The United State Housing Mortgage Crisis and the Great REcession: A Combination of Risk and Irrational Optimism

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Published on November 4, 2016

Author: ThaddeusPinakiewicz


1. 1 Thaddeus Pinakiewicz #737009099 Prof. Normal Abdullah Introductory Macroeconomics The United States Housing Mortgage Crisis and the Great Recession: A Combination of Risk and Irrational Optimism

2. 2 The Financial Crisis of 2008 is the second largest economic downturn in the history of the United States, only surpassed in its depth and severity by the Great Depression of the 1930s. It was caused by two main factors: the faulty assumption that house prices in America would rise indefinitely, and the proliferation of bad Mortgage Backed securities by highly leveraged financial institutions. The financial crisis’s causes were long in the making. In 1995 Bill Clinton revised the Community Reinvestment Act, which established a quota of low income loans that banks had to fill, and increased the punishment for Banks that did not fulfill their quota. President Clinton’s revising was a well-meant piece of legislation aimed at increasing home ownership, but it led to an artificial increase in the supply of loans for low-income buyers. This was good in theory to help low-income borrowers but it contributed to the speculative bubble that eventually burst. Moving forward in time, following the dot-com crash of 2001 the Fed lowered its fund’s rate to lessen the impact of the bust. This was meant to lessen the cost of borrowing and increased the amount of money flowing through the financial systemand the economy as a whole. This was paired with a loosening of the leverage limits on some banks to a level of 30:1 in 2004, letting them increase the value of their assets and liabilities to 30x their base of equity. The increase in leverage let the banks multiply their earnings in good times buts also multiplied their losses in bad times; with a leverage ratio of 30:1 a bank had to only recognize a loss of 3.34% of its assets to result in a decrease of 100% of their equity, leading to insolvency. The increased leverage ratio and cheap money realized through a low Fed Funds rate led to riskier investments by the banks searching for high returns for their cash.

3. 3 These high risk high return investments came in the form of issuing adjustable rate home mortgages to sub-prime borrowers, those who had below average credit ratings and as such were charged a higher interest rate due to their increased likelihood of default and as such were a source of greater revenue. This practice became widespread and borrowers who were less and less likely to pay back their loans were given mortgages in the search for higher returns. Investment banks and Government Sponsored Entities (GSEs) such as Fannie Mae and Freddie Mac then bought up massive pools of mortgages and through a process of securitization, packaged them up to sell as investment products. These products, Mortgage Backed Securities (MBSs) were structured so that the income from the loan payments were their source of revenue, and based off of home mortgages were considered to be long term assets. Through this process of securitization in combination with a complex financial product, Credit Default Swaps (CDSs) it was believed the risk of the MBS were negligible if not zero. The impact of a default on one of the loans packaged in a MBS was minimal as the income from them was based off of a massive pool of loans and the default of one would not adversely affect the whole: CDSs were combined with the MBSs and were designed to further reduce the risk of loss through mortgage default through an insurance of sorts. These products were incredibly complex and the regulatory system in place was not equipped to properly evaluate them. This was also true for credit rating companies as many of these MBSs were given AAA credit ratings based off of their assumed lack of risk, while in reality the pools of mortgages were increasingly composed of poor to toxic quality mortgages. These factors combined with the widely held notion that US housing

4. 4 prices would continue to rise indefinitely, as they had since the 1940s, and formed the structural basis of the financial crisis. There was one final key to the crisis, best put by John Maynard Keynes, which was the markets “animal spirits,” an irrational wave of optimism in the market. Banks kept on lending to risky borrowers, risky borrowers kept on taking out loans that they simply could not afford. Between 1997 and 2006, the price of the average American home increased by 124% (1). The value of American subprime mortgages was estimated at $1.3 trillion as of March 2007(2), Between 2004–2006 the share of subprime mortgages relative to total mortgage originations ranged from 18%–21%(3). In 2006 as there was perceived bubble in housing prices and the fed sought to stem it and increased the Fed Funds rate to 5.25% This increase in fed funds rate saw an increase in the borrowing costs of the bank and as a result they increased the interest rates charged on the adjustable rate loans that they had issued to sub prime lenders. This is the beginning of the crisis, subprime mortgage delinquency, default and foreclosure rates began to rise and housing prices began to fall. Mortgage owners were not paying, which reduced the value of the mortgages on the banks balance sheets, causing banks to seek more returns from other lenders, which in turn led to higher interest rates on adjustable mortgages and a vicious cycle of un performing loans causing raising interest rates and visa-versa. Mortgage foreclosures, rose to 1.3 million properties in 2007, a 79% increase over 2006(4), in 2008 it grew by another %81 compared to 2007(5) and by another 21% increase in 2008 from 2007(6). Housing prices fell 12% rom 2006 to 2007, 28% from 2006-2008 and 24% from 2006-2008(source: Case

5. 5 Schiller Index). This led to the collapse of many sub prime mortgage lenders which climaxed in March of 2008 when 25 sub prime lenders and Bear Stearns, an investment bank with a market value of over $30 Billion, filed for bankruptcy. More Banks continued to fail year after year, in2008 25 banks failed, in 2009 it increased to 140, to 157 at its peak in 2010(7). These bank failures, Bear Stearns’ in particular, all had massive effects on the economy and especially the animal spirits of the market. Due to the high leverage ratios of the banks originating the mortgages and the expansion of bad credit, a large sum of money were put into the economy into non-performing assets. This means that banks increased the value of the assets by issuing loans but in reality there was nothing of value backing the loans, and the banks created a toxic pool of value. This meant that a large sum was lent based on the idea that at least a significant enough amount of the loans would be paid back for them to be worthwhile giving. When those loans were not repaid, the highly leveraged banks exposed to these toxic mortgages saw the value of their assets plummet as they realized the loans they had issued were not going to be paid while more and more mortgage payers were defaulting and being foreclosed upon; forcing banks to write down the value of those mortgages. This combined with the real loss in value from the housing prices plummeting and a stock market drop of a total of 2,399.47 points or 22.11% from October 1st to October 8th 2008(8) which followed the realization of the magnitude of the crisis. These sub-prime mortgages with a total market value of $1.2 Trillion (9) had also been securitized and sold to other investors, banks and pension funds due to the returns

6. 6 on these products. These institutions that had invested in MBSs also faced massive real losses as the value of these securities plunged when it became apparent that they were not performing. These other institutions felt the loss in their balance sheets and banks heretofore considered safe were all at risk of failing. Banks were weary of lending to other banks given the possibility that they might fail and receive a loss, cut off lending to other banks in attempt to reduce their risk. This facilitated a vicious cycle of negative feedback as banks needed capital to shore up their balance sheets but they could not receive lending, as other banks were unwilling to lend. This aversion to giving credit, a credit crunch, led to further instability in the financial market. A large part of this debt was also absorbed by the mortgage owners who saw their personal debt skyrocket, their mortgage payments increase dramatically and the value of their houses go down so much that by 2010 %23 of US homes had a mortgage with a value of more than that of the house itself(10). A serious decrease in aggregate demand followed, and in the crisis many firms failed because of the fall in demand reduced their revenue while a lack of supply of loanable funds reduced their ability to take out a loan to weather the recession as the banks reduced their risk. People became jobless and aggregate demand further decreased, exacerbating the cycle. The crisis became so severe the government succumbed to moral hazard and bailed out the banks in 2008. The government pumped $700 Billion of cash into the economy following the approval of the Emergency Economic Stabilization act of 2008 to purchase bank assets to save the banks from failure and stop the market panic It served to stymy the crisis, and decreased the risk of massive market failure. The act established

7. 7 the federal takeover of Fannie Mae and Freddie Mac, mortgage securitizers, certain failed banks and insurance lenders, and allowed the purchase of toxic bank assets and mortgage backed securities. This infusion of liquidity was a large Keynesian active intervention policy designed to lessen the downturn of the crisis, calminvestors by establishing the United States as a backer of the economy, and most importantly to stabilize the economy. Unfortunately the stimulus was not enough; it did not boost growth as robustly as desired, the ultimate failure in Keynesian policy. For when the government takes on such large debt to stop a financial downturn it is relying on the resulting boost in aggregate demand and resulting increase in tax revenue to pay for the bailout. If the stimulus is not large enough it does not have the desired effect on growth and the government is left with less options available for further intervention. The public debt increase made further massive intervention unfeasible, as it would cause unsustainable government debt and was politically difficult to accomplish regardless. Government policy was not enough to stop the recession, only lessen its impact. A massive amount of value was eliminated from the market, estimated at $8Trillion (11) resulting in countless firms going out of business and in the end, massive unemployment. In 2007 the unemployment rate was 5% but by mid 2009 the unemployment rate peaked at 9.5%, one of the highest in recent memory (12). This massive spike in unemployment resulted in a huge loss to aggregate demand as the amount of money flowing through the economy plummeted. Unlike most recessions where unemployment quickly bounced back after the downturn, unemployment remained high for a protracted period of time, just now only reaching 7.5% in Q2 2013.

8. 8 The lack of Employment growth implies that there is a difference between this recession and previous recessions. This difference stems from corporations lack of willingness to invest and hire new workers after the crisis. Corporations to this day are still weary of investing in such a volatile climate. The global economy is in the doldrums: particularly in Europe where weak banks and weak sovereign states are stuck in a debt crisis amid a recession recession, and Asia where China’s growth has slowed significantly. The chaotic global market combined with a political crisis in America where policy future is unsure and tax rates in particular are vulnerable to change. Because of all of these factors contributing to an unsure future, corporations are unwilling to expand and invest in long-term capital, the driving force of long term growth and employment. This is evidenced by the balance sheets of those corporations that weathered the recession, which shows a massive pile of cash that they have stockpiled, nearing $2 Trillion in 2013(13). The only reason one would hold cash in account and not invest it in performing assets is an uncertainty of the future. Herein lies the remedy of the financial crisis; increased consumer confidence and a certain future. The Fed has attempted to do their part through promising bond purchases and interest rates near zero in the short to medium term until unemployment reaches 6.5%. The Fed can only do so much, while the real issue is in the United States Senate and House of Representatives. The gridlock on such issues that affect the US economy, such as the debt ceiling (which resulted in the downgrading of US Debt to AA+ from AAA), uncertainty over the appropriation of government funds, the sectors where government

9. 9 spending is to be cut, and the future tax rate all increase uncertainty in the future and a disinclination of corporations to invest, expand and hire. What can we learn from this crisis? This crisis had many intertwined causes that led to the recession, but it could have been prevented through various policy implementations. Alan Greenspan, former Chairman of the Fed, realized there was a housing bubble in “late in 2005 and 2006” which was not deflated, and government regulation was lacking in the areas needed most to contain the crisis. Banks had become so large that they posed a systematic risk to the entire economy if they failed earning the moniker “too big to fail”. Regulation lacked on the complex financial products institutions were selling and these institutions were allowed to assess their risk in-house due to the complexity of the financial products they were using (mostly MBSs and CDOs). Government policy needs to keep pace with that of financial product innovation as to reduce the risk in the financial systemas a whole to prevent such speculative bubbles. This is unfortunately a lot to ask of the government, especially considering the glaring gap in efficiency (and dare I say competency) between the government and Financial institutions. More could be have been prevented through a reduction in the acceptable leverage ratios and an increase in the required percentage of liquid or near liquid assets on a banks balance sheet. Thankfully US banks and financial institutions have been more quick to adapt and change to the new realities of the market than our government and following the passing of new Basel iii capital requirements, US banks deleveraged, increased the portion of high quality assets on their balance sheets and in many cases surpassed those requirements in scope and depth.

10. 10 There is unfortunately only so much we can do to prevent recession in the future. We can keep a watchful eye on the markets and try to predict and prevent speculative bubbles and risk buildups, but this is more easily said than done. We cannot truly predict most recessions, as they are inherently unpredictable. Given that, we are on the right track to establish a solid foundation for our financial institutions through the adoption of new capital rules to reduce the possibility of their failure and their risk to the economy as a whole. This combined with new regulation for such institutions that are so large that their failure would present systematic risk can lead to a less volatile future. Unfortunately we cannot predict the future and only time will tell if these policies are effective in preventing these black swan events that cause such cataclysmic change. Sources Cited 1- "CSI: credit crunch". The Economist. 2007-10-18 2- "How severe is subprime mess?". Associated Press. 2007-03-13. Retrieved 2008-07-13. 3- ^ Holmes, Steven A. (1999-09-30). "Fannie Mae Eases Credit To Aid Mortgage Lending". New York Times. 4- "U.S. FORECLOSURE ACTIVITY INCREASES 75 PERCENT IN 2007". RealtyTrac. 2008-01- 29. 5- "RealtyTrac Press Release 2008FY". 2009-01-15. 6- "Realty Trac-2009 Year End Report". 7- "Failed Bank List". Federal Deposit Insurance Corporation. Archived from the original on October 17, 2010. 8- idUSL1N0CE7LC20130322 9- 10- Wells Fargo Economic Research-Weekly Economic and Financial Commentary- September 17, 2010 11- Roger C. Altman. "The Great Crash, 2008 – Roger C. Altman". Foreign Affairs. 12-

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