The Foreign Capital Flow and Domestic Drivers of the US Financial Crisis and Its Spread Globally

Abstract

Jeffrey Shafer discusses the prelude to the 2008 financial crisis during the Great Moderation in the United States. Lax monetary policy, fiscal stimulus, a current account deficit and innovations in financial markets set the stage for the crisis. The capital flowing into the United States fuelled a house price boom that came to a halt in 2006. Several factors contributed to the boom and bust. Long-standing government policy provided support for housing and homeownership; government sponsored Fannie and Freddie aggressively expanded; refinancing to withdraw equity became common; innovations in the retail mortgage-backed securities market enabled mortgages to be packaged with tranches that were rated as equivalent to US Treasuries for which there was strong foreign demand; the risks introduced by packaging and distribution of RMBS was not well understood; underwriting standards deteriorated markedly; and, finally, the losses from bad credit decisions were multiplied by the collapse of vulnerable sources of liquidity in non-banks and off balance sheet entities.