The Great Recession of 2008-2009: Causes ... - Index of - IZA

or reserves.
5. Growth in credit default swaps (CDS) • CDO issuers purchased CDS, which enabled them to
receive AAA ratings. These purchases were not
regulated as over-the-counter transactions.
Source: Adapted from Astley et al. (2009) and Baily et al. (2008).
As argued by Shiller (2008), ‘The housing bubble was a major cause, if not the (author’s
emphasis) cause, of the subprime crisis and of the broader economic crisis...’ (Shiller 2008:
29). However, due to the rapid increase in securitization of mortgage bonds, this was no
ordinary housing bubble insofar it was not only domestic lenders that were exposed to the
stability of the US housing market but investors around the globe. As captured in Table 1,
mortgages were sold on by the originators to third-parties, which were then repackaged as
mortgage-backed securities (MBS) and sold to investors. This enabled lenders to take the
loans off their books. In particular, special investment vehicles (SIVs) were pressed into
service and kept off the balance sheet, which allowed financial institutions to increase
leverage and returns on their investments. Thus, mortgages that were in the past the domain
of the traditional banking system could now be traded in open markets both within the US
and outside its borders, beyond the scope of regulatory measures (because they were
conducted as an over-the-counter transaction thus avoiding the regulations pertaining to the
stock market).
The development of new complex financial products outside the scope of existing rules
proved to be a major regulatory failing (Table 1). Overall, the central elements of this failure
were: inadequate capital requirements on products such as the collateral debt obligations
(CDOs); inadequate use of ratings and the way credit rating agencies themselves were
regulated; and the incentives for risk-taking generated by structured remuneration
arrangements (i.e. bonuses) (Astley et al. 2009; Baily et al. 2008, Bean 2009; Obstfeld and
Rogoff 2009).
This combination of a misperception of risk, lax financial regulation and low returns on
riskless assets fuelled the excessive leverage and investment in risky assets, namely the
mortgage-backed securities. Sub-prime mortgages were at the centre of the crisis but were by
no means the cause.
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