Senator Bernie Sanders has blamed the "big banks" of Wall Street for the financial crash of 2007-2008 and the Great Recession that followed, while Secretary Hillary Clinton has pointed in the direction of the "shadow banking" sector. These two views have stirred a lively debate, but who got it right? It turns out that neither although Secretary Clinton's view is closer to the truth. Below I list the three culprits for the Great Recession.
Several authors, like professor John B. Taylor, have argued that the monetary policy was too loose for several years before the crisis. This was likely to accelerate the housing boom and thus make the bust worse. The vitality of the US economy at the beginning of the 2000s also persuaded capital inflows that fueled both the asset boom and speculation.
The US housing market
The US government has been deeply involved in the housing market with several Acts regulating the mortgage market. Of these, at least the following were directly aimed at expanding credit to "subprime" borrowers and thus likely to accelerate the housing boom. The Community Reinvestment Act passed in 1977 prohibited the indiscrimination of borrowers according to their income level. The Housing and Community Development Act passed in 1992, ordered Fannie Mae and Freddie Mac (Government Sponsored Enterprises, GSEs) to direct a substantial portion of their financing to the lower middle-income and poor households. The American Dream Downpayment Assistance Act passed in 2003 provided the low-income communities down payments and closing cost assistance.
Mismanagement of the risk and the onset of the crisis
Since the 1970s, banks have removed the risks of mortgages from their balance sheet by selling them to investors. This risk management took a leap forward in the 1990s, when Credit Default Swaps, or CDSs, were innovated. In CDS, some third party insures a mortgage or a credit line between two other parties. This led to the rise of the "shadow banks", because banks needed some third party to insure their CDSs. To accomplish this, banks created, e.g., Special Purpose Vehicles (SPV) which were independent companies and thus in the "shadows" (outside the balance sheets of banks). In this setup, a bank creates a SPV, which insures the risk of banks' credit lines, like mortgages, and receives a payment (interest payments, etc.) for this insurance. SPV then securitizes these payments and sells them to investors as bonds backed by the CDS. Because only a miniscule fraction of borrowers are assumed to default, SPV needs to sell a limited amount of bonds to cover the insurance, which made this arrangement, called Synthetic Collateralized Debt Obligations, or CDOs, markedly profitable.
CDOs were originally used in the corporate loans, where default probabilities of different firms were fairly well known, but no such information was available on mortgages. For example, the correlation of default risks related to different mortgages was unknown. This was particularly problematic for the credit rating agencies, who assessed the risks related to CDOS and other securitized mortgage products.
Despite this, the securitization of mortgages became highly popular and exploded in the 2000s. Some of the CDOs were given the highest credit rating (triple A). This implied that they were considered as reliable as the bonds of the US government. Banks created Structured Investment Vehicles (SIVs), which were part of the banks' balance sheet but who still had their own funding, to insure and buy the loans issued by banks. Because banks provided them only short-term credit lines, they were not obligated by the Basel I to hold any capital against those loans. As a result, the "shadow banking" sector took on a massive portion of the risks related to the government subsidized US mortgage boom.
The crisis erupted, because the collapse of the US mortgage market led to dramatic falls in the values of the mortgage backed assets (CDOs, etc.) due to the clustering waves of defaults in mortgages especially among the subprime borrowers. This in turn led to the runs of the assets in the primer broker balances and in the repo and commercial paper markets, which took the majority of the "shadow banks" operating in those markets into bankruptcy. Their losses reverted back to the balance sheets of banks inducing a freeze on the interbank lending market that caused the systemic crisis.
What can be done to avert the next crisis?
Senator Sanders has proposed that the big banks should be broken down and Secretary Clinton has suggested that the shadow banking sector should be regulated to improve financial stability. Unfortunately, both of these measures are likely to be ineffective in averting the next crisis.
The size of the banks was in no way associated to the depth of the Great Recession. "Too-big-to-fail" is also more of a problem in Europe, where the assets of some banks are several times larger than the GDP of the country they originate from. Iceland showed that even this is not a problem during a financial crisis. The assets of the three major banks were over 900 % of the GDP of Iceland before the crisis erupted in 2008. Iceland let the banks fail and saved the depositors. This led to a collapse, but also to rapid economic recovery. Regulating the "shadow banking" would probably help, but regulators tend to lag the financial innovation indicating that it is extremely difficult to assess the risk related to new financial products beforehand.
However, if the banks were let to fail during crises, like in Iceland, their managers would have less incentives to take risks. Finland had a major banking crisis in the beginning of the 1990s, which led to the collapse of one of her major banks. During the crisis of 2007-2008, Finnish banks had very little problems, because they did not own any exotic assets. So, it may be that letting Lehman Brothers fail in September 2008 was the single most important decision in improving the future financial stability of the US.