Behind the low US saving rates and the asset bubble in the real estate market were the expansionary monetary and fiscal policies of the United States, the key factor in the emergence of the global imbalances. This asset bubble fueled an extended consumption spree and rising current account deficits, which the United States was able to finance because of the dollar’s international reserve currency status. But the housing and financial sector policies for opening the mortgage market to borrowers not previously considered creditworthy – the subprime mortgage market – and the financial innovations created to support the subprime mortgages were the primary causes of the rising and bursting of the housing bubble. The financial deregulation and low interest rates brought about by the Federal Reserve’s monetary policy fostered expansion and innovation in the financial sector, and increasingly complex financial derivatives allowed the risks associated with the new instruments to be underestimated and fueled the housing bubble. When the housing bubble burst, these new financial instruments led to financial crises in the United States and the world. How did this happen?

New financial instruments and the housing bubble

Starting in the 1970s, US policy emphasized deregulation in order to encourage business activity. It also reduced oversight and the disclosure of new activities undertaken by banks and other evolving financial institutions. Savings and loan (S&L) associations specialized in taking deposits with short-term maturities and making mortgage loans with long-term maturities. This asset–liability mismatch made them especially vulnerable to the costs of high interest rates. When the Fed increased interest rates to combat inflation in the late 1970s, most thrift institutions reported large losses. By 1982 many institutions had failed, but no systemic reforms were taken.