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securities (MBS), dropping MBS values—and especially those MBS backed by
subprime and other risky loans—to fractions of their former prices. Mark-to-
market accounting then required fi nancial institutions to write down the value of
their assets—reducing their capital positions and causing great investor and creditor
unease. Th e mechanism by which the defaults and delinquencies on subprime and
other high risk mortgages were transmitted to the fi nancial system as a whole is
covered in detail in Part II.
In this environment, the government’s rescue of Bear Stearns in March of
2008 temporarily calmed investor fears but created a signifi cant moral hazard;
investors and other market participants reasonably believed aft er the rescue of
Bear that all large fi nancial institutions would also be rescued if they encountered
fi nancial diffi culties. However, when Lehman Brothers—an investment bank even
larger than Bear—was allowed to fail, market participants were shocked; suddenly,
they were forced to consider the fi nancial health of their counterparties, many of
which appeared weakened by losses and the capital writedowns required by mark-
to-market accounting. Th is caused a halt to lending and a hoarding of cash—a
virtually unprecedented period of market paralysis and panic that we know as the
fi nancial crisis of 2008.

Weren’t Th ere Other Causes of the Financial Crisis?

Many other causes of the fi nancial crisis have been cited, including some in
the report of the Commission’s majority, but for the reasons outlined below none of
them alone—or all in combination—provides a plausible explanation of the crisis.
Low interest rates and a fl ow of funds from abroad. Claims that various policies
or phenomena—such as low interest rates in the early 2000s or fi nancial fl ows from
abroad—were responsible for the growth of the housing bubble, do not adequately
explain either the bubble or the destruction that occurred when the bubble defl ated.
Th e U.S. has had housing bubbles in the past—most recently in the late 1970s and
late 1980s—but when these bubbles defl ated they did not cause a fi nancial crisis.
Similarly, other developed countries experienced housing bubbles in the 2000s,
some even larger than the U.S. bubble, but when their bubbles defl ated the housing
losses were small. Only in the U.S. did the defl ation of the most recent housing
bubble cause a fi nancial meltdown and a serious fi nancial crisis. Th e reason for this
is that only in the U.S. did subprime and other risky loans constitute half of all
outstanding mortgages when the bubble defl ated. It wasn’t the size of the bubble
that was the key; it was its content. Th e 1997-2007 U.S. housing bubble was in a
class by itself. Nevertheless, demand by investors for the high yields off ered by
subprime loans stimulated the growth of a market for securities backed by these
loans. Th is was an important element in the fi nancial crisis, although the number
of mortgages in this market was considerably smaller than the number fostered
directly by government policy. Without the huge number of defaults that arose out
of U.S. housing policy, defaults among the mortgages in the private market would
not have caused a fi nancial crisis.
Deregulation or lax regulation. Explanations that rely on lack of regulation or
deregulation as a cause of the fi nancial crisis are also defi cient. First, no signifi cant
deregulation of fi nancial institutions occurred in the last 30 years. Th e repeal of a