We are currently experiencing a major shock to the financial system, initiated by problems in the subprime mortgage market, which spread to securitization products and credit markets more generally. Banks are being asked to increase the amount of risk that they absorb (by moving off-balance sheet assets onto their balance sheets), but losses that the banks have suffered limit their capacity to absorb those risky assets. The result is a reduction in aggregate risk capacity in the financial system--a bank credit crunch caused by a scarcity of equity capital in banks--as losses force those who are used to absorbing risk to have to limit those exposures.

This essay considers the origins of the subprime turmoil, and the way the financial system has responded to it. There are both old and new components in both the origins and the propagation of the subprime shock. . . .

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Charles W. Calomiris is a visiting scholar at AEI.