12.6 The Crisis of 2007–2008 #Notebook

12.6 The Crisis of 2007–2008 #Notebook

The financial crisis began in 2007 as a nonsystemic crisis linked to subprime mortgages, or risky loans. In 2008, the failure turned it into the most severe systemic crisis in the United States since the Great Depression.

Between January 2000 and 2006, Home prices rose rapidly as mortgage rates were low. Mortgages also became much easier to obtain. 

Traditionally, lenders verified that borrowers were employed or had a stable income from any sources. But it all changed with the widespread advent of securitization which bundling and selling mortgages to institutional investors. 

Then more complex derivatives were created...

Mortgage-backed securities(MBSs), Collateralized mortgage obligations (CMOs)....

MBSs afforded investors the portfolio diversification. 

CMOs allowed investors to pick the risk-return they desired. 

Securitization allowed mortgage lenders to specialize in making loans. 

Origination was much easier than lending because it required little or no capital, Originators had little incentive to screen good borrowers from bad and incentive to sign up anyone with a pulse.

At the height of the bubble, loans to no income, no job or assets borrowers were common...

Regulators allowed Fannie Mae and Freddie Mac, two giant stockholder-owned mortgage securitization companies whose debt was guaranteed by the federal government, to take on excessive risks and leverage themselves to the hilt.

As long as housing prices kept rising, overrated securities were not problems since they all count on selling the house.

By summer 2007, prices were falling quickly, triggered the wide-ranging defaults.

How about bond yields, September–October 2008?

Investors sold corporate bonds, especially the riskier Baa ones, forcing their prices down and yields up. 

In a classic, switch to bought Treasuries, especially short-term ones, the yields dropped from 1.69% to 0.3%.

Policymakers are now carefully trying to prevent a repeat performance or the next bubble.

One approach is by education, to teach investors about bubbles.

Another is by regulation, to keep the leverage to a minimum.

The third approach is to use monetary policy, higher interest rates, or tighter money supply.

However, each of these approaches has its pros and cons.

Education might make investors afraid to take on any risk. Tighter regulation and monetary policy might squelch wealth-creating industries.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.