As I see the financial crisis of 2008, the following steps outline what took place.
1. The US government encouraged – with considerable help from Fannie and Freddie – a large-scale expansion of mortgage lending to people who were unlikely to be able to pay back their loans, especially if home prices declined. These sub-prime mortgages were created on a large scale. The unusually low interest rates set by the Fed encouraged risk taking by artificially reducing mortgage rates, including through teaser loans. There is evidence that housing price inflation rose during this period – temporarily reducing foreclosure rates, which then bounced back during the housing bust.
2. Then the large American banks purchased and securitized these mortgages. Somehow, there was an assumption that the mortgages were sound because Fannie and Freddie stood behind them.
3. Gradually, it became clear that the securities backed by the mortgages were unsound. Nervousness took over as these securities began to lose their value.
4. Enter the federal government. The first domino to fall was a relatively small investment bank, Bear Stearns. Hank Paulson rushed in, doing what Goldman Sachs bankers do, and made a deal. He was aided and abetted by Ben Bernanke at the Federal Reserve who, in an unprecedented move, took over these useless securities. Paulson then worked out a deal with JPMorgan, which became the owner of the remnants of Bear Steans. This was a great deal for JPMorgan because the remnants without the bad mortgages were worth something. Bear Stearns, badly managed, was bailed out, thereby creating an atmosphere that problems could be averted with bailouts. Freddie and Fannie also were bailed out, never having been held accountable for the damage they did.
5. Then a major effort was made to bail out Lehman Brothers. Apparently, a deal was close but at the last minute, a British regulator took an action that aborted the scheme, causing Lehman Brothers to fail suddenly. That failure severely infected the atmosphere. We must note that there is a large difference between an orderly bankruptcy and a sudden one.
6. The Lehman Brothers failure was followed by concerns about the big banks and other organizations such as AIG and large organizations like GM, both of which were bailed out. AIG is especially interesting because it had a sound insurance business but acquired a business in questionable loans with major participants like Goldman Sachs. In some respects, the AIG bailout was a bailout of the Goldman Sachs of this world.
7. One of the principal lessons of the financial crises is the importance of accountability. Bailouts allow people and companies to escape the consequences of bad practices, but a system without accountability will not work in the long run. Americans love sports, and accountability is an essential part of any sport. In golf, you are the one who tees up the ball. You hit it and it comes to rest somewhere. Eventually you get it on the green. It’s up to you to decide on the speed and break in the green and how to make the putt. The ball comes to rest and it is either in the cup or it isn’t. There is nothing ambiguous about the result.
So one of the main lessons to learn from the financial crisis is the importance of holding institutions - large and small, and including the federal government – accountable for their actions.