This page will cover the causes and effects of the latest financial crisis, sometimes referred to as the 'Great Recession', and the consequences of which the world economy is still recovering from.
The page will present a summary of my paper "Political Economy of the US Financial Crisis 2007-2009" where I have carefully analyzed the policies preceding the crisis that happened to had an effect on the housing bubble and the resulting recession.
The paper can be found here: http://ideas.repec.org/a/ipf/finteo/v35y2011i1p91-128.html, or downloaded directly from: http://www.ijf.hr/eng/FTP/2011/1/vukovic.pdf
Any comment and/or constructive criticism is more than welcomed.
The paper begins with an overlook of the international perspective on the current crisis. It focuses around the United States in particular because of its central role in the inception of the crisis which spilled over onto the rest of the world’s financial markets and hence brought about the worldwide recession. Subsequently the paper endeavours to explain opposing views about the causes of the crisis. It continues with a description of the mechanism of adjustable rate mortgages and offers a perspective on increasing bank risk-taking, the burst of the housing bubble and the spill-over effect to the real sector of the economy. In chapter four the paper examines the political and regulatory inducements of the crisis. It covers the impact each of them had on the economy and possible reasons why the policy-makers instituted them. These causes include the general regulatory enhancement of systemic risk by the policy-makers with the unintended consequences on bolstering the crisis, the role of government-sponsored enterprises and the legislative solutions in housing policies as well as the function of rating agencies and intensified banking regulation through the recourse rule. An assessment on whether monetary policy had implications in creating the crisis and the housing bubble is given in chapter five with help of the Taylor rule. Finally the role of the rising influence of the political power of the financial industry as possibly the decisive factor of the crisis is portrayed in chapter six.
Essentially, the paper recognizes several policy decisions that led to an increase of systemic risk in the economy (I'll cover them briefly):
1) Government sponsored enterprises (Fanny Mae and Freddie Mac), whose goal was to "purchase mortgage loans from banks on the sub-prime mortgage market. They could then either keep these loans as monthly source of revenue or to sell them as mortgage-backed securities (MBSs). The banks used the money from selling their loans to acquire new mortgage-based securities and the entire cycle is continued."
The creation of mortgage loans and MBSs gave rise to its prices and its demand.
The GSEs owned half of all american MBSs and half of all low and moderate income mortgage loans, according to the Housing and Urban Department (HUD) - see table 2 in the paper (pg. 104).
The GSEs were the main players in the US sub-prime mortgage market. They quickly achieved a dominant position and were following the targets set by the HUD.
Finally, "the Fed has done a study that showed the GSEs were not even successful in reducing interest rates for middle-class home buyers—the central justification they always claimed for their existence."
2) Community Reinvestment Act and its 1995 revision which pushed for affordable housing for everyone, by making banks "issue more mortgage loans towards unprivileged social groups such as minorities ... Loan requirements were softened due to short-run interests of politicians thinking only of how to win the next election and remain in power. The affordable housing idea proved to be nothing else than a political trick."
3) Rating agency oligopoly - Moody's, S&P and Fitch "were set as NRSROs (Nationally Recognized Statistical Rating Organizations) and they were the only ones good enough to comply with SECs regulatory requirements in order to evaluate the riskiness of a security... The effect was that these rating agencies, although private, due to their oligopoly position, could use any techniques they wished for evaluating riskiness of a company or an asset ... If the rating agencies are making bad decisions and therefore sending wrong signals to investors they don’t account for their decisions because they are being protected by their oligopoly status. Their imprecision and bad evaluations couldn't have hurt them in terms of making a profit because they didn't have any competition to punish them for doing a poor job. According to Friedman (2009) “Moody’s hasn't updated its main statistical assumptions on the American mortgage-backed securities market since 2002. This means that the dynamics of an unprecedented growth on the real-estate and the mortgage market wasn't taken into account at all”. Such behavior could have been prevented in an open competition credit ratings market in which imprecision and neglect in estimates would have been punished by the loss of reputation, clients and money."
4) Recourse rule - steering banks' investments into 'safe' assets. The most important factor in the crisis.
In 2001 the Fed, FDIC and the OTS orchestrated the so-called 'recourse rule' that was supposed to be an American amendment of the Basel capital standards. This rule steered banks investments into safe assets, encouraging them to fill up their assets with AAA rated, GSE backed, MBSs. The rule offered only a 2% capital requirement for holding a GSE issued MBS, compared to 10% for holding a business loan, for example. This regulatory decision obviously guided banks into filling up their assets with, what was pictured to be, the most safest securities in the eyes of the regulators. European banks did the same thing under Basel international standards - they bought American MBSs (banks in Ireland, Iceland, UK), and most of all sovereign debt of eurozone peripheral countries which was also given high investment grades (banks in France, Germany, Austria, Italy, Spain).
Back to the US. Increased demand for MBSs saw banks issuing more and more mortgages in order for the GSEs (Fanny and Freddie) to repackage them into MBSs and sell them back to banks to fill out their capital requirement. This artificially created demand for MBSs led to an artificially created demand for housing and led the banks to lower lending standards in order to issue more and more mortgage loans. It was a cycle of artificial demand spurred by a regulatory desire to make banks safer.
By acknowledging a regulatory decision such as the recourse rule the paper demystifies greed as the main culprit, since banks and investors were investing into low risk, low yield, AAA securities that turned out to be poorly rated.
The regulators always have the best intentions, but in having a desire to plan and create a stable system, they paradoxically do exactly the opposite and become the drivers of instability and increasing systemic risk.
5) Monetary policy (?) - I evaluate the effects of monetary policy via the Taylor rule.
Here is what I find:
|Source: Federal Reserve Board, Data Download Program, |
(data available at [online] www.federalreserve.gov/datadownload)
and authors own calculations (see Table A in the appendix)
“Between the first quarters of 2002 up until the first quarter of 2006 the Fed was conducting a restrictive monetary policy and the interest rate was too low in comparison with the real economic conditions at the time ... The market was sending signals of an increasing economic activity at the time, to which the Fed should have replied by increasing its interest rate. According to this analysis the Fed disregarded the market signals and continued with an expansionary monetary policy giving an additional boost to the growth of the housing bubble.”
However, “the main assumption of the Taylor rule is that output and inflation are the main policy goals of the Fed. The Fed's main policy goals are stable prices, maximum employment and moderate long-run interest rates, which should eventually lead to a stable output and growth levels."
Although employment was highly correlated with output growth up until the end of the 1990s, recently it started to lag behind output growth. “The once interrelated Fed goals became slightly detached as the Fed experienced political pressures if employment is not at its maximum level, even if output and inflation are at their expected levels.”
Therefore, one could argue that the Fed lowered the policy rates and kept them so low due to a jobless growth following the 2001 recession. "Nonetheless the rates were low enough to create a favourable environment for the bubble growth, but had little to do with its rapid bursting and the fact that the demand on the housing market rose so rapidly."