What Caused The Crash: An Autopsy

Certainly, one of the crucial questions for an understanding of our financial system and its vulnerabilities is: Who was responsible for the financial crisis?

The immediate cause of the financial crisis was that about a trillion dollars worth of subprime mortgage-related securities, which had been carried at par, became unsellable and unpriceable almost overnight. The entire global financial system froze up, because every major bank was exposed and no bank’s true solvency could be known (not by anyone). The financial system shut down, credit growth went into reverse, and the household debt bubble began to deflate. Nominal GDP declined for the first time since the Great Depression.

The crisis began in mid-2007, when delinquencies on recent-vintage subprime mortgages began to rise to frightening levels. Overnight, these securities went from liquid commodities to unsellable. Coincidentally, at this very moment the accounting profession was implementing a stricter version of fair-value accounting (FAS-133), which made it more difficult to carry illiquid securities at their “intrinsic value” (i.e., at par). Instead of simply marking their subprime securities to their internal models, as banks had been doing, they were forced to mark to a distressed market where there were no buyers. Accounting losses began to be realized in 2007-08, fitfully and unequally. No one wanted to believe the marks they were getting, and so some of them fudged them to one degree or another.

These problematic subprime securities took two forms: subprime Residential Mortgage-Backed Securities (RMBS), and subprime Collateralized Debt Obligations (CDOs). Prices for RMBS fell rapidly, but the securities were still somewhat analyzable, and were not a complete black box (although no one could predict where the delinquencies were going). However, the subprime CDOs were repackagings of RMBS that were consequently complex and opaque to potential bidders, and thus impossible to value or to sell. Most of these securities were unregistered, and in any case lacked sufficient disclosure for an arms-length investor to make an informed valuation. There was no functioning market for the subprime CDOs.