GREAT RECESSION

2007 – 09:
AMACROECONOMIC
DISASTER REVISITED

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 “U.S. housing policies are the root cause of the
current financial crisis. Other players - “greedy”
Introduction
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
WALLISON, PETER J., “CAUSE AND EFFECT: GOVERNMENT POLICIES AND THE FINANCIAL CRISIS,” AEI FINANCIAL SERVICES
OUTLOOK: HTTPS://WWW.TANDFONLINE.COM/DOI/PDF/10.1080/08913810902934158?NEEDACCESS=TRUE 2
Jul ’06: Home prices Oct ‘09 – Dec ‘10:
peak. Unemployment rate peaks
Apr ’07: NCFC files for at 10%; Dodd Frank;
bankruptcy. Foreclosures peak.

Dec ’07: Recession. Aug ‘11: S&P downgrade.

phenomenon
Unemployment Rate at Sep ‘12: Unemployment at
5%. Fed creates TAF. 8%, lowest since Jan ’09.

onset Feb – Sep ’08: ESA; Lehman Brothers

bankruptcy; FNMA & FMCC takeover; aftermath
BSC collapse; AIG bailout.
Oct – Dec ’08: TARP; TALF; bailout of
giants.
Feb – Jun ‘09: $787B stimulus
package; Recession ends.

“TIMELINE ON THE GREAT RECESSION”, THE CHRISTIAN SCIENCE MONITOR, SEP 8, 2013. AVAILABLE AT:
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HTTPS://WWW.CSMONITOR.COM/BUSINESS/2013/0908/TIMELINE-ON-THE-GREAT-RECESSION
 Key episodes
• Housing price • Rise in ‘teaser’ rate • Foreclosures, fall
increase (2000 – subprime in house prices
06) followed by a mortgages; jump and losses on loan
levelling off and from 8% (2001) to defaults hit the
price decline. 21% (2005). financial markets.

• Securitization a • Investors and • Federal

major financial financial regulators government
innovation; shift fail to act on commits $7.5T in
from originate-to- numerous warning loans, guarantees
hold model to signals that the and bailouts to
originate-to- housing market is address credit
distribute model. overheated. crunch and
liquidity freeze.

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 Annual Existing House Price Change
• Housing prices were relatively stable during
the 1990s, but they began to rise toward
the end of the decade.

• Between January 2002 and mid-year 2006,

housing prices increased at a whopping
rate.

• The boom had turned to a bust, and the

housing price declines continued
throughout 2007 and 2008.

• By the third quarter of 2008, housing prices

were approximately 25 percent below their
2006 peak.

Source: www.standardpoors.com, S&P Case-Schiller Housing Price Index.

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 Default Rate

• The default rate fluctuated, within a

narrow range, around 2 percent prior to
2006.

• It increased only slightly during the

recessions of 1982, 1990, and 2001.
• The rate began increasing sharply during
the second half of 2006

• It reached 5.2 percent during the third

quarter of 2008.

Source: mbaa.org, National Delinquency Survey.

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 S&P500 Total Return
• As of mid-December of 2008, stock returns
were down by 37 percent since the
• As of mid-December of 2008, stock returns
beginning of the year.
were down by 37 percent since the
beginning of the year.
• This is nearly twice the magnitude of any
• This
yearissince
nearly twice the magnitude of any
1950.
year since 1950.
•• This collapse
collapseeroded
erodedthe
thewealth
wealthand
and
endangered
endangeredthe theretirement
retirementsavings ofof many
savings
many Americans.
Americans.

Source: www.standardpoors.com

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what went wrong?
Causes of Crisis

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 Subprime Mortgages
FACTOR 1: Beginning in the mid-1990s,
• As of mid-December
government regulations of
began
2008,tostock
erodereturns
the
conventional
were down lending standards.
by 37 percent since the
25.0%
• FNMA and
beginning FMCC
of the year.hold a huge share of
American mortgages.
20.0%
• This is nearly twice the magnitude of any
15.0%
• HUD
year sinceregulations
1950. required FNMA and
10.0% FMCC to increase their holdings of
loans to low and moderate income
5.0%
• Thisborrowers
collapse eroded the wealth and
(1995) and them to accept
0.0%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
endangered the retirement
more loans savings
with little or of many
no down
Subprime (FRB) Subprime (JCHS) payment (1999)
Americans.

• Subprime mortgages as a share of

total mortgages, increased from 5%
(1994) to 13% (2000) and to 20%
Source: Federal Reserve Board while 2001-2007 & Joint Centre for Housing Studies at
Harvard University (2004-2006).
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 Manipulation of Interest Rates
FACTOR 2: The Fed’s manipulation of interest
•rates
As during
of mid-December
2002-2006.
of 2008, stock returns
were down by 37 percent since the
• Fed's prolonged Low-Interest Rate
beginning of2002-2004
Policy of the year. increased demand
for, and price of, housing.
• This is nearly twice the magnitude of any
• The
year sincelow short-term interest rates
1950.
made adjustable rate loans with low
• Thisdown payments
collapse erodedhighly attractive.
the wealth and
endangered the retirement savings of many
• As the Fed pushed short-term interest
Americans.
rates upward in 2005-2006, adjustable
rates were soon reset, monthly
payment on these loans increased,
housing prices began to fall, and
defaults soared.
Source: www.federalreserve.gov and www.economagic.com

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 Leveraged Lending Practices
FACTOR 3: An SEC Rule change adopted in
•April 2004
As of led to highly
mid-December leverage
of 2008, stocklending
returns
practices
were downby investment banksthe and
by 37 percent since
their quick of
beginning demise when default rates
the year.
increased.
• The
• This ruletwice
is nearly favoured lendingof any
the magnitude for
yearresidential
since 1950.housing.

• Loans for residential housing could be

• Thisleveraged
collapse eroded the wealth and
by as much as 25 to 1, and
endangered
as much the
as retirement savings
60 to 1, when of many
bundled
together and financed with securities.
Americans.

• When default rates increased in 2006

and 2007, the highly leveraged
investment banks soon collapsed.
Source: www.federalreserve.gov and www.economagic.com

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 Household Debt Explosion
FACTOR 4: Doubling of
• As of mid-December the Debt/Income
of 2008, stock returns
Ratio of Households
were down by 37since the since
percent mid-1980s.
the
• From 45
beginning of–the
60 year.
% in the mid-1980s, the
140%
debt-to-income ratio of households
120%
soared to 135% (2007) and so did the
100%
• Thisinterest
is nearly twice the magnitude of any
rates.
year since 1950.
80%

60%
• Because interest on housing loans was
• Thistax deductible,
collapse eroded households had an
the wealth and
incentive the
to wrap more savings
of their of
debt
40%
endangered retirement many
20%
into housing loans.
Americans.
53 955 958 960 963 965 968 970 973 975 978 980 983 985 988 990 993 995 998 000 003 005 008
19 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2

• The heavy indebtedness of households

meant they had no leeway to deal with
unexpected expenses or rising
Source: www.federalreserve.gov and www.economagic.com mortgage payments.
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Behind the crisis

VERICK, SHER AND ISLAM, IYANATUL, THE GREAT RECESSION OF 2008-2009: CAUSES,
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CONSEQUENCES AND POLICY RESPONSES. IZA DISCUSSION PAPER NO. 4934.
 Policy Recommendations
• US banking and • Toward preventing • Formal exchange
financial regulation crisis; greater for CDS; clearing
is multilayered and emphasis on credit houses to cover
overlapping; in dire and capital losses; mark-to-
need of leverage. market pricing.
streamlining.
• Regulators must • Covered bonds as • New approaches to
develop most a complement to promote home
appropriate mix of securitizing ownership such as
private and govt. mortgages; shared equity
responses taking recourse to programs, down
moral hazard originators and payment assistance
issues into lenders. and community
account. land trusts.

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what did we do?
Course Correction

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References:
• Verick, Sher and Islam, Iyanatul, The Great Recession of 2008-2009: Causes, Consequences and Policy Responses. IZA
Discussion Paper No. 4934. Available at SSRN: https://ssrn.com/abstract=1631069.

• Barth, James R. and Li, Tong and Lu, Wenling and Phumiwasana, Triphon and Yago, Glenn, The Rise and Fall of the
U.S. Mortgage and Credit Markets: A Comprehensive Analysis of the Meltdown. Available at
SSRN: https://ssrn.com/abstract=1334936

Suggested Viewings:
• Money, Power and Wall Street, a four-part investigation that tells the story of Great Recession 2007 – 09 produced
by PBS Frontline. Available at: https://www.pbs.org/wgbh/frontline/film/money-power-wall-street/

• Inside Job, a documentary that won the 2010 Academy Award for Best Documentary Feature on the subject of how
the financial services industry fueled the crisis.

• Atif Mian and Amir Sufi, House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent
It from Happening Again. Available at:
https://www.press.uchicago.edu/ucp/books/book/chicago/H/bo20832545.html

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