Subprime mortgage crisis

Boom and bust

According to Robert J. Shiller and other economists, housing price increases beyond the general inflation rate are not sustainable in the long term. From the end of World War II to the beginning of the housing bubble in 1997, housing prices in the US remained relatively stable.^{[53]: 19–21} The bubble was characterized by higher rates of household debt and lower savings rates, slightly higher rates of home ownership, and of course higher housing prices. It was fueled by low interest rates and large inflows of foreign funds that created easy credit conditions.^[54]

Between 1997 and 2006 (the peak of the housing bubble), the price of the typical American house increased by 124%.^[55] Many research articles confirmed the timeline of the U.S. housing bubble (emerged in 2002 and collapsed in 2006–2007) before the collapse of the subprime mortgage industry.^[56][57] From 1980 to 2001, the ratio of median home prices to median household income (a measure of ability to buy a house) fluctuated from 2.9 to 3.1. In 2004 it rose to 4.0, and by 2006 it hit 4.6.^[58] The housing bubble was more pronounced in coastal areas where the ability to build new housing was restricted by geography or land use restrictions.^[59] This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation. US household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990.^[60][61]

While housing prices were increasing, consumers were saving less^[62] and both borrowing and spending more. Household debt grew from $705 billion at year end 1974, 60% of disposable personal income, to $7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008, 134% of disposable personal income.^[63] During 2008, the typical US household owned 13 credit cards, with 40% of households carrying a balance, up from 6% in 1970.^[64]

Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion over the period.^[65][66][67] U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 (~$14.6 trillion in 2023) trillion.^[68] From 2001 to 2007, U.S. mortgage debt almost doubled, and the amount of mortgage debt per household rose more than 63%, from $91,500 to $149,500, with essentially stagnant wages.^[2] Economist Tyler Cowen explained that the economy was highly dependent on this home equity extraction: "In the 1993–1997 period, home owners extracted an amount of equity from their homes equivalent to 2.3% to 3.8% GDP. By 2005, this figure had increased to 11.5% GDP."^[69]

This credit and house price explosion led to a building boom and eventually to a surplus of unsold homes, which caused U.S. housing prices to peak and begin declining in mid-2006.^[70] Easy credit, and a belief that house prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term.

The US home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of 69.2% in 2004.^[71] Subprime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing, which drove prices higher.

Borrowers who would not be able to make the higher payments once the initial grace period ended, were planning to refinance their mortgages after a year or two of appreciation. As a result of the depreciating housing prices, borrowers' ability to refinance became more difficult. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default.

As more borrowers stopped making their mortgage payments, foreclosures and the supply of homes for sale increased. This placed downward pressure on housing prices, which further lowered homeowners' equity. The decline in mortgage payments also reduced the value of mortgage-backed securities, which eroded the net worth and financial health of banks. This vicious cycle was at the heart of the crisis.^[72]

By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak.^[73][74] This major and unexpected decline in house prices means that many borrowers have zero or negative equity in their homes, meaning their homes were worth less than their mortgages. As of March 2008, an estimated 8.8 million borrowers – 10.8% of all homeowners – had negative equity in their homes, a number that is believed to have risen to 12 million by November 2008. By September 2010, 23% of all U.S. homes were worth less than the mortgage loan.^[75]

Borrowers in this situation have an incentive to default on their mortgages as a mortgage is typically nonrecourse debt secured against the property.^[76] Economist Stan Leibowitz argued in the Wall Street Journal that although only 12% of homes had negative equity, they comprised 47% of foreclosures during the second half of 2008. He concluded that the extent of equity in the home was the key factor in foreclosure, rather than the type of loan, credit worthiness of the borrower, or ability to pay.^[77]

Increasing foreclosure rates increases the inventory of houses offered for sale. The number of new homes sold in 2007 was 26.4% less than in the preceding year. By January 2008, the inventory of unsold new homes was 9.8 times the December 2007 sales volume, the highest value of this ratio since 1981.^[78] Furthermore, nearly four million existing homes were for sale,^[79] of which roughly 2.2 million were vacant.^[80]

This overhang of unsold homes lowered house prices. As prices declined, more homeowners were at risk of default or foreclosure. House prices are expected to continue declining until this inventory of unsold homes (an instance of excess supply) declines to normal levels.^[81] A report in January 2011 stated that U.S. home values dropped by 26% from their peak in June 2006 to November 2010, more than the 25.9% drop between 1928 and 1933 when the Great Depression occurred.^[82]

From September 2008 to September 2012, there were approximately 4 million completed foreclosures in the U.S. As of September 2012, approximately 1.4 million homes, or 3.3% of all homes with a mortgage, were in some stage of foreclosure compared to 1.5 million, or 3.5%, in September 2011. During September 2012, 57,000 homes completed foreclosure; this is down from 83,000 the prior September but well above the 2000–2006 average of 21,000 completed foreclosures per month.^[83]

Homeowner speculation

Speculative borrowing in residential real estate has been cited as a contributing factor to the subprime mortgage crisis.^[84] During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, a record level of nearly 40% of homes purchased were not intended as primary residences. David Lereah, National Association of Realtors's chief economist at the time, stated that the 2006 decline in investment buying was expected: "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market."^[85]

Housing prices nearly doubled between 2000 and 2006, a vastly different trend from the historical appreciation at roughly the rate of inflation. While homes had not traditionally been treated as investments subject to speculation, this behavior changed during the housing boom. Media widely reported condominiums being purchased while under construction, then being "flipped" (sold) for a profit without the seller ever having lived in them.^[86] Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.^[87]

One 2017 NBER study argued that real estate investors (i.e., those owning 2+ homes) were more to blame for the crisis than subprime borrowers: "The rise in mortgage defaults during the crisis was concentrated in the middle of the credit score distribution, and mostly attributable to real estate investors" and that "credit growth between 2001 and 2007 was concentrated in the prime segment, and debt to high-risk [subprime] borrowers was virtually constant for all debt categories during this period." The authors argued that this investor-driven narrative was more accurate than blaming the crisis on lower-income, subprime borrowers.^[47] A 2011 Fed study had a similar finding: "In states that experienced the largest housing booms and busts, at the peak of the market almost half of purchase mortgage originations were associated with investors. In part by apparently misreporting their intentions to occupy the property, investors took on more leverage, contributing to higher rates of default." The Fed study reported that mortgage originations to investors rose from 25% in 2000 to 45% in 2006, for Arizona, California, Florida, and Nevada overall, where housing price increases during the bubble (and declines in the bust) were most pronounced. In these states, investor delinquency rose from around 15% in 2000 to over 35% in 2007 and 2008.^[88]

Economist Robert Shiller argued that speculative bubbles are fueled by "contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they're going to keep forming."^[89] Keynesian economist Hyman Minsky described how speculative borrowing contributed to rising debt and an eventual collapse of asset values.^[90]

Warren Buffett testified to the Financial Crisis Inquiry Commission: "There was the greatest bubble I've ever seen in my life...The entire American public eventually was caught up in a belief that housing prices could not fall dramatically."^[39]

High-risk mortgage loans and lending/borrowing practices

In the years before the crisis, the behavior of lenders changed dramatically. Lenders offered more and more loans to higher-risk borrowers.^[26][91] Lending standards deteriorated particularly between 2004 and 2007, as the government-sponsored enterprise (GSE) mortgage market share (i.e. the share of Fannie Mae and Freddie Mac, which specialized in conventional, conforming, non-subprime mortgages) declined and private securitizers share grew, rising to more than half of mortgage securitizations.^[26]

Subprime mortgages grew from 5% of total originations ($35 billion) in 1994,^[92][93] to 20% ($600 billion) in 2006.^[93][94][95] Another indicator of a "classic" boom-bust credit cycle was a narrowing of the difference between subprime and prime mortgage interest rates (the "subprime markup") between 2001 and 2007.^[96]

In addition to considering higher-risk borrowers, lenders had offered progressively riskier loan options and borrowing incentives. In 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever.^[97] By comparison, China has down payment requirements that exceed 20%, with higher amounts for non-primary residences.^[98]

To produce more mortgages and more securities, mortgage qualification guidelines became progressively looser. First, "stated income, verified assets" (SIVA) loans replaced proof of income with a "statement" of it. Then, "no income, verified assets" (NIVA) loans eliminated proof of employment requirements. Borrowers needed only to show proof of money in their bank accounts. "No Income, No Assets" (NINA) or Ninja loans eliminated the need to prove, or even to state any owned assets. All that was required for a mortgage was a credit score.^[99]

Types of mortgages became more risky as well. The interest-only adjustable-rate mortgage (ARM) allowed the homeowner to pay only the interest (not principal) of the mortgage during an initial "teaser" period. Even looser was the "payment option" loan, in which the homeowner has the option to make monthly payments that do not even cover the interest for the first two- or three-year initial period of the loan. Nearly one in 10 mortgage borrowers in 2005 and 2006 took out these "option ARM" loans,^[2] and an estimated one-third of ARMs originated between 2004 and 2006 had "teaser" rates below 4%. After the initial period, monthly payments might double^[93] or even triple.^[100]

The proportion of subprime ARM loans made to people with credit scores high enough to qualify for conventional mortgages with better terms increased from 41% in 2000 to 61% by 2006. In addition, mortgage brokers in some cases received incentives from lenders to offer subprime ARMs even to those with credit ratings that merited a conforming (i.e., non-subprime) loan.^[101]

Mortgage underwriting standards declined precipitously during the boom period. The use of automated loan approvals allowed loans to be made without appropriate review and documentation.^[102] In 2007, 40% of all subprime loans resulted from automated underwriting.^[103][104] The chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to examine whether borrowers could repay.^[105] Mortgage fraud by lenders and borrowers increased enormously.^[106]

The Financial Crisis Inquiry Commission reported in January 2011 that many mortgage lenders took eager borrowers' qualifications on faith, often with a "willful disregard" for a borrower's ability to pay. Nearly 25% of all mortgages made in the first half of 2005 were "interest-only" loans. During the same year, 68% of "option ARM" loans originated by Countrywide Financial and Washington Mutual had low- or no-documentation requirements.^[2]

At least one study has suggested that the decline in standards was driven by a shift of mortgage securitization from a tightly controlled duopoly to a competitive market in which mortgage originators held the most sway.^[26] The worst mortgage vintage years coincided with the periods during which Government Sponsored Enterprises (specifically Fannie Mae and Freddie Mac) were at their weakest, and mortgage originators and private label securitizers were at their strongest.^[26]

In a Peabody Award-winning program, NPR correspondents considered why there was a market for low-quality private label securitizations. They argued that a "Giant Pool of Money" (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade. Further, this pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income-generating investments had not grown as quickly. Investment banks on Wall Street answered this demand with financial innovation such as the mortgage-backed security (MBS) and collateralized debt obligation (CDO), which were assigned safe ratings by the credit rating agencies.

In effect, Wall Street connected this pool of money to the mortgage market in the U.S., with enormous fees accruing to those throughout the mortgage supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted. However, continued strong demand for MBS and CDO began to drive down lending standards, as long as mortgages could still be sold along the supply chain. Eventually, this speculative bubble proved unsustainable. NPR described it this way:^[107]

The problem was that even though housing prices were going through the roof, people weren't making any more money. From 2000 to 2007, the median household income stayed flat. And so the more prices rose, the more tenuous the whole thing became. No matter how lax lending standards got, no matter how many exotic mortgage products were created to shoehorn people into homes they couldn't possibly afford, no matter what the mortgage machine tried, the people just couldn't swing it. By late 2006, the average home cost nearly four times what the average family made. Historically it was between two and three times. And mortgage lenders noticed something that they'd almost never seen before. People would close on a house, sign all the mortgage papers, and then default on their very first payment. No loss of a job, no medical emergency, they were underwater before they even started. And although no one could really hear it, that was probably the moment when one of the biggest speculative bubbles in American history popped.

Subprime mortgage market

Subprime borrowers typically have weakened credit histories and reduced repayment capacity. Subprime loans have a higher risk of default than loans to prime borrowers.^[108] If a borrower is delinquent in making timely mortgage payments to the loan servicer (a bank or other financial firm), the lender may take possession of the property, in a process called foreclosure.

The value of American subprime mortgages was estimated at $1.3 (~$1.84 trillion in 2023) trillion as of March 2007,^[109] with over 7.5 million first-lien subprime mortgages outstanding.^[110] Between 2004 and 2006 the share of subprime mortgages relative to total originations ranged from 18%–21%, versus less than 10% in 2001–2003 and during 2007.^[111][112] The majority of subprime loans were issued in California.^[113] The boom in mortgage lending, including subprime lending, was also driven by a fast expansion of non-bank independent mortgage originators which despite their smaller share (around 25% in 2002) in the market have contributed to around 50% of the increase in mortgage credit between 2003 and 2005.^[114] In the third quarter of 2007, subprime ARMs making up only 6.9% of US mortgages outstanding also accounted for 43% of the foreclosures which began during that quarter.^[115]

By October 2007, approximately 16% of subprime adjustable-rate mortgages (ARM) were either 90-days delinquent or the lender had begun foreclosure proceedings, roughly triple the rate of 2005.^[116] By January 2008, the delinquency rate had risen to 21%^[117] and by May 2008 it was 25%.^[118]

According to RealtyTrac, the value of all outstanding residential mortgages, owed by U.S. households to purchase residences housing at most four families, was US$9.9 trillion as of year-end 2006, and US$10.6 trillion as of midyear 2008.^[119] During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006.^[120] This increased to 2.3 million in 2008, an 81% increase vs. 2007,^[121] and again to 2.8 million in 2009, a 21% increase vs. 2008.^[122]

By August 2008, 9.2% of all U.S. mortgages outstanding were either delinquent or in foreclosure.^[123] By September 2009, this had risen to 14.4%.^[124] Between August 2007 and October 2008, 936,439 US residences completed foreclosure.^[125] Foreclosures are concentrated in particular states both in terms of the number and rate of foreclosure filings.^[126] Ten states accounted for 74% of the foreclosure filings during 2008; the top two (California and Florida) represented 41%. Nine states were above the national foreclosure rate average of 1.84% of households.^[127]

Mortgage fraud and predatory lending

"The FBI defines mortgage fraud as 'the intentional misstatement, misrepresentation, or omission by an applicant or other interest parties, relied on by a lender or underwriter to provide funding for, to purchase, or to insure a mortgage loan.'"^[128] In 2004, the Federal Bureau of Investigation warned of an "epidemic" in mortgage fraud, an important credit risk of nonprime mortgage lending, which, they said, could lead to "a problem that could have as much impact as the S&L crisis".^{[129][130][131][132]} Despite this, the Bush administration prevented states from investigating and prosecuting predatory lenders by invoking a banking law from 1863 "to issue formal opinions preempting all state predatory lending laws, thereby rendering them inoperative."^[133]

The Financial Crisis Inquiry Commission reported in January 2011 that: "... mortgage fraud... flourished in an environment of collapsing lending standards and lax regulation. The number of suspicious activity reports – reports of possible financial crimes filed by depository banks and their affiliates – related to mortgage fraud grew 20-fold between 1996 and 2005 and then more than doubled again between 2005 and 2009. One study places the losses resulting from fraud on mortgage loans made between 2005 and 2007 at $112 billion.

"Predatory lending describes unfair, deceptive, or fraudulent practices of some lenders during the loan origination process."Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities."^[2]

Boom and collapse of the shadow banking system

The Financial Crisis Inquiry Commission reported in January 2011:

In the early part of the 20th century, we erected a series of protections – the Federal Reserve as a lender of last resort, federal deposit insurance, ample regulations – to provide a bulwark against the panics that had regularly plagued America's banking system in the 19th century. Yet, over the past 30-plus years, we permitted the growth of a shadow banking system – opaque and laden with short term debt – that rivaled the size of the traditional banking system. Key components of the market – for example, the multitrillion-dollar repo lending market, off-balance-sheet entities, and the use of over-the-counter derivatives – were hidden from view, without the protections we had constructed to prevent financial meltdowns. We had a 21st-century financial system with 19th-century safeguards.^[135]

In a June 2008 speech, President of the NY Federal Reserve Bank Timothy Geithner, who later became Secretary of the Treasury, placed significant blame for the freezing of credit markets on a "run" on the entities in the "parallel" banking system, also called the shadow banking system. These entities became critical to the credit markets underpinning the financial system, but were not subject to the same regulatory controls as depository banks. Further, these entities were vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that disruptions in credit markets would make them subject to rapid deleveraging, selling their long-term assets at depressed prices.^[18]

Repo and other forms of shadow banking accounted for an estimated 60% of the "overall US banking system," according to Nobel laureate economist Paul Krugman.^[136] Geithner described its "entities":

In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 (~$3.12 trillion in 2023) trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion.

He stated that the "combined effect of these factors was a financial system vulnerable to self-reinforcing asset price and credit cycles."^[18] Krugman described the run on the shadow banking system as the "core of what happened" to cause the crisis.

As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible – and they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank.

He referred to this lack of controls as "malign neglect."^[137][138]

The securitization markets supported by the shadow banking system started to close down in the spring of 2007 and nearly shut-down in the fall of 2008. More than a third of the private credit markets thus became unavailable as a source of funds.^[139] According to the Brookings Institution, the traditional banking system does not have the capital to close this gap as of June 2009: "It would take a number of years of strong profits to generate sufficient capital to support that additional lending volume." The authors also indicate that some forms of securitization are "likely to vanish forever, having been an artifact of excessively loose credit conditions."^[140]

Economist Gary Gorton wrote in May 2009:

Unlike the historical banking panics of the 19th and early 20th centuries, the current banking panic is a wholesale panic, not a retail panic. In the earlier episodes, depositors ran to their banks and demanded cash in exchange for their checking accounts. Unable to meet those demands, the banking system became insolvent. The current panic involved financial firms "running" on other financial firms by not renewing sale and repurchase agreements (repo) or increasing the repo margin ("haircut"), forcing massive deleveraging, and resulting in the banking system being insolvent.^[17]

Fed Chair Ben Bernanke stated in an interview with the FCIC during 2009 that 12 of the 13 largest U.S. financial institutions were at risk of failure during 2008. The FCIC report did not identify which of the 13 firms was not considered by Bernanke to be in danger of failure.^[141]

Economist Mark Zandi testified to the Financial Crisis Inquiry Commission in January 2010:

The securitization markets also remain impaired, as investors anticipate more loan losses. Investors are also uncertain about coming legal and accounting rule changes and regulatory reforms. Private bond issuance of residential and commercial mortgage-backed securities, asset-backed securities, and CDOs peaked in 2006 at close to $2 trillion...In 2009, private issuance was less than $150 billion, and almost all of it was asset-backed issuance supported by the Federal Reserve's TALF program to aid credit card, auto and small-business lenders. Issuance of residential and commercial mortgage-backed securities and CDOs remains dormant.^[142]

The Economist reported in March 2010: "Bear Stearns and Lehman Brothers were non-banks that were crippled by a silent run among panicky overnight "repo" lenders, many of them money market funds uncertain about the quality of securitized collateral they were holding. Mass redemptions from these funds after Lehman's failure froze short-term funding for big firms."^[143]

Securitization

Securitization – the bundling of bank loans to create tradeable bonds – started in the mortgage industry in the 1970s, when Government Sponsored Enterprises (GSEs) began to pool relatively safe, conventional, "conforming" or "prime" mortgages, create "mortgage-backed securities" (MBS) from the pool, sell them to investors, guaranteeing these securities/bonds against default on the underlying mortgages.^[26][144] This "originate-to-distribute" model had advantages over the old "originate-to-hold" model,^[145] where a bank originated a loan to the borrower/homeowner and retained the credit (default) risk. Securitization removed the loans from a bank's books, enabling the bank to remain in compliance with capital requirement laws. More loans could be made with proceeds of the MBS sale. The liquidity of a national and even international mortgage market allowed capital to flow where mortgages were in demand and funding short. However, securitization created a moral hazard – the bank/institution making the loan no longer had to worry if the mortgage was paid off^[146] – giving them incentive to process mortgage transactions but not to ensure their credit quality.^[147][148] Bankers were no longer around to work out borrower problems and minimize defaults during the course of the mortgage.^[149]

With the high down payments and credit scores of the conforming mortgages used by GSE, this danger was minimal.^[150] Investment banks however, wanted to enter the market and avoid competing with the GSEs.^[146] They did so by developing mortgage-backed securities in the riskier non-conforming subprime and Alt-A market. Unlike the GSEs^[151] the issuers generally did not guarantee the securities against default of the underlying mortgages.^[26]

What these "private label" or "non-agency" originators did do was to use "structured finance" to create securities. Structuring involved "slicing" the pooled mortgages into "tranches", each having a different priority in the monthly or quarterly principal and interest stream.^[9][152] Tranches were compared to "buckets" catching the "water" of principal and interest. More senior buckets did not share water with those below until they were filled to the brim and overflowing.^[153] This gave the top buckets/tranches considerable creditworthiness (in theory) that would earn the highest "triple A" credit ratings, making them salable to money market and pension funds that would not otherwise deal with subprime mortgage securities.

To use up the MBS tranches lower in payback priority that could not be rated triple-A and that a conservative fixed income market would not buy, investment banks developed another security – known as the collateralized debt obligation (CDO). Although the CDO market was smaller, it was crucial because unless buyers were found for the non-triple-A or "mezzanine" tranches, it would not be profitable to make a mortgage-backed security in the first place.^[154][155] These CDOs pooled the leftover BBB, A−, etc. rated tranches, and produced new tranches – 70%^[156] to 80%^[157] of which were rated triple A by rating agencies. The 20–30% remaining mezzanine tranches were sometimes bought up by other CDOs, to make so-called "CDO-Squared" securities which also produced tranches rated mostly triple A.^[158]

This process was later disparaged as "ratings laundering"^[159] or a way of transforming "dross into gold"^[160] by some business journalists, but was justified at the time by the belief that home prices would always rise.^[161][162] The model used by underwriters, rating agencies and investors to estimate the probability of mortgage default was based on the history of credit default swaps, which unfortunately went back "less than a decade, a period when house prices soared".^[163]

In addition the model – which postulated that the correlation of default risks among loans in securitization pools could be measured in a simple, stable, tractable number, suitable for risk management or valuation^[163] – also purported to show that the mortgages in CDO pools were well diversified or "uncorrelated". Defaults on mortgages in Orlando, for example, were thought to have no effect on – i.e. were uncorrelated with – the real estate market across the country in Laguna Beach. When prices corrected (i.e. the bubble collapsed), the resulting defaults were not only larger in number than predicted but far more correlated.^[163]

Still another innovative security criticized after the bubble burst was the synthetic CDO. Cheaper and easier to create than original "cash" CDOs, synthetics did not provide funding for housing, rather synthetic CDO-buying investors were in effect providing insurance (in the form of "credit default swaps") against mortgage default. The mortgages they insured were those in "cash" CDOs the synthetics "referenced". So instead of providing investors with interest and principal payments from MBS tranches, payments were the equivalent of insurance premiums from the insurance "buyers".^[164] If the referenced CDOs defaulted, investors lost their investment, which was paid out to the insurance buyers.^[165]

Unlike true insurance, credit default swaps were not regulated to insure that providers had the reserves to pay settlements, or that buyers owned the property (MBSs) they were insuring, i.e. were not simply making a bet a security would default.^[166] Because synthetics "referenced" another (cash) CDO, more than one – in fact numerous – synthetics could be made to reference the same original, multiplying the effect if a referenced security defaulted.^[167][168] As with MBS and other CDOs, triple A ratings for "large chunks"^[169] of synthetics were crucial to the securities' success, because of the buyer/investors' ignorance of the mortgage security market and trust in the credit rating agencies ratings.^[170]

Securitization began to take off in the mid-1990s. The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion. The securitized share of subprime mortgages (i.e., those passed to third-party investors via MBS) increased from 54% in 2001, to 75% in 2006.^[96] In the mid-2000s as the housing market was peaking, GSE securitization market share declined dramatically, while higher-risk subprime and Alt-A mortgage private label securitization grew sharply.^[26] As mortgage defaults began to rise, it was among mortgages securitized by the private banks. GSE mortgages – securitized or not – continued to perform better than the rest of the market.^[26][171] Picking up the slack for the dwindling cash CDO market^[172] synthetics were the dominant form of CDO's by 2006,^[173] valued "notionally"^[174] at an estimated $5 trillion.^[173]

By the autumn of 2008, when the securitization market "seized up" and investors would "no longer lend at any price", securitized lending made up about $10 trillion of the roughly $25 trillion American credit market, (i.e. what "American homeowners, consumers, and corporations owed").^[139][140] In February 2009, Ben Bernanke stated that securitization markets remained effectively shut, with the exception of conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.^[175]

According to economist A. Michael Spence: "when formerly uncorrelated risks shift and become highly correlated ... diversification models fail." "An important challenge going forward is to better understand these dynamics as the analytical underpinning of an early warning system with respect to financial instability."^[176]

Criticizing the argument that complex structured investment securitization was instrumental in the mortgage crisis, Paul Krugman points out that the Wall Street firms issuing the securities "kept the riskiest assets on their own books", and that neither of the equally disastrous bubbles in European housing or US commercial property used complex structured securities. Krugman does agree that it is "arguable is that financial innovation ... spread the bust to financial institutions around the world" and its inherent fragmentation of loans has made post-bubble "cleanup" through debt renegotiation extremely difficult.^[136]

Financial institution debt levels and incentives

The Financial Crisis Inquiry Commission reported in January 2011 that: "From 1978 to 2007, the amount of debt held by the financial sector soared from $3 trillion to $36 trillion, more than doubling as a share of gross domestic product. The very nature of many Wall Street firms changed – from relatively staid private partnerships to publicly traded corporations taking greater and more diverse kinds of risks. By 2005, the 10 largest U.S. commercial banks held 55% of the industry's assets, more than double the level held in 1990. On the eve of the crisis in 2006, financial sector profits constituted 27% of all corporate profits in the United States, up from 15% in 1980."^[2]

Many financial institutions, investment banks in particular, issued large amounts of debt during 2004–07, and invested the proceeds in mortgage-backed securities (MBS), essentially betting that house prices would continue to rise, and that households would continue to make their mortgage payments. Borrowing at a lower interest rate and investing the proceeds at a higher interest rate is a form of financial leverage. This is analogous to an individual taking out a second mortgage on his residence to invest in the stock market. This strategy proved profitable during the housing boom, but resulted in large losses when house prices began to decline and mortgages began to default. Beginning in 2007, financial institutions and individual investors holding MBS also suffered significant losses from mortgage payment defaults and the resulting decline in the value of MBS.^[177]

A 2004 U.S. Securities and Exchange Commission (SEC) decision related to the net capital rule allowed US investment banks to issue substantially more debt, which was then used to purchase MBS. Over 2004–07, the top five US investment banks each significantly increased their financial leverage (see diagram), which increased their vulnerability to the declining value of MBSs. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of US nominal GDP for 2007. Further, the percentage of subprime mortgages originated to total originations increased from below 10% in 2001–03 to between 18–20% from 2004 to 2006, due in-part to financing from investment banks.^[111][112]

During 2008, three of the largest U.S. investment banks either went bankrupt (Lehman Brothers) or were sold at fire sale prices to other banks (Bear Stearns and Merrill Lynch). These failures augmented the instability in the global financial system. The remaining two investment banks, Morgan Stanley and Goldman Sachs, opted to become commercial banks, thereby subjecting themselves to more stringent regulation.^[178][179]

In the years leading up to the crisis, the top four U.S. depository banks moved an estimated $5.2 trillion in assets and liabilities off-balance sheet into special purpose vehicles or other entities in the shadow banking system. This enabled them to essentially bypass existing regulations regarding minimum capital ratios, thereby increasing leverage and profits during the boom but increasing losses during the crisis. New accounting guidance will require them to put some of these assets back onto their books during 2009, which will significantly reduce their capital ratios. One news agency estimated this amount to be between $500 billion and $1 trillion. This effect was considered as part of the stress tests performed by the government during 2009.^[180]

Martin Wolf wrote in June 2009: "...an enormous part of what banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives and the 'shadow banking system' itself – was to find a way round regulation."^[181]

The New York State Comptroller's Office has said that in 2006, Wall Street executives took home bonuses totaling $23.9 billion (~$34.8 billion in 2023). "Wall Street traders were thinking of the bonus at the end of the year, not the long-term health of their firm. The whole system – from mortgage brokers to Wall Street risk managers – seemed tilted toward taking short-term risks while ignoring long-term obligations. The most damning evidence is that most of the people at the top of the banks didn't really understand how those [investments] worked."^[58][182]

The incentive compensation of traders was focused on fees generated from assembling financial products, rather than the performance of those products and profits generated over time. Their bonuses were heavily skewed towards cash rather than stock and not subject to "claw-back" (recovery of the bonus from the employee by the firm) in the event the MBS or CDO created did not perform. In addition, the increased risk (in the form of financial leverage) taken by the major investment banks was not adequately factored into the compensation of senior executives.^[183]

Credit default swaps

Credit default swaps (CDS) are financial instruments used as a hedge and protection for debtholders, in particular MBS investors, from the risk of default, or by speculators to profit from default. As the net worth of banks and other financial institutions deteriorated because of losses related to subprime mortgages, the likelihood increased that those providing the protection would have to pay their counterparties. This created uncertainty across the system, as investors wondered which companies would be required to pay to cover mortgage defaults.

Like all swaps and other financial derivatives, CDS may either be used to hedge risks (specifically, to insure creditors against default) or to profit from speculation. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion.^[184]: 73 CDS are lightly regulated, largely because of the Commodity Futures Modernization Act of 2000. As of 2008, there was no central clearing house to honor CDS in the event a party to a CDS proved unable to perform his obligations under the CDS contract. Required disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as American International Group (AIG), MBIA, and Ambac faced ratings downgrades because widespread mortgage defaults increased their potential exposure to CDS losses. These firms had to obtain additional funds (capital) to offset this exposure. AIG's having CDSs insuring $440 billion of MBS resulted in its seeking and obtaining a Federal government bailout.^[185] The monoline insurance companies went out of business in 2008–2009.

When investment bank Lehman Brothers went bankrupt in September 2008, there was much uncertainty as to which financial firms would be required to honor the CDS contracts on its $600 billion (~$834 billion in 2023) of bonds outstanding.^[186][187] Merrill Lynch's large losses in 2008 were attributed in part to the drop in value of its unhedged portfolio of collateralized debt obligations (CDOs) after AIG ceased offering CDS on Merrill's CDOs. The loss of confidence of trading partners in Merrill Lynch's solvency and its ability to refinance its short-term debt led to its acquisition by the Bank of America.^[188][189]

Economist Joseph Stiglitz summarized how credit default swaps contributed to the systemic meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets froze."^[190]

Author Michael Lewis wrote that CDS enabled speculators to stack bets on the same mortgage bonds and CDO's. This is analogous to allowing many persons to buy insurance on the same house. Speculators that bought CDS insurance were betting that significant defaults would occur, while the sellers (such as AIG) bet they would not. A theoretically infinite amount could be wagered on the same housing-related securities, provided buyers and sellers of the CDS could be found.^[191]

Derivatives such as CDS were unregulated or barely regulated. Several sources have noted the failure of the US government to supervise or even require transparency of the financial instruments known as derivatives.^{[192][193][194]} A 2008 investigative article in The Washington Post found that leading government officials at the time (Federal Reserve Board Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and SEC Chairman Arthur Levitt) vehemently opposed any regulation of derivatives. In 1998 Brooksley E. Born, head of the Commodity Futures Trading Commission, put forth a policy paper asking for feedback from regulators, lobbyists, legislators on the question of whether derivatives should be reported, sold through a central facility, or whether capital requirements should be required of their buyers. Greenspan, Rubin, and Levitt pressured her to withdraw the paper and Greenspan persuaded Congress to pass a resolution preventing CFTC from regulating derivatives for another six months – when Born's term of office would expire.^[193] Ultimately, it was the collapse of a specific kind of derivative, the mortgage-backed security, that triggered the economic crisis of 2008.^[194]

In addition, Chicago Public Radio, Huffington Post, and ProPublica reported in April 2010 that market participants, including a hedge fund called Magnetar Capital, encouraged the creation of CDO's containing low quality mortgages, so they could bet against them using CDS. NPR reported that Magnetar encouraged investors to purchase CDO's while simultaneously betting against them, without disclosing the latter bet.^{[168][195][196]} Instruments called synthetic CDO, which are portfolios of credit default swaps, were also involved in allegations by the SEC against Goldman-Sachs in April 2010.^[197]

The Financial Crisis Inquiry Commission reported in January 2011 that CDS contributed significantly to the crisis. Companies were able to sell protection to investors against the default of mortgage-backed securities, helping to launch and expand the market for new, complex instruments such as CDO's. This further fueled the housing bubble. They also amplified the losses from the collapse of the housing bubble by allowing multiple bets on the same securities and helped spread these bets throughout the financial system. Companies selling protection, such as AIG, were not required to set aside sufficient capital to cover their obligations when significant defaults occurred. Because many CDS were not traded on exchanges, the obligations of key financial institutions became hard to measure, creating uncertainty in the financial system.^[2]

Inaccurate credit ratings

Credit rating agencies – firms which rate debt instruments/securities according to the debtor's ability to pay lenders back – have come under scrutiny during and after the financial crisis for having given investment-grade ratings to MBSs and CDOs based on risky subprime mortgage loans that later defaulted. Dozens of lawsuits have been filed by investors against the "Big Three" rating agencies – Moody's Investors Service, Standard & Poor's and Fitch Ratings.^[198] The Financial Crisis Inquiry Commission (FCIC)^[199] concluded the "failures" of the Big Three rating agencies were "essential cogs in the wheel of financial destruction" and "key enablers of the financial meltdown".^[2] Economist Joseph Stiglitz called them "one of the key culprits" of the financial crisis.^[200] Others called their ratings "catastrophically misleading", (the U.S. Securities and Exchange Commissioner^[201]), their performance "horrendous" (The Economist magazine^[202]). There are indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty.^[203][204]

The position of the three agencies "between the issuers and the investors of securities"^[205] "transformed" them into "key" players in the housing bubble and financial crisis according to the Financial Crisis Inquiry Report. Most investors in the fixed income market had no experience with the mortgage business – let alone dealing with the complexity of pools of mortgages and tranche priority of MBS and CDO securities – and were simply looking for an independent party who could rate securities.^[206] The putatively independent parties meanwhile were paid "handsome fees" by investment banks "to obtain the desired ratings", according to one expert.^[206]

In addition, a large section of the debt securities market – many money markets and pension funds – were restricted in their bylaws to holding only the safest securities – i.e securities the rating agencies designated "triple-A". Hence non-prime securities could not be sold without ratings by (usually two of) the three agencies.^[207]

From 2000 to 2007, one of the largest agencies – Moody's – rated nearly 45,000 mortgage-related securities^[208] – more than half of those it rated – as triple-A.^[209] By December 2008, there were over $11 (~$15.00 in 2023) trillion structured finance securities outstanding in the U.S. bond market debt.^[208] But as the boom matured, mortgage underwriting standards deteriorated. By 2007 an estimated $3.2 (~$4.53 trillion in 2023) trillion in loans were made to homebuyers and owners with bad credit and undocumented incomes, bundled into MBSs and CDOs, and given top ratings^[210] to appeal to global investors.

As these mortgages began to default, the three agencies were compelled to go back and redo their ratings. Between autumn of 2007 and the middle of 2008, agencies downgraded nearly $2 trillion in MBS tranches.^[211] By the end of 2008, 80% of the CDOs by value^[212] rated "triple-A" were downgraded to junk.^[213] Bank writedowns and losses on these investments totaled $523 billion.^{[210][214][215]}

Critics such as the FCIC argue the mistaken credit ratings stemmed from "flawed computer models, the pressure from financial firms that paid for the ratings, the relentless drive for market share, the lack of resources to do the job despite record profits, and the absence of meaningful public oversight".^[2]

Structured investment was very profitable to the agencies and by 2007 accounted for just under half of Moody's total ratings revenue and all of the revenue growth.^[216] But profits were not guaranteed, and issuers played the agencies off one another, 'shopping' around to find the best ratings, sometimes openly threatening to cut off business after insufficiently generous ratings.^[217] Thus there was a conflict of interest between accommodating clients – for whom higher ratings meant higher earnings – and accurately rating the debt for the benefit of the debt buyer/investors – who provided zero revenue to the agencies.^[218]

Despite the profitability of the three big credit agencies – Moody's operating margins were consistently over 50%, higher than famously successful ExxonMobil or Microsoft^[219] – salaries and bonuses for non-management were significantly lower than at Wall Street banks, and its employees complained of overwork.

This incentivized agency rating analysts to seek employment at those Wall Street banks who were issuing mortgage securities, and who were particularly interested in the analysts' knowledge of what criteria their former employers used to rate securities.^[220][221] Inside knowledge of interest to security issuers eager to find loopholes included the fact that rating agencies looked at the average credit score of a pool of borrowers, but not how dispersed it was; that agencies ignored borrower's household income or length of credit history (explaining the large numbers of low income immigrants given mortgages—people "who had never failed to repay a debt, because they had never been given a loan"); that agencies were indifferent to credit worthiness issues of adjustable-rate mortgages with low teaser rates, "silent second" mortgages, or no-documentation mortgages.^[222]

As of 2010, virtually all of the investigations of rating agencies, criminal as well as civil, are in their early stages.^[223] In New York, state prosecutors are examining whether eight banks^[224] duped the credit ratings agencies into inflating the grades of subprime-linked investments.^[225] In the dozens of suits filed against them by investors involving claims of inaccurate ratings^[198] the rating agencies have defended themselves using the First Amendment defense—that a credit rating is an opinion protected as free speech.^[226] In 2013, McClatchy Newspapers found that "little competition has emerged" since the Credit Rating Agency Reform Act of 2006 was passed "in rating the kinds of complex home-mortgage securities whose implosion led to the 2007 financial crisis". The Big Three's market share of outstanding credit rating has barely shrunk, moving from 98% to 97%.^[227]

Decreased regulation of financial institutions

Several steps were taken to deregulate banking institutions in the years leading up to the crisis. Further, major investment banks which collapsed during the crisis were not subject to the regulations applied to depository banks. In testimony before Congress both the Securities and Exchange Commission (SEC) and Alan Greenspan claimed failure in allowing the self-regulation of investment banks.^[230][231]

In 1982, Congress passed the Alternative Mortgage Transactions Parity Act (AMTPA), which allowed non-federally chartered housing creditors to write adjustable-rate mortgages. This bi-partisan legislation was, according to the Urban Institute, intended to "increase the volume of loan products that reduced the up-front costs to borrowers in order to make homeownership more affordable."^[232] Among the new mortgage loan types created and gaining in popularity in the early 1980s were adjustable-rate, option adjustable-rate, balloon-payment and interest-only mortgages. Subsequent widespread abuses of predatory lending occurred with the use of adjustable-rate mortgages.^[34][233] Approximately 90% of subprime mortgages issued in 2006 were adjustable-rate mortgages.^[12]

The Glass–Steagall Act was enacted after the Great Depression. It separated commercial banks and investment banks, in part to avoid potential conflicts of interest between the lending activities of the former and rating activities of the latter. In 1999 Glass–Steagall was repealed by the Gramm-Leach-Bliley Act. Economist Joseph Stiglitz criticized the repeal of Glass–Steagall because, in his opinion, it enabled the risk-taking culture of investment banking to dominate the more conservative commercial banking culture, leading to increased levels of risk-taking and leverage during the boom period.^[234] President Bill Clinton, who signed the legislation, dismissed its connection to the subprime mortgage crisis, stating (in 2008): "I don't see that signing that bill had anything to do with the current crisis."^[235]

The Commodity Futures Modernization Act of 2000 was bi-partisan legislation that formally exempted derivatives from regulation, supervision, trading on established exchanges, and capital reserve requirements for major participants. It "provided a legal safe harbor for treatment already in effect."^[236] Concerns that counterparties to derivative deals would be unable to pay their obligations caused pervasive uncertainty during the crisis. Particularly relevant to the crisis are credit default swaps (CDS), a derivative in which Party A pays Party B what is essentially an insurance premium, in exchange for payment should Party C default on its obligations. Warren Buffett famously referred to derivatives as "financial weapons of mass destruction" in early 2003.^[237][238]

Former Fed Chair Alan Greenspan, who many economists blamed for the financial crisis, testified in October 2008 that he had trusted free markets to self-correct and had not anticipated the risk of reduced lending standards."Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief."^[229]

Some analysts believe the subprime mortgage crisis was due, in part, to a 2004 decision of the SEC that affected 5 large investment banks. The critics believe that changes in the capital reserve calculation rules enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages. These banks dramatically increased their risk taking from 2003 to 2007. By the end of 2007, the largest five U.S. investment banks had over $4 (~$5.66 trillion in 2023) trillion in debt with high ratios of debt to equity, meaning only a small decline in the value of their assets would render them insolvent.^[239][240] However, in an April 9, 2009, speech, Erik Sirri, then director of the SEC's Division of Trading and Markets, argued that the regulatory weaknesses in leverage restrictions originated in the late 1970s: "The Commission did not undo any leverage restrictions in 2004," nor did it intend to make a substantial reduction.^[241]

The financial sector invested heavily to gain clout in the halls of government to bring about these major deregulatory objectives: it spent more than $5 billion over a decade to strengthen its political clout in Washington, DC, including $1.725 billion in political campaign contributions and $3.4 billion on Industry lobbyists during the years 1998-2008.^[242]

Policies to promote private ownership of housing

Several administrations, both Democratic and Republican, advocated private home ownership in the years leading up to the crisis. The Housing and Community Development Act of 1992 established, for the first time, a mandate to Fannie Mae and Freddie Mac for loans to enable home ownership of less expensive housing, a mandate to be regulated by the Department of Housing and Urban Development (HUD). Initially, the 1992 legislation required that 30% or more of Fannie's and Freddie's loan purchases be in support of private home ownership of affordable housing. However, HUD was given the power to set future requirements. During the later part of the Clinton Administration, HUD Secretary Andrew Cuomo announced "new regulations to provide $2.4 trillion in mortgages for affordable housing for 28.1 million families, which increased the required percentage of mortgage loans for low- and moderate-income families that finance companies Fannie Mae and Freddie Mac must buy annually from the then current 42% of their total purchases to a new high of 50%.^[243] Eventually (under the Bush Administration) a 56% minimum was established.^[244] Additionally, in 2003, "The Bush administration today recommended the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis a decade ago."^[245]

"The National Homeownership Strategy: Partners in the American Dream", was compiled in 1995 by Henry Cisneros, President Clinton's HUD Secretary. This 100-page document represented the viewpoints of HUD, Fannie Mae, Freddie Mac, leaders of the housing industry, various banks, numerous activist organizations such as ACORN and La Raza, and representatives from several state and local governments."^[246] In 2001, the independent research company, Graham Fisher & Company, stated: "While the underlying initiatives of the [strategy] were broad in content, the main theme … was the relaxation of credit standards."^[247]

The Financial Crisis Inquiry Commission (majority report), Federal Reserve economists, and several academic researchers have stated that government affordable housing policies were not the major cause of the financial crisis.^[26][114] They also state that Community Reinvestment Act loans outperformed other "subprime" mortgages, and GSE mortgages performed better than private label securitizations.

State and local governmental programs

As part of the 1995 National Homeownership Strategy, HUD advocated greater involvement of state and local organizations in the promotion of affordable housing.^[254] In addition, it promoted the use of low or no-down payment loans and second, unsecured loans to the borrower to pay their down payments (if any) and closing costs.^[255] This idea manifested itself in "silent second" loans that became extremely popular in several states such as California, and in scores of cities such as San Francisco.^[256] Using federal funds and their own funds, these states and cities offered borrowers loans that would defray the cost of the down payment. The loans were called "silent" because the primary lender was not supposed to know about them. A Neighborhood Reinvestment Corporation (affiliated with HUD) publicity sheet explicitly described the desired secrecy: "[The NRC affiliates] hold the second mortgages. Instead of going to the family, the monthly voucher is paid to [the NRC affiliates]. In this way the voucher is "invisible" to the traditional lender and the family (emphasis added)^[257]

Policies of central banks

Central banks manage monetary policy and may target the rate of inflation. They have some authority over commercial banks and possibly other financial institutions. They are less concerned with avoiding asset price bubbles, such as the housing bubble and dot-com bubble. Central banks have generally chosen to react after such bubbles burst so as to minimize collateral damage to the economy, rather than trying to prevent or stop the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to deflate it are matters of debate among economists.^[283][284]

Some market observers have been concerned that Federal Reserve actions could give rise to moral hazard.^[36] A Government Accountability Office critic said that the Federal Reserve Bank of New York's rescue of Long-Term Capital Management in 1998 would encourage large financial institutions to believe that the Federal Reserve would intervene on their behalf if risky loans went sour because they were "too big to fail."^[285]

A contributing factor to the rise in house prices was the Federal Reserve's lowering of interest rates early in the decade. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%.^[286] This was done to soften the effects of the collapse of the dot-com bubble and of the September 2001 terrorist attacks, and to combat the perceived risk of deflation.^[283]

The Fed believed that interest rates could be lowered safely primarily because the rate of inflation was low; it disregarded other important factors. According to Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas, the Fed's interest rate policy during the early 2000s (decade) was misguided, because measured inflation in those years was below true inflation, which led to a monetary policy that contributed to the housing bubble.^[287]

Ben Bernanke and Alan Greenspan — both former chairmen of the Federal Reserve — disagree, arguing decisions on purchasing a home depends on long-term interest rates on mortgages not the short-term rates controlled by the Fed. According to Greenspan, "between 1971 and 2002, the fed funds rate and the mortgage rate moved in lock-step," but when the Fed started to raise rates in 2004,^{[288][289][290]} mortgage rates diverged, continuing to fall (or at least not rise) for another year (see "Fed Funds Rate & Mortgage Rates" graph). Construction of new homes did not peak until January 2006.^[291] Bernanke speculates that a world wide "saving glut" pushed capital or savings into the United States, keeping long-term interest rates low and independent of Central Bank action.^[292]

Agreeing with Fisher that the low interest rate policy of the Greenspan Fed both allowed and motivated investors to seek out risk investments offering higher returns, is finance economist Raghuram Rajan who argues that the underlying causes of the American economy's tendency to go "from bubble to bubble" fueled by unsustainable monetary stimulation, are the "weak safety nets" for the unemployed, which made "the US political system ... acutely sensitive to job growth";^[293] and attempts to compensate for the stagnant income of the middle and lower classes with easy credit to boost their consumption.^[294]

Economist Thomas Sowell wrote that the Fed's decision to steadily raise interest rates was a key factor that ended the housing bubble. The Fed raised rates from the unusually low level of 1% in 2004 to a more typical 5.25% in 2006. By driving mortgage rates higher, the Fed "made monthly mortgage payments more expensive and therefore reduced the demand for housing." He referred to the Fed action as the "nudge" that collapsed the "house of cards" created by lax lending standards, affordable housing policies, and the preceding period of low interest rates.^[49]

Mark-to-market accounting rule

Former Federal Deposit Insurance Corporation Chair William Isaac placed much of the blame for the subprime mortgage crisis on the Securities and Exchange Commission and its fair-value accounting rules, especially the requirement for banks to mark their assets to market, particularly mortgage-backed securities.^[295] Whether or not this is true has been the subject of ongoing debate.^[296][297]

The debate arises because this accounting rule requires companies to adjust the value of marketable securities (such as the mortgage-backed securities (MBS) at the center of the crisis) to their market value. The intent of the standard is to help investors understand the value of these assets at a point in time, rather than just their historical purchase price. Because the market for these assets is distressed, it is difficult to sell many MBS at other than prices which may (or may not) be reflective of market stresses, which may be below the value that the mortgage cash flow related to the MBS would merit. As initially interpreted by companies and their auditors, the typically lower sale value was used as the market value rather than the cash flow value. Many large financial institutions recognized significant losses during 2007 and 2008 as a result of marking-down MBS asset prices to market value.^[298]

Globalization, technology and the trade deficit

In 2005, Ben Bernanke addressed the implications of the United States's high and rising current account deficit, resulting from U.S. investment exceeding its savings, or imports exceeding exports.^[299] Between 1996 and 2004, the U.S. current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. The U.S. attracted a great deal of foreign investment, mainly from the emerging economies in Asia and oil-exporting nations. The balance of payments identity requires that a country (such as the U.S.) running a current account deficit also have a capital account (investment) surplus of the same amount. Foreign investors had these funds to lend, either because they had very high personal savings rates (as high as 40% in China), or because of high oil prices.

Bernanke referred to this as a "saving glut"^[292] that may have pushed capital into the United States, a view differing from that of some other economists, who view such capital as having been pulled into the U.S. by its high consumption levels. In other words, a nation cannot consume more than its income unless it sells assets to foreigners, or foreigners are willing to lend to it. Alternatively, if a nation wishes to increase domestic investment in plant and equipment, it will also increase its level of imports to maintain balance if it has a floating exchange rate.

Regardless of the push or pull view, a "flood" of funds (capital or liquidity) reached the U.S. financial market. Foreign governments supplied funds by purchasing U.S. Treasury bonds and thus avoided much of the direct impact of the crisis. American households, on the other hand, used funds borrowed from foreigners to finance consumption or to bid up the prices of housing and financial assets. Financial institutions invested foreign funds in mortgage-backed securities. American housing and financial assets dramatically declined in value after the housing bubble burst.^[300][301]

Economist Joseph Stiglitz wrote in October 2011 that the recession and high unemployment of the 2009–2011 period was years in the making and driven by: unsustainable consumption; high manufacturing productivity outpacing demand thereby increasing unemployment; income inequality that shifted income from those who tended to spend it (i.e., the middle class) to those who do not (i.e., the wealthy); and emerging market's buildup of reserves (to the tune of $7.6 trillion by 2011) which was not spent. These factors all led to a "massive" shortfall in aggregate demand, which was "papered over" by demand related to the housing bubble until it burst.^[302]

Savings surplus or investment deficit

During the crisis and ensuing recession, U.S. consumers increased their savings as they paid down debt ("deleveraged") but corporations simultaneously were reducing their investment. In a healthy economy, private sector savings placed into the banking system is borrowed and invested by companies. This investment is one of the major components of GDP. A private sector financial deficit from 2004 to 2008 transitioned to a large surplus of savings over investment that exceeded $1 trillion by early 2009 and remained above $800 billion as of September 2012. Part of this investment reduction related to the housing market, a major component of investment in the GDP computation. This surplus explains how even significant government deficit spending would not increase interest rates and how Federal Reserve action to increase the money supply does not result in inflation, because the economy is awash with savings with no place to go.^[355]

Economist Richard Koo described similar effects for several of the developed world economies in December 2011:

Today private sectors in the U.S., the U.K., Spain, and Ireland (but not Greece) are undergoing massive deleveraging in spite of record low interest rates. This means these countries are all in serious balance sheet recessions. The private sectors in Japan and Germany are not borrowing, either. With borrowers disappearing and banks reluctant to lend, it is no wonder that, after nearly three years of record low interest rates and massive liquidity injections, industrial economies are still doing so poorly. Flow of funds data for the U.S. show a massive shift away from borrowing to savings by the private sector since the housing bubble burst in 2007. The shift for the private sector as a whole represents over 9 percent of U.S. GDP at a time of zero interest rates. Moreover, this increase in private sector savings exceeds the increase in government borrowings (5.8 percent of GDP), which suggests that the government is not doing enough to offset private sector deleveraging.^[356]

Sectoral financial balances

Economist Wynne Godley explained in 2004–2005 how U.S. sector imbalances posed a significant risk to the U.S. and global economy. The combination of a high and growing foreign sector surplus and high government sector deficit meant that the private sector was moving towards a net borrowing position (from surplus to deficit) as a housing bubble developed, which he warned was an unsustainable combination.^[357][358]

Economist Martin Wolf explained in July 2012 that government fiscal balance is one of three major financial sectoral balances in the U.S. economy, the others being the foreign financial sector and the private financial sector. The sum of the surpluses or deficits across these three sectors must be zero by definition. In the U.S., a foreign financial surplus (or capital surplus) exists because capital is imported (net) to fund the trade deficit. Further, there is a private sector financial surplus due to household savings exceeding business investment. By definition, there must therefore exist a government budget deficit so all three net to zero. The government sector includes federal, state and local. For example, the government budget deficit in 2011 was approximately 10% GDP (8.6% GDP of which was federal), offsetting a capital surplus of 4% GDP and a private sector surplus of 6% GDP.^[333]

Wolf argued that the sudden shift in the private sector from deficit to surplus forced the government balance into deficit, writing: "The financial balance of the private sector shifted towards surplus by the almost unbelievable cumulative total of 11.2 per cent of gross domestic product between the third quarter of 2007 and the second quarter of 2009, which was when the financial deficit of US government (federal and state) reached its peak...No fiscal policy changes explain the collapse into massive fiscal deficit between 2007 and 2009, because there was none of any importance. The collapse is explained by the massive shift of the private sector from financial deficit into surplus or, in other words, from boom to bust."^[333]

Homeowners Affordability and Stability Plan

On February 18, 2009, U.S. President Barack Obama announced a $73 billion program to help up to nine million homeowners avoid foreclosure, which was supplemented by $200 billion in additional funding for Fannie Mae and Freddie Mac to purchase and more easily refinance mortgages. The plan is funded mostly from the EESA's $700 billion financial bailout fund. It uses cost sharing and incentives to encourage lenders to reduce homeowner's monthly payments to 31% of their monthly income. Under the program, a lender would be responsible for reducing monthly payments to no more than 38% of a borrower's income, with government sharing the cost to further cut the rate to 31%. The plan also involves forgiving a portion of the borrower's mortgage balance. Companies that service mortgages will get incentives to modify loans and to help the homeowner stay current.^{[411][412][413]}