and Response 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 ID: 1029170
Download Presentation The PPT/PDF document "The Great Recession of 2008-2009: Cause..." is the property of its rightful owner. Permission is granted to download and print the materials on this web site for personal, non-commercial use only, and to display it on your personal computer provided you do not modify the materials and that you retain all copyright notices contained in the materials. By downloading content from our website, you accept the terms of this agreement.
1. The Great Recession of 2008-2009: Causes and Response
2. The Crisis of 2008
3. The Crisis of 2008The 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 TreasuryThe crisis reduced the wealth of most Americans and generated widespread concern about the future of the economyThis crisis and the response to it may be the most important macroeconomic event of our lives
4. Key Events Leading up to the Crisis
5. Boom and bust in housing pricesRising default and foreclosure ratesSharp downturn in the stock marketSoaring prices of crude oil and other energy sourcesKey Events Leading Up to the Crisis
6. but began to rise toward the end of the decade.Between Jan. 2002 and mid-year 2006, housing prices increased by a whopping 87%Housing prices were relatively stable during the 1990s … Change in Housing Prices, 1987-2008Housing Prices(annual percent change)- 1001020155- 5- 15- 201987198919911993199519971999200120032005200720082006200420022000199819961994199219901988
7. 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 peakChange in Housing Prices, 1987-2008Housing Prices(annual percent change)- 1001020155- 5- 15- 201987198919911993199519971999200120032005200720082006200420022000199819961994199219901988
8. Mortgage Default Rate, 1979-2008Prior 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 2006It reached 5.2% during the 3rd quarter of 2008.Mortgage Default Rate1979198519882000199401%2%5%6%2003198219911997200620083%4%
9. Housing Foreclosure Rate, 1979-2008The foreclosure rate followed a similar path as the default ratePrior 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 decadesHousing Foreclosure Rate1979198519882000199400.20.41.01.22003198219911997200620080.60.8Percent(%)
10. Changes In Stock Prices, 1996-2009The S&P 500 fell by more than 55% between October 2007 & March 2009This collapse eroded the wealth and endangered the retirement savings of many AmericansS&P 500 Index19961998200020042002012001600200519972001200820094008002003
11. What Caused the Great Recession?
12. Four major causes of the Great Recession:Regulations that lowered mortgage lending standardsA prolonged low interest rate policy of the Fed during 2002-2004Increased debt-to-capital ratio of investment banks and other lending institutionsHigh and growing debt-to-income ratio of American householdsFour Major Causes of theGreat Recession
13. The role of Fannie Mae and Freddie Mac:These two government sponsored enterprises (GSEs) were set up as “for profit” firms by the federal governmentBecause 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 lendersThe GSE structure meant they were asked to serve two masters: (1) their stockholders and (2) Congress and federal regulatorsFactor 1: Change In Mortgage Lending Standards
14. 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 bossesFannie and Freddie did not originate mortgages, instead they operated in the secondary market where they purchased the mortgages originated by banks and other lendersThey dominated the secondary mortgage marketAs a result, their lending practices exerted a huge impact on the standards accepted by mortgage originatorsThe Role of Fannie Mae & Freddie Mac
15. Mortgages of the GSEs, 1990-2008The share of all mortgages held by Fannie and Freddie rose from 25% in 1990 to 45% in 2001Since 2001, their share has fluctuated between 40% and 45%Share of Total Mortgages Outstanding Held by Fannie Mae and Freddie Mac1990199419962002199820253045200419922000200620083540Percent(%)
16. 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 householdsThe 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 2008Regulations and Lending Standards
17. In 1999, HUD guidelines required Fannie and Freddie to accept smaller down payments and extend larger loans relative to incomeIn 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 standardsRegulations and Lending Standards
18. Beginning in 1995, modified regulations imposed by the Community Reinvestment Act (CRA) also lowered mortgage lending standardsThe 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 loansThe 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.Regulations and Lending Standards
19. Subprime and Alt-A MortgagesAlt-A loans were extended with incomplete documentation and verificationBoth subprime and Alt-A loans are risky.These loans rose from 10% of the total in 2001-2003 to 33% in 2005-2006Share of Total Mortgages Outstanding Held by Fannie Mae and Freddie Mac1994199820022000101520302004199620062535Percent(%)05Subprime + Alt-ASubprime
20. 15th editionGwartney-StroupSobel-MacphersonLow-Down Payment Loans by Fannie Mae and Freddie MacLoans 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.19981999200020012002200320042005200620071998199920002001200220032004200520062007Share of Fannie Mae & Freddie Mac loans with less than 5% downNumber of loans extended by Fannie Mae & Freddie Mac 5%10%15%20%25%100k200k300k400k500k600k
21. 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?
22. 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 boomBut, as inflation increased during 2005-2006, the Fed increased interest rates and this helped turn the housing boom to a bustFactor 2: Low-Interest Rate Policy of the Fed During 2002-2004
23. Fed Policy and Short-term Interest Rates, 1995-2009Fed policy kept short-term interest rates at 2% or less throughout 2002-2004As 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 Rate1995199920032001234620051997200757Percent(%)0120091-Year T-billFederal Funds
24. ARM Loans Outstanding, 1990-2008Measured as a share of total mortgages outstanding, ARMs increased from 10% in 2000 to 21% in 2005.ARM Loans as a Share of Total Outstanding Mortgages199019941996200219980510202004199220002006200815Percent(%)
25. Foreclosures on Subprime Loans, 1998-2008The foreclosure rate for subprime loans is shown hereNote, how the foreclosure rate rose for ARM loans during 2006, but this was not true for fixed rate mortgagesForeclosure Rate on Fixed & Adjustable Subprime Mortgages1998200020032002234620051999200757Percent(%)01FixedAdjustable200120042006
26. Foreclosures on Prime Loans, 1998-2008For 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 primeNote, the foreclosure rate was 7 to 10 times higher for subprime than prime loans.Foreclosure Rate on Fixed & Adjustable Prime Mortgages19982000200320020.40.61.02005199920070.8Percent(%)00.2FixedAdjustable200120042006
27. Both the regulations that eroded mortgage lending standards and the Fed’s interest rate manipulations contributed to the housing price boom and bustThey also resulted in malinvestment – investments that should never have been made.It will take time to correct for these malinvestmentsHousing Price Boom and Bust
28. A regulation adopted by the SEC in April 2004, permitted investment banks to leverage their capital by a larger amount and thereby extend more loansBanks 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) securitiesFactor 3: Increased Debt-to-Capital Ratio of Investment Banks
29. Thus, if mortgage-backed securities had a AAA rating they could be leveraged up to 60 to 1 against bank capitalMajor investment banks and many commercial banks bundled mortgages together and received AAA ratings for the securities backing the mortgagesThese highly leveraged securities generated large profits for investment and commercial banks and the GSEs (Fannie and Freddie) during the housing boomFactor 3: Increased Debt-to-Capital Ratio of Investment Banks
30. 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 3: Increased Debt-to-Capital Ratio of Investment Banks
31. The debt-to-income ratio of households has risen sharply since the early 1980sBecause mortgage and home equity loans are tax deductible, but other forms of debt are not, household debt is concentrated against housing assetsAs a result, housing is hit hard when economic conditions weaken.Factor 4: High Debt to Income Ratio of Households
32. Household Debt as a Share of Income,1953-2008Between 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 Income19531963197319931983204080120140200819581968197819881998200360100
33. Housing, Mortgage Defaults, and the Great Recession
34. Housing, Mortgage Defaults, and the Great RecessionRegulations 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.
35. Continuing Impact of the Great Recession
36. Continuing Impact of theGreat RecessionWith 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 housing crisis and Great Recession were a reflection of perverse incentives generated by public policy. Examples include: tax-deductibility of mortgage interest, low-down payment loans, and failure to hold loan originators responsible for the quality of their loans. While corrective action is needed, to date little has been done.
37. 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?
38. 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?
39. End ofSpecial Topic 5