The Nature Of The Housing Price Bubble

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02 Nov 2017

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Introduction

In this chapter, the paper examines the housing price bubble, assessing its cause in the build-up of the recession and looking at the lesson that can be learnt from it. Using these lessons, the paper will to look into the policies that should be implemented to protect the economy from a repeat recession.

The nature of the housing price bubble

An asset price bubble, defined by Case and Shiller (2003, p.299) is "a situation in which excessive public expectations of future price increases cause prices to be temporarily elevated". Housing prices in the US began to increase from 1996 and this continued until 2006, according to Shiller (2007) real house prices rose 86% within this period. Earlier housing bubbles have shown real price increases of about 10% before they broke and as Wallison (2011, p.543) suggests, "asset bubbles in other sectors might be comparable, but none is likely to involve an asset that is one-sixth of the U.S. economy". This housing bubble lasted so long and grew so large over the 10 year period, it was certainly part of the cause for the recession however, the question remains to what extent and what has been learnt from it.

The build-up of the bubble

Interest rates fell from 6.5% in January 2001 to just 1% by June 2003, this meant that debt, and therefore mortgages, became much cheaper, causing houses to become more affordable because of a lower monthly mortgage repayment for the consumer. Within the bubble, there was an increase in the size of the sub-prime mortgage market and its proportion of the whole mortgage market, this increase continued up until the crash in 2008, the percentage of mortgages that were sub-prime increased from historic levels of below 10% up to more than 20% in 2006 (The State of the Nation’s Housing: 2008 2008).This may have been exacerbated by instances of predatory lending by some banks, using teaser rates to increase the chance of consumers taking out a mortgage policy, evidence of this is shown by Agarwal et al. (2012). As house prices began to stagnate and then fall in 2006, many homeowners began to struggle with their mortgage repayments, foreclosures and defaults increased following an inverse relationship with the falling house prices (Shiller 2007). As Gorton and Metrick (2012, p.4) put it, "the prospect of such losses, after house prices started to decline, were a trigger for the crisis", homeowners struggled to pay their monthly repayments, due to the increase in interest rates, which led to an increase in the number of defaults country-wide. The housing price bubble set up the boom in the economy and when this bubble crashed, it triggered the initiation of the crisis.

The lessons

With the housing market established as part of the cause, there needs to be an examination of the lessons learnt:

Earlier identification of such a bubble is required

After identification, there needs to be some intervention to control the bubble

Regulation is required to protect the economy from a repeat scenario.

Bubble Identification

A nation-wide housing bubble is a very large risk to economic performance and future growth, therefore there needs to be a policy of early identification if such a bubble were to arise again. With hindsight we are able to see that there was indeed a bubble in the housing market, Case and Shiller (2003) found strong evidence to support that the housing market at the time was experiencing a bubble, reaching the conclusion that it was likely about to burst. This shows a great deal of awareness by the authors who published their findings whilst in the midst of the bubble and other economists (McCarthy and Peach, 2004; Van Den Noord, 2006) also published works supporting the idea of a housing bubble, before the crash occurred. Yet, there were a great many more economists who either denied or argued against the idea of their being a bubble. Smith and Smith (2006) argue that there is not a housing bubble in US, and that house prices are in fact below their fundamental value. Smith (2005, p.35) agrees and follows this with a forecast that "there should be continued strong housing markets in 2006-2008". Bernanke (2005), while being interviewed showed his view at the time, "We've never had a decline in house prices on a nationwide basis. So what I think is more likely is that house prices will slow, maybe stabilize: might slow consumption spending a bit". Identification of such an asset bubble is key, denying the existence of a housing bubble allowed it to grow and continue over a long period. In the future, the Federal Reserve needs to be more open to the chance of a bubble and act on this in order to intervene.

Monetary policy intervention

In theory, an increase in interest rates by the Federal Bank could control a housing bubble before it gets out of hand. A higher rate increases the cost of borrowing, making monthly mortgage repayments higher, therefore an individual is no longer able to afford the same priced house as before, decreasing demand which causes a reduction in the price, or at least slows down the price increase. The low interest rates of 1% that the Federal Reserve maintained from 2001 onwards could have been part of the reason for the boom, as The Economist (2007) states, "by slashing interest rates (by more than the Taylor rule prescribed), the Fed encouraged a house-price boom". House prices in the US definitely experienced a steep increase during this period of low interest rates. Other countries, such as UK, had an interest rate much higher than this, the UK’s rate was above 4% for most of this period, and they still saw a housing bubble in the same level. This suggests that the low interest rates cannot be the only cause of the boom but they are still likely to have been a contributing factor in US. Intervention could take a number of forms in order to reduce the effects of such an asset bubble. A higher interest rate may have curbed the size of the bubble though, Taylor (2007) used a model to simulate the effects on the economy if the federal funds rate had followed the Taylor rule and the results show that it would have smoothed out the bubble. However, the models from Catte et al. (2010) show that a tighter monetary policy alone would not have had the desired effect of reducing this bubble, although the paper does admit that "a model that allows for self-fulfilling expectations" could show that tighter monetary policy would provide significant effects to dampen the bubble. Another worry here is that if the Fed’s response would have been to tighten monetary policy too much earlier in the cycle then it would have led to stagnation in the mid-2000s as suggested by Baily et al. (2008).

Regulation

Along with US monetary policy effects, lessons also need to be taken from the actions within the housing market, regulators will have to adapt to protect the market and consumers from a repetition of these events. With results showing that monetary policy alone may have been ineffective in controlling the bubble, new regulation could be used in order to have an impact. A lack of regulation gave rise to relaxed lending procedures and a culture of risk taking developed without rules to control it. Increased regulation of the housing market could be an answer to ensure a similar scenario is unlikely to happen again. Corden (2009, p.399) believes that "It is clear enough that ‘sub-prime’ lending in the US housing market was unwise", with this in mind there is a need for heavy reforms in order to regulate the market sufficiently. Excessive demand pushed house prices up, causing speculation and expectations that prices would continue to increase. Xiong (2012, p.1) explains this as "an asset owner is willing to pay a price higher than his own expectation of the asset’s fundamental because he expects to resell the asset to a future optimist at an even higher price", building on the work of Harrison and Kreps (1978). Policies need to be implemented with the aim of lowering the risk of high levels of defaults and foreclosures and also assisting monetary policy in controlling excessive demand in the market.

Regulators need to enforce that more rigorous checks on consumers take place before being accepted for a mortgage, in order to regulate lending practices properly. Regulators could be stronger, pushing requirements to reduce the percentage value of the mortgage compared to the house value to a much lower level, avoiding the situation where households have mortgages of 100% or more of the price of the house. There could also be a restriction on automated mortgage underwriting and require there to be more rigorous checks on household income and job security, for example. This all would reduce the chance of foreclosures and defaults and therefore reduce the chance of market-wide problems and panics as well.. Regulation needs to be put in place so consumers are unable to take out mortgages with little down-payments and where monthly payments are only just affordable, Warren Buffet (2008, p.12) believes "home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified."

Actions taken

Many of the mortgages that were taken out needed little documentation to prove an individual’s income, assets or property value, regulation can solve this easily and create a more secure service of mortgage underwriting. The Dodd–Frank Wall Street Reform and Consumer Protection Act includes Title XIV - Mortgage Reform and Anti-Predatory Lending Act, which has gone some way to solving these issues. The act aims to regulate the mortgage underwriting market, providing specific requirements for lenders before they can issue mortgages. It focuses on the data and documentation the lender needs to obtain, with income verification being a strict necessity. It also requires the loan originators to look at a person’s ability to repay the mortgage, taking into account many factors. Mortgages can only be offered when the lender believes the consumer can afford the monthly payments and manage the payback. The reforms have been criticised widely, many believe it has not been strong enough to stop a repeat of the crisis and it should have gone further, while others such as Wallison (2010) believe it has restricted the financial services market too much and will affect growth of the whole economy because of this loss in productivity.

Conclusion

The housing bubble was a major part in the cause of the recession, regulation needs to be implemented and lessons need to be learnt in order to evolve and protect the economy for the future. Regulation will have to be strong but also fair, Title XIV of the Dodd–Frank Wall Street Reform and Consumer Protection Act has shown that many lessons have been learnt and the government has stepped in to regulate the housing market to a level. Alone, this reform may not be enough to be certain that a similar crisis will not occur, but with increased prudence and awareness by regulators and the Federal Reserve the likelihood of such a repeat has been significantly decreased. The aim of the US government for the majority of the 2000s was to increase home ownership throughout US and it is important that the regulation and reforms do not destroy the chance for many people on lower incomes to get into the housing market in some way, there needs to be a balance to ensure this is not forgotten and the social welfare is maintained. As mentioned earlier, securitization and the financial markets affected the housing bubble and were part of the cause of the recession, in the next chapter we will be looking at this topic.

Financial Markets

Introduction

The aim of this chapter is to explore how the financial markets played a key role in the crisis. looking at the originate-to-distribute (OTD) model, securitization and the credit ratings agencies. The chapter concludes with the lesson that have been learnt and the policies that have been implemented.

Basics

The OTD model was a replacement to the originate-to-hold (OTH) model that has been in place for decades. The OTH model is where an originator will provide a mortgage for a borrower and this mortgages stays on the books of the originator until it is completed. The originator could make as many loans as he had the capital for. The OTD model was seen as advantageous because after the originator has made the mortgage, he then sells it on in the secondary mortgage market. This means he is no longer strictly confined by the capital.

Mortgage backed securities (MBSs) are a form of asset backed security, where mortgages are bought by a institute, eg Fannie Mae, and put into a pool with other mortgages, Fannie Mae then creates a MBS which contains a portion of each mortgage in the pool, with the idea to spread the risk.

Collateralised debt obligations (CDOs) is made up of underlying assets, often including MBS, it is, in simple terms, a promise to pay investors in a sequence, beginning with the ‘senior tranches’ whicha re the ones seen as most safe working down to the least safe, and if there isn’t enough money to cover all the tranches, those at the bottom lose first

Credit default swaps (CDSs) is basically insurance, where the supplier will take ownership of a loan in the scenario where it defaults and the buyer pays the supplier to keep this swap.

Why Financial markets are a cause of recession

The financial markets were a cause of the recession in two major ways, firstly the securitization of mortgages and the OTD model helped fuel the housing bubble and secondly the huge losses made on the financial markets led to runs on the shadow banking system and brought banks and financial institutes to their knees.

Problems

Securitization became a massive market (figure) with financial institutes making huge returns and profits from trading these instruments. Therefore demand for mortgages was very high, so financial institutes could purchase the securitised products. This gave originators the incentive to make as many mortgages as possible, so they could sell them on to make a profit, as shown through empirical evidence by Mian and Sufi (2008).

The originators became lax in checking the creditworthiness of the households applying for mortgages because they were selling the mortgage and its risk on to the financial institutes who securitized the loans. Without the originator understanding the creditworthiness, those institutes that bought the mortgages would understand the risk even less and when the securities that were made up of these mortgages were sold the understanding would be even less, the asymmetry of information in the market was vast and the price of the instruments clearly did not take this into account (reference/figures). The investors who held the securities of the mortgages were so far down the chain from the originator of the mortgages that they had little chance of understanding the risk involved.

The MBSs were created from a geographically diverse pool of mortgages with the idea that if one area suffered a housing crisis then the security would not be affected too much. The problem was that the market failed to correctly factor in the risk of a countrywide crisis and the correlated defaults seen (reference).

The financial institutes creating the securities were working with ratings agencies to create AAA rated products. The ratings agencies clearly did not fully understand the risk involved in the securities and therefore the ratings they were giving were flawed. The extent to this only became apparent after the markets crashed. Stiglitz (reference) investment banks get the top students therefore if investors unable to understand securities and the associated risk, what chance do the credit rating agencies have when they don’t employ the best students.

Financial institutes were able to take the loans off balance sheet moving them to structured investment vehicles (SIVs) which allowed these firms increase their leverage causing them to become over exposed to the markets when the losses started to occur (reference).

The markets were unregulated, especially CDSs, with Greenspan in 1998 objecting to any regulation. Warren Buffet CDSs ‘weapons of financial mass destruction’. The huge losses because of the lack of regulation and misunderstanding of the instruments and their risks led to the crisis seen in the financial markets as they crashed and the ruining of many investment banks and financial institutions, which will be explored in the next chapter.

The losses and crash were due to the fact that no investor could be sure which securities were toxic and who was holding them. People wanted to get rid of their toxic securities by selling them, which meant no one wanted to buy because they could not be sure they were buying a ‘good’ security.

Lessons

Ratings agencies held accountable

Reassess OTD model and accountability of originator

Overall should help protect from massive losses.

Ratings Agencies held accountable

The CRAs claimed that their ratings were only opinions, not to be used for investor information and the CRAs therefore have protected themselves from legal liability, suggesting that they are protected by freedom of speech. The aim of using ratings is to reduce information asymmetry in the market, yet with the level of wrong ratings in the market, it could be argued that asymmetry was not reduced and perhaps even increased.

The ratings agencies have had a problem of conflicts of interest, the financial institutes worked with the CRAs to get the best ratings they could, and with the financial institutes paying the CRAs for their ratings, then it was in CRAs interest to give the best rating they could. Goodhart (reference) suggests that regulation could include requiring issuers to get two or more ratings for a product from different CRAs, justifying this by explaining that the securities are much more complicated than average loans or bonds.

The lack of accountability for the CRAs meant they had little reason to change their behaviour, this is also exacerbated by a lack of competition in the CRA market. This could be solved by having the agencies publish reports detailing the accuracy of their ratings after the ratings have been given, this would also help the agencies build up a reputation and therefore may be a desirable solution for them too.

They used models that did not fully anticipate and include the risks inherent in the real economy and used historical data, that was outdated because of the new economic environment (securities, derivatives…).(reference)

The CRAs helped build a confidence that was unjustifiable and unreasonable, they have been seen as a major cause for the crisis because of their very poor ratings. Yet they have suffered much better than many of their clients thought this period (reference).

Lessons have begun to be learnt from the failures of the CRAs, "the Dodd-Frank Act addresses the following topics with regard to CRAs: increased accountability, conflicts of interest and ratings accuracy, reliance on ratings by federal agencies, and public disclosure of rating methodologies" (Harper, 2011). The Office of Credit Ratings (OCR) has been set up to assist the SEC in governance of CRA (or NRSROs). The Dodd-Frank Act also provides regulation on restricting conflicts of interest by establishing a set of rules, laid out by the Commission in order to "prevent sales and marketing considerations from influencing the ratings issued" (WIKI). The NRSROs also have to provide an in depth annual report to the OCR and the Commission will also require NRSROs to provide a detailed report including methodologies and techniques for ratings, thereby increasing transparency.

Although the majority appear to believe more regulation is needed for CRAs, White (2010) suggests that actually less regulation would provide a better response. In the article, White suggests that if better regulation of financial institutes was to be implemented, a system could be created were bond creditworthiness information could be obtained from a wider range of sources, thus decreasing the necessity for CRAs and paving the way for new methodologies and innovation to credit ratings, increasing competition rather than increasing barriers-to-entry (REREAD).

Reassess OTD model and accountability of originator

Loan originators had very little incentive to make ‘good’ loans because they would just be selling the loan on to be securitised. Purnanandam (2010) shows that the OTD model has given banks incentives to originate inferior loans and the banks with lower capital are more likely to originate inferior loans. This gives the first lesson from the OTD model which is to require banks to hold more capital (basel III), this would decrease the incentive for inferior loans because banks (why?). When the bank sells on the mortgage, they are also selling on its risk so as long as they can sell the mortgage they have no incentive for this reason to make sure it isn’t a ‘lemon’, to counter this regulation could be imposed which requires the originator to hold a certain proportion of the mortgage themselves, therefore bearing some of the risk and default risk. This would provide the incentive for banks to make the better screening of the borrowers they have and balance this risk. This makes the originator accountable for the mortgage because if the borrower defaults they have to bear some of the cost. Another option could be to require banks to disclose more detailed reports on their loans sales activity, showing investors how active a bank is would give them a better understanding of whether the problem of adverse selection was something to be aware of (Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future p268).

Gorton & metrick - Shadow Banking Regulating the Shadow Banking System.

—An important cause of the recent panic was that seemingly safe instruments like MMMF shares and triple-A-rated securitized bonds suddenly seemed unsafe. New regulation should seek to make it clear, through either insurance or collateral, which instruments are truly safe and which are not

WIKI - Martin Wolf wrote in June 2009: "...an enormous part of what banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives and the 'shadow banking system' itself – was to find a way round regulation."[112] (last paragraph, link to C)

Market regulation, increase transparency

CDS market not regulated, they were traded over-the-counter (OTC), there was no CDS clearing house. The market needs to become more transparent than it has been, (greenspan not want regulation)

Conclusion

Losses associated with the financial markets have played a major part in the crisis, they amplified the losses of the sub-prime market and led to the run on the shadow banking market that we will explore in the next chapter. Through regulation, the market needs to become more transparent, leading to a more efficient market. Also originators and credit rating agencies need to be held accountable for their actions in order to align their incentives with the rest of the economy, ACT/POLICY has been introduced to make a step towards this.

Shadow Banking

Introduction

In this chapter, the aim is look at the shadow banking industry, exploring is rise in prominence in the financial industry and the risks it posed to the economy. With this in mind, there will then be an examination of the lessons and changes required to better supervise the industry and help control it.

as Bernanke (2010, p.4) states, "before the crisis, the shadow banking system had come to play a major role in global finance; with hindsight, we can see that shadow banking was also the source of key vulnerabilities". The shadow banking system saw large levels of growth but was largely unregulated, "it grew without adequate oversight and led to systematic risk… it also created the potential for chain reactions leading to systematic risk" (Claessens et al. 2010, p.7).

The Shadow Banking Industry

The first use of the term shadow bank is by McCulley (2008) in which he describes it as "a levered-up financial intermediary whose liabilities are broadly perceived as of similar money-goodness and liquidity as conventional bank deposits". Credit intermediation involving entities and activities (fully or partially) outside the regular banking system (FSB 2012). The shadow banking system is a collective term for financial intermediaries such as, money market funds and structured investment vehicles (SIVs) (hedge-funds questionable). Investment banks are not included but much of their business is conducted within the shadow banking markets. The sector saw massive growth over the last decade, from (find figures) to (find figures), and according to the Financial Stability Board (FSB), it now makes up around 25 to 30 percent of the total financial sector (find reference). The shadow banks do not take deposits like a traditional bank, which therefore means they are not subject to the same restrictions and regulations as traditional banks. The shadow banking system is widely unregulated which is regarded as a main reason for the high level of risk inherent in the system that led to the run on the sector.

Risks

The shadow banking system has been seen as creating a lot of risk in the financial industry and the economy as a whole. Without the same regulation that holds traditional banks, the shadow banking entities do not have to have the same financial reserves to protect themselves, many therefore became highly leveraged, this magnifies the company’s gains and losses, with the intention to maximise their profits. Therefore the high level of leverage within the market meant that when losses started to be incurred in 2008 (find reference), the effects were magnified greatly to see the losses that were seen (find reference). Because the entities do not take deposits, they do not have any support from the central bank, directly or indirectly, and cannot use the central bank as a lender of last resort when liquidity becomes an issue for them. This happened in the financial crisis, when short-term borrowing dried up through the freezing of securities market, the entities became unable to finance themselves leading to bankruptcy. The shadow banking system is interlinked with the traditional banking system through credit intermediation chains (explain better). This means that problems in the shadow banking system can spread to the traditional banking system, which we have seen occur in the crisis. The shadow banking system uses funding from financial markets rather than deposits like a traditional bank does, this funding, unlike deposits does not have the deposit insurance that a traditional bank has, therefore a fall in confidence in a shadow entity could lead to runs like have been seen.

Run on the System

Akin to the run on the banking system prior to the depression, the run on the shadow markets had a serious effect on the overall economy. The run "began in the summer of 2007 and peaked following the failure of Lehman" (Pozsar et al. 2010, p.2). The shadow banking entities used the short term liabilities to fund the purchase of long-term risky and illiquid investments such as the MBS and CDOs. With the losses in the financial markets, seen in the previous chapter, fears from investors arose, concerning the ability on the intermediaries to repay their debts. The funds required by these entities dried up and they could no longer find investment, they were in the "equivalent of a bank run" (WIKI). "Over four days, Bear Stearns’ available cash declined from $18 billion to $3 billion as investors pulled funding from the firm" (WIKI). With many of the shadow banking entities being interlinked with the banking system, a run on the shadow banking system had a knock on effect in the banking system too. The shadow banking system saw a run similar to those from the 1930s on the traditional banking sector, with this in mind, the responses could perhaps be taken from the successful protection of the traditional banking sector in the early 20th Century, So the sector and economy can be protected in much the same way.

Regulation

The major lesson from the crisis in the shadow banking system is the need for regulation, a fact which should have been apparent if lessons from history had been fully incorporated into the present. The traditional banking system is heavily regulated, much heavier than the shadow banking system. This came from the efforts to protect the system and there has been a panic-free system since 1934. The majority do believe that more regulation is needed to help protect the shadow banking system and perhaps recognise it as genuine banking system (Gorton, 2009).

More regulation could be used to decrease regulator arbitrage (Schwarz, p.638), meaning that the shadow banking system is less attractive compared to the traditional banking system because regulation could bring the level of leverage down to reduce the magnification of returns. The other option could be to reduce regulation of the traditional banking system in order to reduce this regulator arbitrage, but the public view would certainly be against this therefore this is a highly unlikely scenario.

The principle-agent problem is also a factor that could be dealt with (Schwarz, p.635), managers have had incentives to look at the short term view of making profits, without the need to care about the risks in the long-term. The objective of bank CEOs to maximise the share price of the bank for the shareholders, in order to justify their pay and bonuses. Stiglitz (2010A, p.19) suggests that "if market participants did not fully understand risk, they might "punish" firms that did not engage in high leverage, because in the short term their performance would be poorer. Even if a CEO realized that increased leverage exposed the firm to a level of risk that he thought was excessive, his responsibility to maximize share value might induce him to take on the high leverage". This means the CEOs of the banks could have been acting rationally, maximising their own income because they were maximising the share price, although it was at the cost of having to bare high leverage.

According to Krugman (2008, p. 163) "influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank". Therefore an examination of the regulation that could be implemented is needed and a look at the regulation already being used (Dodd-Fank)

Gorton (2009) suggests three ways in which the shadow banking system could be more regulated and provide the incentive to self-regulate

Senior tranches of securitizations of approved asset classes should be insured by the government.

The government must supervise and examine "banks," i.e., securitizations, rather than rely on ratings agencies. That is, the choices of asset class, portfolio, and tranching must be overseen be examiners.

Entry into securitization should be limited, and any firm that enters is deemed a "bank" and subject to supervision

Dodd-Frank Act

The Dodd-Frank Act has heavily increased regulation on the traditional banking system, while regulation of the shadow banking system has been far less. This continues the problem of regulatory arbitrage and means the shadow banking system, according to (find reference), is the big winner out of the crisis and the traditional banks lose the most. The banks are being constrained by more regulation, lending less as they try to increase capital reserves and meet the objectives set by regulators. Yet, the shadow banks are thriving, continuing to increase leverage and gaining market share, lending to firms who can’t get loans from the banks. There needs to be something done here, there needs to be protection from another run on the SBS, the government needs to step in and include the non-bank financial institutions in the regulation being propsed.

Dealing with risk

The FSB has defined shadow banking as "credit intermediation involving entities and activities outside the regular banking system" (FSB, 2011) although some definitions of shadow banking include trading activity by hedge funds. The paper by the FSB working group cited above identifies the following as systemic risk factors if business does move to shadow banking:

maturity transformation – funding longer term assets with shorter term liabilities;

liquidity transformation – e.g. depth of markets for financial instruments;

incomplete credit risk transfer – e.g. to off balance sheet vehicles but where risks could fall back on the bank;

leverage.

The shadow banking system’s lender of last resort was the traditional banking system, and the traditional banking system had the Fed as its lender of last resort, yet there was no direct link from the Fed to the shadow banking system. There needs to be this direct link, in order to protect the shadow banking system from a repeat run like seen in this crisis, it need to be protected like the traditional system was back in the 1930s.

AIG

They were insuring against systematic risk, which they didn’t have the reserves to cover and the amounts they were insuring meant there was no possible way they could have the reserves to pay for a failure like we saw in the crisis. AIGs insurance, through CDSs, lifted CDOs to AAA rating even though they weren’t worthy of this, and as they started to default, AIG couldn’t make their payments, creating massive losses for them and for the investors and institutes holding the securities. Professor Mehrling (2009) suggests an idea based on the Bagehot Rule, adapting the rule from lending freely at a high interest rate, in a crisis, for the central banks to insuring freely, but at a high premium. The low premium is what we have seen during the crisis, this cannot be sustainable because the low cost of insurance incentivises investors to take on more systematic risk because the cost is low, therefore increasing fuelling the market’s systematic risk. If there was a credit insurer of last resort, they could value the best collateral in the system and therefore put a base limit on the value of collateral, which may stop the free-fall prices that we saw in the crisis. Stiglitz (2008) the AIG debacle was to do with banks’ failure to assess counterparty risk long recognized as the central issue in derivative transactions.

Examples

Conclusion

Other Causes

Introduction

There are many other causes that have been put forward other than those that have already been mentioned. The aim of this chapter is to review these causes put forward and assess their validity and appropriate responses.

The Additional Causes

The Community Reinvestment Act (CRA) and Fannie Mae and Freddie Mac

Trade deficits. Global imbalances – excessive savings

CEOs of financial institutes -> government departments

Oil prices

CRA and Fannie Mae and Freddie Mac

The Community Reinvestment Act was an act intended to prevent redlining, that is the discrimination of borrowers due to the neighbourhood they live in, usually a racially determined. And also promote the provision of the credit needs of all residents in the areas that a bank works, including low- and moderate-income neighbourhoods. Pinto (2009) argues that the CRA was a cause of the crisis, stating that the ‘Bank of America said in 2008 that while its CRA loans constituted 7 percent of its owned residential-mortgage portfolio, they represented 29 percent of that portfolio’s net losses’. Yet there is strong opposition against this idea, (reference) shows that only about one in four loans that were high risk (better description) were made by CRA-backed institutes between 2004 and 2006. The CRA didn’t force mortgage providers to make loans to households that couldn’t afford them, the OTD model gave them the incentive because the risk was passed on, (reference) says that institutes weren’t providing loans because of a feeling of corporate responsibility, they did it to make a profit. Fannie Mae and Freddie Mac did play a part in the crisis, as seen in chapter Financial Markets, but this was not because of the CRA and the government’s effort to increase homeownership.

Global Imbalances

Argument that it wasn’t the Fed fault that lower interest rates caused crisis but the global imbalances caused a massive capital inflow into US driving down interest rates.

Global imbalances refer to the situation where some countries are running a persistent current account deficit with others balancing that running a persistent surplus. During the 2000s, America ran a persistent deficit, from around 2 percent of GDP in 2000 to 5.8 percent by 2004 (reference), this requires an equal surplus of the capital account, driving a flood of foreign funds to flow into the US, mainly from countries with a current account surplus, for example, oil-exporting countries or the emerging Asian markets, where savings were high (find example and reference). Bernanke coined the term ‘savings glut’ to explain how there were too much saving going on in the global economy, which leads to the situation of financing a current account deficit. Portes (2009) believes that macroeconomic imbalances were the cause of the crisis, (better description). Taylor (2008) shows that worldwide, there was no savings glut, in fact there was a savings shortage compared to investment opportunities and compared to the 1970s and 80s, the savings rate 2002 - 2004 was very low. Outside the US, there was a savings glut, but this was balanced by an equal current account deficit, saving less than investment, within the US. Therefore global interest rates should not have been affected by any global imbalances.

Stiglitz (2009) also agrees with Taylor, arguing that although global imbalances were unsustainable, they were not the cause. The problems leading up to the crisis were happening before the imbalances became unsustainable and the problems could have arisen without the imbalances.

CEO => regulator

Here the problem is one of conflicts of interest,

Oil prices

Oil price changes could been seen as part of the trigger for the recession, prices reached their record peak in … at …(reference). Hamilton finds evidence (reference) that there would not have been a recession during 2007:Q4 – 2008:Q3 without the price increase of oil in this period.

Yet there is another way that oil prices may have been a factor in the cause of the crisis. The price volatility of oil during 2000s could have been a contributing factor behind why the banks were ‘badly behaved’. The idea here is that there was an increase in the volatility of oil price, which leads to volatility in many other products (food, automobiles…), this uncertainty also leads to an increase in the risk of investment, including financial investment. As the initial people work out that this situation is occurring, they are likely to protect themselves first and reap the most benefits they can, in a bank they would have less incentive to work for the shareholders’ value and instead look at their own short-run goal, aiming to leave the market.

Conclusion

Conclusion

In conclusion, the housing bubble expanded greatly over a long period of time, fuelled by the increase in securitisation as banks and mortgage originators moved towards the OTD model. These securities were bought and sold by investors and institutes in the shadow banking system, initially with great success. As house prices fell, default rates started to rise as did the risk of default, and due to the systematic risk inherent in the system and the leverage these institutes had, the losses were amplified and spread. The losses brought the system to its knees, and through its connectivity to the traditional banking system, the crisis spread throughout the whole economy, bringing US into recession in December 2007.

Leading up to the financial crisis, the US and global economy had seen a period of high growth, driven by a strong US financial sector. The reason for this may also be the reason for its eventually downfall, regulators failed to use the appropriate power to protect the market they were regulating and the government didn’t step in to update regulations either, in fact in many ways it deregulated the market, or at least allowed deregulation to occur. Regulating the markets has become a highlighted priority, yet it’s not the only lesson to be learnt.

The individuals in the markets were acting to maximise their own benefits, but this has not lead to an optimal position for society. Government’s role now needs to be to correctly align this problem and protect the economy from a repeat crisis. There is a fine line between the balance of regulation to benefit and their being too much, having a negative impact on the economy, not allowing the full growth potential, adversely affecting households in the US.

No one party is the culprit of causing the crisis, there are many throughout the economy that share that blame and are responding to the … of it. The lessons we’ve learned need to be used to improve the future, not constrict those who behaved wrongly in the past.

There were a catalogue of errors leading up to the crisis, one after another helped push the economy further towards the bust we’ve experienced. Part of our response should try to look at stopping their being this long chain of errors, it would be unreasonable to expect no errors to be made, but this happened on too large a scale which lead to the recession.

The Dodd-Frank Act was aimed to re-regulate much of the financial economy, but has it gone too far and been less help than good. The act is so long and so in depth that is has straight-jacketed the financial market, not allowing the growth that could benefit the whole economy. Perhaps the act could have been a few acts rather than one massive one with many titles, many of the regulations will be so beneficial to the economy, allowing stability to become rooted in the system, strengthening the protection.



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