Overview The crisis can be attributed to several factors, which emerged over a number of years. Causes proposed include the inability of homeowners to make their mortgage payments (due primarily to
adjustable-rate mortgages resetting, borrowers overextending,
predatory lending, and speculation), overbuilding during the boom period, risky mortgage products, increased power of mortgage originators, high personal and corporate debt levels, financial products that distributed and perhaps concealed the risk of mortgage default, monetary and housing policies that encouraged risk-taking and more debt, international
trade imbalances, and inappropriate and insufficient government regulation. Excessive consumer housing debt was in turn caused by the
mortgage-backed security,
credit default swap, and
collateralized debt obligation sub-sectors of the
finance industry, which were offering irrationally low interest rates and irrationally high levels of approval to
subprime mortgage consumers due in part to faulty
financial models. Debt consumers were acting in their rational self-interest, because they were unable to audit the finance industry's opaque faulty risk pricing methodology. Among the important catalysts of the subprime crisis were the influx of money from the private sector, the banks entering into the mortgage bond market, government policies aimed at expanding homeownership, speculation by many home buyers, and the predatory lending practices of the mortgage lenders, specifically the adjustable-rate mortgage,
2–28 loan, that mortgage lenders sold directly or indirectly via mortgage brokers. On Wall Street and in the financial industry,
moral hazard lay at the core of many of the causes. In its "Declaration of the Summit on Financial Markets and the World Economy," dated November 15, 2008, leaders of the
Group of 20 cited the following causes: Federal Reserve Chair
Ben Bernanke testified in September 2010 regarding the causes of the crisis. He wrote that there were shocks or triggers (i.e., particular events that touched off the crisis) and vulnerabilities (i.e., structural weaknesses in the financial system, regulation and supervision) that amplified the shocks. Examples of triggers included: losses on subprime mortgage securities that began in 2007 and a
run on the
shadow banking system that began in mid-2007, which adversely affected the functioning of
money markets. Examples of vulnerabilities in the
private sector included: financial institution dependence on unstable sources of short-term funding such as
repurchase agreements or repos; deficiencies in corporate risk management; excessive use of
leverage (borrowing to invest); and inappropriate usage of
derivatives as a tool for taking excessive risks. Examples of vulnerabilities in the
public sector included: statutory gaps and conflicts between regulators; ineffective use of regulatory authority; and ineffective crisis management capabilities. Bernanke also discussed "
Too big to fail" institutions,
monetary policy, and
trade deficits. During May 2010,
Warren Buffett and
Paul Volcker separately described questionable assumptions or judgments underlying the U.S. financial and economic system that contributed to the crisis. These assumptions included: 1) Housing prices would not fall dramatically; 2) Free and open
financial markets supported by sophisticated
financial engineering would most effectively support market efficiency and stability, directing funds to the most profitable and productive uses; 3) Concepts embedded in mathematics and physics could be directly adapted to markets, in the form of various financial models used to evaluate
credit risk; 4) Economic imbalances, such as large trade deficits and low savings rates indicative of over-consumption, were sustainable; and 5) Stronger regulation of the
shadow banking system and
derivatives markets was not needed. Economists surveyed by the
University of Chicago during 2017 rated the factors that caused the crisis in order of importance: 1) Flawed financial sector regulation and supervision; 2) Underestimating risks in financial engineering (e.g., CDOs); 3) Mortgage fraud and bad incentives; 4) Short-term funding decisions and corresponding runs in those markets (e.g., repo); and 5) Credit rating agency failures. The real estate bubble was initially fueled by a global pool of reserves valued at approximately U.S.$70 trillion. A significant portion of these reserves was utilized by investment banks to purchase securities like mortgage-backed securities (MBSes). MBSes, for example, are derivatives where the issuing banks would secure loans from commercial banks to finance home purchases. To refinance these loans, the banks would seek funding, often drawing on savings from their clients. MBSes, tied to the real estate sector, became highly attractive financial assets during the housing boom. Both individual investors and financial institutions largely ignored the risks associated with these securities. Their value rose steadily, creating a perception of security and profitability. However, when the housing market faltered, the value of MBSes plummeted, leading to significant financial losses and a cascading crisis. This misjudgment of risk, combined with excessive reliance on credit and financial engineering, created the conditions for the eventual collapse, illustrating the vulnerabilities of a system heavily dependent on inflated asset values. Another critical factor in the subprime mortgage crisis was the precarious financial position of major investment banks. The ratio of their leverage ratios was alarmingly low, in some cases reaching 1:40. This meant that for every dollar of equity, these banks owed $40. Such extreme leverage made them highly vulnerable to even minor fluctuations in asset values. These investment banks poured significant resources into MBSes, gambling heavily on the assumption that real estate prices would continue to rise indefinitely. Commercial banks, in turn, loaned substantial sums to individuals and to investment banks involved in issuing these risky MBSes. However, the investment banks failed to properly assess the future value of these financial assets. It was not just a matter of credit expansion but also of widespread overconfidence and naivety—individuals and institutions alike were convinced that the housing bubble would persist. The situation was exacerbated by the deregulation of over-the-counter (OTC) derivatives markets. These markets allowed for the creation and trade of complex financial derivatives, many of which were tied to the real estate sector and, in some cases, to foreign exchange markets. These derivatives often lacked transparency and their behavior was poorly predicted, yet their trade still proliferated in the unregulated OTC markets. The sheer volume of derivatives became staggering, with their total value exceeding the global GDP by more than tenfold. Many of these derivatives were backed by high-risk assets like MBSes and CDOs, further compounding the instability of the financial system. The unregulated creation and trade of derivatives, combined with excessive leverage and misplaced confidence in the housing market, were equally significant contributors. These factors created a fragile financial structure that was doomed to collapse once the bubble burst. Before the subprime crisis, an excessive number of houses were constructed, and resources were disproportionately allocated to the real estate sector. Investment banks issued MBS at unprecedented levels, fueled by the housing boom. Meanwhile, many non-financial corporations prioritized stock buybacks, dividend payments, and speculative investments over reinvesting in productive capital and expanding employment. In some cases, these corporations even incurred debt to finance these financial maneuvers, further diverting resources away from productive sectors. The globalized nature of the modern economy amplifies the effects of crises. When major economies like the U.S. or China experience downturns, the impact spreads worldwide, leading to business defaults, rising unemployment, and economic contraction. Compounding this is the phenomenon of financialization, where banks and non-financial corporations prioritize investments in financial instruments like stocks, derivatives, and bonds over productive investments. A significant portion of the funds used to finance MBSes and other home purchases originated from global savings, not solely from central bank credit expansion. These savings (which amounted to U.S.$70 trillion in total worldwide liquidity) came not just from within the United States but from international sources as well, like China and other Asian developing economies. This shift in economic focus led to a decrease in the production of both capital and consumer goods in Western economies. Outsourcing and risky financial strategies further exacerbated this trend. Credit expansion primarily benefited the real estate sector, leaving other productive parts of the economy underfunded. The U.S.
Financial Crisis Inquiry Commission reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve's failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels."
Narratives There are several "narratives" attempting to place the causes of the crisis into context, with overlapping elements. Five such narratives include: • There was the equivalent of a
bank run on the
shadow banking system, which includes
investment banks and other non-depository financial entities. This system had grown to rival the depository system in scale yet was not subject to the same regulatory safeguards. • The economy was being driven by a housing bubble. When it burst, private residential investment (i.e., housing construction) fell by nearly 4% GDP and consumption enabled by bubble-generated housing wealth also slowed. This created a gap in annual demand (GDP) of nearly $1 trillion. Government was unwilling to make up for this private sector shortfall. • Record levels of
household debt accumulated in the decades preceding the crisis resulted in a
balance sheet recession (similar to
debt deflation) once housing prices began falling in 2006. Consumers began paying down debt, which reduces their consumption, slowing down the economy for an extended period while debt levels are reduced. • Government policies that encouraged home ownership even for those who could not afford it, contributing to lax lending standards, unsustainable housing price increases, and indebtedness. Underlying narratives #1-3 is a hypothesis that growing
income inequality and
wage stagnation encouraged families to increase their
household debt to maintain their desired living standard, fueling the bubble. Further, this greater share of income flowing to the top increased the political power of business interests, who used that power to
deregulate or limit regulation of the shadow banking system.
Housing market Boom and bust relative to
disposable income and
GDPAccording to
Robert J. Shiller and other economists, housing price increases beyond the general inflation rate are not sustainable in the long term. From the end of World War II to the beginning of the housing bubble in 1997, housing prices in the US remained relatively stable. The bubble was characterized by higher rates of household debt and lower savings rates, slightly higher rates of home ownership, and of course higher housing prices. It was fueled by low interest rates and large inflows of foreign funds that created easy credit conditions. Between 1997 and 2006 (the peak of the housing bubble), the price of the typical American house increased by 124%. Many research articles confirmed the timeline of the U.S. housing bubble (emerged in 2002 and collapsed in 2006–2007) before the collapse of the subprime mortgage industry. From 1980 to 2001, the ratio of median home prices to median household income (a measure of ability to buy a house) fluctuated from 2.9 to 3.1. In 2004 it rose to 4.0, and by 2006 it hit 4.6. The housing bubble was more pronounced in coastal areas where the ability to build new housing was restricted by geography or land use restrictions. This
housing bubble resulted in quite a few homeowners
refinancing their homes at lower interest rates, or financing consumer spending by taking out
second mortgages secured by the price appreciation. US
household debt as a percentage of annual
disposable personal income was 127% at the end of 2007, versus 77% in 1990. While housing prices were increasing, consumers were saving less and both borrowing and spending more. Household debt grew from $705 billion in 1974, 60% of disposable personal income, to $7.4 trillion at the end of 2000, and finally to $14.5 trillion in the middle of 2008, 134% of disposable personal income. During 2008, the typical US household had 13 credit cards, with 40% of households carrying a balance, up from 6% in 1970. Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion over the period. U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 (~$ in ) trillion. From 2001 to 2007, U.S. mortgage debt almost doubled, and the amount of mortgage debt per household rose more than 63%, from $91,500 to $149,500, with essentially stagnant wages. Economist
Tyler Cowen explained that the economy was highly dependent on this home equity extraction: "In the 1993–1997 period, home owners extracted an amount of equity from their homes equivalent to 2.3% to 3.8% GDP. By 2005, this figure had increased to 11.5% GDP." This credit and house price explosion led to a building boom and eventually to a surplus of unsold homes, which caused U.S. housing prices to peak and begin declining in mid-2006. Easy credit, and a belief that house prices would continue to appreciate, had encouraged many subprime borrowers to obtain
adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. The US home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of 69.2% in 2004. Subprime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing, which drove prices higher. Borrowers who would not be able to make the higher payments once the initial grace period ended, were planning to refinance their mortgages after a year or two of appreciation. As a result of the depreciating housing prices, borrowers' ability to refinance became more difficult. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default. As more borrowers stopped making their mortgage payments, foreclosures and the supply of homes for sale increased. This placed downward pressure on housing prices, which further lowered homeowners'
equity. The decline in mortgage payments also reduced the value of mortgage-backed securities, which eroded the net worth and financial health of banks. This
vicious cycle was at the heart of the crisis. By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak. This major and unexpected decline in house prices means that many borrowers have zero or
negative equity in their homes, meaning their homes were worth less than their mortgages. As of March 2008, an estimated 8.8 million borrowers – 10.8% of all homeowners – had negative equity in their homes, a number that is believed to have risen to 12 million by November 2008. By September 2010, 23% of all U.S. homes were worth less than the mortgage loan. Borrowers in this situation have an incentive to default on their mortgages as a mortgage is typically
nonrecourse debt secured against the property. Economist Stan Leibowitz argued in the
Wall Street Journal that although only 12% of homes had negative equity, they comprised 47% of
foreclosures during the second half of 2008. He concluded that the extent of equity in the home was the key factor in foreclosure, rather than the type of loan,
credit worthiness of the borrower, or ability to pay. actions by quarter (2007–2012) Increasing foreclosure rates increases the inventory of houses offered for sale. The number of new homes sold in 2007 was 26.4% less than in the preceding year. By January 2008, the inventory of unsold new homes was 9.8 times the December 2007 sales volume, the highest value of this ratio since 1981. Furthermore, nearly four million existing homes were for sale, of which roughly 2.2 million were vacant. This overhang of unsold homes lowered house prices. As prices declined, more homeowners were at risk of
default or foreclosure. House prices are expected to continue declining until this inventory of unsold homes (an instance of excess supply) declines to normal levels. A report in January 2011 stated that U.S. home values dropped by 26% from their peak in June 2006 to November 2010, more than the 25.9% drop between 1928 and 1933 when the
Great Depression occurred. From September 2008 to September 2012, there were approximately 4 million completed foreclosures in the U.S. As of September 2012, approximately 1.4 million homes, or 3.3% of all homes with a mortgage, were in some stage of foreclosure compared to 1.5 million, or 3.5%, in September 2011. During September 2012, 57,000 homes completed foreclosure; this is down from 83,000 the prior September but well above the 2000–2006 average of 21,000 completed foreclosures per month.
Homeowner speculation Speculative borrowing in residential real estate has been cited as a contributing factor to the subprime mortgage crisis. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, a record level of nearly 40% of homes purchased were not intended as primary residences. David Lereah,
National Association of Realtors's chief economist at the time, stated that the 2006 decline in investment buying was expected: "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market." Housing prices nearly doubled between 2000 and 2006, a vastly different trend from the historical appreciation at roughly the rate of inflation. While homes had not traditionally been treated as investments subject to speculation, this behavior changed during the housing boom. Media widely reported condominiums being purchased while under construction, then being "flipped" (sold) for a profit without the seller ever having lived in them. Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties. One 2017 NBER study argued that real estate investors (i.e., those owning 2+ homes) were more to blame for the crisis than subprime borrowers: "The rise in mortgage defaults during the crisis was concentrated in the middle of the credit score distribution, and mostly attributable to real estate investors" and that "credit growth between 2001 and 2007 was concentrated in the prime segment, and debt to high-risk [subprime] borrowers was virtually constant for all debt categories during this period." The authors argued that this investor-driven narrative was more accurate than blaming the crisis on lower-income, subprime borrowers. A 2011 Fed study had a similar finding: "In states that experienced the largest housing booms and busts, at the peak of the market almost half of purchase mortgage originations were associated with investors. In part by apparently misreporting their intentions to occupy the property, investors took on more leverage, contributing to higher rates of default." The Fed study reported that mortgage originations to investors rose from 25% in 2000 to 45% in 2006, for Arizona, California, Florida, and Nevada overall, where housing price increases during the bubble (and declines in the bust) were most pronounced. In these states, investor delinquency rose from around 15% in 2000 to over 35% in 2007 and 2008. Economist
Robert Shiller argued that speculative bubbles are fueled by "contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they're going to keep forming." Keynesian economist
Hyman Minsky described how speculative borrowing contributed to rising debt and an eventual collapse of asset values.
Warren Buffett testified to the
Financial Crisis Inquiry Commission: "There was the greatest bubble I've ever seen in my life...The entire American public eventually was caught up in a belief that housing prices could not fall dramatically." Lending standards deteriorated particularly between 2004 and 2007, as the
government-sponsored enterprise (GSE) mortgage market share (i.e. the share of
Fannie Mae and
Freddie Mac, which specialized in
conventional, conforming, non-subprime mortgages) declined and private securitizers share grew, rising to more than half of mortgage securitizations. to 20% ($600 billion) in 2006. Another indicator of a "classic" boom-bust
credit cycle was a narrowing of the difference between subprime and prime mortgage interest rates (the "subprime markup") between 2001 and 2007. In addition to considering higher-risk borrowers, lenders had offered progressively riskier loan options and borrowing incentives. In 2005, the median
down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever. By comparison, China has down payment requirements that exceed 20%, with higher amounts for non-primary residences. To produce more mortgages and more securities, mortgage qualification guidelines became progressively looser. First, "stated income, verified assets" (SIVA) loans replaced proof of income with a "statement" of it. Then, "no income, verified assets" (NIVA) loans eliminated proof of employment requirements. Borrowers needed only to show proof of money in their bank accounts. "No Income, No Assets" (NINA) or
Ninja loans eliminated the need to prove, or even to state any owned assets. All that was required for a mortgage was a credit score. Types of mortgages became more risky as well. The interest-only adjustable-rate mortgage (ARM) allowed the homeowner to pay only the interest (not principal) of the mortgage during an initial "teaser" period. Even looser was the "payment option" loan, in which the homeowner has the option to make monthly payments that do not even cover the interest for the first two- or three-year initial period of the loan. Nearly one in 10 mortgage borrowers in 2005 and 2006 took out these "option ARM" loans, and an estimated one-third of ARMs originated between 2004 and 2006 had "teaser" rates below 4%. After the initial period, monthly payments might double The proportion of subprime ARM loans made to people with credit scores high enough to qualify for conventional mortgages with better terms increased from 41% in 2000 to 61% by 2006. In addition, mortgage brokers in some cases received incentives from lenders to offer subprime ARMs even to those with credit ratings that merited a conforming (i.e., non-subprime) loan.
Mortgage underwriting standards declined precipitously during the boom period. The use of automated loan approvals allowed loans to be made without appropriate review and documentation. In 2007, 40% of all subprime loans resulted from automated underwriting. The chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to examine whether borrowers could repay.
Mortgage fraud by lenders and borrowers increased enormously.The
Financial Crisis Inquiry Commission reported in January 2011 that many mortgage lenders took eager borrowers' qualifications on faith, often with a "willful disregard" for a borrower's ability to pay. Nearly 25% of all mortgages made in the first half of 2005 were "interest-only" loans. During the same year, 68% of "option ARM" loans originated by
Countrywide Financial and
Washington Mutual had low- or no-documentation requirements. At least one study has suggested that the decline in standards was driven by a shift of mortgage securitization from a tightly controlled duopoly to a competitive market in which mortgage originators held the most sway.
Subprime mortgage market Subprime borrowers typically have weakened credit histories and reduced repayment capacity. Subprime loans have a higher risk of
default than loans to prime borrowers. If a borrower is delinquent in making timely mortgage payments to the loan servicer (a bank or other financial firm), the lender may take possession of the property, in a process called
foreclosure. The value of American subprime mortgages was estimated at $1.3 (~$ in ) trillion as of March 2007, with over 7.5 million first-
lien subprime mortgages outstanding. Between 2004 and 2006 the share of subprime mortgages relative to total originations ranged from 18%–21%, versus less than 10% in 2001–2003 and during 2007. The majority of subprime loans were issued in California. The boom in mortgage lending, including subprime lending, was also driven by a fast expansion of non-bank independent mortgage originators which despite their smaller share (around 25% in 2002) in the market have contributed to around 50% of the increase in mortgage credit between 2003 and 2005. In the third quarter of 2007, subprime ARMs making up only 6.9% of US mortgages outstanding also accounted for 43% of the foreclosures which began during that quarter. By October 2007, approximately 16% of subprime
adjustable-rate mortgages (ARM) were either 90-days delinquent or the lender had begun
foreclosure proceedings, roughly triple the rate of 2005. By January 2008, the delinquency rate had risen to 21% and by May 2008 it was 25%. According to
RealtyTrac, the value of all outstanding residential mortgages, owed by U.S. households to purchase residences housing at most four families, was US$9.9 trillion as of year-end 2006, and US$10.6 trillion as of midyear 2008. During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006. This increased to 2.3 million in 2008, an 81% increase vs. 2007, and again to 2.8 million in 2009, a 21% increase vs. 2008. By August 2008, 9.2% of all U.S. mortgages outstanding were either delinquent or in foreclosure. By September 2009, this had risen to 14.4%. Between August 2007 and October 2008, 936,439 US residences completed foreclosure. Foreclosures are concentrated in particular states both in terms of the number and rate of foreclosure filings. Ten states accounted for 74% of the foreclosure filings during 2008; the top two (California and Florida) represented 41%. Nine states were above the national foreclosure rate average of 1.84% of households.
Mortgage fraud and predatory lending based upon US Department of the Treasury Suspicious Activity Report Analysis "The FBI defines
mortgage fraud as 'the intentional misstatement, misrepresentation, or omission by an applicant or other interest parties, relied on by a lender or underwriter to provide funding for, to purchase, or to insure a mortgage loan.'" In 2004, the
Federal Bureau of Investigation warned of an "epidemic" in mortgage fraud, an important
credit risk of nonprime mortgage lending, which, they said, could lead to "a problem that could have as much impact as the
S&L crisis". Despite this, the
Bush administration prevented states from investigating and prosecuting
predatory lenders by invoking a banking law from 1863 "to issue formal opinions preempting all state predatory lending laws, thereby rendering them inoperative." The
Financial Crisis Inquiry Commission reported in January 2011 that: "... mortgage fraud... flourished in an environment of collapsing lending standards and lax regulation. The number of suspicious activity reports – reports of possible financial crimes filed by depository banks and their affiliates – related to mortgage fraud grew 20-fold between 1996 and 2005 and then more than doubled again between 2005 and 2009. One study places the losses resulting from fraud on mortgage loans made between 2005 and 2007 at $112 billion." The report continued that "Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities." The unfair, deceptive, or fraudulent practices by lenders during the loan origination process was a form of
predatory lending.
Financial markets Boom and collapse of the shadow banking system The
Financial Crisis Inquiry Commission reported in January 2011: In the early part of the 20th century, we erected a series of protections – the Federal Reserve as a
lender of last resort, federal deposit insurance, ample regulations – to provide a bulwark against the panics that had regularly plagued America's banking system in the 19th century. Yet, over the past 30-plus years, we permitted the growth of a shadow banking system – opaque and laden with short term debt – that rivaled the size of the traditional banking system. Key components of the market – for example, the multitrillion-dollar repo lending market, off-balance-sheet entities, and the use of over-the-counter derivatives – were hidden from view, without the protections we had constructed to prevent financial meltdowns. We had a 21st-century financial system with 19th-century safeguards. In a June 2008 speech, President of the NY Federal Reserve Bank
Timothy Geithner, who later became Secretary of the Treasury, placed significant blame for the freezing of credit markets on a "run" on the entities in the "parallel" banking system, also called the
shadow banking system. These entities became critical to the credit markets underpinning the financial system, but were not subject to the same regulatory controls as depository banks. Further, these entities were vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that disruptions in credit markets would make them subject to rapid
deleveraging, selling their long-term assets at depressed prices. The securitization markets supported by the shadow banking system started to close down in the spring of 2007 and nearly shut-down in the fall of 2008. More than a third of the private credit markets thus became unavailable as a source of funds. Economist
Mark Zandi testified to the
Financial Crisis Inquiry Commission in January 2010: The securitization markets also remain impaired, as investors anticipate more loan losses. Investors are also uncertain about coming legal and accounting rule changes and regulatory reforms. Private bond issuance of residential and commercial mortgage-backed securities, asset-backed securities, and CDOs peaked in 2006 at close to $2 trillion...In 2009, private issuance was less than $150 billion, and almost all of it was asset-backed issuance supported by the Federal Reserve's TALF program to aid credit card, auto and small-business lenders. Issuance of residential and commercial mortgage-backed securities and CDOs remains dormant.
The Economist reported in March 2010: "Bear Stearns and Lehman Brothers were non-banks that were crippled by a silent run among panicky overnight "
repo" lenders, many of them money market funds uncertain about the quality of securitized collateral they were holding. Mass redemptions from these funds after Lehman's failure froze short-term funding for big firms."
Securitization structure
Securitization – the bundling of bank loans to create
tradeable bonds – started in the mortgage industry in the 1970s, when Government Sponsored Enterprises (GSEs) began to pool relatively safe, conventional, "
conforming" or "prime" mortgages, create "
mortgage-backed securities" (MBS) from the pool, sell them to investors, guaranteeing these securities/bonds against default on the underlying mortgages. This "originate-to-distribute" model had advantages over the old "originate-to-hold" model, where a bank originated a loan to the borrower/homeowner and retained the credit (default) risk. Securitization removed the loans from a bank's books, enabling the bank to remain in compliance with capital requirement laws. More loans could be made with proceeds of the MBS sale. The
liquidity of a national and even international mortgage market allowed capital to flow where mortgages were in demand and funding short. However, securitization created a
moral hazard – the bank/institution making the loan no longer had to worry if the mortgage was paid off – giving them incentive to process mortgage transactions but not to ensure their credit quality. Bankers were no longer around to work out borrower problems and minimize defaults during the course of the mortgage. With the high
down payments and
credit scores of the conforming mortgages used by GSE, this danger was minimal. Investment banks however, wanted to enter the market and avoid competing with the GSEs. the issuers generally did not guarantee the securities against default of the underlying mortgages. Tranches were compared to "buckets" catching the "water" of principal and interest. More senior buckets did not share water with those below until they were filled to the brim and overflowing. This gave the top buckets/tranches considerable creditworthiness (in theory) that would earn the highest "triple A" credit ratings, making them sellable to
money market and
pension funds that would not otherwise deal with subprime mortgage securities. diagram of
CDO and
RMBSTo use up the MBS tranches lower in payback priority that could not be rated triple-A and that a conservative
fixed income market would not buy, investment banks developed another security – known as the
collateralized debt obligation (CDO). Although the CDO market was smaller, it was crucial because unless buyers were found for the non-triple-A or "
mezzanine" tranches, it would not be profitable to make a mortgage-backed security in the first place. These CDOs pooled the leftover BBB, A−, etc. rated tranches, and produced new tranches – 70% to 80% of which were rated triple A by rating agencies. The 20–30% remaining mezzanine tranches were sometimes bought up by other CDOs, to make so-called "
CDO-Squared" securities which also produced tranches rated mostly triple A. This process was later disparaged as "ratings laundering" or a way of transforming "dross into gold" by some business journalists, but was justified at the time by the belief that home prices would always rise. The
model used by underwriters, rating agencies and investors to estimate the probability of mortgage default was based on the history of
credit default swaps, which unfortunately went back "less than a decade, a period when house prices soared". In addition the model – which postulated that the correlation of default risks among loans in securitization pools could be measured in a simple, stable, tractable number, suitable for risk management or valuation If the referenced CDOs defaulted, investors lost their investment, which was paid out to the insurance buyers. Unlike true insurance, credit default swaps were not regulated to insure that providers had the reserves to pay settlements, or that buyers owned the property (MBSs) they were insuring, i.e. were not simply making a bet a security would default. Because synthetics "referenced" another (cash) CDO, more than one – in fact numerous – synthetics could be made to reference the same original, multiplying the effect if a referenced security defaulted. As with MBS and other CDOs, triple A ratings for "large chunks" of synthetics were crucial to the securities' success, because of the buyer/investors' ignorance of the mortgage security market and trust in the credit rating agencies ratings. Securitization began to take off in the mid-1990s. The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion. The securitized share of subprime mortgages (i.e., those passed to third-party investors via MBS) increased from 54% in 2001, to 75% in 2006. Picking up the slack for the dwindling cash CDO market synthetics were the dominant form of CDO's by 2006, at an estimated $5 trillion. By the autumn of 2008, when the securitization market "seized up" and investors would "no longer lend at any price", securitized lending made up about $10 trillion of the roughly $25 trillion American credit market, (i.e. what "American homeowners, consumers, and corporations owed"). In February 2009,
Ben Bernanke stated that securitization markets remained effectively shut, with the exception of
conforming mortgages, which could be sold to
Fannie Mae and
Freddie Mac. According to economist
A. Michael Spence: "when formerly uncorrelated risks shift and become highly correlated ... diversification models fail." "An important challenge going forward is to better understand these dynamics as the analytical underpinning of an early warning system with respect to financial instability." Criticizing the argument that complex structured investment securitization was instrumental in the mortgage crisis,
Paul Krugman points out that the Wall Street firms issuing the securities "kept the riskiest assets on their own books", and that neither of the equally disastrous bubbles in European housing or US commercial property used complex structured securities. Krugman does agree that it is "arguable is that financial innovation ... spread the bust to financial institutions around the world" and its inherent fragmentation of loans has made post-bubble "cleanup" through debt renegotiation extremely difficult.
Financial institution debt levels and incentives of
investment banks increased significantly between 2003 and 2007. The
Financial Crisis Inquiry Commission reported in January 2011 that: "From 1978 to 2007, the amount of debt held by the financial sector soared from $3 trillion to $36 trillion, more than doubling as a share of gross domestic product. The very nature of many Wall Street firms changed – from relatively staid private partnerships to publicly traded corporations taking greater and more diverse kinds of risks. By 2005, the 10 largest U.S. commercial banks held 55% of the industry's assets, more than double the level held in 1990. On the eve of the crisis in 2006, financial sector profits constituted 27% of all corporate profits in the United States, up from 15% in 1980." Many
financial institutions,
investment banks in particular, issued large amounts of debt during 2004–07, and invested the proceeds in
mortgage-backed securities (MBS), essentially betting that house prices would continue to rise, and that households would continue to make their mortgage payments. Borrowing at a lower interest rate and investing the proceeds at a higher interest rate is a form of
financial leverage. This is analogous to an individual taking out a second mortgage on his residence to invest in the stock market. This strategy proved profitable during the housing boom, but resulted in large losses when house prices began to decline and mortgages began to default. Beginning in 2007, financial institutions and individual investors holding MBS also suffered significant losses from mortgage payment defaults and the resulting decline in the value of MBS. A 2004
U.S. Securities and Exchange Commission (SEC) decision related to the
net capital rule allowed US investment banks to issue substantially more debt, which was then used to purchase MBS. Over 2004–07, the top five US investment banks each significantly increased their financial leverage (see diagram), which increased their vulnerability to the declining value of MBSs. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of US nominal GDP for 2007. Further, the percentage of subprime mortgages originated to total originations increased from below 10% in 2001–03 to between 18–20% from 2004 to 2006, due in-part to financing from investment banks. In the years leading up to the crisis, the top four U.S. depository banks moved an estimated $5.2 trillion in assets and liabilities
off-balance sheet into
special purpose vehicles or other entities in the
shadow banking system. This enabled them to essentially bypass existing regulations regarding minimum capital ratios, thereby increasing leverage and profits during the boom but increasing losses during the crisis. New accounting guidance will require them to put some of these assets back onto their books during 2009, which will significantly reduce their capital ratios. One news agency estimated this amount to be between $500 billion and $1 trillion. This effect was considered as part of the stress tests performed by the government during 2009.
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." The New York State Comptroller's Office has said that in 2006, Wall Street executives took home bonuses totaling $23.9 billion (~$ in ). "Wall Street traders were thinking of the bonus at the end of the year, not the long-term health of their firm. The whole system – from mortgage brokers to Wall Street risk managers – seemed tilted toward taking short-term risks while ignoring long-term obligations. The most damning evidence is that most of the people at the top of the banks didn't really understand how those [investments] worked." The incentive compensation of traders was focused on fees generated from assembling financial products, rather than the performance of those products and profits generated over time. Their bonuses were heavily skewed towards cash rather than stock and not subject to "
claw-back" (recovery of the bonus from the employee by the firm) in the event the MBS or CDO created did not perform. In addition, the increased risk (in the form of financial leverage) taken by the major investment banks was not adequately factored into the compensation of senior executives.
Credit default swaps Credit default swaps (CDS) are financial instruments used as a hedge and protection for debtholders, in particular MBS investors, from the risk of default, or by speculators to profit from default. As the net worth of banks and other financial institutions deteriorated because of losses related to subprime mortgages, the likelihood increased that those providing the protection would have to pay their counterparties. This created uncertainty across the system, as investors wondered which companies would be required to pay to cover mortgage defaults. Like all
swaps and other
financial derivatives, CDS may either be used to
hedge risks (specifically, to insure creditors against default) or to profit from speculation. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. CDS are lightly regulated, largely because of the
Commodity Futures Modernization Act of 2000. As of 2008, there was no central
clearing house to honor CDS in the event a party to a CDS proved unable to perform his obligations under the CDS contract. Required disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as
American International Group (AIG),
MBIA, and
Ambac faced ratings downgrades because widespread mortgage defaults increased their potential exposure to CDS losses. These firms had to obtain additional funds (capital) to offset this exposure. AIG's having CDSs insuring $440 billion of MBS resulted in its seeking and obtaining a Federal government bailout. The monoline insurance companies went out of business in 2008–2009. When investment bank
Lehman Brothers went bankrupt in September 2008, there was much uncertainty as to which financial firms would be required to honor the CDS contracts on its $600 billion (~$ in ) of bonds outstanding.
Merrill Lynch's large losses in 2008 were attributed in part to the drop in value of its unhedged portfolio of
collateralized debt obligations (CDOs) after
AIG ceased offering CDS on Merrill's CDOs. The loss of confidence of trading partners in Merrill Lynch's solvency and its ability to refinance its
short-term debt led to its acquisition by the
Bank of America. Economist
Joseph Stiglitz summarized how credit default swaps contributed to the systemic meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets froze." Author
Michael Lewis wrote that CDS enabled speculators to stack bets on the same mortgage bonds and CDO's. This is analogous to allowing many persons to buy insurance on the same house. Speculators that bought CDS insurance were betting that significant defaults would occur, while the sellers (such as
AIG) bet they would not. A theoretically infinite amount could be wagered on the same housing-related securities, provided buyers and sellers of the CDS could be found. Derivatives such as CDS were unregulated or barely regulated. Several sources have noted the failure of the US government to supervise or even require transparency of the
financial instruments known as
derivatives. Ultimately, it was the collapse of a specific kind of derivative, the
mortgage-backed security, that triggered the economic crisis of 2008. In addition, Chicago Public Radio, Huffington Post, and ProPublica reported in April 2010 that market participants, including a hedge fund called
Magnetar Capital, encouraged the creation of CDO's containing low quality mortgages, so they could bet against them using CDS. NPR reported that Magnetar encouraged investors to purchase CDO's while simultaneously betting against them, without disclosing the latter bet. Instruments called
synthetic CDO, which are portfolios of credit default swaps, were also involved in allegations by the SEC against Goldman-Sachs in April 2010. The
Financial Crisis Inquiry Commission reported in January 2011 that CDS contributed significantly to the crisis. Companies were able to sell protection to investors against the default of mortgage-backed securities, helping to launch and expand the market for new, complex instruments such as CDO's. This further fueled the housing bubble. They also amplified the losses from the collapse of the housing bubble by allowing multiple bets on the same securities and helped spread these bets throughout the financial system. Companies selling protection, such as
AIG, were not required to set aside sufficient capital to cover their obligations when significant defaults occurred. Because many CDS were not traded on exchanges, the obligations of key financial institutions became hard to measure, creating uncertainty in the financial system.
Inaccurate credit ratings credit rating downgrades, by quarter Credit rating agencies – firms which rate debt
instruments/
securities according to the debtor's ability to pay lenders back – have come under scrutiny during and after the financial crisis for having given investment-grade ratings to MBSs and CDOs based on risky subprime mortgage loans that later defaulted. Dozens of lawsuits have been filed by investors against the "
Big Three" rating agencies –
Moody's Investors Service,
Standard & Poor's and
Fitch Ratings. The
Financial Crisis Inquiry Commission (FCIC) concluded the "failures" of the Big Three rating agencies were "essential cogs in the wheel of financial destruction" and "key enablers of the financial meltdown". Economist
Joseph Stiglitz called them "one of the key culprits" of the financial crisis. Others called their ratings "catastrophically misleading", (the
U.S. Securities and Exchange Commissioner), their performance "horrendous" (
The Economist magazine). There are indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty. The position of the three agencies "between the issuers and the investors of securities" "transformed" them into "key" players in the housing bubble and financial crisis according to the
Financial Crisis Inquiry Report. Most investors in the fixed income market had no experience with the mortgage business – let alone dealing with the complexity of pools of mortgages and tranche priority of MBS and CDO securities – and were simply looking for an independent party who could rate securities. The putatively independent parties meanwhile were paid "handsome fees" by investment banks "to obtain the desired ratings", according to one expert. In addition, a large section of the debt securities market – many
money markets and
pension funds – were restricted in their bylaws to holding only the safest securities – i.e securities the rating agencies designated "triple-A". Hence non-prime securities could not be sold without ratings by (usually two of) the three agencies. From 2000 to 2007, one of the largest agencies – Moody's – rated nearly 45,000 mortgage-related securities But as the boom matured, mortgage underwriting standards deteriorated. By 2007 an estimated $3.2 (~$ in ) trillion in loans were made to homebuyers and owners with bad credit and undocumented incomes, bundled into MBSs and CDOs, and given top ratings By the end of 2008, 80% of the CDOs by value rated "triple-A" were downgraded to junk. Bank writedowns and losses on these investments totaled $523 billion. Critics such as the FCIC argue the mistaken credit ratings stemmed from "flawed computer models, the pressure from financial firms that paid for the ratings, the relentless drive for market share, the lack of resources to do the job despite record profits, and the absence of meaningful public oversight". Structured investment was very profitable to the agencies and by 2007 accounted for just under half of Moody's total ratings revenue and all of the revenue growth. But profits were not guaranteed, and issuers played the agencies off one another, 'shopping' around to find the best ratings, sometimes openly threatening to cut off business after insufficiently generous ratings. Thus there was a conflict of interest between accommodating clients – for whom higher ratings meant higher earnings – and accurately rating the debt for the benefit of the debt buyer/investors – who provided zero revenue to the agencies. Despite the profitability of the three big credit agencies – Moody's operating margins were consistently over 50%, higher than famously successful
ExxonMobil or
Microsoft – salaries and bonuses for non-management were significantly lower than at Wall Street banks, and its employees complained of overwork. This incentivized agency rating analysts to seek employment at those Wall Street banks who were issuing mortgage securities, and who were particularly interested in the analysts' knowledge of what criteria their former employers used to rate securities. Inside knowledge of interest to security issuers eager to find loopholes included the fact that rating agencies looked at the
average credit score of a pool of borrowers, but not how dispersed it was; that agencies ignored borrower's household income or length of credit history (explaining the large numbers of low income immigrants given mortgages—people "who had never failed to repay a debt, because they had never been given a loan"); that agencies were indifferent to credit worthiness issues of
adjustable-rate mortgages with low teaser rates, "silent second" mortgages, or
no-documentation mortgages. As of 2010, virtually all of the investigations of rating agencies, criminal as well as civil, are in their early stages. In New York, state prosecutors are examining whether eight banks duped the credit ratings agencies into inflating the grades of subprime-linked investments. In the dozens of suits filed against them by investors involving claims of inaccurate ratings In 2013, McClatchy Newspapers found that "little competition has emerged" since the Credit Rating Agency Reform Act of 2006 was passed "in rating the kinds of complex home-mortgage securities whose implosion led to the 2007 financial crisis". The Big Three's market share of outstanding credit rating has barely shrunk, moving from 98% to 97%.
Governmental policies Government over-regulation, failed regulation and deregulation have all been claimed as causes of the crisis. Increasing home ownership has been the goal of several presidents including Roosevelt, Reagan, Clinton and
George W. Bush.
Decreased regulation of financial institutions {{quote box Several steps were taken to
deregulate banking institutions in the years leading up to the crisis. Further, major investment banks which collapsed during the crisis were not subject to the regulations applied to depository banks. In testimony before Congress both the
Securities and Exchange Commission (SEC) and
Alan Greenspan claimed failure in allowing the self-regulation of investment banks. In 1982, Congress passed the
Alternative Mortgage Transactions Parity Act (AMTPA), which allowed non-federally chartered housing creditors to write adjustable-rate mortgages. This bi-partisan legislation was, according to the Urban Institute, intended to "increase the volume of loan products that reduced the up-front costs to borrowers in order to make homeownership more affordable." Among the new mortgage loan types created and gaining in popularity in the early 1980s were adjustable-rate, option adjustable-rate, balloon-payment and interest-only mortgages. Subsequent widespread abuses of predatory lending occurred with the use of adjustable-rate mortgages. Approximately 90% of subprime mortgages issued in 2006 were adjustable-rate mortgages. President Bill Clinton, who signed the legislation, dismissed its connection to the subprime mortgage crisis, stating (in 2008): "I don't see that signing that bill had anything to do with the current crisis." The
Commodity Futures Modernization Act of 2000 was bi-partisan legislation that formally exempted
derivatives from regulation, supervision, trading on established exchanges, and capital reserve requirements for major participants. It "provided a legal safe harbor for treatment already in effect." Concerns that counterparties to derivative deals would be unable to pay their obligations caused pervasive uncertainty during the crisis. Particularly relevant to the crisis are
credit default swaps (CDS), a derivative in which Party A pays Party B what is essentially an insurance premium, in exchange for payment should Party C default on its obligations.
Warren Buffett famously referred to derivatives as "financial weapons of mass destruction" in early 2003. Former Fed Chair
Alan Greenspan, who many economists blamed for the financial crisis, testified in October 2008 that he had trusted free markets to self-correct and had not anticipated the risk of reduced lending standards."Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief." However, in an April 9, 2009, speech, Erik Sirri, then director of the SEC's Division of Trading and Markets, argued that the regulatory weaknesses in leverage restrictions originated in the late 1970s: "The Commission did not undo any leverage restrictions in 2004," nor did it intend to make a substantial reduction. The financial sector invested heavily to gain clout in the halls of government to bring about these major deregulatory objectives: it spent more than $5 billion over a decade to strengthen its political clout in Washington, DC, including $1.725 billion in political
campaign contributions and $3.4 billion on
Industry lobbyists during the years 1998–2008.
Policies to promote private ownership of housing Several administrations, both Democratic and Republican, advocated private home ownership in the years leading up to the crisis. The
Housing and Community Development Act of 1992 established, for the first time, a mandate to Fannie Mae and Freddie Mac for loans to enable home ownership of less expensive housing, a mandate to be regulated by the
Department of Housing and Urban Development (HUD). Initially, the 1992 legislation required that 30% or more of Fannie's and Freddie's loan purchases be in support of private home ownership of affordable housing. However, HUD was given the power to set future requirements. During the later part of the
Clinton administration, HUD Secretary
Andrew Cuomo announced "new regulations to provide $2.4 trillion in mortgages for affordable housing for 28.1 million families, which increased the required percentage of mortgage loans for low- and moderate-income families that finance companies Fannie Mae and Freddie Mac must buy annually from the then current 42% of their total purchases to a new high of 50%. Eventually (under the Bush administration) a 56% minimum was established. Additionally, in 2003, "The Bush administration today recommended the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis a decade ago." "The National Homeownership Strategy: Partners in the American Dream", was compiled in 1995 by Henry Cisneros, President Clinton's HUD Secretary. This 100-page document represented the viewpoints of HUD, Fannie Mae, Freddie Mac, leaders of the housing industry, various banks, numerous activist organizations such as
ACORN and
La Raza, and representatives from several state and local governments." In 2001, the independent research company, Graham Fisher & Company, stated: "While the underlying initiatives of the [strategy] were broad in content, the main theme … was the relaxation of credit standards." The Financial Crisis Inquiry Commission (majority report), Federal Reserve economists, and several academic researchers have stated that government affordable housing policies were not the major cause of the financial crisis. In 1995 the Clinton administration issued regulations that added numerical guidelines, urged lending flexibility, and instructed bank examiners to evaluate a bank's responsiveness to community activists (such as
ACORN) when deciding whether to approve bank merger or expansion requests. Critics claim that the 1995 changes to CRA signaled to banks that relaxed lending standards were appropriate and could minimize potential risk of governmental sanctions. In its "Conclusions" submitted January 2011, the
Financial Crisis Inquiry Commission reported that "the CRA was not a significant factor in subprime lending or the crisis. Many subprime lenders were not subject to the CRA. Research indicates only 6% of high-cost loans—a proxy for subprime loans—had any connection to the law. Loans made by CRA-regulated lenders in the neighborhoods in which they were required to lend were half as likely to default as similar loans made in the same neighborhoods by independent mortgage originators not subject to the law." Critics claim that the use of the high-interest-rate proxy distorts results because government programs generally promote low-interest rate loans—even when the loans are to borrowers who are clearly subprime. However, several economists maintain that Community Reinvestment Act loans outperformed other "subprime" mortgages, and GSE mortgages performed better than private label securitizations.
State and local governmental programs As part of the 1995 National Homeownership Strategy, HUD advocated greater involvement of state and local organizations in the promotion of affordable housing. In addition, it promoted the use of low or no-down payment loans and second, unsecured loans to the borrower to pay their down payments (if any) and closing costs. This idea manifested itself in "silent second" loans that became extremely popular in several states such as California, and in scores of cities such as San Francisco. Using federal funds and their own funds, these states and cities offered borrowers loans that would defray the cost of the down payment. The loans were called "silent" because the primary lender was not supposed to know about them. A Neighborhood Reinvestment Corporation (affiliated with HUD) publicity sheet explicitly described the desired secrecy: "[The NRC affiliates] hold the second mortgages. Instead of going to the family, the monthly voucher is paid to [the NRC affiliates]. In this way the voucher is "invisible" to the traditional lender and the family (emphasis added)
Role of Fannie Mae and Freddie Mac Fannie Mae and
Freddie Mac are
government-sponsored enterprises (GSE) that purchase mortgages, buy and sell
mortgage-backed securities (MBS), and guarantee nearly half of the mortgages in the U.S. A variety of political and competitive pressures resulted in the GSEs ramping up their purchase and guarantee of risky mortgages in 2005 and 2006, just as the housing market was peaking. Fannie and Freddie were both under political pressure to expand purchases of higher-risk affordable housing mortgage types, and under significant competitive pressure from large investment banks and mortgage lenders. The GSEs dispute these studies and dismissed Greenspan's testimony. Nine of the ten members of the
Financial Crisis Inquiry Commission reported in 2011 that Fannie and Freddie "contributed to the crisis, but were not a primary cause", or that since "credit spreads declined not just for housing, but also for other asset classes like commercial real estate ... problems with U.S. housing policy or markets [could] not by themselves explain the U.S. housing bubble." According to the Commission, GSE mortgage securities essentially maintained their value throughout the crisis and did not contribute to the significant financial firm losses that were central to the financial crisis. The GSEs participated in the expansion of subprime and other risky mortgages, but they followed rather than led Wall Street and other lenders into subprime lending. Several studies by the
Government Accountability Office (GAO), Harvard Joint Center for Housing Studies, the
Federal Housing Finance Agency, and several academic institutions summarized by economist Mike Konczal of the
Roosevelt Institute, indicate Fannie and Freddie were not to blame for the crisis. A 2011 statistical comparisons of regions of the US which were subject to GSE regulations with regions that were not, done by the
Federal Reserve, found that GSEs played no significant role in the subprime crisis. In 2008, David Goldstein and Kevin G. Hall reported that more than 84% of the subprime mortgages came from private lending institutions in 2006, and the share of subprime loans insured by Fannie Mae and Freddie Mac decreased as the bubble got bigger (from a high of insuring 48% to insuring 24% of all subprime loans in 2006). In 2008, another source found estimates by some analysts that Fannie's share of the subprime mortgage-backed securities market dropped from a peak of 44% in 2003 to 22% in 2005, before rising to 33% in 2007. Whether GSEs played a small role in the crisis because they were legally barred from engaging in subprime lending is disputed. Economist
Russell Roberts cites a June 2008
Washington Post article which stated that "[f]rom 2004 to 2006, the two [GSEs] purchased $434 billion in securities backed by subprime loans, creating a market for more such lending." Furthermore, a 2004 HUD report admitted that while trading securities that were backed by subprime mortgages was something that the GSEs officially disavowed, they nevertheless participated in the market. Insofar as Fannie and Freddie did purchase substandard loans, some analysts question whether government mandates for affordable housing were the motivation. In December 2011 the
Securities and Exchange Commission charged the former Fannie Mae and Freddie Mac executives, accusing them of misleading investors about risks of subprime-mortgage loans and about the amount of subprime mortgage loans they held in portfolio. According to financial analyst
Karen Petrou, "The SEC's facts paint a picture in which it wasn't high-minded government mandates that did the GSEs wrong, but rather the monomaniacal focus of top management on marketshare. With marketshare came bonuses and with bonuses came risk-taking, understood or not." However, there is evidence suggesting that governmental housing policies were a motivational factor. Daniel H. Mudd, the former CEO of Fannie Mae, stated: "We were afraid that lenders would be selling products we weren't buying and Congress would feel like we weren't fulfilling our mission." Another senior Fannie Mae executive stated: "Everybody understood that we were now buying loans that we would have previously rejected, and that the models were telling us that we were charging way too little, but our mandate was to stay relevant and to serve low-income borrowers. So that's what we did." In his lone dissent to the majority and minority opinions of the FCIC,
Peter J. Wallison of the
American Enterprise Institute (AEI) blamed U.S. housing policy, including the actions of Fannie and Freddie, primarily for the crisis, writing: "When the bubble began to deflate in mid-2007, the low quality and high risk loans engendered by government policies failed in unprecedented numbers. The effect of these defaults was exacerbated by the fact that few if any investors – including housing market analysts – understood at the time that Fannie Mae and Freddie Mac had been acquiring large numbers of subprime and other high risk loans in order to meet HUD's affordable housing goals." His dissent relied heavily on the research of fellow AEI member Edward Pinto, the former Chief Credit Officer of Fannie Mae. Pinto estimated that by early 2008 there were 27 million higher-risk, "non-traditional" mortgages (defined as subprime and Alt-A) outstanding valued at $4.6 (~$ in ) trillion. Of these, Fannie & Freddie held or guaranteed 12 million mortgages valued at $1.8 trillion. Government entities held or guaranteed 19.2 million or $2.7 trillion of such mortgages total. One counter-argument to Wallison and Pinto's analysis is that the credit bubble was global and also affected the U.S. commercial real estate market, a scope beyond U.S. government housing policy pressures. The three Republican authors of the dissenting report to the FCIC majority opinion wrote in January 2011: "Credit spreads declined not just for housing, but also for other asset classes like commercial real estate. This tells us to look to the credit bubble as an essential cause of the U.S. housing bubble. It also tells us that problems with U.S. housing policy or markets do not by themselves explain the U.S. housing bubble." Economist Paul Krugman wrote in January 2010 that Fannie Mae, Freddie Mac, CRA, or predatory lending were not primary causes of the bubble/bust in residential real estate because there was a bubble of similar magnitude in commercial real estate in America. Countering the analysis of Krugman and members of the FCIC, Peter Wallison argues that the crisis was caused by the bursting of a real estate bubble that was
supported largely by low or no-down-payment loans, which was uniquely the case for U.S.
residential housing loans. He states: "It is not true that every bubble – even a large bubble – has the potential to cause a financial crisis when it deflates." As an example, Wallison notes that other developed countries had "large bubbles during the 1997–2007 period" but "the losses associated with mortgage delinquencies and defaults when these bubbles deflated were far lower than the losses suffered in the United States when the 1997–2007 [bubble] deflated." Other analysis calls into question the validity of comparing the residential loan crisis to the commercial loan crisis. After researching the default of commercial loans during the financial crisis, Xudong An and Anthony B. Sanders reported (in December 2010): "We find limited evidence that substantial deterioration in CMBS [commercial mortgage-backed securities] loan underwriting occurred prior to the crisis." Other analysts support the contention that the crisis in commercial real estate and related lending took place
after the crisis in residential real estate. Business journalist Kimberly Amadeo wrote "The first signs of decline in residential real estate occurred in 2006. Three years later, commercial real estate started feeling the effects." Denice A. Gierach, a real estate attorney and CPA, wrote:...most of the commercial real estate loans were good loans destroyed by a really bad economy. In other words, the borrowers did not cause the loans to go bad, it was the economy. A second counter-argument to Wallison's dissent is that the definition of "non-traditional mortgages" used in Pinto's analysis overstated the number of risky mortgages in the system by including Alt-A, which was not necessarily high-risk. Krugman explained in July 2011 that the data provided by Pinto significantly overstated the number of subprime loans, citing the work of economist Mike Konczal: "As Konczal says, all of this stuff relies on a form of
three-card monte: you talk about 'subprime and other high-risk' loans, lumping subprime with other loans that are not, it turns out, anywhere near as risky as actual subprime; then use this essentially fake aggregate to make it seem as if Fannie/Freddie were actually at the core of the problem."
Other contributing factors Policies of central banks and various
mortgage rates Central banks manage monetary policy and may target the rate of inflation. They have some authority over
commercial banks and possibly other financial institutions. They are less concerned with avoiding asset
price bubbles, such as the
housing bubble and
dot-com bubble. Central banks have generally chosen to react after such bubbles burst so as to minimize collateral damage to the economy, rather than trying to prevent or stop the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to deflate it are matters of debate among economists. Some market observers have been concerned that
Federal Reserve actions could give rise to
moral hazard. A contributing factor to the rise in house prices was the Federal Reserve's lowering of interest rates early in the decade. From 2000 to 2003, the Federal Reserve lowered the
federal funds rate target from 6.5% to 1.0%. This was done to soften the effects of the collapse of the
dot-com bubble and of the
September 2001 terrorist attacks, and to combat the perceived risk of
deflation.
Ben Bernanke and Alan Greenspan — both former chairmen of the Federal Reserve — disagree, arguing decisions on purchasing a home depends on long-term interest rates on mortgages not the short-term rates controlled by the Fed. According to Greenspan, "between 1971 and 2002, the fed funds rate and the mortgage rate moved in lock-step," but when the Fed started to raise rates in 2004, mortgage rates diverged, continuing to fall (or at least not rise) for another year (see "Fed Funds Rate & Mortgage Rates" graph). Construction of new homes did not peak until January 2006. Bernanke speculates that a world wide "saving glut" pushed capital or savings into the United States, keeping long-term interest rates low and independent of Central Bank action. Agreeing with Fisher that the low interest rate policy of the Greenspan Fed both allowed and motivated investors to seek out risk investments offering higher returns, is finance economist
Raghuram Rajan who argues that the underlying causes of the American economy's tendency to go "from bubble to bubble" fueled by unsustainable monetary stimulation, are the "weak safety nets" for the unemployed, which made "the US political system ... acutely sensitive to job growth"; and attempts to compensate for the stagnant income of the middle and lower classes with easy credit to boost their consumption. Economist
Thomas Sowell wrote that the Fed's decision to steadily raise interest rates was a key factor that ended the housing bubble. The Fed raised rates from the unusually low level of 1% in 2004 to a more typical 5.25% in 2006. By driving mortgage rates higher, the Fed "made monthly mortgage payments more expensive and therefore reduced the demand for housing." He referred to the Fed action as the "nudge" that collapsed the "house of cards" created by lax lending standards, affordable housing policies, and the preceding period of low interest rates. Whether or not this is true has been the subject of ongoing debate. The debate arises because this accounting rule requires companies to adjust the value of marketable securities (such as the
mortgage-backed securities (MBS) at the center of the crisis) to their market value. The intent of the standard is to help investors understand the value of these assets at a point in time, rather than just their historical purchase price. Because the market for these assets is distressed, it is difficult to sell many MBS at other than prices which may (or may not) be reflective of market stresses, which may be below the value that the mortgage cash flow related to the MBS would merit. As initially interpreted by companies and their auditors, the typically lower sale value was used as the market value rather than the cash flow value. Many large financial institutions recognized significant losses during 2007 and 2008 as a result of marking-down MBS asset prices to market value.
Globalization, technology and the trade deficit or
trade deficit through 2012 In 2005,
Ben Bernanke addressed the implications of the United States's high and rising
current account deficit, resulting from U.S. investment exceeding its savings, or imports exceeding exports. Between 1996 and 2004, the U.S. current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. The U.S. attracted a great deal of foreign investment, mainly from the emerging economies in Asia and oil-exporting nations. The
balance of payments identity requires that a country (such as the U.S.) running a
current account deficit also have a
capital account (investment) surplus of the same amount. Foreign investors had these funds to lend, either because they had very high personal savings rates (as high as 40% in China), or because of high oil prices. Bernanke referred to this as a "
saving glut" Economist
Joseph Stiglitz wrote in October 2011 that the recession and high unemployment of the 2009–2011 period was years in the making and driven by: unsustainable consumption; high manufacturing productivity outpacing demand thereby increasing unemployment; income inequality that shifted income from those who tended to spend it (i.e., the middle class) to those who do not (i.e., the wealthy); and emerging market's buildup of reserves (to the tune of $7.6 trillion by 2011) which was not spent. These factors all led to a "massive" shortfall in aggregate demand, which was "papered over" by demand related to the housing bubble until it burst. ==Subprime mortgage crisis phases==