Markus Brunnermeier provides an excellent summary graph of the financial crisis, told in “spreads”.
An increase in mortgage delinquencies due to a nationwide decline in housing prices was the trigger for a full-blown liquidity crisis that emerged in 2007 and might well drag on over the next years. While each crisis has its own specificities, the current one has been surprisingly close to a — classical banking crisis. What is new about this crisis is the extent of securitization, which led to an opaque web of interconnected obligations. This paper outlined several amplification mechanisms that help explain the causes of the financial turmoil. These mechanisms also form a natural point from which to start thinking about a new financial architecture. For example, fire-sale externalities and network effects suggest that financial institutions have an individual incentive to take on too much leverage, to have excessive mismatch in asset-liability maturities, and to be too 36 interconnected. Brunnermeier (2008b) discusses the possible direction of future financial regulation using measures of risk that take these domino effects into account. (As an aside, I’ll observe that in this paper, Fannie and Freddie do not make appearances as “causes” of the crisis. I wonder who has an interest in pushing the view of Fannie and Freddie as betes noire. For more recent critiques of the “F&F caused it” meme, see ,  (h/t DeLong).)
Originally published at Econbrowser and reproduced here with the author’s permission.