By Richard W. Evans on October 14, 2008 6:28 PM

In trying to understand the current global financial crisis, the first question I ask is how it all came about. In fact, the proposed solutions for remedying the global economy vary widely depending on what each advocate’s interpretation is of the cause of the crisis. The cause of and responsibility for the current mess are most clear to me when separated into four simple pieces: supply and demand in both the U.S. mortgage market and the global low-risk debt market.

Demand: International Debt Market (1). In a recent panel discussion on the subject at MIT, Ricardo Caballero and William Wheaton highlighted the demand side of the international debt market as a cause for the housing bubble of the early-to-mid 1990s. Large amounts of international capital (demand) were not matched by equal amounts of relatively safe assets (supply). According to Caballero, speculative bubbles were bound to arise in this kind of environment of excess demand. One of the places where this international capital found a home was in U.S. real estate. Keep in mind that this initial role of the demand side of the international debt market was small relative to the role it played in more recent years.

Supply: U.S. Mortgage Market. Because average housing prices in the U.S. had risen consistently in the U.S. since the Great Depression, the assumption was that they would never go down. Couple this belief with the increasing velocity with which home prices grew in the 1990s, and risk seemed to be at such low levels that lending could be safely extended to broad new ranges of borrowers. We know that official lending standards through Fannie Mae and Freddie Mace were relaxed at least as early as the Clinton Administration, and potentially even earlier. These more relaxed lending standards were justified based on the assumption that real estate prices would continue to rise. Think of these relaxed lending standards as in increase in the mortgage supply curve (an outward shift) .

The supply increase in the U.S. mortgage market was clearly the result of policy aimed at relaxing lending standards and increasing the number of households who could qualify for mortgages. The primary responsibility for this piece of the crisis puzzle lies squarely on the shoulders of the policy makers who relaxed lending standards. However, a secondary set of U.S. mortgage market supply-side culprits are the mortgage lenders who took the relaxed lending standards and, sometimes fraudulently, made bad loans as quickly as they could. This was clearly a case of the government creating an unsustainable policy under which the only risk of mortgage lenders was not having a chair when the music stopped.

Demand: U.S. Mortgage Market. I don’t think of demand in the U.S. mortgage market as having shifted. Rather, the increase in the supply side of the market lowered the equilibrium price of mortgages, induced large numbers of marginal borrowers and homeowners into the market, further inflated home prices and home construction, and thereby added to the housing bubble initially created by the excess demand in the international debt market.

In the same way that I assign a secondary level of responsibility to the unscrupulous mortgage lenders on the supply side of the U.S. mortgage market, I think a secondary level of responsibility lies with the U.S. borrowers who got into loans that they could not afford for the sole reason that they could. And just as this environment saw lenders who would knowingly make as many bad loans as they could before the music stopped, we also saw speculative borrowers who would obtained mortgages for as many houses as they could and tried to flip them before the music stopped.

Supply: International Debt Market. The U.S. housing bubble would have been largely contained within the United States except for the creation of mortgage backed securities. These securities bundled large numbers of mortgages in order to diversify away the idiosyncratic risk of individual mortgage holders defaulting on their loan. These securities were then sliced again into traunches of different perceived risk levels, thereby creating a number of different diversified assets that paid off in different states of the world. Given optimistic assumptions about housing prices not going down, the U.S. ratings agencies Standard and Poors and Moody’s assigned the highest ratings (AAA, lowest risk) to these mortgage backed securities.

U.S. financial markets had created a large number of new low-risk high-return assets that could be sold on the world markets. In this case, it is not clear whether these securities were designed in their complexity with the intent to mislead markets about their risk level. To the extent that they were, the financial engineers who originated the mortgage backed securities hold some of the responsibility for the spread of the credit crisis across the globe. However, most of the blame should probably lie with Moody’s and S&P for giving these securities the AAA rating. Their stamp of approval legitimized these securities as a low-risk international asset for global investment.

Demand: International Debt Market (2): Recall that excess capital in international debt markets initially spurred the housing bubble. Now having come full circle, the new supply of low-risk, AAA-rated mortgage backed securities derived from the artificially inflated U.S. mortgage market offered a high-return destination for this global investment capital. Corporations, banks, and governments across the globe purchased these securities in large numbers, further fueling the housing bubble and lax lending practices in the United States. These allegedly low-risk assets became a significant part of the capitalization for banks, insurance companies, and money market funds around the world.

Although these foreign firms, banks, and governments may seem like victims of loose mortgage policy in the U.S. a significant proportion of the responsibility for the current crisis lies with them. At least some of them must have known that the price of the mortgage backed securities did not fully account for true U.S. housing market risks, especially in the last two years. In addition, organizations that simply trusted the rating of the rating agencies were basing their capital investment decisions on a knowingly imperfect barometer of risk. Each of the large banks that have failed or been taken over by their respective governments in the U.S. and abroad have been full of incredibly smart people. Part of the responsibility lies on them collectively for not seeing this coming.

Summary. Our current global financial crisis was caused by (1) an initial excess global demand for investment which found a home in the U.S. housing market. This led to an acceleration in the increase in housing prices, (2) which induced the U.S. government and regulatory establishment to relax lending standards in order get mortgages to a larger segment of society, regardless of ability to pay. These relaxed standards enabled mortgage lenders to vastly increase the number of mortgages they could sell, and some even engaged in fraudulent behavior. (3) The increase in supply in the U.S. mortgage market induced many more Americans to enter the market, both those who could not otherwise afford a mortgage and also those who could not have otherwise borrowed to buy multiple homes.

A problem that might have been largely restricted to the United States, (4) the mortgage bubble and ensuing crisis was exported around the world by the complex financial engineering of mortgage backed securities as well as the overly optimistic rating of the securities by Moody’s and S&P. (5) However, the international buyers of the U.S. mortgage backed securities cannot be held blameless. In the best case scenario, the collective intellectual power of a large portion of the global financial community was hoodwinked by the combination of the mortgage backed securities’ complexity and the designation of the U.S. rating agencies. But in the worst case scenario, many of the big players in global finance knowingly looked the other way when faced with the prospect of an incorrect risk assessment of such a widely held global security. Some of the blame for our current crises can be assigned to each of the afore mentioned parties.