Exploring Causes of the Financial Crisis

I’ve never been happy with the widely-held theories of the causes of the financial crisis. Most are too simple and use movie-type good guy-bad guy themes to explain what went wrong. That’s why I was happy to see a new book is out with a better explanation that is better documented than most others. It’s still lacking a complete explanation, but Engineering the Financial Crisis by Jeffrey Friedman and Wladimir Kraus is a big step forward. Its theory is that regulators helped cause the crisis and made it worse. They steered banks into the same investments, and those investments turned out to be more risky than the regulators assumed. The regulators also made things worse after the crisis began.

Holman Jenkins has a good review and commentary on the book in The Wall Street Journal.

Basel tried to make banks safer by prescribing capital levels, and by steering them toward “safe” assets. Experience had shown that mortgage-backed securities were among the safest, safer than business and consumer loans and even whole mortgages. So the Basel rules strongly favored mortgage-backed securities. Alas, this became an incentive to over-produce these assets until they became very dangerous indeed to the entire financial system (a formula also implicated in Europe’s sovereign debt crisis).