A Simple Explanation of What Went Wrong

Wednesday, September 24, 2008 | 12:15 PM

I read this interesting Brookings paper yesterday, titled "A Brief Guide To Fixing Finance." The most intriguing part of the paper was this simple explanation of exactly how things managed to get so bollocked up in the first place.

The authors note the “domino-like” character to the financial crisis:

1. The bubble in home prices, fueled by the ready availability of credit, resulted in an underestimate of the risks of residential real estate;

2. The peaking of residential home prices in 2006, combined with lax lending standards were followed by a very high rate of delinquencies on subprime mortgages in 2007 and a rising rate of delinquencies on prime mortgages;

3. Losses thereafter on the complex “Collateralized Debt Obligations” (CDOs) that were backed by these mortgages;

4. Increased liabilities by the many financial institutions (banks, investment banks, insurance companies, and hedge funds) that issued “credit default swaps” contracts (CDS) that insured the CDOs;

5. Losses suffered by financial institutions that held CDOs and/or that issued CDS’s;

6. Cutbacks in credit extended by highly leveraged lenders that suffered these losses.

Sure, that's an oversimplification. But it is a good place for the layperson to begin trying to comprehend what exactly went wrong here . . .


A Brief Guide To Fixing Finance
Martin Neil Baily, Senior Fellow, Economic Studies
Robert E. Litan, Senior Fellow, Economic Studies
The Brookings Institution, September 23, 2008

Wednesday, September 24, 2008 | 12:15 PM | Permalink | Comments (86) | TrackBack (0)
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How about an overly simplistic way to fix the problem?

What if the gov't buys these loans and passes on the savings directly to the borrower? For example, if they buy the loans at 60 cents on the dollar, give 35 cents of savings to the borrower directly (through a decrease in loan balance) and the 5 cents left over for the private sector who buys them from the gov't?

Posted by: Joshua | Sep 24, 2008 12:32:08 PM

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