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A Look Into the Monetary Policies During the Great Recession and the Great Depression - Part 9


4.2 Analysis of the Causes of the Great Recession

The causes of the great recession are more exact when compared to the Great Depression. Below is an explanation of the different causes of the Great Recession.

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4.2.1 Mortgage Securitization

One of the biggest causes of the great recession was the unraveling of the mortgage securitization industry that began in 2007. This industry has its roots in 1990s, when it was a relatively niche market. From 1993 to 2007, the mortgage securitization industry transformed to become a core activity of the US financial sector. By 2003, this industry employed ten percent of the total workforce of the country, and generated about 40 percent of profits in the American economy. At this point, the securitization industry was worth $4 trillion (Ashcraft, 2008).

The core business of the mortgage securitization industry was to engage in selling mortgages and to create mortgage-based securities and related financial products that can be bought by investors.  While this was a reasonable kind of financial security until 2003, banks began to lend indiscriminately to people without looking at their creditworthiness. This kind of subprime mortgage was risky, and unfortunately, the American financial sector based its business on selling risky mortgages to individuals and institutional investors. In the period between 2003 and 2007, the number of subprime mortgages went from 30 percent to 70 percent.       The mortgages came with adjustable rates, so the monthly mortgage payment increased only after the first twenty-four or thirty-six months. Therefore, people who borrowed had to make arrangements to pay higher amounts after the first two or three years, and this was when the problem began for people who lived on a tight budget. To start with, people refinanced their mortgages to get the additional money needed for mortgage payments. This refinancing was done based on the appreciation of home prices. However, the prices cannot go up forever, so when the prices stagnated or fell, borrowers could not refinance their mortgages anymore, so they began to default on their payments. Over time, these defaults eventually led to foreclosures.

From the perspective of banks and financial institutions, these mortgages were risky for two reasons. Firstly, the credit worthiness of many borrowers was questionable because a good section of the population did not have the means to fund a large house for themselves. The banks failed to perceive this credit worthiness as a risk, ad they continued to lend money for mortgage, though at higher rates when compared to qualified buyers. In this aspect, the financial sector got itself into risky business because when borrowers fail to pay, the entire product becomes junk.   The second factor is that some of the key features of the mortgage were dependent on the continued growth of the housing market. Unfortunately, this was a risk too because the housing market is like any other industry, and has its own up and down cycles. By 2007, properties in many prime cities such as Las Vegas and Miami had reached its peak. In some parts of the country, housing prices rose dramatically. Below is a chart that shows how the housing price index moved from 1950 to 2007 in the four states of California, Nevada, Florida and Arizona.

These high prices were unsustainable, so the market was long due for a correction. When the housing bubble finally burst, the complicated mortgage securitization industry fell with it.

Between 2003 and 2007, more than $5.2 trillion worth of these risky mortgages were packaged and sold to residential borrowers (Ashcraft, 2008). Banks and other financial institutions made enormous amounts of money by way of fees generated from the sale of mortgages. They also retained a significant portion of the mortgages to profit from the lucrative spread on the high-yield bonds that got its funding through cheaply available capital between the periods of 2001 to 2006. Furthermore, these financial institutions packaged the mortgage into bonds, and sold them to investors. In their lust for more money, banks and financial institutions pumped in enormous amounts of credit into the housing market, and it helped to fuel an artificial bubble in the housing market.

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This increase in credit and the subsequent drop in the value of prices would not have been the primary cause of the recession had the banks and financial institutions refrained from packaging and selling mortgages as bonds. In other words, if the mortgages had simply remained as mortgages, then the fall in housing prices would not have affected the entire economy. However, since these mortgages were converted into complex products, the housing crisis affected the financial industry in a big way. Due to this practice, many banks that were heavily exposed to mortgage-based securities were affected. Since the spring of 2007, the first victim to the crisis was New Century Financial, the largest subprime lender in the country. It was followed by other financial institutions, so the Fed had to intervene and save many banks from a collapse. In 2008, Bear Sterns was forced into a merger with JP Morgan, Merrill Lynch was forced to join hands with Bank of America, and Wachovia was taken over by Wells Fargo.

Though the mortgage securitization industry appeared to be relatively stable for a few years, it began to collapse by 2007, and with it, the financial sector also went down by 2008. In fact, this crisis threatened to shake the very existence of banking system in the US.  Due to the fall of this industry, banks and financial institutions began to panic. As a result, the long-term and short-term liquidity in the economy fell. In turn, businesses and consumers began to feel the pinch because they did not have access to funds needed for spending and expansion. All these factors created a downward spiral in the economy, and it came to virtual standstill.

4.2.2 Housing Market Collapse

There are lots of discussions of whether the housing market collapse led to the financial collapse, or vice-versa. Statistics clearly show that it was the housing market that began the recession while the financial crisis precipitated it, and made the downturn one of the biggest recessions in the history of the US. Even before the financial collapse and before the bank bailouts, the economy began to tank because of the many foreclosures that began in 2007.

The housing crisis set off a vicious circle that became difficult to break. The financial crisis that followed the housing market collapse reduced liquidity in the economy, so businesses did not have the funds for expansion. To cope with the loss of liquidity, businesses began to slash jobs. Due to this measure, the rate of joblessness rose to high levels. In 2008 and 2009, the US economy is believed to have lost more than four million jobs. The worst months for the joblessness are January and February 2009, when the economy lost 750,000 and 850,000 jobs respectively according to ADP report. This loss of jobs created financial hardships for many American families because they did not have the income to meet their mortgage obligations. Therefore, these families also defaulted on their mortgages, and eventually they had to foreclose their homes.

These high numbers of foreclosures worsened the situation because banks were stuck with assets that had no value. These foreclosed homes were difficult to sell because new homeowners were reluctant to make the down payments, and banks did not have the funds to lend. These aspects put more negative pressure on the housing market, and this pushed the crisis deeper.

“By the end of 2009 national composite price indices had fallen by 29 percent from their May 2006 high. In some bubble areas such as Las Vegas and Phoenix, house prices were less than 50 percent of what they had at the peak of the bubble” (Grusky, Western & Wimer, 2011, p.28).

This fall in home prices pushed the housing market collapse beyond subprime mortgage owners. Even those homeowners who had the means and creditworthiness to pay their mortgage refused to pay it because the value of their home was way less than the money they owed. Known as underwater mortgage, this was a dangerous situation because the mortgages were not paid by homeowners by choice. Such a situation threatened the entire country because it was estimated that the banks will have empty asset that they would never be able to sell, and the market will never get its liquidity as all the money was caught up in these empty assets.

These factors worsened the housing market in 2009. “As of the end of the end of 2009, the combined percentage of outstanding mortgages that were either delinquent or in foreclosure exceeded 15 percent, which was an all-time high. Over 40 percent of subprime loans were over three months delinquent. Furthermore, an additional 11.3 million households owed more on their mortgages than the value of the properties, a situation referred to as underwater mortgage. This amounted to over 24 percent of all outstanding mortgages” (Grusky, Western & Wimer, 2011, p.28). In some states like Arizona and Florida, the mortgage rates spiraled out of control. For example, in both Arizona and Florida, the underwater mortgages were estimated to be 50 percent while in Las Vegas alone, this percentage was a whopping 70 percent. These numbers were similar in other states too, and as a result, the housing market collapsed, and along with it, the entire economy tanked.

4.2.3 Role of the Federal Government

Contrary to popular opinion, it is not the financial bankers in Wall Street alone who were responsible for the economic collapse. The complex structure of the mortgage-based securities was invented by the Federal government during the 1960s. It all began with President Lyndon Johnson's idea of promoting home ownership among Americans. To implement this idea, the government wanted to pump in more credit into the economy to make it easy for individuals to buy the home of their choice.

However, at that time it was not easy to pump in credit because of budget deficits. The Vietnam War and the expansion of Medicaid, Medicare and other social benefits severely crunched the federal budget. An expensive housing program was beyond the government's reach, so it had to come up with a way to bring in more money. Therefore, the government floated this idea of mortgage-based securities then.  Though the idea was floated by the government 30 years back, it caught the attention of banks only in 1990. The banks liked the idea, implemented it wrongly and excessively, and in this sense, the Johnson’s government contributed to the Great Recession, several decades later (Grusky, Western & Wimer, 2011).

Besides the Johnson’s government, the Clinton and Bush administration also contributed to the financial collapse in some ways. During Clinton's reign, he legalized interstate banking in 1994 and the combination of commercial and investment banking together in 1999. Furthermore, this administration was responsible for fueling the housing bubble that continued well into the Bush presidency too. The primary contribution of the Bush government was the lack of policy regulations in the financial sector. Though he inherited it from the previous regimes, his lack of initiative to create new regulations contributed to the problem. Though there were hundreds of supervisors and regulators from the New York Fed, none of them raised concerns about the operations of the financial sector. Worst of all were the regulators in Freddic Mac and Fannie Mae who allowed these institutions to go beyond established safety and capital levels. The attitude of these regulators failed to identify the problem that was grooming in the markets. If they had paid more attention, then the collapse could have been avoided altogether or at least it could have been mitigated.

Another contribution was the decision of the Securities and Exchange Commission (SEC) in April 2004. At this time, the SEC relaxed the capital ratio rules for large institutions such as Lehman Brothers and Bear Sterns. This relaxation gave a greater degree of flexibility for banks to indulge in risky investments that went beyond their safety net. The Fed and the government failed to stay on top of this decision of SEC, and they failed to see its long-term implications. All this contributed to the fall of the industry when the housing market fell, and the risky investments were exposed.

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A related policy of the government that created panic in the financial market was its ad-hoc bailout policy. The policy that it followed did not meet any existing standard, and it was not based on any framework. When the government rescued Bear Sterns, most people assumed that it would bailout Lehman Brothers too. However, the government did not do that, and this threw many investors and creditors into a state of panic. It also increased the state of uncertainty that prevailed in the market. If the government had given a better sense of predictability, then the severity of the recession could have been less. More importantly, it would have given a better measure of confidence in the financial markets.

Due to these factors, the federal government had a role in making the recession worse than before.

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