Before 2007, had you ever heard of subprime mortgages, CDOs, or credit default swaps? In 2007, possibly the worst financial crisis in U.S. history began. Through 2008 and 2009 the financial crisis became a global recession. The scale of the financial and economic crisis is measured in tens of trillions of dollars. As this is being written, the economy has slowly begun to recover, but no one is sure if the recovery will be sustained.
Of course you can’t talk about the Great Recession without talking first about the Great Depression, another economic disaster that affected the country for years. You may recall that stock prices began to drop in the fall of 1929 and then crashed on October 29 of that year, a day known as Black Tuesday. Over the next ten years, personal income plunged, investment stalled, unemployment reached a high of 25%, and international trade plummeted.
Unfortunately, the Fed, which was created after an earlier banking crisis (the Panic of 1907), was put to the test during the Great Depression, where it failed to provide the necessary liquidity to stem another systemic bank panic. Critics of the Fed place much of the blame for the severity of the Depression on the Fed. The general consensus is that the Fed restricted the flow of credit when it should have flooded the system with inexpensive credit.
After the stock market collapse in 1929 and the ensuing financial and economic crisis, Congress passed the Glass-Steagall Act of 1933, which created the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits and prevent future bank runs. Glass-Steagall also prohibited commercial banks from engaging in most investment activities. The Bank Holding Company Act prohibited banks from underwriting insurance, further reinforcing Glass-Steagall. Bank regulations had the effect of restoring confidence in the industry. That confidence lasted for just about seventy-five years.
The Great Recession, as it is often called, had its beginnings in the twentieth century during a period of deregulation and rampant financial innovation. The Depression-era Glass-Steagall Act, which acted as a barrier between commercial banks and investment banks, was repealed and a new shadow banking industry was created. At the same time, the Fed and government regulators increasingly relied on business to regulate itself, believing that market forces would lead to self-enforcement of sound practices. While all of this was going on, the stock market was booming, leading to overconfidence by investors.
Consumer and producer expectations are important forces in the economy. Positive expectations tend to boost economic activity while negative expectations tend to suppress economic activity. The president and the Fed chairman are as much cheerleaders for economic optimism as they are serious policymakers.
On September 11, 2001, terrorists hijacked civilian aircraft and flew them into the World Trade Center and Pentagon while another plane crashed in a Pennsylvania field. The impact of the terrorist attacks created fear in a by-then retreating stock market. This fear helped to send the United States into a shallow recession in 2001 and 2002. The Federal Reserve responded by immediately lowering the fed funds rate and injecting large amounts of money into the banking system.
These injections, along with the Bush tax cuts, two wars, and a deregulated financial sector, led to a pool of money that created a boom in residential and commercial real estate investment. Much of the spending that occurred during the years 2002 through 2005 was fueled by home-equity borrowing at historically low rates of interest. Deregulated banks added fuel to the fire by lending money to pretty much anybody who showed up for a loan. Consumers went on a credit spending binge as the booming housing market created a wealth effect. Interest rates that should have otherwise crept up were unusually low as China, Japan, and the oil-producing states continued to save large sums in the United States. Furthermore, faith in the Fed’s inflation-fighting capability kept inflation fears at bay. The private, public, financial, and foreign sectors all had a hand in creating the conditions for disaster.
Asset price bubbles occur when easy credit flows toward a certain class of asset, like stocks, houses, or commodities. Precious metals are currently trading at all-time highs and may be the next bubble to burst. There is a debate among economists as to whether central bankers should raise interest rates to contain asset bubbles or allow them to run their natural course.
In 2006, the overheated housing market began to slow down. Savvy investors soon began pulling away from housing and putting money into commodities like oil and precious metals. In 2007, the housing market went into complete free-fall while oil prices shot up. This combination of events brought the spending party to a halt as consumers saw their wealth decreasing at the same time highly visible energy and food prices increased. Real estate investors, and eventually homeowners, began to walk away from properties that were now worth less than the balance on the mortgage or mortgages. Murmurs of stagflation were heard in the media. They were wrong.
One of the culprits in the run-up to the meltdown was a financial innovation called securitization. Traditionally, banks made loans to customers, carried the loan on their balance sheet, and earned profit from the interest and fees. This gave banks a strong incentive to carefully assess a borrower’s risk of default. With financial innovation and shareholders hungry for ever-greater returns, more and more pressure was put on banks to increase profits by expanding their lending activities. Banks delivered these profits by becoming loan originators that charged fees to make the original loans, which they then sold to investment banks. The investment banks packaged the loans into bundles and sold them as a type of bond called a collateralized debt obligation (CDO).
A principal-agent problem occurs when the incentives of one party come into conflict with the party they represent. In the case of CDOs, investors relied on banks to carefully underwrite the loans that were issued. However, because the banks were no longer on the hook if the loans went bad, they had little incentive to be careful in assessing a borrower’s risk of default.
CDOs were sold to institutional investors, insurance companies, other banks, and hedge funds. The investors believed that CDOs were a basically sound investment because borrowers usually pay their mortgages, and if they don’t, the property is used as collateral. The popularity of CDOs expanded, which increased the size of the market. The increased popularity meant that banks could lend more and more as a ready market existed for their loans. Banks competed for customers by offering even lower interest rates and relaxing their underwriting standards. This led to more loans being offered, and house prices continued to climb. This reinforced the market for CDOs, and a vicious cycle was created that would eventually come crashing down.