How We Got Here

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.


Um, this is a half view at best. The financial crisis was the popping of a balloon that extended way beyond housing. Aggregate demand would not be collapsing around the world if the problem was only MBS and CDS related to those.


It is my understanding that the Austrian school of economics correctly predicted this several years ago.


I definately agree with Jonathan. The credit crisis is just the tip of the iceberg when it comes to today's worldwide financial crisis. Then again, the article clearly states "how we got here"; successfully indicating that the main noticeable source of this crisis is due to the "credit crunch", as some call it. This (unfortunately for many companies), lead to people's warier consumption which sank demand, which then sank companies profits, which then sank employment rates (up to a negative level)..... point is...when the worlds biggest consumer stops buying, world suppliers stop economy freezes(figuratively).


Anything that starts, "Back in september..." leaves a smidge out.


I am amazed at how often people talk about the origins of this crisis without discussing government meddling in the mortgage market by pushing sub-prime with the goal of expanding the "ownership society". If lending institutions weren't forced to lend to people that had no business borrowing, we wouldn't be in this mess at all.

Alex B

The question of where "it" started is also the question of where the bottom is. If you know the answer to that you should be well on your way to riches.


But, it all started with:
1) "Management Capitalism": where management rewarded itself with hugh stock options, based upon quarterly results. Stock Options gave Management plenty of reason to manage the company for short term reward, at the expense of long term company survival.

Lehman's is a perfect example. Not only did they sell Mortgage Backed Securities, but, they were on the Wrong Side of CDO's of those same securities. Taking on Hugh Down Side Risk, for the short term fees, to bump up One Quarter's results.

2) Then there was Alan "Bubbles" Greenspan kissing Wall Street's back side, by not regulating these markets.

These two steps put into place the Catastrophe. Just another on the long line of Chicago School Disasters.


"I am amazed at how often people talk about the origins of this crisis without discussing government meddling in the mortgage market by pushing sub-prime with the goal of expanding the “ownership society”.

No one's discussing it because it isn't true, except in Rush Limbaugh's mind. Mortgage problems are across all type and income level of mortgages.


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.

N Choi

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 .


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.

science minded

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.


Mike Martin

In his 2008 annual letter to shareholders, posted yesterday at, 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.


I think this is a good overview of "how it started" from the financial institution point of view.

The consumer view is a different one that is in parallel.
The Giant Pool of Money highly encouraged consumers to get into mortgages and home equity loans/HELOCs. Advertising promoted tapping home equity. Consumers responded by taking money out of the inflated value of their homes for necessities such as paying medical bills, investments such as paying for the kids' college education or financing a new small business, and for lifestyle choices such as cars, etc.

With deflating home values, they can't take those loans any more, which contributes to less consumer spending on durables and greater consumer debt/bankruptcies. People can't sell their homes because the value has dipped below their mortgage balance.

Banks have greatly tightened up HELOCs, and at the same time credit card issuers are raising interest rates and lowering credit lines in anticipation of new consumer-protection laws that won't take effect for a year. When your available credit shrinks by 75%, people are forced to stop spending on lifestyle items. Everything from restaurant meals to consumer electronics is impacted. People of all income levels are forced to cut out everything they can cut out.

The credit issuers who for years enticed people into more and more credit cards are now contributing to the deep consumer spending recession.

The deep consumer recession leads to massive job losses as the retail industries dependent on a consumer culture see massive loss of income. Losing 1 income in a 2-income family now sends most such families over the edge towards bankruptcy.

Those of us at the top end of the income scale cut back as our investments and retirement accounts have taken massive losses in value.



1. Lehman and Bear Stearns (also Goldman Sachs and Morgan Stanley) were leveraged 33:1 or so and were dependent on renewals of short term debt. Banking regulations were recently changed to allow for this leverage and that never should have happened.
2. Housing prices should never go above a family's ability to pay or about 1/3 of income. Having housing that is more expensive than income allows is simply unsustainable for obvious reasons.
3. As Warren Buffett put it derivatives are weapons of mass destruction with their entangled web. He had been warning about this for several years.

That's just for starters.

J. Daniel Smith

I think there are a couple of "big picture" things behind this whole mess.

The first is as hal (#15) says: we don't make anything in this country anymore. At some point, you have to use human capital (labor) to turn very raw materials (rocks, wood, etc.) into things of higher value. Even "high value" things like automobiles are assembled in the US from imported parts.

The other is that too few people control too much money. This means there is no "free market forces" making decisions, rather it's just a (relative) handful of those with all the money.


Hal...the fix is in on that.