74 share
684 in first 8 days
684 in first 8 days
This is a 29 page print out.
Updated for additional commentary: strangely, this very long posting has more hits than any article written in the past three weeks (over 550 views). Although taken from Wikipedia, the text is documented and very much inline with the early, prepolitics, of the present time. As it turns out, the collapse was precipitated by the repeal of Glass/Steagall during the Clinton presidency in 1998. Ten years after allowing commercial banking to integrate with investment banking, we have the 2008 collapse. Bush and his advisers saw sounded the alarm, making note of the mismanagement of investment/mortgage funding that was growing the high risk, Affordable Housing contract population. While greedy interest within the "investment" community was busy taking advantage of the void existing without the regulatory climate of Glass/Steagall, Fannie and Freddie (largest of the several GSE's), was busy buying up outstanding high risk loans, allowing investment banking to reinvest the funds returned to them via the GSE's "resucue" buy-up policies. Problem: When these high risk loans converted to higher fixed rate contract totals, poorer mortgage holders could not meet their new payment obligations, the flow of cash coming from this source failed, and the resultant 2008 failure was the consequence. Below, is a much more detailed accounting, but includes this bird's eye view of the 2008's doomed history. Sadly, the current Progressive and Establishment leadership, seems to be returning to this failed strategy. The only saving grace, for the American taxpayer, is the fact that Big Banking took the full thrust of fault finding, and was thoroughly demonized by Obama and his anti-capitalist minions. As a result, Big Banking knows what to expect, if such a collapse was to happen, again. It has no interest in repeating that blame game and is being much more responsible in its credit assessments and qualifying conditions. We have all listened to story after story, reporting the difficulties inherent in qaualifying for a present day loan. Now you know why. ~ blog editor.
Background and
timeline of events
Main articles, all taken from Wikipedia 2010 and earlier: Subprime crisis
background information, Subprime crisis
impact timeline, United States
housing bubble, and United States
housing market correction
Factors contributing
to housing bubble
Domino effect as housing prices declined
The immediate cause or trigger of the
crisis was the bursting of the United States housing bubble which peaked in
approximately 2005–2006.[5][6] High default rates on
"subprime" and adjustable rate mortgages (ARM), began to
increase quickly thereafter. An increase in loan incentives such as easy
initial terms and a long-term trend of rising housing prices had encouraged
borrowers to assume difficult mortgages in the belief they would be able to
quickly refinance at more favorable terms. Additionally, the economic
incentives provided to the originators of subprime mortgages, along with outright
fraud, increased the number of subprime mortgages provided to consumers who
would have otherwise qualified for conforming loans. However, once interest rates began to rise and housing prices
started to drop moderately in 2006–2007 in many parts of the U.S., refinancing
became more difficult. Defaults and foreclosureactivity increased dramatically as
easy initial terms expired, home prices failed to go up as anticipated, and ARM
interest rates reset higher. Falling prices also resulted in 23% of U.S. homes
worth less than the mortgage loan by September 2010, providing a financial
incentive for borrowers to enter foreclosure.[7] The ongoing foreclosure epidemic,
of which subprime loans are one part, that began in late 2006 in the U.S.
continues to be a key factor in the global economic crisis, because it drains
wealth from consumers and erodes the financial strength of banking
institutions.
In the years leading up to the crisis,
significant amounts of foreign money flowed into the U.S. from fast-growing
economies in Asia and oil-producing countries. This inflow of funds combined
with low U.S. interest rates from 2002–2004 contributed to easy credit
conditions, which fueled both housing and credit bubbles. Loans of various
types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers
assumed an unprecedented debt load.[8][9] As part of the housing and credit
booms, the amount of financial agreements called mortgage-backed securities (MBS), which
derive their value from mortgage payments and housing prices, greatly
increased. Such financial innovation enabled institutions
and investors around the world to invest in the U.S. housing market. As housing
prices declined, major global financial institutions that had borrowed and
invested heavily in MBS reported significant losses. Defaults and losses on
other loan types also increased significantly as the crisis expanded from the
housing market to other parts of the economy. Total losses are estimated in the
trillions of U.S. dollars globally.[10]
While the housing and credit bubbles
were growing, a series of factors caused the financial system to become
increasingly fragile. Policymakers did not recognize the increasingly important
role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system. Some experts
believe these institutions had become as important as commercial (depository)
banks in providing credit to the U.S. economy, but they were not subject to the
same regulations.[11] These institutions as well as
certain regulated banks had also assumed significant debt burdens while
providing the loans described above and did not have a financial cushion
sufficient to absorb large loan defaults or MBS losses.[12] These losses impacted the ability
of financial institutions to lend, slowing economic activity. Concerns
regarding the stability of key financial institutions drove central banks to
take action to provide funds to encourage lending and to restore faith in the commercial paper markets, which are integral to
funding business operations. Governments also bailed out key financial institutions,
assuming significant additional financial commitments.
The risks to the broader economy
created by the housing market downturn and subsequent financial market crisis
were primary factors in several decisions by central banks around the world to
cut interest rates and governments to implement economic stimulus packages. Effects
on global stock markets due to the crisis have been dramatic. Between 1 January
and 11 October 2008, owners of stocks in U.S. corporations had suffered about
$8 trillion in losses, as their holdings declined in value from $20 trillion to
$12 trillion. Losses in other countries have averaged about 40%.[13] Losses in the stock markets and
housing value declines place further downward pressure on consumer spending, a key
economic engine.[14] Leaders of the larger developed
and emerging nations met in November 2008 and March 2009 to formulate
strategies for addressing the crisis.[15] A variety of solutions have been
proposed by government officials, central bankers, economists, and business
executives.[16][17][18] In the U.S., the Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into
law in July 2010 to address some of the causes of the crisis.
Number of U.S.
residential properties subject to foreclosure actions by quarter (2007–2010).
Subprime borrowers typically have
weakened credit histories and reduced repayment capacity. Subprime loans have a
higher risk of default than loans to prime borrowers.[19] If a borrower is delinquent in
making timely mortgage payments to the loan servicer (a bank or other financial
firm), the lender may take possession of the property, in a process calledforeclosure.
The value of American subprime
mortgages was estimated at $1.3 trillion as of March 2007, [20] with over 7.5 million first-lien subprime
mortgages outstanding.[21] Between 2004–2006 the share of
subprime mortgages relative to total originations ranged from 18%–21%, versus
less than 10% in 2001–2003 and during 2007.[22][23] In the third quarter of 2007,
subprime ARMs making up only 6.8% of USA mortgages outstanding also accounted for
43% of the foreclosures which began during that quarter.[24] By October 2007, approximately
16% of subprime adjustable rate mortgages (ARM) were
either 90-days delinquent or the lender had begun foreclosure proceedings, roughly triple the
rate of 2005.[25] By January 2008, the delinquency
rate had risen to 21%[26] and by May 2008 it was 25%.[27]
The value of all outstanding
residential mortgages, owed by U.S. households to purchase residences housing
at most four families, was US$9.9 trillion as of year-end 2006, and US$10.6
trillion as of midyear 2008.[28] During 2007, lenders had begun
foreclosure proceedings on nearly 1.3 million properties, a 79% increase over
2006.[29] This increased to 2.3 million in
2008, an 81% increase vs. 2007,[30] and again to 2.8 million in
2009, a 21% increase vs. 2008.[31]
By August 2008, 9.2% of all U.S.
mortgages outstanding were either delinquent or in foreclosure.[32] By September 2009, this had risen
to 14.4%.[33] Between August 2007 and October
2008, 936,439 USA residences completed foreclosure.[34] Foreclosures are concentrated in
particular states both in terms of the number and rate of foreclosure filings.[35] Ten states accounted for 74% of
the foreclosure filings during 2008; the top two (California and Florida)
represented 41%. Nine states were above the national foreclosure rate average
of 1.84% of households.[36]
The crisis can be attributed to a
number of factors pervasive in both housing and credit markets, factors which emerged over a number
of years. Causes proposed include the inability of homeowners to make their
mortgage payments (due primarily to adjustable-rate mortgages resetting,
borrowers overextending, predatory lending, and speculation), overbuilding during the boom period,
risky mortgage products, high personal and corporate debt levels, financial
products that distributed and perhaps concealed the risk of mortgage default,
bad monetary and housing policies, international trade imbalances, and inappropriate government
regulation.[37][38][39][40] Three important catalysts of the
subprime crisis were the influx of moneys from the private sector, the banks
entering into the mortgage bond market and the predatory lending practices of
the mortgage lenders, specifically the adjustable-rate mortgage, 2–28 loan, that mortgage lenders sold directly
or indirectly via mortgage brokers.[41] On Wall Street and in the
financial industry, moral hazard lay at the core of many of the
causes.[42]
In its "Declaration of the Summit
on Financial Markets and the World Economy," dated 15 November 2008,
leaders of the Group of 20 cited the
following causes:
During a period of
strong global growth, growing capital flows, and prolonged stability earlier
this decade, market participants sought higher yields without an adequate
appreciation of the risks and failed to exercise proper due diligence. At the
same time, weak underwriting standards, unsound risk management practices,
increasingly complex and opaque financial products, and consequent excessive
leverage combined to create vulnerabilities in the system. Policy-makers,
regulators and supervisors, in some advanced countries, did not adequately
appreciate and address the risks building up in financial markets, keep pace
with financial innovation, or take into account the systemic ramifications of
domestic regulatory actions.[43]
During May 2010, Warren Buffett and Paul Volcker separately described questionable
assumptions or judgments underlying the U.S. financial and economic system that
contributed to the crisis. These assumptions included: 1) Housing prices would
not fall dramatically;[44] 2) Free and open financial
markets supported by sophisticated financial engineering would most effectively
support market efficiency and stability, directing funds to the most profitable
and productive uses; 3) Concepts embedded in mathematics and physics could be
directly adapted to markets, in the form of various financial models used to
evaluate credit risk; 4) Economic imbalances, such as large trade deficits and
low savings rates indicative of over-consumption, were sustainable; and 5)
Stronger regulation of the shadow banking system and derivatives
markets was not needed.[45]
The U.S. Financial Crisis
Inquiry Commission reported its findings in January 2011. It concluded
that "the crisis was avoidable and was caused by: Widespread failures in
financial regulation, including the Federal Reserve’s failure to stem the tide
of toxic mortgages; Dramatic breakdowns in corporate governance including too
many financial firms acting recklessly and taking on too much risk; An
explosive mix of excessive borrowing and risk by households and Wall Street
that put the financial system on a collision course with crisis; Key policy
makers ill prepared for the crisis, lacking a full understanding of the
financial system they oversaw; and systemic breaches in accountability and ethics
at all levels.“[46]
Existing homes sales,
inventory, and months supply, by quarter.
Vicious Cycles in the
Housing & Financial Markets
Low interest rates and large inflows of
foreign funds created easy credit conditions for a number of years prior to the
crisis, fueling a housing market boom and encouraging debt-financed
consumption.[47] The USA home ownership rate
increased from 64% in 1994 (about where it had been since 1980) to an all-time
high of 69.2% in 2004.[48] Subprime lending was a major
contributor to this increase in home ownership rates and in the overall demand
for housing, which drove prices higher.
Between 1997 and 2006, the price of the
typical American house increased by 124%.[49] During the two decades ending in
2001, the national median home price ranged from 2.9 to 3.1 times median
household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006.[50] This housing bubble resulted in quite a few
homeowners refinancing their homes at lower interest rates, or financing
consumer spending by taking out second mortgages secured by the price
appreciation. USA household debt as a percentage of annual disposable personal income was 127% at the
end of 2007, versus 77% in 1990.[51]
While housing prices were increasing,
consumers were saving less[52] and both borrowing and
spending more. Household debt grew from $705 billion at yearend 1974, 60% of disposable personal income, to $7.4 trillion at
yearend 2000, and finally to $14.5 trillion in midyear 2008, 134% of disposable
personal income.[53] During 2008, the typical USA
household owned 13 credit cards, with 40% of households carrying a balance, up
from 6% in 1970.[54] Free cash used by consumers from
home equity extraction doubled from $627 billion in 2001 to $1,428 billion in
2005 as the housing bubble built, a total of nearly $5 trillion dollars over
the period.[55][56][57] U.S. home mortgage debt relative
to GDP increased from an average of 46% during the 1990s to 73% during 2008,
reaching $10.5 trillion.[58] From 2001 to 2007, U.S. mortgage
debt almost doubled, and the amount of mortgage debt per household rose more
than 63%, from $91,500 to $149,500, with essentially stagnant wages.[59]
This credit and house price explosion
led to a building boom and eventually to a surplus of unsold homes, which
caused U.S. housing prices to peak and begin declining in mid-2006.[60] Easy credit, and a belief that
house prices would continue to appreciate, had encouraged many subprime borrowers
to obtain adjustable-rate mortgages. These mortgages
enticed borrowers with a below market interest rate for some predetermined
period, followed by market interest rates for the remainder of the mortgage's
term. Borrowers who would not be able to make the higher payments once the
initial grace period ended, were planning to refinance their mortgages after a
year or two of appreciation. But refinancing became more difficult, once house
prices began to decline in many parts of the USA. Borrowers who found
themselves unable to escape higher monthly payments by refinancing began to
default.
As more borrowers stop paying their
mortgage payments (this is an on-going crisis), foreclosures and the supply of
homes for sale increases. This places downward pressure on housing prices,
which further lowers homeowners' equity. The decline in mortgage payments also
reduces the value of mortgage-backed securities, which erodes the
net worth and financial health of banks. This vicious cycle is at the heart of the crisis.[61]
By September 2008, average U.S. housing
prices had declined by over 20% from their mid-2006 peak.[62][63] This major and unexpected decline
in house prices means that many borrowers have zero or negative equity in their homes, meaning their
homes were worth less than their mortgages. As of March 2008, an estimated 8.8 million
borrowers — 10.8% of all homeowners — had negative equity in their homes, a
number that is believed to have risen to 12 million by November 2008. By
September 2010, 23% of all U.S. homes were worth less than the mortgage loan.[7] Borrowers in this situation have
an incentive to default on their mortgages as a mortgage is typically nonrecourse debt secured against the property.[64] Economist Stan Leibowitz argued
in the Wall Street Journal that although only 12% of homes had negative equity,
they comprised 47% of foreclosures during the second half of 2008. He concluded
that the extent of equity in the home was the key factor in foreclosure, rather
than the type of loan, credit worthiness of the borrower, or ability to pay.[65]
Increasing foreclosure rates increases
the inventory of houses offered for sale. The number of new homes sold in 2007
was 26.4% less than in the preceding year. By January 2008, the inventory of
unsold new homes was 9.8 times the December 2007 sales volume, the highest
value of this ratio since 1981.[66] Furthermore, nearly four million
existing homes were for sale,[67] of which almost 2.9 million
were vacant.[68] This overhang of unsold homes
lowered house prices. As prices declined, more homeowners were at risk of
default or foreclosure. House prices are expected to continue declining until
this inventory of unsold homes (an instance of excess supply) declines to normal
levels.[69] A report in January 2011 stated
that U.S. home values dropped by 26 percent from their peak in June 2006 to
November 2010, more than the 25.9 percent drop between 1928 to 1933 when the Great Depression occurred.[70]
Speculative borrowing in residential
real estate has been cited as a contributing factor to the subprime mortgage
crisis.[71] During 2006, 22% of homes
purchased (1.65 million units) were for investment purposes, with an additional
14% (1.07 million units) purchased as vacation homes. During 2005, these
figures were 28% and 12%, respectively. In other words, a record level of
nearly 40% of homes purchases were not intended as primary residences. David
Lereah, NAR's chief economist at
the time, stated that the 2006 decline in investment buying was expected:
"Speculators left the market in 2006, which caused investment sales to
fall much faster than the primary market."[72]
Housing prices nearly doubled between
2000 and 2006, a vastly different trend from the historical appreciation at
roughly the rate of inflation. While homes had not traditionally been treated
as investments subject to speculation, this behavior changed during the housing
boom. Media widely reported condominiums being purchased while under
construction, then being "flipped" (sold) for a profit without the
seller ever having lived in them.[73] Some mortgage companies
identified risks inherent in this activity as early as 2005, after identifying
investors assuming highly leveraged positions in multiple properties.[74]
Nicole Gelinas of the Manhattan Institute described the
negative consequences of not adjusting tax and mortgage policies to the
shifting treatment of a home from conservative inflation hedge to speculative
investment.[75] Economist Robert Shiller argued that speculative bubbles
are fueled by "contagious optimism, seemingly impervious to facts, that
often takes hold when prices are rising. Bubbles are primarily social
phenomena; until we understand and address the psychology that fuels them,
they're going to keep forming."[76] Keynesian economist Hyman Minsky described how speculative
borrowing contributed to rising debt and an eventual collapse of asset values.[77][78]
Warren Buffett testified to the Financial Crisis
Inquiry Commission: "There was the greatest bubble I've ever seen in my
life...The entire American public eventually was caught up in a belief that
housing prices could not fall dramatically."[44]
A mortgage brokerage
in the US advertising subprime mortgages in July 2008.
In the years before the crisis, the
behavior of lenders changed dramatically. Lenders offered more and more loans
to higher-risk borrowers,[79] including undocumented
immigrants.[80] Subprime mortgages amounted to
$35 billion (5% of total originations) in 1994,[81] 9% in 1996,[82] $160 billion (13%) in 1999,[81] and $600 billion (20%) in 2006.[82][83][84] A study by the Federal Reserve found that the average difference
between subprime and prime mortgage interest rates (the "subprime
markup") declined significantly between 2001 and 2007. The combination of
declining risk premia and credit standards is common to boom and bustcredit cycles.[85]
In addition to considering higher-risk
borrowers, lenders had offered increasingly risky loan options and borrowing
incentives. In 2005, the median down payment for first-time home buyers was 2%,
with 43% of those buyers making no down payment whatsoever.[86] By comparison, China has down
payment requirements that exceed 20%, with higher amounts for non-primary
residences.[87]
Growth in mortgage
loan fraud based upon US Department of the Treasury Suspicious Activity Report
Analysis.
The mortgage qualification guidelines
began to change. At first, the stated income, verified assets (SIVA) loans came
out. Proof of income was no longer needed. Borrowers just needed to
"state" it and show that they had money in the bank. Then, the no
income, verified assets (NIVA) loans came out. The lender no longer required
proof of employment. Borrowers just needed to show proof of money in their bank
accounts. The qualification guidelines kept getting looser in order to produce
more mortgages and more securities. This led to the creation of NINA. NINA is
an abbreviation of No Income No Assets (sometimes referred to as Ninja loans). Basically, NINA loans are official
loan products and let you borrow money without having to prove or even state any
owned assets. All that was required for a mortgage was a credit score.[88]
Another example is the interest-only
adjustable-rate mortgage (ARM), which allows the homeowner to pay just the
interest (not principal) during an initial period. Still another is a
"payment option" loan, in which the homeowner can pay a variable
amount, but any interest not paid is added to the principal. Nearly one in 10
mortgage borrowers in 2005 and 2006 took out these “option ARM” loans, which
meant they could choose to make payments so low that their mortgage balances
rose every month.[59] An estimated one-third of ARMs
originated between 2004 and 2006 had "teaser" rates below 4%, which
then increased significantly after some initial period, as much as doubling the
monthly payment.[82]
The proportion of subprime ARM loans
made to people with credit scores high enough to qualify for conventional
mortgages with better terms increased from 41% in 2000 to 61% by 2006. However,
there are many factors other than credit score that affect lending. In
addition, mortgage brokers in some cases received incentives from lenders to
offer subprime ARM's even to those with credit ratings that merited a
conforming (i.e., non-subprime) loan.[89]
Mortgage underwriting standards
declined precipitously during the boom period. The use of automated loan
approvals allowed loans to be made without appropriate review and
documentation.[90] In 2007, 40% of all subprime
loans resulted from automated underwriting.[91][92] The chairman of the Mortgage
Bankers Association claimed that mortgage brokers, while profiting from the
home loan boom, did not do enough to examine whether borrowers could repay.[93] Mortgage fraud by lenders and borrowers
increased enormously.[94]
The Financial Crisis
Inquiry Commission reported in January 2011 that many mortgage lenders
took eager borrowers’ qualifications on faith, often with a "willful
disregard" for a borrower’s ability to pay. Nearly 25% of all mortgages
made in the first half of 2005 were "interest-only" loans. During the
same year, 68% of “option ARM” loans originated by Countrywide Financial and Washington Mutual had low- or no-documentation
requirements.[95]
So why did lending standards decline?
In a Peabody Award winning program, NPR correspondents
argued that a "Giant Pool of Money" (represented by $70 trillion in
worldwide fixed income investments) sought higher yields than those offered by U.S.
Treasury bonds early in the decade. Further, this pool of money had roughly
doubled in size from 2000 to 2007, yet the supply of relatively safe, income
generating investments had not grown as fast. Investment banks on Wall Street
answered this demand with financial innovation such as the mortgage-backed security (MBS) and collateralized debt
obligation (CDO), which were assigned safe ratings by the credit rating
agencies. In effect, Wall Street connected this pool of money to the mortgage
market in the U.S., with enormous fees accruing to those throughout the
mortgage supply chain, from the mortgage broker selling the loans, to small
banks that funded the brokers, to the giant investment banks behind them. By approximately
2003, the supply of mortgages originated at traditional lending standards had
been exhausted. However, continued strong demand for MBS and CDO began to drive
down lending standards, as long as mortgages could still be sold along the
supply chain. Eventually, this speculative bubble proved unsustainable. NPR
described it this way:[96]
The problem was that
even though housing prices were going through the roof, people weren't making
any more money. From 2000 to 2007, the median household income stayed flat. And
so the more prices rose, the more tenuous the whole thing became. No matter how
lax lending standards got, no matter how many exotic mortgage products were
created to shoehorn people into homes they couldn't possibly afford, no matter
what the mortgage machine tried, the people just couldn't swing it. By late
2006, the average home cost nearly four times what the average family made.
Historically it was between two and three times. And mortgage lenders noticed
something that they'd almost never seen before. People would close on a house,
sign all the mortgage papers, and then default on their very first payment. No
loss of a job, no medical emergency, they were underwater before they even
started. And although no one could really hear it, that was probably the moment
when one of the biggest speculative bubbles in American history popped.
In 2004, the Federal Bureau of
Investigation warned of an "epidemic" in mortgage fraud, an
important credit risk of nonprime mortgage lending, which, they said, could
lead to "a problem that could have as much impact as the S&L
crisis".[97][98][99][100]
The Financial Crisis
Inquiry Commission reported in January 2011 that: "...mortgage
fraud...flourished in an environment of collapsing lending standards and lax
regulation. The number of suspicious activity reports—reports of possible
financial crimes filed by depository banks and their affiliates—related to
mortgage fraud grew 20-fold between 1996 and 2005 and then more than doubled
again between 2005 and 2009. One study places the losses resulting from fraud
on mortgage loans made between 2005 and 2007 at $112 billion. Lenders made
loans that they knew borrowers could not afford and that could cause massive
losses to investors in mortgage securities."[95]
New York State prosecutors are examining
whether eight banks hoodwinked credit ratings agencies, to inflate the
grades of subprime-linked investments. TheSecurities and
Exchange Commission, the Justice Department, the United States
attorney’s office and more are examining how banks created, rated, sold
and traded mortgage securities that turned out to be some of the worst
investments ever devised. As of 2010, virtually all of the investigations, criminal as well as civil, are in their
early stages.[101]
Borrowing under a
securitization structure.
IMF Diagram of CDO
and RMBS
The traditional mortgage model involved
a bank originating a loan to the borrower/homeowner and retaining the credit
(default) risk. With the advent of securitization, the traditional model has given way
to the "originate to distribute" model, in which banks essentially
sell the mortgages and distribute credit risk to investors through mortgage-backed securities and collateralized debt
obligations (CDO). Securitization meant that those issuing mortgages
were no longer required to hold them to maturity. By selling the mortgages to
investors, the originating banks replenished their funds, enabling them to
issue more loans and generating transaction fees. This created a moral hazard in which an increased focus on
processing mortgage transactions was incentivized but ensuring their credit
quality was not.[102][103]
Securitization accelerated in the
mid-1990s. The total amount of mortgage-backed securities issued almost tripled
between 1996 and 2007, to $7.3 trillion. The securitized share of subprime
mortgages (i.e., those passed to third-party investors via MBS) increased from
54% in 2001, to 75% in 2006.[85] A sample of 735 CDO deals
originated between 1999 and 2007 showed that subprime and other less-than-prime
mortgages represented an increasing percentage of CDO assets, rising from 5% in
2000 to 36% in 2007.[104] American homeowners, consumers,
and corporations owed roughly $25 trillion during 2008. American banks retained
about $8 trillion of that total directly as traditional mortgage loans.
Bondholders and other traditional lenders provided another $7 trillion. The
remaining $10 trillion came from the securitization markets. The securitization
markets started to close down in the spring of 2007 and nearly shut-down in the
fall of 2008. More than a third of the private credit markets thus became
unavailable as a source of funds.[105][106] In February 2009, Ben Bernanke stated that securitization
markets remained effectively shut, with the exception of conforming mortgages,
which could be sold to Fannie Mae and Freddie Mac.[107]
A more direct connection between
securitization and the subprime crisis relates to a fundamental fault in the
way that underwriters, rating agencies and investors modeled the correlation of risks among loans in
securitization pools. Correlation modeling—determining how the default risk of
one loan in a pool is statistically related to the default risk for other
loans—was based on a "Gaussian copula" technique
developed by statistician David X. Li. This technique,
widely adopted as a means of evaluating the risk associated with securitization
transactions, used what turned out to be an overly simplistic approach to
correlation. Unfortunately, the flaws in this technique did not become apparent
to market participants until after many hundreds of billions of dollars of ABSs and CDOs backed by
subprime loans had been rated and sold. By the time investors stopped buying
subprime-backed securities—which halted the ability of mortgage originators to
extend subprime loans—the effects of the crisis were already beginning to
emerge.[108]
Nobel laureate Dr. A. Michael Spence wrote: "Financial
innovation, intended to redistribute and reduce risk, appears mainly to have
hidden it from view. An important challenge going forward is to better
understand these dynamics as the analytical underpinning of an early warning
system with respect to financial instability." [109]
MBS credit rating
downgrades, by quarter.
Credit rating agencies are now under
scrutiny for having given investment-grade ratings to MBSs based on risky
subprime mortgage loans. These high ratings enabled these MBS to be sold to
investors, thereby financing the housing boom. These ratings were believed
justified because of risk reducing practices, such as credit default insurance
and equity investors willing to bear the first losses. However, there are also
indications that some involved in rating subprime-related securities knew at
the time that the rating process was faulty.[110]
Critics allege that the rating agencies
suffered from conflicts of interest, as they were paid by investment banks and
other firms that organize and sell structured securities to investors.[111] On 11 June 2008, the SEC proposed rules
designed to mitigate perceived conflicts of interest between rating agencies
and issuers of structured securities.[112] On 3 December 2008, the SEC
approved measures to strengthen oversight of credit rating agencies, following
a ten-month investigation that found "significant weaknesses in ratings
practices," including conflicts of interest.[113]
Between Q3 2007 and Q2 2008, rating
agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities. Financial
institutions felt they had to lower the value of their MBS and acquire
additional capital so as to maintain capital ratios. If this involved the sale
of new shares of stock, the value of the existing shares was reduced. Thus
ratings downgrades lowered the stock prices of many financial firms.[114]
The Financial Crisis
Inquiry Commission reported in January 2011 that: "The three credit
rating agencies were key enablers of the financial meltdown. The
mortgage-related securities at the heart of the crisis could not have been
marketed and sold without their seal of approval. Investors relied on them,
often blindly. In some cases, they were obligated to use them, or regulatory
capital standards were hinged on them. This crisis could not have happened
without the rating agencies. Their ratings helped the market soar and their
downgrades through 2007 and 2008 wreaked havoc across markets and firms."
The Report further stated that ratings were incorrect because of "flawed
computer models, the pressure from financial firms that paid for the ratings,
the relentless drive for market share, the lack of resources to do the job
despite record profits, and the absence of meaningful public oversight."[115]
U.S. Subprime lending
expanded dramatically 2004–2006
Both government failed regulation and
deregulation contributed to the crisis. In testimony before Congress both theSecurities and
Exchange Commission (SEC) and Alan Greenspan conceded failure in allowing the
self-regulation of investment banks.[116][117]
Increasing home ownership has been the
goal of several presidents including Roosevelt, Reagan, Clinton and George W. Bush.[118] In 1982, Congress passed the
Alternative Mortgage Transactions Parity Act (AMTPA), which allowed
non-federally chartered housing creditors to write adjustable-rate mortgages.
Among the new mortgage loan types created and gaining in popularity in the
early 1980s were adjustable-rate, option adjustable-rate, balloon-payment and
interest-only mortgages. These new loan types are credited with replacing the
long standing practice of banks making conventional fixed-rate, amortizing
mortgages. Among the criticisms of banking industry deregulation that
contributed to the savings and loan crisis was that
Congress failed to enact regulations that would have prevented exploitations by
these loan types. Subsequent widespread abuses of predatory lending occurred
with the use of adjustable-rate mortgages.[41][119] Approximately 90% of subprime
mortgages issued in 2006 were adjustable-rate mortgages.[2]
In 1995, the GSEs like Fannie Mae began
receiving government tax incentives for purchasing mortgage backed securities
which included loans to low income borrowers. Thus began the involvement of the
Fannie Mae and Freddie Mac with the subprime market.[120] In 1996, HUD set a goal for Fannie Mae and Freddie Mac that at
least 42% of the mortgages they purchase be issued to borrowers whose household
income was below the median in their area. This target was increased to 50% in
2000 and 52% in 2005.[121] From 2002 to 2006, as the U.S.
subprime market grew 292% over previous years, Fannie Mae and Freddie Mac
combined purchases of subprime securities rose from $38 billion to around $175
billion per year before dropping to $90 billion per year, which included $350
billion of Alt-Asecurities. Fannie
Mae had stopped buying Alt-A products in the early 1990s because of the high
risk of default. By 2008, the Fannie Mae and Freddie Mac owned, either directly
or through mortgage pools they sponsored, $5.1 trillion in residential
mortgages, about half the total U.S. mortgage market.[122] The GSE have always been highly
leveraged, their net worth as of 30 June 2008 being a mere US$114 billion.[123] When concerns arose in September
2008 regarding the ability of the GSE to make good on their guarantees, the
Federal government was forced to place the companies into a conservatorship,
effectively nationalizing them at the taxpayers' expense.[124][125]
The Financial Crisis
Inquiry Commission reported in 2011 that Fannie & Freddie
"contributed to the crisis, but were not a primary cause." GSE
mortgage securities essentially maintained their value throughout the crisis
and did not contribute to the significant financial firm losses that were
central to the financial crisis. The GSEs participated in the expansion of subprime
and other risky mortgages, but they followed rather than led Wall Street and
other lenders into subprime lending.[95]
The Glass-Steagall Act was enacted
after the Great Depression. It separated commercial banks and investment banks, in part to avoid potential conflicts
of interest between the lending activities of the former and rating activities
of the latter. Economist Joseph Stiglitz criticized the
repeal of the Act. He called its repeal the "culmination of a $300 million lobbying effort by the banking and
financial services industries...spearheaded in Congress by Senator Phil Gramm." He believes it contributed to
this crisis because the risk-taking culture of investment banking dominated the
more conservative commercial banking culture, leading to increased levels of
risk-taking and leverage during the boom period.[126] The Federal government bailout of thrifts during the savings and loan crisis of the late
1980s may have encouraged other lenders to make risky loans, and thus given
rise to moral hazard.[42][127]
Conservatives and Libertarians have also
debated the possible effects of the Community Reinvestment Act (CRA), with
detractors claiming that the Act encouraged lending to uncreditworthy borrowers,[128][129][130][131] and defenders claiming a thirty
year history of lending without increased risk.[132][133][134][135] Detractors also claim that
amendments to the CRA in the mid-1990s, raised the amount of mortgages issued
to otherwise unqualified low-income borrowers, and allowed the securitization
of CRA-regulated mortgages, even though a fair number of them were subprime.[136][137]
Federal Reserve Governor Randall Kroszner and Federal Deposit
Insurance Corporation Chairman Sheila Bair have stated
their belief that the CRA was not to blame for the crisis.[138][139]
Economist Paul Krugman argued in January 2010 that the simultaneous
growth of the residential and commercial real estate pricing bubbles undermines
the case made by those who argue that Fannie Mae, Freddie Mac, CRA or predatory lending were primary
causes of the crisis. In other words, bubbles in both markets developed even
though only the residential market was affected by these potential causes.[140]
The Financial Crisis
Inquiry Commission reported in January 2011 that "the CRA was not a
significant factor in subprime lending or the crisis. Many subprime lenders
were not subject to the CRA. Research indicates only 6% of high-cost loans—a
proxy for subprime loans—had any connection to the law. Loans made by CRA-regulated
lenders in the neighborhoods in which they were required to lend were half as
likely to default as similar loans made in the same neighborhoods by
independent mortgage originators not subject to the law."[95]
The George W. Bush administration was
accused of blocking ongoing state investigations into predatory lending
practices as the bubble continued to grow.[141]However, when George W. Bush called for
an investigation and more controls on Fannie Mae and Freddie Mac, Congressman
Barney Frank vocally objected, saying "These two entities -- Fannie Mae and
Freddie Mac -- are not facing any kind of financial crisis." [142]
Federal Funds Rate
and Various Mortgage Rates
Central banks manage monetary policy and may
target the rate of inflation. They have some authority over commercial banks and possibly other financial
institutions. They are less concerned with avoiding asset price bubbles, such as thehousing bubble and dot-com bubble. Central banks have generally chosen
to react after such bubbles burst so as to minimize collateral damage to the
economy, rather than trying to prevent or stop the bubble itself. This is
because identifying an asset bubble and determining the proper monetary policy
to deflate it are matters of debate among economists.[143][144]
Some market observers have been
concerned that Federal Reserve actions could give rise to moral hazard.[42] AGovernment
Accountability Office critic said that the Federal Reserve
Bank of New York's rescue of Long-Term Capital Management in 1998 would
encourage large financial institutions to believe that the Federal Reserve
would intervene on their behalf if risky loans went sour because they were “too
big to fail.”[145]
A contributing factor to the rise in
house prices was the Federal Reserve's lowering of interest rates early in the
decade. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from
6.5% to 1.0%.[146] This was done to soften the
effects of the collapse of the dot-com bubble and of the September 2001 terrorist attacks, and to combat the
perceived risk of deflation.[143] The Fed believed that interest
rates could be lowered safely primarily because the rate of inflation was low; it disregarded other
important factors. Richard W. Fisher, President and CEO of the Federal Reserve
Bank of Dallas, said that the Fed's interest rate policy during the early 2000s
was misguided, because measured inflation in those years was below true inflation,
which led to a monetary policy that contributed to the housing bubble.[147] According to Ben Bernanke, now chairman of the Federal Reserve,
it was capital or savings pushing into the United States, due to a world wide
"saving glut", which kept long term interest rates low independently
of Central Bank action.[148]
The Fed then raised the Fed funds rate
significantly between July 2004 and July 2006.[149] This contributed to an increase
in 1-year and 5-year ARM rates, making ARM interest rate resets more expensive
for homeowners.[150] This may have also contributed to
the deflating of the housing bubble, as asset prices generally move inversely
to interest rates and it became riskier to speculate in housing.[151][152]
Leverage Ratios of
Investment Banks Increased Significantly 2003–2007
The Financial Crisis
Inquiry Commission reported in January 2011 that: "From 1978 to
2007, the amount of debt held by the financial sector soared from $3 trillion
to $36 trillion, more than doubling as a share of gross domestic product. The
very nature of many Wall Street firms changed—from relatively staid private
partnerships to publicly traded corporations taking greater and more diverse kinds
of risks. By 2005, the 10 largest U.S. commercial banks held 55% of the
industry’s assets, more than double the level held in 1990. On the eve of the
crisis in 2006, financial sector profits constituted 27% of all corporate
profits in the United States, up from 15% in 1980."[153]
Many financial institutions, investment banks in particular, issued large
amounts of debt during 2004–2007, and invested the proceeds in mortgage-backed securities (MBS),
essentially betting that house prices would continue to rise, and that
households would continue to make their mortgage payments. Borrowing at a lower
interest rate and investing the proceeds at a higher interest rate is a form of financial leverage. This is analogous
to an individual taking out a second mortgage on his residence to invest in the
stock market. This strategy proved profitable during the housing boom, but
resulted in large losses when house prices began to decline and mortgages began
to default. Beginning in 2007, financial institutions and individual investors
holding MBS also suffered significant losses from mortgage payment defaults and
the resulting decline in the value of MBS.[154]
A 2004 U.S. Securities and
Exchange Commission (SEC) decision related to the net capital rule allowed USA investment banks to
issue substantially more debt, which was then used to purchase MBS. Over
2004–07, the top five US investment banks each significantly increased their
financial leverage (see diagram), which increased their vulnerability to the
declining value of MBSs. These five institutions reported over $4.1 trillion in
debt for fiscal year 2007, about 30% of USA nominal GDP for 2007. Further, the
percentage of subprime mortgages originated to total originations increased
from below 10% in 2001–2003 to between 18–20% from 2004–2006, due in-part to
financing from investment banks.[22][23]
During 2008, three of the largest U.S.
investment banks either went bankrupt (Lehman Brothers) or were sold at fire sale prices to
other banks (Bear Stearns andMerrill Lynch). These failures augmented the
instability in the global financial system. The remaining two investment banks, Morgan Stanley and Goldman Sachs, opted to become commercial banks,
thereby subjecting themselves to more stringent regulation.[155][156]
In the years leading up to the crisis,
the top four U.S. depository banks moved an estimated $5.2 trillion in assets
and liabilities off-balance sheet into special purpose vehicles or other
entities in the shadow banking system. This enabled them
to essentially bypass existing regulations regarding minimum capital ratios,
thereby increasing leverage and profits during the boom but increasing losses
during the crisis. New accounting guidance will require them to put some of
these assets back onto their books during 2009, which will significantly reduce
their capital ratios. One news agency estimated this amount to be between $500
billion and $1 trillion. This effect was considered as part of the stress tests
performed by the government during 2009.[157]
Martin Wolf wrote in June 2009: "...an
enormous part of what banks did in the early part of this decade – the
off-balance-sheet vehicles, the derivatives and the 'shadow banking system'
itself – was to find a way round regulation."[158]
The New York State Comptroller's Office
has said that in 2006, Wall Street executives took home bonuses totaling $23.9
billion. "Wall Street traders were thinking of the bonus at the end of the
year, not the long-term health of their firm. The whole system—from mortgage
brokers to Wall Street risk managers—seemed tilted toward taking short-term
risks while ignoring long-term obligations. The most damning evidence is that
most of the people at the top of the banks didn't really understand how those
[investments] worked."[50][159]
The incentive compensation of traders
was focused on fees generated from assembling financial products, rather than
the performance of those products and profits generated over time. Their
bonuses were heavily skewed towards cash rather than stock and not subject to
"claw-back" (recovery of the bonus from the employee by the firm) in
the event the MBS or CDO created did not perform. In addition, the increased
risk (in the form of financial leverage) taken by the major investment banks
was not adequately factored into the compensation of senior executives.[160]
Credit default swaps (CDS) are
financial instruments used as a hedge and protection for debtholders, in
particular MBS investors, from the risk of default, or by speculators to profit
from default. As the net worth of banks and other financial institutions
deteriorated because of losses related to subprime mortgages, the likelihood
increased that those providing the protection would have to pay their
counterparties. This created uncertainty across the system, as investors
wondered which companies would be required to pay to cover mortgage defaults.
Like all swaps and other financial derivatives, CDS may either be
used to hedge risks (specifically, to insure creditors against
default) or to profit from speculation. The volume of CDS outstanding
increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS
contracts, as of November 2008, ranging from US$33 to $47 trillion. CDS are
lightly regulated, largely because of the Commodities Futures Modernization Act of 2000. As of 2008, there was
no central clearing house to honor CDS in
the event a party to a CDS proved unable to perform his obligations under the
CDS contract. Required disclosure of CDS-related obligations has been
criticized as inadequate. Insurance companies such as American International Group (AIG), MBIA, and Ambac faced
ratings downgrades because widespread mortgage defaults increased their
potential exposure to CDS losses. These firms had to obtain additional funds
(capital) to offset this exposure. AIG's having CDSs insuring $440 billion of
MBS resulted in its seeking and obtaining a Federal government bailout.[161] The monoline insurance companies
went out of business in 2008-2009.
When investment bank Lehman Brothers went bankrupt in September 2008,
there was much uncertainty as to which financial firms would be required to
honor the CDS contracts on its $600 billion of bonds outstanding.[162][163] Merrill Lynch's large losses in 2008 were attributed
in part to the drop in value of its unhedged portfolio of collateralized debt
obligations (CDOs) after AIG ceased offering CDS on Merrill's
CDOs. The loss of confidence of trading partners in Merrill Lynch's solvency
and its ability to refinance its short-term debt led to its acquisition by the Bank of America.[164][165]
Economist Joseph Stiglitz summarized how credit default
swaps contributed to the systemic meltdown: "With this complicated
intertwining of bets of great magnitude, no one could be sure of the financial
position of anyone else-or even of one's own position. Not surprisingly, the
credit markets froze."[166]
Author Michael Lewis wrote that CDS
enabled speculators to stack bets on the same mortgage bonds and CDO's. This is
analogous to allowing many persons to buy insurance on the same house.
Speculators that bought CDS insurance were betting that significant defaults
would occur, while the sellers (such as AIG) bet they would not. A theoretically
infinite amount could be wagered on the same housing-related securities,
provided buyers and sellers of the CDS could be found.[167] In addition, Chicago Public
Radio, Huffington Post, and ProPublica reported in April 2010 that market
participants, including a hedge fund calledMagnetar Capital, encouraged the creation of CDO's
containing low quality mortgages, so they could bet against them using CDS. NPR
reported that Magnetar encouraged investors to purchase CDO's while
simultaneously betting against them, without disclosing the latter bet.[168][169][170] Instruments called synthetic CDO, which are portfolios of credit
default swaps, were also involved in allegations by the SEC against
Goldman-Sachs in April 2010.[171]
The Financial Crisis
Inquiry Commission reported in January 2011 that CDS contributed
significantly to the crisis. Companies were able to sell protection to
investors against the default of mortgage-backed securities, helping to launch
and expand the market for new, complex instruments such as CDO's. This further
fueled the housing bubble. They also amplified the losses from the collapse of
the housing bubble by allowing multiple bets on the same securities and helped
spread these bets throughout the financial system. Companies selling
protection, such as AIG, were not required
to set aside sufficient capital to cover their obligations when significant
defaults occurred. Because many CDS were not traded on exchanges, the
obligations of key financial institutions became hard to measure, creating
uncertainty in the financial system.[59]
U.S. Current Account
or Trade Deficit
In 2005, Ben Bernanke addressed the implications of the
USA's high and rising current account deficit,
resulting from USA investment exceeding its savings, or imports exceeding
exports.[172] Between 1996 and 2004, the USA
current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP.
The US attracted a great deal of foreign investment, mainly from the emerging
economies in Asia and oil-exporting nations. The balance of payments identity requires that a
country (such as the USA) running a current account deficit also have a capital account (investment) surplus of the same
amount. Foreign investors had these funds to lend, either because they had very
high personal savings rates (as high as 40% in China), or because of high oil
prices. Bernanke referred to this as a "saving glut"[148] that may have pushed capital
into the USA, a view differing from that of some other economists, who view
such capital as having beenpulled into the USA by its high
consumption levels. In other words, a nation cannot consume more than its
income unless it sells assets to foreigners, or foreigners are willing to lend
to it. Alternatively, if a nation wishes to increase domestic investment in
plant and equipment, it will also increase its level of imports to maintain
balance if it has a floating exchange rate.
Regardless of the push or pull view, a
"flood" of funds (capital or liquidity) reached the USA financial markets.
Foreign governments supplied funds by purchasing USA Treasury bonds and thus avoided much of the
direct impact of the crisis. USA households, on the other hand, used funds borrowed
from foreigners to finance consumption or to bid up the prices of housing and
financial assets. Financial institutions invested foreign funds in mortgage-backed securities. USA housing and
financial assets dramatically declined in value after the housing bubble burst.[173][174]
Economist Joseph Stiglitz wrote in October 2011 that the
recession and high unemployment of the 2009-2011 period was years in the making
and driven by: unsustainable consumption; high manufacturing productivity
outpacing demand thereby increasing unemployment; income inequality that
shifted income from those who tended to spend it (i.e., the middle class) to
those who do not (i.e., the wealthy); and emerging market's buildup of reserves
(to the tune of $7.6 trillion by 2011) which was not spent. These factors all
led to a "massive" shortfall in aggregate demand, which was
"papered over" by demand related to the housing bubble until it
burst.[175]
Securitization
markets were impaired during the crisis
In a June 2008 speech, President of the
NY Federal Reserve Bank Timothy Geithner, who later became
Secretary of the Treasury, placed significant blame for the freezing of credit
markets on a "run" on the entities in the "parallel"
banking system, also called the shadow banking system. These entities
became critical to the credit markets underpinning the financial system, but
were not subject to the same regulatory controls as depository banks. Further,
these entities were vulnerable because they borrowed short-term in liquid
markets to purchase long-term, illiquid and risky assets. This meant that
disruptions in credit markets would make them subject to rapid deleveraging,
selling their long-term assets at depressed prices. He described the
significance of these entities: "In early 2007, asset-backed commercial
paper conduits, in structured investment vehicles, in auction-rate preferred
securities, tender option bonds and variable rate demand notes, had a combined
asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo
grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8
trillion. The combined balance sheets of the then five major investment banks totaled
$4 trillion. In comparison, the total assets of the top five bank holding
companies in the United States at that point were just over $6 trillion, and
total assets of the entire banking system were about $10 trillion." He
stated that the "combined effect of these factors was a financial system
vulnerable to self-reinforcing asset price and credit cycles."[11]
Nobel laureate Paul Krugman described the run on the shadow
banking system as the "core of what happened" to cause the crisis.
"As the shadow banking system expanded to rival or even surpass conventional
banking in importance, politicians and government officials should have
realized that they were re-creating the kind of financial vulnerability that
made the Great Depression possible—and they should have responded by extending
regulations and the financial safety net to cover these new institutions.
Influential figures should have proclaimed a simple rule: anything that does
what a bank does, anything that has to be rescued in crises the way banks are,
should be regulated like a bank." He referred to this lack of controls as
"malign neglect."[176][177]
The securitization markets supported by
the shadow banking system started to close down in the spring of 2007 and
nearly shut-down in the fall of 2008. More than a third of the private credit
markets thus became unavailable as a source of funds.[105] According to the Brookings Institution, the traditional
banking system does not have the capital to close this gap as of June 2009:
"It would take a number of years of strong profits to generate sufficient
capital to support that additional lending volume." The authors also
indicate that some forms of securitization are "likely to vanish forever,
having been an artifact of excessively loose credit conditions."[106]
Economist Mark Zandi testified to the Financial Crisis
Inquiry Commission in January 2010: "The securitization markets also
remain impaired, as investors anticipate more loan losses. Investors are also
uncertain about coming legal and accounting rule changes and regulatory
reforms. Private bond issuance of residential and commercial mortgage-backed securities, asset-backed securities, and CDOs peaked in 2006
at close to $2 trillion...In 2009, private issuance was less than $150 billion,
and almost all of it was asset-backed issuance supported by the Federal
Reserve's TALF program to aid credit card, auto and small-business lenders.
Issuance of residential and commercial mortgage-backed securities and CDOs
remains dormant."[178]
The Economist reported in March 2010:
"Bear Stearns and Lehman Brothers were non-banks that were crippled by a
silent run among panicky overnight "repo" lenders, many
of them money market funds uncertain about the quality of securitized
collateral they were holding. Mass redemptions from these funds after Lehman's
failure froze short-term funding for big firms."[179]
The Financial Crisis
Inquiry Commission reported in January 2011: "In the early part of
the 20th century, we erected a series of protections—the Federal Reserve as a
lender of last resort, federal deposit insurance, ample regulations—to provide
a bulwark against the panics that had regularly plagued America’s banking
system in the 20th century. Yet, over the past 30-plus years, we permitted the
growth of a shadow banking system—opaque and laden with short term debt—that
rivaled the size of the traditional banking system. Key components of the
market—for example, the multitrillion-dollar repo lending market,
off-balance-sheet entities, and the use of over-the-counter derivatives—were
hidden from view, without the protections we had constructed to prevent
financial meltdowns. We had a 21st-century financial system with 19th-century
safeguards."[59]
Impacts from the
Crisis on Key Wealth Measures
Between June 2007 and November 2008,
Americans lost more than a quarter of their net worth. By early November 2008,
a broad U.S. stock index, the S&P 500, was down 45 percent from its 2007
high. Housing prices had dropped 20% from their 2006 peak, with futures markets
signaling a 30–35% potential drop. Total home equity in the United States, which
was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by
mid-2008 and was still falling in late 2008. Total retirement assets,
Americans' second-largest household asset, dropped by 22 percent, from $10.3
trillion in 2006 to $8 trillion in mid-2008. During the same period, savings
and investment assets (apart from retirement savings) lost $1.2 trillion and
pension assets lost $1.3 trillion. Taken together, these losses total $8.3
trillion.[180] Members of USAminority groups received a
disproportionate number of subprime mortgages, and so have experienced a
disproportionate level of the resulting foreclosures.[181][182][183] The crisis had a devastating
effect on the U.S. auto industry. New vehicle sales, which peaked at 17 million
in 2005, recovered to only 12 million by 2010.[184]
FDIC Graph – U.S.
Bank & Thrift Profitability By Quarter
The crisis began to affect the
financial sector in February 2007, when HSBC, the world's largest
(2008) bank, wrote down its holdings of subprime-related MBS by $10.5 billion,
the first major subprime related loss to be reported.[185] During 2007, at least 100 mortgage companies either shut down,
suspended operations or were sold.[186] Top management has not escaped
unscathed, as the CEOs of Merrill Lynch and Citigroup resigned within a week of each
other in late 2007.[187] As the crisis deepened, more and
more financial firms either merged, or announced that they were negotiating
seeking merger partners.[188]
During 2007, the crisis caused panic in
financial markets and encouraged investors to take their money out of risky
mortgage bonds and shaky equities and put it into commodities as "stores of value".[189] Financial speculation in
commodity futures following the collapse of the financial derivatives markets
has contributed to the world food price
crisisand oil price increases due to a
"commodities super-cycle."[190][191] Financial speculators seeking
quick returns have removed trillions of dollars from equities and mortgage
bonds, some of which has been invested into food and raw materials.[192]
Mortgage defaults and provisions for
future defaults caused profits at the 8533 USA depository institutions insured by the Federal Deposit
Insurance Corporation to decline from $35.2 billion in
2006 Q4 to $646 million in the same quarter a year later, a decline of 98%.
2007 Q4 saw the worst bank and thrift quarterly performance since 1990. In all
of 2007, insured depository institutions earned approximately $100 billion,
down 31% from a record profit of $145 billion in 2006. Profits declined from
$35.6 billion in 2007 Q1 to $19.3 billion in 2008 Q1, a decline of 46%.[193][194]
As of August 2008, financial firms around the
globe have written down their holdings of subprime
related securities by US$501 billion.[195] The IMF estimates that financial
institutions around the globe will eventually have to write off $1.5 trillion
of their holdings of subprime MBSs. About $750 billion in such losses had been
recognized as of November 2008. These losses have wiped out much of the capital
of the world banking system. Banks headquartered in nations that have signed
the Basel Accords must have so many cents of capital for every
dollar of credit extended to consumers and businesses. Thus the massive
reduction in bank capital just described has reduced the credit available to
businesses and households.[196]
When Lehman Brothers and other important financial
institutions failed in September 2008, the crisis hit a key point.[197]During a two day period in September
2008, $150 billion were withdrawn from USA money funds. The average two day outflow had been
$5 billion. In effect, the money market was subject to a bank run. The money market had been a key
source of credit for banks (CDs) and nonfinancial
firms (commercial paper). The TED spread (see graph above), a measure of
the risk of interbank lending, quadrupled shortly after the Lehman failure.
This credit freeze brought the global financial system to the brink of
collapse. The response of the USA Federal Reserve, the European Central Bank, and other central
banks was immediate and dramatic. During the last quarter of 2008, these
central banks purchased US$2.5 trillion of government debt and troubled private
assets from banks. This was the largest liquidity injection into the credit
market, and the largest monetary policy action, in world history. The
governments of European nations and the USA also raised the capital of their
national banking systems by $1.5 trillion, by purchasing newly issued preferred stock in their major banks. [196]
However, some economists state that Third-World economies, such as the Brazilian and Chinese ones, will not
suffer as much as those from more developed countries.[198] However, other analysts have seen
Brazil as entering their own sub-prime crisis.[199]
The International Monetary Fund
estimated that large U.S. and European banks lost more than $1 trillion on
toxic assets and from bad loans from January 2007 to September 2009. These
losses are expected to top $2.8 trillion from 2007–10. U.S. banks losses were
forecast to hit $1 trillion and European bank losses will reach $1.6 trillion.
The IMF estimated that U.S. banks were about 60 percent through their losses,
but British and eurozone banks only 40 percent.[200]
In Spring, 2011 there were about a
million homes in foreclosure in the United States, several million more in the
pipeline, and 872,000 previously foreclosed homes in the hands of banks. Sales
were slow; economists estimated that it would take three years to clear the
backlogged inventory. According to Mark Zandi, of Moody’s Analytics, home
prices were falling and could be expected to fall further during 2011. However,
the rate of new borrowers falling behind in mortgage payments had begun to
decrease.[201]
Economist Carmen Reinhart stated in August 2011: "Debt
de-leveraging [reduction] takes about seven years...And in the decade following
severe financial crises, you tend to grow by 1 to 1.5 percentage points less
than in the decade before, because the decade before was fueled by a boom in
private borrowing, and not all of that growth was real. The unemployment
figures in advanced economies after falls are also very dark. Unemployment
remains anchored about five percentage points above what it was in the decade
before.”[202]
Various actions have been taken since
the crisis became apparent in August 2007. In September 2008, major instability
in world financial markets increased awareness and attention to the crisis.
Various agencies and regulators, as well as political officials, began to take
additional, more comprehensive steps to handle the crisis.
To date, various government agencies
have committed or spent trillions of dollars in loans, asset purchases,
guarantees, and direct spending. For a summary of U.S. government financial
commitments and investments related to the crisis, see CNN – Bailout Scorecard.
The central bank of the USA, the Federal Reserve, in partnership with central banks around the world, has taken
several steps to address the crisis. Federal Reserve Chairman Ben Bernanke stated in early 2008:
"Broadly, the Federal Reserve's response has followed two tracks: efforts
to support market liquidity and functioning and the pursuit
of our macroeconomic objectives through monetary policy."[26] The Fed has:
§ Lowered the target
for the Federal funds rate from 5.25% to
2%, and the discount rate from 5.75% to 2.25%. This took place in six steps
occurring between 18 September 2007 and 30 April 2008;[203][204] In December 2008, the Fed further
lowered the federal funds rate target to a range of 0–0.25% (25 basis points).[205]
§ Undertaken, along
with other central banks, open market operations to ensure
member banks remain liquid. These are effectively short-term loans to member
banks collateralized by government securities. Central banks have also lowered
the interest rates (called the discount rate in the USA) they charge member
banks for short-term loans;[206]
§ Created a variety of
lending facilities to enable the Fed to lend directly to banks and non-bank
institutions, against specific types of collateral of varying credit quality.
These include the Term Auction Facility (TAF) and Term Asset-Backed
Securities Loan Facility (TALF).[207]
§ In November 2008, the
Fed announced a $600 billion program to purchase the MBS of the GSE, to help lower
mortgage rates.[208]
§ In March 2009, the Federal Open Market
Committee decided to increase the size of the Federal Reserve’s
balance sheet further by purchasing up to an additional $750 billion of government-sponsored
enterprise mortgage-backed securities, bringing its total purchases of
these securities to up to $1.25 trillion this year, and to increase its
purchases of agency debt this year by up to $100 billion
to a total of up to $200 billion. Moreover, to help improve conditions in
private credit markets, the Committee decided to purchase up to $300 billion of
longer-term Treasury securities during 2009.[209]
According to Ben Bernanke, expansion of the Fed balance sheet
means the Fed is electronically creating money, necessary "...because our
economy is very weak and inflation is very low. When the economy begins to
recover, that will be the time that we need to unwind those programs, raise
interest rates, reduce the money supply, and make sure that we have a recovery
that does not involve inflation."[210]
On 13 February 2008, President George W. Bush signed into law a $168 billion
economic stimulus package, mainly taking the form of income tax rebate checks mailed directly to
taxpayers.[211] Checks were mailed starting the
week of 28 April 2008. However, this rebate coincided with an unexpected jump in gasoline and food
prices. This coincidence led some to wonder whether the stimulus package would
have the intended effect, or whether consumers would simply spend their rebates
to cover higher food and fuel prices.
On 17 February 2009, U.S. President Barack Obama signed the American Recovery
and Reinvestment Act of 2009, an $787 billion stimulus package with
a broad spectrum of spending and tax cuts.[212] Over $75 billion of which was
specifically allocated to programs which help struggling homeowners. This
program is referred to as the Homeowner Affordability and Stability Plan.[213]
Common Equity to
Total Assets Ratios for Major USA Banks
Losses on mortgage-backed securities
and other assets purchased with borrowed money have dramatically reduced the
capital base of financial institutions, rendering many either insolvent or less
capable of lending. Governments have provided funds to banks. Some banks have
taken significant steps to acquire additional capital from private sources.
The U.S. government passed the Emergency Economic
Stabilization Act of 2008 (EESA or TARP) during October
2008. This law included $700 billion in funding for the "Troubled Assets
Relief Program" (TARP), which was used to lend funds to banks in exchange
for dividend-paying preferred stock.[214][215]
Another method of recapitalizing banks
is for government and private investors to provide cash in exchange for
mortgage-related assets (i.e., "toxic" or "legacy" assets),
improving the quality of bank capital while reducing uncertainty regarding the
financial position of banks. U.S. Treasury Secretary Timothy Geithner announced a plan during March
2009 to purchase "legacy" or "toxic" assets from banks. The Public-Private Partnership Investment Program involves
government loans and guarantees to encourage private investors to provide funds
to purchase toxic assets from banks.[216]
For a summary of U.S. government
financial commitments and investments related to the crisis, see CNN – Bailout Scorecard.
Further information: List of bankrupt or acquired banks during the financial crisis
of 2007–2008, Federal takeover of Fannie Mae and Freddie Mac, National City
acquisition by PNC, Government intervention during the subprime mortgage crisis, and Bailout
People queuing
outside a Northern Rockbank branch in Birmingham, United Kingdomon September 15, 2007, to withdraw their savings because of the subprime crisis.
Several major financial institutions
either failed, were bailed-out by governments, or merged (voluntarily or
otherwise) during the crisis. While the specific circumstances varied, in
general the decline in the value of mortgage-backed securities held by these
companies resulted in either their insolvency, the equivalent of bank runs as investors pulled funds from
them, or inability to secure new funding in the credit markets. These firms had
typically borrowed and invested large sums of money relative to their cash or
equity capital, meaning they were highly leveraged and vulnerable
to unanticipated credit market disruptions.[217]
The five largest U.S. investment banks,
with combined liabilities or debts of $4 trillion, either went bankrupt (Lehman Brothers), were taken over by other companies (Bear Stearns and Merrill Lynch), or were bailed-out by the U.S.
government (Goldman Sachs and Morgan Stanley) during 2008.[218] Government-sponsored enterprises
(GSE) Fannie Mae and Freddie Mac either directly owed or
guaranteed nearly $5 trillion in mortgage obligations, with a similarly weak
capital base, when they were placed into receivership in September 2008.[219] For scale, this $9 trillion in
obligations concentrated in seven highly leveraged institutions can be compared
to the $14 trillion size of the U.S. economy (GDP)[220] or to the total national debt of
$10 trillion in September 2008.[221]
Major depository banks around the world
had also used financial innovations such as structured
investment vehicles to circumvent capital ratio regulations.[222] Notable global failures included Northern Rock, which was nationalized at an
estimated cost of £87 billion ($150 billion).[223]In the U.S., Washington Mutual (WaMu) was seized in September
2008 by the USA Office of Thrift Supervision (OTS).[224] This would be followed by the shotgun wedding of Wells Fargo & Wachovia after it was speculated that
without the merger Wachovia was also going to fail. Dozens of U.S. banks
received funds as part of the TARP or $700 billion bailout.[225] The TARP funds gained some
controversy after PNC Financial Services received TARP
money, only to turn around hours later and purchase the struggling National City Corp., which itself had
become a victim of the subprime crisis.
As a result of the financial crisis in
2008, twenty five U.S. banks became insolvent and were taken over by the FDIC.[226] As of August 14, 2009, an
additional 77 banks became insolvent.[227] This seven month tally surpasses
the 50 banks that were seized in all of 1993, but is still much smaller than
the number of failed banking institutions in 1992, 1991, and 1990.[228] The United States has lost over 6
million jobs since the recession began in December 2007.[229]
The FDIC deposit insurance fund,
supported by fees on insured banks, fell to $13 billion in the first quarter of
2009.[230] That is the lowest total since
September, 1993.[230]
According to some, the bailouts could
be traced directly to Alan Greenspan's efforts to reflate the stock market and
the economy after the tech stock bust, and specifically to a February 23, 2004
speech Mr. Greenspan made to the Mortgage Bankers Association where he
suggested that the time had come to push average American borrowers into more
exotic loans with variable rates, or deferred interest.[231] This argument suggests that Mr.
Greenspan sought to enlist banks to expand lending and debt to stimulate asset
prices and that the Federal Reserve and US Treasury Department would back any
losses that might result. As early as March 2007 some commentators predicted
that a bailout of the banks would exceed $1 trillion, at a time when Ben
Bernanke, Alan Greenspan and Henry Paulson all claimed that mortgage problems
were "contained" to the subprime market and no bailout of the financial
sector would be necessary.[231]
Both lenders and borrowers may benefit
from avoiding foreclosure, which is a costly and lengthy process. Some lenders
have offered troubled borrowers more favorable mortgage terms (i.e.,
refinancing, loan modification or loss mitigation). Borrowers have also been encouraged
to contact their lenders to discuss alternatives.[232]
The Economist described the issue this way:
"No part of the financial crisis has received so much attention, with so
little to show for it, as the tidal wave of home foreclosures sweeping over
America. Government programmes have been ineffectual, and private efforts not
much better." Up to 9 million homes may enter foreclosure over the
2009–2011 period, versus one million in a typical year.[233] At roughly U.S. $50,000 per
foreclosure according to a 2006 study by the Chicago Federal Reserve Bank, 9
million foreclosures represents $450 billion in losses.[234]
A variety of voluntary private and
government-administered or supported programs were implemented during 2007–2009
to assist homeowners with case-by-case mortgage assistance, to mitigate the
foreclosure crisis engulfing the U.S. One example is the Hope Now Alliance, an ongoing collaborative effort
between the US Government and private industry to help certain subprime
borrowers.[235] In February 2008, the Alliance
reported that during the second half of 2007, it had helped 545,000 subprime
borrowers with shaky credit, or 7.7% of 7.1 million subprime loans outstanding
as of September 2007. A spokesperson for the Alliance acknowledged that much
more must be done.[236]
During late 2008, major banks and both
Fannie Mae and Freddie Mac established moratoriums (delays) on foreclosures, to
give homeowners time to work towards refinancing.[237][238][239]
Critics have argued that the
case-by-case loan modification method is ineffective, with too
few homeowners assisted relative to the number of foreclosures and with nearly
40% of those assisted homeowners again becoming delinquent within 8 months.[240][241][242] In December 2008, the U.S. FDIC
reported that more than half of mortgages modified during the first half of
2008 were delinquent again, in many cases because payments were not reduced or
mortgage debt was not forgiven. This is further evidence that case-by-case loan
modification is not effective as a policy tool.[243]
In February 2009, economists Nouriel Roubini and Mark Zandi recommended an "across the
board" (systemic) reduction of mortgage principal balances by as much as
20–30%. Lowering the mortgage balance would help lower monthly payments and
also address an estimated 20 million homeowners that may have a financial
incentive to enter voluntary foreclosure because they are
"underwater" (i.e., the mortgage balance is larger than the home
value).[244][245]
A study by the Federal Reserve Bank of
Boston indicated that banks were reluctant to modify loans. Only 3% of
seriously delinquent homeowners had their mortgage payments reduced during
2008. In addition, investors who hold MBS and have a say in mortgage modifications have not been a
significant impediment; the study found no difference in the rate of assistance
whether the loans were controlled by the bank or by investors. Commenting on
the study, economists Dean Baker and Paul Willen
both advocated providing funds directly to homeowners instead of banks.[246]
The L.A. Times reported the results of a study
that found homeowners with high credit scores at the time of entering the
mortgage are 50% more likely to "strategically default" – abruptly and intentionally
pull the plug and abandon the mortgage—compared with lower-scoring borrowers.
Such strategic defaults were heavily concentrated in markets with the highest
price declines. An estimated 588,000 strategic defaults occurred nationwide
during 2008, more than double the total in 2007. They represented 18% of all
serious delinquencies that extended for more than 60 days in the fourth quarter
of 2008.[247]
On 18 February 2009, U.S. President
Barack Obama announced a $73 billion program to help up to nine million
homeowners avoid foreclosure, which was supplemented by $200 billion in
additional funding for Fannie Mae and Freddie Mac to purchase and more easily
refinance mortgages. The plan is funded mostly from the EESA's $700 billion
financial bailout fund. It uses cost sharing and incentives to encourage
lenders to reduce homeowner's monthly payments to 31 percent of their monthly
income. Under the program, a lender would be responsible for reducing monthly
payments to no more than 38 percent of a borrower’s income, with government
sharing the cost to further cut the rate to 31 percent. The plan also involves
forgiving a portion of the borrower’s mortgage balance. Companies that service
mortgages will get incentives to modify loans and to help the homeowner stay
current.[248][249][250]
Further information: Subprime mortgage
crisis solutions debate and Regulatory
responses to the subprime crisis
President Barack Obama and key advisers introduced a
series of regulatory proposals in June 2009. The proposals address consumer
protection, executive pay, bank financial cushions or capital requirements,
expanded regulation of the shadow banking system and derivatives, and enhanced
authority for the Federal Reserveto safely wind-down systemically
important institutions, among others.[251][252][253] The Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into
law in July 2010 to address some of the causes of the crisis.
A variety of regulatory changes have
been proposed by economists, politicians, journalists, and business leaders to
minimize the impact of the current crisis and prevent recurrence. These
include:
§ Ben Bernanke: Establish resolution procedures for
closing troubled financial institutions in the shadow banking system, such as investment
banks and hedge funds.[254]
§ Joseph Stiglitz: Restrict the leverage that financial
institutions can assume. Require executive compensation to be more related to
long-term performance.[16]Re-instate the separation of commercial
(depository) and investment banking established by the Glass-Steagall Act in
1933 and repealed in 1999 by theGramm-Leach-Bliley Act.[126]
§ Alan Greenspan: Banks should have a stronger capital
cushion, with graduated regulatory capital requirements (i.e., capital ratios
that increase with bank size), to "discourage them from becoming too big
and to offset their competitive advantage."[256]
§ Warren Buffett: Require minimum down payments for
home mortgages of at least 10% and income verification.[257]
§ Eric Dinallo: Ensure any financial institution has
the necessary capital to support its financial commitments. Regulate credit
derivatives and ensure they are traded on well-capitalized exchanges to limit counterparty risk.[222]
§ Raghuram Rajan: Require financial institutions to
maintain sufficient "contingent capital" (i.e., pay insurance
premiums to the government during boom periods, in exchange for payments during
a downturn.)[258]
§ A. Michael Spence and Gordon Brown: Establish an early-warning system to
help detect systemic risk.[259]
§ Niall Ferguson and Jeffrey Sachs: Impose haircuts on bondholders
and counterparties prior to using taxpayer money in bailouts.[260][261]
§ Nouriel Roubini: Nationalize insolvent banks.[262] Reduce debt levels across the
financial system through debt for equity swaps. Reduce mortgage balances to
assist homeowners, giving the lender a share in any future home appreciation.[263]
§ Don Tapscott, 2010. Macrowikinomics, Publisher
Atlantic Books: to promote greater transparency in the financial industry,
encourage financial institutions to apply "crowd sourced" valuation
methods to illiquid debt securities, externally driven quantitative and
econometric modelling as opposed to in-house, and potentially biased valuation
processes.
§ Paul McCulley advocated "counter-cyclical
regulatory policy to help modulate human nature." He cited the work of
economist Hyman Minsky, who believed that human behavior is
pro-cyclical, meaning it amplifies the extent of booms and busts. In other
words, humans are momentum investors rather than value investors.
Counter-cyclical policies would include increasing capital requirements during
boom periods and reducing them during busts.[264]
U.S. Treasury Secretary Timothy Geithner testified before Congress on
October 29, 2009. His testimony included five elements he stated as critical to
effective reform:
1. Expand the Federal Deposit
Insurance Corporation bank resolution mechanism to
include non-bank financial institutions;
2. Ensure that a firm is
allowed to fail in an orderly way and not be "rescued";
3. Ensure taxpayers are
not on the hook for any losses, by applying losses to the firm's investors and
creating a monetary pool funded by the largest financial institutions;
4. Apply appropriate
checks and balances to the FDIC and Federal Reserve in this resolution process;
5. Require stronger
capital and liquidity positions for financial firms and related regulatory
authority.[265]
Significant law enforcement action and
litigation is resulting from the crisis. The U.S. Federal Bureau of
Investigation was looking into the possibility of fraud by mortgage financing
companies Fannie Mae and Freddie Mac, Lehman Brothers, and insurer American International Group, among others.[266] New York Attorney General Andrew
Cuomo is suing Long Island based Amerimod, one of the nation's largest loan
modification corporations for fraud, and has issued 14 subpoenas to other
similar companies.[267] The FBI also assigned more agents
to mortgage-related crimes and its caseload has dramatically increased.[268][269] The FBI began a probe of Countrywide Financial in March 2008
for possible fraudulent lending practices and securities fraud.[270]
Over 300 civil lawsuits were filed in
federal courts during 2007 related to the subprime crisis. The number of
filings in state courts was not quantified but is also believed to be
significant.[271]
VOA Special English
Economics Report from Oct 2010 describing how millions of foreclosed homes were
seized by banks.
Estimates of impact have continued to
climb. During April 2008, International Monetary Fund (IMF) estimated
that global losses for financial institutions would approach $1 trillion.[272] One year later, the IMF estimated
cumulative losses of banks and other financial institutions globally would
exceed $4 trillion.[273]
Francis Fukuyama has argued that the crisis
represents the end of Reaganism in the
financial sector, which was characterized by lighter regulation, pared-back
government, and lower taxes. Significant financial sector regulatory changes
are expected as a result of the crisis.[274]
Fareed Zakaria believes that the crisis may
force Americans and their government to live within their means. Further, some
of the best minds may be redeployed from financial engineering to more
valuable business activities, or to science and technology.[275]
Roger Altman wrote that "the crash of
2008 has inflicted profound damage on [the U.S.] financial system, its economy,
and its standing in the world; the crisis is an important geopolitical
setback...the crisis has coincided with historical forces that were already
shifting the world's focus away from the United States. Over the medium term,
the United States will have to operate from a smaller global platform – while
others, especially China, will have a chance to rise faster."[196]
GE CEO Jeffrey Immelt has argued that U.S. trade
deficits and budget deficits are unsustainable. America must regain its
competitiveness through innovative products, training of production workers,
and business leadership. He advocates specific national goals related to energy
security or independence, specific technologies, expansion of the manufacturing
job base, and net exporter status.[276] "The world has been reset.
Now we must lead an aggressive American renewal to win in the future." Of
critical importance, he said, is the need to focus on technology and
manufacturing. “Many bought into the idea that America could go from a
technology-based, export-oriented powerhouse to a services-led,
consumption-based economy — and somehow still expect to prosper,” Jeff said.
“That idea was flat wrong.”[277]
Economist Paul Krugman wrote in 2009: "The
prosperity of a few years ago, such as it was—profits were terrific, wages not
so much—depended on a huge bubble in housing, which replaced an earlier huge
bubble in stocks. And since the housing bubble isn’t coming back, the spending
that sustained the economy in the pre-crisis years isn’t coming back
either."[278] Niall Ferguson stated that excluding the effect
of home equity extraction, the U.S. economy grew at a 1% rate during the Bush
years.[279] Microsoft CEO Steve Ballmer has argued that this is an
economic reset at a lower level, rather than a recession, meaning that no quick
recovery to pre-recession levels can be expected.[280]
The U.S. Federal government's efforts
to support the global financial system have resulted in significant new
financial commitments, totaling $7 trillion by November, 2008. These commitments
can be characterized as investments, loans, and loan guarantees, rather than
direct expenditures. In many cases, the government purchased financial assets
such as commercial paper, mortgage-backed securities, or other types of
asset-backed paper, to enhance liquidity in frozen
markets.[281] As the crisis has progressed, the
Fed has expanded the collateral against which it is willing to lend to include
higher-risk assets.[282]
The Economist wrote in May 2009: "Having
spent a fortune bailing out their banks, Western governments will have to pay a
price in terms of higher taxes to meet the interest on that debt. In the case
of countries (like Britain and America) that have trade as well as budget
deficits, those higher taxes will be needed to meet the claims of foreign
creditors. Given the political implications of such austerity, the temptation
will be to default by stealth, by letting their currencies depreciate.
Investors are increasingly alive to this danger..."[283]
The crisis has cast doubt on the legacy
of Alan Greenspan, the Chairman of the Federal Reserve
System from 1986 to January 2006. Senator Chris Dodd claimed that Greenspan created
the "perfect storm".[284] When asked to comment on the
crisis, Greenspan spoke as follows:[143]
The current credit
crisis will come to an end when the overhang of inventories of newly built
homes is largely liquidated, and home price deflation comes to an end. That
will stabilize the now-uncertain value of the home equity that acts as a buffer
for all home mortgages, but most importantly for those held as collateral for
residential mortgage-backed securities. Very large losses will, no doubt, be
taken as a consequence of the crisis. But after a period of protracted
adjustment, the U.S. economy, and the world economy more generally, will be
able to get back to business.
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