Causes of the Financial Crisis
Released: 2010-04-09T00:00:00

Summary:
The current financial crisis began in August 2007, when financial stability replaced inflation as the Federal Reserve's chief concern. The roots of the crisis go back much further, and there are various views on the fundamental causes.
It is generally accepted that credit standards in U.S. mortgage lending were relaxed in the early 2000s, and that rising rates of delinquency and foreclosures delivered a sharp shock to a range of U.S. financial institutions. Beyond that point of agreement, however, there are many questions that will be debated by policymakers and academics for decades.
Why did the financial shock from the housing market downturn prove so difficult to contain? Why did the tools the Fed used successfully to limit damage to the financial system from previous shocks (the Asian crises of 1997-1998, the stock market crashes of 1987 and 2000-2001, the junk bond debacle in 1989, the savings and loan crisis, 9/11, and so on) fail to work this time? If we accept that the origins are in the United States, why were so many financial systems around the world swept up in the panic?
To what extent were long-term developments in financial markets to blame for the instability? Derivatives markets, for example, were long described as a way to spread financial risk more efficiently, so that market participants could bear only those risks they understood. Did derivatives, and other risk management techniques, actually increase risk and instability under crisis conditions? Was there too much reliance on computer models of market performance? Did those models reflect only the post-WWII period, which may now come to be viewed not as a typical 60-year period, suitable for use as a baseline for financial forecasts, but rather as an unusually favorable period that may not recur?
Did government actions inadvertently create the conditions for crisis? Did regulators fail to use their authority to prevent excessive risk-taking, or was their jurisdiction too limited and/or compartmentalized?
The multiple roots of the crisis are mirrored in the policy response. Two bills in the 111th Congress—H.R. 4173, passed by the House on December 11, 2009, and Senator Dodd's Restoring American Financial Stability Act, as ordered reported by the Senate Banking Committee on March 22, 2010—address many of the purported causal factors across the entire financial system. The bills address systemic risk, too-big-to-fail, prudential supervision, hedge funds, derivatives, payments systems, credit rating agencies, securitization, and consumer financial protection. (For a summary of major provisions, see CRS Report R40975, Financial Regulatory Reform and the 111th Congress, coordinated by [author name scrubbed].)
This report consists of a table that presents very briefly some of the arguments for particular causes, presents equally brief rejoinders, and includes a reference or two for further reading. It will be updated as required by market developments.

subsections: section_title: Introduction
paragraphs: The financial crisis that began in 2007 spread and gathered intensity in 2008, despite the efforts of central banks and regulators to restore calm. By early 2009, the financial system and the global economy appeared to be locked in a descending spiral, and the primary focus of policy became the prevention of a prolonged downturn on the order of the Great Depression.
The volume and variety of negative financial news, and the seeming impotence of policy responses, has raised new questions about the origins of financial crises and the market mechanisms by which they are contained or propagated. Just as the economic impact of financial market failures in the 1930s remains an active academic subject, it is likely that the causes of the current crisis will be debated for decades to come.
This report sets out in tabular form a number of the factors that have been identified as causes of the crisis. The left column of Table 1 below summarizes the causal role of each such factor. The next column presents a brief rejoinder to that argument. The right-hand column contains a reference for further reading. Where text is given in quotation marks, the reference in the right column is the source, unless otherwise specified.