In 2008 the world’s economy had its biggest crisis since the Great Depression in 1930. According to Britannica, this epidemic “began in 2007 when sky-high home prices in the United States finally turned decisively downward, spread quickly, first to the entire U.S. financial sector and then to financial markets overseas” (para. 1). The individuals and firms associated with this were commercial banks, savings and loans lender, mortgage offices, insurance companies, and the entire banking investment industry. It affected many other industries such as the auto industry, making this “the longest recession since World War III’ (Brittanica, para.1). The 2008 financial crisis resulted in a 10 percent unemployment rate in 2009 (Bureau of Labor Statistics, 2012, 2). $8.8 million jobs were lost, and $19.2 trillion were lost in household wealth (Department of the Treasury, 2012). Real GDP fell more than 5 percent from the pre-recession peak (Department of the Treasury, 2012). This paper is going to outline and explain all the factors that acted as a cause to this situation. The factors that caused this crisis are securitization, growth on subprime mortgage and housing initiatives and other policy factors.
Subprime Mortgages
Subprime mortgages, mortgages that are normally issued to borrowers with low credit ratings, were a vital part of the 2008 financial crisis. The banks took advantage of relaxed regulations to look for new ways to generate profits. The troubles began with the changing role of banks. The bank’s profits came from interest rates, but they weren’t enough. Therefore, higher profits motivated them to come up with new ways to make a profit. These banks decided to create new mortgage products, and instead of protecting borrowers from risk, they increased risks and made new fees. There are several innovative mortgages that the banks gave during the housing boom (Stiglitz, 2010, 85). The 100 percent loan had banks’ lending “100 percent, or more, of the value of the house” (Stiglitz, 2010, 85). The problem with 100 percent loans was that it was “what an economist calls an option”, and this means that the borrower receives a profit if the price of the home goes up and has the option to walk away if the price happens to go down (Stiglitz, 2010, 85). If the borrower could not pay the mortgage payment, they could foreclose and leave the bank holding both the mortgage and the home, and the borrower lost nothing.
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Also, ARMs were introduced. An adjustable-rate mortgage is a mortgage where interest rates can change during the time they are being paid. Banks would tease a low rate, and then increase it drastically after a period of time. For example, you may apply and get a mortgage worth $150,000 with a 2.4% interest in 2008. Suddenly, the rate may increase to 9%, now you have to pay more than triple the amount you pay toward interest. Teaser rate mortgages had temporary low rates and increased dramatically after a few years, and balloon payment mortgages took advantage of the low interest rates at the time but had to be refinanced when interest rates went up or the time of the balloon occurred (Stiglitz, 2010, 85). Mortgages required the borrower to repeatedly refinance their mortgages, and the lenders profited from this because each refinancing required the borrower to pay a new set of fees (Stiglitz, 2010, 85).
The teaser period would end, and families would have a very challenging time making payments. This cycle would continue repeatedly. The lenders would assure them not to worry about this due to the fact that their home price would increase and allow them to easily refinance and have money left over for a vacation or a car (Stiglitz, 2010, 85). The lenders encouraged the borrowers to take a gamble on their mortgages and increase their debt because the lenders had the incentive to do so regardless of how it affected the borrowers in the long run. Lenders had the incentive to originate mortgages in order to sell them off, and once they were sold off, the lenders did not have to deal with how the borrowers were affected by their increasing debt.
Negative amortization mortgages are another innovation of subprime mortgages. Lenders utilized these “mortgages that allowed the borrower to choose how much he paid back”, and there was not even a requirement “to pay the full amount of interest he owed each month” (Stiglitz, 2010, 86). By the end of the year, the borrower would end up owing more than at the beginning, but the lenders persuaded the borrowers by using the increasing house prices as justification (Stiglitz, 2010, 86). Regulators and investors should have been suspicious of all of these new “mortgages that left the borrower increasingly in debt and those that forced him to refinance and refinance” (Stiglitz, 2010, 86). Liar loans “were the most peculiar of the new products” because many borrowers were encouraged to lie and 7 exaggerate their income; there were also times when loan officers lied about the borrower’s income (Stiglitz, 2010, 86). The lenders allowed for these innovative subprime mortgages to be made because they had only one thing in mind and that was that larger mortgages would give them higher fees (Stiglitz, 2010, 86). The lenders would receive fees from the borrower for refinancing. The initial fee that the lender charges on a mortgage is a point, and each point equals one percent of the loan. The charge can be one point or multiple points. The lenders did not think of any of the problems they were causing for the future (Stiglitz, 2010, 86).
Ben S. Bernanke (2013) argues that the increase house prices and the deterioration in the quality of mortgage standards are two key events that led to the 2008 financial crisis (41-42). Housing prices were increasing and feeding the bubble while mortgage underwriting standards became worse and worse (Bernanke, 2013, 42). Before the 2000s, borrowers had to provide detailed documents of their finances to convince the bank to give them a loan, but as housing prices increased, the lenders began giving mortgages to borrowers that were less qualified (Bernanke, 2013, 42-43). These mortgages are called “nonprime” mortgages because there were mortgages that were above subprime and below prime that were not up to the traditional standard and “often required little or no down payment and little or no documentation” (Bernanke, 2013, 43). Mortgage quality was declining because lenders were “lending to more and more people whose credit was less than stellar” (Bernanke, 2013, 43). The overall mortgage deterioration can be seen in 2007 where 60 percent of all “nonprime loans had little or no documentation of the creditworthiness of the borrower” (Bernanke, 2013, 43).
The deterioration of mortgage standards became a problem as house prices began to decrease. As house prices increased, “the share of borrowers’ incomes being spent on their monthly mortgage payments went up”, and the increasing costs of homeownership decreased the demand for new houses (Bernanke, 2013, 43-44). The earlier increase in house prices caused an excess in the supply market. Therefore, “the bubble burst and house prices fell” (Bernanke, 2013, 45). Bernanke (2013) argues that “the decline in house prices and the mortgage losses were a trigger”, and they “set afire” the “vulnerabilities in the economy and in the financial system” (48). The borrowers and lenders in the private sector “took on too much debt, too much leverage”, and the banks and other financial institutions were not able to keep up with monitoring the risk of the innovative and complex transactions (Bernanke, 2013, 48-49). Financial firms were also relying “very heavily on short-term funding such as commercial paper”, and their short-term and “liquid form of liability” became “subject to runs in the same way deposits were subject to runs in the nineteenth century” (Bernanke, 2013, 49). The vulnerabilities in the public sector include an outdated regulatory structure that “did not keep up with the changes in the structure of the financial system” (Bernanke, 2013, 50). The Federal Reserve also created vulnerabilities in the economy by providing poor supervision of banks and poor consumer protection because “the Fed has authority to provide some protections to mortgage borrowers 9 that, if used effectively, would have reduced at least some of the bad lending” (Bernanke, 2013, 51). Bernanke (2013) makes the final point that the structure of the regulatory system caused weaknesses because there was not much attention paid to problems affecting the entire system due to having many different regulatory institutions being responsible for different, specific financial institutions (51). Bernanke argues that the deterioration of mortgage standards coupled with the decrease in house prices exposed the vulnerabilities in both the private and public sector, leading to the 2008 financial crisis. The amount of subprime mortgages increased from $35 billion (5 percent of all originations) in 1994 to $625 billion (20 percent of all originations) in 2005 (Blinder, 2013, 70). People previously purchased homes with a 20 percent down payment, but this all changed because of the real estate boom due to the “can’t lose” mentality developed towards real estate (Blinder, 2013, 47). Mortgages that required only 5 percent or less down payment became common, and there were times when the down payment for the house was borrowed (Blinder, 2013, 47). Banks were making risky mortgages and quickly passing them on before they could bear the consequences (Blinder, 2013, 69). Specific subprime mortgages are highlighted, and they are “low doc” mortgages, “no doc” mortgages, “liar loans”, “option ARMs,” and “negative amortization mortgages” (Blinder, 2013, 70-71). No doc and low-doc mortgages were about one-third of the total of all subprime 10 mortgages (Blinder, 2013, 70). NINJA loans were loans “granted to people with no income, no jobs, and no assets”, and “no one seems to know how many NINJA loans were actually granted” (Blinder, 2013, 70). These are all “risky mortgages that should never have been created” (Blinder, 2013, 68). The option ARMs gave the borrower a choice each month of whether to pay the contractual payment, the interest, or pay less than the interest and add the rest to the principle (Blinder, 2013, 71). It is, however, important to note that these risky mortgages were only risky because of the people they were offered to (Blinder, 2013, 71). Subprime mortgages can be a good risk for people that can afford to gamble with their money, but banks offered these mortgages to people who could not afford a loss (Blinder, 2013, 71). There is a clear difference between “almost qualified” borrowers who would like to own homes and banks looking for anyone who would sign a mortgage document (Blinder, 2013, 69-70). Banks should not have offered loans that were “designed to default” to “unsophisticated borrowers” because it “violates the principle of sound banking” (Blinder, 2013, 71).
Securitization
Securitization is another cause of the financial crisis that occurred in 2008. Initially, the purpose of securitization was to reduce risks and make mortgages more liquid. It seemed perfect because it gave the bank the ability to sell mortgages and use the money for other purposes. However, the process of securitization severed the relationship between the lender and the borrower and worsened problems caused from imperfect information (Stiglitz, 2010, 14). In the past, banks would originate loans and hold onto them, so they had an incentive to ensure that the borrower had the means and the incentive to repay the loan over time (30 years). They would bear the consequences of the borrower defaulting because each mortgage the banks made was held by them (Stiglitz, 2010, 90). Holding onto the loans forced the banks to be held accountable for their loan decisions, so they had to make sure the loan was good. Borrowing was a personal process in the past before securitization, and the bank would know when it was worth it to extend credit and be able help out a borrower that had trouble paying because the bankers had the opportunity to know the borrowers (Stiglitz, 2010, 90). Foreclosure only happened when it was absolutely necessary, and banks could judge this situation because they had a more personal relationship with the borrower (Stiglitz, 2010, 90). Securitization put distance between the lender and the borrower because the lender became an investor that was completely separated from the borrower (Stiglitz, 2010, 90). The shift to lenders becoming the investors put the borrowers at a disadvantage because investors could potentially be very removed from the community and less understanding of hardships. Investors often put restrictions on the loans and made it more difficult for the borrower to refinance if any problems arose (Stiglitz, 2010, 96). The understanding friendly banker no 13 longer existed because of the new distance between the lender and the borrower put there by securitization (Stiglitz, 2010, 96). Securitization did not begin as a dangerous innovation, but it became one.
Securitization allowed banks to produce bad mortgages and then pass them on as quickly as possible (Stiglitz, 2010, 14). A bad mortgage is one that is made to either a person with bad credit, does not have the income to pay the mortgage back, or the terms of the mortgage are too risky for the borrower. A good mortgage is one that is made to a person with good credit, the income to pay the mortgage back, and a borrower that can withstand the risk involved. The securitization process had banks making subprime mortgages and knowing they should find a buyer for them while they were still good (Blinder, 2013, 72). Investment banks paid cash for the mortgages, bundled them with mortgages from all over the country, packaged them into “well-diversified mortgage-backed securities”, and sold them to investors around the world (Blinder, 2013, 73). The mortgages were pooled like mutual funds and therefore, less risky to invest in because the investment was no longer in an individual mortgage (Blinder, 2013, 73- 74). The complexity of securitization does not end there.
Securitization became even more complex with tranching, and tranching was done in order to decrease the risk of the upper tranches to achieve higher credit ratings. Banks had the opportunity to “tranche” the mortgage pools (Blinder, 2013, 74). To do this, the bank sliced up the pool into different tranches. For example, there would be three different tranches: the “toxic waste” tranche, the “mezzanine” tranche, and the “senior” tranche (Blinder, 2013, 74). The tranche bundle of 14 securities is now a collateralized debt obligation (CDO), and most CDOs had seven or eight tranches (Blinder, 2013, 74). The “toxic waste” tranche was the most junior tranche, and it would absorb the first percentage of losses in the pool (Blinder, 2013, 74). The “mezzanine” tranche was the middle tranche and would absorb the next percentage of losses, and the “senior” tranche was the top-rated tranche and was vulnerable only to losses above the other tranches’ combined percentages (Blinder, 2013, 74). The complexity of securitization, unfortunately, still does not end with these CDOs. Wall Street engineers began to combine the junior tranches of securities into a new CDO and tranche that “CDO of CDOs” (Blinder, 2013, 75). The lowest tranche of the new CDO protected the other four tranches from risk by absorbing the first percentage of losses that accumulated across all of the underlying mortgage pools involved (Blinder, 2013, 75). The securitization process became extremely complex. Each link in the chain of this process added risk, complexity, and confusion (Blinder, 2013, 76). “The mortgage originators knew something about their local markets and the creditworthiness of their borrowers”, and “the investment banks that did the securitizing knew less” than the mortgage originators (Blinder, 2013, 76). Those on Wall Street “who created the CDOs and the CDO2s were performing mathematical exercises with complex securities; they had no clue about - and little interest in - what was inside” (Blinder, 2013, 76). “The ultimate investors, ranging from sophisticated portfolio managers to treasurers of small towns in Norway, were essentially clueless” (Blinder, 2013, 76).
The bankers did not realize that a rise in the interest rate or unemployment rate could have effects on multiple parts of the country (Stiglitz, 2009, 141). The banks failed to assess the risks associated with the new financial products such as the low-documentation loans that were the underlying loans for some of the mortgage-backed securities (Stiglitz, 2009, 141). Bankers also did not correctly 16 predict the risk of a decline in real-estate price or the effect the decline would have in many parts of the country (Stiglitz, 2009, 141). Focusing the main cause of the crisis on securitization disregards the legislation passed to initially allow banks to be involved with securitization. For example, the passing of the Gramm-Leach-Bliley Act allowed for the conflict of interest that securitization caused (Stiglitz, 2009, 143). Gramm-Leach-Bliley Act “transmitted the risk-taking culture of investment banking to commercial banks” (Stiglitz, 2009, 143). However, securitization alone is not the main cause of the crisis. The following figure explains how often securitization was taking place
Housing Initiatives and Other Policy Factors
Housing initiatives from the government along with monetary policy is possibly the main cause of the 2008 financial crisis. John B. Taylor (2009) claims that monetary excesses were the main cause of the crisis (150). The Federal Reserve did not follow the typical structure of interest rate decisions because “actual interest rate decisions fell below what historical experience would suggest policy should be and thus provides an empirical measure that monetary policy was too easy” (Taylor, 2009, 152). Taylor (2009) uses regression techniques to measure “a model of the empirical relationship between the interest rate and housing starts” (152). The results from the regression show, according to Taylor (2009), that there would not have been as large of a boom and bust had the “interest rates followed the rule”, and that the “unusually low interest rate policy was a factor in the housing boom” (153). Taylor (2009) uses this to establish “Taylor rule”, and it “shows what the interest rate would have been if the Fed had followed the kind of policy that had worked well during the historical experience of the ‘Great Moderation’ that began in the early 1980s” (151). The regulatory agencies and the financial markets let the low interest rates feed the bubble instead of using their power to stop it (Stiglitz, 2009, 145). The financial markets had the choice to use the funds in productive ways, but they chose not to (Stiglitz, 2009, 145). Financial markets and regulatory authorities had the tools to stop the low interest rates from feeding the bubble, but they did not use any of the tools they could have (Stiglitz, 2009, 145). The Federal Reserve could have used open market operations, reserve requirements, or the federal funds rate target in order to slow down the economy. Furthermore, the housing bubble was a major cause. As housing prices rose, the share of income spent on monthly mortgage payments increased (Bernanke, 2013, 43-44). People felt rich during the bubble because the increasing prices of their homes, so they borrowed more than they could afford (Bernanke, 2013, 46-47). After the bubble burst, mortgage 26 delinquencies increased, people were not paying on time, and banks were taking over properties to resell (Bernanke, 2013, 47). The bursting of the housing bubble caused banks and other holders of mortgage related securities to suffer sizable losses becoming a cause of the 2008 financial crisis (Bernanke, 2013).
Conclusion
In summary, banks increased the rate of mortgages and interests to create more profit. This increased the risk for borrowers and made them unable to pay in full. Also, securitization took away the personal relationship between the borrower and the banker, making it worse for the borrower. The lenders were now investors and they weren’t so understanding of hard times in one’s life. Moreover, the government and the fed had opportunities to stop the expansion of the bubble, but chose not to, so eventually it busted. All of these caused borrowers to be unable to pay mortgages, resulting in millions of dollars lost. This is the 2008 financial crisis.
References
- Blinder, A.S. (2013). After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead. New York, NY: The Penguin Group.
- Finder-Wustil, C (2018). How We Can Prevent Another Financial Crisis. Futurity. Retrieved from https://www.futurity.org/financial-crises-regulation-insolvency-1712122/
- Stiglitz, J. E. (2009). The Anatomy of a Murder: Who Killed America’s Economy? ln J. Friedman (Ed.). What Caused the Financial Crisis? (pp. 139-149). Philadelphia, PA: University of Pennsylvania Press.
- Stiglitz, J.E. (2010). Freefall: America, Free Markets, and the Sinking of the World Economy. New York, NY: W.W. Norton & Company.
- Taylor, J. B. (2008). The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong. November. Retrieved from https://web.stanford.edu/~johntayl/FCPR.pdf
- Taylor, J. B. (2009). Monetary Policy, Economic Policy, and the Financial Crisis: An Empirical Analysis of What Went Wrong. ln J. Friedman (Ed.). What Caused the Financial Crisis? (pp. 150-171). Philadelphia, PA: University of Pennsylvania Press US.
- Bureau of Labor Statistics. (2012). The Recession of 2007-2009. BLS Spotlight on Statistics, February. Retrieved from http://www.bls.gov/spotlight/2012/recession/pdf/recession_bls_spotlight.pdf
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