Easy Money

1. The 2008 financial crisis stemmed from a complex web of factors

"While it is natural to crave simple explanations, complicated events are, well, complicated. It is hard to imagine how something as sweeping and multifaceted as the financial crisis could have stemmed from single cause or had a single villain."

Multiple interconnected causes. The 2008 financial crisis was not the result of a single factor or decision, but rather the culmination of numerous interconnected issues within the global financial system. These included:

• Deregulation of financial markets
• Low interest rates and easy credit
• Rapid growth of the shadow banking system
• Misaligned incentives in the financial sector
• Global trade imbalances
• Overconfidence in financial models and risk assessment

Systemic vulnerabilities. The crisis exposed deep-seated vulnerabilities in the financial system that had been building for years. It revealed how interconnected and fragile the global economy had become, with problems in one sector quickly spreading to others.

2. Subprime mortgages and securitization fueled a housing bubble

"How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans."

Predatory lending practices. Banks and mortgage lenders aggressively marketed subprime mortgages to borrowers with poor credit, often using deceptive tactics:

• Adjustable-rate mortgages (ARMs) with low teaser rates
• No-documentation "liar loans"
• Negative amortization loans where the principal increased over time

Securitization boom. These risky mortgages were bundled into complex securities and sold to investors worldwide:

• Mortgage-backed securities (MBS)
• Collateralized debt obligations (CDOs)
• Synthetic CDOs based on derivatives

This process removed risk from bank balance sheets and fueled further lending, inflating housing prices to unsustainable levels.

3. Credit default swaps and CDOs amplified systemic risk

"CDO equity and mezzanine as 'toxic waste'."

Explosion of derivatives. The market for credit default swaps (CDS) grew exponentially, reaching an estimated $62 trillion by 2007. These instruments allowed investors to bet on or insure against defaults without owning the underlying assets.

Concentrated risk. CDOs and synthetic CDOs further concentrated risk:

• Repackaging lower-rated tranches into new "AAA" securities
• Creating leveraged bets on subprime mortgages
• Obscuring the true level of risk in the system

Financial institutions became highly interconnected through these instruments, amplifying the potential for systemic collapse.

4. Rating agencies failed to accurately assess financial products

"We rate every deal. It could be structured by cows and we would rate it."

Conflict of interest. Rating agencies were paid by the issuers of securities they were rating, creating a strong incentive to provide favorable ratings:

• Nearly 90% of CDOs with residential MBSs were rated AAA
• Agencies used flawed models that underestimated correlation risk
• Competition between agencies led to a "race to the bottom" in standards

Misplaced trust. Investors relied heavily on these ratings, often without conducting their own due diligence. This misplaced trust allowed risky securities to proliferate throughout the global financial system.

5. Government policies and low interest rates contributed to the crisis

"The way out of the crisis cannot be still more borrowing and spending, especially if the spending does not build lasting assets that will help future generations pay off the debts they will be saddled with."

Promotion of homeownership. Government policies actively encouraged homeownership, even for those who couldn't afford it:

• Affordable housing goals for Fannie Mae and Freddie Mac
• Relaxed lending standards and down payment requirements
• Tax incentives for homeowners

Easy money policy. The Federal Reserve kept interest rates low for an extended period, fueling the housing bubble and encouraging risk-taking:

• Federal funds rate cut to 1% in 2003 and held there for a year
• "Greenspan put" created moral hazard by implying Fed would backstop markets
• Global savings glut further depressed long-term interest rates

6. The "too big to fail" mentality led to moral hazard

"If the vanishing of an institution will destroy the network of our economy, it is too large to survive."

Implicit guarantees. The perception that certain financial institutions were too big to fail encouraged excessive risk-taking:

• Creditors assumed government would bail out large banks if necessary
• This allowed big banks to borrow at lower rates than smaller competitors
• Incentivized growth and consolidation in the financial sector

Socialized losses. When the crisis hit, the government was forced to rescue many of these institutions to prevent systemic collapse, effectively socializing their losses while privatizing their gains.

7. Unprecedented bailouts and quantitative easing followed the crash

"The scars from the current crisis seem likely to be felt for a generation."

Massive interventions. The government and Federal Reserve took extraordinary measures to stabilize the financial system:

• $700 billion Troubled Asset Relief Program (TARP)
• Nationalization of Fannie Mae and Freddie Mac
• Rescue of AIG, Bear Stearns, and other financial institutions

Quantitative easing. The Federal Reserve embarked on a massive program of quantitative easing:

• Expanded balance sheet from $900 billion to over $4.5 trillion
• Purchased government bonds and mortgage-backed securities
• Aimed to lower long-term interest rates and stimulate the economy

These actions prevented a complete meltdown but have had long-lasting consequences for the economy and monetary policy.

8. Income inequality and consumer debt played a significant role

"Borrowing became a substitute for rising incomes."

Stagnant wages. Despite rising productivity, wages for most Americans had stagnated in the decades leading up to the crisis:

• Top 1% of earners captured an increasing share of economic gains
• Middle-class living standards maintained through increased borrowing

Debt-fueled consumption. Easy credit allowed consumers to maintain spending despite flat incomes:

• Home equity extraction used to finance consumption
• Credit card debt and auto loans proliferated
• Student loan debt skyrocketed

This reliance on debt made the economy vulnerable to a shock in the housing market.

9. The crisis exposed flaws in financial regulation and oversight

"The best short-term policy response is to focus on long-term sustainable growth."

Regulatory gaps. The crisis revealed significant gaps in financial regulation:

• Shadow banking system largely unregulated
• Derivatives markets operated with little oversight
• Regulators lacked tools to deal with systemic risks

Regulatory capture. Financial institutions wielded significant influence over their regulators:

• Revolving door between Wall Street and regulatory agencies
• Heavy lobbying against increased oversight
• Belief in efficient markets led to light-touch regulation

Post-crisis reforms like the Dodd-Frank Act attempted to address some of these issues, but many argue they didn't go far enough.

10. Global imbalances and the dollar's reserve status factored in

"The US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost."

Global savings glut. Large trade surpluses in countries like China led to massive accumulations of dollar reserves:

• These reserves were invested back into US Treasury bonds and other securities
• Helped keep US interest rates low despite large budget deficits
• Fueled the housing bubble and encouraged risk-taking

Dollar dominance. The dollar's status as the world's reserve currency allowed the US to finance large deficits:

• Oil and other commodities priced in dollars
• Global trade primarily conducted in dollars
• Created a "exorbitant privilege" for the US economy

This dynamic contributed to global financial instability and the buildup of risks in the US financial system.

11. The aftermath saw calls for reform but limited structural changes

"The opportunity to reform the financial system has been missed."

Initial push for reform. In the immediate aftermath of the crisis, there were widespread calls for fundamental changes to the financial system:

• Increased capital requirements for banks
• Stricter regulation of derivatives
• Breaking up "too big to fail" institutions

Limited implementation. While some reforms were enacted, many argue they didn't address the root causes of the crisis:

• Dodd-Frank Act implemented new regulations but left much to regulators' discretion
• Basel III increased capital requirements but implementation has been slow
• Many large banks have grown even larger since the crisis

The financial industry's lobbying power and the fading memory of the crisis have limited more radical reforms, leaving some to worry that the system remains vulnerable to future shocks.

Last updated: September 6, 2024