Financial Markets and Institutions (2-downloads)

Was the Fed to Blame for the Housing Price Bubble?

Some economists—most prominently, John Taylor of

Stanford University—have argued that low interest

policies of the Federal Reserve in the 2003 to 2006

period caused the housing price bubble.

1

During this

period, the Federal Reserve drove the federal funds

rate to the very low level of 1%. The low federal

funds rate led to low mortgage rates that stimulated

housing demand and encouraged the issuance of

subprime mortgages, both of which led to rising

housing prices and a bubble.

In a speech given in January of 2009, the

Chairman of the Federal Reserve, Ben Bernanke coun-

tered this argument.

2

He concluded that monetary pol-

icy was not to blame for the housing price bubble.

First, he said, it is not at all clear that the federal

funds rate was below what the Taylor rule suggested

would be appropriate. Rates only seemed low when

current values, not forecasts, were used in the output

and inflation calculations for the Taylor rule. Rather,

the culprits were the proliferation of new mortgage

products that lowered mortgage payments, a relax-

ation of lending standards that brought more buyers

into the housing market, and capital inflows from

emerging market countries such as China and India.

Bernanke’s speech was very controversial, and the

debate over whether monetary policy was to blame

for the housing price bubble continues to this day.

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Chapter 8 Why Do Financial Crises Occur and Why Are They So Damaging to the Economy?

175

With rising defaults on mortgages, the value of mortgage-backed securities fell,

which then led to a rise in haircuts. At the start of the crisis, haircuts were close

to zero, but eventually rose to nearly 50%.

3

The result was that the same amount

of collateral would only allow financial institutions to borrow half as much. Thus,

in order to raise funds, financial institutions had to sell off assets. The fire sales

led to a further decline in asset values that lowered the value of collateral fur-

ther, raising haircuts, thereby forcing financial institutions to scramble even more

for liquidity. The result was similar to the run on the banking system that occurred

during the Great Depression, causing a restriction of lending and a decline in

economic activity.

The decline in asset prices in the stock market (which fell by over 50% from

October 2007 to March 2009 as seen in Figure 8.5) and the more than 25% drop

in residential house prices (shown in Figure 8.4), along with the fire sales result-

ing from the run on the shadow banking system, weakened both firms’ and house-

holds’ balance sheets. This worsening of asymmetric information problems

manifested itself in widening credit spreads (Figure 8.6), causing higher costs of

credit for households and businesses and tighter lending standards. The resulting

decline in lending meant that both consumption expenditure and investment fell,

causing a sharp contraction in the economy.

3

See Gary Gorton and Andrew Metrick, “Securitized Banking and the Run on Repo,” National Bureau

of Economic Research Working Paper No. 15223 (August 2009).

50.0

60.0

70.0

2002

2003

2004

2005

2006

2007

2008

2009

90.0

80.0

100.0

Stock Prices

(Dow-Jones Industrial Average,

October 2007 = 100)

F I G U R E   8 . 5

Stock Prices and the Financial Crisis of 2007–2009

Stock prices fell by 50% from October 2007 to March of 2009.

Source: Dow-Jones Industrial Average (DJIA), available at 

http://finance.yahoo.com/q/hp?s=%5EDJI

.

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176

Part 3 Fundamentals of Financial Institutions

0.0%

4.0%

2.0%

6.0%

2002

2003

2004

2005

2006

2007

2008

2009

Baa-U.S. Treasury

Spread (%)

F I G U R E   8 . 6

Credit Spreads and the 2007–2009 Financial Crisis

Credit spreads (the difference between rates on Baa corporate bonds and U.S. Treasury bonds) rose by

more than 400 basis points (4 percentage points) during the crisis.

Source: Federal Reserve Bank of St. Louis FRED database, 

http://research.stlouisfed.org/fred2/categories/22

.

Global Financial Markets

Although the problem originated in the United States,

the wake-up call came from Europe, a sign of how extensive the globalization of

financial markets had become. After Fitch and Standard & Poors announced rat-

ings downgrades on mortgage-backed securities and CDOs totaling more than $10

billion, the asset-based commercial paper market seized up and a French invest-

ment house, BNP Paribas, suspended redemption of shares held in some of its

money market funds on August 7, 2007. The run on the shadow banking system

began, only to become worse and worse over time. Despite huge injections of liq-

uidity into the financial system by the European Central Bank and the Federal

Reserve, discussed later in this chapter, banks began to horde cash and were unwill-

ing to lend to each other. The drying up of credit led to the first major bank fail-

ure in the United Kingdom in over 100 years when Northern Rock, which had relied

on wholesale short-term borrowing rather than deposits for its funding, collapsed

in September 2007. A string of other European financial institutions then failed

as well. Particularly hard hit were countries like Ireland, which up until this crisis

was seen as one of the most successful countries in Europe with a very high rate

of economic growth (see the Global box, “Ireland and the 2007–2009 Financial

Crisis”). European countries actually experienced a more severe economic down-

turn than in the United States.

Failure of High-Profile Firms

The impact of the financial crisis on firm balance

sheets forced major players in the financial markets to take drastic action. In March

of 2008, Bear Stearns, the fifth-largest investment bank, which had invested heav-

ily in subprime related securities, had a run on its repo funding and was forced to

sell itself to J.P. Morgan for less than 5% of what it was worth just a year earlier.

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Chapter 8 Why Do Financial Crises Occur and Why Are They So Damaging to the Economy?

177

To broker the deal, the Federal Reserve had to take over $30 billion of Bear Stearn’s

hard-to-value assets. In July, Fannie Mae and Freddie Mac, the two privately owned

government-sponsored enterprises that together insured over $5 trillion of mort-

gages or mortgage-backed assets, was propped up by the U.S. Treasury and the

Federal Reserve after suffering substantial losses from their holdings of subprime

securities. In early September 2008, they were then put into conservatorship (in

effect run by the government).

On Monday, September 15, 2008, after suffering losses in the subprime market,

Lehman Brothers, the fourth-largest investment bank by asset size with over $600 bil-

lion in assets and 25,000 employees, filed for bankruptcy, making it the largest bank-

ruptcy filing in U.S. history. The day before, Merrill Lynch, the third-largest investment

bank who also suffered large losses on its holding of subprime securities, announced

its sale to Bank of America for a price 60% below its price a year earlier. On Tuesday,

September 16, AIG, an insurance giant with assets over $1 trillion, suffered an extreme

liquidity crisis when its credit rating was downgraded. It had written over $400 bil-

lion of insurance contracts called credit default swaps that had to make payouts on

possible losses from subprime mortgage securities. The Federal Reserve then stepped

in with an $85 billion loan to keep AIG afloat (with total government loans later 

increasing to $173 billion).

G L O B A L