George H. Blackford, Ph.D.

 Economist at Large

 Email: george(at)


It ain't what you don't know that gets you into trouble.

It’s what you know for sure that just ain't so.
Attributed to Mark Twain (among others)


Economic Papers
Political Essays

A Primer on Economic Crises

Part I: Origins of the Crash

George H. Blackford © 2008/9


Now that the election is over, a new administration is in Washington, and there has been a host of congressional hearings (Hearings) investigating last fall’s financial crisis (NYT) a consensus is beginning to emerge as to how this crisis came about.  The story begins with deregulation of the financial system.[1]


The Role of Deregulation 

Four legislative acts since 1980 have significantly reduced the power of government to control our financial system: 

  1. Depository Institutions Deregulation and Monetary Control Act (DIDMCA) in 1980. This act eliminated Regulation Q that allowed the Federal Reserve to set maximum interest rates on bank deposits, and it also allowed thrift institutions to issue checking deposits and expanded the types of loans they could make.

  2. Garn-St. Germain Depository Institutions Act (GGDIA) in 1982.  This act lowered the capital requirements of depository institutions.

  3. Financial Services Modernization Act (FSMA) in 1999, also known as the Gramm-Leach-Bliley Act (GLBA).  This act repealed portions of the Glass-Steagall Act of 1933 by allowing commercial bank holding companies to become conglomerates that are able to provide both commercial and investment banking services along with insurance and brokerage services.

  4.  Commodity Futures Modernization Act (CFMA) in 2000. This act prevented the Commodity Futures Trading Commission (CFTC) and state gambling regulators from regulating the over-the-counter derivatives markets, including the market for credit default swaps (CDSs). 

The evidence seems clear from the testimony before congressional hearings in the fall of 2008 (Hearings) by economists, lawyers, regulators, CEOs, and a host of others who are in some way knowledgeable or personally involved in the financial crisis that passage of these acts, and, specifically, the last two (FSMA and CFMA) played a major role in the financial crisis of 2008.  (Deregulation


The tale told in these Hearings is that the passage of the Financial Services Modernization Act (FSMA)  and the Commodity Futures Modernization Act (CFMA) combined with five other factors to bring about this crisis:

  1. New economic models for evaluating the risk of securitized debt instruments were created in the nineties.  This led to an expansion in the markets for Mortgage Backed Securities (MBSs), Collateralized Debt Obligations (CDOs), and other Asset Backed Securities along with the market for Credit Default Swap (CDSs) to insure these assets.

  2. There was a virtual explosion in the demand for securitized assets and the concomitant Credit Default Swaps  that insured these assets that began after the passage of the Financial Services Modernization Act (FSMA) and the Commodity Futures Modernization Act (CFMA).  This increase in demand was fueled by the increasing federal budget and foreign exchange current account deficits that took place after 2000 and was financed by the Federal Reserve through a low interest rate policy that pumped sufficient reserves into the financial system to maintain extraordinarily low interest rates. 

  3. The increase in demand for securitized assets  led to an increase in the demand for the mortgages that were a major component of these assets  with a particular emphasis on subprime and alt-A mortgages since these were the most profitable for the mortgage originators to sell.  This led to an extraordinary expansion in the mortgage origination business as mortgage originators expanded their operations to meet this increased demand. 

  4. After the passage of the Financial Services Modernization Act and the Commodity Futures Modernization Act the Federal government lacked a comprehensive framework within which to regulate the newly legitimized conglomerate banks.  Nor did they have the legal authority to regulate  or the Credit Default Swaps (CDSs) market.

  5. An anti-regulation bias within the Federal government led to a situation in which regulatory agencies were underfunded and lacked the staff, resources, expertise, and motivation necessary to effectively regulate the financial sector of the economy.  The result was an extraordinary lack of enforcement of existing regulations throughout the financial system.

These five factors along with the passage of the Financial Services Modernization Act and the Commodity Futures Modernization Act led to a financial regulatory system that was totally inadequate.  At the same time there was so much money to be made in the subprime, alt-A, and Mortgage Backed Securities (MBS) markets that the temptation for recklessness, corruption, and  fraud was irresistible. 


Mortgage Origination

The problem started with mortgage origination.  Since there were not enough qualified subprime and alt-A borrowers to meet the demands for these kinds of mortgages, predatory mortgage originators (such as Countrywide and CitiFinancial) talked a host of naive people into applying for these mortgages by misrepresenting them to the mortgagor.  The most serious misrepresentation was to offer borrowers an adjustable rate, negative amortization mortgage with an unreasonably low initial (teaser) rate without explaining the effect on their monthly payment when the initial rate adjusted to the contract rate.  Using this and other ploys (Spitzer), borrowers qualified for modest subprime mortgages at reasonable subprime rates were talked into applying for exorbitant subprime and alt-A mortgages at rates they could not afford.  Even borrowers qualified for modest prime rate mortgages at reasonable prime rates were talked into applying for exorbitant subprime and alt-A mortgages they could not afford.  At the same time borrowers not qualified for any kind of mortgage were approved for subprime and alt-A mortgages. 


Next, in order to sell these mortgages it was necessary for mortgage originators to obtain appraisals of the underlying properties consistent with the values of the mortgages being originated.  To obtain these appraisals mortgage originators shopped around for appraisers who would write consistent appraisals and shunned appraisers who would not.  This guaranteed a rising income for appraisers that cooperated with the mortgage originators and a falling income for those that did not.  The result was a systematic upward bias in real-estate appraisals and, hence, housing prices. 


At this point real-estate speculators got into the act.  As housing prices rose, and speculators discovered they could get alt-A mortgages with no money down, a host of disreputable speculators took out alt-A mortgages knowing if the prices of their properties increased they would make out like the bandits they were, and if the prices of their properties went down they could walk away from these mortgages with little or no loss. 



Firms that securitize mortgages were the next link in the financial food chain that fed off these fraudulent subprime and alt-A mortgages.  In order for investment banks and other firms that securitized mortgages to sell their products (the Mortgage Backed Securities they created from the subprime and alt-A mortgages) at the highest possible price they had to receive the highest possible ratings from a bond rating agency.  To accomplish this they followed the lead of the mortgage originators to steer their business to bond rating agencies that would give them the highest rating and away from those that would give them a lower rating.   In this way the companies that securitized fraudulently obtained mortgages were able to get the three major bond rating agencies (Moody’s, Standard and Poor’s, and Fitch) to give triple-A ratings to their Mortgage Backed Securities that contained these mortgages even though these bond rating agencies had no basis on which to evaluate the quality of these securities. 


As this process played itself out from 2002 through 2007 literally millions of fraudulent obtained subprime and alt-A mortgages provided the collateral for trillions of dollars of collateralized securities that were spread throughout the financial system of the entire world, and there was a failure of government regulation at every step in the process to keep this from happening. 


When state or local authorities complained to the federal government about the predatory lending practices in their communities, not only did the Federal Reserve, which had the absolute authority to stop these practices (Natter), do nothing to clamp down on the mortgage market, the Bush Justice Department actually went to court to keep state and local authorities from regulating this market.  (Spitzer)  As a result no restraints were placed on mortgage originators. 


When the conglomerate banks created after the passage of the Financial Services Modernization Act (FSMA) came into existence in the absence of a comprehensive framework within which to regulate them.  This combined with the anti-regulation attitude of the government made it possible for these banks to increase their leverage  (i.e., the ratio of their debt to their equity) without effective oversight or control.  As a result, leverage grew in these institutions beyond all reason.  At the same time, no one paid any attention to the bond rating agencies as they gave meaningless triple-A ratings to securities for which they had no basis to justify these ratings.  As a result, unsuspecting investors purchased these securities without any idea how dangerously risky they were. 


The CDS Market and Leverage

The most insidious failure of the regulatory system, however, was the failure to regulate the markets for Asset Backed Securities (ABSs) and Credit Default Swaps (CDSs) while at the same time allowing the newly legalized conglomerate entities to take the Mortgage Backed Securities (MBSs) and other kinds of Asset Backed Securities (ABSs) they were creating off their balance sheets


The importance of this last point must be emphasized.  To avoid the kind of financial crisis we are experiencing today the amount of leverage a financial institution is allowed to have must be inversely related to the riskiness of the assets held—the riskier the asset the lower the leverage.  The total leverage (hence, the resulting risk implicit in this leverage) in the system as a whole must be kept at a level commensurate with the riskiness of the assets in the system. 


When a financial institution purchases financial assets, bundles them together, and sells Asset Backed Securities to other financial institutions it creates a huge liability on its balance sheet since it is responsible for the Asset Backed Securities it sold that are backed by the financial assets it bundled.  When it purchases Credit Default Swaps  to insure the assets that backed the securities it sold it, in effect, ‘swapped’ the huge liability for the promises of the CDS sellers of the Credit Default Swaps to assume (insure against loss) this huge liability for the financial institution.  This eliminates the financial institution’s liability, but only to the extent the CDS sellers of the CDSs are, in fact, able to perform on their promises.   


It may make sense, in theory, to allow an individual institution to take its insured assets and corresponding liabilities off its balance sheet (though this is highly dubious given the experience with Enron taking its obligations off its balance sheet) as it purchases Credit Default Swaps to shed the risk associated with the securities it created, but only if the market for Credit Default Swaps is regulated.  If there are no regulations on the institutions that sell Credit Default Swaps there is no way to control the total amount of leverage in the system as a whole since there is nothing to keep an unregulated institution that sells CDSs from leveraging its equity at a 75 or 100 or higher to 1 ratio


When this was allowed, financial institutions that held assets which require something like a 12 to 1 leverage ratio for the system to be safe shifted the risk associated with these assets to financial institutions that leverage their equity at a 30 or 70 or whatever they wanted to 1 ratio.  This increases the leverage in the system as a whole from the 12 to 1 ratio to whatever the leverage was in the institutions that sold the assets and thereby assumed the risk associated with the assets. 


Allowing financial institutions to take their insured assets and corresponding liabilities off their balance sheets when the institutions that insured these assets where unregulated and the Credit Default Swaps  that insured their assets were traded in unregulated markets made it impossible for regulators to even know what the total amount of leverage (hence, the resulting risk implicit in this leverage) in the system was, let alone keep this leverage at a level commensurate with the riskiness of the assets in the system.  The result was an explosive increase in leverage in the system as a whole and, hence, an explosive increase in the risk to the system as a whole. 


This situation was further compounded by the fact that investors were able to buy Credit Default Swaps for Asset Backed Securities even though the investors had no connection to these securities. Combined with the failure to control the leverage in the rest of the financial system, the result was an explosion in the value of CDSs that grew to five or ten times the total value of the Asset Backed Securities they insured as well as the explosion in the leverage created in the financial system as a whole. 


The failure to regulate the CDS market made this situation untenable because in the absence of regulation there was no way to know the financial situations of the institutions that sold Credit Default Swaps and how much leverage they contributed to the system.  In addition, there was no way to know the financial situation of the entire CDS market—to know which of the sellers in this market were sound and which were not.  Hence, there was no way to know which Asset Backed Securities were actually insured and which Asset Backed Securities were, in fact, not insured by virtue of the fact that the sellers of the Credit Default Swaps that insured them would be unable to meet their financial obligations. 


The history of this period is yet to be written, but to date virtually all of the economists, regulators, lawyers, bankers, bond raters, and other individuals that either participated in, or in some other way gained firsthand knowledge of this debacle that testified before the congressional hearings on the financial crisis have agree that the scenario laid out above is essentially what brought us to where we are today.  (Hearings)  The end result of these forces combined created a huge speculative bubble in the housing market where prices rose beyond all reason, and when this bubble burst it brought down the system as a whole. 


But why has the bursting of this bubble cause so much turmoil in the economic system, especially since only 2% or 3% of mortgages were in default at the beginning of this crisis?  To answer this question we have to begin with an understanding of how the financial system works and the role it plays in the economy.


Part II: The Nature of Financial Institutions





[1] Since this piece was written in the fall of 2008 and updated in 2009 two comprehensive studies have come out that that fill in the details of the broad outline presented in this paper of the causes of the financial crisis that reached its climax in September of 2008.  The first is The Financial Crisis Inquiry Report, Authorized Edition: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (2011) produced by the Financial Crisis Inquiry Commission.  The second is  the Majority and Minority Staff Report of the Permanent Subcommittee On Investigations, WALL STREET AND THE FINANCIAL CRISIS: Anatomy of a Financial Collapse (2011).



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