The Crisis of 2008: Causes & Lessons For the Future

The Crisis of 2008

The Crisis of 2008 The headlines of 2008 were about falling housing prices, rising default and foreclosure rates, failure of large investment banks, and huge bailouts arranged by both the Fed and the Treasury The crisis reduced the wealth of most Americans and generated widespread concern about the future of the economy This crisis and the response to it may be the most important macroeconomic event of our lives

Key Events Leading up to the Crisis

Key Events Leading Up to the Crisis Boom and bust in housing prices Rising default and foreclosure rates Sharp downturn in the stock market Soaring prices of crude oil and other energy sources

Change in Housing Prices, 1987-2008 Housing Prices (annual percent change) 20 15 10 5 - 5 - 10 - 15 - 20 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Housing prices were relatively stable during the 1990s … but began to rise toward the end of the decade. Between Jan. 2002 and mid-year 2006, housing prices increased by a whopping 87%

Change in Housing Prices, 1987-2008 Housing Prices (annual percent change) 20 15 10 5 - 5 - 10 - 15 - 20 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 In late ‘06, the boom turned to a bust and housing prices declined throughout 2007-’08. By year-end 2008, housing prices were approximately 30% below their 2006 peak

Mortgage Default Rate, 1979-2008 Prior to 2006, the default rate fluctuated within a narrow range (around 2%). It increased only slightly during the recessions of 1982, 1990, and 2001. The rate began increasing sharply during the 2nd half of 2006 It reached 5.2% during the 3rd quarter of 2008. Mortgage Default Rate 6% 5% 4% 3% 2% 1% 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2008

Housing Foreclosure Rate, 1979-2008 The foreclosure rate followed a similar path as the default rate Prior to mid-2006, the foreclosure rate fluctuated between 0.15% and 0.50% But in 2007-2008, it increased sharply and moved to the highest level in decades Percent (%) 1.2 1.0 0.8 0.6 0.4 0.2 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2008

Changes In Stock Prices, 1996-2009 S&P 500 Index 1600 The S&P 500 fell by more than 55% between October 2007 & March 2009 This collapse eroded the wealth and endangered the retirement savings of many Americans 1200 800 400 1996 1997 1998 2000 2001 2002 2003 2004 2005 2008 2009

What Caused the Crisis of 2008?

Four Major Causes of the Crisis of 2008 Regulations that lowered mortgage lending standards A prolonged low interest rate policy of the Fed during 2002-2004 Increased debt-to-capital ratio of investment banks and other lending institutions High and growing debt-to-income ratio of American households

Factor 1: Change In Mortgage Lending Standards The role of Fannie Mae and Freddie Mac: These two government sponsored enterprises (GSEs) were set up as “for profit” firms by the federal government Because of their GSE status and the perceived government backing of their bonds, they could borrow funds at 50 to 75 basis points cheaper than other lenders The GSE structure meant they were asked to serve two masters: (1) their stockholders and (2) Congress and federal regulators

The Role of Fannie Mae & Freddie Mac The GSEs were highly political: their top management provided key congressional leaders with large contributions and often hired away congressional staffers into high paying jobs lobbying former bosses Fannie and Freddie did not originate mortgages, instead they operated in the secondary market where they purchased the mortgages originated by banks and other lenders They dominated the secondary mortgage market As a result, their lending practices exerted a huge impact on the standards accepted by mortgage originators

Mortgages of the GSEs, 1990-2008 Share of Total Mortgages Outstanding Held by Fannie Mae and Freddie Mac The share of all mortgages held by Fannie and Freddie rose from 25% in 1990 to 45% in 2001 Since 2001, their share has fluctuated between 40% and 45% Percent (%) 45 40 35 30 25 20 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Regulations and Lending Standards Regulations imposed by the Department of Housing and Urban Development (HUD) in the mid-1990s, forced Fannie and Freddie to extend more loans to low and moderate income households The HUD mandates required Fannie and Freddie to extend 40% of their new loans to borrowers with incomes below the median in 1996. This mandated share was increased to 50% in 2000 and 56% in 2008

Regulations and Lending Standards In 1999, HUD guidelines required Fannie and Freddie to accept smaller down payments and extend larger loans relative to income In order to meet HUD mandates, the GSEs accepted more subprime loans. Mortgage originators were willing to make subprime and other high risk loans because they could be passed on to the GSEs. This resulted in the deterioration of lending standards

Regulations and Lending Standards Beginning in 1995, modified regulations imposed by the Community Reinvestment Act (CRA) also lowered mortgage lending standards The CRA pushed banks to extend more loans to high risk borrowers. Mortgage loans to subprime borrowers soared as a result of these regulations. This is important because the foreclosure rate on subprime loans is 7 to 10 times higher than for prime loans The intent was to promote affordable housing, but the regulations eroded lending standards, fueled the housing price boom & bust, and the defaults and foreclosures that followed.

Subprime and Alt-A Mortgages Alt-A loans were extended with incomplete documentation and verification Both subprime and Alt-A loans are risky. These loans rose from 10% of the total in 2001-2003 to 33% in 2005-2006 Share of Total Mortgages Outstanding Held by Fannie Mae and Freddie Mac Percent (%) Subprime + Alt-A 35 30 25 20 15 10 Subprime 5 1994 1996 1998 2000 2002 2004 2006

Low-Down Payment Loans by Fannie Mae and Freddie Mac Number of loans extended by Fannie Mae & Freddie Mac 600k 500k 400k Loans to borrowers with 5% or less down payment extended by Fannie Mae and Freddie Mac jumped from less than 100,000 in 1998 to more than 600,000 by 2007. These low-down payment loans increased from 4% in 1998 to 12% in 2003, and more than 23% in 2007. Predictably, many of these low-down payment loans extended to borrowers would end up in default & foreclosure. 300k 200k 100k 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 25% Share of Fannie Mae & Freddie Mac loans with less than 5% down 20% 15% 10% 5% 15th edition Gwartney-Stroup Sobel-Macpherson 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Questions for Thought: 1. Why did regulators and the politicians who directed them want to make it easier for low- and middle-income households to borrow more money and obtain a mortgage with little or no down payment? 2. What is the predictable impact of the increase and subprime and Alt-A loans on the default and foreclosure rates? Explain. 3. What impact will an increase in the share of low-down payment loans extended to borrowers have on the future default and foreclosure rates?

Factor 2: Low-Interest Rate Policy of the Fed During 2002-2004 During 2002-04 the Fed supplied additional reserves to the banking system & kept short-term interest rates low. This policy supplied additional bank credit, increased the attractiveness of adjustable rate mortgages (ARMs), and fueled the housing price boom But, as inflation increased during 2005-2006, the Fed increased interest rates and this helped turn the housing boom to a bust

Fed Policy and Short-term Interest Rates, 1995-2009 Fed policy kept short- term interest rates at 2% or less throughout 2002-2004 As inflation rose in 2005-2006, the Fed pushed interest rates upward. Interest rates on adjustable rate mortgages rose and the default rate began to increase rapidly. Federal Funds Rate and 1-Year T-Bill Rate Percent (%) 7 6 5 4 3 2 1 1995 1997 1999 2001 2003 2005 2007 2009 Federal Funds 1-Year T-bill

ARM Loans Outstanding, 1990-2008 ARM Loans as a Share of Total Outstanding Mortgages Percent (%) Measured as a share of total mortgages outstanding, ARMs increased from 10% in 2000 to 21% in 2005. 20 15 10 5 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Foreclosures on Subprime Loans, 1998-2008 Foreclosure Rate on Fixed & Adjustable Subprime Mortgages Percent (%) The foreclosure rate for subprime loans is shown here Note, how the foreclosure rate rose for ARM loans during 2006, but this was not true for fixed rate mortgages 7 6 5 4 3 2 1 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Adjustable Fixed

Foreclosures on Prime Loans, 1998-2008 For prime loans, the foreclosure rate for ARMs also rose in 2006 while it was relatively constant for fixed rate loans. Thus, the pattern was the same for both subprime and prime Note, the foreclosure rate was 7 to 10 times higher for subprime than prime loans. Foreclosure Rate on Fixed & Adjustable Prime Mortgages Percent (%) 1.0 0.8 0.6 0.4 0.2 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Adjustable Fixed

Housing Price Boom and Bust Both the regulations that eroded mortgage lending standards and the Fed’s interest rate manipulations contributed to the housing price boom and bust They also resulted in malinvestment – investments that should never have been made. It will take time to correct for these malinvestments

Factor 3: Increased Debt-to-Capital Ratio of Investment Banks A regulation adopted by the SEC in April 2004, permitted investment banks to leverage their capital by a larger amount and thereby extend more loans Banks were required to maintain 8% capital against commercial loans, but only 4% against residential housing loans, and only 1.6% against low-risk (AAA rated) securities

Factor 3: Increased Debt-to-Capital Ratio of Investment Banks Thus, if mortgage-backed securities had a AAA rating they could be leveraged up to 60 to 1 against bank capital Major investment banks and many commercial banks bundled mortgages together and received AAA ratings for the securities backing the mortgages These highly leveraged securities generated large profits for investment and commercial banks and the GSEs (Fannie and Freddie) during the housing boom

Factor 3: Increased Debt-to-Capital Ratio of Investment Banks Based on prior history of default rates, lending institutions thought the mortgage-backed securities were quite safe. But they failed to recognize that the erosion of the lending standards would lead to higher default and foreclosure rates. As housing prices leveled off in the latter half of 2006, default rates increased and the value of the highly leveraged mortgage-backed securities plummeted. This led to the collapse of investment banks like Bear Stearns and Lehman Brothers, and serious problems for other financial institutions.

Factor 4: High Debt to Income Ratio of Households The debt-to-income ratio of households has risen sharply since the early 1980s Because mortgage and home equity loans are tax deductible, but other forms of debt are not, household debt is concentrated against housing assets As a result, housing is hit hard when economic conditions weaken.

Household Debt as a Share of Income, 1953-2008 Between 1953-1980, household debt as a share of disposable (after-tax) income ranged from 40% to 65%. Since the early 1980s, the debt-to-income ratio of households has risen at an alarming rate. It reached 135% in 2007, more than twice the level of the mid-1980s. Ratio of Household Debt to Disposable Personal Income 140 120 100 80 60 40 20 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008

Housing, Mortgage Defaults, and the Crisis of 2008

Housing, Mortgage Defaults, and the Crisis of 2008 Regulations that eroded lending standards, the Fed’s interest rate policy, imprudent leverage lending by banks with the help of security rating firms, and the growth of household debt combined to create the 2008 financial crisis. Mortgage-backed securities were marketed throughout the world, and as default rates rose, the value of the securities plummeted and the crisis spread around the world. Default and foreclosure rates rose well before the recession started in December 2007, indicating that it was the housing crisis that caused the recession, not the other way around.

Continuing Impact of the 2008 Crisis

Continuing Impact of the 2008 Crisis With the Treasury takeover of Fannie Mae and Freddie Mac, the mortgage lending market has, essentially, been nationalized. 90% of the new mortgages for housing are currently financed by the Federal Government. The 2008 crisis reflects what happens when policies confront people with perverse incentives. Institutional reforms that restore sound lending practices, strengthen the property rights of shareholders, and provide corporate managers with a stronger incentive to pursue long-term success would help prevent future crises. Regulation, however, is a two-edged sword – it can generate adverse as well as positive results.

Questions for Thought: Many politicians have responded to the financial crisis by calling for more regulations and closer oversight of banks. Do you think more regulation will prevent the occurrence of another financial crisis? Why or why not? Was the 2008 crisis a failure of markets or government? Why? The Federal Reserve and Treasury provided bailouts to Fannie and Freddie, Wall Street investment banks, and large commercial banks. Many of these firms were insolvent. Why didn’t they go into bankruptcy and have their assets liquidated?

Questions for Thought: 4. Did political action save us from the disastrous consequences of the 2008 crisis? Did the politicians inadvertently cause the crisis and then attempt to shift the blame elsewhere?

End of Special Topic 5