INTRO In 2008, the United States experienced a major financial crisis which led to the worst recession since World War II. Both the financial crisis and the downturn in the U.S. economy spread to many foreign nations, resulting in a global economic crisis. In the months following the initial decline, the U.S. stock market plummeted, liquidity dried up, successful companies began laying off employees by the thousands, and it became apparent that a recession was upon the American people.
THE ORIGINS OF THE FINANCIAL CRISIS In mid 1990’s to 2006, the fundamentals of the housing market became distorted as increasing house prices across the U.S. formed a bubble. In 2003 a survey was conducted by Karl Case and Robert Shiller, it concluded that an overwhelming majority of people agreed with the statement that real estate is the best investment for longterm holders. Real estate was was a great investment and perceived as a safe investment. At the time people were oblivious to what was actually going on, as a result they assumed or even expected the prices to continue to rise. This occurred right up until the peak of the bubble in the housing prices. The problem was house prices started to grow much faster than real household income, a problem because home buyers were stretching themselves thin. Low interest rates only contributed to the increase in demand for mortgagefinanced housing. The number of mortgage frauds, according to the Financial Crimes Enforcement
Network, went from 3,500 in 2000 to 53,000 in 2007. Mortgage brokers where helping potential buyers navigate the application process, sometimes encouraging lying or misrepresentation of information. Credit scores were being manipulated and overall deceptive practices by borrowers and lenders were often linked together. Another problem was speculators, which are home buyers with investment intentions. The problem with that is 40 to 50 percent of them had delinquent mortgages. Fannie Mae and Freddie Mac, are two very large governmentsponsored enterprises (GSE) committed to mortgage lending. Originally they set out to guarantee mortgage backed securities (MBS) given to “prime” borrowers, to ensure their marketability. Which was good and meant the borrower had a conforming loan and met their standards. The private sector on the other hand had developed mortgage backed securities backed for nonconforming loans. The market remained relatively small until the late 1990’s. GSEs would either sell MBS on the open market or issue their own bonds, and then using that revenue to buy MBSs that they hold on their books. The problem with GSEs are they’re seen as implicitly guaranteed by the federal government. This gave them the opportunity to pay only a few basis points above treasury yields on their bond issuance which led to a low cost in borrowing and a balance sheet that was enormously inflated. The federal chairman at the time, Alan Greenspan, did eventually pose regulatory restrictions on the GSEs, but evidently not enough. By 2008 Fannie Mae and Freddie Mac held or guaranteed $5.4 trillion in mortgage debt. In the first two quarters of 2008 they had a combined $5.5 billion in losses. In 2007 they were overleveraged by a staggering amount,
their leverage ratio was over twice that of commercial banks. Unrealistic goals set by Congress to increase affordable housing only enabled GSEs to over extend themselves. Under the old system, lenders could only make limited numbers of loans which was based on their balance sheet. With the new system lenders were able to sell off loans to...
Cited: Baily, Neil Martin, Robert E. Litan, and Matthew S. Johnson. 2008. The Initiative On Business and Public Policy, Brookings Institute, “The origins of the financial crisis” http://www.brookings.edu/~/media/Files/rc/papers/2008/11_origins_crisis_baily_lita n/11_origins_crisis_baily_litan.pdf Caballero, Ricardo J. 2009. MIT Working Paper, “The “Other” Imbalance and the Financial Crisis” http://www.iadb.org/intal/intalcdi/PE/2010/04930.pdf Ellis, Luci. 2008. “The housing meltdown: Why did it happen in the United States?”, Bank for International Settlements, Working papers No 259. http://www.bis.org/publ/work259.pdf Salmon, Felix. Wired. 02/23/09. “Recipe for Disaster: The formula That Killed Wall Street” http://www.wired.com/techbiz/it/magazine/1703/wp_quant?currentPage=all
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