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The Crisis:

What Caused It?

By Julio Huato
Associate Professor of Economics
St. Francis College
The appearance of the crisis

On the surface, the crisis appears to

regular people as suddenly increased risk
of losing their homes , their savings , and
their jobs .
On Wall Street, it manifests itself as a
sudden, large drop in asset prices, a
“flight to safety,” and the credit freeze.
How did we get here?
The chain of causation

In the last few days , stock prices fell, not because the
economy is in a recession (job creation: negative,
industrial production: falling), but because financial firms
(“banks”) were going broke.
In the last few weeks , financials were going broke
because they held bad loans, directly and packaged in
complex “derivatives,” as a result of credit freeze. (A
global problem: banks everywhere bought them. Risk
was underestimated or disregarded.)
In the last few months , credit froze, mainly to other
banks (but also to consumers and businesses, including
short-term), because banks’ suspected other banks may
go broke.
The toxic assets

The bad assets held by banks were subprime mortgage

loans (SML). A SML is a loan to people with weak or no
credit histories [higher default risk].
Why did subprime borrowers borrow? Because they:
needed a home (state of the economy, inequality, poverty) [CB:
Owner-occupied homes < 70%, including partial rentals. JH:
45-65% not owners],
were manipulated by predatory lenders (“asymmetric
information”) [variable rates, low initial 6m-3y rates, that then
jumped sharply], and
thought home prices would keep going up (“housing bubble”)
[see next slide].
Home prices
The credit boom For households, it was
mainly a boom in
mortgage credit, but
also in commercial
The credit boom Household debt led –
to fund consumption.
Maybe because gov’
slacked and people
Made up for it?
The credit boom The debt of the non-
financial sector was the
most dynamic of them
especially households
(previous graph)
Notice the log scale: change
The credit boom: Debtors reads as growth rate
(percentage change). Who
borrowed fastest? Insurers,
ROW, B&Ds.
Who lent? In speed,
The credit boom: Creditors funding corps, S&Ds,
ROW. In size, ROW,
commercial banks, GSE’s
(e.g. Fanny Mae, Freddy
The macroeconomics of the credit boom

By definition of savings: S = Y – T – C.
Hence: Y = C + S + T (1)
By the basic national accounting identity: Y
= C + I + G + (X – M) (2)
Subtract (2) from (1) and re-arrange to get: Savings declined from mid 1980s,
(X – M) = (S – I) + (T – G) public finances temporarily improved
That is, our trade and budget deficits are (1992-2000), but then biggest deficits
funded by the ROW! ever. Hence, current account deficits,
foreign funding of those deficits.
Why did the financial sector grow so
Financial firms are for-profits. Changes in the legal
framework spawned the financial sector:
1971: Nixon unilaterally withdrew from the Bretton
Woods agreement, which ensured some stability in
exchange rates [boom of forex markets]
1980: Depository Institutions Deregulation and
Monetary Control Act, began repealing the Glass-
Steagall Act 1933
1989: Gramm-Leach-Bliley Financial Services
Modernization Act, completed the repeal of Glass-
Steagall [boom of non-bank financial firms, derivatives,
hedge funds]

Credit boom (fueled by profit motive, unleashed

by de-reg)
Target of funds: Domestic consumption,
especially at the top, but also below (out of
Source of funds: the ROW
Poverty and inequality hurts us in many ways
[much more $ blown now in bailing out banks
than would have been required to help poor
people buy homes safely to begin with]