Notes on the financial crisis and recession

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Notes on the Financial Crisis and Recession of 2007 - 2009

Recession began December 2007 and probably ended during the summer of 2009 (The official dating of the end has not occurred yet.) Unemployment rose from 4.6% during June 2007 to a peak of 10.2% in October 2009. Real GDP declined from $13,321.1 bil. in the third quarter of 2007 to $12,901.5 bil. in the second quarter of 2009. This is comparable to the recession in 1981-2.

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1. Between 2002 and 2005 the actual federal funds rate was below the rate predicted by the Taylor rule. You would have to go back to 1975-78 to find similar multi-year period of sustained expansionary monetary policy. Between 2003 and 2005, the gap was 200 basis points or 2 percentage points. The M2 money supply grew at an annual rate of 8 to 10 percent during this period. In addition, strong demand for medium- and long-term U.S. Treasury bonds from Asian countries placed downward pressure on longer-term interest rates. The low interest rates are linked to the housing boom during this time.

In 2005 the Fed became concerned about inflation rather than recession and began tightening monetary policy with the federal funds rate reaching 5.25 percent in 2007. This shift in policy contributed the housing downturn and recession. Tighter monetary policy raised interest rates reducing housing demand. This caused housing prices to decline and defaults to increase. This reduced the mortgage payment flow into banks reducing the value of bank assets and bank stocks. A number of banks failed. This caused an increase in uncertainty (interbank lending declined because you were unsure about the balance sheets of the borrowing bank). The interbank loan market froze, resulting in a decline in credit, more bank failures, and a recession.

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2. The relatively low short-term interest rates relative to long-term rates changed the type of mortgage borrowers used. They switched from 15 or 30 year fixed rate loans to adjustable rate mortgages (ARMs). Now borrowers take on the risk of refinancing. Borrowers were betting housing prices would continue to rise. They were speculating in the housing market. Once interest rates rose, the mortgages were reset at higher interest rates. Combined with declining home prices, defaults increased (home values less than amount borrowed). This became a problem for both subprime and prime mortgages.

3. Financial innovations and government policies resulted in rapid grown in non-prime mortgages. They increased from 10 percent of mortgages in 2001 to 23 percent in 2006.

4. The financial industry significantly underestimated the risk in mortgage lending. The credit rating companies did a poor job assessing risk. There was questionable lending and borrowing (fraud). The systematic underestimation of risk (rather than a few individual firms) suggests there were other factors contributing to this problem.

5. Loan companies did not hold the mortgages they were originating. As a result, many were not careful about the loans they made. Loans were bundled together into a security (mortgage backed securities) and sold to banks, investors, Fannie Mae, and Freddie Mac. It appears that some investors did not understood the complexity of these securities. The owners of these securities were paid as the mortgages are paid off. As defaults increased, these securities lost value worsening the balance sheets of banks. Securitization has worked well in the past. It diversifies risk and increases funds available to borrowers.

6. Commercial real estate loans are still a major problem in the financial system.

7. Crude oil prices rose from $65 per barrel in the beginning of 2006 to almost $134 per barrel in June 2008. This 106 percent increase represented a major negative shock to the economy.

8. Four policy mistakes.

A. The Federal Housing Administration or FHA (insures mortgages of qualified borrowers) lowered mortgage down-payment requirements from 20 percent of a loan in the 1930s to 3 percent by 2004. The industry followed the FHA lead and did the same. Mortgages with lower down-payments default more often.

B. Community Reinvestment Act (1977) expanded reporting requirements (how well are they serving their community). If a bank gets a low CRA rating, regulators could limit mergers and expansions. This put political pressure on the banks to make more risky loans over the last 15 years.

C. Fannie Mae (Federal National Mortgage Association) was founded in 1938. It became stockholder owned (private ownership) as a government sponsored enterprise (GSE) in 1968. Freddie Mac (Federal Home Loan Mortgage Corporation) was established in 1970 as a GSE as well. The purpose of these organizations is to purchase and securitize conforming mortgages helping to ensure the expansion and liquidity of this market. Because of losses in the mortgage market, both were placed under government conservatorship (management) September 2008. They own or guarantee about one half of the $12 trillion mortgage market.

Congress pressured Fannie Mae and Freddie Mac to expand their activities in order to help expand affordable housing. It purchased more subprime (riskier) mortgages. This was possible because they can borrow at low interest rates (government guarantees borrowing). They package these mortgages into securities (mortgage backed securities) and sold many of them to private banks. For a fee, they guaranteed payment of these securities. Once housing prices declined and defaults increased, they lost money. Once their capital was wiped out, the U.S. Treasury (you the taxpayer) bailed them out. Fannie Mae lost $72 billion in 2009.

D. The Financial Accounting Standards Board (FASB) decided to use mark-to-market accounting rules in November 2007 for the first time since 1938. Mark-to-market accounting rules required financial institutions to use the current market price to value assets. It requires banks to adjust the value of their assets on their books to reflect their market value. This is a good idea in principal because it allows investors to better judge the value of a financial institution. However, in the middle of a crisis where few asset trades occur, and the price of securities dramatically decline, it became very difficult to determine market value. An asset sold at a very low price forced other financial institutions to mark down the value of their assets (even if the borrowers were making their payments), reducing net worth making them more likely to fail.

This policy was modified by the FASB in April 2009 allowing banks to use the cash flow from an asset to value a security when few trades are occurring in the market. In other words, even if the market value of these assets have fallen, so long as borrowers are making payments, the banks do not need to write down the value of these assets. This was one of the most important actions that help stabilize financial markets last spring. Private funds began flowing into banks following the rule change. This has help banks pay off the taxpayer bailout. There is some evidence that bank regulators are currently implicitly forcing banks to follow the old rule. If this is true, it is a policy mistake because the financial system has not completely recovered. Also, mark-to-market accounting was probably overstating the value of these assets during the boom.

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9. What has been the policy response to the crisis?

A. Expansionary monetary policy has been followed by the Fed since 2007. They have expanded lending to banks and other firms. The value of the Fed’s balance sheet has doubled to more than $2 trillion over this period. In addition to loans, they have been purchasing longer-term Treasury bonds and mortgage backed securities. The Fed will have to remove these funds soon to prevent inflation. If done to fast, they can cause a recession. If done to slowly, inflation can result. It will be difficult to pull off.

B. Fiscal policy consisting of higher government spending and lower taxes was used to try stabilize the economy in early 2009. A stimulus package was passed by Congress and signed into law by President Obama February 17, 2009. The package was worth $787 billion ($500 billion spending and $250 billion in tax cuts). About $185 billion was spent in 2009 and $400 billion will be spent this year. The Administration argued that their economic models predicted that without the stimulus, the unemployment rate would rise to 8%. Their forecast was off significantly.

There are a number of issues surrounding this policy choice. First, economic research suggests permanent cuts in income tax rates have a bigger impact on the economy than additional spending or tax rebates. Permanently higher after tax income because of tax rate decreases causes people to increase spending. Also, many small businesses pay income taxes not corporate taxes. The lower tax rates increase the incentive to supply labor, hire workers, and invest. The tax cuts in the stimulus package were tax rebates and had little impact on the economy.

Second, there is disagreement on the size of the impact of government spending on the economy. The emerging consensus is that the impact is less than 1. This means there is offsetting declines in consumption, investment, or net exports.

Third, you also have to finance the spending. Currently banks are financing the deficit rather than private investment. This is bad for long term economic growth.

C. Troubled Asset Relief Program or TARP was a $700 billion program used to stabilize the financial system. It was approve by Congress in the fall of 2008. It allowed the U.S. Treasury to purchase (or insure) assets and equity from financial institutions. It was mostly used to boast the capital of major banks. Most of TARP expenditures (but no all) has been repaid by the major financial institutions.

D. Regulatory reform of the financial system has not been passed by Congress. Important questions that need to be addressed include capital requirements (banks held much higher levels of capital in the past) and creating the right incentives to monitor and manage risk taking. The fundamental problem facing financial regulators is that repeated bailouts have created incentives for banks to take on greater risk (major moral-hazard problem) than they would have without the bailouts. We have been bailing out the financial sector since the early 1980s. It will be hard for the government to credible break this pattern.

We could require banks (especially large ones) to raise more capital and set loan loss reserves aside during good times so they would be better positioned to handle the bad times. They would not be forced to raise capital and reduce lending in a downturn. Banks could be required to issue non-guaranteed debt. The holders of this debt would have an incentive to monitor the banks. If a bank was taking on risk, the interest on this debt would rise providing a signal to investors and regulators.

Bankers, regulators, and politicians are not angels. You should lower your expectations concerning the ability of regulation to solve all these problems.

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