Understanding the causes of the Great Recession

Great Debates
1

I still don’t really have my head around this, so let me tell you what I think happened and you, if you want, can correct any mistakes.

Banks sold mortgages to consumers, many of whom were high-risk, a.k.a. sub-prime. Many of these customers chose adjustable rate mortgages in order to get favorable rates on the theory that the value of their home would continue to increase (home values were on fire after all and they aren’t making more real estate). Some of the borrowers were the victims of predatory lending (the idea of which is that you can bleed a borrower dry and when he can no longer pay, you get the collateral back which you can sell to make a profit on the whole deal). Other borrowers were encouraged to misstate their ability to pay the loan back, resulting in the so-called “liar loans” (the idea being that the lender would sell the debt and make it someone else’s problem).

Initial lenders packaged up loans, some of which were likely to be paid back, and some of which weren’t, into securities called collateralized debt obligations. These were further broken up and repackaged in an attempt to spread the risk around. I don’t know what the face value at maturity of these CDOs were.

These securities were risky, so to make them investment-grade, they were insured, mostly by AIG. Once that was done, ratings agencies were free to rate them AAA or whatever, neglecting a run on AIG. AIG figured that all the borrowers wouldn’t go belly up at once, so they were able to leverage their position.

When interest rates rose, many subprime borrowers could no longer make their payments. At the same time, new borrowers were unable or unwilling to take on loans at the higher rates. Borrowers who could not afford their homes anymore found that the pool of buyers had shrunk, lowering the value of the homes. Many went underwater and many were foreclosed upon. The default rate increased and, crucially, the effect was widespread and so the risk was not as diversified as expected.

The CDOs became illiquid (i.e. “toxic”), because no one could adequately assess the risk due to the complicated mixture of mortgages that comprised them. I am not sure why. After all, someone had to figure out how to take the mortgage payments from the borrower and funnel that money to the right places.

If the CDOs were illiquid, it doesn’t exactly mean they are worthless, does it? After all, many borrowers whose mortgages were wrapped up in CDOs continued to make the payments and therefore interest continued to be payed on them, didn’t it? For whatever reason, claims were made to AIG that the CDOs were no good. AIG couldn’t cover the losses. Many institutions had too much exposure to CDOs and were suddenly strapped for cash. The rest is history.

What have I failed to comprehend?

Thanks,
Rob

2

You have correctly diagnosed the sub prime crisis but not the great recession. Bubbles such as the internet boom had burst before without leading to a huge recession. The great recession was a world wide phenomenon and the sub prime crisis was an american phenomenon. What happened was the sub prime crisis weakened the banks and credit started to dry up. The Fed then kept monetary policy too tight. As the market noticed the Fed was not responding, demand started to fall. This led to unemployment, which led to more defaults on loans, which led to tighter credit, which led to lower demand, which led to more unemployment in a cycle. This cycle is what caused the great recession. When the Fed announced quantitative easing to stop the fall in demand the economy was able to get out of the bad cycle and start producing jobs and growing again.
Contrast this with Europe who did not have a sub-prime bubble burst but had similarly tight money. They had a large recession as well and their central bank has not been loosening monetary policy enough, so they are not recovering as well. Also look at England which has had a much looser monetary policy then the rest of Europe and recovered much more quickly.

3

What is the timeline of that? When do you feel the Fed should have lowered rates?

Rob

4

Mostly correct, as far as I remember. A few things to add. Since the CDOs were not as good as claimed, the market for them vanished, and thus it became impossible to value them. That led to a lot of the debt market freezing. If you remember, states and businesses who depended on borrowing couldn’t, which is one of the things that led to the massive layoffs and thus increase in unemployment. That led to people who got loans honestly not being able to keep up payments either, which intensified the crash and led to foreclosures in neighborhoods where people were relatively well off.
With wage stagnation during the Bush years a lot of consumer spending was financed by home equity loans or from consumers feeling rich based on their home prices. When prices fell the home equity loan market vanished and consumers retrenched. (The fall of the Dow helped too.) Thus consumption declined, there were more layoffs, and that led to a spiral downwards.

One quibble. I don’t think interest rates in general rose that much in the beginning. Interest rates for variable rate loans did raise because the first borrowers reached the reset point. Lots of them couldn’t get out to refinance, because of restrictive terms, or couldn’t refinance because the market finally slowed. Then they couldn’t afford the new much higher rate, and the situation you mention cut in.

Another root cause was that soaring housing prices turned conventional wisdom on its head. You are supposed to save for a down payment - but those who did found themselves getting further and further behind. Those who got in early with little money down saw their equity soar. Throughout the bubble, like in all bubbles, some people said a crash was just around the corner, but for years prices kept rising - until they didn’t. So not everyone who got caught was stupid.

On preview: I agree that the banks and credit spread this worldwide. But housing bubbles were not restricted to the US.

5

Is it true that AIG did not correctly evaluate the risk? Also, how did CDO’s work? Did you buy at a price below face value and were paid in installments until they totaled face value? I know the secondary market is a big part of the equation, but if you pretend that it doesn’t exist, how many CDOs were worthless in the end? Or was it just that they could no longer be borrowed against because they were illiquid?

Thanks,
Rob

6

Early 2007. For a more detailed look at this with graphs and everything look at this blog post. He does a good job presenting the timeline.

7

Banks and mortgage companies have to follow the rules. They couldn’t have sold unverified sub prime mortgages if our elected representatives (Congress and Banking Committee) hadn’t changed the rules to allow the practice. Even after questions were raised about the stability of the sub prime market, Congress chose to continue to roll the dice with the hope that the growing bubble wouldn’t burst. Some 10 years later, POP!

8

Which rule?

9

For what happened here (America) I recommend the book,

All the Devils are Here
The Hidden History of the Financial Crisis
By
Bethany McLean and Joe Nocera.

It’s really informative and the authors give a complete picture of what went wrong and why.

10

One person I encountered on another forum was adamant that the CRA was at fault because it forced banks to make iffy loans to poor people. He also asserted that Fannie and Freddie were somehow making banks write subprime mortgages in order to be able to do business with them. That, of course, is AEI/Cato/Heritage type noise that no one serious about the matter takes seriously.

11

That’s been refuted many times here. Some of the worst culprits weren’t even under CRA. Nowhere does it say that you have to encourage potential borrowers to lie.
Anyhow, place like Countrywide gave incentives for their people to sell bad loans - hardly what you’d expect if they were forced to sell them against their will.

12

It’s been disputed, not refuted.

I don’t think anyone claims that all bad loans were the result of CRA, so saying “some of the worst culprits” were not under CRA is attacking a strawman. The question is whether CRA contributed to the problem and it’s a serious question. And even if CRA doesn’t say to get potential borrowers to lie, if a bank has quotas and goals that have to be met, that could be a forseeable result.

What you write about Countrywide doesn’t logically follow. Regardless of why Countrywide wanted to sell those mortgages - whether they thought it was a great idea or were compelled by CRA - once they decided to do it it made the same sense for them to incent their people to sell them. (Note: I have no idea whether Countrywide was motivated by CRA or not, but I’m just noting that giving incentives to their people to sell them doesn’t shed light on their motivation for selling them.)

13

Countrywide, because it wasn’t a bank, wasn’t subject to the CRA at all; it was simply irrelevant to their operations. The Community Reinvestment Act applies specifically to banking institutions covered by the FDIC.

Countrywide was motivated to write lots of mortgages (good, bad, and otherwise) because they made money writing mortgages. Those mortgages would be securitized and sold off immediately, so the risk went to the security holders rather than remaining with Countrywide. In other words, as long as the market existed for those securities, there was no reason for Countrywide NOT to make bad loans.

14

It’s possible. But see: Three Ways the CRA Pushed Countrywide to Lower Lending Standards - Business Insider

15

A big part of the problem seems to have been the misapplication of the CDO concept. Initially, they were viewed as a good thing because they spread risk across investors, so that if there was a failure in a CDO component, the whole instrument would drop a little but overall it would recover and remain profitable. Originally, CDOs were very heterogenous, protecting investors from the dangers of market sector crashes, but after 2000 or so, they trended into large packages of mortgages, many of them poorly, negligently or maliciously written. The market, not surprisingly, experienced a single-sector crash, and the lion’s share of the CDOs were rooted firmly in the landslide, so the real benefit of the CDO instrument type was completely lost because there was not enough diversification in them to make them worthwhile.

16

However, look at this.

The demand for these loans can hardly have been primarily for CRA obligations - that wouldn’t have encourage their packaging to look safe. Given the low interest rates at the time there was a demand for high return low risk investments. (Or ones sold that way.) Subprimes fit the bill. If the lenders really did it to fulfill their CRA obligations they’d stop once done - as we see they did not.

17

You can’t just borrow 100 million from grandpa and start making home loans. Banks and mortgage companies are regulated by federal or state agencies and laws. Agencies, such as the Office of the Comptroller of the Currency (OCC) which charters, regulates, and supervises all national banks and federal savings associations as well as federal branches and agencies of foreign banks, were to ensure that national banks and federal savings associations operate in a safe and sound manner.

http://www.occ.gov/about/what-we-do/mission/index-about.html

That began to change in 1977. Prior to 1977, potential homeowners were required meet certain standards in order to qualify for a loan. Mortgage companies were required to see that these homeowners actually qualified for the loans they were seeking. In 1977, Congress reduced those requirements.

*HOUSING AND COMMUNITY DEVELOPMENT ACT OF 1977—TITLE VIII (COMMUNITY REINVESTMENT)

SEC. 802. CONGRESSIONAL AND STATEMENT OF PURPOSE.

(a) The Congress finds that–

(1) regulated financial institutions are required by law to demonstrate that their deposit facilities serve the convenience and needs of the communities in which they are chartered to do business;

(2) the convenience and needs of communities include the need for credit services as well as deposit services; and

(3) regulated financial institutions have continuing and affirmative obligation to help meet the credit needs of the local communities in which they are chartered.

(b) It is the purpose of this title to require each appropriate Federal financial supervisory agency to use its authority when examining financial institutions, to encourage such institutions to help meet the credit needs of the local communities in which they are chartered consistent with the safe and sound operation of such institutions.

[Codified to 12 U.S.C. 2901]*

There were plenty of villains in the sub-prime mortgage debacle but the people who were elected to look out for us (aka We The People) repeatedly failed stop this downhill slide.

18

It has been refuted. Only RW think-tankers still assign blame to the CRA.

19

Great. Congress investigated the issue and found that even though Congress had altered the rules and requirements to obtain a mortgage, and refused to readdress the issue after warning signs began to appear, Congress found itself to not be responsible for the creation, sales, or resales of the no-money-down, sub-prime loans, which could not have existed until Congress made them possible. :rolleyes:

20

Economists studied the issue.