Irrational Exuberance: The Economic Crisis

Irrational Exuberance: The Economic Crisis of 2007-2009

According to the National Bureau of Economic Research, what will no doubt become known as first Great Recession of the 21st century began in 2007. "The NBER said that the deterioration in the labor market throughout 2008 was one key reason why it decided to state that the recession began [in 2007]…the NBER also looks at real personal income, industrial production as well as wholesale and retail sales. All those measures reached a peak between November 2007 and June 2008, the NBER said. In addition, the NBER also considers the gross domestic product, which is the reading most typically associated with a recession" (Isidore 2008). However, while the official start of the recession may be dated to 2007, its systemic causes run far deeper, and far earlier, back to the recession of 2001. The main causes of the economic crisis of 2007 are the growth of the housing bubble, lax credit conditions, subprime lending, and incorrect pricing of risk. The crisis, which had both impact on financial markets and the economy at large, was mitigated through short-term and long-term responses.

Two economic forces conspired to create the conditions that fostered the credit crisis and the subsequent economic meltdown. The first was the drop in interest rates, lax credit screening, and subsequent growth of the housing bubble that was not 'pierced' by the Federal Reserve Bank. The second was poor regulation of investment banking firms that were able to create financial instruments in a non-transparent fashion that made it difficult for investors to engage in effective risk management.

The crisis, which at one point threatened to spiral into a world-wide economic collapse, had an impact on the financial markets and the lives of homeowners and consumers all over the globe. It was only contained by aggressive federal and monetary policy, including several unpopular bank bailouts, radically lowering the interest rate to stimulate the economy, and an economic stimulus package. The credit crisis and recession was the most catastrophic economic event the nation faced since the Great Depression of 1930. It brought to light hidden flaws in financial regulation that still have not been addressed and led to an economic decline which continues to impact many American's lives.

Causes of the Great Recession of 2007

Finger-pointing is rife regarding the creation of the housing bubble. "A diverse cast of characters combined to launch the once-in-a-lifetime housing boom of the past five years. Traditional mortgage companies and banks unleashed a barrage of loans, many to borrowers with iffy credit histories who didn't bother to read the fine print about upwardly mobile interest rates" (Der Hovanesian 2007). Adjustable rate mortgages meant that many homebuyers with a poor understanding of how rates operated (and even poorer credit scores) could not afford the monthly mortgage payment on their homes, once initially low rates increased.

In the wake of the attacks of 9/11, Alan Greenspan, then the chairman of the Federal Reserve, wished to stimulate the U.S. economy. To do so, Greenspan lowered interest rates, "eventually to 1%. They kept rates below 2% for 36 months, and at 1% for over a year. This was unprecedented" in the history of the Fed as an institution (Ritholtz 2010). Only in the wake of the 2007 recession did the Fed Chair Ben Bernanke lower interest rates as radically as Greenspan, effectively dropping them to zero.

Homes are "leveraged credit" purchases (Ritholtz 2010). Homeowners borrow money for a large purchase, in hopes of recouping their investment. Thus "lowering the cost of that credit has an inverse effect on prices -- i.e., cheaper mortgages = more expensive houses" (Ritholtz 2010). As interest rates dropped, more people could afford to take out mortgages (or felt that they could, given that the media presented home ownership and investment properties as easy to afford). The low, low interest rates created pressure to take out a mortgage before rates increased. "Since most people budget monthly, carrying costs are more important than actual purchase prices. Hence, a big drop in interest rates can cause a spike in home prices, with monthly payments remaining fairly similar" (Ritholtz 2010). As home values increased in the wake of increased demand, the ideal of homeownership seemed even more desirable. People sought to buy houses with the sole intent of reselling them and making a profit.

Poor regulation of the credit markets further fueled the housing bubble. Not only did many banks lend to poor credit risks, homebuilding companies did as well. "Homebuilders really started to push these more aggressive mortgages down the throats of potential buyers to boost sales… provided developers with financing for their mortgage operations, then resold the loans to investment banks, which packaged them as securities and hawked them to hedge funds and insurance companies. The whole process added liquidity to the market and made it easier for developers to build and sell expansively" in the short-term (Der Hovanesian 2007). However, the buyers of these bundled assets did not know the real credit risks of the borrowers.

When it seemed that housing prices could only go up, many individuals who would not normally be candidates for houses began to think of buying one as an 'investment.' And banks, because of the ability to repackage and resell securities, were only too happy to oblige, along with building a development companies seeking to find buyers for their creations. One young couple, Travis and Kelly Gunther is typical. Although only intermittently employed, the Gunthers were told that their "initial monthly payment of $1,160 would rise $100 a year, to $1,360 in 2006. In fact, the payment rose by more than $200 a month each year, to $1,599. She [Kelly] says Dominion salespeople described annual homeowner association fees of $50 a year that ballooned to $285, while taxes turned out to be double the company's projection" (Der Hovanesian 2007). Another man, Adrian Lee said the bank and the building company "didn't explain the [$163,800] loan to me. I didn't know after the buy-down mortgage that my payment would be so high. The same people who help you get a home won't help you maintain and keep it" (Der Hovanesian 2007).

Wall Street had been securitizing (insuring) mortgages for years. Lending to people with weaker credit scores, lower incomes, or more debt was a risky proposition but the greater the risk, the greater the profit for the insurer, since the more they could charge to the bank they were insuring. There was "a finite number of people who afford mortgages, they [banks] got creative with ways to make mortgages even cheaper. First came the 2/28 variable loans, with a cheap teaser rate the first two years," interest-only loans "where there was no principal repayment" and negative amortization "mortgages, where the borrower paid less than the monthly interest charges, with the difference added to the principal owed. Hence, with each passing month, the mortgagee actually owed more on the house than the month before, rather than less. These loans defaulted in enormous numbers" (Ritholtz 2010).

While it was the Fed's job to regulate these institutions, and Fed Chair Alan Greenspan warned of irrational exuberance in the housing market, no regulations were forthcoming for 'innovative' financial instruments until it was too late. Anti-predatory lending laws often were unenforced, even in states that had them: "The Bush White House issued its doctrine of federal pre-emption "which essentially told the states to step out of the way of these lenders. The data shows that states with anti-predatory lending laws had much lower defaults and foreclosures than states that did not; the Federal Pre-emption significantly raised default rates in these states" (Ritholtz 2010).

Effects of the housing market bubble and credit market implosion

According to the New York Times, "as hundreds of billions in mortgage-related investments went bad, mighty investment banks that once ruled high finance crumbled… the crisis spread around the globe, toppling banks across Europe and driving countries from Iceland to Pakistan to seek emergency aid from the International Monetary Fund. A vicious circle of tightening credit, reduced demand and rapid job cuts took hold, and the world fell into recession." Between 2004 and 2006, the Federal Reserve was eventually forced to increase U.S. interest rates from 1% to 5.35%, triggering a slowdown in the U.S. housing market. "Homeowners, many of whom could only barely afford their mortgage payments when interest rates were low, began to default on their mortgages" ("Timeline," BBC, 2009).Wall Street's fifth-largest bank Bear Sterns was acquired by JP Morgan Chase and Lehman Brothers, a smaller but still well-known investment banking firm collapsed. The failure of the federal government to shore up Lehman Brothers caused even micro-credit markets to tighten (the market for small, courtesy overnight loans between banks which enabled them to operate on a day-to-day basis).

As "the financial market and credit crisis worsened" Congress, the Treasury Department and the Fed had little choice other than to "pump trillions of dollars into the economy through a variety of programs, including a $700 billion bailout of banks and Wall Street firms and hundreds of billions of lending by the Fed to major companies and lenders" (Isidore 2008). As banks faltered and default rates rose, rates of consumption and demand plummeted. Unemployment began to increase, and in a predictable Keynesian fashion, as individuals grew more insecure about their job prospects they began to spend less money. The United States has a particularly consumer-driven economy -- Americans are known for having historically low rates of savings and to engage in high rates of spending -- so this was particularly disruptive to the usual rhythms of the economy.

Young people graduating from college suffered some of the worst effects of the recession. "Unemployment rates for individuals younger than 25 are currently 21% in the euro area and 19% in the U.S." (Branchflower 2010). They were competing with older, more experienced workers who had recently lost their jobs. The fear is that today's low starting salaries create a class of permanently low-earning graduates, many of whom have high levels of college debt. Graduates today often find themselves forced to live with their parents rather than aspire to own their own homes as they build faltering careers. The rush to create a new class of homeowners may have ironically created a permanent class of younger people with slim hopes of ever owning their own abode.

Responses to the financial crisis

"Even before taking office, President Obama began work on a stimulus package. On Feb. 11, 2009, Congress gave final approval to a $787 billion bill, the American Recovery and Reinvestment Act" ("Economic stimulus," Times topics, 2010). However, the bill was considerably leaner than originally intended, because of Republican opposition to the spending bill. The Obama Administration was pressured both on the right and the left. Leftist critics were angry that banks and large industries, such as the automotive industry, had been bailed out by the federal government, while ordinary people were still floundering. They argued that the bill offered little help or hope for Americans under water with their mortgages, who owed more on their homes than the homes were worth. Republicans criticized the deficit-making potential of the bill and called for tax cuts rather than government spending. However, even Democrats such as Harry Reid supported a "$15 billion measure focused on a payroll tax exemption for companies that hire new workers, an idea that had been raised by Republicans as well as Democrats" ("Economic stimulus," Times topics, 2010). While the stimulus bill was praised for creating an estimated 2.5 million to 3.6 million jobs, a number of the stimulatory measures have been called transient rather than truly radical and transformative of the nation's infrastructure unlike Roosevelt's New Deal. The 'Cash for Clunkers' program designed to encourage the purchase of newer and more fuel-efficient cars and a tax credit for first time homebuyers temporarily caused a boost in sales and the economy as a whole but dissipated when the programs ended.