate and process the mortgages. They also recommend reforms of financial institutions, government regulators, and credit rating agencies.

Thanks to Larry Willmore for the Tdj. Larry says this is a superb 47 page analysis of the financial mess, and wishes to thank Michael Littlewood for bringing it to his attention.