“Housing bubble”. “Easy money” as the main cause of subprime mortgage crisis. The 2008 stock market crash. The Troubled Asset Relief Program as a remedy for the crisis
However, the tactics of easy money finally begin to exert an effect on the economy, although unintended (that fact was proved only six years later). With interest rates hovering near historic lows (the average 30-year mortgage rate for all US regions ranged from 5% to 5.02%, with the exception of the West where it averaged 4.91%.)[1], it was no wonder that Americans rushed into the decision to invest in what seemed like the safest bet: their homes. Credit into the housing market was pumping by the Federal National Mortgage Association (known as Fannie Mae)[2] and the Federal Home Loan Mortgage Corporation Federal Home Loan Mortgage Corporation, (known as Freddie Mac)[3], privately owned but government-sponsored organization that used private capital to buy home mortgages as a means to help lower housing costs. The low interest rates prompted an activity and jobs for builders and real estate brokers and other specialists (among them mortgage brokers), feeding consumer spending.
The housing market started to thrive. Pearl Kamer, chief economist of the Long Island Association on September 12, 2003 referring to the low interest rates, wrote: It had an enormous impact on housing and increased consumer spending. (…) It contributed directly to employment”.[4]
A similar opinion expressed Carolyn Weber, president of Re/Max of New York in Garden City:
It was the most aggressive real estate market I saw in 34 years(…) We had more transactions and business than we ever did before. We opened 10 new offices on Long Island alone.[5]
The housing boom has the additional effect – exploiting decreases in interest rates, homeowners refinanced their mortgages to consolidate debt. Saving by that on installment gave them “additional” money, that could be spent on consumption. With new spending and - as an effect - the rising economy, home prices also began to increase, particularly since investing in home market was then considered safer than in the stock market. From 2001 to 2006 The S&P/Case Shiller U.S. National Home Price Index almost doubled its value, forming a new bubble.[6]
Meanwhile, with home prices continuing to soar and the remarkable run of real estate, some banks lowered the minimum credit score necessary to obtain a home loan or increased the percentage of income that would be spent on a mortgage. Others went so far as to introduce loans that required no proof of income at all. It were so-called “subprime loans”, referring to borrowers that were not “prime” so they might be less likely to repay a loan. According to Creditor Web, subprime borrowers would be classified as subprime because of (among others): “Bad credit or lack of a credit history, low income or poor debt to income ratios, Large loans relative to the securing property”.[7]
Even though lenders were warned against easing loan restrictions, they did not stop these practices. Many people were eager to invest money in real estate and lenders wanted to earn as much money as possible. With home prices increasing steadily, loans for buying homes seemed to be a safe undertaking. Borrowers who failed to pay back the bank, were sued to court which ordered the property to be sold. (The process was called ‘foreclosure’) A bank would sold a property at public auction for even higher price.
This assumption proved to be right while home prices were rising rapidly. Unfortunately, between 2006 and 2007 prices began to stabilize and next fell. Moreover, with inflation soaring, within the period from May 2004 to July 2006 the FED was forced to increase interest rates from 1% to 5,25%[8], what contributed to higher costs of credit and more foreclosures and as a feedback home prices got into a long-term, downward trend.
Since 1981 the mortgage industry was financing its activities by issuing mortgage-backed securities. According to U.S. Securities and Exchange Commission:
Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization.[9]
With the housing market falling, an increasing number of borrowers stopped paying their mortgage payments foreclosures. The decline in mortgage payments reduced the value of mortgage-backed securities, which erodes the worth of banks. This vicious cycle made a huge crisis in the whole banking sector. Policymakers did not recognize the increasingly important role played by financial institutions greatly contributing to the crisis. In a testimony before the US Congress, the Securities Exchange Commission (SEC) and Alan Greenspan conceded their failure in effective regulation of the shadow banking system in allowing the self-regulation of Wall Street's investment banks.[10]
Consequences of the crisis were huge. According to analysis of Association of Customers of Financial Entities:
Top five US investment banks reported over $4.1 trillion in debt for fiscal year 2007 (roughly 30% the size of the U.S. economy). Lehmann Brothers went bankrupt, Bear Sterns and Merrill Lynch had to be sold off and Goldman Sachs and Morgan Stanley had to convert themselves to commercial banks (…) These losses impacted the ability of financial institutions to lend, slowing economic activity.[11]
Effects on global stock markets due to the subprime mortgage crisis was dramatic. The US economy found itself on the brink of disaster. The crisis was doomed to negatively influence the world’s economy. In order to assuage it, the US government implemented means, that were intended to stabilize the financial system. The most important was the plan to purchase large amounts of illiquid, risky mortgage backed securities (estimated at minimum $700 billion of commitments) from all financial institutions in needs, known as The Troubled Asset Relief Program, commonly referred to as TARP[12]. Among others were ban on short-selling of financial stocks in order to prevent them from falling further and implementing some regulatory solutions in the banking system.
However, looking for causes of the crisis, people governed the country did not find themselves guilty and did not notice the hazardous feedback between the stock market bubbles and the condition of the economy. Senate reported on the financial crisis: “The crisis was (…) the result of high risk; complex financial products; undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street”.[13]
In spite of efforts, between October 8, 2007 and March 2, 2009 the US indexes crashed. The Dow Jones index fell from 14066,6 to 6627,7[14] and the index of the broad market S&P500 from 1501 to 666,6.[15] Investors in the U.S. stocks had suffered about $8 trillion in losses as their assets declined in value from $20 trillion to $12 trillion.[16] Losses in the stock markets and housing value declines put further downward pressure on consumer spending.
2. The Fed and the government once more in action. The Economic Stimulus Act along with the American Recovery and Reinvestment Act as ways of stimulating economy. Printing new money by Quantitative Easing (QE)
As an answer to the crash, on September 18, 2007, the Fed slashed interest rates for the first time in 4 years, from 5,25% to 4.75%, signaling that more cuts could be coming. (Actually, the total number of cuts was 11 and ended on December 16, 2008, within the range between 0% zero to 0.25%.)[17]
However, as 2008 began, economic indicators further suggested an increased risk of recession, and some economists suggested that the economy may already be in one. Big banks - Citigroup and Merrill Lynch - reported huge quarterly losses this week resulting from bad mortgage investments. It became clear that without special means the US economy would derail. Federal Reserve Chairman Ben Bernanke testifying before the House Budget Committee said that quick action was needed and suggested stimulating the economy through government spending and tax incentives. He said: “To be useful, a fiscal stimulus package should be implemented quickly and structured so that its effects on aggregate spending are felt as much as possible within the next twelve months or so."[18]
The actions undertaken by policymakers and lawmakers as an answer were quick and beyond anything attempted in the last 50 years. On February 13, 2008, Congress passed law, called The Economic Stimulus Act, aimed to stimulate spending by businesses and consumers. It was intended to boost the United States economy and to avert a recession. Wikipedia gives some important facts about The Economic Stimulus Act:
The Economic Stimulus Act of 2008 (…) was an Act of Congress providing for several kinds of economic stimuli intended to boost the United States economy in 2008 and to avert a recession, or ameliorate economic conditions. (…) The law provides for tax rebates to low- and middle-income U.S. taxpayers, tax incentives to stimulate business investment, and an increase in the limits imposed on mortgages eligible for purchase by government-sponsored enterprises (e.g., Fannie Mae and Freddie Mac). The total cost of this bill was projected at $152 billion for 2008.[19]
Unfortunately, lowering interest rates and The Economic Stimulus Act failed to produce the desired effect of growing economy. Statistics of 2008 and 2009 showed that the economy was in a recession. The US GDP fell consecutively: in the 1st quarter of 2008 by 0,7%, in the 3rd quarter of 2008 by 4%, in the 4th quarter of 2008 by 6,8%, in the 1st quarter of 2009 by 4,9%, and in the 2nd quarter of 2009 by 0,7%.[20]
In this situation the US policymakers acknowledged that economic stimulus must be continued. On February 17th, 2009 President Obama signed the American Recovery and Reinvestment Act (also known as ‘Stimulus Package’) to improve the economy (the House passed the bill on January 28, 2009). The package contained funding for science, research and infrastructure, education, social sciences and the arts.[21]
Acknowledging that these means may be insufficient to maintain the economy on the path of growth, in March 2009 the Federal Reserve used one more financial tool - quantitative easing (QE), a highly controversial way of stimulating economy when conventional monetary policy becomes ineffective (interest rates are so low that it’s impossible to cut them further). Quantitative easing is a method of increasing the “quantity” of money. “Financial Times Lexicon” describes the idea of QE as follows:
When interest rates are close to zero there is another way of affecting the price of money: Quantitative Easing (QE). The aim is still to bring down interest rates faced by companies and households and the most important step in QE is that the central bank creates new money for use in an economy. Only a central bank can do this because its money is accepted as payment by everybody[22]
However, some experts see the QE otherwise. For example, Cheryl Hall from Dallas News wrote: “Quantitative easing is a euphemism for creating money out of thin air. In the vernacular, we call it "printing money," even though it really has nothing to do with the U.S. Bureau of Engraving and Printing.”[23]
In late November 2008 the US Federal Reserve implemented QE. Technically, it consisted in extending the amount of money on its balance sheet from $884 billion on August 28 to $2.1 trillion on November 28. This “additional” money was used for purchasing the US Treasury notes.
Meanwhile, some economist warned that Quantitative Easing may be dangerous for economy since creating “additional” money carries risk of higher inflation or simply hyperinflation and could destroy the value of the currency. However, the Fed paid no heed to the warnings as for it more important was the fact that the economy was not growing sufficiently and decided to renew the process of quantitative easing. In November 2010 the Fed announced that by the end of the second quarter of 2011 it would buy additional $600 billion of Treasury securities.[24]
[1] http://www.property-investing.org/30-year-mortgage.html
[2] http://en.wikipedia.org/wiki/Fannie_Mae
[3] http://en.wikipedia.org/wiki/Freddie_Mac
[4] http://www.allbusiness.com/business-finance/business-loans-interest-rate/970020-1.html
[5] ibidem
[6] http://en.wikipedia.org/wiki/Case-Shiller_home_price_index#The_national_index
[7] http://banking.about.com/od/loans/g/subprime.htm
[8] http://www.tradingeconomics.com/united-states/interest-rate
[9] http://www.sec.gov/answers/mortgagesecurities.htm
[10]http://www.scribd.com/doc/34991160/Sub-Prime-Crisis
[11] http://www.acfglobal.com/source/3_rep_art_articales_02.html
[12]http://www.law.harvard.edu/programs/about/pifs/llm/select-papers-from-the-seminar-in-international-finance/llm-papers-2009-2010/wall.pdf
[13]http://www.housingwire.com/2011/04/13/senate-report-on-financial-crisis-rips-regulators-banks-investment-firms
[14] http://finance.yahoo.com/echarts?s=^DJI+Interactive#chart2:symbol=^dji;range=5y
[15] http://finance.yahoo.com/echarts?s=^GSPC+Interactive#symbol=^GSPC;range=5y
[16] http://en.wikipedia.org/wiki/Subprime_mortgage_crisis
[17] http://en.wikipedia.org/wiki/Federal_funds_rate#Historical_rates
[18] http://money.cnn.com/2008/01/17/news/economy/fed_bernanke/index.htm
[19] http://en.wikipedia.org/wiki/Economic_Stimulus_Act_of_2008
[20] http://www.tradingeconomics.com/united-states/gdp-growth
[21] http://www.washington.edu/research/gca/recovery/
[22] http://lexicon.ft.com/Term?term=quantitative-easing
[23]http://www.dallasnews.com/business/columnists/cheryl-hall/20101109-What-is-Fed-s-QE2-6107.ece
[24]http://www.creditwritedowns.com/2008/11/quantitative-easing-printig-money-like-mad-to-ward-off-deflation.html
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