The U.S. financial crisis of 2008–2009 owed its origins to a failure of institutions to adjust to rapid innovation in the home mortgage industry. The size and importance of the United States in the global economic and financial system left little doubt that the outcome would take on global dimensions.
The roots of the U.S. financial crisis go back to the aftermath of the 1990s economic prosperity. The 1990s saw the longest economic expansion recorded in U.S. history. The long expansion received its thrust from an investment boom in information technology industries. Easy credit fed the investment boom for a time. When the United States started tightening credit, a high-tech stock bubble burst, the investment boom ended, and the United States entered into recession. In a bid to resuscitate the United States economy, the government again turned to easy credit and bargain basement interest rates.
Low interest rates and easy credit between 2002 and 2005 sparked a boom in housing, creating a housing bubble comparable to the high-tech stock bubble of the 1990s. A housing bubble posed special risk to the financial system because houses are one asset that can be purchased with small down payments. Compared to purchasers of corporate stock, purchasers of houses can put in a much smaller share of their own money.
Dodd and Mills (June 2008) lay out every step in the development of the crisis. A long upswing in house prices had put creditors at ease about the risk of home mortgages. A house seemed to be bullet-proof collateral. Lenders began granting riskier loans and being less thorough in verifying the income, jobs, and assets of borrowers. Some mortgage originators went so far as to offer interest-only loans and negative amortization payment options. Negative amortization meant the borrower’s monthly payment was not even covering all the interest charges, much less paying down the principal. Lenders felt that escalation in house prices assured that a house could always be refinanced for larger amounts, or sold to pay off a mortgage. Rising house prices should translate into falling loan-to-value ratios for creditors.
Another weak link in the stability of the financial situation was in the process of packaging home mortgages into financial securities. Investors buying these mortgage-backed securities had to rely on the same credit rating agencies that rated bonds. Well-established and reputable rating agencies such as Standard and Poor’s and Moody’s had performed well in rating bonds but had little knowledge or experience in mortgage-backed securities. Since mortgage-backed securities were new, no historical data existed to estimate past performance and risk. These agencies awarded top ratings of AAA to over 90 percent of the mortgage-backed securities based on subprime loans (Dodd and Mills, June 2008).
Investors purchased mortgage-backed securities with borrowed funds and counted on being able to trade out of these investments in a hurry to cut losses. Mortgage-backed securities, however, were sold in an over-thecounter market, and no dealers committed themselves to making a market for them. As the poor quality of the mortgages became evident, no dealers came forward willing to maintain an inventory of these securities. The market for mortgage-backed securities became a market where everybody wanted to sell and nobody wanted to buy.
The magnitude of investor losses from mortgage-backed securities would have been easily manageable if the problem had not had wider implications. Mortgage delinquencies and home foreclosures began to mount in 2006 and 2007 amid an otherwise expanding economy. It became clear that many homeowners could only make their mortgage payments if home prices continued to escalate, allowing them to refinance their homes before the teaser interest rates on their existing home mortgages expired. It was equally obvious that many loan applications had inflated measures of borrowers’ income and house appraisal values. Falling home prices triggered a wave of foreclosures. Upward interest rate adjustments on adjustable-rate mortgages worsened an already bad situation.
A related casualty of the mortgagebacked securities market debacle was investor confidence in the credit ratings agencies such as Standard and Poor’s and Moody’s. These agencies were forced to downgrade the credit ratings of mortgage-backed securities at a much faster pace than had ever been seen for corporate bonds.
The month of July 2007 saw a significant round of ratings downgrades for mortgage-backed securities. Wall Street hedge funds began trying to liquidate large positions in these securities. In August 2007, the French bank BNP Paribas suspended withdrawals from some money market funds that were heavily invested in U.S. mortgage-backed securities. The bank claimed it had no way of putting a value on these assets. Expecting a wave of customer cash withdrawals, other money market fund managers shifted these portfolios from medium- and long-term bank deposits and commercial paper to overnight deposits. The strong demand for liquidity drained the supply of funds for short-term commercial credit instruments. The market for what was called “asset-backed commercial paper” collapsed.
The collapse of the asset-backed commercial paper market brought to the surface the role of the structured investment vehicles that a number of banks sponsored as off-balance sheet entities. Banks sponsored these off-balance sheet entities to skirt banking regulations. They amounted to a hidden banking system. These structured investment vehicles raised funds by selling asset-backed commercial paper and invested the funds in longer-term assets that paid higher interest rates. Part of the arrangement was that the sponsoring banks were obligated to provide credit to the structured investment vehicle when necessary. When the market for asset-backed commercial paper collapsed, sponsoring banks had to meet unwanted and inconvenient loan commitments.
Banks, unable to raise funds by selling loans and fearful of depositor withdrawals, set to hoarding liquidity. They were caught in a squeeze between keeping loans on their books that they had planned on selling, and honoring loan commitments to hedge funds and corporate entities, commitments that they wished they had not made.
In March 2008, the Wall Street firm of Bear Stearns saw a run on its deposits that would have ended in bankruptcy if the Federal Reserve had not assisted in its acquisition by JPMorgan Chase. In September, the United States government announced a takeover of Fannie Mae and Freddie Mac, two government-sponsored enterprises concerned exclusively with the home mortgage market. Later in September, the Wall Street firm Lehman Brothers failed. The United States Treasury refused to bail out Lehman Brothers but did encourage other firms to acquire it. When no buyers appeared, Lehman Brothers went into liquidation.
Another important industry found itself drawn in to the mortgage-backed security debacle. Bond insurers usually provided investors with default insurance against municipal and infrastructure bonds. The firms had begun selling default insurance for the mortgagebacked securities. Rising mortgage delinquencies and foreclosures hammered the stocks and credit ratings of bond-insuring companies and left in doubt the ability of these companies to honor default insurance claims in the municipal bond market and the student loan market, making these investments much less attractive.
The outcome of these developments was a banking system less willing and able to make loans and demanding U.S. Financial Crisis of 2008–2009 | 415 Media and pedestrians gather in front of the Lehman Brothers headquarters in New York on September 15, 2008, the day the 158-year-old financial firm filed for bankruptcy. (AP Photo/ Louis Lanzano) tighter criteria of credit worthiness. A seizing of credit markets hobbled private initiative among producers and consumers. The forces of recession gathered strength as firms across industries reported falling earnings. October 2008, stock markets around the world entered a steep slide. The world braced for a global recession. Economic policy makers assumed that the economic situation in the United States was developing along the lines of a liquidity trap. The Federal Reserve System, the central bank of the United States, pushed its policy interest rate to near zero and allowed banks to use a wider range of assets to borrow funds. The U.S. government met the crisis with plans for massive increases in deficit spending. In a liquidity trap, massive government spending is needed to offset the combined effects of strong liquidity preference and pessimistic expectations.
See also: Liquidity Trap
