NYU’s Thomas Cooley explains the credit crisis.

Question: How does the credit crisis fit into the macroeconomic picture?

Thomas Cooley:  Yes, so the question is, I gather your question is how did this happen?  So there were three-- there were several ingredients.  Okay, one ingredient was, there was a bubble in housing prices.  People assumed that housing prices would just continue to go up and up and up and that they could take on unrealistic amounts of debt because the appreciation and the value of their houses would make it possible for them to deal with that amount of debt.  The other thing that happened was that there was a break down in lending practices by mortgage lenders.  So there was not sufficient oversight.  The fee structure for people issuing mortgages was such that their only incentives were to get mortgages out there, to grant them.  And then the other ingredient was sort of the rapid securitization of lending throughout the economy and throughout the world.  So what happened is, these mortgages got bundled and sliced into different pieces that supposedly represented different risk characteristics.  And then there's the vast machinery of the securitization industry, which rated a lot of these things as triple A or very, very safe securities, when they, in fact, they were not.  And so there was a whole un-virtuous circle of things that resulted from this.  That meant when housing prices began to fall, this whole business collapsed and that caused panic essentially in the credit markets because many people found themselves holding these exotic securities that were these bundled mortgages or pieces of them that they could not sell.

Recorded: 3/21/08