The global financial crisis began on Aug. 9, 2007 when BNP Paribas halted redemptions in three hedge funds that had invested in U.S. subprime residential mortgage loans. The most intense phase of the global financial crisis commenced on Sept. 15, 2008 when Lehman Brothers Holdings, Inc. filed for Chapter 11 bankruptcy protection and ended on Oct. 14, 2008 when Secretary of the Treasury Henry Paulson, chair of the Board of Governors of Federal Reserve System Ben Bernanke, and Federal Deposit Insurance Corporation (FDIC) Chair Shelia Baer effectively ordered Bank of America, JPMorgan-Chase, Wells Fargo, Citigroup, Merrill Lynch, Goldman Sachs, Morgan Stanley, Bank of New York-Mellon and State Street to accept Troubled Asset Relief Program (TARP) funds in the form of preferred shares. A decade later, it is worthwhile to ascertain what really caused the global financial crisis.
Many observers have assigned blame solely on their favorite hobbyhorse – (1) the Great Moderation that lessened the perception of risk; (2) financial models that lessened perceptions of uncertainty; (3) the Fed’s overly accommodative monetary policy between 2002 and 2006; (4) financial services deregulation; (5) Fannie Mae’s and Freddie Mac’s exploitation of the implicit guarantee of their debt and residential mortgage-backed securities (MBS); (6) affordable housing quotas for Fannie Mae and Freddie Mac; (7) the Community Reinvestment Act (CRA); (8) house flipping by speculators; (9) recklessness among investment bankers; and (10) the failure of rating agencies to asses risk in MBS and complex financial products properly. However, the global financial crisis had multiple, interacting causes.
Briefly, greed was not a cause of the global financial crisis. If greed were a cause, one would have to explain how and why greed increased or became more potent in the early 2000s. No one can, since greed has been a constant in human affairs.
Risk and uncertainty
A combination of policy changes produced long and strong expansions and moderate inflation in the 1980s and 1990s. This Great Moderation lessened the perception of risk in financial products. Simultaneously, increasingly sophisticated risk models lessened the perception of uncertainty in financial markets. While perceptions of less risk and uncertainty promoted financial risk-taking in the early 2000s, they alone could not cause a global financial crisis without major policy mistakes.
Monetary laxity was a necessary, but not a sufficient, cause, for the global financial crisis. Inflation targeting helped the Federal Reserve and other central banks to stabilize inflation and inflationary expectations in 1980s and 1990s. Inflation targeting provides central banks with useful guidance to respond to demand shocks since real GDP and prices move in the same direction. In contrast, inflation targeting does not provide useful guidance to respond to supply shocks since real GDP and prices move in opposite directions.
Between 1989 and 1992, the opening of the People’s Republic of China, the abandonment of autarky in India, and the collapse of the Soviet Bloc, the world trading system added 1.5 billion potential workers. That was a 90 percent increase in the potential labor supply, about one-half of which was attributable to China.
The rapid expansion of Chinese manufacturing and China’s increasing share of global trade in manufactured goods, particularly after China acceded to the World Trade Organization (WTO) on Dec. 11, 2000, intensified global price competition for manufactured goods. This positive supply shock reduced the prices for U.S. manufactured goods by 7.6 percent between 2000 and 2006 and depressed inflation as measured by price indices both in the United States and around the world.
Inflation targeting misled the Federal Reserve to pursue an overly accommodative monetary stance between 2001 and 2006. Not all disinflations or deflations are bad. The Fed should counter disinflations or deflations from negative demand shocks with accommodative monetary policy, while disinflations or deflations from positive supply shocks should flow through to households, boosting real wages through lower prices. By trying to achieve its inflation target of 2 percent, the Fed left the world awash with liquidity and ignited a credit explosion that helped to inflate an unsustainable housing bubble in the United States. Through the U.S. dollar’s status as the world’s reserve currency, the Fed’s monetary policy influenced other central banks. This linkage helped to inflate asset bubbles in a number of other countries as well.
U.S. laws and regulatory policies caused excessive liquidity from the Fed to flow into housing and escalate housing prices to unsustainable levels. During the early 1990s, four economic and political trends interacted in unexpected ways to begin inflating a housing bubble.
First, community groups such as ACORN perceived lending discrimination in the extension of residential mortgage loans to low-income and moderate-income households in majority-minority neighborhoods. Community groups blamed this perceived discrimination on (1) the underwriting standards that Fannie Mae and Freddie Mac used for securitizing conventional residential mortgage loans, and (2) the ineffectiveness of CRA.
Second, Fannie Mae and Freddie Mac decided to exploit their funding advantage from the perception that their debt securities and their residential MBS had the implicit guaranty of the U.S. Treasury. Instead of holding only the residential mortgage loans necessary for ongoing securitization, Fannie Mae and Freddie Mac wanted to balloon their balance sheets by issuing debt securities to invest in residential mortgage loans and residential mortgage-backed securities. Since their new business models depended on their funding advantage, Fannie Mae and Freddie Mac were willing to do anything to preserve it.
Third, after states began repealing their prohibitions on multistate bank holding companies in 1980s, President Bill Clinton signed the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, completing the geographic deregulation of U.S. banks. A wave of bank acquisitions and mergers followed.
Fourth, the Budget Enforcement Act of 1990, the Federal Credit Reform Act of 1990, and the Omnibus Budget Reconciliation Act of 1990 restricted the ability of Congress to increase housing subsidies for low-income and moderate-income households through on-budget programs at the Department of Housing and Urban Development (HUD) and residential mortgage loan guarantees by the Federal Housing Administration (FHA). Consequently, Congress sought off-budget ways to increase housing subsidies.
Regulatory-induced relaxation of underwriting standards
In 1992, the Federal Reserve Bank of Boston published a study using Home Mortgage Disclosure Act (HMDA) data that claimed minorities were denied residential mortgage loans at higher rates than whites were after controlling for variables associated with creditworthiness. After correcting for flaws in Boston Fed study, subsequent studies found scant or no evidence of discrimination. Nevertheless, the Boston Fed study influenced (1) Congress to (a) impose affordable housing quotas on Fannie Mae and Freddie Mac in the Housing Enterprises Financial Safety and Soundness Act of 1992 (a.k.a. GSE Act), and (b) strengthen the CRA in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994; and (2) federal regulators to press originators to relax traditional underwriting standards for residential mortgage loans.
In 1994, President Bill Clinton declared, “More Americans should own their own homes.” According to HUD documents, Clinton sought to “reduce down-payment requirements and interest costs by making terms more flexible” and “increase the availability of alternative financing products in housing markets throughout the country.”
Employing the CRA, the Clinton Administration pressed banks to relax their underwriting standards, reduce down-payment requirements, and promote exotic alternatives to traditional fixed-rate, fully amortizing residential mortgage loans. The administration ordered the FHA to relax its underwriting standards for guaranteeing residential mortgage loans. Consequently, the percentage of FHA-guaranteed residential mortgage loans with down payments of 3 percent or less rose from 13 percent in 1992 to 50 percent in 2000. Moreover, the administration directed the FHA to press mortgage bankers, not otherwise subject to federal regulation, to agree to “Fair Lending, Best Practices” that relaxed underwriting standards.
Because of their duopoly in securitizing conforming conventional residential mortgage loans, the relaxation of underwriting standards for residential MBS by Fannie Mae and Freddie Mac affected all originators. Indeed, a Fannie Mae Foundation report (2002) asserted, “The GSEs have introduced a new generation of affordable, flexible, and targeted mortgages, thereby fundamentally altering the terms upon which mortgage credit was offered in the United States from the 1960s through the 1980s.”
These regulatory initiatives were successful in relaxing underwriting standards for residential mortgage loans. Down-payments fell dramatically. In 1989, only one in 230 homebuyers had down payments of 3 percent or less. In 2003, one in seven homebuyers had down payments of 3 percent or less. In 2007, one in three homebuyers had down payments of 3 percent or less. Low-income households that could not qualify for conventional residential mortgage loans under traditional underwriting standards began to receive interest-only and negatively amortizing residential mortgage loans.
Exploiting the wave of bank consolidation, community groups filed the CRA protests against bank acquisitions and mergers and triggered lengthy investigations by federal regulators. To avoid costly delays, banks settled these protests by pledging among other things to make more residential mortgage loans to low-income and moderate-income households in majority-minority neighborhoods. Indeed, the National Community Reinvestment Coalition reported that banks made $4.5 trillion in CRA commitments between 1992 and 2005 in contrast with $8.8 billion between 1977 and 1991.
While banks would have extended many of these loans regardless of the CRA, a substantial number of CRA-induced loans were high-risk subprime and alt-A residential mortgage loans. Bank CEOs agreed to these settlements, knowing that the risk to their banks was limited since most of these CRA-induced residential mortgage loans would be bought and securitized by Ginnie Mae (if FHA-qualified) or by Fannie Mae and Freddie Mac (if not).
The GSE Act directed the HUD Secretary to set affordable housing quotas for Fannie Mae and Freddie Mac quadrennially beginning in 1996. These affordable housing quotas gave Congress an off-budget means of increasing housing subsidies, while Fannie Mae and Freddie Mac acquiesced to these quotas as the political price for maintaining their funding advantage.
On Oct. 31, 2000, HUD Secretary Andrew Cuomo boosted the affordable housing quotas for 2001 to 2004. Fannie Mae and Freddie Mac could not meet their higher quotas by purchasing of conforming residential mortgage loans for securitization. Speaking to the American Bankers Association on Oct. 30, 2000, Fannie Mae Vice Chair Jamie Gorelick stated, “We want your CRA loans because they help us meet our housing goals.” Moreover, Fannie Mae and Freddie Mac began purchasing AAA-rated tranches of privately issued residential mortgage-backed securities containing subprime and alt-A residential mortgage loans.
Advocating an “ownership society,” President George W. Bush accelerated Clinton’s housing policies. Indeed, HUD Secretary Alphonso Jackson boosted the affordable housing quotas even higher for 2005 to 2008.
The regulatory-induced demand from the affordable housing quotas on Fannie Mae and Freddie caused the explosive growth of subprime and alt-A lending and the private securitization of subprime and alt-A residential mortgage loans from 2001 to 2006. The origination of subprime residential mortgage loans boomed from $190 billion in 2001 to $600 billion in 2006, while the origination of alt-A residential mortgage loans soared from $11.4 billion in 2001 to $400 billion in 2006. Private MBS issuance increased $241 billion in 2001 to $1.033 trillion in 2006.
Moreover, the composition of private MBS shifted dramatically from jumbo residential mortgage loans (i.e., prime residential mortgage loans that are too large for Fannie Mae or Freddie Mac to securitize) to subprime and alt-A residential mortgage loans. In 2001, private MBS issuance was 59.1 percent jumbo mortgages, 36.2 percent subprime mortgages, and 4.7 percent alt-A mortgages. In 2006, private MBS issuance was 21.2 percent jumbo mortgages, 43.4 percent subprime mortgages, and 35.4 percent alt-A mortgages.
Speculators and flipping
After the dot.com stock bubble crashed in 2000, speculators flocked to the housing market. The combination of rising housing prices, low interest rates, and relaxed underwriting standards made house flipping attractive to speculators. In 2005, the National Association of Realtors estimated that 28 percent of all home sales were speculative. Generally, speculators focused on homes in middle-income and high-income neighborhoods rather than homes in low-income neighborhoods.
Thus, the regulatory-induced relaxation of underwriting standards for residential mortgage loans to redress perceived lending discrimination artificially boosted housing demand among marginal buyers and increased the prices for starter homes and homes in low-income to moderate-income neighborhoods. Simultaneously, the regulatory-induced relaxation of underwriting standards boosted housing demand among speculators for homes in upper middle-income and upper-income neighborhoods and increased prices for more expensive homes.
Because post-crisis studies found that defaults and foreclosures were not highly concentrated among less creditworthy, low-income and moderate-income households, some supporters of relaxed underwriting standards have mistakenly claimed that the regulatory-induced relaxation of underwriting standards did not contribute to the global financial crisis. The post-crisis studies actually proved that the effects of relaxing underwriting standards were bifurcated. In the bottom half of the housing market, defaults and foreclosures were concentrated among less creditworthy, low-income to moderate-income households. In the top half of the housing market, defaults and foreclosures were concentrated among speculators.
And the rest
The contributions of investment banks and rating agencies to the global financial crisis were very minor. Investment banks were a part of the shadow banking system that collectively performed the liquidity and maturity transformation functions of commercial banks without access to a lender of last resort. While this flaw proved fatal to investment banks during the global financial crisis, this flaw did not cause the crisis. Finally, the payment-by-the-issuer model may have biased ratings on complex financial products by the rating agencies. But even if the rating agencies had assigned less favorable ratings, the global financial crisis would have occurred largely as it did.
In summary, the Great Moderation reduced perceptions of financial risk, while sophisticated risk models reduced perceptions of uncertainty. Inflation targeting during a positive supply shock misled the Fed into pursuing an overly accommodative monetary policy between 2002 and 2006, leaving the world awash with excess liquidity. In response to the lending discrimination alleged in a Boston Fed study that was subsequently discredited, U.S. policymakers used their regulatory authority to (1) relax underwriting standards, and (2) create a demand for subprime and alt-A residential mortgage loans. These policies ensured that excess liquidity would flow into housing. As the housing bubble inflated in the early 2000s, speculators were drawn into the housing market. Relaxed underwriting standards and low interest rates made flipping common. Every asset bubble must eventually pop. Once the housing bubble began to deflate, a global financial crisis became inevitable.
The author of this article, who goes by the name Hamilton, is a senior U.S. economist who frequently writes under a nom de plume.