The Us Housing Bubble

Published Date: 02 Nov 2017

The crisis quickly Transformed into a global financial crisis and many financial institutions all over the world were pushed into the edge of bankruptcy. In the U.S., banks and other financial institutions become victims of the bursting of the housing bubble and would lose hundreds of billions of dollars since they were heavily invested in the mortgage market. Some of these banks and financial institutions are too big to fail. Mid-March 2008, the Bear Stearns was sold to JP Morgan Chase with a $30 billion loan that made by the Federal Reserve. (http://www.nytimes.com/2008/03/17/business/17fed.html?_r=0)

On September 15,2008, Lehman Brothers one of the largest investment bank in the U.S. files for Chapter 11 bankruptcy protection.( http://timeline.stlouisfed.org/index.cfm?p=timeline#2008-9 ) after a meeting with the president of the Federal Reserve Bank of New York on September 13, 2008 and failed to find a buyer. Merrill Lynch agreed to sell itself to Bank of America for $50 billion to avoid a deepening financial crisis on September 14,2008.

http://www.nytimes.com/2008/09/15/business/15lehman.html

The National Bureau of Economic Research, the semi-official organization that dates recessions, determined that a recession began in December 2007. By April 2009, the unemployment rate had risen to 8.9%, up from its low of 4.4% before the recession. (http://iosrjournals.org/iosr-jbm/papers/vol1-issue3/C0131624.pdf)

Too big to fail took down the ertire U.S economy

Federal Reserve was pushed to the cusp during the crisis.

In the early stage of the financial crisis, in order to allow banks meet the outstanding credit line commitments the Federal Reserve provided short term funding which allow banks to exchange their holdings of Treasury securities for cash. Bu jiu zhihou Federal Reserve realized that their traditional tools were inadequate for dealing with the crisis. Under the pressure, at the mid-December 2007, Federal Reserve created a series of new tools such as the creation of a Term Auction Facility and the Primary Dealer Credit Facility in response for the crisis.

In this paper I will analyze the 2007-2008 financial crisis and the actions that Federal Reserve implemented to rescue financial markets during the crisis and the subsequent Dodd-Frank Act.

Subprime mortgage crisis

The U.S. Housing Bubble

The U.S. housing bubble is an economic bubble that has the huge impact on the United States housing market. An economic bubble occurs when "trade is in high volumes at prices that are considerably at variance with intrinsic values."3 (Ronald R. King, Vernon L. Smith, Arlington W. Williams, and Mark V. van Boening, "The Robustness of Bubbles and Crashes in Experimental Stock Markets," in Richard H. Day and Ping Chen, eds., Nonlinear Dynamics and Evolutionary Economics (New York, Oxford University Press)

U.S. house price increase substantially since 1990. The Standard Poor’s Case-Shiller Home Price Indices shows a significantly larger increase in house price that starting in 1988 and it peaked in 2006. Between 1997 and 2006, U.S. house price increased by 124% (http://www.economist.com/node/9972489?story_id=9972489)

After 2006 house price began to decline to its present level and housing bubble start bursting. The Taxpayer Relief Act 1997 offer tax relief for people on the profit gained from the sale of their house. Low interest rates and large inflows foreign funds created an easy credit conditions and Fannie Mae started to encourage financial institutions to offer home loans even to people who do not qualify for traditional loans. Congress also passes the American Dream Down Payment Act to further stimulate home ownership. As the result, People start spending more and borrowing more and start investing in second homes and investment properties. A report from Bureau of Economic Analysis indicate that saving rate is steadily declining and the consumer and mortgage debts increase to 133% of disposable income in 2008. U.S. homeownership rate now reaches 66.1% (

Picture (http://research.stlouisfed.org/publications/review/12/09/341-368Cohen.pdf)

By September 2008, the house price declined by over 20%from the 2006 peak (figer 1) and this unexpected decline caused borrowers have zero or negative equity in their homes which means the value of the mortgage loan is less than the house value. About 23% total U.S. mortgage holders their house worth less value than the mortgage loan. (http://www.bloomberg.com/news/2010-05-10/u-s-mortgage-holders-owing-more-than-homes-are-worth-rise-to-23-of-total.html)

( http://www.economist.com/node/12470547)

This situation increases the probability that borrowers might default on their mortgages. According to the Commerce Department, at the same period the sales of new house declined by 26.4 %

Realty Trac TM U.S. Foreclosure Market Report , that there are about 846,982 properties entering some stage of foreclosure in 2005 and more than 1.2 million foreclosure filings were reported nationwide in 2006 which means for every 92 U.S. households there is one foreclosure filing. http://www.realtytrac.com/content/press-releases/more-than-12-million-foreclosure-filings-reported-in-2006-2234 The burst of the U.S. housing bubble trigger the subprime mortgage crisis which led to the 2007-2008 financial crisis and subsequent recession.

Increasing of the Subprime Mortgage Market

Increase in high risk subprime mortgage loans during the housing bubble is one of the major causes of the subprime mortgages crisis. The mortgages qualification becomes more and more loose. Banks lend money to the borrowers without concern for whether they could repay the loans. According National Association of realtors report, during the housing bubble period, 43% of first time home buyers purchased their house with a zero down payment loans.( http://usatoday30.usatoday.com/money/perfi/housing/2006-01-17-real-estate-usat_x.htm) .Stated income verified assets loans(SIVA) makes people more easy to get a mortgage loan. In order to get SIVA borrower merely need to verbally state their income to make qualify for the mortgage. No income, verified assets (NIVA) which borrowers no longer need to have job, as long as borrowers show some proofs that they have money in their bank account. NINA loans provide loan to borrowers without proof or even state anything, except a credit score.

Adjustable rate mortgage(ARM) which has a lower starter rates and interest-only ARM even allows the borrower pay only the interest during an initial period.

Under such loose mortgages qualification, some borrowers grabbed this opportunity of cheap credit to take on debt that they impossible to afford.

American CoreLogic study shows that one-third of ARMs taken out between 2004 to 2006 began with a rates below 4% and payments on these loans will double on average.( http://www.npr.org/templates/story/story.php?storyId=12561184) ARM was initially designed to borrower who will live in their homes for few years and then sell at a profit or refinance. http://www.npr.org/templates/story/story.php?storyId=12561184). but now These loans was made to borrowers with a poor credit and carry a higher interest rates to compensated for the risks. Most of these loans are ARMs(http://www.npr.org/templates/story/story.php?storyId=12561184). With housing bubble burst, poor credit borrowers were locked up, the value of their house became less compared to the value of their mortgage. This created extremely high default rates in the subprime mortgages market.

increased the chances of default on their loan and often face foreclosures which

At 2006, the percentage of subprime loan to the total mortgage originations had increased to about 25%. There are about 7.75 million outstanding subprime mortgage loans in later 2007 which counted 14% of the overall mortgage market (See remarks by Federal Reserve Governor Randall S. Kroszner at the Consumer Bankers Association 2007 Fair Lending Conference,

Washington, D.C., "The Challenges Facing Subprime Mortgage Borrowers" (November 5, 2007).

www.federalreserve.gov/newsevents/speech/kroszner20071105a.htm#f2) From 1994 to 2006, subprime lending increased from an estimated $35 billion, or 4.5 percent of all one-to-four family mortgage originations, to $600 billion, or 20 percent of originations.(http://www.federalreserve.gov/newsevents/speech/bernanke20080314a.htm)

Securitization: Mortgage-backed security

According to the U.S. Securities and Exchange Commission "Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization." http://www.sec.gov/answers/mortgagesecurities.htm gai xie jia ru subprime

Financial institution use securitization as a long term fund which also helps reduce risk of fluctuations in interest rates. And securitization also transferred the loan specific risk such as the default risk of the mortgages from the originator to the buys of collateralized securities. However, the buys or investors of the MBS have less information about the mortgage market which makes them bear most default risk. In order to make MBS attractive to investors, some well capitalized financial institution, government or GSEs provides a guarantee for MBS.

In 1968,Federal National Mortgage Association (FNMA) was split into two entities, the Government National Mortgage Association(GNMA-Ginnie Mae) and the Federal National Mortgage Association(FNMA-Fannie Mae).(BOOK 283). GNMA does not originate or purchase mortgages. As a government agency, it directly bear credit risk by guaranteeing the timely payment of principal and interest payments on mortgage-backed securities issued by approved lenders(book 283). FNMA was established as a private hold corporation after 1968. It still consider as a government agency by investors and investers believe federal government will rescue if it became insolvent.

Like FNMA, (Federal Home Loan Mortgage corporation (FHLMC) was established by Congress in 1970 to assist savings and loan association and other mortgage lenders to attracting funds and provide competition for FNMA. FNMA and FHLMC there were all referred to as government- sponsored enterprise (GSE ).

Securitizationçš„ rates

With the mortgage originations start to drop during the 2006 increased the demand on securitization as a source of funding. Figure shows that mortgage origination volume fell sharply in 2007 and 2008 . the percent of originated mortgage that were funded through securitization keep increasing and reaching 85% in 2009.( Competition and Crisis in Mortgage Securitization

MICHAEL SIMKOVIC*_

In 2000, value of non agency (investment banks, commercial banks) mortgage-backed security start increasing rapidly and overtaking agency mortgage-backed security in 2005.

Due to extremely increased market value and high default rates of subprime mortgages, value of securitized subprime mortgage evaporated caused the collapsed of private non GSE securitizers. U.S.government provided low cost capital, gurantees and other public support to some of the large non-GSE securitizers. FNMA and FHLMC were placed into the conservatorship of the Federal Housing Finance Association on September 7, 2008. (Book 284)

Source:

Inside Mortgage Finance

(http://www.realtytrac.com/news/customer/2006.4/index.asp)

Rating Agencies (http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf)

Three large U.S. credit rating agencies, Standard poor’s, Moody’s and Fitch were accused for lack of effective regulation. They provided favorable ratings on the mortgage-backed securities that by subprime mortgage loans, many of which were subsequently downgraded to junk status{ https://www.fas.org/sgp/crs/misc/R40173.pdf}. As the market’s heavily reliance on ratings and by numerous laws and regulations that use ratings as acriterion for permissible investments or as a factor in required capital levels(https://www.fas.org/sgp/crs/misc/R40173.pdf) . Many major firms and private investors blindly use rating as a guide when making investment decisions. Investors bought the high risk mortgage-backed securities and the CDOs which were rated as AAA and believed they were putting their money in a low risk investment. As the result of extremely increased market value and high default rates of subprime mortgages, value of securitized subprime mortgage collapsed, financial institutions which had invested in those bonds suffered huge loss.

Inherent conflict of interest that ratings agencies presented is the major cause of the problem. European Union's Charlie McCreevy points out; rating agencies have a conflict of interest, since they are paid by the issuers whose securities they rate. (http://www.economist.com/node/9769471?story_id=9769471). A favorable credit ratings is necessary for investment banks to sell structured products so investment banks paid huge fees to the rating agencies to obtain the desiredratings.[http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf]

According to the financial crisis inquiry report in 2005 to 2007 about half of Moody’s rating revenues comes from the rating of structured finance products such as mortgage-backed securities. Moody’s net income rose from $298 milliom in 2002 to $745 million in 2007. With the housing prices dropped, in October 2007, 73% of all the AAA mortgage-backed seurities were downgraded to junk by Moody’s. http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf (http://www.economist.com/node/9769471?story_id=9769471)

This crisis could be avoid if the rating agencies do the right job.

PR.pdf

Risky investment and excessive borrowing

Many financial institutions and private investors become vulnerable to this financial crisis since they were highly levered. Excessive debt leverage that allowed financial institutes such as banks and hedge funds to create assets composed of corporate and mortgage-backed securities . In order to transfer the risks of borrower ‘ default risk these mortgage-backed securities were sell to buyers.( http://challengemagazine.com/extra/023_054.pdf) In 2007, the five major investment banks-Goldman Sachs, Bear Stearns, Merrill Lynch ,Lehman Brother and Morgan Stanley were operating with extraordinarily thin capital (http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf). Their leverage ratio were as high as 40 to 1 which means for every $40 in assets, there was only $1 in capital to cover losses and less than a 3% declined in asset values could led the bankruptcy of the firm. Much of their borrowing were short term and in the overnight market which means these borrowing had to be renewed every day. Within the current financial system, due to the lack of transparency, the risks of heavy debt taken were magnified. The leverage was held off-balance sheet and in derivatives positions in order to hide from investors and regulators. According to the financial crisis inquiry report Fannie Mae and Freddie Mac has a combined leverage ratio which including loans they owned and guaranteed stood at 75 to 1. (http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf pag 21) The high leverage ratio by some financial institutions was deteriorated by the risky assets these firms were acquiring whit the debt such as the commercial and residential real estate holdings and mortgage-backed securities.( http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf page21)

For example by the end of 2007, Lehman had cumulated $111 billion in risky assets, more than four times of its total equity.

When the housing bubble burst, high leverage ratio, short-term borrowing, risky assets and lack of transparency pushed financial institutions to the edge of bankruptcy.

Responses to the Crisis

The exposure to subprime mortgage market loans and high leverage ratio makes banks and other financial institutions face the serious consequence that they would lose billions of dollars and bankruptcy. The failure of these banks and financial institution could pose risk to broader economy and create an greater calamity for the country. U.S. Government and Federal undertook various actions to prevent that outcome and help ease the crisis.

In a speech given by Ben S.Bernanke, the chairman of the Federal Reserve, he stated "Broadly, the Federal Reserve’s response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy." http://www.federalreserve.gov/newsevents/speech/bernanke20080110a.htm

The Federal Reserve control the quantity of funds available in the financial market by expended or contracted its balance through lending and investing activities. At the beginning stage, the Federal Reserve expanded its lending to address the significant strains in short-term money market by cut the discount rate by 0.5 percentages. The Fed also extended the maximum term for borrowing to 30 days and could be renew at the request of the borrower in 2007 and then to 90 days in march 2008(http://www.cepr.org/meets/wkcn/1/1716/papers/prol.pdf) Loans though discount window are made directly to individual banks and against much wild range of collateral , it is different from the traditional open market operations which against government and agency securities with a limited set of dealers http://www.federalreserve.gov/newsevents/speech/bernanke20080110a.htm )

Loans though discount window are different from traditional open market operations in that the loans can be made directly to individual banks. In contrast, open market operations are arranged with a limited set of dealers of government securities. However many banks fear that their borrowing would known and would be seen as a sign of financial weakness. http://www.federalreserve.gov/newsevents/reform_taf.htm

In order to provider long term liquidity and meet the demands for term funding more directly, The Federal Reserve Board announces the creation of a Term Auction Facility(TAF). Under the TAF, The Fed auctioned 28 days or 84 days loans to depository institutions to provide term funds to a border range of counterparties. http://www.federalreserve.gov/newsevents/reform_taf.htm.

In March, 2008, after the collapse of Bear Stearns, The Federal Reserve establishes the Primary Dealer Credit Facility (PDCF).

The purpose of PDFC is to provide an overnight loan to primary dealers in exchange for a range of eligible collateral.( http://www.newyorkfed.org/markets/pdcf.html) . The Term Securities Lending Facility(TSLF) was established and follow by creation of the TSLF Options Program (TOP) to increase liquidity in Treasury and other collateral markets. (http://www.newyorkfed.org/markets/tslf.html)

Commercial Paper Funding Facility(CPFF), Asset-Backed Commercial Paper Money Mutual Fund Liquidity Facility(AMLF) and Money Market Investor Funding Facility(MMIFF) were established with the Term Asset-Backed Securities Loan Facility (TALF) to promote liquidity directly to investors and borrowers in key credit market.

With the creation a series of new tools and facilities, the Federal Reserve also expended its traditional tool of open market operations to support and maintain the functioning of credit markets. The Fed put downward pressure on long term interest rates and purchase of long term securities for the Federal Reserve’s portfolio to make broader financial condition more accommodative. http://www.federalreserve.gov/monetarypolicy/bst_crisisresponse.htm

During 2007 to 2010, The Treasury and Federal Reserve increased their holdings of MBS while most private investors stopped buying MBS.

Troubled Asset Relief Program (TARP) was created to implement programs to stabilize the financial system during the crisis. According to the U.S Department of the Treasury, TARP was authorized by Congress through the Emergency Economic Stabilization Act of 2008 and is overseen by the office of Financial Stability at the U.S. Department of the Treasury http://www.treasury.gov/initiatives/financial-stability/about-tarp/Pages/default.aspx#

TARP allow government to purchase assets and equity from financial institutions to make them survive the crisis. $700 billion was originally authorized to TARP program. According to the Congressional Budget Office

Undeniable Troubled Asset Relief Program played a key role in settle this financial crisis. TARF provides government funds into the U.S. banking system to stabilize the financial market. However it created a moral hazard, government bailouts create a signal to financial institutions that if it collapse will cause a chain reaction and will sufficient affect the financial market, government will provide support. The concept of "Too big to fail" create incentives for the large financial institutions to take more risk, because the government and taxpayer will bear the loss.

Economic Conditions

According to the national Bureau of Economic Research, the recession started in December 2007, the Lehman Brothers the fourth largest investment bank in the United State filed the bankruptcy protection which increased the fear of investors and accelerated the pace of economic contraction.

(http://www.federalreserve.gov/newsevents/speech/yellen20110108a.pdf)

As the result of economic contraction, by December 2008, unemployment rate hit the 7.2% up from 4.4% before recession.

(http://useconomy.about.com/od/economicindicators/a/unemploy-curren.htm)

The unemployment rate continues growth under the aftershock of the crisis and reached the 10% in October 2009 as the highest rate in the past 26 years. (http://data.bls.gov/pdq/SurveyOutputServlet)

As the result of low rates of resource utilization, Personal consumption expenditures (PCE )have declined since 2008. According to a report from The Brimmer Policy Forum, Allied Social Science Associations Annual Meeting, with inflation decreases, "As inflation has trended downward, measures of underlying inflation have fallen somewhat below the levels of about 2 percent or a bit less that most Committee participants judge to be consistent, over the longer run, with the FOMC’s dual mandate. In particular, a modest positive rate of inflation over time allows for a slightly higher average level of nominal interest rates, thereby creating more scope for the FOMC to respond to adverse shocks. A modest positive inflation rate also reduces the risk that

such shocks could result in deflation, which can be associated with poor macroeconomic

performance." (http://www.federalreserve.gov/newsevents/speech/yellen20110108a.pdf)

At the end of 2007 bear stearns had 11.8billion in equity and 383.6 billion in liabilities and was borrowing as much as 70 billion in the overnight market.