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Economic Crisis 2008

Economic Crisis 2008

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The Economic Crisis of 2008

Cause and Aftermath
James Gwartney

Prepared by Meghan E. Walker

U.S. housing policies are the root cause of the current financial crisis. Other players-- “greedy” investment bankers; foolish investors;

imprudent bankers; incompetent rating agencies; irresponsible housing speculators; short sighted homeowners; and predatory mortgage brokers, lenders, and borrowers--all played a part, but they were only following the economic incentives that government policy laid out for them.

- Peter J. Wallison

rev200902

The Economic Crisis of 2008: Cause and Aftermath

Slide 2 of 31

Key Events Leading up to the Crisis
• Housing price increase during 2000-2005, followed by a levelling off and price decline • Increase in the default and foreclosure rates beginning in the second half of 2006 • Collapse of major investment banks in 2008

• 2008 collapse of stock prices

rev200902

The Economic Crisis of 2008: Cause and Aftermath

Slide 3 of 31

S and P Case-Schiller Housing Price Index.0% Source: www.0% 10.com. but they began to rise toward the end of the decade. and the housing price declines continued throughout 2007 and 2008. The boom had turned to a bust.standardpoors.0% -10. Annual Existing House Price Change 20. housing prices increased by a whopping 87 percent. housing prices were approximately 25 percent below their 2006 peak.0% -20. rev200902 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 The Economic Crisis of 2008: Cause and Aftermath Slide 4 of 31 .Exhibit 1: House Price Change • • • • Housing prices were relatively stable during the 1990s.0% 5.0% 0.0% -5. Between January 2002 and mid-year 2006.0% -15. By the third quarter of 2008.0% 15.

within a narrow range. 1990. The rate began increasing sharply during the second half of 2006 It reached 5.2 percent during the third quarter of 2008. around 2 percent prior to 2006. National Delinquency Survey.org. and 2001. The Economic Crisis of 2008: Cause and Aftermath Slide 5 of 31 .Exhibit 2a: The Default Rate • • • • The default rate fluctuated. It increased only slightly during the recessions of 1982. Default Rate 6% 5% 4% 3% 2% 1% 0% rev200902 19 79 19 80 19 81 19 82 19 84 19 85 19 86 19 87 19 89 19 90 19 91 19 92 19 94 19 95 19 96 19 97 19 99 20 00 20 01 20 02 20 04 20 05 20 06 20 07 Source: mbaa.

4% 1. and the housing price declines continued throughout 2007 and 2008. housing prices increased by a whopping 87 percent. but they began to rise toward the end of the decade.2% 1.8% 0.0% Source: www. housing prices were approximately 25 percent below their 2006 peak. By the third quarter of 2008. National Delinquency Survey.0% 0.mbaa.6% 0.org.4% 0. The boom had turned to a bust. rev200902 19 79 19 80 19 81 19 82 19 84 19 85 19 86 19 87 19 89 19 90 19 91 19 92 19 94 19 95 19 96 19 97 19 99 20 00 20 01 20 02 20 04 20 05 20 06 20 07 The Economic Crisis of 2008: Cause and Aftermath Slide 6 of 31 .2% 0. Foreclosure Rate 1.Exhibit 2b: Foreclosure Rate • • • • Housing prices were relatively stable during the 1990s. Between January 2002 and mid-year 2006.

Exhibit 3: Stock Market Returns • • • As of mid-December of 2008. This is nearly twice the magnitude of any year since 1950. S and P 500 Total Return 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% 19 50 19 53 19 56 19 59 19 62 19 65 19 68 19 71 19 74 19 77 19 80 19 83 19 86 19 89 19 92 19 95 19 98 20 01 20 04 Source: www. stock returns were down by 37 percent since the beginning of the year. This collapse eroded the wealth and endangered the retirement savings of many Americans.standardpoors.com rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 7 of 31 20 07 .

rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 8 of 31 .Key Questions About the Crisis of 2008 • Why did housing prices rise rapidly and then fall? • Why did the mortgage default and housing foreclosure rates begin to increase more than a year before the recession of 2008 started? • Why are the recent default and foreclosure rates so much higher than at any time during the 1980s and 1990s? • Why did investment banks like Bear Stearns and Lehman Brothers run into financial troubles so quickly? • Four factors provide the answers to all of these questions.

What Caused the Crisis of 2008? FACTOR 1: Beginning in the mid-1990s. • 1995 regulations stemming from an extension of the Community Reinvestment Act required banks to extend loans in proportion to the share of minority population in their market area. government regulations began to erode the conventional lending standards. • HUD regulations imposed in 1999 required Fannie and Freddie to accept more loans with little or no down payment. • Beginning in 1995. rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 9 of 31 . Conventional lending standards were reduced to meet these goals. • Fannie Mae and Freddie Mac hold a huge share of American mortgages. HUD regulations required Fannie Mae and Freddie Mac to increase their holdings of loans to low and moderate income borrowers.

ofheo. Freddie Mac/Fannie Mae Share of Outstanding Mortgages 50% 45% 40% 35% 30% 25% 20% 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 Source: Office of Federal Housing Enterprise Oversight.Exhibit 4: Fannie Mae/Freddie Mac Share • • The share of all mortgages held by Fannie Mae and Freddie Mac rose from 25 percent in 1990 to 45 percent in 2001. rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 10 of 31 20 08 .gov. www. Their share has fluctuated modestly around 45 percent since 2001.

0% 0.0% 15.1: Subprime Mortgages • Subprime mortgages as a share of total mortgages originated during the year. increased from 5% in 1994 to 13% in 2000 and on to 20% in 2004-2006. Subprime Mortgage Originations as a Share of Total 25.0% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Subprime (FRB) Subprime (JCHS) Source: Data from 1994-2003 is from the Federal Reserve Board while 2001-2007 is from the Joint Center for Housing Studies at Harvard University rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 11 of 31 .Exhibit 4.0% 10.0% 20.0% 5.

and Home Equity • • Like subprime. subprime. and home equity loans accounted for almost half of the mortgages originated during the year. Alt-A. Alt-A and home equity loans have increased substantially as a share of the total since 2000. Subprime. Alt-A. In 2006.Exhibit 4. and Home Equity as a Share of Total 50% 40% 30% 20% 10% 0% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Subprime (FRB) Subprime (JCHS) Subprime + Alt-A Subprime + Alt-A + Home Equity Source: Data from 1994-2003 is from the Federal Reserve Board while 2001-2007 is from the Joint Center for Housing Studies at Harvard University rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 12 of 31 . Alt-A.2: Subprime.

and price of. and defaults soared. housing.What Caused the Crisis of 2008? FACTOR 2: The Fed’s manipulation of interest rates during 2002-2006 • Fed's prolonged Low-Interest Rate Policy of 2002-2004 increased demand for. rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 13 of 31 . adjustable rates were soon reset. housing prices began to fall. • The low short-term interest rates made adjustable rate loans with low down payments highly attractive. • As the Fed pushed short-term interest rates upward in 2005-2006. monthly payment on these loans increased.

Federal Funds Rate and 1-Year T-Bill Rate 8% 7% 6% 5% 4% 3% 2% 1% 0% rev200902 19 95 19 95 19 96 19 96 19 97 19 97 19 98 19 99 19 99 20 00 20 00 20 01 20 02 20 02 20 03 20 03 20 04 20 04 20 05 20 06 20 06 20 07 20 07 20 08 Federal Funds Source: www. Due to rising inflation in 2005. Interest rates on adjustable rate mortgages rose and the default rate began to increase rapidly.Exhibit 5: Short-Term Interest Rates • • • The Fed injected additional reserves and kept short-term interest rates at 2% or less throughout 2002-2004. the Fed pushed interest rates upward.federalreserve.com 1 year T-bill The Economic Crisis of 2008: Cause and Aftermath Slide 14 of 31 .gov and www.economagic.

ofheo.gov. rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 15 of 31 20 08 . Adjustable Rate Mortgages (ARMs) increased sharply. www. ARM Loans Outstanding 25% 20% 15% 10% 5% 0% 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 Source: Office of Federal Housing Enterprise Oversight. Measured as a share of total mortgages outstanding.Exhibit 5. ARMs increased from 10% in 2000 to 21% in 2005.1: ARM Loans Outstanding • • Following the Fed's low interest rate policy of 2002-2004.

But this was no longer true because regulations had seriously eroded the lending standards and the low interest rates of 2002-2004 had increased the share of ARM loans with little or no down payment. when bundled together and financed with securities. • When default rates increased in 2006 and 2007. the highly leveraged investment banks soon collapsed. and as much as 60 to 1. • The rule favored lending for residential housing. rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 16 of 31 . • Based on historical default rates.What Caused the Crisis of 2008? FACTOR 3: An SEC Rule change adopted in April 2004 led to highly leverage lending practices by investment banks and their quick demise when default rates increased. • Loans for residential housing could be leveraged by as much as 25 to 1. mortgage loans for residential housing were thought to be safe.

5 31.2: Leverage Ratios • • The leverage ratios of loans and other investments to capital assets for various financial institutions are shown here. Note. this was not particularly unusual for the GSEs and large investment banks.S.Exhibit 5. Mortgage and Credit Markets: A Comprehensive Analysis of the Meltdown.4 9.9 Source: The Rise and Fall of the U. Milken Institute rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 17 of 31 .8 9.6 67. When Bear Stearns was acquired by JP Morgan Chase its leverage ratio was 33 to 1.1 20 40 60 80 21. Leverage Ratios (June 2008)‫‏‬ Freddie Mac Fannie Mae Brokers/hedge Funds Savings institutions Commercial banks Credit unions 0 9.

• Because interest on housing loans was tax deductible. By 2007. • Interest on household debt also increased substantially. the debt-toincome ratio of households had increased to 135 percent. • The heavy indebtedness of households meant they had no leeway to deal with unexpected expenses or rising mortgage payments. households had an incentive to wrap more of their debt into housing loans.What Caused the Crisis of 2008? FACTOR 4: Doubling of the Debt/Income Ratio of Households since the mid-1980s. • The debt-to-income ratio of households was generally between 45 and 60 percent for several decades prior to the mid 1980s. rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 18 of 31 .

the debt-to-income ratio of households has been climbing at an alarming rate. household debt as a share of disposable (after-tax) income ranged from 40 percent to 60 percent. However. since the early 1980s. It reached 135 percent in 2007. Household Debt to Disposable Personal Income Ratio 140% 120% 100% 80% 60% 40% 20% Source: www.Exhibit 6a: Household Debt as a Share of Income • • • Between 1950-1980.com rev200902 19 53 19 55 19 58 19 60 19 63 19 65 19 68 19 70 19 73 19 75 19 78 19 80 19 83 19 85 19 88 19 90 19 93 19 95 19 98 20 00 20 03 20 05 20 08 The Economic Crisis of 2008: Cause and Aftermath Slide 19 of 31 . more than twice the level of the mid-1980s.economagic.

economagic. Debt Payments to Disposable Personal Income Ratios 16% 14% 12% 10% 8% 6% Source: www. up from about 10 percent in the early 1980s.com rev200902 19 80 19 81 19 82 19 83 19 85 19 86 19 87 19 88 19 90 19 91 19 92 19 93 19 95 19 96 19 97 19 98 20 00 20 01 20 02 20 03 20 05 20 06 20 07 Total Debt Mortgage The Economic Crisis of 2008: Cause and Aftermath Slide 20 of 31 .Exhibit 6b: Debt Payments as a Share of Income • Today. interest payments consume nearly 15 percent of the after-tax income of American households.

NJ: Transaction Publishers. 13 in Randall G. Stan J. Housing America: Building Out of a Crisis (New Brunswick.Exhibit 7a: Foreclosure Rates on Subprime • Compared to their prime borrower counterparts. “Anatomy of a Train Wreck: Causes of the Mortgage Meltdown. rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 21 of 31 20 07 . eds. there was a sharp increase in the adjustable rate mortgage foreclosure rate. 2009 (forthcoming) We would like to thank Professor Liebowitz for making this data available to us. the foreclosure rate for subprime borrowers is approximately 10 times higher for fixed rate mortgages and 7 times higher for adjustable rate mortgages.” Ch. Starting in 2006.. There was no trend in the foreclosure rate prior to 2006 for adjustable rate or fixed rate mortgages. Holcombe and Be njamin Powell. Foreclosure Rates on Subprime Mortgages 6% 5% 4% 3% 2% 1% 0% • • 19 98 19 98 19 99 19 99 20 00 20 00 20 01 20 01 20 02 20 02 20 03 20 03 20 04 20 04 20 05 20 05 20 06 20 06 20 07 Fixed Adjustable Source: Liebowitz.

Holcombe and Be njamin Powell. Housing America: Building Out of a Crisis (New Brunswick. “Anatomy of a Train Wreck: Causes of the Mortgage Meltdown. the foreclosures on adjustable rate mortgages began to soar in the second half of 2006.6% 0.2% 0. 2009 (forthcoming) We would like to thank Professor Liebowitz for making this data available to us.Exhibit 7b: Foreclosure Rates on Prime • • While the foreclosure rate on fixed rate mortgages was relatively constant. Foreclosure Rates on Prime Mortgages 1.4% 0. Stan J. This was true for both prime and subprime loans.0% 19 98 19 98 19 99 19 99 20 00 20 00 20 01 20 01 20 02 20 02 20 03 20 03 20 04 20 04 20 05 20 05 20 06 20 06 20 07 Fixed Adjustable Source: Liebowitz.” Ch.0% 0. rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 22 of 31 20 07 .8% 0.2% 1. NJ: Transaction Publishers. 13 in Randall G. eds..

rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 23 of 31 .Fixed vs. • In contrast. the default and foreclosure rates on adjustable rate mortgages soared during 2007 and 2008 for both prime and sub-prime borrowers. Variable Rate Mortgages • Default and foreclosure rates on fixed interest rate mortgages did not rise much in 2007 and 2008. and the Fed's interest rate policies of 2002-2006 was disastrous. adjustable rate loans. This was true for loans to both prime and subprime borrowers. • The combination of lower lending standards. • Incentives matter and perverse incentives created the crisis of 2008.

Are We Headed Toward Another Great Depression? • Are the current conditions unprecedented? • How do the current conditions compare with the Great Depression? rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 24 of 31 .

6% 1980-82 1990-91 2007-? rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 25 of 31 .0% 8.gov 9.Exhibit 8a: Unemployment in Recent Severe Recessions • • • At the end of January 2009. 7 percent for almost two years. the unemployment rate rose to nearly 8 percent and it remained at. and to 10. The unemployment rate rose to 9. This is not unprecedented.0% 10.8 percent during the 1980-1982 recession.0% 6.6 percent and it will surely go higher.0% 2.8% 7.0% 4.0% 1973-75 Source: www.bls. or near. Peak Monthly Unemployment Rates in Recent Severe Recessions 12.6 percent during the 1974-75 recession.0% 7.0% 0.8% 10. Even during the relatively short recession of 1990-1991. the unemployment rate was 7.

The Statistical History of the United States from Colonial Times to the Present (New York: Basic Books.Exhibit 8b: Great Depression Unemployment • • The unemployment rate soared to nearly 25 percent during 1933. Unemployment Rates During the Great Depression 30% 25% 20% 16% 15% 10% 5% 0% 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 25% 22% 20% 17% 14% 19% 17% 24% 9% Source: Bureau of the Census. 1976) rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 26 of 31 . The unemployment rate was 14 percent or more every year throughout 1931-1939.

Lessons From the Great Depression Avoid these policies: • Monetary contraction • Trade restrictions • Tax increases • Constant changes in policy. rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 27 of 31 . this merely creates uncertainty and delays private sector recovery.

The recent policies of the Bush Administration illustrate this point. rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 28 of 31 . • Danger: Frequent policy changes will retard recovery. • Various types of stimulus packages are not likely to be very effective.This Recession is Likely to be Lengthy • It will take time for the malinvestments to be corrected and for households to improve their personal financial situation.

There will be no repeat of the Great Depression. President Obama and Congress should announce that: i. The keys to sound policy are well-defined property rights. but neither will there be a repeat of the 1970s. In the future. control of government spending. neutral treatment of both people and enterprises. 2. 3. The mistakes of the 1930s will not be repeated. open markets. The Fed needs to announce it will follow a stable course in the future. low taxes.What Needs to be Done? 1. Monetary policy is way off track. and above all. government spending will be controlled and the deficit reduced. rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 29 of 31 . Since the late 1990s it has been on a stop-and-go course that generates instability. monetary and price stability. including the uncertainty generated by the frequent policy changes that characterized the New Deal. ii.

• During the Great Depression era.Crisis of Markets or a Crisis of Politics? • Are the current conditions unprecedented? • Both the Great Depression and the current crisis are the result of perverse policies. Will the same thing happen this time? The answer to this question will determine the future economic status of Americans. rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 30 of 31 . disastrous policies led to a huge expansion in the size and role of government.

END rev200902 The Economic Crisis of 2008: Cause and Aftermath Slide 31 of 31 .

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