Table of contents for Financial shock : a 360 look at the subprime mortgage implosion, and how to avoid the next financial crisis / Mark Zandi.

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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.