Why Our Models Missed the Financial Crisis

Ezra Klein wrote last week, Why our models missed the financial crisis. "The difference, writes Peter Orszag, is that the housing crisis took place in ‘the highly leveraged financial sector.’ And that’s why all the models missed the damage it would do: ‘The macroeconometric models used by the Fed -- like those used by the Congressional Budget Office, the White House and others -- had at best a very rudimentary financial sector built into them.’ So ‘they treated the housing collapse as if it were merely dot-com bust 2.0.’ And that’s still the case today, he says. Yikes."

There's a little more but I still think this misses the point. The reason the housing bubble collapse caused a financial crisis is because there was an unregulated shadow banking world betting on the housing market. There was (and is) no transparency in derivatives trading and no one, not even many of the banks themselves, knew how over-leveraged they were. When the bubble burst, the banks collapsed (Bear, Lehman, AIG) and most of the others were stunned and fearful of what would happen next so they stopped lending (digging themselves in deeper).