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

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

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% -20.0% www.standardpoors.com, S and P Case-Schiller Housing Price Index. Source:
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

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% 0%

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

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% 0.0%

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

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 &P 500Total Return
60% 50% 40% 30% 20% 10% 0% -10% -20% -30% -40%

19 50

19 53

19 56

19 59

19 62

19 65

19 68

19 71

19 74

19 77

19 80

19 83

19 86

19 89

19 92

19 95

19 98

20 01

20 04

20 07

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 (United States Department of Housing and Urban Development)regulations required Fannie Mae(Federal National Mortgage Association)and Freddie Mac (Federal Home Loan Mortgage Corporation)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. 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.

FACTOR 2:
The Feds 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.

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 (Adjustable Rate Mortgages )loans with little or no down payment. When default rates increased in 2006 and 2007, the highly leveraged investment banks soon collapsed.

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-to-income 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.

Factor 5
Mortgages were further dispersed into securitization structures called Collateral Debt Obligations (CDOs). These were complicated securities designed to further reduce the risk of mortgage debt as well as consumer credit debt into slices of securities called tranches. As markets were developed and the number of potential investors was grown, the markets got more capable of absorbing the riskier pieces of an issue. It is still a serious question that in the securitization process was how did almost all the securities being issued get rated AAA? At the heart of the portfolios of many of the companies were investments whose assets had been derived from bundled home mortgages. Exposure to these mortgage-backed securities, or to the credit derivatives used to insure them against failure, caused the collapse or takeover of several key firms such as Lehman Brothers, AIG, Merrill Lynch, and HBOS

Factor 6
Incentive problem between stock holders and managers. While the managers of these companies earned more and more from the extra ordinary bonuses, some of the companies like Goldman Sachs didnt just sell toxic CDOs, they started betting against them at the same time. They were telling customers that they were high-quality investments. It was a smart way to insure themselves regardless of considering customers benefits.

Factor 7
Greed
Recently, neuroscientists have done experiments where they have taken individuals and put them into an MRI machine and they have them play a game where the prize is money and they noticed that when the subjects earn money the part of brain that gets stimulated is the same part that cocaine stimulates. In other words, they captivated by money just like what happens in gambling.

Emergency Economic Stabilization Act of 2008

Impact on financial markets

The US stock market peaked in October 2007, when the Dow Jones Industrial Average index exceeded 14,000 points. It then entered a pronounced decline, which accelerated markedly in October 2008. By March 2009, the Dow Jones average reached a trough of around 6,600. It has since recovered much of the decline, exceeding 12,000 for most of the first half of 2011. Likely, the aggressive Federal Reserve policy of quantitative easing spurred the recovery in the stock market

What is quantitative easing?

Quantitative easing (QE) is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital, in an effort to promote increased lending and liquidity.

Central banks tend to use quantitative easing when interest rates have already been lowered to near 0% levels and have failed to produce the desired effect. The major risk of quantitative easing is that, although more money is floating around, there is still a fixed amount of goods for sale. This will eventually lead to higher prices or inflation.

Quantitative easing was used by United States, the United Kingdom and the Eurozone during this Financial crisis as their risk-free short-term nominal interest rates are either at, or close to, zero. In US, this interest rate is the federal funds rate. In UK, it is the official bank rate.

During the peak of the financial crisis in 2008, in the United States the Federal Reserve expanded its balance sheet dramatically by adding new assets and new liabilities without "sterilizing" these by corresponding subtractions. In the same period the United Kingdom also used quantitative easing as an additional arm of its monetary policy in order to alleviate its financial crisis.

Bailout of the U.S. financial system

bailout of the U.S. financial system, is a law enacted in response to the subprime mortgage crisis authorizing the United States Secretary of the Treasury to spend up to US$700 billion to purchase distressed assets, especially mortgage-backed securities, and give cash directly to banks. Both foreign and domestic banks are included in the program. The Federal Reserve also extended help to American Express, whose bankholding application it recently approved. The Act was proposed by Treasury Secretary Henry Paulson during the global financial crisis of 2008.

Rationale for the bailout

Stabilize the economy Improve liquidity Comprehensive strategy Immediate and significant Broad impactInvestor confidence Impact on Economy and GDP

After all
Economist Dean Baker explained the reduction in the availability of credit this way: Yes, consumers and businesses can't get credit as easily as they could a year ago. There is a really good reason for tighter credit. Tens of millions of homeowners who had substantial equity in their homes two years ago have little or nothing today.

References
http://en.wikipedia.org/wiki/Freddie_Mac http://en.wikipedia.org/wiki/Quantitative_easing
http://www.investopedia.com/terms/q/quantitativ e-easing.asp http://en.wikipedia.org/wiki/Late2000s_financial_crisis#Impact_on_financial_mark ets http://www.wikinvest.com/concept/2008_Financi al_Crisis