The Commission was established to examine the causes of the 2008 Great Recession—an economic crisis that gripped our country—and to explain its causes to the American people. The financial crisis of 2007 and 2008 was not a single event but a series of crises that rippled through the financial system and, ultimately, the economy. Distress in one area of the financial markets led to failures in other areas by way of interconnections and vulnerabilities that bankers, government officials, and others had missed or dismissed. Five of the primary causes of the economic crash as established by the Commission were as follows:
1. Consolidations and Concentrations in the Industry
From 1978 to 2007, the financial sector’s amount of debt soared from $3 trillion to $36 trillion. The very nature of many Wall Street firms changed—from relatively straight private partnerships to publicly traded corporations taking greater and more diverse kinds of risks. By 2005, the ten largest U.S. commercial banks held 55 percent of the industry’s assets, more than double the level held in 1990. As a result, two parallel financial systems of enormous scale emerged—shadow banks and commercial banks were codependent competitors. Their new activities were very profitable—and, it turned out, very, very risky.
The phenomenal growth of the shadow banking system freely operated in capital markets, still beyond the reach of the regulatory agencies that had been put in place in the wake of the crash of 1929 and the Great Depression.
Deregulation went beyond dismantling regulations; its supporters were also disinclined to adopt new regulations or challenge the industry on the risks of innovations. Federal Reserve officials argued that financial institutions, with strong incentives to protect shareholders, would regulate themselves by carefully managing their own risks. In a 2003 speech, Federal Reserve Vice Chairman Roger Ferguson praised “the truly impressive improvement in methods of risk measurement and management and the growing adoption of these technologies by mostly large banks and other financial intermediaries.”
3. Credit Expansion and Rapid Growth
By the end of the 2000s, the economy had grown 39 straight quarters. Federal Reserve Chairman Alan Greenspan boasted that the financial system had achieved unprecedented resilience. Large financial companies appeared to be profitable, diversified, and–executives and regulators agreed–protected from catastrophe by sophisticated new managing risk techniques.
The housing market was also strong. Between 1995 and 2000, prices rose at an annual rate of 5.2 percent. Then between 2005 and 2010, the rate hit 11.5 percent.
Lower interest rates for mortgage borrowers were partly the reason, as was greater access to mortgage credit for households who had traditionally been left out—subprime borrowers. This would also include other risky loans such as credit cards and auto loans.
Taylor, a Stanford economist and former Undersecretary of Treasury, blamed the crisis primarily on this action. If the Fed had followed its usual pattern, he told the FCIC, short-term interest rates would have been much higher, discouraging excessive investment in mortgages. “The boom in housing construction starts would have been much milder, might not even call it a boom, and the bust as well would have been mild,” Taylor said.
Loosening of Credit Terms
In May 2008, Fannie Mae introduced an overlay for mortgages with Debt to Income (DTI) ratios between 55 and 65 percent. Before 2003 alone, when lenders refinanced over 15 million mortgages, more than one in four was an unprecedented level. Lending standards collapsed, and there was a significant failure of accountability. Loans were often premised on ever-increasing home prices and were made regardless of ability to pay.
4. The Rise of Shadow Banking
During the 1990s, the shadow banking system steadily gained ground on the traditional banking sector—and briefly surpassed the banking sector after 2000. Investment bankers like Lehman Brothers and Bear Stearns were two of the more famed Non-Bank Financial Companies (NBFCs) at the center of the meltdown. Shadow banking proliferates for a reason: Free from the shackles of regulation, it gets money to where it’s needed. The chief obstacle, however, is controlling the greed.
As Yale economist Gary Gorton put it in his book, Misunderstanding Financial Crises: Why We Don’t See Them Coming, the 2008 financial crisis was triggered by a run on short-term bank debt, illiquidity in the commercial paper market, and a sudden lack of confidence in the money market mutual fund industry. All three are part and parcel of what is called the “shadow banking system,” which cannot depend on the safety net of either a lender of last resort like the Fed or regulatory agencies that can intervene to deal with the volatility of a run.
5. Securitization and Structured Finance Securities
Private securitizations, or structured finance securities, had two key benefits to investors: pooling and tranching. If many loans were pooled into one security, a few defaults would have minimal impact. Structured finance securities could also be sliced up and sold in portions, known as tranches. Securitization was designed to benefit lenders, investment bankers, and investors.
Lenders earned massive fees for originating and selling loans. Investment banks earned massive fees for issuing mortgage-backed securities. Securitization was not just a boon for commercial banks; it was also a lucrative new line of business for the Wall Street investment banks with which the commercial banks worked to create the new securities.
The Pipeline Necessary to Carry Out their Demand
The Commission concluded that the nonprime mortgage securitization process created a pipeline through which risky mortgages were conveyed and sold throughout the financial system. This pipeline was essential to the origination of the burgeoning numbers of high-risk mortgages.