Who Was to Blame for the Subprime Crisis?

Today, even those sympathetic to Bush say he cannot disentangle himself from a home-lending industry run amok or a banking industry that mortgaged its future on toxic loans. Instead, voices inside the administration who favored tougher policing of Wall Street found themselves with few supporters. The contention that the severity of the recession makes recovery to a pre-recession peak take longer can perhaps be better addressed by indexing employment levels to the previous business-cycle peak rather than to the recession’s trough.

“The no-money-down loans of 2005 and 2006 were a key part of the problem.” For all that faith, Bush’s first two Treasury secretaries, Paul O’Neill and John Snow, came from top jobs in industry, not Wall Street. They were viewed in Washington as advocating the interests of business, and being less comfortable with the mysteries of the markets. These experts, from both political parties, say Bush’s early personnel choices and overarching antipathy toward regulation created a climate that, if it did not trigger the turmoil, almost certainly aggravated it. The president’s first two Treasury secretaries, for instance, lacked the kind of Wall Street expertise that might have helped them raise red flags about the use of complex financial instruments at the heart of the crisis.

Over-leveraging, credit default swaps and collateralized debt obligations as causes

Ultimately, TARP did not endear the government to the American public, which saw Wall Street reap benefits as average citizens struggled with debt, unemployment, and foreclosures in the wake of the Great Recession. In December 2013, the Treasury wrapped up TARP, and the government concluded that its investments had earned more than $11 billion for taxpayers. Specifically, TARP recovered funds totaling $441.7 billion from $426.4 billion invested.

During the boom years, investment banks provided a staggering amount of cash to subprime lenders so they could make loans. On Oct. 3, 2008, former President Bush signed the $700 billion Emergency Economic Stabilization Act of 2008 into law. The legislation created the “Troubled Asset Relief Program” — or TARP, as it is known — to buy up mortgage-backed securities and hold them, ideally, until they recovered some of their value and could be auctioned. By removing the so-called “toxic” assets from the banks’ balance sheets, it was hoped they would begin lending again.

Dennis Carlton: Have the Draft Guidelines Demoted Economics?

In December 2001, Federal Reserve Chairman Alan Greenspan lowered the fed funds rate to 1.75%. Regardless of the criticism surrounding the relationship between underwriters and rating agencies, the fact of the matter is they were simply bringing bonds to market based on market demand. Moreover, some have pointed to the conflict of interest of rating agencies which receive fees from a security’s creator and their ability to give an unbiased assessment of risk. The argument is rating agencies were enticed to give better ratings to continue receiving service fees, or they ran the risk of the underwriter going to a different agency. “The Democrats pushed affordable housing goals, even in the face of evidence that people who got the loans shouldn’t have gotten them,” said Robert Litan, a senior fellow at the Brookings Institution, a research organization in Washington.

These firms had once been Wall Street’s “bulge bracket,” the companies that led underwriting syndicates. These institutions had become so big that the failure of just one of them would pose a systemic risk. Institutional investors could be persuaded to buy the SIV’s supposedly high-quality, short-term commercial paper, allowing the vehicles to acquire longer-term, lower quality assets, and generating a profit on the spread between the two.

The Fed Raised Rates on Subprime Borrowers

Their analysis of meeting transcripts reveal that as housing prices were quickly rising, FOMC members repeatedly downplayed the seriousness of the housing bubble. Even after Lehman Brothers collapsed in September 2008, the committee showed little recognition that a serious economic downturn was underway. The authors argue that the committee relied on the framework of macroeconomics to mitigate the seriousness of the oncoming crisis, and to justify that markets were working who is to blame for the great recession of 2008 rationally. They note that most of the committee members had PhDs in Economics, and therefore shared a set of assumptions about how the economy works and relied on common tools to monitor and regulate market anomalies. These topics were often discussed separately in FOMC meetings rather than connected in a coherent narrative. This made it nearly impossible for FOMC members to anticipate how a downturn in housing prices would impact the entire national and global economy.

Mortgage-backed securities were typically held by hedge funds and other financial institutions, but they were also in pension funds, corporate assets, and mutual funds. And since the financial markets seemed stable overall, investors felt secure about taking on more debt. Those securities were sold from an underlying pool of 9,388 second-lien loans that Goldman Sachs bought from Long Beach Mortgage Co., a company that ranks No. 5 on the Center’s list of the top 25 subprime lenders. Long Beach was a subsidiary of Washington Mutual, which collapsed in 2008 thanks largely to losses in the subprime mortgage market. The Center found that U.S. and European investment banks invested enormous sums in subprime lending due to unceasing demand for high-yield, high-risk bonds backed by home mortgages. The banks made huge profits while their executives collected handsome bonuses until the bottom fell out of the real estate market.

Ameriquest was the subject of at least four settlements involving predatory lending since 1996, including charges of excessive fees and misleading poor and minority borrowers. Indeed, subprime lenders have paid billions to settle charges of abusive lending practices. At least 11 of the lenders on the Center’s list have paid significant sums to settle allegations of abusive or predatory lending practices. No. 1 was Calabasas, California-based Countrywide Financial Corp., with at least $97.2 billion worth of subprime loans from 2005 through the end of 2007. Countrywide was bought by Bank of America last year, saving it from probable bankruptcy.

Financial Crisis Was Avoidable, Inquiry Finds

Further, the output gaps were substantially smaller at the troughs of the early 1990s and early 2000s recessions, and so monetary policy did not have to work as hard to return the economy to full employment. Eventually, investment banks started repackaging and selling mortgage-backed securities on the secondary market as collateralized debt obligations (CDOs). These financial instruments combined multiple loans of varying quality into one product, divided into segments, or tranches, each with its own risk levels suitable for different types of investors.

By any measure, the cost of the 2008 financial crisis, to the U.S. and globally, was significant. Some economists have estimated that the bailouts alone cost the U.S. $500 billion, and others have projected that the extended recession and slow recovery cost each American $70,000 in lifetime earnings. The 2008 financial crisis has similarities to the 1929 stock market crash. Both involved reckless speculation, loose credit, and too much debt in asset markets, namely, the housing market in 2008 and the stock market in 1929. The hedge fund then bundles your mortgage with a lot of other similar mortgages. They used computer models to figure out what the bundle is worth based on several factors.

These agencies placed AAA ratings — usually reserved for the safest investments — on many securities, even though they contained a healthy share of risky mortgages. The economics profession failed to cover itself in glory in the run-up to 2007. Not only did economists fail to spot that financial institutions were loading themselves up with vast quantities of toxic sub-prime debt, most of them thought it was theoretically impossible for a crisis to happen. Many of those with adjustable-rate loans didn’t realize the rates would reset in three to five years. What is remarkable is the level of agreement between economists on two sides of the Atlantic. Yet this similarity hides a great deal of variation within each group.

But Bush’s first SEC chairman – Harvey Pitt, a prominent securities lawyer – was brought down by political missteps. For workers and households, the outlook was less promising, particularly for Millennials who had just graduated and entered the workforce at the cusp of the crisis and landed in a terrible job market. His actions drew the interest of banker Jared Vennett, hedge-fund manager Mark Baum, and other opportunistic characters. Together, we observe these men making a fortune by exploiting the corrupt system and the impending economic downfall in America. But when the MBS market caved in, insurers did not have the capital to cover the CDS holders.

No rogues’ gallery of the crisis would be complete without a representative of the credit rating agencies. These were the bodies that took fees from the banks while giving the top AAA rating to collateralised debt obligations, the hugely complex financial instruments that bundled together the toxic sub-prime mortgages with the sound home loans. After the housing bubble burst, many homeowners found themselves stuck with mortgage payments they just couldn’t afford. This led to the breakdown of the mortgage-backed security market, which were blocks of securities backed by these mortgages, sold to investors who were hungry for great returns. Investors lost money, as did banks, with many teetering on the brink of bankruptcy. In early 2000, the economy was at risk of a deep recession after the dotcom bubble burst.

Excessive private debt levels

For example, Nobel prizewinner Bengt Holmstrom considers fraud and incentives in mortgages very unimportant (score of 1), while fellow Nobel prizewinners Angus Deaton and Richard Thaler consider them very important (score of 5). Nobel prizewinner Oliver Hart rates loose monetary policy at 4, while his fellow Nobel prizewinner (and colleague) Eric Maskin rates it at only 1. Several respondents rate loose monetary policy as the most important cause (5), while many others attribute it no importance whatsoever (0). Not a great success for a discipline that claims to be empirically based. It aggravated the problem not only by pushing rates lower, but also by fueling market volatility that caused investor losses.

• For workers and households, the outlook was less promising, particularly for Millennials who had just graduated and entered the workforce at the cusp of the crisis and landed in a terrible job market.
• The Center analyzed these loans from 2005 through the end of 2007 to come up with its top 25 list of high-interest lenders.
• Furthermore, because CDS transactions didn’t show up on institutions’ balance sheets, investors couldn’t evaluate the actual risks these enterprises had assumed.
• But most of the big investment banks also purchased subprime loans made by other lenders and sold them as securities.

In addition, Freddie Mac and Fannie Mae aggressively backed the market by issuing scores of MBS. But unfortunately, the MBS created were increasingly low-quality, high-risk investments. Many subprime mortgages were adjustable-rate mortgages (ARM), where interest rates rise along with the Fed funds rate. As a result, borrowers already on shaky financial footing stood little chance of being able to make payments when the interest rate increased in the following years.