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US economic effects

The Gramm-Rudman Act was the real villain. It allowed banks to engage in trading profitable derivatives that they sold to investors. These mortgage-backed securities needed home loans as collateral. The derivatives created an insatiable demand for more and more mortgages.

The Federal Reserve believed the subprime mortgage crisis would remain confined to the housing sector. Fed officials didn’t know how far the damage would spread. They didn’t understand the actual causes of the subprime mortgage crisis until later.

Hedge funds and other financial institutions around the world owned the mortgage-backed securities. The securities were also in mutual funds, corporate assets, and pension funds. The banks had chopped up the original mortgages and resold them in tranches. That made the derivatives impossible to price.

Why did stodgy pension funds buy such risky assets? They thought an insurance product called credit default swaps protected them. A traditional insurance company known as the American International Group sold these swaps. When the derivatives lost value, AIG didn’t have enough cash flow to honor all the swaps.