Causes of the 2008 economic crisis and a few suggestions to move forward

David J. Moore, Ph.D.

www.efficientminds.com

Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com

The big picture

1. Over-regulation: requiring Fannie Mae/Freddie Mac to purchase sub-prime loans and securities, Fed raising/lowering interest rates at inopportune times 2. Under-regulation: unchecked deceptive loan practices, mixing of investment and commercial bank operations/assets, easing of leverage requirements, virtually unmonitored credit rating agencies 3. Over-confidence in rising home prices: the credit/profit machine worked as long as prices were rising, but it was of course unsustainable. 4. Over-consumption: homes used as ATM machines, foreign countries provided credit, we purchased more foreign goods, which enabled them to supply more credit and so on. Another 2008, David J. Moore, Ph.D. unsustainable cycle Copyright www.efficientminds.com

Over-regulation

Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com

Over-regulation
1992: HUD becomes Fannie/Freddie regulator and requires them to buy a portion of mortgages that are part of the affordable housing initiative 1995: HUD allows subprime mortgage derivative securities to count towards affordable housing goals 2002: Fed lowers rates to help our slow-moving economy limping along thereby inducing people to take on larger mortgages 2004: HUD raises affordable housing goal from 50% to 56% requiring Freddie/Fannie to purchase even more subprime securities and loans 2004+: Fed raises rates to pre-empt inflation but higher rates led to higher mortgage payments given the proliferation of ARMs thereby contributing to increased foreclosure rates
Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com

Subprime purchases by Fannie/Freddie (in billions of dollars)

Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com

Under-regulation

Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com

Under-regulation: pre-1999
1980: Depository Institutions Deregulation and Monetary Control Act: Allowed banks to merge -> a step towards mixing commercial and investment bank assets 1982: Garn-St. Germain Depository Institutions Act - Allowed adjustable rate mortgages -> transfers risk from bank to homeowner 1999: Gramm-Leach-Biley Act allows investment bank (risky operations) operations and commercial bank (savings accounts, home mortgages, etc.) operations to merge. Passed after $200M in lobbying in 1998 Credit rating agencies (Standard and Poors and Moodys) earned huge fees from investment banks (e.g., $850 million in structured finance products in 2006 for Moodys alone) -> conflict of interest -> higher ratings than justified assigned to mortgage-derived securities
Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com

Under-regulation: post-1999
2000: HUD disallows affordable housing credit for predatory loans - but how can anyone assess the terms of loans within the exotic subprime securities which still count as credit? 2001: HUD researchers warn of higher subprime foreclosure rates but do nothing to curtail the market for subprime loans 2004: SEC allows leverage ratio for investment banks to go from 12:1 to 40:1 and also allows a greater percentage of derivative security value to count towards capital 2006: 1977 CRA simply told banks do not discriminate" 2008: SEC withdraws credit rating level requirement of investment banks, allows them to take deposits, and allows private equity to own more of a banks equity (and openly influence bank decisions)
Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com

% of home loans covered by 1977 CRA

Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com

% of loans that are subprime

Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com

Home price appreciation over-confidence

Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com

Overconfidence in home price appreciation

Subprime security purchasers: perceive risk to be lower than it actually is and leverage to buy more -> improperly priced securities purchased on credit! Home builders: build more homes using more leverage -> Over supply of homes -> downward price pressure Home owners: take out zero-money down and teaser loans along with cash-out refinances -> unable to make loan payments after teaser period is over -> foreclosure -> downward pressure on home prices
Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com

Over-consumption

Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com

Over-consumption
By 2004, roughly $310 billion per year was being cashed out of home equity to finance personal consumption What was being consumed? Products from overseas What do overseas companies do with all the money? Reinvest in US credit markets (buy government and corporate bonds and securities) Money received from bond purchases used to finance further spending on guess what? Foreign goods (consumers) and the exotic securities (investment bankers)
Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com

Moving forward

Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com

Moving forward
Government
Greater oversight of lenders; make deceptive loans illegal Do not allow Fannie/Freddie to purchase loans and/or securities where lending standards were not met Re-establish the separation of investment and commercial banks: do not let savings accounts and mortgages get in the hands of investment bankers

Consumers
Do not buy more home than you can afford. Do not buy at all if you can not afford. Reduce consumption patterns: stop trying to keep up with the Jones

Investment bankers
Spend time and energy investing in companies and technologies, not fancy and exotic securities
Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com

Contact information
David J. Moore, Ph.D. djm@efficientminds.com www.efficientminds.com

Copyright 2008, David J. Moore, Ph.D. www.efficientminds.com