After the Music Stopped

1. The Crisis Was Avoidable: A Perfect Storm of Weaknesses

This financial crisis was avoidable.

Interconnected Failures. The 2007-2009 financial crisis wasn't the result of a single cause but a confluence of factors. These included inflated asset prices, excessive borrowing, weak regulation, and unethical banking practices. Each vulnerability amplified the others, creating a "perfect storm" that overwhelmed the system.

Systemic Vulnerabilities. The crisis exposed deep-seated weaknesses in the U.S. financial system. These vulnerabilities, if addressed earlier, could have mitigated the severity of the crisis. The Financial Crisis Inquiry Commission (FCIC) concluded that the crisis did not have to happen.

Multiple Culprits. While greedy bankers deserve blame, they were not the sole cause. A range of actors, including regulators, rating agencies, and even ordinary Americans, contributed to the crisis. Understanding these multiple causes is essential for preventing future crises.

2. Double Bubbles: Housing and Bonds Fueled the Fire

The U.S. financial system, which had grown far too complex and far too fragile for its own good—and had far too little regulation for the public good—experienced a perfect storm during the years 2007–2009.

Housing Market Mania. The housing bubble, characterized by rapidly rising prices and lax lending standards, is widely recognized as a major cause of the crisis. Real house prices soared by 85% between 1997 and 2006, followed by a dramatic crash. This boom-and-bust cycle left a glut of vacant houses and millions of underwater mortgages.

The Bond Bubble. Less recognized but equally damaging was the bond bubble, driven by investors underestimating default risk and "reaching for yield." Low interest rates led investors to seek higher returns in riskier assets like mortgage-backed securities (MBS), driving up their prices and creating a bubble. This was exacerbated by the belief that mortgages never default.

Consequences of Bursting. The bursting of both bubbles had severe consequences. The housing collapse led to a decline in residential construction and related industries. The bond bubble implosion triggered widespread losses in the financial sector, as the value of MBS and other fixed-income securities plummeted.

3. Excessive Leverage Amplified the System's Fragility

Like a little wine, a little leverage can be good for you. But just as with consumption of alcoholic beverages, excesses can lead to disaster because leverage is the proverbial double-edged sword.

Magnified Returns and Losses. Leverage, the use of borrowed funds to purchase assets, magnifies both gains and losses. While it can boost returns in good times, it can also lead to rapid and devastating losses when asset values decline.

Widespread Leverage. Excessive leverage was prevalent throughout the financial system. Homebuyers took on mortgages with little or no money down, banks created off-balance-sheet entities to circumvent capital requirements, and investment banks operated with leverage ratios as high as 30 to 1 or 40 to 1.

Synthetic Leverage. Derivatives, such as credit default swaps (CDS), created synthetic leverage, allowing investors to make large bets with relatively little capital. This amplified the impact of the housing and bond bubble bursts, as losses on underlying assets were magnified by leveraged derivative positions.

4. Lax Regulation Left the Financial System Unchecked

When foxes are left to guard chicken coops, the chickens are in mortal danger.

Regulatory Failures. Financial regulators failed to adequately oversee the growing risks in the financial system. The Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS) all exhibited lax oversight of subprime lending and other risky practices.

Shadow Banking System. The shadow banking system, a complex network of nonbank financial institutions and markets, operated largely outside the regulatory purview. This allowed risky activities, such as the creation and trading of complex derivatives, to proliferate unchecked.

Derivatives Deregulation. The Commodity Futures Modernization Act of 2000 explicitly removed any threat of CFTC regulation of derivatives contracts among "sophisticated parties." This hands-off approach allowed the derivatives market to explode in size and complexity, contributing to systemic risk.

5. Disgraceful Lending Practices Sowed the Seeds of Default

Many of them were inherently crazy, and they became the basis for even greater zaniness in the wild worlds of mortgage-backed securities and derivatives.

Subprime Lending Explosion. Subprime mortgages, loans to borrowers with poor credit histories, grew rapidly in the early 2000s. By 2005, they accounted for 20% of all new mortgage lending.

Predatory Lending. Many subprime mortgages were "designed to default," with features like low teaser rates that reset to unaffordable levels after a few years. "Low-doc," "no-doc," and "NINJA" loans (no income, no jobs, and no assets) became prevalent, indicating a decline in underwriting standards.

GSE Involvement. Fannie Mae and Freddie Mac, the government-sponsored enterprises (GSEs), also lowered their underwriting standards to compete with private-sector securitizers. This added fuel to the fire and increased the risk in the mortgage market.

6. Complex Securities Obscured Risk and Spread Contagion

The more complex and customized the security, the harder it is to comparison shop for the best price.

Securitization Process. The securitization process, in which mortgages were bundled into mortgage-backed securities (MBS) and sold to investors, allowed banks to offload risk and generate fees. However, it also created a disconnect between lenders and borrowers, reducing incentives for careful underwriting.

Tranching and CDOs. Mortgage-backed securities were often "tranched," or divided into different risk classes. Collateralized debt obligations (CDOs) were created by repackaging these tranches, often including the riskiest "toxic waste" tranches. This created even more complex and opaque securities.

Derivatives on Derivatives. Credit default swaps (CDS) were used to insure against the default of CDOs, creating a web of interconnected risk. The complexity and opacity of these securities made it difficult for investors to understand the risks they were taking.

7. Rating Agencies Failed as Gatekeepers

The credit-rating agencies—led by Standard & Poor’s, Moody’s, and Fitch—were supposed to be one of the safety rails that would prevent the financial system from running off the road. Instead, they failed us, turning out to be part of the problem rather than part of the solution.

Grade Inflation. The credit rating agencies, responsible for assessing the risk of securities, assigned AAA ratings to many complex mortgage-related products. This grade inflation misled investors and contributed to the bond bubble.

Incentive Problems. The "issuer pays" model, in which the rating agencies were paid by the firms whose securities they rated, created a conflict of interest. This incentivized the agencies to provide favorable ratings in order to win business.

Reliance on Ratings. Investors, regulators, and analysts relied too heavily on the opinions of the rating agencies, rather than performing their own due diligence. This created a system in which the agencies had undue influence over the market.

8. Perverse Incentives Drove Reckless Risk-Taking

If you give smart people go-for-broke incentives, they will go for broke.

Go-for-Broke Incentives. Compensation systems in many financial institutions created perverse incentives for employees to take excessive risks. Traders were rewarded handsomely for short-term profits, with little downside risk if their bets went sour.

Executive Compensation. Top executives also had incentives to take on excessive risk, as their compensation was often tied to short-term stock performance. This encouraged them to prioritize profits over long-term stability.

Mortgage Broker Commissions. Mortgage brokers were often paid higher commissions for selling riskier mortgage products, creating an incentive to push borrowers into loans they couldn't afford.

9. The Government's Response: Rescue and Reform

We came very, very close to a global financial meltdown.

Emergency Measures. The U.S. government responded to the crisis with a range of emergency measures, including the Troubled Asset Relief Program (TARP), the Federal Reserve's lending facilities, and deposit insurance. These actions were intended to stabilize the financial system and prevent a complete collapse.

Fiscal Stimulus. The government also enacted large-scale fiscal stimulus programs, such as the American Reinvestment and Recovery Act (ARRA), to boost aggregate demand and fight the recession. These programs included tax cuts, infrastructure spending, and aid to state and local governments.

Financial Reform. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was enacted to address the underlying causes of the crisis. The law created new regulatory agencies, increased oversight of the financial system, and implemented reforms to protect consumers.

10. The Lingering Foreclosure Crisis: A Missed Opportunity

The housing sector didn’t just experience a recession; it had a depression.

Foreclosure Tsunami. Despite the government's efforts, the foreclosure crisis continued to plague the U.S. economy for years after the initial crisis. Millions of families lost their homes, and the overhang of foreclosed properties depressed house prices and hindered the economic recovery.

Inadequate Mitigation Efforts. The government's foreclosure mitigation programs, such as HAMP and HARP, were largely ineffective. They were often too complex, too limited in scope, and lacked sufficient incentives for lenders to participate.

Missed Opportunity. A more aggressive approach to foreclosure mitigation, such as a large-scale principal reduction program, could have helped more homeowners stay in their homes and stabilized the housing market. However, political opposition and concerns about moral hazard prevented such action.

11. The Backlash: Anger, Distrust, and Political Polarization

We saved the economy, but we kind of lost the public doing it.

Public Outrage. The government's response to the financial crisis, particularly the bank bailouts, sparked widespread public outrage. Many Americans felt that the government was helping Wall Street while Main Street suffered.

Political Polarization. The crisis and the policy responses to it contributed to increased political polarization. The Tea Party movement emerged as a powerful force on the Right, while the Occupy Wall Street movement protested corporate greed and inequality from the Left.

Electoral Consequences. The backlash against government intervention had significant electoral consequences. Democrats lost control of the House of Representatives in the 2010 midterm elections, and the political climate became even more hostile to government action.

12. Lessons Learned: A Path to a More Resilient Future

History doesn’t repeat itself, but it does rhyme.

Financial Commandment #1: Remember That People Forget. Financial crises are cyclical. Complacency and amnesia can lead to a repeat of past mistakes.

Financial Commandment #2: Thou Shalt Not Rely on Self-Regulation. Government oversight is essential to prevent excessive risk-taking and protect consumers.

Financial Commandment #3: Honor Thy Shareholders. Corporate boards must prioritize the long-term interests of shareholders over short-term profits.

Financial Commandment #4: Elevate the Importance of Risk Management. Risk management systems must be robust and independent, with the authority to challenge business decisions.

Financial Commandment #5: Use Less Leverage. Excessive leverage amplifies both gains and losses. Financial institutions must operate with thicker capital cushions.

Financial Commandment #6: Keep It Simple, Stupid. Complex and opaque financial products can obscure risk and facilitate fraud. Simplicity and transparency are essential.

Financial Commandment #7: Standardize Derivatives and Trade Them on Organized Exchanges. Standardized, exchange-traded derivatives are safer and more transparent than customized, over-the-counter (OTC) derivatives.

Financial Commandment #8: Keep Things on the Balance Sheet. Off-balance-sheet entities can be used to circumvent capital requirements and hide risk.

Financial Commandment #9: Fix Perverse Compensation Systems. Compensation systems must be designed to align the interests of employees with the long-term stability of the firm.

Financial Commandment #10: Watch Out for Ordinary Consumer-Citizens. Protecting consumers from predatory financial practices is essential for maintaining a healthy and stable economy.

Last updated: April 5, 2025