Here's an excellent radio program from NPR that explains the banking crisis more clearly than any other source I've found (about 45 minutes).
PBS Video on the Debate Between "Rational" and "Behavioral" Models and their impact in the crash
There's a Credit Crunch when Financial Institutions Don't Want to Lend
Here's a short letter explaining the credit crunch1 from the Wall Street Journal. The basic explanation is simple. There's a credit crunch when banks don't want to lend money. They don't want to lend money if they think they might not be repaid. To reduce that risk they often ask for collateral. However, financial services firms are holding a lot of collateral from past lending whose value is highly uncertain right now, in the form of securities tied to mortgages that themselves may not be repaid. So banks are worried about the value of the assets they are holding themselves, so they choose to hoard cash instead of lending it out.
Lack of Financing Reduces Business Profits, Making Banks less Likely to Lend to Them - A Vicious Cycle
But the problem gets even worse. Banks are further discouraged from lending because the poor economy means that many businesses and individuals who would normally get loans are now considered too risky to lend to, because their own financial situations are so tenuous. Customers who can't get loans reduce their spending. Businesses lose revenue due to lower customer spending, and they can't get credit from banks, increasing the risk that the banks' loans will not be repaid. See how this is a vicious cycle? Banks get into trouble, which reduces lending, which causes businesses to get into trouble, which makes banks get into even more trouble as their loans turn bad! That's called "positive feedback"2, but there's nothing positive about it.
The Federal Reserve is trying to help banks get money by providing cash against collateral that others feel is too risky. The Treasury is also providing capital to banks. However, as of January 2009 banks were still so worried about going broke that they did not lend out the money they received.
Financial Institutions Were Hurt by a Bubble that Went "Pop" in Real-Estate Investments
Here's a link to an article about the housing bubble in the New York Times (April 27, 2008)3 and the role of the credit rating agencies in producing it. The bottom line is that investors in mortgage-backed securities relied on the credit rating agencies to evaluate risk, and the credit rating agencies did a terrible job. Rather than looking at the default risk of each individual mortgage, they bundled groups of mortgages together and used historical default rates to estimate the likelihood of default. But the historical data were completely useless. New lax lending standards (such as "no-documentation" mortgages) meant that the old data did not represent the new situation. The problem was exacerbated by a conflict of interest. The ratings agencies only got paid if they found a way to make the securities attractive to investors - that is, if they assessed the risk of default as low. Therefore they had no incentive to dig too deep.
Here's the Einhorn speech4 that Ben Stein recommended in an April 27, 2008 NYT blog5 if you want to understand the credit crisis.
A Wall St Journal blog post6 points out that warnings about the increased risks in the financial markets were ignored by many economists. A 2005 (technical) paper by Raghuram Rajan7 suggested that there was danger due to changes in the financial systems that gave investment managers greater incentive to take risks.
The Wall Street Journal produced a series of short videos about the credit crunch "the end of Wall St":
Cengage (the textbook publisher) has a blog following developments in the Global Economic Crisis.
Microeconomics of the Credit Crisis
Need to clarify the incentives that were at work here.
IN March 2009 NYU Stern put out a series of white papers on "Restoring Financial Stability", with policy recommendations on everything from regulation to incentive structures for finance professionals. One of the more interesting ideas was a "bonus/malus" incentive structure, where "bonuses" in good years would be reduced by "maluses" in bad ones. However, there's till the issue of timing, with powerful incentives for people to get out in the good years.
I think the leverage cycle (Geanakoplos) is an important insight into booms and busts. Asset prices are influenced not just be interest rates but also be leverage offered by lenders.
- Why would you lend money if you didn't think it was going to be repaid?
- Why would you borrow more money (take on more debt) than you could afford?
- Idea of leverage
- Asset bubbles
- "Flipping" houses
- Why did house prices increase so much?
- Why have they now fallen so much?
The New York Times had an interesting column on how Hegel would see the philosophical problems of Wall St behavior. The key idea is that individual actions need a "world" in which they can achieve their objectives.