Leir Center Financial Bubble Research
Working Paper #7
2007-2009 Financial Meltdown
New Jersey Institute Of Technology
In the Fall of 2007 the Dow Jones Industrial index reached an all time high over 14,000. By November 2008 it had fallen under 8000. Other stock market indices worldwide including the high growth emerging economies of India and China saw similar or greater drops. Those predicting these economies had developed an Asian regional economy that would prove relatively robust despite problems in US and European financial markets were wrong. Mirroring this change in financial fortune in March 2008 Bear Sterns one of five major US investment banks and a leader in subprime mortgage lending collapsed leading to a rescue merger with JP Morgan Chase engineered by the Federal Reserve. This was followed in September by the failure of another major US investment bank and leader in subprime mortgage financing, Lehman Brothers. It was the largest bankruptcy in US history at over $600 billion. Then came the disappearance of Washington Mutual, the largest bank collapse in US history, and another JP Morgan Chase rescue, this time engineered by the Federal Deposit Insurance Corporation (FDIC). Further during 2008 and later in early 2009 the US government needed to rescue several large financial institutions with billions of dollars in loans and capital injections. These included AIG, Citicorp, and Bank of America. European governments too had to undertake similar actions. Yet despite its global reach and historically severe adverse economic impact the meltdown reflects all the traditional characteristics of a classic boom and bust fed by excess credit. This is seen in the development of the housing bubble beginning in 2003 through its peak in August 2005 and finally the collapse in 2007 and 2008 of the mortgage and housing markets with their legal, economic and political aftermath. Indeed any reasonable analysis of the boom based on the classic boom and bust scenario should have raised early policy warnings about the housing bubble and its inherent risks. What was not fully appreciated even by those predicting a collapse was the scale and worldwide scope that magnified the financial and economic impact of the housing market’s collapse so as to trigger a global decline in credit availability even to large corporations and financial institutions resulting in a global recession. However, to grasp how the subprime and US housing bubbles and their crash triggered the 2007-2009 Financial Meltdown and its current aftershocks, one must understand key changes that have occurred in the markets for US mortgage related securities and their legal underpinnings along with how computerization and the Internet provided global scale, while changes in US banking and security laws have complicated finding a solution.
Structure And Evolution Of The US Mortgage Market
The US residential mortgage market is a multi-trillion dollar market that dramatically increased between 2002 and 2007. In June 2007 US residential and non-profit mortgages were $10.143 trillion up from $5.833 trillion in September 2002 and $2.3 trillion in 1989. They took 13 years to increase $2.5 trillion but only five years to increase by $4.3 even though population growth was not increasing proportionately. This acceleration in growth is one indicator of a bubble. In turn the number of firms and organizations participating in this huge market proliferated. Until about twenty-five years ago home loans and mortgages were usually arranged between a local bank or local savings and loan [S&L] and a local borrower with the bank or S&L holding the mortgage until maturity or the home was sold or the mortgage refinanced. But starting in the 1980s and expanding in 1990s and the first years of this century, that changed. Banks and S&Ls discovered the benefits of securitization and balance sheet turnover. They realized mortgages and regular payment...
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