The Cascading Financial Crisis


I. Fannie and Freddie Play with Fire

Prior to 2007

For many years, AEI scholars have been observing and warning about the giant government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. But as the economy boomed, few wanted to deal with the risks the GSEs posed to taxpayers and the financial system. Scholars at AEI were arguing that Fannie and Freddie posed systemic risk to the financial system, but policymakers would not listen. Congress routinely ignored calls for GSE reform. According to Peter J. Wallison and Charles W. Calomiris, in 2003-2004, when Fannie and Freddie went through multibillion-dollar accounting scandals, they wiggled their way out of these scandals by signing onto one of Congress's pet causes: increasing the stock of affordable housing. Fannie and Freddie used their massive size to steer the U.S. housing market toward subprime and Alt-A home buyers--that is, toward borrowers with the poorest credit records. But Fannie and Freddie did not pay a price for their risky financial behavior, because, as always, those who purchased their debt assumed that the GSEs enjoyed the backing of the federal government.

II. Subprime: Not So Sublime

March 2007

Thomas Zimmerman, Nouriel Roubini,
and Alex J. Pollock

Fueled by low interest rates, easy credit, and a host of unorthodox financing mechanisms like adjustable-rate mortgages, the U.S. housing market took off between 2000 and 2006. Bad credit or a lack of a down payment did not hinder many home buyers, and lenders overlooked these subprime borrowers' poor credit, counting on home values to rise. From 2005 to 2007, 20 percent of mortgages originated were subprime.

But beginning in early 2007, the U.S. housing bubble began to deflate. As home prices leveled off or began to decline, borrowers began to default, followed by big subprime lenders going bust. Credit dried up for the most risky borrowers, but the rest of the financial sector seemed to hold.

III. How Subprime Hit Primetime

Spring 2007

Pollock's one-page mortgage form.
Photo by Jennifer Morretta.

The subprime crisis could not remain isolated for long. One recent financial innovation was securitization of mortgages. Mortgages--including the huge number of those that were subprime--were packaged into securities and sold to investors throughout the financial system. All of the major investment banks' balance sheets had large swathes of mortgage-backed securities (MBS). While these were a hot option in a rising real estate market, a bursting bubble made them loss leaders. But even worse, financial institutions could not properly value their MBS, and their counterparties could not accurately assess their exposure to bad mortgage loans. Credit began to dry up across the board as financial institutions sought to adjust their balance sheets and avoid risk.

For strapped borrowers, many of whom were already suffering in the slowing economy and seeing their homes' values sink below the purchase price, foreclosure became a grim option. Alex J. Pollock proposed a one-page mortgage form to ensure that all home buyers are aware of their obligations and the terms of their loans. This form would be incorporated into congressional legislation and adopted by local communities, including the District of Columbia.

IV. The Infection Spreads

Summer and Fall 2007

Visiting Scholar
John H. Makin

In the summer of 2007, the fallout from subprime mortgage losses spread to the big financial houses. Credit began to contract in the global economy, and the Federal Reserve began acting to counteract the fears of anxious investors. Even as they worried about a liquidity crisis, banks remained reluctant to borrow through the Federal Reserve's discount window to shore up their own liquidity. Doing so would have required them to "discount" the collateral for these loans--the very instruments whose value was questionable and on which they would face steep losses if forced to declare their value. The Treasury got involved, creating a "superconduit" by which a group of banks would purchase troubled mortgage-related assets and speed up the process of discovering the assets' actual value. And not a moment too soon, or so it seemed: several leading banks declared huge subprime-related losses in the fall and going into 2008. As the losses mounted, would a major financial house go under?

V. Bear Necessities

March 2008

Treasury Secretary Henry M. Paulson
at AEI in 2007.

Bear Stearns was known to be exceptionally exposed to subprime-related losses--in the summer of 2007 it spent more than $3 billion bailing out two of its hedge funds' related losses--but in one weekend in March, Bear came perilously close to collapse. Treasury Secretary Henry M. Paulson engineered an unprecedented takeover, with Bear selling itself to JPMorganChase at a fire-sale price and the Fed taking $30 billion of Bear's riskiest assets onto its balance sheet. The financial policy world was in an uproar over the introduction of moral hazard. Although Peter J. Wallison rejected the notion that Bear was "too big to fail," the firm may indeed have been too interconnected to fail. Regardless, Vincent R. Reinhart, a former senior Fed official, regarded the Fed's decision to intervene as "the worst policy decision in a generation."

VI. The Future Shape of Regulation

April 2008

Arthur F. Burns Fellow
Peter J. Wallison

On March 31, Paulson unveiled a major overhaul of U.S. financial regulation. His report, which began as an effort to respond to concerns about the competitiveness of U.S. companies, was instead a far more ambitious blueprint for change. In an interview with the Wall Street Journal describing the effort, the secretary said that everywhere he looked, the "plumbing hasn't changed to meet the realities." One of the proposals would expand the role of the Fed in overseeing the financial system. Congress declined to act on Paulson's proposals, but Peter J. Wallison had written about regulatory and litigation burdens facing Americans firms and has urged an optional federal charter for insurance companies, all components of the Treasury plan. Wallison was particularly critical of the weakness of the Securities and Exchange Commission, an agency slated in the Treasury plan to be merged with the Commodity Futures Trading Commission.

VII. The Great Recession Debate

Spring 2008

Charles W. Calomiris, Allan. H. Meltzer,
Desmond Lachman, John H. Makin,
Vincent R. Reinhart, and Kevin A. Hassett

Figures showed that the U.S. economy grew by only 0.6 percent in the first quarter of 2008, identical to the final quarter of 2007. The official figures did not meet the classic criteria for a recession--two or more quarters of negative GDP growth--but they made it clear that the economy was slumping. Wages and compensation grew by 0.7 percent in the first quarter, less than expected, and consumer spending grew by its lowest rate since 2001. The Federal Reserve, battling the twin specters of recession and inflation, cut interest rates by a quarter of a point while promising to watch inflation closely. Although "economic stimulus" payments began flowing to taxpayers in April, they provided only a phantom boost to the economy that was expended by summer's end, when the economy became extremely dicey.

VIII. The Gathering Storm

Summer 2008

Visiting Scholar Charles W. Calomiris
and Resident Fellow Desmond Lachman

In the summer of 2008, financial news rarely hit the headlines, as Americans focused instead on the presidential election and other summertime diversions. But bubbling underneath were several troubling developments. In July, Paulson approved a lifeline for Fannie Mae and Freddie Mac, granting them access to the Fed's discount window and allowing the Treasury to purchase GSE stock. Although they provided temporary relief, they took away the government's room to maneuver and limited its policy options. Late July saw Congress pass a housing bill focused on Main Street worries. It authorized the Federal Housing Administration to insure up to $300 billion in fixed-rate mortgages for homeowners in trouble and established, too late, a strong regulator for the GSEs. Later in the summer, as Americans prepared to tune into the Olympics, Merrill Lynch wrote down $30 billion in mortgage-related assets. Even a firm thought to be in good financial shape still faced huge mortgage exposure. Bear was only the beginning.

IX. Fannie and Freddie's Day of Reckoning

September 2008

The headquarters of Fannie Mae in Washington,
D.C. Photo by Matti Mattila / Creative Commons.

The weekend was the new weekday in 2008, with many of the unusual financial interventions being negotiated and announced in time for Monday's trading. And over the weekend of September 6-7, Fannie Mae and Freddie Mac were nationalized. Paulson made clear that the winking federal guarantee of the GSEs' debts was real. The companies entered "conservatorship" under the newly created Federal Housing Finance Agency, sparing debt holders but pinning the companies' $5 trillion in liabilities on U.S. taxpayers. Paulson banned the companies from lobbying and fired their CEOs.

Shortly before the nationalization, Peter J. Wallison reviewed the options and suggested that the best course from the standpoint of taxpayers would have been to allow the GSEs to go into receivership, which would have allowed the management to wipe out shareholders and minimize taxpayers' losses, unlike the conservatorship, which Wallison characterized as "a gift" to shareholders. Furthermore, Wallison argued, bailing out Fannie and Freddie without reforming them means that a future Congress or administration can easily make the same errors and allow the GSEs to repeat their mistakes.

  • Wallison wrote in the Wall Street Journal that Paulson's approach to the GSEs neglects the systemic risk they cause, and he called the rescue "a major disappointment."
  • Alex J. Pollock, a historian of banking and former president of the Federal Home Loan Bank of Chicago, wrote that the "most radical part" of the GSE bailout is that the Treasury will become directly involved in mortgage finance. He called for the taxpayers' commitment to Fannie and Freddie to be defined and codified.

X. We All Fall Down

September 2008

Lehman Brothers' headquarters
in New York City, September 14, 2008.
Photo by Flickr user tschein /
Creative Commons.

A week later, Fannie and Freddie were all but forgotten as America awakened Monday to what was to be called "the week that changed American capitalism." Paulson declined to bail out Lehman Brothers, long teetering on the edge due to its exposure to bad mortgages. Lehman, finding no one else interested in rescuing it, declared bankruptcy. Merrill Lynch, not as weak but unlikely to survive on its own, sold itself over the weekend to Bank of America. "This was the right time for the government to draw the line," Vincent R. Reinhart said of the Treasury's lack of action.

That was all changed a day later, when the insurance giant AIG faltered suddenly. Reversing its position, the U.S. government lent AIG $85 billion in exchange for an 80 percent equity stake. The financial world was stunned that the U.S. government had effectively nationalized an insurance company--what would come next? Stocks fell freely in the confusion, and by Thursday, even "safe" money market funds lost money. Even worse, the credit markets--the "lifeblood" of the U.S. financial system--seized up in midweek. To calm the markets and avert further losses, Paulson took urgent action.

XI. The Mother of All Bailouts

September-October 2008

On Friday, September 19, Paulson announced the framework of a bailout of the entire financial industry. The U.S. financial system's exposure to mortgage-related losses had not been effectively mitigated by the previous weeks' actions, and the subprime shadow continued to haunt Wall Street. The trauma continued as the last two independent investment banks standing, Goldman Sachs and Morgan Stanley, reorganized as bank holding companies able to take deposits and subject to the Fed's regulation.

Under Paulson's proposal, backed by the rest of the Bush administration, the Treasury would spend "hundreds of billions" of dollars--perhaps as much as $1 trillion--buying illiquid assets from financial institutions. The assets would be managed and disposed of with an eye toward minimizing taxpayer losses, and firms would be able to resume raising capital once freed from the bad assets on their balance sheets.

Stocks rallied upon news of the plan, but the following week brought a mixed response as Congress pushed back on the plan. It drew criticism from both right and left for its sheer size and for its lack of oversight: "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency." Congressional Democrats sought to add their own provisions to the bailout, such as allowing bankruptcy judges to modify mortgages, placing executive compensation limits on companies participating in the bailout, and increasing funding for affordable housing.

XII. Obama Wins and Prepares to Govern

November-December 2008

The economic panic probably mortally wounded the already-underdog McCain-Palin campaign, and Barack Obama swept to a major victory, with 53 percent of the popular vote and 365 electoral votes. Obama unveiled his transition team, announcing a key player in the bailouts of the fall--New York Fed president Timothy Geithner--as his treasury secretary nominee. Obama also named Paul Volcker to chair his Economic Recovery Advisory Board.

In a sign of further interventions to come, executives from Ford,Chrysler, and General Motors came to Washington in November 2008 toseek massive infusions of taxpayer cash in order to stay afloat. Speaking at AEI, President Bush said that he did not want to leave the automakers collapsing as his successor took office, so he approved the bailouts.

The transition was punctuated in early December by the declaration from the National Bureau of Economic Research that the U.S. economy had entered recession in December 2007. With the recession officially declared, the financial crisis had morphed into a wider economic crisis that was engulfing the entire world. Political leaders worldwide began debating the merits of fiscal versus monetary stimulus and the extent to which the latter was even possible in struggling eurozone economies like Ireland and Hungary.

This summary ends with the official declaration of recession. To follow the latest economic developments, visit's section on Economic Policy Studies.