The following is a very crude and general overview of the Financial Crisis of 2007-8, which spurred on the recession the United States, and the rest of the world, is grappling with today. The idea behind this “report” is to break it down into terms such that anyone could understand it. Perhaps later I’ll go into the actual economics of it.
In order to grasp a firm understanding of the phenomenon that has been termed as the “Financial Crisis of 2007-08,” by some, one must look into the events precluding the recession which had begun in January of 2008 (Modjtahedi, p.3). Many of our current problems can be tied back to the splicing and dicing of risk which then extended to consumer lending in the form of asset-backed securities (Cecchetti, p.2). It is generally agreed upon that this trend began in 2000 with the rapid rise in home prices. In fact, these increases were higher than justified by fundamental values or replacement costs (Cecchetti, p.2). This post will discuss the economics of mortgage loans, the different banking models in the time of the crisis, the slicing and dicing of credit and asset securitization, the effects of the crisis itself, and finally, the macroeconomics of the crisis along with the policy options of the United States—and other international—governments.
To begin, mortgage loans are loans that people take out from financial institutions—lenders, such as banks—towards the purchase of a house. If the borrower defaults on the loan, any of the following may occur:
- The loan may become immediately due and payable.
- The loan may be turned over to a collection agency
- The borrower’s credit rating can be negatively affected.
It is important to note that if the borrower does not respond appropriately, the house may become forfeit and the property of the lender to do with as they please, the term for this being “foreclosure.”
As a result of the aforementioned housing boom, real estate rose and mortgage borrowing increased exponentially. At this time, the government had low restrictions on banks with regards to lending. It is important to note that mortgage brokers earn commission, so they have greater incentive to close a larger volume of deals. Lack of sufficient oversight and the financial prosperity of the time resulted in irresponsible loans. The banks would receive bonds from these loans after determining a term, generally 30 or 40 years, over which time the loan would be amortized (Modjtahedi, p.7).
In the wake of the Dotcom bust and the terrorist acts of September 11th, the Federal Reserve lowered interest rates down to a mere 1% to encourage investment spending and account for potential increases in aggregate demand. This encouraged borrowing money, as there arose an abundance in credit (Jarvis). Banks then used this credit to borrow money and amplify the outcomes of their deals, or “leverage” (Jarvis). With leverage, higher volumes of transactions were made possible. The process by which this occurred and the role these transactions had on the crisis is outlined in the following steps (Jarvis):
- A family saves money for a down payment.
- Mortgage broker connects family to a lender who gives them a mortgage, broker makes a commission.
- Family becomes homeowners. Have positive prospects because house values have been on the rise.
- Investment bankers buy these mortgages from the mortgage lenders, doing this in vast quantities.
- Homeowners’ payments then go to these investment bankers.
- Investment bankers then create collateralized debt obligations (CDO).
- CDO’s are divided up into three troughs based on level of risk.
- These slices were then sold and the investment bankers repaid their loans.
- With time, most of the potential homeowners who actually qualified for loans already had one, and so spawned some of the unsafe lending practices mentioned before; irresponsible people—or those unable to pay off their loans—were lent money.
- Foreclosures occurred, loans were not repaid, debts were not cleared, and the financial system collapsed.
Initially, before people caught on to the realities of the situation, it seemed that no one had actually carefully considered the following flaw in this system: where would the money come from? No one was worried because as soon as one party sold off the mortgage to another, it was no longer their concern. The monthly payments which were meant to go to the investment bankers disappeared, with houses serving as the collateral. These houses were then put on the market to be sold. As this process continued, the housing supply substantially increased and demand shrunk. All of this resulted in the plummeting of housing prices. Once housing prices dropped, people stopped paying because their mortgages cost more than their homes were worth, more people walked away from their houses, prices continued to plummet, and the trend continued.
Keeping this process in mind, let us return to the different kinds of mortgages. There are fixed rate mortgages where the rate taken out stays constant despite market fluctuation. The borrower will repay the debt in equal monthly payments over a period of time, and during the first years of the loan, the money paid goes toward paying off the interest on the loan. The advantages to such a mortgage are the security and consistent payments that accompany it. If overall rates decrease, however, you will still be paying the same amount. Adjustable rate mortgages are such that the interest rate can change based on the market. The rate can increase or decrease depending on the rate agrees d upon. With adjustable rates, some of the risk is transferred to the borrower because the rate could suddenly go up. It is essential that borrowers think critically about the pros and cons to each mortgage type before they take out loans.
Another important concept to consider is the loan-to-value, or LTV, ratio. This is the ratio of the total outstanding loan to the value of the house. There is actually a percentage calculated by dividing the amount borrowed by the price or appraised value of the home to be purchased; the higher the LTV, the less cash a borrower is required to pay as a down payment. Lenders obviously prefer lower LTV ratios and higher equity ratios due to the consideration of moral-hazard (Modjtahedi).
Equity is equal to the market value of house minus the outstanding loan. It is essentially the amount the home owner actually owns of the house. For example if your house is worth $100,000, and you owe $70,000, then you have $30,000 in equity. A borrower can have positive, zero, or negative equity. Negative equity is when the price of the house falls below the outstanding loan. Now the borrower would have to pay more on the loan then what the house is worth.
For a person with positive equity, it is not favorable for them to default on their house. It is in fact advantageous for the borrower to make a profit by keeping the house, paying off the mortgage, and selling it for a higher price then they originally bought it for.
Negative equity, however, is a “necessary but not sufficient” reason to default on loan. If the borrower decides to default on the mortgage and walk out on the house, the borrower could save money because they owe more than the house is worth in mortgage payments. The borrower at this time would not want to sell house at negative equity because no profit would be made and they still owe the bank money for the remaining mortgage payments. Therefore, foreclosures increase when house prices fall because negative equity increases.
There are many reasons not to default and continue paying mortgage as well. First of all, and perhaps most importantly in the long run, defaulting on a house would result in the borrower gaining bad credit. Having bad credit would make it harder to borrow money in the future because banks see you as a higher risk. Secondly, there is no penalty in waiting to see if the market will improve, and if it doesn’t, the owner can always default later. Thirdly, the homeowner would still require a place to live. If they default on their house they are going to have to pay additional money to rent an apartment or even try and find cheaper house. Moving is an expense that should be avoided when possible. Finally, for many people there houses have a lot of sentimental value you to them. It might be worth it to some home owner to continue to paying the mortgage in order to keep the house they consider to be their “home.”
Negative equity is not just bad for the homeowner, but for the lender and community as well. When a person defaults on their house the bank—the lender—will collect the house as collateral. When they end up with too many foreclosed houses and have to sell the house at reduced price. This in turn lowers housing prices in the neighborhoods, forcing more home owners in to negative equity and causing even more foreclosures. When this happens it is referred to as a deflation spiral.
The originate-and-hold banking system is the original banking system. This system was very simple and straightforward and also included less people. In this banking system there are the depositors, the bank, and mortgage borrowers. Depositors are people who put money into banks. These deposits are usually relatively small, short term deposits. People put their money into banks in order to save and receive interest on their deposits. The banks, in return, take the depositor’s money and lend it out to the mortgage borrowers as loans. The mortgage borrows in return give the bank a bond. A bond is basically an “I owe you.” It is a contract by which the borrower agrees to pay back the loan, and with it a set interest. The contract usually also states that if the mortgage is not fully amortized, or paid off, by the given period, the bank will take over their property. The borrower pays back the principal, the amount borrowed, and interest on the principal payment.
Adverse Selection is a problem with this banking system that occurs before transactions. The banks are at a disadvantage because borrowers could have poor credit and be a high risk but they won’t tell the banks that, therefore the banks are at risk of the borrower defaulting. In order to help prevent this, banks will to do background checks on the home owners to see if they have poor credit. Another way to help prevent the home owner from defaulting if to have the owner put down a down payment on the house. This prevents the home owner from being a “moral hazard.” The home owner has money invested in the house and is less likely to walk out on the house and is more likely to keep it up.
Maturity mismatch is another problem with the originate and hold banking system Because depositors are usually short term deposits while loans, especially mortgage loans can last up to 40 years. If a lot of depositors decided that they wanted to take money out of the bank, then the bank would not have their money because it is tied up in long term loans that have not yet been paid back. And reversely, if many people want to get a loan, the bank may not have enough money from deposits to fund the loans. They are also unable to raise interest on loans because of regulation from the government. This is referred to as an “inelastic source of funds.”
Originate and distribute, the current banking system used today, is much more complex than the originate and hold system. This second banking system still involves depositors, a bank, and mortgage borrowers the way that the originate and hold model does. However, the system also involves, as the name suggests, originators. These institutes give home owners a loan and in return receive a mortgage bond from the borrower. The originator then sells that same bond to a bank and receives a profit on the sale in addition to the origination fees they earn from the borrower. The reason the bank will pay more for the bond is that the bond is likely to increase in value over the years and also the bank will receive interest on the loan. Now that the bank is in control of the bond, the mortgage borrower will pay back the principal and interest to the bank, not the originator. In this way the originator has effectively taken themselves out of the loop. Because of this, the originators do not have as much incentive to do background checks and check the borrower’s credit. This causes a major problem because the banks could be purchasing bonds from originators in which the borrower of that bond is a moral hazard.
One of the big problems that occurred with this type of banking system was that originators encouraged low income, high risk homebuyers to take out mortgages. Then when these borrowers defaulted it was not a problem to the originator because they did not hold the bond. Instead, the banks lost money because they were the holders of the borrowers bonds.
Recall the decline in the value of homes as the supply of houses increased and demand subsequently fell. One amplification mechanism that operated during this liquidity crises works through asset prices and balance sheets (Krishnamurthy, p.2). Balance sheets are deteriorated when prices are lowered which comes about as a result of negative shocks of asset-holders (Krishnamurthy, p.2). To counter this, the Federal Reserve actively purchased mortgage-backed securities, essentially taking the “bad” loans and mortgages out of others’ hands to help alleviate the strains on the market (Krishnamurthy, p.13). Another strategy they have utilized is their offerings to finance the asset holdings of commercial and investment banks at margin requirements far lower than is offered in private-sector transactions (Krishnamurthy, p.13).
The lack of knowledge and uncertainty during the recent crisis served as a significant amplification mechanism (Krishnamurthy, p.17). As was mentioned before, mortgage brokers, financial intermediaries, and essentially everyone involved in the system practiced unsafe lending practices, classifying certain, and relatively risky credit structures as AAA (Krishnamurthy, p.17). When these tranches suffered losses and people defaulted on their loans, people did not know how to react, for these were supposed to be the safest of investments. All of this created an atmosphere of uncertainty, paralyzing many into inaction, devastating the private sector.
While the roots of the crisis may be firmly planted in United States soil, the repercussions already have impacted the economy on a global scale because of all of the foreign investment. It is important to remember that people and institutions from around the world purchased these mortgages and CMO’s. Paul Volcker, former Chairman of the Federal Reserve and the current chairman of the Economic Recovery Advisory Board said that the crisis that began in the U.S. housing market has become a global problem that requires a global solution (Policy Options, p.5). In response, many countries have provided public capital to financial institutions with guarantees on their liabilities (Shirakawa, p.5). The United States, along with Germany and several other countries, have instigated economic stimulus packages designed to stave off some of the destruction, though these actions are not always enough to counteract the downturns as Germany’s output is still projected to fall by 2.5% in 2009 (Andersen).
The Federal Reserve itself “has responded aggressively to the financial crisis since its emergence in the summer of 2007” (Federal Reserve). The Reserve has instigated a cut in the discount rate as early as September of 2007, prodding an increase in investment rather than savings, increasing aggregate demand and GDP (Federal Reserve). As the crisis continued and matters intensified, the Committee “responded by cutting the target for the federal funds rate” (Federal Reserve). It has also provided liquidity to the private sector in order to support the functioning of credit markets and reduce financial strains (Federal Reserve). It has become the responsibility of all nations to combat the repercussions of the crisis and promote global economic recovery. International cooperation is essential to achieving sustained recovery.
This video is an absolute must if this topic is of any interest to you:
By Edris and Louise Marquino
Modjtahedi, Bagher. Sept. 2009. “Financial Crisis of 2007-09: Causes, Consequences, and Policy Options.” Dec. 2009.
Cecchetti, Stephen G. April 2008. “Monetary Policy and the Financial Crisis of 2007-2008.” Centre for Economic Policy Research. Dec. 2009.
Jarvis, Jonathan. The Crisis of Credit Visualized: The Short and Simple Story of the Credit Crisis. Video. March 2009. <http://vimeo.com/3261363>.
Krishnamurthy, Arvind. “Amplification Mechanisms in Liquidity Crises.” June 2009. National Bureau of Economic Research. Dec. 2009. <http://papers.nber.org/papers/w15040.pdf>.
“Policy Options for Global Financial Crisis.” Jan. 2009. Lee Kuan Yew School of Public Policy. Dec. 2009. <http://www.spp.nus.edu.sg/docs/global_is_asian/LKYNewsletter_Issue1.pdf>.
Shirakawa, Masaaki. “International Policy Response to Financial Crises.” Aug. 2009. Bank of Japan. Dec. 2009. <http://www.kc.frb.org/publicat/sympos/2009/papers/Shirakawa.08.24.09.pdf>.
Andersen, Camilla. “Germany Faces Extended Downturn Despite Stimulus.” Jan. 2009. International Monetary Fund. Dec. 2009. <http://www.imf.org/external/pubs/ft/survey/so/2009/car012209a.htm>.
“The Federal Reserve’s response to the crisis.” Nov. 2009. Board of Governors of the Federal Reserve System. Dec. 2009. <http://www.federalreserve.gov/monetarypolicy/bst_crisisresponse.htm