Chapter 12 The Financial Crisis of 2007–2009

12.1 Financial Crises

A financial crisisThe functioning of one or more financial markets or intermediaries becomes erratic or ceases altogether.occurs when one or more financial markets or intermediaries cease functioning or function only erratically and inefficiently. A nonsystemic crisisA particular market or intermediary functions erratically or inefficiently. involves only one or a few markets or sectors, like the Savings and Loan Crisis described in Chapter 11 "The Economics of Financial Regulation". A systemic crisisThe functioning of all, or nearly all, of the financial system degrades. involves all, or almost all, of the financial system to some extent, as during the Great Depression.

Financial crises are neither new nor unusual. Thousands of crises, including the infamous Tulip Mania and South Sea Company episodes, have rocked financial systems throughout the world in the past five hundred years. Two such crises, in 1764–1768 and 1773, helped lead to the American Revolution.Tim Arango, “The Housing-Bubble and the American Revolution,” New York Times (29 November 2008), WK5. http://www.nytimes.com/2008/11/30/weekinreview/30arango.html?_r=2&pagewanted=1&ref=weekinreview After its independence, the United States suffered systemic crises in 1792, 1818–1819, 1837–1839, 1857, 1873, 1884, 1893–1895, 1907, 1929–1933, and 2008. Nonsystemic crises have been even more numerous and include the credit crunch of 1966, stock market crashes in 1973–1974 (when the Dow dropped from a 1,039 close on January 12, 1973, to a 788 close on December 5, 1973, to a 578 close on December 6, 1974) and 1987, the failure of Long-Term Capital Management in 1998, the dot-com troubles of 2000, the dramatic events following the terrorist attacks in 2001, and the subprime mortgage debacle of 2007. Sometimes, nonsystemic crises burn out or are brought under control before they spread to other parts of the financial system. Other times, as in 1929 and 2007, nonsystemic crises spread like a wildfire until they threaten to burn the entire system.

Both systemic and nonsystemic crises damage the real economy by preventing the normal flow of credit from savers to entrepreneurs and other businesses and by making it more difficult or expensive to spread risks. Given the damage financial crises can cause, scholars and policymakers are keenly interested in their causes and consequences. You should be, too.

12.2 Asset Bubbles

Asset bubblesIn this context, a rapid increase in asset prices that is not easily justified by fundamentals like expected earnings, interest rates, and the like.are rapid increases in the value of some asset, like bonds, commodities (cotton, gold, oil, tulips), equities, or real estate. Some combination of low interest rates, new technology, unprecedented increases in demand for the asset, and leverage typically create bubbles.

Low interest rates can cause bubbles by lowering the total cost of asset ownership. Recall from Chapter 4 "Interest Rates" that interest rates and bond prices are inversely related. Algebraically, the i term is in the denominator of the PV formula—PV = FV/(1 + i)ⁿ—so as it gets smaller, PV must get larger (holding FV constant, of course).

The effect of new technology can be thought of as increasing FV, leading, of course, to a higher PV. Or, in the case of equities, low interest rates decrease k (required return) and new inventions increase g (constant growth rate) in the Gordon growth model—P = E × (1 + g)/(k – g)—both of which lead to a higher price.

Large increases in the demand for an asset occur for a variety of reasons. Demand can be increased merely by investors’ expectations of higher prices in the future, as in the one period valuation model—P = E/(1 + k) + P₁/(1 + k). If many investors believe that P₁ must be greater than P a year (or any other period) hence, demand for the asset will increase and the expectation of a higher P₁ will be vindicated. That sometimes leads investors to believe that P₂ will be higher than P₁, leading to a self-fulfilling cycle that repeats through P₃ to P_x. At some point, the value of the asset becomes detached from fundamental reality, driven solely by expectations of yet higher future prices. In fact, some scholars verify the existence of an asset bubble when news about the price of an asset affects the economy, rather than the economy affecting the price of the asset.

To increase their returns, investors often employ leverage, or borrowing. Compare three investors, one who buys asset X entirely with his own money, one who borrows half of the price of asset X, and one who borrows 90 percent of the price of asset X. Their returns (not including the cost of borrowing, which as noted above is usually low during bubbles) will be equal to those calculated in Figure 12.1 "The effects of leverage on returns in a rising market".

Figure 12.1 The effects of leverage on returns in a rising market

The figures were calculated using the rate of return formula: R = (C + P_t1 – P_t0)/P_t0 discussed in Chapter 4 "Interest Rates". Here, coupons are zero and hence drop out so that R = (P_t1 – P_t0)/P_t0.

In this example, returns for the unleveraged investor are great:

But the returns are not as high as the investor who borrowed half the cash, in essence paying only $50 of his own money for the $100 asset at the outset:

But even he looks like a chump compared to the investor who borrowed most of the money to finance the original purchase, putting up only $10 of his own money:

If you are thinking the most highly leveraged investor is the smart one, go back and reread the section of Chapter 2 "The Financial System"that discusses the trade-off between risk and return before continuing.

12.3 Financial Panics

A financial panicPanicked selling occurs during the rapid de-leveraging of the financial system following the bursting of an asset bubble.occurs when leveraged financial intermediaries and other investors must sell assets quickly in order to meet lenders’ callsA lender asks a borrower to repay, usually because interest rates have increased and/or the value of collateral has declined.. Lenders call loans, or ask for repayment, when interest rates increase and/or when the value of collateral pledged to repay the loan sinks below the amount the borrower owes. Calls are a normal part of everyday business, but during a panic, they all come en masse due to some shock, often the burstingWhen an asset bubble rapidly deflates, i.e., the price of the asset rapidly decreases. of an asset bubble. Bubbles, like people, are bound to die but nobody knows in advance when they will do so. A burst is sometimes triggered by an obvious shock, like a natural catastrophe or the failure of an important company, but sometimes something as seemingly innocuous as a large sell order can touch them off.

During a panic, almost everybody must sell and few can or want to buy, so prices plummet, triggering additional calls, and yet more selling. Invariably, some investors, usually the most highly leveraged ones, cannot sell assets quickly enough, or for a high enough price, to “meet the call” and repay their loans. Banks and other lenders begin to suffer defaults. Their lenders (other banks, depositors, holders of commercial paper), in turn, begin to wonder if they are still credit-worthy. Asymmetric information and uncertainty, as described in Chapter 11 "The Economics of Financial Regulation", reign supreme, inducing lenders to restrict credit. At some point, investors’ emotions take over, and they literally go into a panic, one that makes Tony Soprano’s panic attacks seem like a stroll in the park.http://www.menshealth.com/cda/article.do?site=MensHealth&channel= health&category=stress.management&conitem=04f999edbbbd201099edbbbd2010 cfe793cd____

Panics often cause the rapid de-leveragingLenders force borrowers to invest more of their own equity in assets.of the financial system, a period when interest rates for riskier types of loans and securities increase and/or when a credit crunchThe volume of loans decreases dramatically, usually in response to the bursting of an asset bubble during a financial crisis., or a large decrease in the volume of lending, takes place. Such conditions often usher in a negative bubbleA bubble characterized by prices that are far below their rational value., a period when high interest rates, tight credit, and expectations of lower asset prices in the future cause asset values to trend downward, sometimes well below the values indicated by underlying economic fundamentals. During de-leveraging, the forces that drove asset prices up now conspire to drag them lower.

As shown in Figure 12.2 "The effects of leverage on returns in a falling market", the most highly leveraged investor suffers most of all.

Figure 12.2 The effects of leverage on returns in a falling market

Again, I used the rate of return formula, but coupons are zero so that R = (P_t1 – P_t0)/P_t0. As the price of the asset falls, the unleveraged investor suffers negative returns:

The leveraged investors lose the same percentage and must now pay a high interest rate for their loans, or put up the equity themselves, at a time when the opportunity cost of doing so is substantial:

The higher the leverage, the larger the sum that must be borrowed at high rates.

Also, the higher the leverage, the smaller the price change needs to be to trigger a call. At 50 percent leverage, a $100 asset could drop to $50 before the lender must call. At 90 percent leverage, a $100 asset need lose only $10 to induce a call.

12.4 Lender of Last Resort

As noted above, financial panics and the de-leveraging that often occur after them can wreak havoc on the real economy by decreasing the volume of loans, insurance contracts, and other beneficial financial products. That, in turn, can cause firms to reduce output and employment. Lenders of last resort try to stop panics and de-leveraging by adding liquidity to the financial system and/or attempting to restore investor confidence. They add liquidity by increasing the money supply, reducing interest rates, and making loans to worthy borrowers who find themselves shut off from their normal sources of external finance. They try to restore investor confidence by making upbeat statements about the overall health of the economy and/or financial system and by implementing policies that investors are likely to find beneficial. During the darkest days of 1933, for example, the U.S. federal government restored confidence in the banking system through strong executive leadership and by creating the Federal Deposit Insurance Corporation.

The most common form of lender of last resort today is the government central bank, like the European Central Bank (ECB) or the Federal Reserve. The International Monetary Fund (IMF) sometimes tries to act as a sort of international lender of last resort, but it has been largely unsuccessful in that role. In the past, wealthy individuals like J. P. Morgan and private entities like bank clearinghouses tried to act as lenders of last resort, with mixed success. Most individuals did not have enough wealth or influence to thwart a panic, and bank clearinghouses were at most regional in nature.

12.5 Bailouts

As noted above, lenders of last resort provide liquidity, loans, and confidence. They make loans to solvent institutions facing temporary solvency problems due to the crisis, not inevitable bankruptcy.Doug Arner, Financial Stability, Economic Growth, and the Role of Law (New York: Cambridge University Press, 2007), 139–140. BailoutsWhen taxpayer money is used to restore losses suffered by economic agents., by contrast, restore the losses suffered by one or more economic agents, usually with taxpayer money. The restoration can come in the form of outright grants or the purchase of equity but often takes the form of subsidized or government-guaranteed loans. Unsurprisingly, bailouts are often politically controversial because they can appear to be unfair and because they increase moral hazard, or risk-taking on the part of entities that expect to be bailed out if they encounter difficulties. Nevertheless, if the lender of last resort cannot stop the formation of a negative bubble or massive de-leveraging, bailouts can be an effective way of mitigating further declines in economic activity.

During the Great Depression, for example, the federal government used $500 million of taxpayer money to capitalize the Reconstruction Finance Corporation (RFC). In its initial phase, the RFC made some $2 billion in low-interest loans to troubled banks, railroads, and other businesses. Though at first deprecated as welfare for the rich, the RFC, most observers now concede, helped the economy to recover by keeping important companies afloat. Also during the depression, the Home Owners Loan Corporation (HOLC), seeded with $200 million of taxpayer dollars, bailed out homeowners, many of whom had negative equityThe market price of an asset is less than the sum borrowed to acquire it. Also known as being “in the bucket” or “under water.” in their homes, by refinancing mortgages on terms favorable to the borrowers. Similarly, in the aftermath of the Savings and Loan Crisis, the Resolution Trust Corporation (RTC) closed 747 thrifts with total assets of almost $400 billion. Both HOLC and RTC made the best of bad situations. HOLC made a small accounting profit, and the RTC cost taxpayers a mere $125 billion while staving off a more severe systemic crisis.

12.6 The Crisis of 2007–2008

The most recent financial crisis began in 2007 as a nonsystemic crisis linked to subprime mortgagesLoans to risky borrowers collateralized with real estate, usually primary residences but sometimes vacation homes., or risky loans to homeowners. In 2008, the failure of several major financial services companies turned it into the most severe systemic crisis in the United States since the Great Depression.

The troubles began with a major housing asset bubble. As shown in Figure 12.3 "Case-Shiller U.S. Home Price Composite Index, 2000–2010", between January 2000 and 2006, a major index of housing prices in the United States more than doubled. (Prices went up more in some areas than in others because real estate is a local asset.) Home prices rose rapidly for several reasons. As shown in Figure 12.4 "U.S. interest rates, 2000–2010", mortgage rates were quite low, to a large extent because the Federal Reserve kept the federal funds rate, the rate at which banks lend to each other overnight, very low.

Figure 12.3 Case-Shiller U.S. Home Price Composite Index, 2000–2010

Figure 12.4 U.S. interest rates, 2000–2010

Mortgages also became much easier to obtain. Traditionally, mortgage lenders held mortgage loans on their own balance sheets. If a homeowner defaulted, the lender, usually a bank or life insurance company, suffered the loss. They were therefore understandably cautious about whom they lent to and on what terms. To shield themselves from loss, lenders insisted that borrowers contribute a substantial percentage of the home’s value as a down payment. The down payment ensured that the borrower had some equity at stake, some reason to work hard and not to default. It also provided lenders with a buffer if housing prices declined. Traditionally, lenders also verified that borrowers were employed or had other means of income from investments or other sources.

All that changed with the widespread advent of securitization, the practice of bundling and selling mortgages to institutional investors. Banks also began to “financial engineerA person who engages in financial engineering, the process of creating new, hopefully improved, financial products by redesigning or repackaging existing financial instruments.” those bundles, called mortgage-backed securitiesA bundle of home mortgages. (MBSs), into more complex derivative instruments like collateralized mortgage obligationsA type of derivative formed by financial engineering mortgage-backed securities into tranches with different risk-return characteristics. (CMOs). MBSs afforded investors the portfolio diversification benefits of holding a large number of mortgages; CMOs allowed investors to pick the risk-return profile they desired. They did so by slicing a group of MBSs into derivative securities (aka tranchesFrench for “slice.” Part of a structured finance instrument such as a collateralized mortgage obligation.) with credit ratings ranging from AAA, which would be the last to suffer losses, to BBB, which would suffer from the first defaults. The AAA tranches, of course, enjoyed a higher price (lower yield) than the lower-rated tranches. The holders of the lowest-rated tranches, those who took on the most risks, suffered most during the subprime maelstrom.

Securitization allowed mortgage lenders to specialize in making loans, turning them more into originators than lenders. Origination was much easier than lending because it required little or no capital. Unsurprisingly, a large number of new mortgage originators, most mere brokers, appeared on the scene. Paid a commission at closing, originators had little incentive to screen good borrowers from bad and much more incentive to sign up anyone with a pulse. A race to the bottom occurred as originators competed for business by reducing screening and other credit standards. At the height of the bubble, loans to no income, no job or assets (NINJA) borrowers were common. So-called liars’ loans for hundreds of thousands of dollars were made to borrowers without documenting their income or assets. Instead of insisting on a substantial down payment, many originators cajoled homeowners into borrowing 125 percent of the value of the home because it increased their commissions. They also aggressively pushed adjustable rate mortgages (ARMs) that offered low initial teaser rates and later were reset at much higher levels.

Regulators allowed, and even condoned, such practices in the name of affordable housing, even though six earlier U.S. mortgage securitization schemes had ended badly.Kenneth Snowden, “Mortgage Securitization in the United States: Twentieth Century Developments in Historical Perspective,” in Michael Bordo and Richard Sylla, eds., Anglo-American Financial Systems: Institutions and Markets in the Twentieth Century (Burr Ridge, IL: Irwin Professional Publishing, 1995), 261–298. Regulators also allowed Fannie Mae and Freddie Mac, two giant stockholder-owned mortgage securitization companies whose debt was effectively guaranteed by the federal government, to take on excessive risks and leverage themselves to the hilt. They also allowed credit-rating agencies to give investment-grade ratings to complicated mortgage-backed securities of dubious quality. (For the problem with credit-rating agencies, see Chapter 8 "Financial Structure, Transaction Costs, and Asymmetric Information".)

Observers, including Yale’s Robert Shillerhttp://www.econ.yale.edu/~shiller/ and Stern’s Nouriel Roubini,http://pages.stern.nyu.edu/~nroubini/ warned about the impending crisis, but few listened. As long as housing prices kept rising, shoddy underwriting, weak regulatory oversight, and overrated securities were not problems because borrowers who got into trouble could easily refinance or sell the house for a profit. Indeed, many people began to purchase houses with the intention of “flipping” them a month later for a quick buck.

In June 2006, however, housing prices peaked, and by the end of that year it was clear that the bubble had gone bye-bye. By summer 2007, prices were falling quickly. Defaults mounted as the sale/refinance option disappeared, and borrowers wondered why they should continue paying a $300,000 mortgage on a house worth only $250,000, especially at a time when a nasty increase in fuel costs and a minor bout of inflation strained personal budgets. Highly leveraged subprime mortgage lenders, like Countrywide and Indymac, suffered large enough losses to erode their narrow base of equity capital, necessitating their bankruptcy or sale to stronger entities. By early 2008, investment bank Bear Stearns, which was deeply involved in subprime securitization products, teetered on the edge of bankruptcy before being purchased by J. P. Morgan for a mere $10 per share.

As the crisis worsened, the Federal Reserve responded as a lender of last resort by cutting its federal funds target from about 5 to less than 2 percent between August 2007 and August 2008. It also made massive loans directly to distressed financial institutions. Mortgage rates decreased from a high of 6.7 percent in July 2007 to 5.76 percent in January 2008, but later rebounded to almost 6.5 percent in August 2008. Moreover, housing prices continued to slide, from an index score of 216 in July 2007 to just 178 a year later. Defaults on subprime mortgages continued to climb, endangering the solvency of other highly leveraged financial institutions, including Fannie Mae and Freddie Mac, which the government had to nationalize (take over and run). The government also arranged for the purchase of Merrill Lynch by Bank of America for $50 billion in stock. But it decided, probably due to criticism that its actions were creating moral hazard, to allow Lehman Brothers to go bankrupt. That policy quickly backfired, however, because Lehman dragged one of its major counterparties, AIG, down with it. Once bitten, twice shy, the government stepped in with a massive bailout for AIG to keep it from bankrupting yet other large institutions as it toppled.

Figure 12.5 Daily closing value of the Dow Jones Industrial Average, September–October 2008

Figure 12.6 Bond yields, September–October 2008

The damage, however, had been done and panic overtook both the credit and stock markets in September and October 2008. Figure 12.5 "Daily closing value of the Dow Jones Industrial Average, September–October 2008" and Figure 12.6 "Bond yields, September–October 2008" portray the carnage graphically.

With an economic recession and major elections looming, politicians worked feverishly to develop a bailout plan. The Bush administration’s plan, which offered some $700 billion to large financial institutions, initially met defeat in the House of Representatives. After various amendments, including the addition of a large sum of pork barrel sweeteners, the bill passed the Senate and the House. The plan empowered the Treasury to purchase distressed assets and to inject capital directly into banks. Combined with the $300 billion Hope for Homeowners plan, a bailout for some distressed subprime borrowers, and the direct bailout of AIG, the government’s bailout effort became the largest, in percentage of GDP terms, since the Great Depression. The Treasury later decided that buying so-called toxic assets, assets of uncertain and possibly no value, was not economically or politically prudent. Government ownership of banks, however, has a shaky history too because many have found the temptation to direct loans to political favorites, instead of the best borrowers, irresistible.“Leaving Las Vegas: No Dire Mistakes so Far, but Governments Will Find Exiting Banks Far Harder Than Entering Them,” The Economist (22 November 2008), 22.

Economists and policymakers are now busy trying to prevent a repeat performance, or at least mitigate the scale of the next bubble. One approach is to educate people about bubbles in the hope that they will be more cautious investors. Another is to encourage bank regulators to use their powers to keep leverage to a minimum. A third approach is to use monetary policy—higher interest rates or tighter money supply growth—to deflate bubbles before they grow large enough to endanger the entire financial system. Each approach has its strengths and weaknesses. Education might make investors afraid to take on any risk. Tighter regulation and monetary policy might squelch legitimate, wealth-creating industries and sectors. A combination of better education, more watchful regulators, and less accommodative monetary policy may serve us best.

12.7 Suggested Reading

Ben-Shahard, Danny, Charles Ka Yui Leung, and Seow Eng Ong. Mortgage Markets Worldwide. Hoboken, NJ: John Wiley and Sons, 2007.

Kindleberger, Charles, and Robert Aliber. Manias, Panics, and Crashes: A History of Financial Crises, 5th ed. Hoboken, NJ: John Wiley and Sons, 2005.

Mishkin, Frederic. “How Should We Respond to Asset Price Bubbles?” in Banque de France, Financial Stability Review. October 2008, 65–74.

Reinhart, Carmen, and Kenneth Rogoff. This Time Is Different: Eight Centuries of Financial Folly. Princeton: Princeton University Press, 2009.

Roubini, Nouriel, and Brad Stetser. Bailouts or Bail-ins: Responding to Financial Crises in Emerging Markets. New York: Peterson Institute, 2004.

Shiller, Robert. Irrational Exuberance. New York: Doubleday, 2006.

The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do About It. Princeton, NJ: Princeton University Press, 2008.

Sprague, Irvine. Bailout: An Insider’s Account of Bank Failures and Rescues. New York: Beard Books, 2000.

Wright, Robert E., ed. Bailouts: Public Money, Private Profit. New York: Columbia University Press, 2010.