The Economic Crisis of 2008

Cause and Aftermath

James Gwartney
Prepared by Meghan E. Walker
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de 2 #f ()
*.'. h#us$ng p#l$"$es are the r##t "ause #f the "urrent f$nan"$al "r$s$s.
+ther players,, -greedy. $nvestment bankers/ f##l$sh $nvest#rs/
$mprudent bankers/ $n"#mpetent rat$ng agen"$es/ $rresp#ns$ble h#us$ng
spe"ulat#rs/ sh#rt s$ghted h#me#wners/ and predat#ry m#rtgage
br#kers0 lenders0 and b#rr#wers,,all played a part0 but they were #nly
f#ll#w$ng the e"#n#m$" $n"ent$ves that g#vernment p#l$"y la$d #ut f#r
them.
- Peter J. Wallison
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de ( #f ()
1ey Events 2ead$ng up t# the Cr$s$s
3#us$ng pr$"e $n"rease dur$ng 2000,20040 f#ll#wed by a levell$ng #ff and pr$"e
de"l$ne
5n"rease $n the default and f#re"l#sure rates beg$nn$ng $n the se"#nd half #f
2006
C#llapse #f ma7#r $nvestment banks $n 200%
200% "#llapse #f st#"k pr$"es
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de 8 #f ()
E9h$b$t )& 3#use Pr$"e Change
3#us$ng pr$"es were relat$vely stable dur$ng the )0s0 but they began t# r$se t#ward
the end #f the de"ade.
:etween January 2002 and m$d,year 20060 h#us$ng pr$"es $n"reased by a wh#pp$ng %;
per"ent.
!he b##m had turned t# a bust0 and the h#us$ng pr$"e de"l$nes "#nt$nued thr#ugh#ut
200; and 200%.
:y the th$rd <uarter #f 200%0 h#us$ng pr$"es were appr#9$mately 24 per"ent bel#w the$r
2006 peak.
Annual Existing House Price Change
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rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de 4 #f ()
E9h$b$t 2a& !he >efault ?ate
!he default rate flu"tuated0 w$th$n a narr#w range0 ar#und 2 per"ent pr$#r t# 2006.
5t $n"reased #nly sl$ghtly dur$ng the re"ess$#ns #f )%20 )00 and 200).
!he rate began $n"reas$ng sharply dur$ng the se"#nd half #f 2006
5t rea"hed 4.2 per"ent dur$ng the th$rd <uarter #f 200%.
Default Rate
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rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de 6 #f ()
E9h$b$t 2b& @#re"l#sure ?ate
3#us$ng pr$"es were relat$vely stable dur$ng the )0s0 but they began t# r$se t#ward
the end #f the de"ade.
:etween January 2002 and m$d,year 20060 h#us$ng pr$"es $n"reased by a wh#pp$ng %;
per"ent.
!he b##m had turned t# a bust0 and the h#us$ng pr$"e de"l$nes "#nt$nued thr#ugh#ut
200; and 200%.
:y the th$rd <uarter #f 200%0 h#us$ng pr$"es were appr#9$mately 24 per"ent bel#w the$r
2006 peak.
Foreclosure Rate
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rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de ; #f ()
E9h$b$t (& 't#"k Market ?eturns
As #f m$d,>e"ember #f 200%0 st#"k returns were d#wn by (; per"ent s$n"e the
beg$nn$ng #f the year.
!h$s $s nearly tw$"e the magn$tude #f any year s$n"e )40.
!h$s "#llapse er#ded the wealth and endangered the ret$rement sav$ngs #f many
Amer$"ans.
S and P 5 !otal Return
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rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de % #f ()
1ey Auest$#ns Ab#ut the Cr$s$s #f 200%
Why d$d h#us$ng pr$"es r$se rap$dly and then fallB
Why d$d the m#rtgage default and h#us$ng f#re"l#sure rates beg$n t#
$n"rease m#re than a year bef#re the re"ess$#n #f 200% startedB
Why are the re"ent default and f#re"l#sure rates s# mu"h h$gher than at
any t$me dur$ng the )%0s and )0sB
Why d$d $nvestment banks l$ke :ear 'tearns and 2ehman :r#thers run
$nt# f$nan"$al tr#ubles s# <u$"klyB
@#ur fa"t#rs pr#v$de the answers t# all #f these <uest$#ns.
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de #f ()
What Caused the Cr$s$s #f 200%B
FAC!"R #$ :eg$nn$ng $n the m$d,)0s0 g#vernment regulat$#ns began
t# er#de the "#nvent$#nal lend$ng standards.
@ann$e Mae and @redd$e Ma" h#ld a huge share #f Amer$"an m#rtgages.
:eg$nn$ng $n )40 3*> regulat$#ns re<u$red @ann$e Mae and @redd$e
Ma" t# $n"rease the$r h#ld$ngs #f l#ans t# l#w and m#derate $n"#me
b#rr#wers.
3*> regulat$#ns $mp#sed $n ) re<u$red @ann$e and @redd$e t# a""ept
m#re l#ans w$th l$ttle #r n# d#wn payment.
)4 regulat$#ns stemm$ng fr#m an e9tens$#n #f the C#mmun$ty
?e$nvestment A"t re<u$red banks t# e9tend l#ans $n pr#p#rt$#n t# the
share #f m$n#r$ty p#pulat$#n $n the$r market area. C#nvent$#nal lend$ng
standards were redu"ed t# meet these g#als.
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de )0 #f ()
E9h$b$t 8& @ann$e MaeC@redd$e Ma" 'hare
!he share #f all m#rtgages held by @ann$e Mae and @redd$e Ma" r#se fr#m 24 per"ent
$n )0 t# 84 per"ent $n 200).
!he$r share has flu"tuated m#destly ar#und 84 per"ent s$n"e 200).
Freddie %ac&Fannie %ae Share of "utstanding %ortgages
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rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de )) #f ()
E9h$b$t 8.)& 'ubpr$me M#rtgages
'ubpr$me m#rtgages as a share #f t#tal m#rtgages #r$g$nated dur$ng the year0
$n"reased fr#m 4= $n )8 t# )(= $n 2000 and #n t# 20= $n 2008,2006.
Su'(ri)e %ortgage "riginations as a Share of !otal
'#ur"e& >ata fr#m )8,200( $s fr#m the @ederal ?eserve :#ard wh$le 200),200; $s fr#m the J#$nt Center f#r 3#us$ng 'tud$es at 3arvard *n$vers$ty
)8 )4 )6 ); )% ) 2000 200) 2002 200( 2008 2004 2006 200;
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rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de )2 #f ()
E9h$b$t 8.2& 'ubpr$me0 Alt,A0 and 3#me E<u$ty
2$ke subpr$me0 Alt,A and h#me e<u$ty l#ans have $n"reased substant$ally as a share #f
the t#tal s$n"e 2000.
5n 20060 subpr$me0 Alt,A0 and h#me e<u$ty l#ans a""#unted f#r alm#st half #f the
m#rtgages #r$g$nated dur$ng the year.
Su'(ri)e* Alt-A* and Ho)e E+uit, as a Share of !otal
'#ur"e& >ata fr#m )8,200( $s fr#m the @ederal ?eserve :#ard wh$le 200),200; $s fr#m the J#$nt Center f#r 3#us$ng 'tud$es at 3arvard *n$vers$ty
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E<u$ty
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de )( #f ()
What Caused the Cr$s$s #f 200%B
FAC!"R -$ !he @edGs man$pulat$#n #f $nterest rates dur$ng 2002,2006
@edHs pr#l#nged 2#w,5nterest ?ate P#l$"y #f 2002,2008 $n"reased
demand f#r0 and pr$"e #f0 h#us$ng.
!he l#w sh#rt,term $nterest rates made ad7ustable rate l#ans w$th l#w
d#wn payments h$ghly attra"t$ve.
As the @ed pushed sh#rt,term $nterest rates upward $n 2004,20060
ad7ustable rates were s##n reset0 m#nthly payment #n these l#ans
$n"reased0 h#us$ng pr$"es began t# fall0 and defaults s#ared.
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de )8 #f ()
E9h$b$t 4& 'h#rt,!erm 5nterest ?ates
!he @ed $n7e"ted add$t$#nal reserves and kept sh#rt,term $nterest rates at 2= #r less
thr#ugh#ut 2002,2008.
>ue t# r$s$ng $nflat$#n $n 20040 the @ed pushed $nterest rates upward.
5nterest rates #n ad7ustable rate m#rtgages r#se and the default rate began t# $n"rease
rap$dly.
Federal Funds Rate and #-.ear !-/ill Rate
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@ederal @unds ) year !,b$ll
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de )4 #f ()
E9h$b$t 4.)& A?M 2#ans +utstand$ng
@#ll#w$ng the @edHs l#w $nterest rate p#l$"y #f 2002,20080 Ad7ustable ?ate M#rtgages
DA?MsE $n"reased sharply.
Measured as a share #f t#tal m#rtgages #utstand$ng0 A?Ms $n"reased fr#m )0= $n
2000 t# 2)= $n 2004.
AR% 0oans "utstanding
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rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de )6 #f ()
What Caused the Cr$s$s #f 200%B
FAC!"R 1$ An 'EC ?ule "hange ad#pted $n Apr$l 2008 led t# h$ghly
leverage lend$ng pra"t$"es by $nvestment banks and the$r <u$"k dem$se
when default rates $n"reased.
!he rule fav#red lend$ng f#r res$dent$al h#us$ng.
2#ans f#r res$dent$al h#us$ng "#uld be leveraged by as mu"h as 24 t# )0
and as mu"h as 60 t# )0 when bundled t#gether and f$nan"ed w$th
se"ur$t$es.
:ased #n h$st#r$"al default rates0 m#rtgage l#ans f#r res$dent$al h#us$ng
were th#ught t# be safe. :ut th$s was n# l#nger true be"ause regulat$#ns
had ser$#usly er#ded the lend$ng standards and the l#w $nterest rates #f
2002,2008 had $n"reased the share #f A?M l#ans w$th l$ttle #r n# d#wn
payment.
When default rates $n"reased $n 2006 and 200;0 the h$ghly leveraged
$nvestment banks s##n "#llapsed.
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de ); #f ()
E9h$b$t 4.2& 2everage ?at$#s
!he leverage rat$#s #f l#ans and #ther $nvestments t# "ap$tal assets f#r var$#us
f$nan"$al $nst$tut$#ns are sh#wn here.
When :ear 'tearns was a"<u$red by JP M#rgan Chase $ts leverage rat$# was (( t# ).
I#te0 th$s was n#t part$"ularly unusual f#r the G'Es and large $nvestment banks.
0e2erage Ratios 3June -45
'#ur"e& !he ?$se and @all #f the *.'. M#rtgage and Cred$t Markets& A C#mprehens$ve Analys$s #f the Meltd#wn0 M$lken 5nst$tute
Cred$t un$#ns
C#mmer"$al banks
'av$ngs $nst$tut$#ns
:r#kersChedge @unds
@ann$e Mae
@redd$e Ma"
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rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de )% #f ()
What Caused the Cr$s$s #f 200%B
FAC!"R 6$ >#ubl$ng #f the >ebtC5n"#me ?at$# #f 3#useh#lds s$n"e the
m$d,)%0s.
!he debt,t#,$n"#me rat$# #f h#useh#lds was generally between 84 and 60
per"ent f#r several de"ades pr$#r t# the m$d )%0s. :y 200;0 the debt,t#,
$n"#me rat$# #f h#useh#lds had $n"reased t# )(4 per"ent.
5nterest #n h#useh#ld debt als# $n"reased substant$ally.
:e"ause $nterest #n h#us$ng l#ans was ta9 dedu"t$ble0 h#useh#lds had
an $n"ent$ve t# wrap m#re #f the$r debt $nt# h#us$ng l#ans.
!he heavy $ndebtedness #f h#useh#lds meant they had n# leeway t# deal
w$th une9pe"ted e9penses #r r$s$ng m#rtgage payments.
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de ) #f ()
E9h$b$t 6a& 3#useh#ld >ebt as a 'hare #f 5n"#me
:etween )40,)%00 h#useh#ld debt as a share #f d$sp#sable Dafter,ta9E $n"#me
ranged fr#m 80 per"ent t# 60 per"ent.
3#wever0 s$n"e the early )%0s0 the debt,t#,$n"#me rat$# #f h#useh#lds has been
"l$mb$ng at an alarm$ng rate.
5t rea"hed )(4 per"ent $n 200;0 m#re than tw$"e the level #f the m$d,)%0s.
Household De't to Dis(osa'le Personal 7nco)e Ratio
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rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de 20 #f ()
E9h$b$t 6b& >ebt Payments as a 'hare #f 5n"#me
!#day0 $nterest payments "#nsume nearly )4 per"ent #f the after,ta9 $n"#me #f
Amer$"an h#useh#lds0 up fr#m ab#ut )0 per"ent $n the early )%0s.
De't Pa,)ents to Dis(osa'le Personal 7nco)e Ratios
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rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de 2) #f ()
E9h$b$t ;a& @#re"l#sure ?ates #n 'ubpr$me
C#mpared t# the$r pr$me b#rr#wer "#unterparts0 the f#re"l#sure rate f#r subpr$me
b#rr#wers $s appr#9$mately )0 t$mes h$gher f#r f$9ed rate m#rtgages and ; t$mes h$gher
f#r ad7ustable rate m#rtgages.
!here was n# trend $n the f#re"l#sure rate pr$#r t# 2006 f#r ad7ustable rate #r f$9ed rate
m#rtgages.
'tart$ng $n 20060 there was a sharp $n"rease $n the ad7ustable rate m#rtgage
f#re"l#sure rate.
Foreclosure Rates on Su'(ri)e %ortgages
'#ur"e& 2$eb#w$tJ0 'tan J.0 -Anat#my #f a !ra$n Wre"k& Causes #f the M#rtgage Meltd#wn0. Ch. )( $n ?andall G. 3#l"#mbe and :en7am$n P#well0 eds0 Housing America: Building
Out of a Crisis DIew :runsw$"k0 IJ& !ransa"t$#n Publ$shers0 200 Df#rth"#m$ngE We w#uld l$ke t# thank Pr#fess#r 2$eb#w$tJ f#r mak$ng th$s data ava$lable t# us.
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rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de 22 #f ()
E9h$b$t ;b& @#re"l#sure ?ates #n Pr$me
Wh$le the f#re"l#sure rate #n f$9ed rate m#rtgages was relat$vely "#nstant0 the
f#re"l#sures #n ad7ustable rate m#rtgages began t# s#ar $n the se"#nd half #f 2006.
!h$s was true f#r b#th pr$me and subpr$me l#ans.
Foreclosure Rates on Pri)e %ortgages
'#ur"e& 2$eb#w$tJ0 'tan J.0 -Anat#my #f a !ra$n Wre"k& Causes #f the M#rtgage Meltd#wn0. Ch. )( $n ?andall G. 3#l"#mbe and :en7am$n P#well0 eds0 Housing America: Building
Out of a Crisis DIew :runsw$"k0 IJ& !ransa"t$#n Publ$shers0 200 Df#rth"#m$ngE We w#uld l$ke t# thank Pr#fess#r 2$eb#w$tJ f#r mak$ng th$s data ava$lable t# us.
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rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de 2( #f ()
@$9ed vs. Kar$able ?ate M#rtgages
>efault and f#re"l#sure rates #n f$9ed $nterest rate m#rtgages d$d n#t r$se
mu"h $n 200; and 200%. !h$s was true f#r l#ans t# b#th pr$me and sub,
pr$me b#rr#wers.
5n "#ntrast0 the default and f#re"l#sure rates #n ad7ustable rate
m#rtgages s#ared dur$ng 200; and 200% f#r b#th pr$me and sub,pr$me
b#rr#wers.
!he "#mb$nat$#n #f l#wer lend$ng standards0 ad7ustable rate l#ans0 and
the @edHs $nterest rate p#l$"$es #f 2002,2006 was d$sastr#us.
5n"ent$ves matter and perverse $n"ent$ves "reated the "r$s$s #f 200%.
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de 28 #f ()
Are We 3eaded !#ward An#ther Great >epress$#nB
Are the "urrent "#nd$t$#ns unpre"edentedB
3#w d# the "urrent "#nd$t$#ns "#mpare w$th the Great >epress$#nB
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de 24 #f ()
E9h$b$t %a& *nempl#yment $n ?e"ent 'evere
?e"ess$#ns
At the end #f January 2000 the unempl#yment rate was ;.6 per"ent and $t w$ll surely
g# h$gher. !h$s $s n#t unpre"edented.
!he unempl#yment rate r#se t# .6 per"ent dur$ng the );8,;4 re"ess$#n0 and t# )0.%
per"ent dur$ng the )%0,)%2 re"ess$#n.
Even dur$ng the relat$vely sh#rt re"ess$#n #f )0,))0 the unempl#yment rate r#se t#
nearly % per"ent and $t rema$ned at0 #r near0 ; per"ent f#r alm#st tw# years.
Pea8 %onthl, 9ne)(lo,)ent Rates in Recent Se2ere Recessions
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rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de 26 #f ()
E9h$b$t %b& Great >epress$#n *nempl#yment
!he unempl#yment rate s#ared t# nearly 24 per"ent dur$ng )((.
!he unempl#yment rate was )8 per"ent #r m#re every year thr#ugh#ut )(),)(.
9ne)(lo,)ent Rates During the :reat De(ression
'#ur"e& /ureau of the Census0 The Statistical History of the United States from Colonial Times to the resent DIew L#rk& :as$" :##ks0 );6E
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rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de 2; #f ()
2ess#ns @r#m the Great >epress$#n
Av#$d these p#l$"$es&
M#netary "#ntra"t$#n
!rade restr$"t$#ns
!a9 $n"reases
C#nstant "hanges $n p#l$"y/ th$s merely "reates un"erta$nty and delays
pr$vate se"t#r re"#very.
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de 2% #f ()
!h$s ?e"ess$#n $s 2$kely t# be 2engthy
5t w$ll take t$me f#r the mal$nvestments t# be "#rre"ted and f#r
h#useh#lds t# $mpr#ve the$r pers#nal f$nan"$al s$tuat$#n.
Kar$#us types #f st$mulus pa"kages are n#t l$kely t# be very effe"t$ve.
>anger& @re<uent p#l$"y "hanges w$ll retard re"#very. !he re"ent p#l$"$es
#f the :ush Adm$n$strat$#n $llustrate th$s p#$nt.
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de 2 #f ()
What Ieeds t# be >#neB
). !he keys t# s#und p#l$"y are well,def$ned pr#perty r$ghts0 m#netary and
pr$"e stab$l$ty0 #pen markets0 l#w ta9es0 "#ntr#l #f g#vernment spend$ng0
and ab#ve all0 neutral treatment #f b#th pe#ple and enterpr$ses.
2. M#netary p#l$"y $s way #ff tra"k. '$n"e the late )0s $t has been #n a
st#p,and,g# "#urse that generates $nstab$l$ty. !he @ed needs t#
ann#un"e $t w$ll f#ll#w a stable "#urse $n the future. !here w$ll be n#
repeat #f the Great >epress$#n0 but ne$ther w$ll there be a repeat #f the
);0s.
(. Pres$dent +bama and C#ngress sh#uld ann#un"e that&
$. !he m$stakes #f the )(0s w$ll n#t be repeated0 $n"lud$ng the
un"erta$nty generated by the fre<uent p#l$"y "hanges that
"hara"ter$Jed the Iew >eal.
$$. 5n the future0 g#vernment spend$ng w$ll be "#ntr#lled and the def$"$t
redu"ed.
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de (0 #f ()
Cr$s$s #f Markets #r a Cr$s$s #f P#l$t$"sB
Are the "urrent "#nd$t$#ns unpre"edentedB
:#th the Great >epress$#n and the "urrent "r$s$s are the result #f
perverse p#l$"$es.
>ur$ng the Great >epress$#n era0 d$sastr#us p#l$"$es led t# a huge
e9pans$#n $n the s$Je and r#le #f g#vernment. W$ll the same th$ng
happen th$s t$meB !he answer t# th$s <uest$#n w$ll determ$ne the future
e"#n#m$" status #f Amer$"ans.
rev20002 !he E"#n#m$" Cr$s$s #f 200%& Cause and Aftermath 'l$de () #f ()
EI>