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Impact on financial markets

There were competing theories on how so many pillars of finance in the U.S. crumbled so quickly. One held the issuers of subprime mortgages ultimately responsible for the debacle. According to this view, when mortgage-backed securities were flying high, mortgage companies were eager to lend to anyone, regardless of the borrower’s financial condition. The firms that profited from this—from small mortgage companies to giant investment banks—deluded themselves that this could go on forever. Joseph E. Stiglitz of Columbia UniversityNew York City, the chairman of the Council of Economic Advisersduring former president Bill Clinton’s administration, summed up the situation this way: “There was a party going on, and no one wanted to be a party pooper.”

Some claimed that deregulation played a major role. In the late 1990s, Congress demolished the barriers between commercial and investment banking, a change that encouraged risky investments with borrowed money. Deregulation also ruled out most federal oversight of “derivatives”—credit default swaps and other financial instruments that derive their value from underlying securities. Congress also rejected proposals to curb “predatory loans” to home buyers at unfavourable terms to the borrowers.

Deregulators scoffed at the notion that more federal regulation would have alleviated the crisis. Phil Gramm, the former senator who championed much of the deregulatory legislation, blamed “predatory borrowers” who shopped for a mortgage when they were in no position to buy a house. Gramm and other opponents of regulation traced the troubles to the 1977 Community Reinvestment Act, an antiredlining law that directed Fannie Mae and Freddie Mac to make sure that the mortgages that they bought included some from poor neighbourhoods. That, Gramm and his allies argued, was a license for mortgage companies to lend to unqualified borrowers.

As alarming as the blizzard of buyouts, bailouts, and collapses might have been, it was not the most ominous consequence of the financial crisis. That occurred in the credit markets, where hundreds of billions of dollars a day are lent for periods as short as overnight by those who have the capital to those who need it. The banks that did much of the lending concluded from the chaos taking place in September that no borrower could be trusted. As a result, lending all but froze. Without loans, businesses could not grow. Without loans, some businesses could not even pay for day-to-day operations.