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THE ECONOMIC CRISISOF 2008
Rupesh Chandra
BBA VIth TermSBS
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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 onlyfollowing the economic incentives that government policy laid out for
them.
- Peter J. Wallison
School of Business Studies, Sharda University, Greater Noida, U.P, India
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KEY EVENTS LEADINGUPTOTHE CRISIS
Housing price increase during 2000-2005, followed by a levelling off and pricedecline
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
School of Business Studies, Sharda University, Greater Noida, U.P, India
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School of Business Studies, Sharda University, Greater Noida, U.P, India
Source: www.standardpoors.com, S and P Case-Schiller Housing Price Index.
Housing prices were relatively stable during the 1990s, but they began to risetoward the end of the decade.
Between January 2002 and mid-year 2006, housing prices increased by awhopping 87 percent.
The boom had turned to a bust, and the housing price declines continuedthroughout 2007 and 2008.
By the third quarter of 2008, housing prices were approximately 25 percent belowtheir 2006 peak.
HOUSE PRICE CHANGE
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
-20.0%
-15.0%
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
Annual Existing House Price Change
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School of Business Studies, Sharda University, Greater Noida, U.P, India
Default Rate
Source: mbaa.org, National Delinquency Survey.
1979
1980
1981
1982
1984
1985
1986
1987
1989
1990
1991
1992
1994
1995
1996
1997
1999
2000
2001
2002
2004
2005
2006
2007
0%
1%
2%
3%
4%
5%
6%
The default rate fluctuated, within a narrow range, around 2 percentprior to 2006.
It increased only slightly during the recessions of 1982, 1990, and2001.
The rate began increasing sharply during the second half of 2006
It reached 5.2 percent during the third quarter of 2008.
THE DEFAULT RATE
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FORECLOSURE RATE
Housing prices were relatively stable during the 1990s, but they began to risetoward the end of the decade.
Between January 2002 and mid-year 2006, housing prices increased by awhopping 87 percent.
The boom had turned to a bust, and the housing price declines continuedthroughout 2007 and 2008.
By the third quarter of 2008, housing prices were approximately 25 percent below
their 2006 peak.
School of Business Studies, Sharda University, Greater Noida, U.P, India
Foreclosure Rate
Source: www.mbaa.org, National Delinquency Survey.
1979
1980
1981
1982
1984
1985
1986
1987
1989
1990
1991
1992
1994
1995
1996
1997
1999
2000
2001
2002
2004
2005
2006
2007
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
1.4%
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STOCK MARKET RETURNS
School of Business Studies, Sharda University, Greater Noida, U.P, India
Total Return
Source: www.standardpoors.com
1950
1953
1956
1959
1962
1965
1968
1971
1974
1977
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
As of mid-December of 2008, stock returns were down by 37percent since the beginning of the year.
This is nearly twice the magnitude of any year since 1950.
This collapse eroded the wealth and endangered the retirementsavings of many Americans.
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8/31School of Business Studies, Sharda University, Greater Noida, U.P, India
Why did housing prices rise rapidly and then fall?
Why did the mortgage default and housing foreclosure rates begin toincrease more than a year before the recession of 2008 started?
Why the default and foreclosure rates were so much higher during 2007-
2008?
Why did investment banks like Bear Stearns and Lehman Brothers run
into financial troubles so quickly?
KEY QUESTIONS ABOUTTHE CRISISOF 2008
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WHAT CAUSEDTHE CRISISOF 2008?
FACTOR 1: Beginning in the mid-1990s, government regulations beganto erode the conventional lending standards.
Fannie Mae and Freddie Mac hold a huge share of American mortgages.
Beginning in 1995, HUD regulations required Fannie Mae and FreddieMac to increase their holdings of loans to low and moderate incomeborrowers.
HUD regulations imposed in 1999 required Fannie and Freddie to accept
more loans with little or no down payment. 1995 regulations stemming from an extension of the Community
Reinvestment Act required banks to extend loans in proportion to theshare of minority population in their market area. Conventional lendingstandards were reduced to meet these goals.
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GreaterNoida,U.P,Ind
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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 in2001.
Their share has fluctuated modestly around 45 percentsince 2001.
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GreaterNoida,U.P,Ind
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Freddie Mac/Fannie Mae Share of Outstanding Mortgages
Source: Office of Federal Housing Enterprise Oversight, www.ofheo.gov.
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
20%
25%
30%
35%
40%
45%
50%
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EXHIBIT 4.1: SUBPRIME MORTGAGES
Subprime mortgages as a share of total mortgagesoriginated during the year, increased from 5% in 1994 to
13% in 2000 and on to 20% in 2004-2006.
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usinessStudies,Shard
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University,
GreaterNoida,U.P,India
Subprime Mortgage Originations as a Share of Total
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
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
Subprime (FRB) Subprime (JCHS)
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EXHIBIT 4.2: SUBPRIME, ALT-A, AND HOME EQUITY
Like subprime, Alt-A and home equity loans haveincreased substantially as a share of the total since 2000.
In 2006, subprime, Alt-A, and home equity loansaccounted for almost half of the mortgages originatedduring the year.
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usinessStudies,Shard
a
University,
GreaterNoida,U.P,India
Subprime, Alt-A, and Home Equity as a Share of Total
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
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
0%
10%
20%
30%
40%
50%
Subprime (FRB) Subprime (JCHS) Subprime + Alt-A Subprime + Alt-A + HomeEquity
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WHAT CAUSEDTHE CRISISOF 2008?
FACTOR 2:The Feds manipulation of interest rates during 2002-2006
Fed's prolonged Low-Interest Rate Policy of 2002-2004 increased demandfor, and price of, housing.
The low short-term interest rates made adjustable rate loans with lowdown payments highly attractive.
As the Fed pushed short-term interest rates upward in 2005-2006,adjustable rates were soon reset, monthly payment on these loans
increased, housing prices began to fall, and defaults soared.
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EXHIBIT 5: SHORT-TERM INTEREST RATES
The Fed injected additional reserves and kept short-terminterest rates at 2% or less throughout 2002-2004.
Due to rising inflation in 2005, the Fed pushed interest ratesupward.
Interest rates on adjustable rate mortgages rose and the defaultrate began to increase rapidly.
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SchoolofB
usinessStudies,Shard
a
University,
GreaterNoida,U.P,India
Federal Funds Rate and 1-Year T-Bill Rate
Source: www.federalreserve.gov and www.economagic.com
1995
1995
1996
1996
1997
1997
1998
1999
1999
2000
2000
2001
2002
2002
2003
2003
2004
2004
2005
2006
2006
2007
2007
2008
0%
1%
2%
3%
4%
5%
6%
7%
8%
Federal Funds 1 year T-bill
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EXHIBIT 5.1: ARM LOANS OUTSTANDING
Following the Fed's low interest rate policy of 2002-2004,Adjustable Rate Mortgages (ARMs) increased sharply.
Measured as a share of total mortgages outstanding,ARMs increased from 10% in 2000 to 21% in 2005.
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usinessStudies,Shard
a
University,
GreaterNoida,U.P,India
ARM Loans Outstanding
Source: Office of Federal Housing Enterprise Oversight, www.ofheo.gov.
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
0%
5%
10%
15%
20%
25%
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WHAT CAUSEDTHE CRISISOF 2008?
FACTOR 3: An SEC Rule change adopted in April 2004 led to highlyleverage lending practices by investment banks and their quick demise
when default rates increased.
The rule favored lending for residential housing.
Loans for residential housing could be leveraged by as much as 25 to 1,and as much as 60 to 1, when bundled together and financed withsecurities.
Based on historical default rates, mortgage loans for residential housingwere thought to be safe. But this was no longer true because regulationshad seriously eroded the lending standards and the low interest rates of2002-2004 had increased the share of ARM loans with little or no downpayment.
When default rates increased in 2006 and 2007, the highly leveragedinvestment banks soon collapsed.
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EXHIBIT 5.2: LEVERAGE RATIOS
The leverage ratios of loans and other investments to capitalassets for various financial institutions are shown here.
When Bear Stearns was acquired by JP Morgan Chase itsleverage ratio was 33 to 1. Note, this was not particularlyunusual for the GSEs and large investment banks.
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SchoolofB
usinessStudies,Shard
a
University,
GreaterNoida,U.P,India
Leverage Ratios (June 2008)
Source: The Rise and Fall of the U.S. Mortgage and Credit Markets: A Comprehensive Analysis of the Meltdown, Milken Institute
Credit unions
Commercial banks
Savings institutions
Brokers/hedge Funds
Fannie Mae
Freddie Mac
0 20 40 60 80
67.9
21.5
31.6
9.4
9.8
9.1
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WHAT CAUSEDTHE CRISISOF 2008?
FACTOR 4: Doubling of the Debt/Income Ratio of Households since themid-1980s.
The debt-to-income ratio of households was generally between 45 and 60percent for several decades prior to the mid 1980s. By 2007, the debt-to-income ratio of households had increased to 135 percent.
Interest on household debt also increased substantially.
Because interest on housing loans was tax deductible, households had an
incentive to wrap more of their debt into housing loans. The heavy indebtedness of households meant they had no leeway to deal
with unexpected expenses or rising mortgage payments.
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EXHIBIT 6A: HOUSEHOLD DEBTASA SHAREOF INCOME
Between 1950-1980, household debt as a share of disposable(after-tax) income ranged from 40 percent to 60 percent.
However, since the early 1980s, the debt-to-income ratio ofhouseholds has been climbing at an alarming rate.
It reached 135 percent in 2007, more than twice the level of themid-1980s.
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SchoolofB
usinessStudies,Shard
a
University,
GreaterNoida,U.P,India
Household Debt to Disposable Personal Income Ratio
Source: www.economagic.com
1953
1955
1958
1960
1963
1965
1968
1970
1973
1975
1978
1980
1983
1985
1988
1990
1993
1995
1998
2000
2003
2005
2008
20%
40%
60%
80%
100%
120%
140%
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EXHIBIT 6B: DEBT PAYMENTSASA SHAREOF INCOME
Today, interest payments consume nearly 15 percent of
the after-tax income of American households, up fromabout 10 percent in the early 1980s.
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usinessStudies,Shard
a
University,
GreaterNoida,U.P,India
Debt Payments to Disposable Personal Income Ratios
Source: www.economagic.com
1980
1981
1982
1983
1985
1986
1987
1988
1990
1991
1992
1993
1995
1996
1997
1998
2000
2001
2002
2003
2005
2006
2007
6%
8%
10%
12%
14%
16%
Total Debt Mortgage
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EXHIBIT 7A: FORECLOSURE RATESON SUBPRIME
Compared to their prime borrower counterparts, the
foreclosure rate for subprime borrowers is approximately10 times higher for fixed rate mortgages and 7 timeshigher for adjustable rate mortgages.
There was no trend in the foreclosure rate prior to 2006 foradjustable rate or fixed rate mortgages.
Starting in 2006, there was a sharp increase in theadjustable rate mortgage foreclosure rate.
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usinessStudies,Sharda
University,
GreaterNoida,U.P,India
Foreclosure Rates on Subprime Mortgages
Source: Liebowitz, Stan J., Anatomy of a Train Wreck: Causes of the Mortgage Meltdown, Ch. 13 in Randall G. Holcombe and Benjamin Powell, eds, Housing America: BuildingOut of a Crisis(New Brunswick, NJ: Transaction Publishers, 2009 (forthcoming) We would like to thank Professor Liebowitz for making this data available to us.
1998
1998
1999
1999
2000
2000
2001
2001
2002
2002
2003
2003
2004
2004
2005
2005
2006
2006
2007
2007
0%
1%
2%
3%
4%
5%
6%
Fixed Adjustable
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EXHIBIT 7B: FORECLOSURE RATESON PRIME
While the foreclosure rate on fixed rate mortgages was
relatively constant, the foreclosures on adjustable ratemortgages began to soar in the second half of 2006.
This was true for both prime and subprime loans.
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SchoolofB
usinessStudies,Sharda
University,
GreaterNoida,U.P,India
Foreclosure Rates on Prime Mortgages
Source: Liebowitz, Stan J., Anatomy of a Train Wreck: Causes of the Mortgage Meltdown, Ch. 13 in Randall G. Holcombe and Benjamin Powell, eds, Housing America: BuildingOut of a Crisis(New Brunswick, NJ: Transaction Publishers, 2009 (forthcoming) We would like to thank Professor Liebowitz for making this data available to us.
1998
1998
1999
1999
2000
2000
2001
2001
2002
2002
2003
2003
2004
2004
2005
2005
2006
2006
2007
2007
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
Fixed Adjustable
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FIXEDVS. VARIABLE RATE MORTGAGES
Default and foreclosure rates on fixed interest rate mortgages did not risemuch in 2007 and 2008. This was true for loans to both prime and sub-
prime borrowers.
In contrast, the default and foreclosure rates on adjustable rate
mortgages soared during 2007 and 2008 for both prime and sub-prime
borrowers.
The combination of lower lending standards, adjustable rate loans, and
the Fed's interest rate policies of 2002-2006 was disastrous.
Incentives matter and perverse incentives created the crisis of 2008.
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usinessStudies,Sharda
University,
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RE E EADED OWARD NOTHER REAT
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RE E EADED OWARD NOTHER REATDEPRESSION?
Are the current conditions unprecedented?
How do the current conditions compare with the Great Depression?
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University,
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EXHIBIT 8A: UNEMPLOYMENT IN RECENT SEVERE
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EXHIBIT 8A: UNEMPLOYMENTIN RECENT SEVERERECESSIONS
At the end of January 2009, the unemployment rate was
7.6 percent and it will surely go higher. This is notunprecedented.
The unemployment rate rose to 9.6 percent during the1974-75 recession, and to 10.8 percent during the 1980-1982 recession.
Even during the relatively short recession of 1990-1991,the unemployment rate rose to nearly 8 percent and itremained at, or near, 7 percent for almost two years.
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usinessStudies,Sharda
University,
GreaterNoida,U.P,India
Peak Monthly Unemployment Rates in Recent Severe Recessions
Source: www.bls.gov
1973-75 1980-82 1990-91 2007-?
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
9.0%
10.8%
7.8% 7.6%
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EXHIBIT 8B: GREAT DEPRESSION UNEMPLOYMENT
The unemployment rate soared to nearly 25 percent
during 1933. The unemployment rate was 14 percent or more every
year throughout 1931-1939.
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usinessStudies,Sharda
University,
GreaterNoida,U.P,Indi
a
Unemployment Rates During the Great Depression
Source: Bureau of the Census, The Statistical History of the United States from Colonial Times to the Present (New York: Basic Books, 1976)
1930 1931 1932 1933 1934 1935 1936 1937 1938 1939
0%
5%
10%
15%
20%
25%
30%
9%
16%
24%25%
22%20%
17%
14%
19%17%
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LESSONS FROMTHE GREAT DEPRESSION
Avoid these policies:
Monetary contraction Trade restrictions
Tax increases
Constant changes in policy; this merely creates uncertainty and delays
private sector recovery.
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THIS RECESSIONIS LIKELYTOBE LENGTHY
It will take time for the malinvestments to be corrected and for householdsto improve their personal financial situation.
Various types of stimulus packages are not likely to be very effective.
Danger: Frequent policy changes will retard recovery. The recent policies
of the Bush Administration illustrate this point.
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WHAT NEEDSTOBE DONE?
1. The keys to sound policy are well-defined property rights, monetary andprice stability, open markets, low taxes, control of government spending,
and above all, neutral treatment of both people and enterprises.2. Monetary policy is way off track. Since the late 1990s it has been on a
stop-and-go course that generates instability. The Fed needs toannounce it will follow a stable course in the future. There will be norepeat of the Great Depression, but neither will there be a repeat of the
1970s.3. President Obama and Congress should announce that:
i. The mistakes of the 1930s will not be repeated, including theuncertainty generated by the frequent policy changes thatcharacterized the New Deal.
ii. In the future, government spending will be controlled and the deficitreduced.
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CRISISOF MARKETSORA CRISISOF POLITICS?
Are the current conditions unprecedented?
Both the Great Depression and the current crisis are the result ofperverse policies.
During the Great Depression era, disastrous policies led to a huge
expansion in the size and role of government. Will the same thing
happen this time? The answer to this question will determine the future
economic status of Americans.
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END
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University,GreaterNoida,U.P,India