Monetary Policy and Modern Mortgage Model

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1. What accounts for the subprime financial turmoil which burst onto the scene in the summer of 2007? Who is most to blame for this mess?

A number of interrelated factors can be pointed to in accounting for the subprime mortgage crisis and resulting credit crunch that exploded in the summer of 2007. Overly loose monetary policy, poor regulation of financial markets, the overexpansion of the subprime mortgage market and accompanying housing bubble, and the rapid growth of complex financial derivatives based on pooled mortgage loans all played significant roles in bringing about the crisis.

Looking back at the actions of the Federal Reserve in the aftermath of the 2001 recession, it is evident that the Fed made a fundamental error in ignoring soaring asset prices in their decisions to keep lowering interest rates through 2003 to a low of 1%, even as the economy recovered, and then to keep rates at historically low levels through the first half of 2004. The Fed justified its actions by pointing out that relatively low inflation during the period leading up to the crisis, as measured by the Consumer Price Index (CPI), led them to see no need to raise interest rates and stifle the economic recovery underway. Unfortunately, instead of bidding up the prices of goods and services included in the CPI, the excess money supply created by extremely low interest rates found its way into assets—homes and commercial real estate—and helped to create the housing bubble.

While it is clear that monetary policy errors played a foundational role in creating the economic environment that enabled and accelerated the housing bubble, the greatest responsibility for the catastrophic extent of the crisis rests with the managers of mortgage lenders and financial institutions. Irresponsible lending practices, unrealistic expectations about future home values, the euphoria over high returns from mortgage backed securities (CDOs), along with the inaccurate pricing of risk, are...
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