Background
One major proximate cause of the Financial crisis of 2007-2008 is the problem of "legacy assets" both real estate loans held directly on the books of banks ("legacy loans") and securities (ABS's and MBS's) backed by loan portfolios ("legacy securities"). These assets create uncertainty around the balance sheets of these financial institutions, compromising their ability to raise capital and their willingness to increase lending.
Earlier in the decade, in response to the economic downturn caused by the September 11, 2001 attacks, the Federal Reserve lowered its target interest rates which, along with securitized credit instruments (legacy assets), caused increased credit availability for real estate loans. This increase in the availability of credit pushed up housing prices, causing a bubble.
The problem came with the bursting of the housing bubble in 2007, which generated losses for investors and banks. Losses were compounded by the lax underwriting standards that had been used by some lenders and by the proliferation of the complex securitization instruments, some of whose risks were not fully understood. The resulting need by investors and banks to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales. As prices declined, many traditional investors exited these markets, causing declines in market liquidity. As a result, a negative cycle developed where declining asset prices have triggered further deleveraging, which has in turn led to further price declines. The excessive discounts embedded in some legacy asset prices are now straining the capital of U.S. financial institutions, limiting their ability to lend and increasing the cost of credit throughout the financial system. The lack of clarity about the value of these legacy assets also made it difficult for some financial institutions to raise new private capital on their own.
It is widely held that because of the stringent mandates from the U.S. government, financial institutions were forced to lend cheap money to unqualified borrowers increasing the risk on their books.
Read more about this topic: Public-Private Investment Program For Legacy Assets
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