What really caused the financial crisis?

Kashyap, Rajan, and Stein have lots of explanation but here is the initial bottom line:

The proximate cause of the credit crisis (as distinct from the housing crisis) was the interplay between two choices made by banks. First, substantial amounts of mortgage-backed securities with exposure to subprime risk were kept
on bank balance sheets even though the “originate and distribute” model of securitization that many banks ostensibly followed was supposed to transfer risk to those institutions better able to bear it, such as unleveraged pension funds. Second, across the board, banks financed these and other risky assets with short-term market borrowing.

In other words, one problem was not enough (!) securitization.  They also call for counter-cyclical capital requirements.  They like mandatory capital insurance — with payments triggered by capital disasters — even better.  My main worry, of course, is how we should regulate (or not) the entities which offer this insurance.  Will they too engage in liquidity transformation and if so who ensures them?

And, going back to banks, part of the governance problem was this:

…it is very hard, especially in the case of new products, to tell whether a financial manager is generating true excess returns adjusting for risk, or whether the current returns are simply compensation for a risk that has not yet shown itself but that will eventually materialize.

Their phrase "recapitalization as a public good" should not soon be forgotten.  And it is leverage which is dangerous, a lesson becoming clearer every day.

This paper is essential reading for anyone following the crisis and it makes more sense than just about anything else I’ve read on the topic.  I thank David L., a loyal MR reader, for the pointer.