As the stock market continues to search for a bottom, it’s worth another look back at how we got here.
Back in September, University of Chicago professors Douglas W. Diamond and Anil K. Kashyap explained for our readers the trouble with Lehman Brothers and A.I.G.
Lehman’s trouble began with the collapse of the housing bubble. But where did that come from? Alex Blumberg and Adam Davidson did a great job explaining the flood of money into (and then, catastrophically, out of) the U.S. housing market in their must-hear This American Life segment, “The Giant Pool of Money.”
As debt started to go bad across the housing market, Wall Street miscalculated its response, in part because many of the major players in the financial system were over relying on risk models that couldn’t see the turbulence that was coming. Joe Nocera, writing for The Times Magazine, recently described the perilous faults of risk models in great and compelling detail.
What happened next — as the bad debt contagion jumped from mortgages into the rest of the financial markets — makes for a thrilling, if terrifying, hour of television, which you can see, compliments of Frontline, below.
Last but hardly least, check out Markus K. Brunnermeier‘s academic overview of the credit crunch (pdf here). Highlights:
First, the effects of the hundreds of billions of dollars of bad loan write-downs on borrowers’ balance sheets caused two “liquidity spirals.” As asset prices dropped, financial institutions not only had less capital but also a harder time borrowing, because of tightened lending standards. The two spirals forced financial institutions to shed assets and reduce their leverage. This led to fire sales, lower prices, and even tighter funding, amplifying the crisis beyond the mortgage market.
Second, lending channels dried up when banks, concerned about their future access to capital markets, hoarded funds from borrowers regardless of credit-worthiness. Third, runs on financial institutions, as occurred at Bear Stearns, Lehman Brothers, and others following the mortgage crisis, can and did suddenly erode bank capital.
Fourth, the mortgage crisis was amplified and became systemic through network effects, which can arise when financial institutions are lenders and borrowers at the same time. Because each party has to hold additional funds out of concern about counterparties’ credit, liquidity gridlock can result.
and 
. You can also watch it on 
That is not how it started, the meltdown started when people started losing their homes en masse. The banks got what they earned and most of them spat in the faces of the bailout by giving bonuses equal to a THIRD of their 2008 losses.
When any business becomes too big to fail, anti-trust lawsuits should have started.
Ben Bernanke was too slow for the rust belt as foreclosures went to 5% of mortgages in early 2007. He started lowering interest rates in Q2 2008.
There’s an article in the latest issue of Wired magazine on why that “giant pool of money” was comfortable making what we now know as very risky investments, and attributes that to the misuse of a flawed formula used to rate investment risks. If all those risky mortgage-backed securities were not incorrectly rated as “safe”, the scale of the collapse may not have been this great. I find it a fascinating read http://www.wired.com/techbiz/it/magazine/17-03/wp_quant .
then,i really have no idea how we got here!
And now for something COMPLETELY different- I am digging this post based solely on its use of printed, audio, and video links and components. Way to pull it all in- great post.
The cause begins with people, business people and consumers of what business produce.
People generally do what is in their perceived ‘best interests.’ We can probably imagine why consumers of stuff and consumers of debt did what they did: they wanted things and they paid for some (much?) of those things by leveraging their their future.
If you want to know why people were allowed to borrow beyond their means, start by asking, “What incentives did lenders have to make unsound business decisions and bad loans?” The compensation committees of boards of directors know the answer to these twi question but in my experience will not provide answers.
It’s how we get out of here? a timely prediction–Monday will be a good indicator!
All of these theoretical explanations don’t reflect a further under-the-radar reality. The US economy is not producing goods and services that are valued in the world economy. We have high cost labor rates and low productivity per unit of energy (relatively speaking). Frankly, we are just not competitive in a free market world, at least not enough to sustain our current standard of living.
That means our hard assets (machinery for production, methods, inventions) are being transferred overseas. Sit next to the main US rail line between San Francisco and Memphis. Every ten minutes there is a 2-mile trainload of goods in intermodal containers from China, Korea, Japan and India – but mostly China. Those trains, and shiploads of containers, return home filled, not with US made goods, but with scrap plastics, metals and cardboard used to make more products for us to import.
So we buy a $3000 TV with money borrowed from our soon-to-disappear home equity. That TV was made in China by a Japanese company and shipped on a Korean container ship, then transported on a train and truck (made in Europe) using fuel from Venezuela. And every step along the way was funded by vapor-dollars. But we still owe the money. That’s why we’re sinking so fast. Our entire economy is based on fictitious paper being exchanged for real goods and services.
The consumption a of 5 times the average per capita energy and goods cannot be sustained with no products of value on the market. At the moment agriculture is the only economic engine keeping us afloat – and it is so heavily subsidized that there is a bubble in its future as well.
We’re in for a long period of adjustment. Or something worse.
In his 2008 annual letter to shareholders, posted yesterday at http://www.berkshirehathaway.com/letters/2008ltr.pdf, Warren Buffett has interesting things to say about Berkshire subsidiary Clayton Homes (pages 10-11). A third of its borrowers score as subprime but at year end, delinquincy rate was only 3.6%, up from 2.9% in 2006.
It is perfectly clear that, provided prudent lending practices are followed, subprime borrowers can be excellent customers. The idea that the whole mess started with government pressure to increase subprime lending is complete nonsense.