So what caused the financial crisis?

I have heard/read conflicting stories (at least conflicting to my understanding) on why this now has happened and am curious what OT's several conclusions are. Especially as some are way better educated in economics than me.

The main narrative is that the cunning financial industry brought it upon itself and the world by selling financial packages for sums way beyond their actual worth which was made possible by making them so complex that many lost their overview and weren't able to realistically assess those packages. This worked for a while and brought in a lot of money until it was generally realized and accepted how worth-less a lot of that stuff actually was.

The main backbone of those packages is supposed to be found in the American real estate market. There demand and prices were on a steady rise - largely financed by private financial loans, which as I seem to recall was endorsed by the US government.

Now I am not exactly sure how this system came to a burst. I read somewhere that many home owners were perfectly able to repay their debts before the interests experienced a dramatic rise. However those rises where a result of the financial crisis, right? So how came that into being? Where there only a relatively small share of home owners who couldn't repay their debts and which then caused the rising interest rates which then caused more and more people to not be able to repay? Or what?

Also - if the American real estate crisis is the backbone of the financial crisis - where come those "too complex to understand financial packages" into play? They seem unnecessary as until the crisis the American real estate was indeed a cash cow where the money also was flowing in the desired directions - or not? Which again brings me to the question why the real estate market bursted in the first place.

The government forcing banks to lend to untrustworthy minorities via HUD.

Okay, honestly? If you can figure it out in the details, you know, beyond things like a housing bubble and creative betting mechanisms, you'd be ahead of the government, who is in charge of fixing the mess, and... ahead of the people who got the world into the mess as well.

Congressman Barney Frank caused it. That is, he tipped over the first domino.

The actual financial crisis itself was very small. Very few banks/companies actually crashed. What caused the economy to tank afterwards was everybody else's response to the collapse of a very few (but highly visible!) dominoes. Other banks, in order to avoid the same fate as those that imploded, clamped up and refused to lend to anybody--thereby causing, among other things, the Big Three auto company crisis. Chain of dominoes.

Aside from the first few dominoes (such as Fannie Mae and Freddie Mac) the economic crisis we're now in is a direct result of companies becoming fiscally responsible. Loose lending means higher salaries, more construction, more investment. Tight lending produces the opposite. Look around you, folks. This is what financial responsibility looks like. You demanded it, you got it. Get used to it, because nothing is going to improve until Evil Corporations become irresonsible again.

Summary:

So let me summarize and see if I got this all straight.

The government has been pushing/sponsoring/facilitating home ownership for decades. But over the last 1-2 decades that has become more aggressive and with looser controls.

Regulations that control the financial industry have been gutted both formally by Congressional actions and informally by executive and independent agency inaction on enforcement.

Mortgage originators and financiers first made riskier and riskier loans, because the risk did not fall on them. And then they made more and more fraudulent loans for the same reason.

The privatization of the government entities freddie and fannie made them more and more willing to take risks for their own profits at the public expense.

The Federal Reserve kept interest rates too low for too long. Possibly with the contributing factor that the fear of exploding the bubble of ARMS tied their hands.

The major financial institutions gamed the regulatory system even as that system was declining to aggressively do its job. Resulting in uncontrolled risk.

They also had, systemically, an internal failure to understand and control for their own risk. With a contributing factor of perverse incentives to leading actors and executives and the fact that the executives were no longer fully on the hook for personal losses.

The ratings agencies, which in theory exist to add transparency to the system, were instead captured by the mortgage banks and failed to do their jobs.

The complexity of the system came to exceed people's, even experts, ability to evaluate.

The unrestrained merger mania on Wall St resulted in far too many financial institutions which were simply too big to manage, regulate, or control in any way. And they are so big that letting them fail causes far too much collateral damage to the system as a whole.

Globalization of private institutions make them harder to control and regulate.

Excessive tax cuts added fuel to the bubble.

A widely accepted, erroneous, view of market rationality and people protecting their own money led to a hands off policy which allowed an opportunity for the system to go to hell in a handbasket.

An extremely poorly designed regulatory structure combined with lax enforcement allowed financial institutions to get away with just about anything that they tried.

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The Jews, if 25% of non-Jewish Americans are to be believed.

Excessive tax cuts added fuel to the bubble.

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Could you please explain this to me?

BuckeyeJim said:

Could you please explain this to me?

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presumably more capital to throw around in investment

Mise's quick and dirty guide to the financial crisis:

1. American subprime mortgage crisis. This was the start of it. Subprime mortgages are mortgages made to people who have "no proof of income, no job and no assets", otherwise known as NINJA loans. Normally, there would be no way that banks would lend to these people, because they are absolutely not credit-worthy. However:

2. Banks weren't making loans directly to these people. They were making them via mortgage brokers, who got paid on commission for each loan they sold. This clearly gives the brokers an incentive not to vet the people they make their loans to, because if they don't vet them they can sell more loans => more commission. Further, because they were passing all responsibility for the loans back to the bank, they had no interest in whether the loans would be repaid, so didn't care one bit if their customers were credit worthy. Clearly this is going to lead to a lot of defaults - a lot more than you would expect based on historical figures.

3. Banks were also not particularly interested in how credit worthy their loans were, because banks, too, weren't holding these loans on their own books. They were packaging the loans up and selling them on to institutional investors. The process is called Securitisation, and the product was called a CDO - collateralised debt obligation. These were supposed to reduce the risk to the buyer, because lots of loans were bundled together, so the standard deviation on the losses should be lower (similar to how insurance companies reduce risk, wiki Law of Large Numbers). Again, this provided little incentive for banks to do proper credit checks and assess the quality of loans, because the loans weren't being held by the originating banks.

4. All this easy credit, combined with historically low interest rates set by the federal reserve after the dotcom crash, lead to a huge housing boom. People took out loans left and right, bought houses like nobody's business, and also borrowed using their homes as collateral. Household debt soared; many people borrowed 120% of their home's value from the banks, and the banks were happy to lend because they weren't holding the loans on their books, but merely passing the risk on to somebody else. To make matters worse, a lot of these loans were deceptive - they were fixed at a low "teaser" rate to begin with, but later converted to a much, much higher rate after a year or two. Combined with the fact that a lot of these loans were unaffordable to begin with, it made a recipe for disaster.

5. While it's true that securitisation reduced random risk, it did not reduce "model risk". The people who rated the CDOs (credit rating agencies, e.g. Moody's, S&P's, Fitch) used models with highly unrealistic assumptions, notably that (a) US house prices will continue to rise as they have done for the past 50 years, (b) default rates would be pretty much the same as they always have been, and (c) if it did crash, homeowners would only default on their homes as an absolute last resort. Historically homeowners have first defaulted on credit cards (i.e. things they don't need), car loans (i.e. things they can easily trade in for a cheaper version), any other loan e.g. student debt, and only after that do they default on their house, because the last thing you want to do is lose your house. People tend to cling to their houses, naturally, and avoid losing them at all cost. HOWEVER, this time was different, because the mortgages were often far in excess of what their homes were worth. This meant it made sense for people to just walk away from their mortgages, rather than try to repay a ridiculously big loan. The banks, in turn, desperate for cash, sold the houses far below market price to get cash in a hurry, which further exacerbated the housing bust. And, of course, default rates were much higher than they have been, because of what I said in point 2. All this left banks with a lot of sub prime losses.

6. But because banks had been selling CDOs to other institutional investors (notably French and German "universal" banks, as well as "safe names" like UBS, Credit Suisse, HSBC, etc; wiki has a full list IIRC), these other banks also took a hit. And, to further complicate matters, banks had been selling (what amounted to) insurance packages... to each other... that paid out if the CDOs went bad. These were known as CDSs (credit default swaps), and were bought and sold by a whole bunch of other banks, hedge funds, etc -- notably AIG (who were bailed out) and.....:

7. Lehman Bros, who weren't bailed out. Lehman Bros had huge exposure to CDOs via CDSs they sold to all those banks and stuff. Now, at the time, regulators thought that letting Lehman go bust was a good idea. However, it turned out to be a god damn terrible idea. Because Lehman was so interconnected with all the other banks and financial institutions (it was a SIFI - a systemically important financial institution), when Lehman couldn't pay its creditors, it started a huge chain reaction that lead to near catastrophic meltdown of the entire global financial system. That's when governments around the world set about bailing out banks and guaranteeing their balance sheets, in order to prevent a whole bunch of banks worldwide from basically going bust all at once.

9/11. Ofcourse the banking system requires more attention anyway, but the goodwill which allowed it to function properly previously was lost with the consequences of 9/11.

another thing i dont like are the phrases whats up and see you later. theyre presumptious and common in american speech. how are you and goodbye please.

In the documentary, Insider Job, about the collapse of the financial system it mentioned how because the Fed didn't take into account foreign laws regarding insurance and banking agencies it siezed up credit and added to the confusion. How much of an impact did this have?

I still say rising oil prices caused the bubble to burst. Although I have no evidence to back me up, I'm not even sure if oil prices can affect an economy that fast. But it has been proven that high energy costs do cause recessions. This is not in doubt.

And since Bush and the republicans are the cause of the high oil prices , we can safely blame them.

BuckeyeJim said:

Could you please explain this to me?

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Tax cuts for the rich do not result in increases in business investment. But neither does the money lie idle. Hoarding of cash, in the way the term is used old school, doesn't exist to any meaningful extent. When the rich have more money, they either spend it on conspicuous consumption, or they use it to try to make more money. Business investment is one way in which money can be "put to work". But it isn't the only one. Money can also be loaned to others for the consumption of others. Such as home mortgages. And money can go to fuel bubbles, by bidding up the price of existing assets. That's speculation. In the short run, speculation and consumer loans can generate a higher rate of return than business investment.

So the tax cuts meant that the wealthy had huge increases of money, but nothing to do with it. Much of it went to conspicuous consumption, but the rest was bubble fuel.

I have been asking people for 25 year if there was any evidence of increased business investment resulting from tax cuts for the rich. So far no one has provided any reason to expect that there ever has been any.

So if none of the money goes to (domestic) investment, and not all of it is consumed, then bubble fuel is really the main other place for it to go.

Disgustipated said:

I still say rising oil prices caused the bubble to burst. Although I have no evidence to back me up, I'm not even sure if oil prices can affect an economy that fast. But it has been proven that high energy costs do cause recessions. This is not in doubt.

And since Bush and the republicans are the cause of the high oil prices , we can safely blame them.

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I think oil prices may have, in part, been the straw that broke the camel's back. But not the cause beyond that.

Tight monetary policy caused the recession. Cut and Mise have adequately dealt with financial issues.

Cutlass said:

I think oil prices may have, in part, been the straw that broke the camel's back. But not the cause beyond that.

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I have to agree with that. Mise's post shows how the pieces fell into place that really allowed it all to fail at once.

One thing that annoys me is all these people bailing on their homes. I know a few people like this. What's worse, isn't that they can't pay their loan (both the husband and wife are working), but they just don't want to because the house isn't worth anything. That strikes me as dishonest, and I would never do such a thing.

We were due for a large-scale financial crisis.

Overconfidence was widespread across the board; in government, in the private sector, and in academia.

Laws and regulations were relaxed that shouldn't have been.

We'll learn from our mistakes and do better next time, just as "this time" we did better than "last time"

Disgustipated said:

I have to agree with that. Mise's post shows how the pieces fell into place that really allowed it all to fail at once.

One thing that annoys me is all these people bailing on their homes. I know a few people like this. What's worse, isn't that they can't pay their loan (both the husband and wife are working), but they just don't want to because the house isn't worth anything. That strikes me as dishonest, and I would never do such a thing.

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There's been a lot of talk about that. It is within the contractual obligation to walk away. And other than that, these people are all in part a victim of the bubble. And of the fraud that created the bubble.

Cutlass said:

Tax cuts for the rich do not result in increases in business investment. But neither does the money lie idle. Hoarding of cash, in the way the term is used old school, doesn't exist to any meaningful extent. When the rich have more money, they either spend it on conspicuous consumption, or they use it to try to make more money. Business investment is one way in which money can be "put to work". But it isn't the only one. Money can also be loaned to others for the consumption of others. Such as home mortgages. And money can go to fuel bubbles, by bidding up the price of existing assets. That's speculation. In the short run, speculation and consumer loans can generate a higher rate of return than business investment.

So the tax cuts meant that the wealthy had huge increases of money, but nothing to do with it. Much of it went to conspicuous consumption, but the rest was bubble fuel.

I have been asking people for 25 year if there was any evidence of increased business investment resulting from tax cuts for the rich. So far no one has provided any reason to expect that there ever has been any.

So if none of the money goes to (domestic) investment, and not all of it is consumed, then bubble fuel is really the main other place for it to go.

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Man, talk about stretching an argument. Yeesh.

Thanks for convincing me that tax cuts are not a root cause for the financial collapse. And irresponsibility and reckless greed was.

BuckeyeJim said:

Man, talk about stretching an argument. Yeesh.

Thanks for convincing me that tax cuts are not a root cause for the financial collapse. And irresponsibility and reckless greed was.

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Not a root cause. But definitely a contributing cause. They helped make the bubble bigger.

Personally I don't buy the "evil bankers' greed caused the crisis" argument. Which isn't to say I want to defend those greedy bankers that certainly exist - but it was the state's* job to keep it in check. Human nature doesn't change that drastically in a couple of years or even decades - instead, there was a system in place that didn't only allow these kind of exploits, but actively encouraged it.

This is why the whole "state failure or market failure?" battle neoliberals and statists are constantly giving each other is moot - it was a double failure, which allowed the crisis to become this severe in the first place.

*depending on which state you look, the repercussions were of course different - it's not difficult to see the obvious correlation between banking limitations and crisis effects when comparing different countries. And while we got hit quite severely as well, I'm glad Germany in the end didn't sacrifice its industrial core to set up a finance driven economy like the Anglosaxon world was constantly preaching.