With All Due Respect, 2

My guesses go as follows:

1) There was a liquidity problem. That's why the Fed lent to broker/dealers, to the commercial paper market, etc. The liquidity problem was resolved in fairly short order. That's why the Fed is no longer lending much to these entities.

2) There was and is a solvency problem. A minor part of it had to do with losses taken on securities by commercial banks but mostly by investment banks -- partly in firesales, as Gorton would say.

3) The major solvency problem is with commercial banks (and with S&Ls and finance companies) and emanates from losses on loans on their books.

I think the shadow bank/repo market phenomenon described by Gorton existed, but his view vastly exaggerates it.

The solvency problem is endemic to the system. Under fractional reserve no bank is ever solvent, thus crises are inevitable.

Here's my story:

* Way too much investment in real estate, due to a combination of low interest rates and bad government policy. By design, the policy caused a significant fraction of this investment to be financed through borrowing by people who would not repay the loans in the absence of the bubble. The real loss of wealth occurred due to this mal-investment. But the damage to the real economy was masked by inflated housing prices.

* Housing prices finally reached the point of implausibility, at least in some large zoned markets. Buyers lost confidence that prices would go on rising long enough to allow them to cash out at a profit.

* People who had bought real estate expecting to make easy money decided they'd better get out ASAP. Dumping that excess housing on the market precipitated a drop in the price. Some of this was 2nd or 3rd houses bought as investments, but a lot was people who owed more than the new value of their houses and simply walked away from their mortgages rather than realize the loss. That meant the lenders, or more precisely the loan guarantors, took the losses.

* Approximately $1T of this debt was exposed as 'toxic'.

* Never mind credit default swaps, leveraging, and all that. You can't inject $1T of bad debt into the economy and expect nothing bad to happen.

* Some people argue that leveraging amplified the shock. Maybe they're right. But I suspect that a lot of that talk is politically motivated: it tends to transfer blame for the crisis from Washington to Wall Street.