From the article: "As the housing market deteriorated the perceived risk of mortgage backed securities increased."

This drew me up a bit short.  With the low rate of inflation that has existed over the past decade, a financial instrument that claims to return 12%+/year, reliably, consistently, and with low risk, is a scam, pure and simple.  There are certainly investments that can provide this rate of return, but they are extremely risky - they are called "junk" bonds.  How any of this MBS crap got rated AAA I have no idea - but if you are looking for a proximate cause, look no further than ridiculous ratings given to mortgage backed securities.  

To anybody who's taken finance 101, the sky high returns on these mortgage backed securities should have been a red flag from day one, it shouldn't have taken a deterioration in the housing market to make the market realize that "perceived risk" had increased.

I've been under the weather, so I still haven't read the pdf. Here is some more related:

See U. Chicago economist Robert Shimer concise overview of his understand of the problem, and why the Fed bailout won't work right. Read the whole thing.

See also the article Shimer links to, written in part by some of the authors of that pdf, which proposes:

The authorities could require all regulated financial institutions, no matter how well capitalized, to present plans to raise 2% of their assets in additional capital over the next quarter to preserve the stability of the financial system. This increased capital will not represent an increase in the permanent level of required capital for bank holding companies, but instead give institutions the extra capital that will allow them to lend.

Why a mandate? Thus far banks have been urged to voluntarily go out and raise capital, and some, including Goldman Sachs on Wednesday, have. But banks, especially some of the best managed ones, have been hesitant, in part because potential investors might view a bank's approach to the market as reflecting the bank's expectation that it will have to bear additional losses, which will cause them to lose confidence in the bank. The value of mandating this decision is that no individual bank sends an adverse signal to the market when it goes to raise capital.

Excerpts from Harvard panel on crisis (Merton, Rogoff, Mankiw) with link to webcast of whole thing.

The Fed's balance sheet.

Economist Casey Mulligan observes:

There are two basic obstacles that Washington might create in this process, both of which are included in the Bernanke-Paulson-Bush proposal. One is to pile on regulation and further impede entry by new firms that might provide financial services to the non-financial sector in the years ahead. The second is to impose a heavy tax burden on the non-financial sector to pay for Wall Street subsidies. The Treasury and the Fed should let Wall Street drown alone, to be replaced by new financial service providers who can swim as robustly as are non-financial American businesses.

Thank you for posting this interesting link, Steve.

That mortgage originators kept some of the mortgage they originated is in fact the traditional way the industry worked, and is unusual only in comparison to the "originate and distribute" business model they claimed to follow.  In fact this business model was, as is noted elsewhere in the article, in itself a principal cause of the problem, in that it gave originators little incentive to be careful of the quality of the debt they were taking on, since it would soon be out of their hands.

Sections 2-4 of the paper are quite strong, but it really goes of the rails with their proposal to fix things in section 5, which is much less interesting than some of the solutions they reject, such as reverse-convertible bonds, and a time-dependent reserve ratio requirement.  Specifically, their proposal seems rather blase about  the costs of carrying such a huge amount of capital, just to provide capital insurance in times of trouble, does a worse job of minimizing externalized consequences of bank failures than the other proposals, and does little to explore the issue it raises of how to minimize the "governance and internal agency problems" which make additional capital injections above the regulatory minimum so penalized by the market, which doesn't properly reward the additional stability they provide.

I know this is truthout and all that crap but some of the quotes are still very insightful. One of the best (and buried) points that no one seems interested in bringing up yet is that an aggravating factor in this mess is existing regulations. Some current government mandated accounting practices are focused around the win-now obsession of Wall Street that doesn't reflect the reality of long term mortgage investment.

It is easy to buy small plaster models of what you think life is like.

Piss all your money away or otherwise run your company into the ground? You go out of business and some guy in surplus cammo who smells stale cigarettes auctions off your office furniture. It's called capitalism.

I suppose if you must spend $700B you can just FedEx it to my house.

Spread it on!

Anyone still unclear as to why we need a bailout need only watch this explanation, and everything will become clear.

Why is it that the government needs to buy the most risky loans out there?  Shouldn't they be trying to reduce the risk they take on by owning less risky loans?

The problem for the rest of the economy is that there is a capital shortage amongst thrifts, and that the shortage of capital relative to that required by regulations will lead to thrifts turning down otherwise profitable loans.  But if this is the problem we want to fix, why not fix it directly?   Wouldn't we be better off starting a new bank, using the $700 billion as its capital and making $7 trillion of loans, instead of giving away a large fraction of the cash to the people who got us into the problem in the first place?  Wouldn't our capital be a hell of a lot safer starting a new bank than putting it into defaulted mortgages?

Why is it morally acceptable to those who have been advocates of the ability of the free market to fix all economic problems that the government should come in after the roulette wheel has stopped and bail out corporations who took losses, while it is morally repugnant that the government should engage in normal economic activity when there are no private firms able to do so?

Why is it that, if you go open a margin stock market account, the government will require 50% margin capital, but banks are regulated to require only 10% margin capital (including corporate borrowing and not including safe loans), and investment banks and hedge funds were only required to have 2% margin capital?

The problem we have discovered (and should have predicted) with the Mark-to-Market rule is that, given that many bank assets are highly illiquid (and are more so because of the lemon problem), running a bank with 10% capital like a margin stock account doesn't work.  You take 10% losses selling your assets, so that there is no way to recover by selling assets.  But how is this fixed by eliminating (as is being proposed) the Mark-to-Market rule, which would only hide bad loans and make the thrift's collapse all the bigger when it finally comes?  At least for the illiquid assets, wouldn't we be much better off just forcing a stop to new loans and other risk increases, and slowly unwinding the assets of the thrift has as they mature?

For existing loans, why is it that mortgage companies and MBS partners require that borrowers require payment in full with no modified terms or negotiation from anyone meeting their payments, even from people badly underwater on their house purchase and living in a state where they can just walk away from the mortgage?  Why is it that if you just miss a couple payments, suddenly they will suddenly agree to dramatically lower your payments?  Doesn't this just encourage people to miss payments?

Why is it that even when they do renegotiate payments, they renegotiate only the payment, and capitalize all payment drops, even where the loan is already badly underwater?  Doesn't this just create an even bigger incentive for the borrower to default?

Why is it that we have provided full federal insurance of money market mutual funds, whose owners willingly trade the safety of the regulated banking system for higher returns, but we have yet to fully insure the "low risk" bank deposits themselves?  Why is this type of scenario repeated several more times across different markets?

If the goal of the FDIC is to stabilize financial institutions by preventing bank runs, what is the point of leaving FDIC insurance incomplete so that we still have bank runs like the one which recently took down Washington Mutual?  If the lack of full FDIC insurance is what was responsible for this bank run, what is the point of having FDIC insurance in the first place?  If it's useless for the function for which it was designed, why not just get rid of FDIC insurance?