Acharya, Viral V., and Matthew Richardson. "Causes of the Financial Crisis". Critical Review, Vol.21, No.2-3 (2009): 195-210.

Acharya, Viral V., and Matthew Richardson. "Causes of the Financial Crisis". Critical Review, Vol.21, No.2-3 (2009): 195-210.

• The twin causes of the 2008 financial crisis were the housing bubble and the credit boom (195).
• The causes of the mortgage crisis were the granting of mortgages to people without the ability to pay them back and the granting of mortgages purposefully designed to default after a period. The securitization of these mortgages led to a rapid expansion in the credit market, further increasing the number of mortgages sold by people who didn't care about the end result. All of these packaged mortgage securities were then given AAA ratings by severely compromised ratings agencies (196).
• Between 2002 and 2007, housing prices increased by 11% per annum and the ratio of debt to national income increased from 3.75:1 to 4.75:1, an increase of the same magnitude that had previously taken 10 or 15 years (195-196). 
• The average American family had 35% of their equity in the value of their home, which at this point had a heavily inflated price, and felt the brunt of the housing crash. This loss of equity was then reflected in significantly lower levels of household consumption, with a detrimental effect on the economy (196).
• The idea behind subprime mortgages was they offered a 'teaser rate' for the first two or three years then increased, which would force the homeowner to default unless the price of the house also went up, in which case they could refinance (208).
• The 2008 subprime loan crisis became a general financial crisis, while the 2000 dot-com crash did not because large and complex financial institutions, including investment banks, insurance companies, universal banks, and hedge funds, decided not to use securitization to collectivize risk among large groups of investors, instead issuing securities primarily to avoid capital leverage requirements and issue more loans (196-197).
• From around 2002 onward, banks began to sell riskier and riskier securities, transferring this risk from their own balance sheets to those of investors. Most of these new securities were structured into 'tranches' of assets with different risk levels, with riskier tranches paying higher premiums. All structured securities had the same risk levels, but those buying at higher tranches would continue to receive income from interest payments even if the riskier assets failed (199).
• Between 2002 and 2007, the number of riskier securities backed by commercial loans, mortgages, student loans, and leveraged loans tripled from $767 billion in 2001 to $2.7 trillion (199-200). 
• Most of these securities, marketed as 'collectivized debt obligations' [CDOs] or 'collectivized loan obligations' [CLOs], were believed by investors to be as safe as corporate bonds, largely thanks to the stellar ratings provided by rating agencies (200).
• In addition to issuing these securities, banks also became the primary investors and purchasers of these securities. By creating 'conduit' subsidiaries for the sole purpose of holding these securities, whose purchases were then backed by the sale of short-term bonds referred to as 'asset-backed commercial paper [ABCP]', banks were able to hold more assets without violating capital adequacy rules, all at the cost of being exposed to risk (200-201).
• This system worked because it avoided the Basel requirements for capital adequacy, thus allowing for a massive expansion in leverage for loans. The ABCP issued by banks was also rated AAA by rating agencies, allowing it to be issued at very low interest rates, meaning that the underlying cost was similar to making loans with bank deposits (201).
• This was the most common system, but other banks never issued ABCP and itself directed purchased the highest tranches of its own and other banks' securities. Purchasing these AAA rated securities was also an effective strategy because their high rate meant they had very low risk-adjusted asset value, meaning they carried low capital adequacy requirements. This was because in 2004, the SEC gave banks the permission to conduct their own capital risk assessment and determine appropriate capital buffer levels for themselves, meaning assets grew much more rapidly than risk-adjusted assets (201-204).
• When the crisis hit in 2008, there was no longer a market for ABCP and the loans for securities had be returned to bank balance sheets just as many of those loans were defaulting (201, 207-208). The vast majority of these losses, around $1.2 billion was born by banks, threatening bank solvency (201), as banks held the vast majority of CDOs (202).
• The concentration of bank assets in mortgage-backed securities meant that they were the biggest losers from the precipitous decline in the value of these CDOs after the start of the crash in 2007, after which they lost as much as 60% of their value. The decline in value of AAA rated securities alone resulted in between $158 billion and $473 billion in losses (205-206).
• The basic theory of banking is that banks are intermediaries between depositors and borrowers. Depositors provide banks with the capital needed to make loans to suitable borrowers, whereupon banks distribute some portion of the profits from those loans back to the depositor. The margin from these loans and interest on them is the bank's primary source of profit (197).
• The majority of a bank's liabilities are its deposits, since they can be recalled, and most of its assets are loans made using those deposits. To prevent the a run on the bank, during which depositors ask for more of their deposits than the bank has on hand, bank deposits are insured by the US government. In return for this government guarantee, banks are required to hold a minimum threshold of capital -- usually in the form of saved profits or equity from sales of stock -- in reserve (197).
• In a system without government deposit insurance, capital adequacy requirements would be unnecessary as avoiding a bank run would disincentivize risky decisions, and private bondholders and depositors would also demand higher interest for a bank's risky decisions. Having government deposit insurance created a moral hazard because big banks felt like they could rely on government bailouts (197-198).
• Most countries based their rules for capital adequacy on the Basel Accords recommended by the Bank of International Settlement, which advises that banks have an 8% capital buffer against a risk-adjusted measure of assets. In the USA, banks that want to attain 'well capitalized' status and its lower deposit insurance premiums need to meet a minimum 10% capital buffer (198).
• Maintaining a capital buffer is costly for banks, as it cannot be lent out as loans. Additionally, if a bank cannot meet its capital adequacy requirements with saved earnings, it has to sell equity, which is usually seen as a bad sign by investors and consequently reduces its share price (198).
• The modern banking system has far more loans than it does deposits, because banks are not limited to supplying loans from their own deposits, but can also receive capital from investors, use this outside capital to make loans, then sell those loans back to investors as securities. The classic example of this is mortgage securities, which are bundles of interest-bearing mortgage loans (198-199). 
• Issuing securities allows banks to get around capital adequacy requirements by using capital reserves to underwrite these security and then quickly selling them off, taking the security liabilities off bank balance sheets, and thus not affecting buffer capital levels, while still generating revenue (198).
• Banks purchased the subprime mortgage securities that they themselves created because the lower tranches of these securities had very high payouts and would only default if thousands of subprime mortgages defaulted. Banks bet that this would not happen (204-205).
• Insurance companies sold massive amounts of insurance to banks to cover the risk that mass defaults on mortgages would occur, which they also believed would be very unlikely. When this happened, insurance companies were rendered insolvent as they could not cover the full scope of these losses. The failure of insurance companies left banks exposed to the full brunt of their losses (206).
• Banks were willing to take such extraordinary risks because individual bankers were largely paid in short-term bonuses based on the volume and short-term profit generated by their sales. Bankers had no incentives to care about the long-term risk or sustainability of their sales, and lots of incentives to make these sales (206, 209).
• Moreover, the same incentive structures based on short-term profit led banks to hold far larger amounts of subprime mortgage securities for much longer than would be expected because of the immediate premiums from interest gained by holding these assets. They thus prioritized the short-term profit of premiums on assets with essentially no risk-adjusted value affect on capital adequacy requirements over the recognized medium-term risks of holding such risky assets (207).
• The 2008 financial crisis unfolded in a number of stages. The first stage was signaled by the collapse of Ownit Solutions, which sold subprime and other high risk mortgages, in 2006. An insufficient increase in home prices during the same period of the refinancing of subprime mortgages occurred led to mass defaults, forcing specialist agencies like Ownit into bankruptcy. Bankruptcies like Ownit signaled that subprimes would experience mass defaults (208).
• The next stage of the crisis began on 9 August 2007, when three investment funds associated with BNP Paribas stopped redemption payments on subprime mortgages because they could no longer calculate their value, leading to a larger realization that the assets might have low values or be worthless. This triggered a general freeze in the purchase of ABCP and forced CDOs back onto bank balance sheets (208).
• The final stage of the crisis occurred in 2008 when the actual assessed value of securities began to fall, reducing the balance sheets of major banks by trillions of dollars. During this stage, Lehman Brothers, Freddie Mac, and Fannie Mae also became insolvent (208-209).
• The failure of major financial institutions in 2008 led banks to then overassess risk and resulted in a general capital freeze, triggering a global recession. This decline in lending reflected both fear of greater losses and the sudden paucity of leverage available to major banks due to their losses in the subprime mortgage crisis (209).