Implicit in these ratings was the assumption that a large, national decline in home prices was extraordinarily unlikely. The rise in home prices led to a surge in construction activity, which helped to sustain the housing boom for a time. This effect was particularly powerful in states such as Arizona, California, Florida, and Nevada. Rising home prices also bolstered the economy by supporting consumption, as households monetized these gains by cash-out refinancings and home equity lines of credit. The housing boom was also supported by an accompanying financial boom. The financing activity associated with the surge in mortgage originations and securitizations pushed up the earnings of the major banking and securities firms. These strong earnings created incentives to ease underwriting standards further. But, as housing supply responded to the increase in home prices—housing starts rose from a 1.5 million annual rate in mid-2000 to a 2.3 million annual rate in early 2006—the positive feedback loop began to run in reverse. Home prices began to soften, subprime borrowers found it more difficult to refinance, and mortgage loan defaults and delinquencies rose. As the bust got underway in earnest, residential investment declined and consumer spending was undercut as home equity levels fell. The housing boom and bust underscores several important lessons. First, the financial sector is not only a very complex system, but also one that can be inherently unstable—subject to excess, then sharp reversal.

The bust exposed many structural flaws in the financial system that exacerbated its instability. Without being exhaustive, these included the instability of the tri-party repo system, which supported the nation’s short-term funding markets; the risks of runs in the money market mutual fund industry; and the risk of contagion caused by the huge volume of outstanding bilateral (noncentrally cleared) over-the-counter (OTC) derivative obligations between the major financial intermediaries. The tri-party repo system was centered on two of the major U.S. banks. The system matched investors and borrowers each day—with the investors lending cash, secured by Treasuries and other collateral, to the major securities firms. But, the system was unstable. In times of stress, clearing banks could be faced with very large single-firm exposures—of potentially hundreds of billions of dollars. Not surprisingly, when such counterparties became troubled, the clearing banks were less willing to take on these large intraday exposures. As a result, repo investors, who were primarily worried about getting repaid each morning, were motivated to simply withdraw from the market. As short-term investors withdrew funding, the liquidity buffer of the troubled securities firm was quickly exhausted, particularly as other counterparties to that firm demanded additional collateral to secure their own exposures. Structural weaknesses in the money market mutual fund industry—which was a major source of short-term wholesale funding to the securities industry and various non-bank financial corporations—also exacerbated the crisis. When Lehman Brothers failed, the value of its outstanding short-term obligations collapsed.