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The causes of our

a commercial bank subsidiary may now also

Introduction

own insurance, mutual fund, and investment-

financial troubles

bank subsidiaries. Far from contributing to the

were unusual

recent turmoil, the greater freedom allowed by

Mortgage foreclosure rates in the United

monetary policy

the act has clearly been a blessing in containing

States have risen to the highest level since the

it. Without it, JPMorgan Chase could not have

Great Depression. The nation's two largest

moves and novel

acquired Bear Stearns, nor could Bank of

financial institutions, the government-spon-

federal regulatory

America have acquired Merrill Lynch--acquisi-

sored mortgage purchasers and repackagers

tions that avoided losses to Bear's and Merrill's

Fannie Mae and Freddie Mac, have gone into

interventions.

bondholders. Without it, Goldman Sachs and

bankruptcy-like "conservatorship." Several

Morgan Stanley could not have switched spe-

major investment banks, insurance companies,

cialties to become bank holding companies

and commercial banks heavily tied to real

when it became clear that they could no longer

estate lending have gone bankrupt outright or

survive as investment banks.

have been sold for cents on the dollar. Prices

and trading volumes in mortgage-backed secu-

rities have shrunk dramatically. Reluctance to

What Did Happen--

lend has spread to other markets. To prepare

and Why?

the ground for a return to normalcy in

American credit markets we must understand

The actual causes of our financial troubles

the character of the problems we currently face

were unusual monetary policy moves and nov-

and how those problems arose.

el federal regulatory interventions. These poor-

ly chosen public policies distorted interest

What Didn't Happen

rates and asset prices, diverted loanable funds

into the wrong investments, and twisted nor-

Some commentators (and both presiden-

mally robust financial institutions into unsus-

tial candidates) have blamed the current

tainable positions.

financial mess on greed. But if an unusually

Let's review how the crisis has unfolded.

high number of airplanes were to crash this

Problems first surfaced in "exotic" or "flexible"

year, would it make sense to blame gravity?

home mortgage lending. Creative lenders and

No. Greed, like gravity, is a constant. It can't

originators had expanded the volume of

explain why the number of financial crashes

unconventional mortgages with high default

is higher than usual. There has been no

risks (reflected in nonprime ratings), which are

unusual epidemic of blackheartedness.

the housing market's equivalent of junk

Others have blamed deregulation or (in the

bonds. Unconventional mortgages helped to

words of one representative) "unregulated free-

feed a run-up in condo and house prices.

market lending run amok." Such an indict-

House prices peaked and turned downward.

ment is necessarily skimpy on the particulars,

Borrowers with inadequate income relative to

because there has actually been no recent dis-

their debts, many of whom had either counted

mantling of banking and financial regulations.

on being able to borrow against a higher house

Regulations were in fact intensified in the

value in the future in order to help them meet

1990s in ways that fed the development of the

their monthly mortgage payments, or on being

housing finance crisis, as discussed below. The

able to "flip" the property at a price that would

last move in the direction of financial deregula-

more than repay their mortgage, began to

tion was the bipartisan Financial Services

default. Default rates on nonprime mortgages

Modernization Act of 1999, also known as the

rose to unexpected highs. The high risk on the

Gramm-Leach-Bliley Act, signed by President

mortgages came back to bite mortgage hold-

Clinton. That act opened the door for financial

ers, the financial institutions to whom the

firms to diversify: a holding company that owns

monthly payments were owed. Firms directly

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