The crisis disrupted housing markets, mortgage markets, and finance and credit markets generally. These developments reduced aggregate demand and brought on an economic recession that adversely affected most businesses and shook public confidence in financial institutions and government.
Beginning during the summer of 2007, worsening conditions in the United States housing and home-finance sectors led to an escalation of financial distress. Average
Government intervention was not primarily motivated by concern for the failing institutions. Rather, it was undertaken in an effort to prevent a decrease in aggregate demand (as measured by gross domestic product–GDP) that would cause a decrease in production and employment. There was fear that loans would not be available for business spending for new capital equipment. More specifically, government interventions sought to prevent a serious decrease in the construction and sale of new homes–an important component of GDP. Surprisingly, even by mid-2008, GDP was still increasing. Another objective was to prevent foreign investors from selling off their holdings of American securities, which would increase interest rates in the U.S. and drive down the international value of the dollar. This objective was achieved.
At the center of
In 1977, Congress passed the
Traditionally, mortgage lenders wanted to be sure the loans that they made would be repaid and evaluated loan applicants on the basis of their incomes, wealth, and credit experience. Now those standards were increasingly set aside, particularly in view of the rapid increase in house prices that was raising the market value of borrowers’ collateral. In 2007, 45 percent of first-time home buyers made no down payments; they were thus borrowing the entire prices of their houses. The rapid rise in house prices generated demand for houses by speculators who expected to be able to resell the houses at still higher prices.
The expansion of subprime lending was financed in large degree by the creation of
The opportunity to issue low-interest CDOs to finance high-interest mortgages created large profit opportunities, and private firms flocked to the field in the new millennium. Whereas in 2003, Fannie and Freddie accounted for three fourths of CDO issues, by mid-2006 their share had fallen to 43 percent. In 2003, prime (top-grade) mortgages were half the basis for CDOs, but by 2006, they were down to one fourth.
In retrospect, many problems can be identified in CDO issues. Often the issuers offered guarantees to persons buying their bonds. Such loan guarantees became a big business in themselves, in the form of “credit-default swaps.” Fannie and Freddie guaranteed many privately issued CDOs. Both issuers and bond buyers lacked adequate information about the risk characteristics of the various CDO issues. Not only did the mortgage pools contain debts of persons of diverse credit standing, but the mortgages themselves were often loaded with complex provisions such as adjustable interest rates or interest-only payment schedules.
The national securities rating agencies, such as Moody’s or Standard and Poor’s, usually gave the high-priority bonds top investment grades–again without adequate information. The opportunity to purchase “insurance” against loan defaults, often at low cost, enabled many investors to ignore considerations of credit risk. The nominal value of credit-default swaps reached $62 trillion by the end of 2007. Many of these were simple financial speculations, for the volume of corporate debt was only about $6 trillion. Some of these speculations were unbelievably profitable: According to Fortune magazine, “Hedge fund star John Paulson . . . made $15 billion in 2007, largely by using [credit-default swaps] to bet that other investors’ subprime mortgage bonds would default.”
The security issues arising from CDOs were subject to surveillance by the Securities and Exchange Commission. However, this only involved confirming that issuers accurately described the new securities, not trying to assess their riskiness. In contrast, credit-default swaps had been explicitly exempted from government regulation by federal legislation in 2000.
In March, 2008,
On September 7, 2008, the federal government (through Treasury Secretary Henry Paulson) took control of Fannie and Freddie. The Treasury provided each with a $100 billion line of credit in exchange for an ownership share. Existing stockholders lost most of their investment. The two firms had liabilities exceeding $5 trillion and were providing as much as 80 percent of new mortgage financing. They continued operating under supervision from the Federal Housing Finance Agency. A week later,
A Dow Jones news ticker in New York’s Times Square displayed news about AIG and Lehman Brothers on September 16, 2008.
The Lehman failure led to an avalanche of security sales by financial firms desperate to raise cash, driving down stock prices and bond prices. Firms that had provided loan guarantees were under pressure to make good. One such troubled firm was
On September 25, 2008, the FDIC presided over the forced merging of
The spectacle of financial institutions trying to sell assets and driving markets down finally provoked major federal intervention. On October 3, Congress approved a Treasury plan to use as much as $700 billion to buy distressed financial assets and to inject capital into banks. Included in the Emergency Economic Stabilization Act was an increase in the coverage of federal insurance of bank deposits from $100,000 to $250,000. For the week following, stock prices experienced one of their most severe declines, prompting the Federal Reserve to lower its already-low target interest rate. Another large troubled bank, Wachovia, was absorbed by Wells Fargo.
On November 25, an additional initiative was undertaken, chiefly involving a commitment by the Federal Reserve to buy up to $600 billion in debts issued by or backed by Fannie, Freddie, and other housing lenders. It committed an additional $200 billion to enable investors to carry securities backed by student loans, automobile loans, credit card debt and small-business loans.
Almost simultaneously, a major rescue effort was directed toward banking conglomerate Citigroup, with the government providing $20 billion in capital and a guarantee covering about $250 billion in real estate loans and securities held by Citi.
On February 17, 2009, President Barack Obama signed into law the American Recovery and Reinvestment Act, a $787 billion recovery package that included funds for renewable energy, infrastructure, education, and health care, as well as about $282 billion in tax relief for individuals and businesses. The next day, Obama announced a $275 billion housing relief plan designed to help people refinance their mortgages and stay in their homes.
One of the primary questions that this crisis raised is how a relatively minor increase in mortgage defaults–as measured by dollar magnitude–developed into a worldwide financial meltdown. One contributing factor was the layering of debts through several stages of financial intermediation. Grassroots lenders initiated mortgages, some of which they held pending resale, borrowing 80 to 90 percent of the value of their holdings. Fannie and Freddie bought mortgages using mostly borrowed money. They and other firms pooled some mortgages into CDOs, some of which they held pending resale, financed by borrowing. Hedge funds bought the high-risk equity tranches of CDOs, financed by borrowing. For every $100 of underlying mortgage debt, there could easily be $500 or more of interlocking institutional debts. Interwoven with these were the debts implicit in the purchase and sale of credit-default swaps.
Firms that were deeply involved in CDOs were most likely to experience a crisis. Relatively small increases in mortgage defaults became magnified for several reasons:
Firms that made major investments in CDOs or in mortgages were heavily dependent on short-term loans that needed to be rolled over continuously. Inability to renew loans precipitated most of the firm closures.
The firms did not have capital accounts sufficient to their risk exposure. The capital account shows the amount by which the value of assets exceeds the value of liabilities. Fannie and Freddie had capital accounts less than 2 percent of their assets. A decline of 2 percent in the value of their assets would make them technically insolvent. Government regulations establish minimum capital requirements, but in many cases these were not large enough. A major reason was that many firms had extensive “off-balance-sheet” liabilities, such as loan guarantees. Firms like AIG had more liabilities than they acknowledged, and the rules for minimum capital failed to adjust for these invisible liabilities.
Firms that sold large amounts of credit-default swaps, such as Fannie, Freddie, and AIG, believed they were providing “insurance.” They had elaborate computer algorithms to calculate probabilities of loss. The calculations were simply wrong, and the sellers did not have enough solid assets to cover their bad bets.
When financial markets are smoothly functioning, many transactions and relationships substitute trust in place of information. Few Americans, after all, carefully scrutinize the asset portfolios of their automobile insurance providers. The crisis of 2007-2008 broke down trust in many relationships. In particular, potential suppliers of short-term loan funds lost trust in the potential borrowers, particularly after the Lehman collapse.
The crisis occurred in a context that included the extremely low saving rate in the United States and the large flow of international capital into the U.S. CDOs and credit-default swaps experienced explosive growth in part because they facilitated marketing American CDOs to foreign investors. In 2007, the financial services industry received 40 percent of all U.S. corporate profits. It seems unlikely the sector contributed to American economic welfare in such a proportion.
Critics blamed the crisis in part on the federal government policy of trying to expand home ownership. Many people may prefer or are better off living in rental housing because they move frequently, lack financial decision-making skills, have better use for their capital than a house, or do not want to spend time maintaining the property. The government’s programs increased spending for housing and increased home prices–so first-time home buyers had to pay more and did not really gain from the underlying policies. Capital that flowed into overpriced and underfunded homes could have gone into productive capital assets, buildings, and machines to raise labor productivity and real wages. A substantial share of the losses from asset defaults were experienced by foreign investors.
Bandler, James. “Hank’s Last Stand.” Fortune 158, no. 7 (October 13, 2008): 112-131. A play-by-play look at the collapse of AIG from the perspective of its longtime head, Maurice “Hank” Greenberg. “Briefing: A Short History of Modern Finance.” The Economist, October 18, 2008, 79-81. Excellent overview, stressing long-term and international aspects. Dodd, Randall. “Subprime: Tentacles of a Crisis.” Finance and Development (December, 2007): 15-19. Clear and detailed explanation of the emergence and role of collateralized debt obligations. Mizen, Paul. “The Credit Crunch of 2007-2008: A Discussion of the Background, Market Reactions, and Policy Responses.” Review (Federal Reserve Bank of St. Louis, September/October, 2008): 531. Detailed scholarly examination of long- and short-term aspects, with attention to the international dimension. Varchaver, Nicholas, and Katie Benner. “The $55 Trillion Question.” Fortune 158, no. 7 (October 13, 2008): 135-140. Explains everything about credit-default swaps except why they are called “swaps.”
Asian financial crisis of 1997
Deregulation of financial institutions
Federal Deposit Insurance Corporation
Federal monetary policy