Name Sabyasachi Dey Subject Macroeconomic Theory and Policy

Roll Number G22034 Assignment Assignment 2 - Individual

U.S Subprime Mortgage Crisis: Policy Reactions

1. Case Background
In the US, during the early 2000s, there was a trend of people with immense credit risk
buying overpriced homes. This resulted in a real estate boom fuelled by financial institutes
giving out mortgages. The reduced interest rates for the buyers and the search for newer
avenues by financial institutes to utilize their liquidity led to a lot of financial innovation
being brought about to make housing options affordable, and incentivize people into
opting for them more. It was not too long when the real estate values started decreasing
and people soon found the mortgage amount for their houses to be more than their home
valuation. The number of defaults on the loans increased as time went by and the lender
financial institutes soon realized the impact of the huge amount of high-risk loans that
were given. Some of the major financial institutes took the brunt of the insolvency and
need relief to sustain themselves. The government of the United States had to step in to
safeguard some of these financial institutes. While some suffered worse. With the news of
the Lehman brothers, one of the premier banks in the USA filing for bankruptcy,
widespread panic was created for the investors leading to a loss of confidence. Nothing
seemed to the work, and the situation spiralled out of control to become one of the worst
financial and economic crises for the country after the Great Depression in the 1930s.
The case discusses the different financial and monetary policies attempted by the
government of the United States and what are the repercussions. A sneak peek is also
provided on how these varied measures to restore the economy of the United States were
evaluated by experts in the industry.

2. Critical issues and challenges

A. Insolvency of Financial Institutes:

There was an increased demand for single houses which prompted quick sales in the
early 2000s. Housing for the borrowers was quite affordable during this boom in the US
housing market. The US subprime mortgage sector greatly benefitted from this. People
with poor or no credit history were given mortgages at higher-than-normal rates, which
they were able to avail themselves of due to the low-interest rates. The financial
institutes fuelled this by bringing in financial innovation to make the market more
lucrative. However, this was done recklessly, especially with schemes like CDOs.

Added to this, the Hedge funds, which were not regulated gave tough competition for
these loans. Everyone wanted to get profit from this boom. Then, when inflation was
evident, the government responded by increasing the interest rate sharply. This led the
borrowers to feel the brunt, as there were no longer able to pay their dues. Defaults
happened in large numbers and subsequent foreclosures happened. The institutes
struggled with buyback demands for the defaulting mortgages. As investors realized the
problem was out of control, panic hit the market and a number of these distressed banks

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Name Sabyasachi Dey Subject Macroeconomic Theory and Policy
Roll Number G22034 Assignment Assignment 2 - Individual

needed help to stay afloat. The government did not help them all, leading to the
bankruptcy of institutes like the Lehman brothers. This further fuelled the panic in the
market and investors became weary of the situation.
B. Fear of Deflation

The expansionary policy of the government increases the growth of the economy by
reducing interest rates in the early 2000s. This helped in the housing boom with more
borrowers taking mortgages to buy properties they may not have earlier. With the
increased demand, the prices of housing started increasing and doubled eventually. To
keep inflation under check, the government increased the interest rate which led to
decreased demand and defaulting, which collapsed the financial institutions. The
government responded with interest rate cuts now. However, with the collapsing
consumer demand, inflation reversed its trend and started moving down rapidly. The
deflation encouraged people to hold off their purchases in hopes of cheaper purchases
later. This led to weak demand and deterred businesses to increase production or make
new investments.
C. Ineffectiveness of Government measures

To combat the situation, the government did try to come up with a number of measures.
From Stimulus packages to nationalizations for financial institutes to bring more
control. But nothing seemed to work. The inducement of more money in the economy
and cutting back interest rates in the hopes of increasing consumption and escaping
deflation did not work. People used the excess money to pay off their debts rather than
increase consumption. The government also tried a bailout program by TARP to
purchase the troubled financial assets and provide the banks with liquidity. However,
the problem seemed to be with the insolvency and the deteriorated confidence in the
market and the financial institutes refrained from lending.

3. Case Analysis and Interpretation

The core of the problem or crisis of the US Subprime mortgage can be attributed to the
expansionary policy of the government targeted at economic growth and the negligent
concern about price stability and inflation. The stance of the government of the United
States was to reduce the interest to stimulate economic growth coupled with the
misjudged duration of such low interest. They neglected the concern for inflation by
keeping the reduced interest for a very long period of time. The decrease in the interest
rates did increase consumption creating what is called the housing bubble or the real
estate bubble. However, with the rapid increase and sustained demand, led to an increase
in the prices of housing to 124%. This increase in demand and subsequent rise in the
prices of assets and commodities gave rise to inflation. The federal government of the
United States realized this too late. Their efforts to increase the interest rates to curb
inflation did more harm than good.
Another root cause of the economic crisis of the United States in the year 2008, more
specifically the US subprime mortgage market was the irresponsible and reckless
business strategy taken by the multiple financial institutes of the United States. The

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Name Sabyasachi Dey Subject Macroeconomic Theory and Policy
Roll Number G22034 Assignment Assignment 2 - Individual

financial institutes had much to gain from the housing lending market. The reduced rate
of interest had left them with a lot of liquidity and the market for Subprime was also
looking good. The borrowers with low or no credit risk scores lined up for loans to
purchase the houses. The financial institutes came up with more risky financial
innovations to capture the market. There was an immense competition within the banks
to do so. Some of them resorted to poor checking measures while dealing out loans and
borrowing. In one of the reports of a research firm, it was found that borrowers with
incomplete information and documentation to prove their income and ability to pay back
surged from 17% to 44%. To add to that, there was increased competition from
investment banks, hedge funds, and other firms involved in the financial innovation
brought about. There was a growing practice of the financial institutes to give out loans
to the borrowers without complete disclosure of all necessary disclosures for the
borrower to understand the complex financial terms and the risks associated with the
borrowing. Hence when the interest rates were increased to curb the price inflation,
borrowers could longer pay their dues. It is evident that the crisis was created by the
bank’s attitudes and mistake of rewarding this risk-taking behaviour by perceiving it as
value creation.
There was no regulation of most of these financial entities. Even during the damage
control measures of the government where thought and nationalization of the banks were
perceived to be an alternative. Questions were raised regarding the interference of the
government and it was said that the laissez-faire market is the best and operates best
when left untouched and un-interfered by the government. The lack of control by the
federal government of the United States in curbing such practices led to this downward
spiral of the situation.
The ineffectiveness of the multiple government initiatives also shows up as a major
contributor to the economic crisis that the United States went through. Sometimes it did
more harm than good.
The government aided the purchase of Bear steam by JP Morgan, the former was debt-
ridden and suffering. The huge amount of money infused by the government contributed
to the moral hazard.
It gave the sense that the government would bail out institutes in case of failure and gave
encouragement for practices. However, the government did not come to aid by bailing
out the Lehman brothers when they filed for bankruptcy. The realization across the
market sank in that nothing is safe. This created panic in the market and very low
confidence in investments.
From the fiscal policy front, the government of the United States launched a stimulus
package worth $150 billion, though it was debated who would bear the brunt of the
measure. However, the timeliness of the implementation of the policy was not
appropriate. The tax rebates were expected to be brought in early summer. The fiscal
package needed to be implemented fast in order to maximize the effect. The government
package was aimed at maintaining a high rate of personal consumption which would not
be feasible. The idea was that low-income consumers would spend the money they saved
from the scheme and help the economy. However, it was misjudged. The people used

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Name Sabyasachi Dey Subject Macroeconomic Theory and Policy
Roll Number G22034 Assignment Assignment 2 - Individual

their savings to pay off their excessive debts instead of spending on consumption. Also,
concerns about the nation’s budget deficit came associated with how long the tax cuts
could be sustained.
The government also tried to fix the financial sector. A big initiative came in the form of
$700 billion financial bailout scheme called the troubled asset relief program. The aim of
the scheme was that the government would buy the toxic assets at their current market
value and provide liquidity to the banks. However, the financial sector did not respond as
thought it would. The issue was not with the liquidity but rather with the insolvency
along with the lack of confidence in the value of bank liabilities. The loan amounts were
perceived to have been worth much lesser than their face value. Thus, the financial
institutions were not persuaded to loan money to other banks. The plan was scrapped
later which shows it was not well thought of before implementation. The next approach
was to directly invest $250 billion into the banks and provide guarantees and insurance
for the new debts issued by the banks. As major banks lined up, the automotive giants
were not left behind. Eventually, only $15 Billion of the proposed amount in the first
trance was left.
The TARP program was not well received as it was seen as a reward to the financial
institutions by recapitalizing them for their irresponsible behaviour. Also, the conditions
on which the funds were extended were negligible. The banks could just keep the money
with them without lending them. That would entirely defeat the purpose.
The administration under president Obama tried to make some improvements by
increasing government spending on expanding unemployment benefits, building new
infrastructure, education spending, and tax relief. The aim was to increase jobs and
disposable income. However, the attempt was marred by political melodrama.
It was still a question if people would spend their tax savings from the reliefs for the
benefit of the economy.
The “Buy American” for public projects was initiated to fuel the economy, however, the
drive was significantly dialled down to comply with the World Trade Organization rules.
The initiative would create only 1000 jobs and become insignificant in comparison with
the labour force size of the United States.
This also brought about the fear of trade wars and was being closely watched by United
States’ biggest trade partners like Canada and China.

4. Justification of Macroeconomic tools

During the case, we see numerous instances of the use of monetary policies and fiscal
policy to be used to combat the financial crisis that was prevailing in the United States of
America. We also see how they have impacted the economy. Hence the use of
macroeconomic tools of fiscal policy and monetary policies (also may be called
Stabilization policies) can be used to analyze the case.
Stabilization policies are used to control the fluctuation in GDP and inflation. Also, the
stabilization policies are not easy to implement, since there is always some time lag

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Name Sabyasachi Dey Subject Macroeconomic Theory and Policy
Roll Number G22034 Assignment Assignment 2 - Individual

associated with the process. It may be the process of recognizing the financial crisis issue
or the lag in between the application or implementation of any policy and the results of the
policy becoming clear. These are called recognition lag, implementation lag, and response
lag. All of this is clearly evident in the case of U.S Subprime mortgage case.
For example, the delayed realization of the issue of inflation and the failure of some of the
policies to bring about the result as desired because of the lag that may not have been
considered appropriately.
The case also talked about the low national savings and deficits. The reduction of the
interest rates and the tax reliefs have impacted them. The use of deficit targeting for the
analysis of the case is also useful and appropriate.

5. Learnings the case

From the case, the urgency and need for vigilance on the part of the governments when
implementing economic measures can be highly appreciated. There is a need for
government to consider all the impacts of the measure being taken and keep a constant
watch on all the impacts, short term, and long term to ensure the desired outcome of any
particular economic measure.
The crisis of the U.S subprime mortgage was aggravated by the reckless practices of the
financial institutes due to the unregulated nature of the market. The need for regulation of
the financial institutes and tools is clearly illustrated by the case. Had there been a
regulation or watch from the government of the United States, the practices could have
been curbed and the situation may not have escalated to the level it went.
Government policies are tools to control the economy or crisis of the economy. However,
if not well thought out during the formation or implementation can do more harm than
good. There is a need for properly targeted policy and timely implementation, or else the
purpose will be defeated.
We also learn there is a lag in the recognition or response to any financial crisis and there
will be some time before the impact of policies to fight those can show results. So while
formation and implementation, this should also be taken into consideration.
The power of the government to control the economy has been clearly understood during
the analysis of the case. The mechanism of the government in terms of fiscal and monetary
policies has an impact on the economy.

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