S8 Capital Markets Law Journal, Vol. 4, No.

S1

The roots of the financial crisis

Stephen Wallenstein*

Key points
 The crisis was caused by wilful indifference to risk management. The indifference manifested itself
in policy and implementation at all levels of finance from mortgage brokers to boardrooms, and it
spilled over into the rating agencies and those responsible for government regulatory oversight.
 This indifference was driven by increased investor demand for secure, high yield investments and the
increased liquidity created by global trade imbalances, and foreign investment including sovereign
wealth funds.
 Demand for mortgage-backed securities was compounded by the policies at the Federal Reserve.
Low interest rates and high levels of liquidity encouraged more lending, less attention to oversight
and an increase in leverage ratios.
 Despite easy credit, increased demand would not have been possible without the assurance of safety
provided by the rating agencies. The innovative new financial products provided high yields that were
highly rated and therefore perceived to be safe.
 Brokers, bankers and regulators ignored basic risk management practices in the securitization process.
The financial community worldwide denied the possibility of a real estate bubble, and based its loans,
bonds and ratings on a continuing rise in real estate. FAS 157 and mark-to-market accounting
helped expose the bubble.
 Compensation policies for the creation and sales of mortgage-backed securities were tied to each
individual trader’s profit-and-loss. This prodded traders to risk shareholders’ capital with no thought
to long-term consequences. Investment banks moved from private partnerships to limited liability,
publicly traded firms, providing incentives to bet the firm.

1. Introduction
The global financial crisis that has gripped world markets began in an overheated housing
market in the USA.1 Monetary policies at Alan Greenspan’s Federal Reserve accelerated
this boom. The potential for trouble grew as lenders, bankers and brokers at every level
ignored traditional risk-management controls, and assumed prices would continue to rise
indefinitely.

* Stephen Wallenstein is a professor of the Practice of Law, Business and Finance at the Fuqua School of Business at Duke
University. Professor Wallenstein is a recognized expert in corporate governance and best practices for publicly traded companies
in the USA and abroad. He founded the Duke Directors’ Education Institute (DEI) in 2002, and established the Duke Global
Capital Markets Center in 1998, a collaborative venture between Fuqua and Duke Law, and served as Executive Director from
inception through 2006. He has extensive experience in emerging markets, having spent fifteen years as Senior Counsel and Senior
Investment Officer at the International Finance Corporation in Washington DC. The author gratefully acknowledges the assistance
of Ryan Martin and Slavik Gabinsky, students at Duke Law School, in preparing this article, as well as helpful comments from Ray
Groth, Stanley Greig, Roger Low, Arthur Hahn, Peter Slotta and Lachlan Burn.
1 MN Baily, RE Litan and MS Johnson, The Origins of the Financial Crisis. Initiative on Business and Public Policy at Brookings
(2008), 7–8.

ß The Author (2009). Published by Oxford University Press. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org
doi:10.1093/cmlj/kmp018 Advance Access publication 6 June 2009
Stephen Wallenstein
The roots of the financial crisis S9

These conditions were exacerbated by a loose regulatory climate. Two decades of

deregulation were capped by Congress’s repeal of Glass-Steagall in 1999, effectively
removing many of the barriers between traditional commercial banking and investment
banking.
This environment allowed consumers to borrow at interest rates well below historical
precedent, and allowed financial institutions to assume greater levels of risk and leverage,
funded with low interest debt. Consumers were offered innovative loan structures, which
allowed banks to take on greater levels of debt. Armed with larger loans, these consumers
were able to purchase homes at higher prices, creating a self-reinforcing cycle of single-
family home appreciation. The potential for cataclysm grew as lenders, bankers
and brokers at every level, encouraged by rising home prices and easy credit, ignored
traditional risk-management controls and further expanded lending and the packaging of
mortgage-backed securities (MBSs) to capture new, untapped segments of the
population. The demand for MBSs was so great that it eventually outstripped
the supply of eligible borrowers. Lenders could only respond by expanding lending to
higher-risk borrowers. Mortgages were written with no down payment, interest only,
negative amortization (interest added to principal), no income verification and little or
no documentation.
Greed may have been the biggest factor. Bankers wanted more business, investors
wanted more yield and homebuyers want bigger and better homes with higher resale
value. In this atmosphere, old standards and practices seemed outmoded. Commercial
banks and investment banks relied too heavily on what became an accepted industry-
wide standard known as ‘value at risk’. This was designed to measure the maximum daily
exposure of these financial institutions. The standard proved to be illusory. In an era
when home prices far outpaced inflation, prospective buyers were encouraged to
purchase ever-larger homes. Mortgage originators and brokers were paid immediately for
each new loan that they originated, allowing them to escape accountability for the loan’s
ultimate performance. Furthermore, investment and commercial banks used their
increasingly well-developed securitization mechanisms to bundle subprime mortgages
with more conventional loans.
As homebuyers took on more and more debt, financiers used that debt to create more
MBSs. This spurred the growth of a worldwide securitization market with overseas buyers
seeking more high-yield bonds. Mortgage lenders relaxed risk assessments for home-
buyers, which led to more loans. These grew into a huge pool of subprime mortgages.
Brokers and bankers, with help from the credit-rating agencies (CRAs), whose job it was to
give objective assessments, packaged these loans into MBSs. Brokers and insurers backed
up the sales of these bonds with credit default swaps (CDSs), a form of risk management
that insured one gamble with an even greater gamble. Adding to the complexity, CDS
contracts were routinely traded in an unregulated market without a central clearinghouse.
In an increasingly lenient regulatory climate, a large portion of the financial sector had
no outside oversight at all. Even among the regulators little attention was paid to this
S10 Capital Markets Law Journal, 2009, Vol. 4, No. S1

risk-built-on-risk approach. Shadow banks and new securities fell between the cracks of
regulatory jurisdiction. Even in areas where they still had power, the securities and
exchange commission (SEC) and other agencies relaxed their standards, accepting the
premise that real estate would never fall into a downturn, and allowing investment banks
to increase their leverage ratios from 12:1 to as much as 40:1.
When US homebuyers began to fall short on payments on these innovative and often
adjustable-rate loans, investors began to take cover. Foreclosures increased at alarming
rates. Holders of mortgages and MBSs found that these assets had turned toxic. As issuers
of bonds failed to pay the promised yields, the bonds themselves fell in price. Investors
found themselves holding securities that could not be properly valued, and that therefore
could not be sold. In an environment where it was no longer possible to measure the
risks, these securities were impossible to value and institutions were not willing to carry
them on their books. Furthermore, the ownership of any individual mortgage within the
pool was impossible to determine, making it extremely difficult to renegotiate the terms
of the loan. This forced many mortgages into foreclosure, when restructuring might have
saved them. A fire sale dynamic took hold as foreclosed homes sold at deeper discounts
and pushed real estate prices down further. These multi-level failures of risk management
and the resulting global crisis, were created in large part by the expansion of mortgage
lending made possible through exotic forms of securitization.

The emergence of new forms of securitization

Securitization occurs when a broker packages a number of income-producing fixed assets
into a security, along with the right to the combined assets’ income stream, then the
broker sells it, allowing investors to diversify their exposure through the number and
variety of assets.2 Rather than investing in a single loan and thereby assuming the full risk
of default, securitization pools hundreds of loans. Bankers and investors rely on historical
default rates to calculate the value of the income stream. If the default rate stays within
historical norms and the purchase price is properly discounted, investors are protected.
The process of securitization begins with the lender selling a mortgage to a bank.
The bank bundles large groups of loans into a corporate entity or trust known as a special
purpose vehicle (SPV). The SPV then issues securities to be sold to investors.
The demand for these non-traditional securities was driven in large part by the search
for yield, and institutional investors, pension funds and sovereign wealth funds soon
exhausted the supply of securities backed by traditional 30 year fixed interest rate
mortgages. Once this source of MBSs was depleted, investment banks began to expand
the mortgage market by creating new products based on non-traditional mortgages
(including subprime, interest only, negative amortization, stated income and other Alt-A
structures). Institutional investors such as pension funds, university endowments and
insurance companies are normally restricted to investments that are rated ‘investment
grade’ by one of the major ratings agencies. Mortgage products were not typically rated
2 Ibid 1–46; C Morris, The Trillion Dollar Meltdown (Public Affairs, New York 2008) 60–5.
Stephen Wallenstein
The roots of the financial crisis S11

investment grade, and were therefore not an investment opportunity. To facilitate

institutional investor participation, investment banks created, and began to market,
collateralized debt obligations (CDOs), which produced investment grade securities out
of non-investment grade mortgage portfolios.
The aggregate pool of loans in a CDO was divided into tranches. Each tranche
represented a specific level of priority in payment. The highest tranche was paid first, and
so on down the priority structure. Since the historical risk of default seemed to guarantee
that the top tranches would always be paid in full, rating agencies provided an investment
grade rating. Thus, mortgage-backed products provided legitimate, high-yield investment
opportunity for institutional investors, resulted in the rapid expansion of MBSs, and the
erosion of risk assessment and underwriting. CDSs also exacerbated the problem
since many investors believed their positions were adequately hedged by these ‘insurance’
products, and thus were confident that their risk of loss was zero. Investors
underestimated the importance of counter party strength. Indeed, many CDSs were
traded, and many investors did not actually know which counter party would cover
an event of default under the agreement.

The emergence of shadow banking

This multi-level failure of risk management brought the downfall of brokerages such as
Bear Stearns and Lehman Brothers, leading to huge governmental and international
rescue efforts, and a global crisis that is currently reshaping the world’s financial system.
Much of the financial activity shifted from the highly regulated traditional banking sector
to the unregulated, secretive shadow-banking sector.3 The shadow-banking sector
includes hedge funds, private investment banks and private equity funds, as well as many
of the activities of more traditional financial institutions such as investment banks and
deposit banks. Both the size of the shadow-banking sector and its impressive growth
were made possible by the significant financial innovations discussed above, as well as
deregulation.
The central purpose of any banking system is to facilitate the efficient allocation of
capital. To accomplish this, banks provide a venue for accessing and storing capital.
Banks provide the promise of ready access to capital placed in their care, even while much
of the money is invested in non-liquid assets. Traditional banks—those that take deposits
and hold a portion in reserve and lend at 10:1 leverage—are perhaps the clearest example
of this model. Hedge funds, investment banks and insurance companies provide
similar promises of access to capital.
In June 2008, New York Federal Reserve Bank president, Timothy Geithner
(now Secretary of the Treasury), described the fundamental shift in financial activity
to the shadow-banking system:
The structure of the financial system changed fundamentally during the boom, with dramatic growth in
the share of assets outside the traditional banking system. This non-bank financial system grew to be

3 P Krugman, The Return of Depression Economics and the Crisis of 2008 (W.W. Norton & Company, New York 2009).
S12 Capital Markets Law Journal, 2009, Vol. 4, No. S1

very large, particularly in money and funding markets. 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 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 the total assets of the entire banking system
were about $10 trillion.4

2. Monetary policy and other early causes

The policies of Alan Greenspan’s Fed
In 1999, Alan Greenspan was regarded in most quarters as a financial genius. He had been
appointed in 1987, just months before that year’s stock market crash. Although
Greenspan could not be blamed for a disaster that happened so soon after he took office,
his response to the crisis could make or break his reputation, setting the tone for his
chairmanship. In the days following the crash, Greenspan reacted quickly, lowering
interest rates and injecting money into the financial system.5 The market stabilized, then
recovered within months, and Greenspan received most of the credit. After a brief,
shallow recession in the early 1990s, prosperity returned and the stock market began
another sustained climb. Greenspan gained praise from most of the financial community,
despite his occasional expressions of mild doubt, such as his famous ‘irrational
exuberance’ remark concerning the risks of overvaluation of assets in 1996.
As he entered his 12th year as Fed Chairman, Greenspan had stopped talking about
irrational exuberance and was well on his way to seeing the world economy through a
new theoretical paradigm. In February 1999, Time Magazine ran a cover story about
Greenspan and his associates, Clinton Administration Treasury Secretary Lawrence
Summers and former Treasury Secretary Robert Rubin. Greenspan was seen as the leader
of these ‘Three Marketeers’. The article described a trio with ‘a passion for thinking and
an inextinguishable curiosity about a new economic order that is unfolding before them
like an Alice in Wonderland world. The sheer fascination of inventing a 21st century
financial system motivates them more than the usual Washington drugs of power and
money.’6 Like his colleagues, Greenspan had been seduced by an economy that appeared
to have no major weaknesses.
The article appeared in the aftermath of an economic debacle: the collapse of the newly
emerging economies in Asia. This bursting bubble had spread its contagion through the
Philippines, Taiwan, Malaysia and other Pacific Rim nations. It worried US policymakers,
but most of their concerns were about the effects here in the USA.
Over the following year, as it became apparent that fallout from Asia would not spread
to more developed Western economies, Greenspan’s legend only grew. Administrations
4 Ibid.
5 M Carlson, A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response (Federal Reserve
Board, Finance and Economics Discussion Series, Washington, DC 2006).
6 JC Ramo, ‘The Three Marketeers’, Time Magazine (New York 15 February 1999).
Stephen Wallenstein
The roots of the financial crisis S13

changed, Summers and Rubin left, but the ‘new economic order’ marched on.
Greenspan’s policies appeared to be applicable to every nuance and problem. His Fed
lowered interest rates slowly and steadily, a quarter point at a time. As recession loomed
in 2001, he loosened credit even more, and in the aftermath of 9/11 he continued the
process.7 At the start, the Fed rate had been 6.25 per cent. By early 2003, it was down to
2 per cent and that summer it dropped to 1 per cent.8 The US economy had survived
another brief recession and was now weathering a two-front war. At home the low
interest rates were creating unprecedented liquidity.
The Federal Reserve’s largess allowed banks to loan more and more money. The retail
consumers of this money were the nation’s homebuyers. Lenders encouraged them with
interest rates commensurate with the Fed’s loosened credit policies. Century-old
American cultural and social forces contributed to an atmosphere where homeownership
was seen as a perquisite to full participation in the life of the community and the nation.
Greenspan’s new economic order gave a green light to a financial community, already
largely deregulated, and attuned to new products and methods. As lower rates and
creative marketing brought more borrowers and debt, financiers grouped their new loans
into CDOs. As willing buyers queued up for these new bonds, a new market was created.
Though the securities were backed by collateral—the homes themselves—international
buyers weren’t so sure about them. After all, these were financial securities—always a
somewhat mysterious area—and a new kind of security at that. The investors might have
felt reassured to learn that the bond ultimately rested on the foundation of the US
housing market, but there were always a few pessimists about. Euro Pacific’s Peter Schiff
was one of these. In 2006 Schiff, who had long been cautious about housing prices,
predicted a deep recession starting either in 2007 or 2008, saying: ‘We have too much
consumption and borrowing, and not enough production and savings.’9
Although Schiff, and those who agreed with him, were largely derided throughout the
boom, many of the new investors still felt it was best to keep one’s assets covered. Often
the buyers realized that they weren’t sure exactly what they were buying, so they wanted
insurance. There was already a form of insurance for such investments: CDSs.
A purchaser of a CDS makes payments (much like insurance premiums) to a seller,
and if the financial instrument in question (in this case a bond containing a large number
of mortgages) defaults, then the seller pays the buyer a part, or all, of the original price.
If you bought a CDO, and coupled it with a CDS, your investment seemed to go
beyond foolproof. Now it appeared to be invulnerable.
Greenspan and his Fed had no direct control over CDOs or CDSs (and, in contrast,
Greenspan lobbied against any regulation or oversight of these instruments, preferring
the market to regulate itself), but the Fed did take action again and again to create fertile
7 C Morris (n 2).
8 The Federal Reserve of New York 5http://www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html4 accessed 31 March
2009.
9 Interview on Fox News, 31 December 2006 5http://www.huffingtonpost.com/2008/11/14/this-guy-predicted-the-
fi_n_143965.html4 accessed 1 April 2009.
S14 Capital Markets Law Journal, 2009, Vol. 4, No. S1

conditions for the growth of these new financial instruments. The Fed controlled the
supply of dollars and key interest rates. If the money supply had been lower and interest
rates higher the search for yield would not have led investors to demand ever increasing
amounts of MBS products. But Greenspan’s support of increased liquidity did not do the
whole job. The conditions for disaster emerged from a complex web of policy, law
and greed.
Repeal of Glass-Steagall
One of the earliest products of the New Deal era was the 1932 Glass-Steagall Act, passed
the year before Roosevelt took office. This law’s provisions separated banks into two
broad categories: commercial and investment. Investment banks specialized in financial
activity of greater risk such as financing business ventures and underwriting the issuance
of stock and bond instruments. Commercial banks, on the other hand, provided
individuals with savings and checking accounts, made loans to corporations and
specialized in lower risk financial activity. Glass-Steagall separated the risk banks took on
individuals from the higher stakes of big business. As one writer put it: ‘Commercial
banking and investment banking were put asunder on the grounds that the safety and
soundness of the former would always be compromised by the latter.’10 In 1999, Congress
repealed Glass-Steagall.
Commercial banks were provided access to the Fed’s discount window, which offered
short-term, low-interest financing, providing them with a significant competitive
advantage over investment banks. In order to compete, investment banks relied on the
repo market, which took advantage of low-interest financing from various sources,
including money market funds and insurance companies. This short-term financing came
with significant liquidity risk, since it needed to be rolled over on a daily basis. For
example, when Bear Stearns failed, they had $17 billion in capital but $75 billion in
overnight liabilities secured by long-term assets. When lenders refused to roll over
the debt, Bear Stearns faced an insurmountable liquidity crisis and was driven into the
hands of JPMorgan.11
Bankers and brokers
Though Greenspan’s Fed created conditions conducive to financial bubbles, they did not
do the daily chores of lending money to homebuyers and creating and marketing
securities. Nor did Congress’s repeal of key provisions in the Glass-Steagall Act. These
government actions set the stage, but the bankers were the primary movers, both in the
home loans, and now in this new field of mortgage securitization. They sold CDOs and
CDSs as quickly as they could assemble them. Banks and other financial institutions, such
as insurance companies like AIG, quickly expanded the derivatives market to a size and
scope that defied traditional risk-management practices. Buyers, seeing high yields in
bond markets, which had always seemed safe, created demand for these instruments.
10 J Grant, Mr. Market Miscalculates: The Bubble Years and Beyond (Axios Press, Virginia 2008).
11 W Cohan, House of Cards (Doubleday, New York 2009).
Stephen Wallenstein
The roots of the financial crisis S15

As the largest financial institutions sold more CDOs and CDSs, they also encouraged
more lending on the commercial side. Here they could take full advantage of low
interest rates, enticing more people to buy homes. At local branches loan officers were
given new bonus and benefit incentives, if they could increase the volume and dollar
value of new mortgages.
After traditional mortgage markets were saturated, investor demand was satisfied by
expanding lending to non-traditional borrowers. Many of these new homebuyers had
poor credit, low income and no assets. As the profit motive trickled down from the
boardroom to the bank branch loan officer, risk management standards were lowered so
even the most marginal buyers could gain approval. In addition, this pressure for yield
from the top led to deterioration in the quality of data on borrowers at the bottom.
Much anecdotal evidence points to informal, yet systemic, encouragement for borrowers
to fudge the numbers on income, assets and other essential areas. This systematic skewing
of data meant that the basic assumptions underlying housing-based securities had
serious flaws.
Much of the popularity for these bonds was due to two factors: their profitability and
their ratings. These securities paid up to 2–3 per cent more than similar corporate bonds,
and received consistently high ratings, usually AAA. Like any other securities, the CDOs
were judged by CRAs, usually Standard & Poor’s, Fitch or Moody’s. Relying on past
history of housing prices and mortgage default rates, these agencies looked favourably at
CDOs made up of home loans. One huge flaw was the CRAs’ definition of ‘past history’.
They based their expectations on mortgage default rates in the years starting with 1992.12
Though the peak of the housing boom came in the middle years of the present decade,
home prices had been rising at a respectable rate for at least a quarter century before
that—all the way back to 1975. As long as prices rose, defaults were rare. In a rising
market, a homeowner who defaulted could always sell the house and pay off the loan.
By not including any off years in their history (such as the early 1970s or the 1930s),
the CRAs were rating these mortgage bonds using only a best-case scenario. They ignored
the basic principle that ratings on securities made up of long-term loans should use
long-term historical models reflecting a range of possibilities, including a flat or declining
market.

The CRAs and the SEC

Another inherent problem lay in the relationship between the financial institutions and
the CRAs. The financial institutions issuing the securities paid the CRAs for their services,
not the ultimate investors. Soon the banks were asking for something more than
a straightforward evaluation. If a bond’s rating was not what it should be, how could it
be redesigned to get a better one? When the banks asked, the CRAs took action. The
agencies assumed an active role in creating the securities they would ultimately be rating.
12 MN Baily, DW Elmendorf and RE Litan, The Great Credit Squeeze: How It Happened, How to Prevent Another (The Brookings
Institution, Washington, DC 2008).
S16 Capital Markets Law Journal, 2009, Vol. 4, No. S1

The CRAs examined how the bonds were structured, recommending ways to improve
their yield and quality at the lowest cost to the bank. This gave the rating agencies a huge
incentive to create as many AAA tranches as possible. The agencies were helping create
risk, rather than simply examining, evaluating and reporting their findings. This when
added to their optimistic pricing models, which ignored any risk of a sustained drop in
housing prices, created a situation where agencies blinded by self-interest were leading
institutions blinded by greed. Each reinforced the other’s illusion of safety. While
this teamwork guaranteed high bond ratings, those ratings were as inflated as the value
of the securities to which they were applied.
The CRAs were virtually unregulated and that has not changed. The rating agencies
have an oligopoly, with three rating agencies accounting for 95 per cent of the total
ratings. Despite numerous concerns, the idea of regulation of CRAs has yet to be
addressed by Congress or the White House.
Even when regulators were present, the low quality of regulation allowed the causes of
the crisis to develop. Banks and other financial institutions faced government regulation,
but the supposedly steadying hand of official oversight lost its grip. The continual easing
of regulatory legislation and policy sent a message to government overseers to allow the
markets to function unhindered.
Since the 1930s, Americans have relied on the SEC to act as their watchdog for
securities markets, but the SEC of the last decade seemed eager to allow the largest
institutions the kind of freedom they had not seen since the bull market of the 1920s.
The SEC had a leverage rule requiring broker dealers to keep a debt-to-net capital ratio
below 12:1. In addition, companies were supposed to warn regulators if their ratios were
rising to nearly that level. In June 2004, the SEC made an exception for five large brokers:
Goldman Sachs, Morgan Stanley, Bear Stearns, Lehman Brothers and Merrill Lynch.
In that same year, the SEC’s European Union counterpart made similar moves. This
relaxation allowed leverage ratings to rise to as much as 40:1, allowing the investment
banks to take on greater risk than ever before.13

SIVs, mortgage originators and the fall of Bear Stearns and Lehman
Brothers
These rule relaxations kept capital flowing, as it never had before. As the new CDOs
and their securities sold to investors worldwide, brokers had more funds than ever. Much
of this wealth became the basis for more mortgages, which created more resources for
more securities and a continually expanding market. A better description might have
been that of a self-feeding Ponzi scheme. Because banks sold their mortgage portfolios to
investors, they were not concerned with what would happen if the borrowers at
the bottom came up short, let alone whether it was possible that default rates would
rise to a level that would wipe even the AAA tranches.

13 J Satow, ‘Ex-SEC Official Blames Agency for Blow-Up of Broker-Dealers’ The New York Sun (New York 18 December 2008).
Stephen Wallenstein
The roots of the financial crisis S17

In the days when commercial banks held mortgages on their own balance sheets, that
gave them the incentive to honestly evaluate the risk of each individual mortgage.
In those days, a loan officer would have told a prospective homebuyer with low income
or faulty credit that he or she must find a more affordable home or postpone the
purchase until the borrower had better numbers to offer.
In the fast-paced markets of 2004, the home mortgage, which had always been the solid
bulwark of lenders’ portfolios, was fast becoming a fluid thing as sensitive to economic
turmoil as some securities. As mortgages were being packaged, sold, then re-packaged
and resold to one third-party investor after another, commercial and investment banks
were compounding the problem by acquiring mortgage originators. This was the best way
to capture an ever-increasing flow of loans for bundling into an ever-increasing flow of
securities. Bank of America, Bear Stearns and Lehman Brothers all made substantial
purchases of mortgage originators. This process soon became a primary example of
the institutional policy blunders that led to the financial meltdown.
Demand for these securities was also inflated by the Federal Reserve’s historically
low short-term interest rates. These rates kept credit flowing to both homebuyers and
bond buyers. This, combined with an increasingly lenient SEC and the banks’ own
undermining of traditional risk-management techniques, made for a market that
operated with no thought of control. When bankers needed a new way to manage and
bundle these products they created off-balance-sheet entities known as SIVs to purchase
and hold MBSs. Although SIVs caused uproar during the Enron scandal of 2001, leading
to the passage of the Sarbanes-Oxley Act of 2002, that didn’t stop commercial banks from
following the same model in their efforts to avoid regulatory scrutiny and capital
requirements.
Boards of directors, audit committees, risk committees and chief risk officers, all
charged with mitigating risk, did little to stop the creation of the SIVs. To compete with
the low-cost financing advantage that these SIVs gave the commercial banks, investment
banks entered into overnight repurchase agreements. By 2006, these repos had some of
the largest investment institutions rolling over about 25 per cent of their liabilities on
a daily basis. The growth in these short-term liabilities and the inability to keep rolling
them over would prove fatal to Bear Stearns and Lehman Brothers when the crisis hit.
When they could no longer get low interest overnight loans, they could no longer finance
their long-term assets either. Paper profits turned into real losses and ruin virtually
overnight.

Private partnerships, public companies and the structure of compensation

It was no accident that just as investment banks began transforming themselves from
private partnerships into public companies in the 1990s, they also allowed prudent risk-
management standards to erode. In a private partnership, capital belongs to the partners
encouraging diligent risk management. But in the newly formed public corporations,
bankers were using other people’s money to build bigger and bigger positions. Often their
S18 Capital Markets Law Journal, 2009, Vol. 4, No. S1

only stake was in the structure of their incentives. Executive pay packages were devised
with a focus on short-term sales of high-yield assets, as many banks paid as much as
50 per cent or 60 per cent of revenues in compensation. If these bankers had been
playing with their own money, they would have been much more cautious in their risk-
assessment techniques. The compensation packages now drawing public outrage in the
wake of failure and bailouts were a problem from the start. Even when the banks were
making huge profits, guaranteed executive pay packages undermined their incentives to
manage risk more prudently. As long as big risks brought big returns, few questioned
these compensation policies.
In the 1970s and the 1980s, it was common practice for commercial and investment
banks to have investment committees staffed by senior executive officers. All credit
proposals would go through these committees where standards were high. Junior bankers
spent long hours stress testing their assumptions and performing sensitivity analysis
to prepare themselves for the inevitable grilling they would receive in the committee
meetings.
Over time the importance of the investment committee was allowed to ebb. As the
business of finance grew more complex and institutions became more diversified, more
investment decisions fell into the hands of the banks’ unit managers, rather than being
decided by the committee as a whole. Banks were constantly restructuring so that they
could best take advantage of booming markets and a changing regulatory atmosphere.
Senior executives focused their attention on how each division or department could best
produce the highest return. Most of the potential was in securitization. Many of the
newer securitization techniques relied on complex mathematical formulae understood
only by the bank’s recently hired PhDs. The sheer complexity of these risk-assessment
models made them almost impossible to understand and almost no one admitted to not
understanding. These young financiers were attracted by great compensation packages,
and the prestige that went with being on the cutting edge of the new economy. They were
hired to make money, not monitor it. For a time they did what they were hired to do.
Bankers were paid to believe in these models, and there was collective resistance to
dealing with the fact that models are inherently limited.
At many financial institutions oversight of investments devolved upon a chief risk
officer. The office of the chief risk officer was not a profit centre; rather, it was responsible
for scrutinizing all the major investments the bank made. As a result, the office needed
personnel with sophisticated expertise, but it often lacked the money and backing to find
them. Besides, in an industry whose policies celebrated massive profit and opposed most
regulation, an in-house regulator devoted to limits and caution wasn’t likely to get
the lion’s share of funds, power or prestige.
Without effective monitoring, banks failed to follow standard procedures in risk
assessment and risk management. No one asked the difficult questions. Much of the
financing for these investments came from the interbank market, where responsibility
and authority for scrutiny lay entirely with the banks themselves. Few bankers questioned
Stephen Wallenstein
The roots of the financial crisis S19

the mix of assets and risks. Even fewer had any inkling of the percentages of subprime
mortgages in these bonds. Those few who had a notion of the scope of the problems
closed their eyes. They based their investment decisions on the assumption that a
financial institution could not go bust, and if it did, the Fed would come along and save
it, lest the whole system be thrown into chaos. In many cases they were right.

FAS 157 and mark-to-market

While they were guilty of a whole web of misjudgements, many of these investors were
also unwitting victims of new accounting rules. These new rules required financial
instruments to be recorded at fair value on the company’s balance sheet, which could
lead to write-downs that might exaggerate losses.
Statement of Financial Accounting Standards No. 157 (FAS 157) was issued by the
Financial Accounting Standards Board (FASB) in September 2006, and took effect at the
end of calendar year 2007. It deals with the evaluation of certain kinds of assets that
should be recorded at ‘fair value’, and it is applicable to securities containing subprime
loans. It requires that assets be recorded at a price for which they could be sold: ‘the price
that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date.’ This goes to the core
of a long-standing accounting debate: should assets be recorded at cost or by their current
market value (mark-to-market)? Historical cost is often outdated quickly, as in the
instance of a home bought in 2003, which gains tens of thousands in value by 2004, or the
same home bought in 2007, which loses tens of thousands by 2008.
Formerly assets consisting of subprime loans could be recorded at historical costs and
depreciated over a number of years. Fair value or market accounting requires that these
assets be recorded at market prices. In a fast failing subprime securitization market, the
spread between a bid and ask price often reached historical proportions. A bid might be
20 cents, while the price at which the banks were trying to sell the assets, based on their
cash-flow projections, might be 70 cents. As the market seized up buyers and sellers had
no way to value the underlying assets (the homes and the credit worthiness of the
homeowners themselves). The timing could not have been worse. This change took effect
in August 2007 for fiscal years ending after 15 December 2007, just months after the
collapse of the two Bear Stearns hedge funds that traded in these securities. It coincided
with the onset of the subprime and securitization crisis. As the crisis developed
and Congress brought pressure, FASB revised the rules in April 2009 allowing banks to
switch to mark-to-model valuation for their 2009 first-quarter results.

3. Global liquidity
Pension funds, sovereign wealth funds and insurance companies
Pension funds and insurance companies are legally required to invest in investment-
grade securities. Securitization created a whole new asset class, in which these
S20 Capital Markets Law Journal, 2009, Vol. 4, No. S1

financial institutions could invest, provided they had high enough ratings. In a low
interest rate environment, these investors were especially attracted to high-yield MBS
products.
Though traditionally securities were created and marketed by banks, an increasing
number were made and sold by a process known as ‘reverse inquiry’. This came about
when a manager of a pension fund or sovereign wealth fund would initiate the search for
more high-yield securities, prodding bankers to come up with them. Pension funds and
insurance companies with fixed liabilities had traditionally invested in government
securities and investment grade bonds.
These investments were safe, but their yields were usually not that much higher than
the inflation rate. When the fund managers heard of safe bonds with much higher yields,
they would make the call, which initiated the reverse inquiry. These investor-initiated
approaches fuelled more demand and the bankers, certain of their complex mathematical
models, were more than happy to supply the products. The demand, the models
and the expectations were all based on one theory: housing prices were going to
rise forever.
When the bonds kept paying, it was not surprising that demand increased from these
sectors. Securities based on housing seemed almost as safe as the old T-bills, and far more
profitable. Managers asked themselves: what better than a bond backed by a wide range
of mortgages? In such an atmosphere the answer was obvious.
But these managers were only seeing the surface appearance of these bonds. They were
not scrutinizing the mortgages themselves, or the assumptions of those who were
bundling them. Here was one more level where risk management failed. In this case the
money in America’s 401ks and the savings of developing nations through Sovereign
Wealth Funds were being fed into risks that would fail as soon as the US housing
market showed any weakness.

Japan
In the mid-1980s Japan appeared to be the spur that drove the world economy. As the
US and Europe began recovering from over a decade of malaise and India, China and
the other Pacific Rim countries took their first halting steps toward real economic
influence, Japan seemed positioned to assume the role of the world’s most powerful
economy.
Just as most prognosticators were praising Japan as the likely heir to American
economic hegemony, the Rising Sun hit a snag. As the 1980s progressed and America
recovered, Japan developed some unsettling Western habits. Savings declined,
consumption rose and debt mounted. Though prosperity continued, Japan was now
just one of several nations sitting at the top of the world’s economy. At this point
Japan began to experience its own real estate boom. Most of the activity was in
commercial real estate but this eventually spilled over into residential. It was a classic
bubble, and became the most visible cause of the crash in Japan’s economy in the
Stephen Wallenstein
The roots of the financial crisis S21

early 1990s. Like the US in the 1970s, Japan’s stocks tumbled and prices began to drop.
This was followed by a decade of stagnation.14
Their response was similar to the classic American reaction to a downturn: an
increase in deficit spending and lower interest rates. It worked, but not at all smoothly.
Interest rates had never risen much in Japan, so the decrease had only limited effects on
domestic transactions. Recovery has been slow, but in the last few years Japan’s investors
have taken advantage of those low interest rates to fuel a huge repo market for US
mortgage securities. Under such an agreement, a borrower sells a lender a security,
agreeing to buy it back later at a set price.15 The repurchase price is higher, the difference
being the price of the loan. In this way Japanese financiers borrow the money, then get
more than they are paying in interest on the repurchase. One of the most active players in
this market was Lehman Brothers, and when they went bankrupt in September 2008,
Japanese investors began fleeing securities issued by American institutions.
Japan’s low interest rates do encourage consumer spending domestically, but they
discourage investment by currency traders. Instead, bankers borrow yen at low rates, and
then invest in a higher yielding currency, in what’s called the carry trade. Much of
this ended up in US dollar-denominated securities such as CDOs and CDSs issued by
Lehman Brothers and other banks. The collapse took much of that money with it.

China and the developing countries

For decades, China was the world economy’s sleeping giant, with well over a billion
potential producers and consumers who had yet to venture out into the world economy.
In 1979, they opened up to global investment. In the 1980s, they were beginning to cause
ripples in international finance, but they were still held back by politics and habits
left over from isolation.
Over time, politics and habits adapted and by the 1990s, China’s people and
institutions had emerged as a growing force in the global economy. As Japan stagnated,
China seemed ready to take its place. Chinese growth has been accompanied by inflation.
At the same time, the Chinese government held down interest rates, often below the rate
of inflation. This kept the yuan artificially low and created a real negative interest rate.
The global economic trading imbalance led to the accumulation of excess reserves in
China and other emerging economies, principally Singapore, and the oil-producing states
of the Persian Gulf. Until the Asian financial crisis of 1997–1998, most emerging
economies imported capital from abroad to finance their growth, recording balance of
payments deficits in the process. In much of Asia and in emerging economies, such as
Brazil and Russia, the financial crisis changed this.
After the crisis, many of the Asian countries, particularly China, began to generate
capital surpluses in their balance of payments. These surpluses were recycled to the US
and other Western countries as portfolio investments. A lot of these funds flowed into the
14 The Economist, ‘Lessons from a Lost Decade’ (21 August 2008).
15 P Krugman (n 3).
S22 Capital Markets Law Journal, 2009, Vol. 4, No. S1

subprime mortgage sector in the US and Europe. This was a large factor in the increase in
the annual volume of US subprime and other securitized mortgages from $100 billion
in 2002 to over $600 billion in 2005 and 2006.

Europe
For a half century Europe has been uniting. It began with the European Economic
Community (EEC), which was superseded by the European Union. Strengthened political
bonds led to a common currency.
While the EU performs many of the functions of a nation, it is not one. Its members
are still sovereign states, and while in many respects they have united their economies, in
some ways they are still quite separate. Some of these divisions come from culture, others
from language differences and some conflict is rooted in old rivalries that still play out in
the world of international finance. Britain, Sweden and nine other EU countries have
never switched over to euros. Ever since the era of Margaret Thatcher, British economic
and financial systems have moved closer to those of the USA. Though governments and
banks on the Continent have made some similar moves, they have consciously retained
a more European character, with the exception of Switzerland.
This is a part of why British and Swiss financial institutions were more heavily invested
in American CDOs and CDSs, while the Germans, French and most other EU members
had less exposure. Spain was the only other EU member with a subprime exposure as
large as Britain’s. UBS and CSFB from Switzerland were also big players.
But other European nations did not escape the crisis. European and British banks
financed their own bubble as housing prices rose almost as much as in the USA.16
Though EU banks did not use the same risk management methods, they did trust their
American counterparts, and invested in American mortgage securities. Like the managers
of pension funds and sovereign wealth funds, these European investors did not examine
the components of these securities as carefully as they should have.
As the crisis developed in fall 2008, Europe’s central banks followed the US
lead, pumping more capital into their financial system to shore up shortfalls and prevent
panics.

4. The breakdowns
Fannie Mae and Freddie Mac: undercapitalization and government
guarantees
Government-backed institutions were hardly immune to the failures in risk assessment.
Fannie Mae and Freddie Mac, two government-affiliated banks, whose extraordinary
accrual of mortgages reflected America’s vision of universal home ownership, suffered
from the same blindness as the private sector. Though many thought these institutions
were invulnerable to economic catastrophe, changes made during the Clinton years

16 Organisation for Co-operation and Economic Development, Economic Outlook No. 78, 2005.
Stephen Wallenstein
The roots of the financial crisis S23

created an undetected potential for the massive risks inherent in undercapitalization.

The perceived government backing of these government-sponsored entities (GSEs) led to
significant moral hazard allowing investors to assume greater levels of risk-taking under
the assumption that the debt instruments issued by Fannie and Freddie were guaranteed
by the US government. When the meltdown came, this guarantee was tested, the
government honoured this guarantee but found the price tag of financial failure was far
higher than had ever been envisioned.
The process that led to this situation was further compounded by the lack of regulatory
oversight. Regulatory responsibilities were handled by a single, understaffed government
regulator: the Office of Federal Housing Enterprise Oversight (OFHEO). Furthermore,
Congress routinely avoided imposing rational capital requirements or leverage ratios.
In 1995, Fannie and Freddie were permitted to invest up to 40 times their capital in
mortgages. Between 1990 and 2007, the mortgage debt held by Americans rose from
$2.5 trillion to $12 trillion. The officers of these GSEs were compensated with salaries and
bonuses that rivalled some on Wall Street, and as on Wall Street, these compensation
policies encouraged irresponsible underwriting and risk assessment.
In a clear indication that even the US government bought into the idea that home
prices would continue to rise, Fannie Mae and Freddie Mac purchased half of all US
mortgages. To increase their portfolio and maximize short-term profits (and their
compensation packages) the managers of Fannie and Freddie created the largest
portfolios of subprime mortgages in America.
The intimate intertwining of Freddie and Fannie with the US government was taken at
face value by the rest of the financial world. It was this presumed relationship that gave
these institutions their aura of invincibility. Investors were convinced that if either of
these giants were to reach the brink of failure, the government would step in and clean up
the mess. More than that, most investors agreed with Fannie and Freddie that the US
housing market would continue to rise. These perceptions and judgements underpinned
the private sector’s confidence. Housing prices would certainly rise, and if anything
happened to change that, the federally backed mortgage giants would buy all the
subprime paper in the country if necessary. With that kind of insurance, why would a
private bank think of subprime paper as toxic? After all, they could sell it to Fannie or
Freddie and let them worry about whether the mortgages were serviced properly.
This further reduced the banks’ incentives to properly assess the risks of the loans and
of their derivatives.

CDSs: a systemic breakdown of risk management

The growth in CDSs was one of the largest abuses in the boom. First introduced in 1997,
the CDS market was valued at under a trillion dollars in 2000, only to grow to $62 trillion
by 2008.17 When this figure was revealed in news stories even some bankers were stunned.
17 MN Baily, RE Litan and MS. Johnson, The Origins of the Financial Crisis (The Brookings Institution, Washington, DC 2008).
S24 Capital Markets Law Journal, 2009, Vol. 4, No. S1

The figure of $62 trillion is more than most estimates of the combined GDPs of all the
nations in the world.18
CDSs fell beneath the radar of real regulation, and though a seller had a legal
obligation to honour the terms of the contract, there was no requirement to keep enough
capital on hand to pay the buyer if things went bad. Yet companies kept the CDSs on
their books. To a seller they were worth whatever the buyer would pay. But the base value
of a CDS was no more than the issuer could actually pay if the CDO defaulted. If even
a 100th of them were to come due in a single year, issuers would have to come up with
$620 billion for bondholders. Could AIG, or any other company, produce that kind
of cash quickly? Or was this the point where liquidity froze?
A single set of high-risk derivatives purporting to represent $62 trillion should be a
sure indication of a worldwide problem. Though the financial crisis of the last 2 years
stems from the US housing market, that’s not the only root in this tree. Americans could
not have bought their houses without those mortgages, and the banks could not have
funded the mortgages without some kind of credit support.

AIG, Lehman and the destructive force of derivatives

In the course of the boom in MBSs, the insurance giant AIG, agreed to guarantee huge
amounts of these securities against default. In doing this AIG executives were putting
faith into all the faulty risk assessments that had gone into these bonds. They trusted the
homebuyers, the loan officers, the risk officers, the managers who bundled the securities
and the housing market’s ability to keep rising.
They were willing to write insurance against all these risks in the form of CDSs. Rather
than closely examining the basis of CDOs, AIG looked only to the market and the issuers
themselves. As long as the market was booming and the issuers had track records of
profits, AIG was willing to buy in.
This was a total breakdown in risk management. It was also when high-level executives
became embroiled in the scandal that is now leading to a partial disgorgement of the
compensation they received for their work on these now-failed investments.
The September 2008 failure of Lehman Brothers, coupled with the near failure of AIG
and Merrill Lynch, tested the world financial system and showed the true consequences of
widespread counterparty failure. On 15 September all of the major CRAs downgraded
AIG. As a result AIG was forced to come up with tens of billions of additional collateral
immediately. This came on top of billions it owed to its trading partners. The world’s
largest insurance company did not have the money. For all intents and purposes it was
bankrupt. Lehman Brothers failed on the same day. In the week that followed Bank of
America bought Merrill Lynch and the government agreed to lend AIG $85 billion to
facilitate an orderly sell-off of its assets in exchange for 79.9 per cent of the company’s
equity.
18 Various papers of the International Monetary Fund 5http://www.imf.org4 accessed 31 March 2009.
Stephen Wallenstein
The roots of the financial crisis S25

The collapse of the credit default swap market made it much harder for investment
banks to insure their obligations, which reduced their ability to borrow money. As the
repo markets dried up, investment banks had to rely on the Federal Reserve to fund their
daily operations. At this writing banks, insurance firms and investment banks have
borrowed $348 billion from the Federal Reserve. Nearly all of this lending took place
following AIG’s failure.

5. This is not the first time

Though every financial crisis is unique, each new one has echoes from those of the
past. As soon as our current crisis began, economic historians began looking for parallels
from earlier financial downturns.
While American history is a story of incredible economic growth, it is also a tale of
cataclysms. The nation’s first depression came in the 1780s, as the 13 new states
foundered in debts created by the Revolutionary War. Panics and crises hit again in 1819,
1837, 1857, 1873, 1893, 1907, 1920 and most famously in 1929. Among our seniors,
we still have plenty of survivors of the Great Depression, and many more of us recall
the economic turmoil of the 1970s and early 1980s.

1929 and the Great Depression

While the cause of the Great Depression remains controversial and unsettled, the
conditions that preceded its emergence have been thoroughly discussed.19 In the 1920s,
political philosophy and government policy were dominated by laissez faire economics.
Policymakers recognized that the normal business cycle would have periods of economic
contraction but they saw no need for, or benefit from government action.
It was not until the decade-long Depression of the 1930s, with its record
unemployment, price deflation, falling wages and failing markets (including that of
real estate) that government took an active role in stimulating the economy. Initially, the
government’s response was minimal and destructive: the President and Congress did
little, the Federal Reserve tightened credit before the crash, then loosened it slightly just
after, but the nation’s laws, conventional wisdom and the Fed’s governors were not
attuned to notions of large-scale intervention. In 1929 the nation’s money supply was
still hitched firmly to the gold standard. Federal expenditures were less than 4 per cent
of GDP.20
As the crisis deepened the government did react. After failing in his attempts to balance
the federal budget, President Hoover proposed the Reconstruction Finance Corporation.
For a time this agency was the only active lender in the nation. Even so, at each step,
government actions were reluctant, tentative and nowhere near enough. It was not until
the election of FDR and the coming of the New Deal that government took on a more
19 RS McElvaine, The Great Depression (Times Books, New York 1984) 25–50.
20 5http://www.usgovernmentspending.com/year1929_0.html4 accessed 2 April 2009.
S26 Capital Markets Law Journal, 2009, Vol. 4, No. S1

activist role. The effects of this expansion have been debated ever since, but the federal
government has never again given up its role as an active player in the economy.21
The economic environment leading up to the market crash of 1929 had key
characteristics paralleling the US economy prior to the present crisis. As in the 1920s, the
last decade has seen an increase in social stratification and concentration of wealth.
Speculation accompanied the general attitude of optimism that marked the 1920s.
That decade’s stock market boom served many of the same functions that the real estate
bubble has in our time. The bull market of the 1920s was fuelled in part by the Federal
Reserve Board’s implementation of lower interest rates. Speculation was made worse by
increased leverage. In the 1920s, investors purchased stock on margin, which allowed
greater returns as stock prices appreciated, but significant losses in even minor
downturns. Home speculation from 1996 to 2006 was driven by the same dynamic.

The real Great Depression—1873

Many authors have drawn parallels between the crisis of 2008 and the Great Depression,
in part, because it is the worst economic crisis within public memory.22 However, a more
apt comparison may be the depression of 1873.
The problems that led to the crash of 1873 began in Europe around 1870. New lending
institutions emerged and mortgage lending expanded. Building increased in response to
easier financing. Real estate valuations began to inflate. A bubble was born. As Scott
Reynolds Nelson has explained in a recent article in The Chronicle Review:
As continental banks tumbled, British banks held back their capital, unsure of which institutions were
most involved in the mortgage crisis. The cost to borrow money from another bank—the interbank
lending rate—reached impossibly high rates.
This initial round of lending contraction put strains on complex financial arrangements
structured on optimistic assumptions that were no longer applicable. This crisis hit the
USA in 1873 and as Mr Nelson explains, focused first on railroads:
They had crafted complex financial instruments that promised a fixed return, though few understood
the underlying object that was guaranteed to investors in case of default. (Answer: nothing). The bonds
had sold well at first, but they had tumbled after 1871 as investors began to doubt their value, prices
weakened, and many railroads took on short-term bank loans to continue laying track. Then, as short-
term lending rates skyrocketed across the Atlantic in 1873, the railroads were in trouble. When the
railroad financier Jay Cooke proved unable to pay off his debts, the stock market crashed in September,
closing hundreds of banks over the next three years. The panic continued for more than four years in
the United States and for nearly six years in Europe.
The panic in the USA started when Jay Cooke & Company defaulted on its debt. Soon
panic swept Wall Street and dozens of other prominent financial firms failed, including
some that had appeared to be among the richest and safest. The government stepped in
21 AM Schlesinger and others, The National Experience: a history of the United States (Harcourt Brace Jovanovich, Inc., New York
1973) and JK Galbraith, The Great Crash 1929 (Houghton, Mifflin Company, New York 1955).
22 SN Nelson, ‘The Real Great Depression’, The Chronicle Review (2008), S Mixon, The Crisis of 1873: Perspective from Multiple
Asset Classes r (2007) 4–10. G Akerlof and R Schiller, Animal Spirits: How Human Psychology Drives the Economy, and Why It
Matters for Global Capitalism (Princeton University Press, Princeton 2008) 59–73.
Stephen Wallenstein
The roots of the financial crisis S27

and announced a programme to purchase the debt of financial firms, which it did, buying
an unprecedented $13 million in bonds. Despite this infusion, credit markets froze and
the overnight lending rate increased significantly. These frozen credit markets had a
lasting impact on commercial activity throughout the country. Though the panic was
over, the commercial crisis was just beginning. Businesses went bankrupt, commercial
and retail activity slowed and unemployment rose sharply.
The echoes of the past in the current problems with residential mortgages point to
a severe and prolonged economic problem if left unchecked. In the aftermath of Lehman
and the near collapse of AIG, some of the market stress was caused by the unwinding
process of CDS contracts, leading to the unprecedented credit freeze. As in 1873,
a complex financial pyramid rested on complex, hard-to-value, illiquid securities.
In response, banks began hoarding cash. Banks that hoard cash do not make short-term
loans. Today businesses of all sizes face unprecedented difficulties in getting loans to
finance operations and inventory.

Crises in developing nations: Latin America and Asia

In the late 20th century two debt crises emerged on two continents: South America and
Asia. Both were exacerbated by the financial pressures that come with the transition from
a poor, mostly subsistence-level economy, into a modern system employing modern
industry and technology.
In the 1960s and 1970s, the economies of countries south of the US border were
beginning to take off. As bankers saw strong growth, and apparently boundless
opportunities for economic expansion, they were glad to lend these countries the money
they needed. As the oil shocks of the early 1970s unhinged even the largest economies,
reducing the flow of capital to Latin America, the new oil-rich countries provided more
capital by depositing their profits in international banks, which recycled these dollars
to Latin America.
But by the early 1980s interest rates were soaring through most of the world, and the
increase in oil prices had slowed considerably. Much of the Latin American debt was
short term, with repayment dependent upon rapid turnover of funds—new loans paying
off old ones. These new loans came with ever-rising interest rates. This fed the debt,
and by 1982, many Latin American countries had borrowed so much that they could
no longer pay the interest on what they owed. In August 1982, Mexico announced
that it could no longer service its debt. Banks reacted with sharp reductions in further
loans to most Latin American nations. Since much of their debt was short term,
this brought on a situation that threatened to push most of South and Central America
into default.
Asia’s economic crisis is more recent. Through the 1990s the economies of Asia’s
developing nations had been growing quickly, often by as much as 10 per cent annually,
but growth depended on continued borrowing. Thailand’s new economy was char-
acterized by a boom in real estate, attracting foreign investment. In 1997, when Thailand
S28 Capital Markets Law Journal, 2009, Vol. 4, No. S1

became insolvent and was unable to pay its foreign debts, it reacted by floating its
currency, the baht. As repercussions spread through the Pacific Rim, the IMF stepped in,
providing $40 billion to Thailand as well as South Korea and Indonesia to help stabilize
their currencies. By 1999 Thailand and South Korea were beginning to recover, but rising
prices in Indonesia contributed to the instability that brought down its president.

The last American economic crisis

For most living Americans the last serious recession was that of 1981–1983. It came
on the heels of over a decade of economic woes that had followed a quarter century
of post-war boom. From 1969 to 1980 the USA suffered three recessions, each
followed by an anaemic recovery.23 These downturns featured a new phenomenon which
economists labelled ‘stagflation’, the coupling of inflationary prices with high
unemployment. In 1979, just as inflation was peaking at 13.3 per cent, Paul Volker
arrived at the Federal Reserve with a mandate to do whatever was necessary to tame the
rise in prices. Volker decided that the key to controlling inflation was control of the
money supply, so he tightened credit. In 1981, as he saw the beginnings of the second
recession of his less-than-two-year tenure, Volker’s Fed raised interest rates to 21.5 per
cent. Business contracted, private borrowing plummeted and unemployment soared to
10.8 per cent, but the economy recovered, going into its first sustained boom since the
1960s. In the ensuing quarter century, America has enjoyed the most consistent economic
growth in its history with only two recessions, one in 1990–1991 and the next in 2001.
Both were relatively brief and shallow. This extended period of sustained prosperity has
ended with our present crisis.

6. Conclusion
New Deal: failure or success?
Some historians see the New Deal as a failure, and contend that little occurred to ease the
Great Depression until 1941, with America’s entry into World War II. They argue that
only war could bring recovery. There is some truth to this. At the Depression’s low point
in 1933, unemployment stood near 25 per cent and GNP was down by nearly a third.
It had taken almost 4 years to sink that low, and recovery proved to be an even longer
road. By the beginning of 1940, unemployment still hung on at nearly 15 per cent, though
GNP had recovered to above pre-crash levels. That year the war buildup began in earnest,
and after Pearl Harbour, America became a virtually full employment economy fuelled by
deficit spending far beyond that of the New Deal budgets. Oddly, many of the same
historians who contend that the one-and-only fix for those hard times was the massive
World War II spending use that same contention as an argument against government
measures today. They argue that public spending will not work, and that the private
sector should be left to find its way out of this crisis on its own.
23 National Bureau of Economic Research 5http://www.nber.org/cycles/4 accessed 30 March 2009.
Stephen Wallenstein
The roots of the financial crisis S29

The New Deal was the US government’s largest intervention in a peacetime economy
up to that time. It did have effects on business and workers, and these showed themselves
in a slow, fitful fall in unemployment and a large increase in GNP. In the course of their
attempts to bring back prosperity, New Deal advocates constructed the safety net that
keeps us from an even worse downturn today. We might ask critics of government
measures: how deep a hole would we be in if there were no Social Security
or unemployment benefits?

A different success
In 1930s Washington an activist administration went on an unprecedented spending
binge. While some dollars went to welfare and make-work projects, more were invested
in programmes that laid much of the groundwork for the world we know today. Federal
roads built in that decade were the precursors of today’s interstates. Rural electrification
brought farms into the modern world. Government programmes encouraged the arts,
education, public health, science and agriculture.
These programmes were created by smart, innovative people from all over America.
In an era when financial institutions had failed, the government spent on ways to harness
the nation’s real wealth: its people, their energy and their hopes for the future. Through
much of that decade, the smart minds went where they were needed most: to a
government open to innovation.
That government spending encouraged a different kind of profit. At first it was profit
that couldn’t be measured in dollars. Instead success came in an end to hunger, and in
families who could work, and raise their children to grow up and make a new and better
world. Though many had seen their lives shattered, they were ready to try again.
Once they did, their efforts translated into real dollars—the kind of dividend any investor
would be happy to see.
Any government response to today’s crisis should take into account the change in
dynamic that occurred between the 1920s and 1930s. In the 1920s, the financial sector
attracted the most creative talent in the nation. Our best minds applied themselves to the
task of making money. This was true in banking, industry, law, science and even
medicine. The market dictated the development of new inventions and drugs. New laws
were business friendly, and judicial appointments went to candidates with pro-business
credentials. In education, colleges concentrated more and more of their focus on business
and business-related specialties. The new mediums of movies and radio celebrated
education and the professions for the money they could bring, glorifying the drive to get
rich. President Calvin Coolidge captured the decade’s tone, saying: ‘The business of
America is business.’ He brought religious awe to his viewpoint when he added: ‘The man
who builds a factory builds a temple . . . the man who works there worships there, and to
each is due, not scorn and blame, but reverence and praise.’
The arrival of the Great Depression sent Coolidge’s ideas into eclipse. With the
downturn many of the workers who had worshipped at his factory/temple were pushed
S30 Capital Markets Law Journal, 2009, Vol. 4, No. S1

back out the doors. When they lost their homes they found different places to worship:
the breadline and the open road.
When FDR initiated the New Deal he did not claim to know exactly what he was
doing, but he knew why he was doing it. He wanted a recovery that raised people up from
poverty, while it rescued them from fear. He appealed to the finest young minds in the
nation to apply themselves to a solution. He redefined the Depression as a set of problems
subject to corrective action, while stimulating Americans to greater creativity and
innovation. The people came through. Much of the inventive thinking that would have
gone into making money in the 1920s was now redirected at pulling a nation up from
disaster. That talent, energy and drive did contribute to easing the worst effects of the
Depression and the same resources helped win the War. As the discussion above shows,
our current crisis echoes history, which if repeated, suggests severe and prolonged
economic contraction. When banks fail on Wall Street, they stop commerce on Main
Street. The effects of such a collapse last for extended periods of time.