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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.