The Crisis:

What Caused It?

By Julio Huato
juliohuato@gmail.com
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
credit.
The credit boom Household debt led –
to fund consumption.
Maybe because gov’
ts
slacked and people
Made up for it?
The credit boom The debt of the non-
financial sector was the
most dynamic of them
all,
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
Mac).
 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
much?
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]
Summary

Credit boom (fueled by profit motive, unleashed

by de-reg)
Target of funds: Domestic consumption,
especially at the top, but also below (out of
need)
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]