LESSONS FROMTHE FINANCIAL

CRISIS

The Robert W. Kolb Series in Finance series provides a comprehensive view of thefield of finance in all of its variety and complexity. The series is projected to includeapproximately 65 volumes covering all major topics and specializations in finance,ranging from investments, to corporate finance, to financial institutions. Each vol-ume in the Kolb Series in Finance consists of new articles especially written for thevolume.

Each Kolb Series volume is edited by a specialist in a particular area of finance, whodevelops the volume outline and commissions articles by the world’s experts inthat particular field of finance. Each volume includes an editor’s introduction andapproximately thirty articles to fully describe the current state of financial researchand practice in a particular area of finance.

The essays in each volume are intended for practicing finance professionals, grad-uate students, and advanced undergraduate students. The goal of each volume isto encapsulate the current state of knowledge in a particular area of finance so thatthe reader can quickly achieve a mastery of that special area of finance.

LESSONS FROMTHE FINANCIAL

CRISIS

Causes, Consequences, andOur Economic Future

Robert W. Kolb

The Robert W. Kolb Series in Finance

John Wiley & Sons, Inc.

Copyright c© 2010 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, ortransmitted in any form or by any means, electronic, mechanical, photocopying,recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the1976 United States Copyright Act, without either the prior written permission of thePublisher, or authorization through payment of the appropriate per-copy fee to theCopyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923,(978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests tothe Publisher for permission should be addressed to the Permissions Department,John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011,fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have usedtheir best efforts in preparing this book, they make no representations or warranties withrespect to the accuracy or completeness of the contents of this book and specificallydisclaim any implied warranties of merchantability or fitness for a particular purpose. Nowarranty may be created or extended by sales representatives or written sales materials.The advice and strategies contained herein may not be suitable for your situation. Youshould consult with a professional where appropriate. Neither the publisher nor authorshall be liable for any loss of profit or any other commercial damages, including but notlimited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support,please contact our Customer Care Department within the United States at (800) 762-2974,outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content thatappears in print may not be available in electronic formats. For more information aboutWiley products, visit our Web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data:Lessons from the financial crisis : causes, consequences, and our economic future /Robert W. Kolb, editor.

p. cm. — (The Robert W. Kolb series in finance)Includes bibliographical references and index.ISBN 978-0-470-56177-5 (cloth)1. Financial crises. 2. Global Financial Crisis, 2008-2009.

3. Financial crises—United States. I. Kolb, Robert W., 1949–HB3722.L476 2010330.9—dc22 2009050964

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

For Lori, as always.

Contents

Acknowledgments xv

Editor’s Note xvii

Introduction xix

PART I Overview of the Crisis 1

1 Leverage and Liberal Democracy 3George Bragues

2 A Property Economics Explanation of the GlobalFinancial Crisis 9Gunnar Heinsohn and Frank Decker

3 Of Subprimes and Sundry Symptoms: The PoliticalEconomy of the Financial Crisis 17Ashok Bardhan

4 The Political Economy of the Financial Crisis of 2008 23Roger D. Congleton

5 The Global Financial Crisis of 2008: What Went Wrong? 31Hershey H. Friedman and Linda Weiser Friedman

6 The Roots of the Crisis and How to Bring It to a Close 37James K. Galbraith

7 Enron Rerun: The Credit Crisis in Three Easy Pieces 43Jonathan C. Lipson

8 The Global Crisis and Its Origins 51Peter L. Swan

vii

viii Contents

9 Four Paradoxes of the 2008–2009 Economic andFinancial Crisis 59John E. Marthinsen

10 Understanding the Subprime Financial Crisis 69Steven L. Schwarcz

PART II Causes and Consequences of theFinancial Crisis 77

11 The Origins of the Financial Crisis 79Martin N. Baily, Robert E. Litan, and Matthew S. Johnson

12 Ten Myths about Subprime Mortgages 87Yuliya Demyanyk

13 The Financial Crisis: How Did We Get Here and WhereDo We Go Next? New Evidence on How the CrisisSpread Among Financial Institutions 95James R. Barth, Tong Li, Lu Wenling, and Glenn H. Yago

14 A Decade of Living Dangerously: The Causes andConsequences of the Mortgage, Financial, andEconomic Crises 103Jon A. Garfinkel and Jarjisu Sa-Aadu

15 Making Sense of the Subprime Crisis 109Kristopher S. Gerardi, Andreas Lehnert, Shane M. Sherlund, and Paul Willen

16 Miraculous Financial Engineering or Legacy Assets? 119Ivo Pezzuto

17 The Making and Ending of the Financial Crisis of2007–2009 125Austin Murphy

18 The Subprime Mortgage Problem: Causes andLikely Cure 133Ronald D. Utt

19 Sequence of Asset Bubbles and the GlobalFinancial Crisis 139Abol Jalilvand and A. G. (Tassos) Malliaris

CONTENTS ix

PART III Borrowers 147

20 The Past, Present, and Future of SubprimeMortgages 149Shane M. Sherlund

21 FHA Loans and Policy Responses toCredit Availability 155Dr. Marsha Courchane, Rajeev Darolia, and Dr. Peter Zorn

22 The Single-Family Mortgage Industry in the InternetEra: Technology Developments and Market Structure 163Forrest Pafenberg

23 Speed Kills? Mortgage Credit Boom and the Crisis 175Giovanni Dell’Ariccia, Deniz Igan, and Luc Laeven

24 Subprime Mortgages: What We Have Learned From aNew Class of Homeowners 181Todd J. Zywicki and Satya Thallam

25 Rating Agencies: Facilitators of Predatory Lendingin the Subprime Market 191David J. Reiss

PART IV The Process of Securitization 197

26 A Primer on the Role of Securitization in the CreditMarket Crisis of 2007 199John D. Martin

27 Incentives in the Originate-to-Distribute Model ofMortgage Production 209Robert W. Kolb

28 Did Securitization Lead to Lax Screening? Evidencefrom Subprime Loans 217Benjamin J. Keys, Tanmoy Mukherjee, Amit Seru, and Vikrant Vig

29 Tumbling Tower of Babel: Subprime Securitizationand the Credit Crisis 225Bruce I. Jacobs

x Contents

30 The Incentives of Mortgage Servicers and DesigningLoan Modifications to Address the Mortgage Crisis 231Larry Cordell, Karen Dynan, Andreas Lehnert, Nellie Liang,and Eileen Mauskopf

31 The Contribution of Structured Finance to theFinancial Crisis: An Introductory Overview 239Adrian A.R.J.M. van Rixtel and Sarai Criado

32 Problematic Practices of Credit Rating Agencies:The Neglected Risks of Mortgage-Backed Securities 247Phil Hosp

33 Did Asset Complexity Trigger Ratings Bias? 259Vasiliki Skreta and Laura Veldkamp

34 The Pitfalls of Originate-to-Distribute inBank Lending 267Antje Berndt and Anurag Gupta

PART V Risk Management and Mismanagement 275

35 Behavioral Basis of the Financial Crisis 277J. V. Rizzi

36 Risk Management Failures During theFinancial Crisis 283Dr. Michel Crouhy

37 The Outsourcing of Financial Regulationto Risk Models 293Erik F. Gerding

38 The Future of Risk Modeling 301Elizabeth Sheedy

39 What Happened to Risk Management During the2008–2009 Financial Crisis? 307Michael McAleer, Juan-Angel Jimenez-Martin, and Teodosio Perez-Amaral

40 Risk Management Lessons from the Global FinancialCrisis for Derivative Exchanges 317Jayanth Varma

CONTENTS xi

PART VI The Problem of Regulation 325

41 Regulation and Financial Stability in the Ageof Turbulence 327David S. Bieri

42 The Financial Crisis of 2007–2009: Missing FinancialRegulation or Absentee Regulators? 337George G. Kaufman and A. G. Malliaris

43 The Demise of the United Kingdom’s Northern Rockand Large U.S. Financial Institutions: PublicPolicy Lessons 345Robert A. Eisenbeis and George G. Kaufman

44 Why Securities Regulation Failed to Prevent theCDO Meltdown 355Richard E. Mendales

45 Curbing Optimism in Managerial Estimates ThroughTransparent Accounting: The Case of Securitizations 361Stephen Bryan, Steven Lilien, and Bharat Sarath

46 Basel II Put on Trial: What Role in the Financial Crisis? 369Francesco Cannata and Mario Quagliariello

47 Credit Rating Organizations, Their Role in the CurrentCalamity, and Future Prospects for Reform 377Thomas J. Fitzpatrick IV and Chris Sagers

48 Global Regulation for Global Markets? 383Michael W. Taylor and Douglas W. Arner

49 Financial Regulation, Behavioral Finance, and theGlobal Financial Crisis: In Search of a NewRegulatory Model 391Emilios Avgouleas

PART VII Institutional Failures 401

50 Why Financial Conglomerates Are at the Center ofthe Financial Crisis 403Arthur E. Wilmarth

xii Contents

51 Corporate Governance and the Financial Crisis:A Case Study from the S&P 500 411Brian R. Cheffins

52 Secondary-Management Conflicts 419Steven L. Schwarcz

53 The Financial Crisis and the Systemic Failure ofAcademic Economics 427David Colander, Michael Goldberg, Armin Haas, Alan Kirman, Katarina Juselius,Brigitte Sloth, and Thomas Lux

54 Fannie Mae and Freddie Mac: Privatizing Profit andSocializing Loss 437David Reiss

55 Disclosure’s Failure in the Subprime Mortgage Crisis 443Steven L. Schwarcz

PART VIII The Federal Reserve, Monetary Policy,and the Financial Crisis 451

56 Federal Reserve Policy and the Housing Bubble 453Lawrence H. White

57 The Greenspan and Bernanke Federal Reserve Rolesin the Financial Crisis 461John Ryan

58 The Risk Management Approach to Monetary Policy:Lessons from the Financial Crisis of 2007–2009 467Marc D. Hayford and A. G. Malliaris

59 Reawakening the Inflationary Monster: U.S. MonetaryPolicy and the Federal Reserve 475Kevin Dowd and Martin Hutchinson

60 The Transformation of the Federal Reserve SystemBalance Sheet and Its Implications 483Peter Stella

CONTENTS xiii

PART IX Implications of the Crisis for OurEconomic Systems 493

61 Systemic Risk and Markets 495Steven L. Schwarcz

62 The Transmission of Liquidity Shocks During the Crisis:Ongoing Research into the Transmission of LiquidityShock Suggests the Emergence of a Range of NewChannels During the Credit Crisis 501Nathaniel Frank, Brenda Gonzalez-Hermosillo, and Heiko Hesse

63 Credit Contagion From Counterparty Risk 509Philippe Jorion and Gaiyan Zhang

PART X International Dimensions of theFinancial Crisis 517

64 Only in America? When Housing Boom Turnsto Bust 519Luci Ellis

65 The Equity Risk Premium Amid a GlobalFinancial Crisis 525John R. Graham and Campbell R. Harvey

66 Australia’s Experience in the Global Financial Crisis 537Christine Brown and Kevin Davis

67 Collapse of a Financial System: An Icelandic Saga 545Tryggvi Thor Herbertsson

68 Iceland’s Banking Sector and the Political Economyof Crisis 551James A. H. S. Hine and Ian Ashman

69 The Subprime Crisis: Implications forEmerging Markets 559William B. Gwinner and Anthony B. Sanders

xiv Contents

PART XI Financial Solutions and Our Economic Future 569

70 The Long-Term Cost of the Financial Crisis 571Murillo Campello, John R. Graham, and Campbell R. Harvey

71 Coping with the Financial Crisis: Illiquidity andthe Role of Government Intervention 579Bastian Breitenfellner and Niklas Wagner

72 Fiscal Policy for the Crisis 587Antonio Spilimbergo, Steven Symansky, Olivier Blanchard, and Carlo Cottarelli

73 The Future of Securitization 595Steven L. Schwarcz

74 Modification of Mortgages in Bankruptcy 601Adam J. Levitin

75 The Shadow Bankruptcy System 609Jonathan C. Lipson

76 Reregulating Fannie Mae and Freddie Mac 617Dwight M. Jaffee

77 Would Greater Regulation of Hedge Funds ReduceSystemic Risk? 625Michael R. King and Philipp Maier

78 Regulating Credit Default Swaps 633Houman B. Shadab

Index 641

Acknowledgments

My first appreciation extends to the authors who contributed to this volume.Their work is what makes the volume possible. I would also like to thankPamela Van Giessen, Jennifer MacDonald, and Melissa Lopez at John

Wiley & Sons for their editorial expertise and their support and encouragementof the idea behind this volume. I also wish to thank Sarah Schaffer for her expertediting work.

xv

Editor’s Note

Taken together, the articles in this volume present a deep understanding ofthe financial crisis we have all endured. But it must be acknowledged thateven this volume is only an initial view. The financial crisis has been an

economic event that ranks second only to the Great Depression. Like the GreatDepression, the financial crisis will be studied for decades to come, and yet greaterunderstanding of these recent events is sure to emerge with further study. Muchof that understanding will come from the further researches of those representedin this volume.

xvii

Introduction

Many efforts to understand the historical origins, the present meaning,and the future trajectory of the present financial crisis rely on the GreatDepression as a touchstone. For some, the Great Depression serves merely

as a metaphor, while others try to use that great historical event as a reliableguide to our future. While the current financial crisis differs greatly from the GreatDepression, there is at least one important similarity—those who are enduring thecrisis struggle to understand the event even as it evolves, and many will continueto study the crisis for decades to come.

Already many popular and journalistic books on the crisis have appeared andgained considerable attention. Some are quite good and make fascinating reading.Yet the broad scope of these books and their focus on drama and personalitiesimplies that they cannot provide the definitive word on the crisis. Far from thelimelight of the best-seller list and television interview shows, an entirely alter-native literature continues to develop, a literature that will ultimately be of morevalue in understanding the crisis than the rapidly produced and impressionisticaccounts that already sit on bookstore shelves.

Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Futureaims to bring to the attention of the general public an understanding of the concep-tual underpinnings of the issues that lie at the heart of the crisis. Objective concep-tual studies of the crisis are being produced mainly by academics and economistsat government agencies, and this research is directed toward policy makers andacademic economists. Not surprisingly, much of this thought and study is notaccessible to a wider public because the work is often highly mathematical, usescomplex econometric techniques, and appears in academic journals. The core ideaof Lessons from the Financial Crisis is to bring the broader meaning of this contem-porary research to a wider audience, and to achieve this now, rather than at theleisurely academic pace of the usual publication outlets.

This book consists of 78 articles written specifically for this volume. Almost allof them present the conclusions of more formal studies that are in preparation byprofessional economists. In the writing of these articles, every care has been takento reduce academic jargon and superfluous technology and thus to focus on thebroader meaning of the specific discoveries of the underlying research. As such,this book is really about understanding the financial crisis, why it began, how itdeveloped, its effects on people, its implication for our economy, and its broaderramifications for our society.

xix

xx Introduction

The articles are arranged into eleven broad sections:

1. Overview of the Crisis2. Causes and Consequences of the Financial Crisis3. Borrowers4. The Process of Securitization5. Risk Management and Mismanagement6. The Problem of Regulation7. Institutional Failures8. The Federal Reserve, Monetary Policy, and the Financial Crisis9. Implications of the Crisis for our Economic System

10. International Dimensions of the Financial Crisis11. Financial Solutions and Our Economic Future

OVERVIEW OF THE CRISISThe discussion in this first section takes the broadest overview of the crisis. Forexample, most analysts believe that leverage played a pivotal role in causing thecrisis. But do perhaps the roots of the crisis lie in the very nature of our society?One paper in this section considers whether the tendency toward excessive lever-age lies in the very nature of liberal democracy. Another article focuses on theimportant role of subprime mortgages in the crisis, but argues that the problemsthat arose in the mortgage market are but a symptom of deeper structural andpolitico-economic problems of present-day globalized capitalism, rather than theprimary cause of the crisis. Another contribution asks: “Should we have seen itcoming?” and argues that the present crisis is a rerun of previous crises from whichwe have failed to learn our lessons.

CAUSES AND CONSEQUENCESOF THE FINANCIAL CRISISThe second section moves to consider more proximate causes of the crisis and toevaluate the emerging consequences of the crisis for our economy and our lives.In retrospect, it does seem clear that housing prices in the United States rose to un-sustainable extremes, and one article in this section argues that this “asset bubble”interacted with financial innovation to create a disaster of a proportion beyond thatwhich could have been created by either factor alone. In the rush to understandthe causes of the crisis, it is not surprising that many initial analyses were faulty.One paper debunks various “myths of the subprime crisis” and concludes: “Thesubprime crisis was building for years before showing any signs and was fed bylending, securitization, leveraging, and housing booms.”

To some extent, the cause of the crisis can be traced to good intentions ofgovernment policy: the urge to extend the perceived benefits of homeownership toa portion of society for which owning a home has always been out of reach. One ofthe consequences of this well-intentioned effort was the inflicting of financial harmon exactly those families that were supposed to benefit. But beyond that effect, the

INTRODUCTION xxi

crisis has had great societal effects with a tremendous socialization of risk and thesaddling of our society with a debt burden of enormous proportions.

BORROWERSBeyond controversy, problems in the housing market lie at the heart of the broaderfinancial crisis, and at the heart of the housing market lie those who borrowed tobuy homes. This section considers the role of borrowers, and most specifically sub-prime borrowers, in fomenting the crisis. Of course, one cannot speak of millionsof borrowers in a meaningful way without taking into account their individualdifferences. Furthermore, some of the borrowers contributed to causing the crisis,while many others were simply victims. Without doubt, still others of these sub-prime borrowers unwittingly contributed to causing the crisis and yet fell victimto the crisis as well.

One simple development appears to have had a profound effect on borrowersand the generation of the crisis. As one article in this section shows, automatedunderwriting systems greatly accelerated the loan approval process and reducedthe cost of making loans. The cost savings of this automated process made itprofitable to lend to borrowers that were previously not attractive. As a result, loanorigination expanded considerably.

Predation in subprime lending has garnered considerable emotional attention.As some articles in this section explain, many subprime borrowers were the victimsof predatory lending, in which mortgage brokers and lending institutions profitedby putting naıve borrowers into homes and mortgages that they could not afford.Yet at the same time, other borrowers engaged in predatory borrowing, or mortgagefraud, in which they acquired homes by misrepresenting their financial capabilitiesand their intentions for the property.

THE PROCESS OF SECURITIZATIONThe securitization of mortgages consists essentially in purchasing mortgages, col-lecting them into a pool, and then selling securities that give ownership to portionsof the cash flows from that pool of mortgage. The first mortgage securities weremerely pass-through certificates that gave each holder a fractional ownership of all ofthe payments from the pool of mortgages, and this simple method of securitizationworked quite well for decades.

In recent years, financial innovation in mortgage securitization proceeded tocreate many more types of securities based on pools of mortgages. It is not too muchto say that the payments from mortgage pools were “sliced and diced” into evermore complicated and obscure packages called a collateralized debt obligation, or aCDO. The actual valuation of these securities quickly becomes extremely difficult asthe securities become more complex. Yet this entire process of securitization playeda tremendous role in the mortgage market and in the broader financial crisis.

Partially due to the obscurity of these instruments and the difficulties in as-sessing their true value, it appears in retrospect that there was a tremendousunderpricing of risk. Because these convoluted securities were overpriced, giventhe true risks they have proven to embody, losses were tremendous when defaults

xxii Introduction

on the underlying mortgages started to bloom and markets eventually began torealize just how risky these securities actually were.

Beyond the complexity of the securities, the movement from the old simpleoriginate-to-hold model of mortgage production to the originate-to-distribute modelhad a tremendous effect. In the originate-to-hold model, a lender, typically a localbank or savings and loan, would lend to a home buyer and hold the mortgagefor the life of the loan. By contrast, in the originate-to-distribute model, the lendermakes the loan with no intention of holding the mortgage, but rather with the planof selling the mortgage into the securitization process. As articles in this sectionexplain, this new way of originating mortgages involved a change in incentivesfor various participants in the mortgage origination process that has proven to beextremely perverse. For example, a lender planning to hold a mortgage among itsown assets will ensure that the borrower can pay as promised, but if the mortgageis to be originated and sold immediately, the borrower’s capacity to pay becomesa matter of limited importance if not indifference.

RISK MANAGEMENT AND MISMANAGEMENTBefore its humbling in the subprime and broader financial crisis, contemporaryfinance prided itself on its sophistication in evaluating and managing risk. Thefailures of those methods of risk analysis and management are now painfullyapparent. The articles in this section appraise the errors in risk management andlook to ways to improve the process.

In recent years, financial analysis has become increasingly sophisticated andmuch more mathematical. These complicated techniques, it now seems, failedto capture the true risk of mortgage-backed securities. There is now a painfulreassessment of those techniques, and the immediate future is sure to witness lessreliance on these more sophisticated techniques. In spite of stunning failure, it alsoseems clear that these mathematical techniques can be very useful, so the questionbecomes how to harness the benefits of greater analytical power without becomingthe mere captive of these sophisticated models.

One risk management flaw that is now apparent can be characterized as anoutsourcing of risk management to credit rating agencies, such as Standard & Poor’s,Moody’s, and Fitch. Due to analytical errors and perverse incentives, it now seemsclear that these agencies wildly overstated the safety of many mortgage-backedsecurities. Yet while these credit agencies deserve much criticism, so do thoseinvestors who failed to take responsibility for their own risk assessment. Again inretrospect, it now seems clear that many investors were foolish and irresponsiblein taking a triple-A rating from the credit agencies as a green light for investingwithout any further inquiry.

THE PROBLEM OF REGULATIONPerhaps the most frequently hailed cause of and presumed remedy for the financialcrisis turns on regulation. According to one facile analysis, deregulation causedthe entire problem, and what is needed is more regulation. The truth is morecomplicated, of course. The articles in this section consider the role of regulation,its absence, and the failure of regulators to enforce existing regulations.

INTRODUCTION xxiii

Some analysts regard the structure of housing regulation as a prime causeof the crisis, as the United States has had a policy that goes back to the GreatDepression of encouraging ever more widespread home ownership. Furthermore,if one looks at the institutions that took the largest and most foolish risks, manyof them are the most particular creatures of government, such as large commercialbanks and government-sponsored entities such as Fannie Mae and Freddie Mac.

But it must also be acknowledged that beyond poorly designed regulation,relaxation of regulation and weak regulatory enforcement also played a role. Forexample, the SEC loosened its capital requirements for investment banking firmsin 2004, and the firms responded by increasing their leverage and risk. Similarly,in 2000 the government abjured the regulation of credit default swaps, a locus ofenormous losses in the crisis that threatened profound systemic risk.

INSTITUTIONAL FAILURESBeyond the debacle in regulation, other social and economic institutions failedto perform and thereby contributed to the economic crisis. In a disaster of theproportions that we are experiencing, there is plenty of blame to share, and thearticles in this section analyze some of the particular institutional problems thatwere revealed in the crisis.

For example, the last 20 years have seen the rise of financial firms of enormouspower and scope. We might call them financial conglomerates. Citicorp, for ex-ample, gave a signal of its size on November 18, 2008, when it announced that itwould lay off 50,000 employees worldwide. (A firm that can suddenly discover ithas 50,000 extra people on the payroll must be a very large firm indeed!) As onearticle in this section indicates, a very large proportion of the losses in the crisiswere concentrated in these financial conglomerates.

Economists and finance academics come in for a share of the blame as wellfor emphasizing elegant models divorced from real-world markets. In addition,the financial crisis has revealed serious problems in corporate governance, includ-ing management conflicts within firms that arise between senior and mid-levelmanagers. Also, government-sponsored entities, a peculiar kind of firm that is pri-vate, yet government-created and government-controlled, have failed their socialfunction as well.

THE FEDERAL RESERVE, MONETARY POLICY,AND THE FINANCIAL CRISISBy mid-2009, the financial crisis seemed to be waning, and there was talk of “greenshoots” in an economy on the mend. Virtually every day the Federal ReserveSystem was in the news taking action in one way or another to help end the crisis.But the Federal Reserve, according to many analysts, helped to foment the crisis,then played a critical role during the crisis in limiting its effect, and presently maybe laying the foundation for more financial problems in the future by the veryactions that it has taken to avert disaster.

Some charge that a Federal Reserve policy of easy money and artificially lowinterest rates before the crisis helped to fuel a mortgage borrowing binge that led

xxiv Introduction

directly to the housing crisis and its subsequent systemic effects. On that analysis,the Fed receives a share of the blame for actually causing the crisis.

While the Fed may have played a role in starting the crisis, it has been a majoractor in efforts to preserve the financial system from ruin as well. Ben Bernanke,chairman of the Federal Reserve Board, has, in effect, been training his wholeprofessional life for this crisis, as he made his academic reputation by his work onthe Great Depression. Now as things seem to be more stable and it looks like a totalfinancial collapse has been averted, the Fed has received considerable credit for itsdecisive action in response to the crisis as it deepened. Yet new worries arise fromthe Fed’s apparently successful actions in saving the financial system. The veryactions that helped avert disaster during the crisis may be laying the foundationfor serious inflation in the months and years to come.

IMPLICATIONS OF THE CRISIS FOR OURECONOMIC SYSTEMThe financial crisis has certainly revealed that our financial and economic systemis not as robust as we may have thought previously. Externally imposed stressesoften reveal the weaknesses in all kinds of structures, from bridges to marriages,and that has certainly been the case as the financial crisis has tested our entireeconomic system.

The articles in this section consider some of the specific weaknesses revealed byour financial crisis. Perhaps foremost among these is the exposure of our complexand worldwide financial system to systemic weaknesses in which a challenge toone part of the structure is transmitted quickly to other parts that were previouslythought to be well-insulated from the original source of trouble. The Asian financialcrisis and the collapse of Long-Term Capital Management in the 1990s providedearly signals of the systemic linkages in our era of financial globalization, but thatpoint has been driven home with tremendous force by our present crisis.

New linkages have been revealed as well, perhaps most strongly in two ar-eas: credit contagion and counterparty risk. For example, the rumors that swirledaround Bear Stearns brought the creditworthiness of its obligations into doubt, butthe uncertainty attached to Bear quickly brought suspicion upon the other firmswith which it dealt, for if Bear failed to honor its obligations, what would be theeffect on the financial soundness of its creditors? Closely related to this issue ofcredit contagion is the idea of counterparty risk, a problem that emerged as par-ticularly acute with credit default swaps. When AIG was revealed to have writteninsurance against the failure of many firms that were suddenly defaulting, whatwas the implication for the counterparties to those swaps, and what was the likelyeffect on them if AIG defaulted on its own promises? As the financial crisis revealedwith amazing suddenness, fear of insolvency traveled as fast as rumor itself.

INTERNATIONAL DIMENSIONSOF THE FINANCIAL CRISISAccording to some, the navel of the world lies somewhere between New York Cityand Washington, D.C. While such an idea may be false in general, it does seem

INTRODUCTION xxv

that the United States played a special role in the crisis with its huge subprimemortgage market and its insatiable demand for investment from abroad. Even ifthe financial crisis illustrates the idea of American exceptionalism, the crisis spreadfar beyond its shores, as the articles in this section demonstrate.

While the subprime crisis and mortgage problems may have been most acutein the United States, other countries clearly experience similar problems. Further-more, the flight from risk experienced in the United States was a phenomenonshared around the world.

Perhaps the experience of Iceland was the most acute among all nations. Im-probably, the financial crisis that may have been centered in the United Stateseventually spread to overwhelm the entire banking system of Iceland and to leadto a virtually complete, if temporary, economic collapse.

FINANCIAL SOLUTIONS AND OURECONOMIC FUTUREThe articles in this section provide a summing up along with some signpoststoward an improved future. After any disaster, one of the first tasks is a damageassessment, and articles in this section analyze the long-term economic implicationsof the crisis. But beyond that evaluation, other articles point the way forward toresponses and possible solutions.

So often, efforts to respond to one problem lay the foundations for the next, sothere is a great incentive to respond to the present crisis in a way that will not createfuture harm. The process of securitization of home mortgages has been revealedto contain disastrous flaws. Yet, securitization offers the promise of a financialsystem that can stimulate the flow of credit in a socially beneficial manner. Thisraises the question of how the process of securitization might be restructured toavoid the pitfalls of the previous system while preserving the benefits of heightenedcredit availability.

There can be no doubt that more financial regulation is on the way, but howshould that be structured? Credit default swaps have been virtually unregulatedto date, but potential default on these agreements was shown to have very serioussystemic implications. It is now virtually certain that those instruments will be reg-ulated. Some have called for the banning of naked credit default swaps—a nakedswap being one in which one of the contracting parties has no underlying financialrisk or exposure. But such a proposal may merely reveal a lack of understandingof how such derivatives markets operate and the valuable role that market makersperform in bearing risk for those who wish to transfer it away.

Fannie Mae and Freddie Mac are government creatures in at least two impor-tant senses. First, before the crisis, they were regulated by the federal government,and the president appointed a plurality of their board members. Second, duringthe crisis, they were taken into conservatorship, and their obligations were guar-anteed by the federal government. The government presumably does not want tooperate these firms forever. As a consequence, it will need to create a new reg-ulatory structure for these firms that will be more successful than the previousfailed system.

LESSONS FROMTHE FINANCIAL

CRISIS