How Politicians and Regulators Caused the Sub-Prime Financial Crisis of 2007 and the Subsequent Crash of the Global Financial System in 2008, and Likely Will Again

This is a summary of a working paper available at the links for which comments are welcome. (A later post on related topics appears here.)

Download the paper (1 MB pdf).

That the US financial system crashed and almost collapsed in 2008, causing a globally systemic financial crisis and precipitating a global recession is accepted fact. That US sub-prime lending funded the excess housing demand leading to a bubble in housing prices is also generally accepted. That extremely imprudent risks funded with unprecedented levels of financial leverage caused the failures that precipitated the global systemic crash is a central theme in most explanations. All of the various economic theories of why this happened, from the technicalities of security design (Gorton, 2009) to the failure of capitalism (Stiglitz, 2010) can be reduced to two competing hypotheses: a failure of market discipline or a failure of regulation and politics.

While still sifting through the wreckage and rebuilding the economy in mid July, 2010, the Congress passed the 2,315 page Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 to prevent a reoccurrence of this disaster. The disagreement in the debates regarding the appropriate policy prescription reflected the lack of a consensus on which of these two competing hypotheses to accept. The risk was that, following the precedent established in the Great Depression, politicians will blame markets and use the crisis to implement pre-collapse financial reform agendas and settle other old political scores. By having done just that, this Act  worsens future systemic risk.

That there was little or no market discipline is obvious. Contrary to the deregulation myths, regulation and politics had long since replaced market discipline in US home mortgage markets. Regulators didn’t just fail systemically to mitigate excessive risk and leverage, they induced it. This didn’t reflect a lack of regulatory authority or zeal, as politicians openly encouraged it.

The politically populist credit allocation goals that promoted risky mortgage lending, whether or not morally justifiable, are fundamentally in conflict with prudential regulation. The system of “pay-to-play” politically powerful government sponsored enterprises (GSEs) was a systemic disaster waiting to happen. The recent advent of the private securitization system built upon a foundation of risk-based capital rules and delegation of risk evaluation to private credit rating agencies and run by politically powerful too-big-to-fail (TBTF) government insured commercial banks and implicitly backed TBTF investment banks was a new disaster ripe to happen. Easy money and liquidity policies by the central bank in the wake of a global savings glut fueled a competition for borrowers between these two systems that populist credit policies steered to increasingly less-qualified home buyers. This combination created a perfect storm that produced a tsunami wave of sub-prime lending, transforming the housing boom of the first half decade to a highly speculative bubble. The bubble burst in mid-2007 and the wave crashed on US shores in the fall of 2008, reverberating throughout global financial markets and leaving economic wreckage in its wake. 

By the time the financial system finally collapsed bailouts and fiscal stimulus were likely necessary even as they risked permanently convincing markets that future policy will provide a safety net for even more risk and more leverage. Given this diagnosis, how to impose market and regulatory discipline before moral hazard behavior develops is the most important and problematic challenge of systemic financial reform.

The public policy prescription is simple and straightforward. Prudential regulation remains necessary so long as government sponsored deposit insurance is maintained, which seems inevitable. Prospectively the traditional regulatory challenge of promoting market competition and discipline while safeguarding safety and soundness remains paramount. But the prudential regulation of commercial banks needs to be de-politicized and re-invigorated, with greater reliance on market discipline where public regulation is most likely to fail due to inherent incentive conflicts. This means sound credit underwriting and more capital, including closing the off balance sheet loopholes typically employed by big banks and eliminating the incentives for regulatory arbitrage. Universal banking should remain, but divested of hedge fund and proprietary trading activity. In addition, firms that are “too big to fail” (TBTF) are probably too big to be effectively controlled by regulators and should either be broken up or otherwise prevented from engaging in risky financial activities by reducing or eliminating their political activities.

Most importantly, the two main sources of TBTF systemic risk and subsequent direct government bailout cost, Fannie Mae and Freddie Mac, no longer serve any essential market purpose. The excess investor demand for fixed income securities backed by fixed rate mortgages that fueled their early growth is long gone and now easily met by Ginnie Mae and Federal Home Loan Bank securities alone, as fixed nominal life and pension contracts have largely been replaced by performance and indexed plans. Fannie Mae and Freddie Mac should be unambiguously and expeditiously liquidated subsequent to implementing an adequate transition plan for mortgage markets.

Download the paper (1 MB pdf).


Kevin Villani is former SVP/acting CFO and Chief Economist at Freddie Mac and Deputy Assistant Secretary and Chief Economist at HUD, as well as a former economist with the Federal Reserve Bank of Cleveland. He was the first Wells Fargo Chaired Professor of Finance and Real Estate at USC. He has spent the past 25 years in the private sector, mostly at financial service firms involved in securitization. He is currently a consultant residing in La Jolla, Ca. He may be reached at kvillani at san dot rr dot com.

17 thoughts on “How Politicians and Regulators Caused the Sub-Prime Financial Crisis of 2007 and the Subsequent Crash of the Global Financial System in 2008, and Likely Will Again”

  1. A very substantial paper, more book length than paper length. Sent to my Kindle. I hope to look at it soon.

  2. There is one thing missing from this list of causations of the bubble and resulting crash…. and that is lack of discipline. It would not matter if Barney Frank himself came to offer my Grandfather a sub prime loan, he would not take it. It did not make financial sense. His children were also unlikely to take out such a loan or any kind of refinance, they might pause for a moment (unlike my grandfather) but would conclude it does not make sense. The grandchildren were another case, some of them would fall for the enticements and the great grandchildren fell easily as they did not understand the dangers having never experienced a deep recession let alone some part of a depression. When we look at the economic numbers from unemployment to real estate we are seeing numbers that haven’t been hit for 30, 40, even 60 years. It is very hard to understand the need for preparation for a major economic downturn if you have never experienced one and the closest place for warning was the stories about your father’s father. It is a natural impulse to blame the government or big business as the sole cause of our problems (I would love to blame the government) but we have a generational memory loss that brought on most of our problem. The problem with the new socialist tendency is that it prevents us from learning our lesson that might last us another 60 years or so. We could get another strong economic engine built after this pain has implanted badly needed education and we find a deep rooted determination to move forward with thrift, self reliance, and hard work. See these pics to remember


  3. I will read the paper but I hope it also emphasizes the moral hazard problem created by the bailout of the Mexican bonds when Rubin was Clintons Sec Treas. There is far too much coziness between Goldman Sachs and the White House under both administrations.

  4. I kinda agree with the second comment, although I suspect that ignorance played a role, too. Picking one example from a few years ago, the interest only mortgage, the only people I could see choosing that other than people who despised their relatives were people who honestly didn’t understand what would happen next. Frankly, I thought the interest only mortgage was a stupid idea, but apparently it was a hot commodity for a while.

  5. Of course, regulation is systemic risk.

    And, if certain banks are “too big to fail”, surely the US govt is as well.

  6. The beginning of a good dialogue and debate.

    Gee … too bad they didn’t think of having this discussion and analysis before they settled on FranknDodd.


    for several posts on this topic and a solution informed by reputation theory.

  7. So young Toby turns 21 and his uncle treats him to a trip to the tables. Toby hasn’t paid attention in school and besides history is boring and needs to be revised. Uncle Sam stacks Toby to $500,000 and Toby, try as he might to produce excellent returns on the investment … loses it all. But Uncle Sam gives him a cool $250,000 for trying and a job at the oversight department of the Savings and Loan Industry.

    So Toby turns 30 and his uncle treats him to a trip to the table. Toby now has an MBA, he has learned how to play this game. Uncle Sam gives him a cool million to “invest”. Toby is skilled at this. He has been trained in the latest theory on the New Economy. Try as he might the tables are better than him. Toby loses it all … again. But Uncle Sam gives him a cool $500,000 and a job at Fannie Mae.

    Now Toby is turning 40 and Uncle Sam gives Toby a cool Billion to play with…

    This is the story of our banking industry and Federal regularitory system over the last 40 years.

    Regulatory oversight? Not from these politicians or civil servants.
    Market Discipline? Why? If every time you get bailed out why be disciplined? For the last 60+ years we have avoided discipline and disciplining our kids.

  8. The housing bubble occurred worldwide. The US Congress was only capable of damaging the US market with their policies. Whatever happened to the economy was a worldwide phenomenon that the US was caught up in, worsened by but not caused by the US meltdown.

    I await a better explanation for what went wrong than has been offered here and elsewhere.

  9. Quite a bit of blame to go around. One of the worst elements to come out of this was the Negative Amortization loans. Also known as “pick a pay”, they allowed borrowers to choose between four payments. A full PITI payment amortized over 30 years; a full PITI payment amortized over 15 years; an interest only payment; and a “minimum” payment that was LESS than the interest, whereby the “difference” between the interest only and this “minimum” payment could be “borrowed” and placed on the back of the loan as an additional debt.

    The underwriting standards for qualifying borrowers were thrown out the window. Many were being qualified based on “Ninja” standards. (no income, no job, no assets)…where they “stated” their income and assets, without verification.

    The underwriting standards were virtually eliminated on these “stated” applications, thus allowing otherwise completely unqualified buyers to become “homeowners”.

    Not only did they often buy ONE home, but they also bought “second” homes or “investment” properties…with no money down, stated income, stated assets, neg am/pick a pay mortgages…in which they paid the “minimum” payments and “borrowed” throughout the entire “available” time to do so.

    This last sentence gives away the trick. The ‘teaser’ rates go away. The 1% minimum payment is not available forever. When the “borrowed” amount exceeds 125% of the home value for instance, the borrower must pay a fully amortized amount. Then, they would often owe 3-5 times as much each month…and they can’t afford the payment.

    The banks (Countrywide, WaMu, World Savings (Wachovia now)
    sold thousands and thousands of these loans.

    There is NOTHING that can help most of these folks. You can’t modify the loan to a level that helps them make affordable payments.

    The disappearing underwriting standards were a response to the mandated “anti-redline loan” requirements, forcing them to loan to targeted segments of the population who would not qualify under traditional underwriting. The lenders got creative in “complying” with the mandate, people snapped up loans that were destined to come crashing down on our heads and Barney Frank and Chris Dodd continued to say everything was fine with Fannie and Freddie. It wasn’t.

  10. to scott black: the housing bubble did not quite occur worldwide. the (mbs/cds) market occurred worldwide. when the securities were unable to trade on a market and therefore deemed worthless banks, companies and collateral was required to replace the devaluation of the worthless bonds. this sucked other capital out of the economy and caused lenders to restrict future lending. the explanation is quite accurate and based on a rational premise. if there is no market for something you want to sell, what is that objects price….or value?

  11. Literally none of this is new. This is an old conclusion backed up by old incomplete arguments and no hard data.

    Take Villani’s criticism of central banking, for example. Greenspan defended his policy by pointing out that from 2000 to 2005 (when the bubble emerged), the central bank raised its interest rates substantially. But mortgage interest rates didn’t budge. He argues (using, um, data) that after many years of tight correlation between the central bank’s interest rates and those on mortgages, monetary policy and the long-term interest rate “decoupled”. Greenspan blames the global savings glut for that decoupling. Villani does not show how that argument could be wrong–he just swears it is.

  12. Scott Black –
    The housing bubble was not a worldwide phenomenon, it occurred in the US. What did happen worldwide was this:

    – The subprime mortgages (to include the no-verification, so-called “liar’s mortgages) Countrywide and others wrote were sold to a profit-hungry Fannie and Freddie.
    – F&F in turn bundled the mortgages into securities that they over-rated. (Some of the smarter folks realized that over-rating was occurring, but they did not realize the magnitude of such until everything turned to poop.)
    – A whole host of characters worldwide — pension funds, governmental units, individuals — bought the “risk-free” (because of implicit US government guarantees) bundled securities because they were driven by a hunger for yield to meet their near- and long-term obligations.

    The worldwide problem was one of trust in the value of the security purchased. I suspect that all the shenanigans involved in propping up AIG and making good on loans to Deutsche Bank and others was merely a sort of hush money to keep the gorillas from suing to recover their losses while ignoring the larger amounts (in the aggregate) due Norwegian, Icelandic, and other holders of now worthless obligations from recovering their investments from the US Treasury.

  13. Your corporate overlords ran their “greed is good” fiasco into the ground. Anyone with a brain knows “greed is stupid”, it’s a useful response built into animals to exploit windfalls. As greed is stupid the results were too.

    Then they decided they were not going to bite their bullet and pay for their stupid actions and stiffed you with the bill.

    That’s what happened.

  14. It all flows from the notion that just because you’re poor is no reason you shouldn’t have a nice place to live, plenty of good food, an excellent education, professioal day-care, top-notch health care, ready transportation . . . as long as somebody else is paying for it.

    Can’t stop the problem until we stop that line of thinking.





  16. PenGun,

    Your corporate overlords ran their “greed is good” fiasco into the ground.

    Blaming financial or economic problems on “greed” is as stupid as blaming a building collapse on gravity. “Greed” is a human universal and constant. All systems have to be designed to take it into account. Anyone who sits up a system that will work just fine as long as no one gets “greedy” is an idiot.

    Every single one of us is “greedy” because greed has no meaningful definition. We call other people greedy when we think they got more than we personally think they should. That’s all it is. Somehow, we seldom see our own rewards as “greed”.

  17. The problem you had was as all indexes continued to rise there was no way to keep the party going without encouraging further … stupidity.

    The reason real estate was pushed so hard is that it was the last major source of money/debt for your unbelievably greedy financial oligarchs. Even though they knew, placed bets against, this would inevitably fail they took you off the cliff fully intending to bail themselves out. Pure stupid greed.

    You may not recover.

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