January 1, 2008 As the new year begins, the United States is faced with an accelerating economic crisis. The price of oil will soon top $100 a barrel for the first time in history, driven by rising demand in the developed world and in India and China—and by the prospect of continuing Middle Eastern uncertainties. Although the fact will not be established for another year, when the National Bureau of Economic Research issues its December 2008 report, the U.S. economy has entered a recession.

The catalyzing event is the collapse of the subprime-mortgage market. During the past 12 months there have been nearly 1.3 million foreclosure filings. The losses flow upward. In March, J. P. Morgan Chase and the Federal Reserve Bank of New York provide massive emergency loans to prevent a default by Bear Stearns, one of the nation’s largest financial institutions; Bear Stearns is ultimately absorbed by J. P. Morgan. A cascade of economic woe ensues.

Some regulators had been warning for years about the threat posed by bad mortgages and the housing market, but steps to tighten the rules were successfully opposed by lenders.

Robert Shiller, Yale economist who warned of a housing bubble: The Bush strategists were aware of the public enthusiasm for housing, and they dealt with it brilliantly in the 2004 election by making the theme of the campaign the ownership society. Part of the ownership society seemed to be that the government would encourage home ownership and, therefore, boost the market. And so Bush was playing along with the bubble in some subtle sense. I don’t mean to accuse him of any—I think it probably sounded right to him, and the political strategists knew what was a good winning combination.

I don’t think that he was in any mode to entertain the possibility that this was a bubble. Why should he do that? Attention wasn’t even focused on this. If you go back to 2004, most people were just—they thought that we had discovered a law of nature: that housing, because of the fixity of land and the growing economy and the greater prosperity, that it’s inevitable that this would be a great investment. It was taken for granted.

John C. Dugan, comptroller of the currency A lot of mortgages got made to people who could not afford them and on terms that would get progressively worse over time, and that created the seeds of an even bigger problem. As the whole market became even more dependent on house-price appreciation, when house prices flattened and then started to decline the whole situation began to unravel. The question you have to ask yourself: Why did credit become so easy? Why would lenders make mortgages that became increasingly less likely to be repaid?

Part of the answer is that there was a huge chunk of the mortgage market that was not regulated to any significant extent. The overwhelming proportion of subprime loans were being done in entities that were not banks and not regulated as banks—I’m talking here about mortgage brokers and non-bank mortgage lenders that could originate these mortgages and then sell them to Wall Street firms that could package them into new kinds of mortgage securities, which arguably could take into account the lower credit risks and still be salable to investors worldwide.

Unfortunately, the theory was not in accord with the reality. Although they thought they had accurately gauged that risk, they too were in fact depending—when you get to the bottom of it—on house prices continuing to go up and up and up. And they did not.

Henry Paulson, secretary of the Treasury: I easily could imagine and expected there to be financial turmoil. But the extent of it, O.K., I was naïve in terms of—I knew a lot about regulation but not nearly as much as I needed to know, and I knew very little about regulatory powers and authorities. I just had not gone into it in that kind of detail. This’ll be the longest we’ve gone in recent history without there being turmoil, and given all the innovation in the private pools of capital and the over-the-counter derivatives and the excesses around the world, we figured that when there was turmoil, and these things were tested for the first time by stress, it would be more significant than anything else.