The financial crisis that has developed around subprime mortgages is so so astounding in so many different ways that, like many others I suppose, I am still having difficulty getting my mind around it. The whole thing is a big surprise for me. I would have been pretty ready to assert, as late as 6 months ago, that financial crises of this magnitude had become solely a developing-country phenomenon and that rich countries had developed the regulatory and other mechanisms that would prevent them from getting into such a mess. Yes, there would be smaller scale hiccups, such as the S&Ls or LTCM, but you certainly couldn't have a meltdown a la East Asia 1997-98 or Mexico 1994 in an economy such as the U.S.
Now we know that I would have been wrong. What is happening in the U.S. is no different from what took place in Thailand in 1997 or in Argentina in 1999, with the entire financial sector going belly-up. The only thing that remains to be seen is whether the costs to the real economy will be as high too. The rough rule of thumb for emerging markets is that banking crises are associated with an output loss of around 10% (see here for example). The best estimate we have at present is that U.S. real GDP will take a hit of something like 3.6% over the next couple of years. This is a fraction of the loss experienced in a typical emerging market crash--but of course this particular estimate may also prove to be wildly optimistic.
But here is what I would love to know. What is the single thing that, had it not happened or happened differently, would have prevented this crisis from turning into the meltdown it has? In other words, what is it that has allowed a regular credit cycle to metamorpose into a systemic crash? Here are some of the culprits we regularly see mentioned:
- A bubble in the housing market
- The originate-to-distribute model of mortgage lending
- Lack of transparency in structured finance and mortgage-backed securities
- Lack of regulation of derivatives
- Poor credit-rating practices
- Fannie Mae and Freddie Mac straying from their original mandates
- Implicit government guarantees for Fannie and Freddie
- Lack of regulation of hedge funds and private equity
- Inadequate capital requirements for financial intermediaries
- The too rapid or generous extension of Fed credit to non-banks
- The rescue of Bear Stearns
- The failure to rescue Lehman
I am sure you can add a few more to the list.
What I am asking is this: which one of these items--individually or taken in groups--was both necessary and sufficient to bring us to our current impasse, where the government has little choice but to take over all mortgage-related assets off the books of private financial institutions? If you answer "all of the above," you are not being helpful at all.