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Peter J. Wallison 473

2. The Defaults Begin
Th e best summary of how the defl ation of the housing bubble led to the
fi nancial crisis was contained in the prepared testimony that FDIC chair Sheila Bair
delivered to the FCIC in a September 2 hearing:
Starting in mid 2007, global fi nancial markets began to experience serious liquidity
challenges related mainly to rising concerns about U.S. mortgage credit quality. As
home prices fell, recently originated subprime and non-traditional mortgage loans
began to default at record rates. Th ese developments led to growing concerns about
the value of fi nancial positions in mortgage-backed securities and related derivative
instruments held by major fi nancial institutions in the U.S. and around the world.
Th e diffi culty in determining the value of mortgage-related assets and, therefore, the
balance-sheet strength of large banks and non-bank fi nancial institutions ultimately
led these institutions to become wary of lending to one another, even on a short-term
basis. [emphasis supplied]
47
All the important elements of what happened are in Chairman Bair’s succinct
statement: (i) in mid 2007, the markets began to experience liquidity challenges
because of concerns about the credit quality of NTMs; (ii) housing prices fell; NTMs
began to default at record rates; (iii) it was diffi cult to determine the value of MBS,
and thus the fi nancial condition of the institutions that held them; and, (iv) fi nally, as
a consequence of this uncertainty—especially aft er the failure of Lehman—fi nancial
institutions would not lend to one another. Th at phenomenon was the fi nancial
crisis. Th e following discussion will show how each of these steps operated to bring
down the fi nancial system.

Markets Began to Experience Liquidity Challenges
To understand the transmission mechanism, it is necessary to distinguish
between PMBS, on the one hand, and the MBS that were distributed by government
agencies such as FHA/Ginnie Mae and the GSEs (referred to jointly as “Agencies”
in this section). As shown in Table 1, by 2008, the 27 million NTMs in the U.S.
fi nancial system were held as (i) whole mortgages, (ii) MBS guaranteed by the GSEs,
or insured or held by a government agency or a bank under the CRA, or (iii) as
PMBS securitized by private fi rms such as Countrywide. Th e 27 million NTMs had
an aggregate unpaid principal balance of more than $4.5 trillion, and the portion
represented by PMBS consisted of 7.8 million mortgages with an aggregate unpaid
principal balance of approximately $1.9 trillion. As mortgage delinquencies and
defaults multiplied in the U.S. fi nancial system, the losses were transmitted to
fi nancial institutions through their holdings of PMBS. How did this happen, and
what role was played by government housing policy?
Both Agency MBS and PMBS pass through to investors the principal and
interest received on the mortgages in a pool that backs an issue of securities; the
diff erence between them is the way they protect investors against credit risk—i.e.,
the possibility of losses in the event that the mortgages in the pool begin to default.
Th e Agencies insure or place a guarantee on all the securities issued by a pool they
or some other entity creates. Because of the Agencies’ real or perceived government
47 Sheila C. Bair, “Systemically Important Institutions and the Issue of ‘Too-Big-to-Fail,’” Testimony to
the FCIC, September 2, 2010, p.3.