The deregulation of American finance proceeded across three decades with the confidence of settled science. The efficient market hypothesis, the idea that prices incorporate all available information and that markets self-correct, was not just an academic proposition but an operating assumption of regulatory philosophy. If markets processed information efficiently, then additional rules were friction, not protection. The 1999 repeal of Glass-Steagall's separation of commercial and investment banking, the Commodity Futures Modernization Act of 2000 that exempted derivatives from oversight, the SEC's 2004 decision allowing investment banks to increase their leverage ratios: these were not accidents but policies that reflected a coherent worldview taught in economics and business schools across the country. Students graduating with degrees in finance and economics in the mid-2000s had been educated in this framework as if it were physics.
The mortgage-backed security was presented, in this framework, as a triumph of financial engineering. By bundling thousands of individual mortgages into tradable instruments and then slicing those bundles into tranches of varying risk, banks could supposedly distribute risk throughout the system rather than concentrate it. The mathematics of the rating models, built on the assumption that housing prices across different regions would not all fall at once, appeared to validate the innovation. Credit default swaps, contracts that allowed investors to insure against default, would further distribute any remaining risk to parties willing to hold it. The entire edifice rested on models that used historical data from an era when mortgage underwriting meant something, when lenders held loans on their own books and therefore cared whether borrowers could actually pay.
What the models could not account for was their own influence on the system they modeled. As mortgage origination became a volume business, with lenders selling mortgages immediately to be bundled rather than holding them, the incentive to assess borrower quality evaporated. A loan officer in California had no reason to care whether a borrower in Florida could sustain payments, because that loan would be someone else's problem within days. The chain of parties between the original borrower and the ultimate holder of the risk grew so long that no single actor needed to care about the whole picture. Risk had not been distributed; it had been hidden behind layers of complexity that made it impossible to trace. When housing prices stopped rising in 2006, the mechanism that had allowed even unqualified borrowers to refinance their way out of trouble disappeared.
Bear Stearns collapsed in March 2008, acquired by JPMorgan in a fire sale backed by Federal Reserve financing. Lehman Brothers filed for bankruptcy on September 15, 2008, the largest bankruptcy in American history. Within days, the credit markets froze. Institutions that had relied on overnight lending to fund their operations suddenly could not borrow. AIG, which had sold $441 billion in credit default swaps it could not cover, required an $85 billion government rescue. Merrill Lynch was sold to Bank of America. Washington Mutual failed. The Treasury and Federal Reserve improvised responses to a crisis for which no playbook existed, because the crisis was one that the prevailing theory had declared impossible. Markets, it turned out, were not self-correcting when everyone was making the same mistake at once.
The final accounting took years to compile. Eleven trillion dollars in household wealth erased. Nearly nine million jobs lost. Millions of foreclosures. A Great Recession that produced the worst employment prospects since the 1930s and fundamentally altered the economic trajectories of everyone entering the workforce between 2008 and 2012. Alan Greenspan, who had presided over much of the deregulatory era as Fed chairman, testified before Congress in October 2008 that he had found "a flaw" in his ideology, that he had been wrong about whether institutions would protect their own shareholders and the equity in their firms. The admission was remarkable because Greenspan had been one of the most influential architects of the worldview that markets knew best.
The crisis did not merely disprove a policy preference. It exposed how a set of theoretical assumptions, taught as if they were laws of nature, had become self-fulfilling until they catastrophically were not. The framework that had shaped a generation of economic education was revealed as contingent, a model that worked only under conditions it assumed into existence.
