REPUBLICAN COMMISSIONERS

ON THE FINANCIAL CRISIS INQUIRY COMMISSION

FINANCIAL CRISIS PRIMER

QUESTIONS AND ANSWERS ON THE CAUSES OF THE FINANCIAL CRISIS

Delivered as required by P.L. 111-21: The Fraud Enforcement and Recovery

December 15, 2010

Introduction ..................................................................................................................................... ii
Why was there a housing bubble? .................................................................................................. 1
How did the U.S. government contribute to declining lending standards? .................................... 2
How did important financial firms become exposed to the mortgage market? .............................. 3
How did mortgage-related losses lead to the failures of important financial firms? ...................... 5
How did the panic start, and why did it end? .................................................................................. 6
Why was the panic so painful for the economy? ............................................................................ 7

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Introduction

On May 20, 2009, Public Law No. 111-21, the Fraud Enforcement and Recovery Act of
2009, was enacted into law, creating the Financial Crisis Inquiry Commission (FCIC). According
to the Act, the FCIC was established to “examine the causes, domestic and global, of the current
financial and economic crisis in the United States.” The law requires that today, December 15,
2010, the FCIC submit “to the President and to the Congress a report containing the findings and
conclusions of the Commission on the causes of the current financial and economic crisis in the
United States.”
This primer contains preliminary findings and conclusions released by Vice Chairman Bill
Thomas, Commissioner Keith Hennessey, Commissioner Douglas Holtz-Eakin, and
Commissioner Peter J. Wallison, and represents a portion of the findings and conclusions
resulting from our work on the FCIC. As the transmission of the report of the FCIC to the
President and Congress requires a majority vote of the Commission, these findings and
conclusions do not constitute the Commission’s report. Rather, this document is an effort to
reflect the clear intention of our enabling legislation.
Our views have been shaped, in part, by our knowledge of economics and financial markets
generally. In the course of our examination, we have studied and drawn from the extensive work
already available on the financial crisis. This crisis that we were tasked to study is neither the
first nor likely the last of its type, and thus our examination of similar, previous episodes also
informed our findings and conclusions. To that end, we see this document as a part of an already
rich discussion of the causes of financial crises, both in the United States and around the world.
This document adds to that conversation rather than closing it. The two seminal works on
the causes of the Great Depression, Milton Friedman and Anna Schwartz’s A Monetary History
of the United States, 1867–1960 and Ben Bernanke’s “Nonmonetary Effects of the Financial
Crisis in the Propagation of the Great Depression,” were published in 1963 and 1983,
respectively, many decades after the crisis had ended. We anticipate that future generations will
continue to provide additional insights into the causes of this financial crisis as well.
Further, we want to stress the extent to which our views have been influenced by the
research and investigations conducted by the FCIC since our first meeting in September 2009.
The work included conversations with economic historians, finance experts, and other
academics, and hundreds of interviews with market participants, regulators, and government
officials. While we may have organized and conducted some of these investigations differently
given the choice, we have found many elements to be useful. We thank the FCIC staff for their
hard work.
We have tried to distill those issues that we think are most important into a series of
questions and answers. Different questions were included for different reasons, including those
topics that, in our view, are commonly mischaracterized and those most relevant to future policy
discussions. Certainly, this is not an exhaustive list.
Our framework reflects a central premise that the financial crisis was distinct from other
recent important economic events, including the housing bubble and the prolonged economic
recession. We believe that the financial crisis was, at its core, a financial panic that was
precipitated by highly correlated mortgage-related losses concentrated at large financial firms in
the United States and Europe. While the housing bubble, the financial crisis, and the recession
are surely interrelated events, we do not believe that the housing bubble was a sufficient

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condition for the financial crisis. The unprecedented number of subprime and other weak
mortgages in this bubble set it and its effect apart from others in the past.
We look forward to continuing to participate in the ongoing dialogue on the causes of the
financial crisis and providing our additional views as they develop.

Vice Chairman Bill Thomas

Commissioner Keith Hennessey

Commissioner Douglas Holtz-Eakin

Commissioner Peter J. Wallison

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Why was there a housing bubble?

Bubbles happen. In retrospect, they always seem easy to identify, but as they are building,
experts debate whether they exist—and, if so, why. The recent housing bubble was no different.
Despite national home price appreciation well above the historical trend for almost a decade, and
local markets with even more pronounced price swings, most homeowners and mortgage
investors believed there were sound fundamentals underpinning their investments.
We will likely never have a complete explanation for why there was a housing bubble, but
we have some clues. First, even without a big change in the costs of building a home, a sharp
increase in demand for homes can cause rapid price increases until new homes are built, bringing
prices back down.
Warren Buffett, in testimony before the Commission, echoed sentiments heard again and
again by the Commission: “My old boss, Ben Graham, used to say, ‘You get in much more
trouble in investments with a sound premise than a bad premise because the bad premise you
recognize immediately doesn’t make any sense.’” Buffett continued, “A home is a sound
investment. I mean, 66 or 67 percent of the people are going to be in one. And, if you believe
house prices are going to go up next year, you’re going to stretch to buy one this year, and the
world enabled people to stretch.” Investors of all kinds found themselves exposed to the housing
market: homeowners, insurance companies, commercial banks and thrifts, investment banks,
pension funds, the U.S. government, and ultimately the American taxpayer. Some identified
froth in the national market and expected to see home prices plateau, or fall slightly. But a 30
percent national decline in just over two years—that was beyond their wildest fears.
As home prices ballooned, the costs of borrowing dropped dramatically. Homeowners were
still able to borrow, even given the higher prices. Mortgage interest rates dropped to all-time low
levels. The percentage of nontraditional mortgage products in the mortgage market exploded.
Low mortgage rates meant that borrowers could buy a larger, more expensive home for the same
monthly payment. Nontraditional mortgage products, such as 2/28s and option ARMs, meant
that, unlike in the standard thirty-year fixed-rate mortgage, borrowers could make a lower
payment up front and refinance their mortgage a few years later at a lower rate when their home
had appreciated in value (or so they thought).
Why the sudden change in borrowing costs? For a borrower, a mortgage is a big part of the
cost of buying a home. But for a lender, a mortgage is an investment like any other. Lenders, in
theory, demand higher interest payments from riskier borrowers because the lender needs to be
compensated for the risk that a borrower will default and the lender will have to sell the home for
a loss. As long as home prices did not fall too far, mortgage lending was thought to be a
relatively safe business. Even if the borrower could not make their payments, the lender could
still make good on their investment by selling the foreclosed home.
In retrospect, however, it is clear that lenders—including the government, which held the
credit risk on most of the subprime and other weak mortgages outstanding—were not requiring
big enough returns to compensate for the risks they were taking. The real risk of a mortgage
investment became delinked from the premium demanded by investors to make a loan. Why?
For one, investors shared the same mindset as borrowers, enticed by the belief that home prices
would never fall on a national scale. Further, the returns on investments thought to be
comparably safe were yielding far less than mortgage-related investments. In the case of the

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government, it was following a social policy in addition to an investment policy. There were
three important ways that the government pushed investors toward investing in mortgage debt.
First, the regulatory capital requirements associated with mortgage debt were lower than for
other investments. Second, the government encouraged the private market to extend credit to
previously underserved borrowers through a combination of legislation, regulation, and moral
suasion. Third, and most important, during the bubble’s expansion, the largest investors in the
mortgage market, the government-sponsored enterprises (GSEs)—Fannie Mae and Freddie
Mac—were instruments of U.S. government housing policy.
In time, the areas of the country with rapid home price appreciation became overbuilt, and
home prices began to decline. A series of indices were created based on subprime mortgage-
backed securities (MBS)—debt securities collateralized by subprime mortgage pools—that
allowed investors to invest in housing without having to buy actual mortgage debt. These indices
fell as bearish investors became increasingly pessimistic, indicating to the market as a whole that
all was not well in the mortgage market. Demand for homes declined, and demand for mortgage
investments followed. The U.S. government stepped in, but it was too little, too late. The bubble
had burst.

How did the U.S. government contribute to declining lending standards?

During the boom, the biggest participants in the mortgage market were the GSEs. Unlike
other investors, who are profit-maximizing and will invest in whatever will bring them the best
returns, Fannie Mae and Freddie Mac had a number of competing investment objectives.
Fannie Mae and Freddie Mac were established in 1938 and 1970, respectively, by the
government to invest in mortgages and thereby provide liquidity in the mortgage market. In
recent years, the GSEs were also bound by a set of “affordable housing goals” established in the
1992 GSE Act to direct a certain proportion of their investments to low- and moderate-income
borrowers and to homes located in low-income neighborhoods. In order to accomplish these dual
goals, the government explicitly subsidized the investments of the GSEs.
However, Fannie Mae and Freddie Mac were not a part of the U.S. government. To remove
Fannie Mae’s debt load from the budget, Congress re-commissioned it as a privately run
government-sponsored corporation in 1968, and Freddie Mac was similarly situated when it was
created two years later. Despite being privately owned, the GSEs retained an implicit
government guarantee. Investors believed that the government would always stand behind the
GSEs, and the government encouraged that perception.
The GSEs easily met the affordable housing goals during the 1990s, but these goals were
incrementally increased as part of a new housing policy agenda that began during the mid-1990s
under President Bill Clinton and continued through the 2000s under President George W. Bush.
President Clinton announced a “national homeownership strategy” that would increase the
homeownership rate in America from the then-current level of 65 percent to 67.5 percent by
2000. Subsidizing mortgages through the GSEs was a particularly politically expedient way to
increase the homeownership rate.
The government has always supported homeownership. But trying to get something for
nothing—to subsidize homeownership without increasing the budget deficit—was a recipe for a
crisis. The government, in effect, encouraged the GSEs to run two enormous monoline hedge
funds that invested exclusively in mortgages and were implicitly backed by the U.S. taxpayer.

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 The GSEs had traditionally only purchased or guaranteed the highest-quality mortgages
from low-risk borrowers. But from 1993 to 2007, the government-established affordable housing
goals grew beyond the GSEs’ ability to meet them. Shrinking their quantity of prime purchases,
thus increasing the proportion of “goals” investments, would have violated their mission of
providing liquidity to the mortgage market. Further, as publicly traded companies, they had a
fiduciary duty to their stockholders. The only option available was to invest in mortgages of
increasingly lower quality and higher risk to the taxpayer. That is precisely what they did.
During the inflation of the housing bubble, the GSEs lowered their standards and began investing
in subprime and Alt-A mortgages—and to great fanfare, as the national homeownership rate
averaged 68.7 percent from 2003 to 2006.
The GSEs invested in high-risk mortgages in two ways. The first was by doing exactly what
the GSEs had done for decades: guaranteeing loans. The GSEs would provide a credit guarantee
on mortgage pools that were sold to them by originators and then issued back to the lender as a
GSE-guaranteed MBS, or “agency MBS.” The GSEs would charge a guarantee fee in exchange
for taking on the credit risk of the pool of mortgages. But in an effort to meet their affordable
housing goals, the GSEs began guaranteeing ever-riskier loans.
The second way the GSEs invested in high-risk mortgages was through MBS backed by
subprime and Alt-A mortgages, which they held on balance sheet. Although some of these loans
qualified for affordable housing goals, these investments were also, to a large extent, pure
interest-rate arbitrage, given the low cost of funding for the GSEs.
The GSEs were not the only means by which the government supported the financing of
high-risk mortgages. Through the GSEs, FHA loans, VA loans, the Federal Home Loan Banks,
and the Community Reinvestment Act, among other programs, the government subsidized and,
in some cases, mandated the extension of credit to high-risk borrowers, propagating risks for
financial firms, the mortgage market, taxpayers, and ultimately the financial system.

How did important financial firms become exposed to the mortgage market?

The primary role that financial firms played in mortgage lending was that of financial
intermediary, providing a link between those who wished to invest in mortgages and those who
wanted to take out a mortgage to buy a home. This is the value of a robust financial system—it
allows investors to make investments wherever they choose and borrowers to borrow at the
lowest cost. Without this web of mortgage originators, depository institutions, broker-dealers,
money funds, insurance companies, hedge funds, and the GSEs, it would have been incredibly
hard for a retiree in California to lend his savings to a homebuyer in Miami, much less a
diversified group of homebuyers across the country. But with financial firms acting as
intermediaries, getting exposure to the U.S. mortgage market was made incredibly easy.
The process by which financial firms acted as intermediaries is known as securitization.
Rather than holding a loan to maturity, the loan originator would sell the loan as part of a pool of
loans into the secondary market for mortgages. These loan pools would be purchased, turned into
MBS, and sold to investors. The system had worked this way for decades, and worked well.
However, in the past, the majority of loans in the secondary market were sold to, guaranteed by,
and securitized by the GSEs. During the 2000s, the non-agency MBS market boomed, and more
types of financial firms became part of the chain linking borrowers and lenders.

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 There were two ways that financial firms became exposed to the housing downturn. Some
financial firms, including Fannie Mae and Freddie Mac, were in the business of taking on
mortgage risk, rather than passing it along to a new investor. Insurance companies comprised
another group of firms that played a similar role in the mortgage market during the boom. These
companies took on the credit risk of highly rated securities in exchange for a protection payment.
Many mortgage investors were happy to rid themselves of the credit risk associated with their
mortgage-related investments in exchange for a slightly lower return. These insurance
companies, with their large and diverse balance sheets, felt that they would be able to withstand
these very low probability risks. In the end, they were spectacularly wrong. Further, a number of
banks, thrifts, and others did make investments in residential and commercial real estate for the
purpose of holding those loans to maturity and took very large losses in the process.
However, important financial firms principally involved in pure credit intermediation—that
is, providing the link between investors and borrowers—were exposed to the downturn as well,
but did not understand the risks they were taking at the time. The Commission found three
primary ways that the risk of the mortgage market found its way onto the balance sheets of these
financial firms: pipeline risk, super-senior risk, and reputational risk. All three were important
sources of liquidity risk, which is the risk that a financial firm will not have sufficient cash on
hand to pay its debts as they come due. During a crisis, when depositors make withdrawal
requests, or investors request that their short-term loans be repaid rather than rolled over,
liquidity risk becomes a primary concern. If the financial firm does not have enough cash on
hand, then it will have to sell assets into a depressed market. Liquidity risks can quickly evolve
into solvency concerns once a run begins. A striking conclusion we drew from the FCIC’s work
is the extent to which these liquidity risks proved to be systemically underappreciated.
Pipeline risk: Firms involved in the structuring of mortgage-backed products had to hold the
underlying loans or MBS on their balance sheets while these structured products were in the
process of being created. Although the underlying loans or MBS were acquired with the
intention of pooling and selling them, the market for mortgage-backed structured products
collapsed quickly. Not all of the accumulated loans and MBS could be sold for a profit, or sold at
all.
Super-senior risk: The safest, “super-senior” tranches 1 of mortgage-backed structured
products were less attractive to investors because they did not provide a sufficient spread above
other, safer securities, like U.S. Treasuries. Some financial firms, therefore, held these exposures
on their balance sheets, rather than selling them. Others sold the super-senior tranches with
enhancements, such as liquidity put options, which gave the investor the ability to sell the
security back to the issuer. In both cases, the firms issuing the products retained some risk. But it
was risk that they believed was minuscule. After all, these products were rated Aaa. However,
the complexity of these highly rated securities made them very hard to sell during the crisis.
Reputational risk: A number of financial firms made mortgage investments available by
creating “off-balance-sheet” entities, which were self-financing, arms-length investment
vehicles. Many of these investments came with an implicit promise that the sponsoring firm

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MBS issuances were “tranched” in order to give investors the ability to take different quantities of risk associated
with different yields, depending on the priority of payments from the mortgage pool. The senior tranches were the
safest and lowest yielding, followed by the mezzanine tranches, which were higher-risk but still investment-grade,
and the residual tranches, which were the riskiest and highest-yielding. Collateralized debt obligations often
consisted of a pool of these MBS tranches, sometimes combined with other debt products, and were similarly
pooled, tranched, and sold to investors.

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would stand behind its product, even in the absence of an explicit legal obligation. If the sponsor
would not stand behind its off-balance-sheet entities, it brought the viability of the rest of the
firm into question, which could be enough to spark a run on its own. However, the decision to
stand behind these entities during the crisis added stress to already fragile firms. It was a Catch-
22.
The credit rating agencies made many of the same mistakes as mortgage investors, and their
ratings on MBS proved to be severely inflated—an important reason that these credit and
liquidity risks were not appreciated by financial firms. Collateralized debt obligation (CDO)
ratings used MBS ratings and added another layer of complexity: default correlation. A CDO is a
pool of different structured products, such as MBS tranches, created in order to provide
additional diversification to the investment and thus, in theory, lower risks. Mezzanine CDOs,
which were a significant source of losses for financial firms during the crisis, consisted of a pool
of mezzanine tranches of MBS. For a bond rated Baa3 by Moody’s—the lowest-rated investment
grade bond—the five-year idealized expected loss rate is 1.7 percent. Given these loss
assumptions, it made sense that there would be some benefit to diversification among mezzanine
tranches of MBS. Imagine you are a landlord who manages one hundred properties in an area
that is frequently buffeted by rainstorms. In a given storm, chances are that one or two of your
basements will flood, and in a really hard storm, maybe five or six. So, that is what you prepare
for. But this was not a normal storm. It was, to quote Goldman Sachs CEO Lloyd Blankfein, “a
hurricane.” The diversification benefits of a mezzanine CDO were overwhelmed by the rising
tide of foreclosures.
Put simply, the risk of a housing collapse was simply not appreciated. Not by homeowners,
not by investors, not by banks, not by rating agencies, and not by regulators.

How did mortgage-related losses lead to the failures of important financial firms?

When Fed Chairman Ben Bernanke came before the Commission in a closed session, he
highlighted one of the biggest questions that the Commission would have to address. Subprime
mortgages constitute a small asset class in comparison to the vast size of the global financial
markets. And yet, these mortgages were the trigger for the collapse of some of the most
important financial firms in the world, a financial panic, and ultimately severe economic losses.
How did it happen?
The answer: leverage and maturity mismatch. Because of the perceived safety of highly
rated MBS and CDOs, firms held minuscule capital against the probability of loss. We have
already discussed how leverage on mortgage assets permeated the regulatory apparatus. The
danger was not in the size of the market; the danger was that no one expected the market to turn
down, and mortgage investments were thus leveraged to the hilt.
Because these assets were considered so safe, and therefore so liquid, firms also funded their
mortgage exposures using very short-term debt. Mortgage exposures are long term—that is, the
actual loan payments accrue over a period of years. Yet, many firms were funding these
exposures using debt that matured as quickly as overnight.
Leverage and maturity mismatch are not bad things. The financial system and the economy
as a whole need them in order to operate. When a bank takes a deposit and lends a portion of that
deposit to a business so that the business can finance a new long-term investment, that is

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leverage and maturity mismatch at work. Leverage and maturity transformation are, to a large
extent, what banks do.
But both of these factors also create fragility. If the bank uses deposits to fund poorly
performing projects, depositors can become concerned that eventually their bank is going to fail
and they will not get their deposits back. If a bank lends too much of its deposits to finance long-
term projects, depositors might begin to worry that they will not be able to withdraw their money
according to their needs. Therefore, banks hold enough cash on hand, or “liquidity,” to be able to
honor withdrawal requests and offer confidence to depositors that their money will be there when
they want it. If depositors lose confidence in their bank, the only rational thing to do is to
withdraw their money and move it to a safer place.
With each depositor withdrawal, the bank becomes more leveraged, the mismatch between
its assets and liabilities becomes more pronounced, and liquidity on hand is further diminished.
Even more confidence is lost in the bank’s ability to meet future withdrawal requests. As rumors
spread that the bank is in danger of failure, all the bank’s depositors will want their money back
at once—a bank run. Runs can be sparked by real losses, but in the end, they are all about the
loss of confidence that depositors will get their money back.
Bank runs have not been all that common in recent history because banks facing a run can
borrow from the Federal Reserve to meet liquidity needs, and most deposits are insured by the
Federal Deposit Insurance Corporation. But other types of financial firms fund themselves using
a similar mechanism without the government backstop. They issue short-term debt to investors
and pay a small interest payment in return. Investors will usually choose to roll over their loans
when they mature, similar to a depositor choosing to keep their money in the bank. But once
investors get spooked, and a run begins, there is nothing that a financial firm can do except try to
regain the market’s confidence.
Runs are contagious. During a panic, fear of loss spreads quickly. When one firm is failing,
investors will often lose confidence in firms with similar business models, or similar asset
holdings. This is how the panic spread in the fall of 2008.

How did the panic start, and why did it end?

Following the successive collapses of Bear Stearns, Fannie Mae, Freddie Mac, Lehman
Brothers, and American International Group (AIG), what had begun in the second half of 2007
as a run on those firms that the market identified as having large mortgage exposures and acute
liquidity risks exploded into a generalized market panic. Depository institutions had failed.
Investment banks had failed. A major insurance holding company was rescued by the U.S.
government. Even the GSEs, with their implicit guarantee, were taken into conservatorship by
their regulator. Few firms were considered safe, and if they were, it was only because they had a
government backstop.
Lehman’s bankruptcy had an important effect on debt markets. Lehman had been unable to
find a merger partner due to its hard-to-value commercial real estate portfolio and a perceived
considerable capital hole. Following the government rescue of Bear Stearns, counterparties of
Lehman expected that they, too, would be made whole. This perception was further reinforced
by the bailout of the GSEs, as Fannie Mae and Freddie Mac debtholders were protected by the
U.S. government as well. But when Lehman went into bankruptcy, debtholders took losses.
Suddenly, holding debt of large financial firms seemed much more risky for investors.

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 This is the moral hazard problem caused by “too big to fail.” If the government is expected
to be unwilling to let a firm fail, debtholders will continue to lend money to that firm regardless
of the underlying strength of the firm’s balance sheet. This perception was an important source
of stability in financial markets during the summer of 2008. After Bear was rescued, Lehman had
been perceived as “too big to fail” by the markets, and when it failed, debtholders of other
financial firms fled to safer investments.
Think about the state of the world in September 2008 from the perspective of a short-term
lender. Your deposits and investments in short-term debt are based on the expectation that these
are very safe and liquid. However, with the financial system in crisis, uncertainty abounds, and
liquidity is paramount. What if one of your lenders refuses to lend you money or calls in your
loan? The rational response is to hoard cash, or at least to move your investments away from
counterparties that might be at risk of failure.
With everybody hoarding cash, and nobody lending, financial intermediation operated with
escalating friction, and the panic spread rapidly. The first firms to experience problems after
Lehman Brothers were the money market mutual funds and the two remaining investment banks,
Morgan Stanley and Goldman Sachs. The runs then spread to Washington Mutual, Wachovia,
and Citigroup.
By the end of 2008, the panic had spread to the widest corners of the financial system.
Thrifts IndyMac and Washington Mutual had failed, and Countrywide had been acquired by
Bank of America. Commercial banks Wachovia and National City had been acquired by Wells
Fargo and PNC, respectively, and Citigroup had been rescued by the U.S. government.
Investment banks Bear Stearns and Merrill Lynch had merged with JPMorgan Chase and Bank
of America, respectively; Lehman Brothers had failed; and Morgan Stanley and Goldman Sachs
had re-chartered as bank holding companies. AIG, one of the largest insurance holding
companies in the world, had effectively been seized by the U.S. government.
The panic ended when confidence returned. Automatic stabilizers exist in the financial
system. Once market participants believe that the weakest firms have failed, and asset prices fall
far enough so that market participants believe that bargains abound, lending and borrowing
return to normal. But the government played a big role in stemming the panic as well. The only
response to a panic is to credibly assure debtholders that firms have sufficient liquidity to honor
their commitments. By acting as a lender of last resort—that is, a counterparty willing to make
secured loans when no one else will—the government played a key role in preventing runs on
otherwise strong firms. Over the course of 2008, the Federal Reserve backstopped the financial
system by providing loans to a wide variety of financial firms backed by an expanded number of
collateral types. The passage of the Troubled Asset Relief Program helped restore confidence as
well. The government’s commitment to stand behind financial firms, combined with capital
injections and a guarantee of bank debt, helped to moderate the panic and stabilize financial
markets.
These were the best of a series of bad options, and policymakers had extremely limited
information to work with. While we believe that the government deserves quite a lot of the
blame for getting our financial system and our nation into trouble in the first place, we applaud
the quick and decisive actions taken by our nation’s leaders during the panic.

Why was the panic so painful for the economy?

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 We do not often think about how many everyday activities are connected in some way to the
functioning of the financial system, beyond the ability to access deposits at the local bank. But
for businesses to function, they need access to credit. This is why financial crises are so
destructive.
For large businesses that fund their liquidity needs through debt markets, strains in the
commercial paper market and the market for repurchase agreements—two important short-term
debt markets heavily relied on by large businesses for short-term funding prior to the crisis—
meant that they had to pay much more for ever-limited available funds. That is, if they could
access these debt markets at all. Many firms drew down existing lines of credit, fearful that if the
panic continued, they might be unable to continue to borrow. Small businesses, which rely
primarily on credit from banks, found borrowing increasingly difficult as well, as banks were
unwilling to take additional risk. No one was willing to lend.
The credit freeze affected consumers, too. Securitization markets for credit cards and student
loans, debts that had previously been securitized in similar fashion to mortgages, dried up.
Without a private securitization market operating, the GSEs were the only investor remaining for
homeowners looking to refinance their mortgages. Given the wealth loss that households faced
with the diminished value of their homes and the plunging of the stock market, consumers were
scared, and they decreased their spending.
The historical record is rich with examples of the prolonged and devastating economic
impact of financial crises. University of Maryland economist Carmen Reinhart and Harvard
economist Kenneth Rogoff have extensively studied the causes and aftermath of financial crises.
The patterns they identify align with our nation’s experience:
“Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of
severe financial crises share three characteristics. First, asset market collapses are deep and
prolonged. Real housing price declines average 35 percent stretched over six years, while equity
price collapses average 55 percent over a downturn of about three and a half years.” 2

National home prices fell 32 percent from their peak in April 2006 to their trough in March
2009. The Dow Jones Industrial Average dropped 54 percent from its peak in October 2007 to its
trough in March 2009.
“Second, the aftermath of banking crises is associated with profound declines in output and
employment. The unemployment rate rises an average of 7 percentage points over the down
phase of the cycle, which lasts on average four years. Output falls (from peak to trough) an
average of over 9 percent, although the duration of the downturn, averaging roughly two years,
is considerably shorter than for unemployment.”

The unemployment rate increased from 4.4 percent in May 2007 to a peak of 10.1 percent in
October 2009, a 5.7 percentage point increase. Output, in real terms, dropped 4.1 percent from its
peak in the fourth quarter of 2007 to its trough in the second quarter of 2009.
“Third, the real value of government debt tends to explode, rising an average of 86 percent in
the major post-World War II episodes. Interestingly, the main cause of debt explosions is not the
widely cited costs of bailing out and recapitalizing the banking system. Admittedly, bailout costs
are difficult to measure, and there is considerable divergence among estimates from competing

2
Carmen M. Reinhart and Kenneth S. Rogoff (2009) “The aftermath of financial crises.” American Economic
Review: Papers & Proceedings 99 (2): 466–472.

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studies. But even upper-bound estimates pale next to actual measured rises in public debt. In
fact, the big drivers of debt increases are the inevitable collapse in tax revenues that
governments suffer in the wake of deep and prolonged output contractions, as well as often
ambitious countercyclical fiscal policies in advanced economies aimed at mitigating the
downturn.”

From the end of 2007 to the end of September 2010, the federal government debt has
increased 47 percent, from $9.2 trillion to $13.6 trillion. The Congressional Budget Office
(CBO) estimates that the total cost of the Troubled Asset Relief Program will be $25 billion.
CBO projects that the cost of continuing to support the GSEs will be $53 billion over ten years
on a fair-value basis. And CBO estimates that the expanded Federal Reserve programs will be a
net gain to the budget, as the subsidy costs involved will be more than outweighed by the
increased remittances to the Treasury as the Federal Reserve accrues interest on its asset
holdings.
It seems like the current episode fits the historical pattern quite well. But how much of the
economic cost has come directly from the financial crisis, and how much has come from the
downturn in the housing market and other weaknesses in the economy at the time—for example,
the sky-high oil prices in the summer of 2008? To try to answer this question, former Treasury
Assistant Secretary for Economic Policy Phillip Swagel examined the difference between CBO
forecasts published in September 2008, right before the crisis, and the actual data. It is probably
as good a hypothetical as we can run. 3
Compared to the CBO forecast of essentially flat growth in the fourth quarter of 2008 and
the first quarter of 2009, the economy contracted 5.4 percent and 6.4 percent at an annual rate in
these two quarters, respectively. From the beginning of October 2008 to the end of December
2009, lost GDP relative to the September 2008 forecast amounted to $648 billion. By the end of
2009, the economy lost an additional 5.5 million jobs above and beyond CBO’s September 2008
projection. Wealth losses were particularly acute following the crisis as well. From July 2008
through March 2009, real estate wealth fell $3.4 trillion, and stock wealth, $7.4 trillion. Swagel
also projected the increase in wage losses and foreclosure starts due to the economic slowdown
resulting from the crisis. He estimates that there was a $3,250 loss in wages per household and
that over 500,000 foreclosures would not have occurred had the crisis not weakened the
economy in 2008.
Reinhart and Rogoff also find that financial crises often precede sovereign debt crises, given
the rapid increase in public debt. To this end, it is not by pure coincidence that our Commission
was set up at roughly the same time as the National Commission on Fiscal Responsibility and
Reform, which recently presented its report on the looming fiscal crisis in our country.
In their panoramic study of financial crises and the debt crises that follow, Reinhart and
Rogoff identify perhaps the four most dangerous words expressed by investors, regulators, and
policymakers before a crash: “This time is different.” We could not agree more. We caution our
nation’s leaders to learn the appropriate lessons from history and take seriously the need to
reduce our federal deficit.

3
Phillip Swagel (2009) “The cost of the financial crisis: the impact of the September 2008 economic collapse.” Pew
Financial Reform Project, Briefing Paper #18. http://www.pewfr.org/admin/project_reports/files/Cost-of-the-Crisis-
final.pdf.