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
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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
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The Economic Crisis of 2008: Cause and Aftermath
Slide 3 of 31
Exhibit 1: 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 by a whopping 87
percent.
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.
Annual Existing House Price Change
20.0%
15.0%
10.0%
5.0%
0.0%
-5.0%
-10.0%
-15.0%
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
-20.0%
Source: www.standardpoors.com, S and P Case-Schiller Housing Price Index.
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The Economic Crisis of 2008: Cause and Aftermath
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Exhibit 2a: The 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.
Default Rate
6%
5%
4%
3%
2%
1%
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
0%
Source: mbaa.org, National Delinquency Survey.
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The Economic Crisis of 2008: Cause and Aftermath
Slide 5 of 31
Exhibit 2b: Foreclosure Rate
•
•
•
•
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 by a whopping 87
percent.
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.
Foreclosure Rate
1.4%
1.2%
1.0%
0.8%
0.6%
0.4%
0.2%
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
0.0%
Source: www.mbaa.org, National Delinquency Survey.
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The Economic Crisis of 2008: Cause and Aftermath
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Exhibit 3: Stock Market Returns
•
•
•
As of mid-December of 2008, stock returns were down by 37 percent 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 retirement savings of many
Americans.
S and P 500 Total Return
60%
50%
40%
30%
20%
10%
0%
-10%
-20%
-30%
20
07
20
04
20
01
19
98
19
95
19
92
19
89
19
86
19
83
19
80
19
77
19
74
19
71
19
68
19
65
19
62
19
59
19
56
19
53
19
50
-40%
Source: www.standardpoors.com
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The Economic Crisis of 2008: Cause and Aftermath
Slide 7 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.
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The Economic Crisis of 2008: Cause and Aftermath
Slide 8 of 31
What Caused the Crisis of 2008?
FACTOR 1: Beginning in the mid-1990s, government regulations began
to 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 Freddie
Mac to increase their holdings of loans to low and moderate income
borrowers.
• 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 the
share of minority population in their market area. Conventional lending
standards were reduced to meet these goals.
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The Economic Crisis of 2008: Cause and Aftermath
Slide 9 of 31
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.
Their share has fluctuated modestly around 45 percent since 2001.
Freddie Mac/Fannie Mae Share of Outstanding Mortgages
50%
45%
40%
35%
30%
25%
20
08
20
07
20
06
20
05
20
04
20
03
20
02
20
01
20
00
19
99
19
98
19
97
19
96
19
95
19
94
19
93
19
92
19
91
19
90
20%
Source: Office of Federal Housing Enterprise Oversight, www.ofheo.gov.
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The Economic Crisis of 2008: Cause and Aftermath
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Exhibit 4.1: 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%
20.0%
15.0%
10.0%
5.0%
0.0%
1994
1995
1996
1997
1998
1999
Subprime (FRB)
2000
2001
2002
2003
2004
2005
2006
2007
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
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The Economic Crisis of 2008: Cause and Aftermath
Slide 11 of 31
Exhibit 4.2: Subprime, Alt-A, and Home Equity
•
•
Like subprime, Alt-A and home equity loans have increased substantially as a share of
the total since 2000.
In 2006, subprime, Alt-A, and home equity loans accounted for almost half of the
mortgages originated during the year.
Subprime, Alt-A, and Home Equity as a Share of Total
50%
40%
30%
20%
10%
0%
1994
1995
1996
Subprime (FRB)
1997
1998
1999
Subprime (JCHS)
2000
2001
2002
2003
Subprime + Alt-A
2004
2005
2006
2007
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
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The Economic Crisis of 2008: Cause and Aftermath
Slide 12 of 31
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, and price of, housing.
• 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,
adjustable rates were soon reset, monthly payment on these loans
increased, housing prices began to fall, and defaults soared.
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The Economic Crisis of 2008: Cause and Aftermath
Slide 13 of 31
Exhibit 5: Short-Term Interest Rates
•
•
•
The Fed injected additional reserves and kept short-term interest rates at 2% or less
throughout 2002-2004.
Due to rising inflation in 2005, the Fed pushed interest rates upward.
Interest rates on adjustable rate mortgages rose and the default rate began to increase
rapidly.
Federal Funds Rate and 1-Year T-Bill Rate
8%
7%
6%
5%
4%
3%
2%
1%
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
0%
Federal Funds
1 year T-bill
Source: www.federalreserve.gov and www.economagic.com
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The Economic Crisis of 2008: Cause and Aftermath
Slide 14 of 31
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.
ARM Loans Outstanding
25%
20%
15%
10%
5%
20
08
20
07
20
06
20
05
20
04
20
03
20
02
20
01
20
00
19
99
19
98
19
97
19
96
19
95
19
94
19
93
19
92
19
91
19
90
0%
Source: Office of Federal Housing Enterprise Oversight, www.ofheo.gov.
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The Economic Crisis of 2008: Cause and Aftermath
Slide 15 of 31
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.
• 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 with
securities.
• Based on historical default rates, mortgage loans for residential housing
were thought to be safe. 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 default rates increased in 2006 and 2007, the highly leveraged
investment banks soon collapsed.
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The Economic Crisis of 2008: Cause and Aftermath
Slide 16 of 31
Exhibit 5.2: Leverage Ratios
•
The leverage ratios of loans and other investments to capital assets for various
financial institutions are shown here.
•
When Bear Stearns was acquired by JP Morgan Chase its leverage ratio was 33 to 1.
Note, this was not particularly unusual for the GSEs and large investment banks.
Leverage Ratios (June 2008)
Freddie Mac
67.9
Fannie Mae
21.5
Brokers/hedge Funds
31.6
Savings institutions
9.4
Commercial banks
9.8
Credit unions
9.1
0
20
40
60
80
Source: The Rise and Fall of the U.S. Mortgage and Credit Markets: A Comprehensive Analysis of the Meltdown, Milken Institute
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The Economic Crisis of 2008: Cause and Aftermath
Slide 17 of 31
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. By 2007, the debt-toincome 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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The Economic Crisis of 2008: Cause and Aftermath
Slide 18 of 31
Exhibit 6a: Household Debt as a Share of 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 of households has been
climbing at an alarming rate.
It reached 135 percent in 2007, more than twice the level of the mid-1980s.
Household Debt to Disposable Personal Income Ratio
140%
120%
100%
80%
60%
40%
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
20%
Source: www.economagic.com
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The Economic Crisis of 2008: Cause and Aftermath
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Exhibit 6b: Debt Payments as a Share of Income
•
Today, interest payments consume nearly 15 percent of the after-tax income of
American households, up from about 10 percent in the early 1980s.
Debt Payments to Disposable Personal Income Ratios
16%
14%
12%
10%
8%
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
6%
Total Debt
Mortgage
Source: www.economagic.com
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The Economic Crisis of 2008: Cause and Aftermath
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Exhibit 7a: Foreclosure Rates on Subprime
•
•
•
Compared to their prime borrower counterparts, the foreclosure rate for subprime
borrowers is approximately 10 times higher for fixed rate mortgages and 7 times higher
for adjustable rate mortgages.
There was no trend in the foreclosure rate prior to 2006 for adjustable rate or fixed rate
mortgages.
Starting in 2006, there was a sharp increase in the adjustable rate mortgage
foreclosure rate.
Foreclosure Rates on Subprime Mortgages
6%
5%
4%
3%
2%
1%
Fixed
20
07
20
07
20
06
20
06
20
05
20
05
20
04
20
04
20
03
20
03
20
02
20
02
20
01
20
01
20
00
20
00
19
99
19
99
19
98
19
98
0%
Adjustable
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: Building
Out of a Crisis (New Brunswick, NJ: Transaction Publishers, 2009 (forthcoming) We would like to thank Professor Liebowitz for making this data available to us.
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The Economic Crisis of 2008: Cause and Aftermath
Slide 21 of 31
Exhibit 7b: Foreclosure Rates on Prime
•
•
While the foreclosure rate on fixed rate mortgages was relatively constant, the
foreclosures on adjustable rate mortgages began to soar in the second half of 2006.
This was true for both prime and subprime loans.
Foreclosure Rates on Prime Mortgages
1.2%
1.0%
0.8%
0.6%
0.4%
0.2%
Fixed
20
07
20
07
20
06
20
06
20
05
20
05
20
04
20
04
20
03
20
03
20
02
20
02
20
01
20
01
20
00
20
00
19
99
19
99
19
98
19
98
0.0%
Adjustable
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: Building
Out of a Crisis (New Brunswick, NJ: Transaction Publishers, 2009 (forthcoming) We would like to thank Professor Liebowitz for making this data available to us.
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The Economic Crisis of 2008: Cause and Aftermath
Slide 22 of 31
Fixed vs. Variable Rate Mortgages
• Default and foreclosure rates on fixed interest rate mortgages did not rise
much in 2007 and 2008. This was true for loans to both prime and subprime 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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The Economic Crisis of 2008: Cause and Aftermath
Slide 23 of 31
Are We Headed Toward Another Great Depression?
• Are the current conditions unprecedented?
• How do the current conditions compare with the Great Depression?
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The Economic Crisis of 2008: Cause and Aftermath
Slide 24 of 31
Exhibit 8a: Unemployment in Recent Severe
Recessions
•
•
•
At the end of January 2009, the unemployment rate was 7.6 percent and it will surely
go higher. This is not unprecedented.
The unemployment rate rose to 9.6 percent during the 1974-75 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 it remained at, or near, 7 percent for almost two years.
Peak Monthly Unemployment Rates in Recent Severe Recessions
12.0%
10.8%
10.0%
9.0%
8.0%
7.8%
7.6%
1990-91
2007-?
6.0%
4.0%
2.0%
0.0%
1973-75
1980-82
Source: www.bls.gov
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The Economic Crisis of 2008: Cause and Aftermath
Slide 25 of 31
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.
Unemployment Rates During the Great Depression
30%
25%
24%
25%
22%
20%
20%
19%
16%
14%
15%
10%
17%
17%
9%
5%
0%
1930
1931
1932
1933
1934
1935
1936
1937
1938
1939
Source: Bureau of the Census, The Statistical History of the United States from Colonial Times to the Present (New York: Basic Books, 1976)
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The Economic Crisis of 2008: Cause and Aftermath
Slide 26 of 31
Lessons From the 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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The Economic Crisis of 2008: Cause and Aftermath
Slide 27 of 31
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.
• 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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The Economic Crisis of 2008: Cause and Aftermath
Slide 28 of 31
What Needs to be Done?
1. The keys to sound policy are well-defined property rights, monetary and
price 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 to
announce it will follow a stable course in the future. There will be no
repeat 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 the
uncertainty generated by the frequent policy changes that
characterized the New Deal.
ii. In the future, government spending will be controlled and the deficit
reduced.
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The Economic Crisis of 2008: Cause and Aftermath
Slide 29 of 31
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.
• 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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The Economic Crisis of 2008: Cause and Aftermath
Slide 30 of 31
END
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The Economic Crisis of 2008: Cause and Aftermath
Slide 31 of 31