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.

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  1. jonathan says:

    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.

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  2. EP says:

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

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  3. PedroCMS says:

    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 selling…world economy freezes(figuratively).

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  4. charles says:

    Anything that starts, “Back in september…” leaves a smidge out.

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  5. Dober says:

    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.

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  6. Alex B says:

    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.

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  7. Mike99 says:

    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.

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  8. Mike99 says:

    “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.

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