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Subprime Financial Shock Table of Contents Chapter 1: Subprime Pr¿cis The timeline of the subprime financial shock is presented via an easy to digest narrative in this chapter. The story provides the reader with a broad understanding of what happened. The various institutions, financial markets, and financial instruments are introduced to the reader in a comprehensible way. Chapter 2: Sizing Up Subprime It is hard to imagine that a subprime mortgage loan, a loan to a borrower with a blemished credit history, has brought the global financial system to its knees and pushed the U.S. economy into recession. It?s all the more amazing since while a subprime loan has been around in some form for a quarter century, it is only in this decade it has became widely available. Examining the terms under which borrowers were able to get loans is essential to understanding why so many are now losing their homes. This chapter sorts through the smorgasbord of loans offered up to borrowers during the housing boom. Chapter 3: Everyone Should Own a Home To understand the genesis of the subprime financial shock it is necessary to consider the central role a home plays in the minds of most households and the formulation of economic policy since the Great Depression. Americans are nearly unique in the pecuniary and psychological benefits they attach to homeownership. Policies designed to put and keep people in homes range from the tax deductibility of mortgage interest expense to the formation of Fannie Mae and Freddie Mac. This chapter explains why the subprime financial shock (or something like it) was inevitable. The motivations behind the homebuying frenzy and subsequent bust are also explored in this chapter. The various types of buyers that made the housing market of the past decade unique are identified. These include first-time homebuyers, trade-up buyers, long-term housing investors, and short-term investors or flippers. Chapter 4: Chairman Greenspan Counts on Housing The catalyst for the housing boom was falling mortgage rates driven by a Federal Reserve on high alert. Then Fed Chairman Alan Greenspan felt that a dramatic lowering in rates was necessary to lift the economy out of its miasma following a seemingly unending string of calamities from the bursting of the internet stock bubble through 9-11 and the invasions of Afghanistan and Iraq. Greenspan believed that if rates got low enough, quick enough, they would ignite a surge in housing activity, and they did as home sales, construction and house prices took off. The housing boom had begun. Greenspan took solace in his belief that while stocks and other financial assets were prone to bubbles, housing was not. The cost of buying and selling homes was too high for speculation to take root and housing was inherently a local and not a national market. Greenspan correctly calculated that the economy would revive in the wake of the housing boom, but he miscalculated as the boom devolved into a bubble, creating the fodder for the subprime financial shock. Chapter 5: Global Money Men Want a Piece A flood of global capital also powered the housing boom and ultimately added to the inflating housing bubble. Empowering global investors was the ballooning U.S. trade deficit as American consumers were on a buying binge. Aggressive Fed easing, the massive Bush tax cuts and ample credit enticed households to spend through thick and thin. Imported goods were especially hard to pass up given the mighty U.S. dollar and the seeming explosion of cheap Chinese goods on global markets. Hundreds of billions of dollars flowed overseas in exchange for the imported goods, enriching global investors, for whom the credit instruments devised by Wall Street were perfect investments. Global money men showered U.S. financial markets with liquidity pushing interest rates on long-term Treasury, corporate, and most importantly for the housing market, mortgage-backed bonds, lower. Chapter 6: Gresham?s Law at Work Internet-technology and access to global capital markets tore down barriers to entry in the mortgage lending industry, opening up the industry to increasingly aggressive financial institutions. As competitive pressures intensified, bad lenders drove out the good ones, as even well-established and previously conservative lenders allowed their lending standards to drop. At its most crazed point, disingenuous, predatory, and even fraudulent lending had corrupted large parts of the mortgage market. This chapter follows the dramatic changes in the lending industry that ultimately created the fodder for the subprime shock. Chapter 7: Financial Engineers and Their Creations Empowering mortgage lenders were Wall Street?s financial engineers. Through cutting edge statistical techniques and a bit of financial alchemy, a plethora of mortgage loans was conjured up to allow mortgage lenders to continue pushing out credit. New financial instruments and markets were invented, honed, and then ramped-up so that the originated loans could be made into financial securities and sold to a plethora of investors across all corners of the globe. While a complex process, it becomes approachable in this chapter. Chapter 8: Rating Agencies Opine Wall Street?s financial handiwork would have gone for naught without the imprimatur of the rating agencies. The agencies used suspect data on mortgage borrowers, built models with little historical information, and made na¿ve assumptions about the future in order to pass judgment on the quality of the financial securities Wall Street was offering up. Given that Wall Street pays for the opinions there is at the very least an appearance the opinions were not unbiased. This would be of little relevance, save that global regulatory bodies are requiring that institutions they oversee to use the rating agencies? opinions when determining what to invest in and how much capital to hold. Chapter 9: Homebuilders Will Be Builders The hubris of homebuilders has been instrumental driving in all housing cycles, and this one is no different, as this chapter will document. It was supposed to be different this time, as the homebuilding industry rapidly evolved from one dominated by a large number of privately-held small builders with very narrow regional footprints to one increasingly dominated by a dozen publicly-traded national builders. The big builders had better information, so the argument went, and would be more disciplined as their investors would demand it of them. Instead, the greater access to capital afforded these homebuilders allowed them to continue putting up homes long after demand waned. The realty industry?s marketing machine also went into overdrive during the housing boom, fueling the through-the-roof expectations that ultimately infected the housing and mortgage markets. This chapter explores the role realtors, and other housing-industry trade groups, had in fomenting the hubris of the period and reinforcing the mistakes made by homebuyers and sellers. Chapter 10: As the Regulatory Cycle Turns Where were the regulators? Most of the financial institutions at the center of the subprime financial shock were subject to some regulatory oversight. This includes a blizzard of government bodies ranging from the Office of the Comptroller of the Currency, who watches over the largest money center banks, to fifty-state organizations that are responsible for most of the smaller mortgage brokers and finance companies. Regulators were unable to rein in the egregious lending and investment decisions made during the boom and our busily issuing guidance now that the excesses have been exposed. The nation?s regulatory institutions were established during the Great Depression, and little has seemingly changed since then. Chapter 11: How Overvalued? The housing and mortgage markets and the broader financial system had become increasingly frenzied by mid- decade. House prices had doubled in just five years and investors in far-flung financial markets were taking on increasing amounts of risk for very little extra return. Speculation and leverage were seemingly inflating bubbles in these markets to unprecedented proportion. All of the pre-conditions for a major financial shock were in place. This chapter provides an understanding of the degree to which house prices and prices in other financial markets were overvalued at their peak and thus whey the subsequent unraveling of these markets have been so financially painful. Chapter 12: Trapped In a Vicious Cycle(s) The housing market burst first and those in other financial markets began popping soon thereafter. The fallout reverberated increasingly widely, as the financial system and economy became gripped by several very pernicious self-reinforcing cycles. A foreclosure cycle developed in many parts of the country in which declining house prices forced rising foreclosures. The foreclosed property was then dumped onto the fragile housing market at distressed prices weighing on all house prices and starting the cycle anew. A mark-to-market cycle developed in which accounting rules obliged financial institutions to mark down the value of their mortgage and other security holdings to their lower market prices. The resulting hit to their available capital forced them to reduce their leverage and sell their holdings, further undermining their value and forcing another round of writedowns. A regulatory cycle took hold as previously lax regulators and rating agencies responded to the eroding credit conditions by heightening their oversight and lowering ratings. Financial institutions were forced to batten down their underwriting standards and investors to sell their downgraded security holdings. Credit conditions tightened even further, exacerbating the credit problems and inducing even stiffer regulatory oversight and more downgrades. Chapter 13: Timid Policymakers Turn Bold Policymakers? early response to the subprime shock was at times halting and other times confused. The Federal Reserve initially misjudged the extent of the damage from the shock and was reticent to lower rates. When policymakers did lower rates they did so grudgingly for fear of fanning inflation; even suggesting that further rate cuts may not be forthcoming. Moral hazard concerns, the fear of appearing to bail out borrowers and lenders, and the complexity of the problems stymied any quick response to the crises by the Bush Administration. As the shock continued on, the economic fallout became clearer, and the Presidential election approached, policymakers moved into high gear. The Federal Reserve engaged in an unprecedented easing in monetary policy by slashing rates and establishing new mechanisms for providing cash to the cash-strapped financial system. The Administration and Congress implemented a fiscal stimulus package including tax rebates, facilitated efforts to modify mortgage loans, and expanded the mortgage lending authority of Fannie, Freddie and the FHA. This chapter critiques the monetary and fiscal policy response to the subprime shock and determines the lessons learned for future policymaking. Chapter 14: The Economic Fallout The link between the subprime financial shock, the broader economy, and the financial fallout on the average American household is drawn in this chapter. The subprime financial shock has induced a recession and there are substantial risks that the downturn will be longer and more severe than anticipated. Not only are many people losing homes and their jobs, but the wealth of every American household is lower. Credit is no longer nearly as ample or as cheap, even for households with good credit scores and stable incomes. The shock also has long-term economic ramifications as it signals the end of nearly a quarter century of increasingly available credit to households. This borrowing has supplemented household incomes and allowed lower and middle income households to maintain their living standards. In the wake of the subprime shock, households will no longer be able to increase their debt loads, however, suggesting the living standards will be under substantial pressure going forward. Chapter 15: Back to the Future The financial and economic damage emanating from the subprime financial shock will prompt many changes, particularly given this is all happening in the political cauldron of a Presidential election. The mortgage lending industry will face new guidelines and rules, the rating agencies new standards and oversight, Wall Street will have to re-engineer the subprime loan and the entire process of securitization more broadly, and even the regulatory framework will be upgraded to be more effective in a global financial system. In a real sense, many of the changes will simply be a re-affirmation of the principles that have long been the basis for sound risk management; principles that were seemingly forgotten in the frenzied subprime boom. While it is certain these changes will address the problems exposed by the subprime financial shock, however, they likely will do little to forestall the next financial crisis. After all, if there is one thing we?ve learned from the subprime financial shock is that that no matter how sophisticated the financial institutions, markets, and products, those animal spirits will ultimately prevail.
Library of Congress Subject Headings for this publication:
Mortgage loans -- United States.
Housing -- United States -- Finance.