283
Special Topic 5
The Crisis of 2008: Causes and Lessons for the Future
OUTLINE
I. The Crisis of 2008
A. The headlines of 2008 were about falling housing prices, rising default and foreclosure
rates, failure of large investment banks, and huge bailouts arranged by both the Fed
and the Treasury.
B. The crisis reduced the wealth of most Americans and generated widespread concern
about the future of the economy.
C. This crisis and the response to it may be the most important macroeconomic event of
our lives.
II. Key Events Leading Up to the Crisis
A. Boom and bust in housing prices
B. Rising default and foreclosure rates
C. Sharp downturn in the stock market
D. Soaring prices of crude oil and other energy sources
III. What Caused the Crisis of 2008?
A. Change in Mortgage Lending Standards
1. The role of Fannie Mae and Freddie Mac
a.
.
b. Because of their GSE status and the perceived government backing of their
bonds, they could borrow funds at 50 to 75 basis points cheaper than other
lenders.
c. The GSE structure meant they were asked to serve two masters: (1) their
stockholders and (2) Congress and federal regulators.
2. Regulations imposed by the Department of Housing and Urban Development
(HUD) in the mid-1990s, forced Fannie and Freddie to extend more loans to low
and moderate income households.
3. The HUD mandates required Fannie and Freddie to extend 40% of their new loans
to borrowers with incomes below the median in 1996. This mandated share was
increased to 50% in 2000 and 56% in 2008.
284 Special Topic 5/ The Crisis of 2008: Causes and Lessons for the Future
4. In 1999, HUD guidelines required Fannie and Freddie to accept smaller down
payments and extend larger loans relative to income.
5. In order to meet HUD mandates, the GSEs accepted more subprime loans.
6. Mortgage originators were willing to make subprime and other high risk loans
because they could be passed on to the GSEs.
B. Low-Interest Rate Policy of the Fed During 2002-2004
1. During 2002-2004 the Fed supplied additional reserves to the banking system and
kept short-term interest rates low.
2. This policy supplied additional bank credit, increased the attractiveness of
C. Increased Debt to Capital Ratio of Investment Banks
1. A regulation adopted by the SEC in April 2004, permitted investment banks to
leverage their capital by a larger amount and thereby extend more loans.
2. Banks were required to maintain 8% capital against commercial loans, but only 4%
against residential housing loans, and only 1.6% against low-risk (AAA rated)
securities.
3. Thus, if mortgage-backed securities had a AAA rating they could be leveraged up
to 60 to 1 against bank capital.
4. Major investment banks and many commercial banks bundled mortgages together
and received AAA ratings for the securities backing the mortgages.
D. High Debt to Income Ratio of Households
1. The debt to income ratio of households has risen sharply since the early 1980s
2. Because mortgage and home equity loans are tax deductible, but other forms of
debt are not, household debt is concentrated against housing assets.
3. As a result, housing is hit hard when economic conditions weaken.
Special Topic 5/ The Crisis of 2008: Causes and Lessons for the Future 285
IV. Housing, Mortgage Defaults, and the Crisis of 2008
A.
leverage lending by banks with the help of security rating firms, and the growth of
household debt combined to create the financial crisis of 2008.
V. Lessons From the Crisis
A. Regulation is a two-edged sword it can generate adverse as well as positive results
B. Monetary policy should focus on monetary and price stability, rather than trying to
control real output and employment.
1. If it creates a stable monetary price environment, this will help promote strong
growth and a high level of employment.
OBJECTIVES
The headlines of 2008 were dominated by falling housing prices, rising default and foreclosure
rates, failure of large investment banks, and huge bailouts arranged by both the Federal Reserve and
the U.S. Treasury. The Crisis of 2008 substantially reduced the wealth of most Americans and
generated widespread concern about the future of the U.S. economy. This crisis and the response to
it will probably be the most important macroeconomic event of our lives. Thus, it is vitally important
to understand what happened, why things went wrong, and the lessons that need to be learned from
the experience.
This special topic examines at the key events leading up to the crisis and the underlying
factors that generated the collapse.
IMPORTANT POINTS AND TEACHING SUGGESTIONS
1. The housing boom and bust during the first seven years of this century are central to
understanding the economic events of 2008. Exhibit 1 shows that housing prices increased
slowly during the 1990s, but they began rising more rapidly toward the end of the decade.
Between January 2002 and mid-year 2006, housing prices increased by a whopping 87 percent.
But the boom turned to a bust during the second half of 2006, and the housing price decline
continued throughout 2007 2008. Exhibit 2 shows that the mortgage default and foreclosure
rates rate fluctuated within a narrow range for more than two decades prior to 2006. Both soared
starting 2006.
286 Special Topic 5/ The Crisis of 2008: Causes and Lessons for the Future
2. Be sure to discuss the four factors that caused the Crisis of 2008: (1) Change in Mortgage
3. Emphasize the three lessons to be drawn from the Crisis of 2008: (1) Regulation is a two-edged
sword it can generate adverse as well as positive results; (2) Monetary policy should focus on
reforms need to focus on getting the incentives right.
4. Critical Analysis Questions 2 and 6 are good discussion starters.
HINTS FOR ANSWERING CRITICAL ANALYSIS QUESTIONS