The US Economic Crisis of 2008

Cause and Aftermath

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

Exhibit 1: 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%

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

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

Exhibit 2a: 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
Source: mbaa.org, National Delinquency Survey.

Exhibit 2b: 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%

Source: www.mbaa.org, National Delinquency Survey.

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

Exhibit 3: 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 and P 500 Total 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

Source: www.standardpoors.com

20 07

Key Questions About the Crisis of 2008

Why did housing prices rise rapidly and then fall?

Why did the mortgage default and housing foreclosure rates begin to
increase more than a year before the recession of 2008 started? Why are the recent default and foreclosure rates so much higher than at

any time during the 1980s and 1990s?

Why did investment banks like Bear Stearns and Lehman Brothers run into financial troubles so quickly? Four factors provide the answers to all of these questions.

What Caused the Crisis of 2008?

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 regulations required Fannie Mae and Freddie Mac 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.

Exhibit 4: Fannie Mae/Freddie Mac Share

The share of all mortgages held by Fannie Mae and Freddie Mac rose from 25 percent in 1990 to 45 percent in 2001. Their share has fluctuated modestly around 45 percent since 2001.

Freddie Mac/Fannie Mae Share of Outstanding Mortgages

50% 45% 40% 35% 30% 25% 20%

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

Source: Office of Federal Housing Enterprise Oversight, www.ofheo.gov.

20 08

Exhibit 4.1: Subprime Mortgages

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.

Subprime Mortgage Originations as a Share of Total

25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Subprime (FRB)

Subprime (JCHS)

Source: Data from 1994-2003 is from the Federal Reserve Board while 2001-2007 is from the Joint Center for Housing Studies at Harvard University

Exhibit 4.2: Subprime, Alt-A, and Home Equity

Like subprime, Alt-A and home equity loans have increased substantially as a share of the total since 2000. In 2006, subprime, Alt-A, and home equity loans accounted for almost half of the mortgages originated during the year.

Subprime, Alt-A, and Home Equity as a Share of Total

50% 40% 30% 20% 10% 0% 1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Subprime (FRB)

Subprime (JCHS)

Subprime + Alt-A

Subprime + Alt-A + Home Equity

Source: Data from 1994-2003 is from the Federal Reserve Board while 2001-2007 is from the Joint Center for Housing Studies at Harvard University

What Caused the Crisis of 2008?

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.

Exhibit 5: Short-Term Interest Rates

The Fed injected additional reserves and kept short-term interest rates at 2% or less throughout 2002-2004. Due to rising inflation in 2005, the Fed pushed interest rates upward. Interest rates on adjustable rate mortgages rose and the default rate began to increase rapidly.

Federal Funds Rate and 1-Year T-Bill Rate

8% 7% 6% 5% 4% 3% 2% 1% 0%

19 95 19 95 19 96 19 96 19 97 19 97 19 98 19 99 19 99 20 00 20 00 20 01 20 02 20 02 20 03 20 03 20 04 20 04 20 05 20 06 20 06 20 07 20 07 20 08
Federal Funds
Source: www.federalreserve.gov and www.economagic.com

1 year T-bill

Exhibit 5.1: ARM Loans Outstanding

Following the Fed's low interest rate policy of 2002-2004, Adjustable Rate Mortgages (ARMs) increased sharply. Measured as a share of total mortgages outstanding, ARMs increased from 10% in 2000 to 21% in 2005.

ARM Loans Outstanding

25%

20%

15%

10%

5%

0%

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

Source: Office of Federal Housing Enterprise Oversight, www.ofheo.gov.

20 08

What Caused the Crisis of 2008?

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

Exhibit 5.2: Leverage Ratios

The leverage ratios of loans and other investments to capital assets for various financial institutions are shown here. When Bear Stearns was acquired by JP Morgan Chase its leverage ratio was 33 to 1. Note, this was not particularly unusual for the GSEs and large investment banks.

Leverage Ratios (June 2008)

Freddie Mac Fannie Mae Brokers/hedge Funds Savings institutions Commercial banks Credit unions 0 9.4 9.8 9.1 20 40 60 80 21.5 31.6 67.9

Source: The Rise and Fall of the U.S. Mortgage and Credit Markets: A Comprehensive Analysis of the Meltdown, Milken Institute

What Caused the Crisis of 2008?

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-toincome 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.

Exhibit 6a: Household Debt as a Share of Income

Between 1950-1980, household debt as a share of disposable (after-tax) income ranged from 40 percent to 60 percent. However, since the early 1980s, the debt-to-income ratio of households has been climbing at an alarming rate. It reached 135 percent in 2007, more than twice the level of the mid-1980s.

Household Debt to Disposable Personal Income Ratio

140% 120% 100% 80% 60% 40% 20%

Source: www.economagic.com

19 53 19 55 19 58 19 60 19 63 19 65 19 68 19 70 19 73 19 75 19 78 19 80 19 83 19 85 19 88 19 90 19 93 19 95 19 98 20 00 20 03 20 05 20 08

Exhibit 6b: Debt Payments as a Share of Income

Today, interest payments consume nearly 15 percent of the after-tax income of American households, up from about 10 percent in the early 1980s.

Debt Payments to Disposable Personal Income Ratios

16% 14% 12% 10% 8% 6%

Source: www.economagic.com

19 80 19 81 19 82 19 83 19 85 19 86 19 87 19 88 19 90 19 91 19 92 19 93 19 95 19 96 19 97 19 98 20 00 20 01 20 02 20 03 20 05 20 06 20 07
Total Debt Mortgage

Exhibit 7a: Foreclosure Rates on Subprime

Compared to their prime borrower counterparts, the foreclosure rate for subprime borrowers is approximately 10 times higher for fixed rate mortgages and 7 times higher for adjustable rate mortgages. There was no trend in the foreclosure rate prior to 2006 for adjustable rate or fixed rate mortgages. Starting in 2006, there was a sharp increase in the adjustable rate mortgage foreclosure rate. Foreclosure Rates on Subprime Mortgages
6% 5% 4% 3% 2% 1% 0%

19 98

19 98

19 99

19 99

20 00

20 00

20 01

20 01

20 02

20 02

20 03

20 03

20 04

20 04

20 05

20 05

20 06

20 06

20 07

Fixed

Adjustable

Source: Liebowitz, Stan J., Anatomy of a Train Wreck: Causes of the Mortgage Meltdown, Ch. 13 in Randall G. Holcombe and Be njamin Powell, eds, Housing America: Building Out of a Crisis (New Brunswick, NJ: Transaction Publishers, 2009 (forthcoming) We would like to thank Professor Liebowitz for making this data available to us.

20 07

Exhibit 7b: Foreclosure Rates on Prime

While the foreclosure rate on fixed rate mortgages was relatively constant, the foreclosures on adjustable rate mortgages began to soar in the second half of 2006. This was true for both prime and subprime loans.

Foreclosure Rates on Prime Mortgages

1.2% 1.0% 0.8% 0.6% 0.4% 0.2% 0.0%

19 98

19 98

19 99

19 99

20 00

20 00

20 01

20 01

20 02

20 02

20 03

20 03

20 04

20 04

20 05

20 05

20 06

20 06

20 07

Fixed

Adjustable

Source: Liebowitz, Stan J., Anatomy of a Train Wreck: Causes of the Mortgage Meltdown, Ch. 13 in Randall G. Holcombe and Be njamin Powell, eds, Housing America: Building Out of a Crisis (New Brunswick, NJ: Transaction Publishers, 2009 (forthcoming) We would like to thank Professor Liebowitz for making this data available to us.

20 07

Fixed vs. Variable Rate Mortgages

Default and foreclosure rates on fixed interest rate mortgages did not rise much in 2007 and 2008. This was true for loans to both prime and subprime borrowers. In contrast, the default and foreclosure rates on adjustable rate mortgages soared during 2007 and 2008 for both prime and sub-prime

borrowers.
The combination of lower lending standards, adjustable rate loans, and the Fed's interest rate policies of 2002-2006 was disastrous. Incentives matter and perverse incentives created the crisis of 2008.

Extent of the Crisis

The current economic crisis has been deep and widespread on a global basis, especially in the U.S. In the epicenter of the crisis, in the United States, unemployment increased from 7 million in December 2007 to 16 million in October 2010 Counting the discouraged and part-time workers, the unemployment rate reached 18% in 2010 Foreclosures have been running over 1 million a year Poverty is on the rise (now 44 million Americans 1 in 7 live at or below the poverty line)

Are We Headed Toward Another Great Depression?

Are the current conditions unprecedented?

How do the current conditions compare with the Great Depression?

Exhibit 8a: Unemployment in Recent Severe Recessions

At the end of January 2009, the unemployment rate was 7.6 percent and it will surely go higher. This is not unprecedented. The unemployment rate rose to 9.6 percent during the 1974-75 recession, and to 10.8 percent during the 1980-1982 recession. Even during the relatively short recession of 1990-1991, the unemployment rate rose to nearly 8 percent and it remained at, or near, 7 percent for almost two years.

Peak Monthly Unemployment Rates in Recent Severe Recessions

12.0% 10.8% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 1973-75
Source: www.bls.gov

9.0% 7.8% 7.6%

1980-82

1990-91

2007-?

Exhibit 8b: Great Depression Unemployment

The unemployment rate soared to nearly 25 percent during 1933. The unemployment rate was 14 percent or more every year throughout 1931-1939.

Unemployment Rates During the Great Depression

30% 25% 20% 16% 15% 10% 5% 0% 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 25% 22% 20% 17% 14% 19% 17%

24%

9%

Source: Bureau of the Census, The Statistical History of the United States from Colonial Times to the Present (New York: Basic Books, 1976)

Lessons From the Great Depression

Avoid these policies:
Monetary contraction
Trade restrictions Tax increases Constant changes in policy; this merely creates uncertainty and delays private sector recovery.

This Recession is Likely to be Lengthy

It will take time for the malinvestments to be corrected and for households to improve their personal financial situation. Various types of stimulus packages are not likely to be very effective. Danger: Frequent policy changes will retard recovery. The recent policies of the Bush Administration illustrate this point.

What Needs to be Done?

1. The keys to sound policy are well-defined property rights, monetary and price stability, open markets, low taxes, control of government spending, and above all, neutral treatment of both people and enterprises. 2. Monetary policy is way off track. Since the late 1990s it has been on a stop-and-go course that generates instability. The Fed needs to announce it will follow a stable course in the future. There will be no repeat of the Great Depression, but neither will there be a repeat of the 1970s. 3. President Obama and Congress should announce that: i. The mistakes of the 1930s will not be repeated, including the uncertainty generated by the frequent policy changes that characterized the New Deal. ii. In the future, government spending will be controlled and the deficit reduced.

Crisis of Markets or a Crisis of Politics?

Are the current conditions unprecedented?

Both the Great Depression and the current crisis are the result of
perverse policies. During the Great Depression era, disastrous policies led to a huge

expansion in the size and role of government. Will the same thing
happen this time? The answer to this question will determine the future economic status of Americans.

END