Macroeconomic factors in the subprime mortgage crisis

Subprime Mortgage Crash

In the third quarter of 2009, the United States GDP rose 3.8%, the first increase in several quarters (Bureau of Economic Analysis, 2009). The increase has its skeptics, who feel that government intervention drove the GDP higher in the quarter and that the economy would continue to contract over the coming quarters. Unemployment, a lagging indicator, will surely continue to be a poor number for months to come. Economies around the world have been damaged by the slowdown in the United States, earning the crisis the sobriquet of "Global Economic Downturn." Before that turn of phrase was developed, however, it was simply known as the subprime mortgage crisis. That the crisis spread from one particular segment of the U.S. economy around the world is a function of global economic interdependency, but it remains a crisis that developed in subprime mortgages.

This paper will examine the macroeconomic causes of the crisis. The prevailing view is that the crisis was a function of both macro- and microeconomic antecedents. The two are, ultimately, intertwined. The microeconomic antecedent of banks responding to fiscal stimulus and lack of oversight by doling out subprime mortgages to all and sundry regardless of qualifications was born from the macroeconomic antecedent of excess money in the financial system. Another key microeconomic antecedent was irrational real estate investing that led to investors purchasing complex derivative instruments -- the so-called collateralized debt obligations -- that they did not understand. Yet even that antecedent has its roots in macroeconomics, including taxation and the money supply. This paper, then, shall focus on the macroeconomic factors that contributed to the subprime crisis. Interest rate policy takes primacy, but there are other factors as well. Consumer spending plays a role in the latter stages of the crisis. Government spending plays a role in the recovery plan. The spread of the crisis beyond the real estate market derived largely from the impacts that the credit crunch had on business investment spending. These issues will each in turn be given examination, the hypothesis being that the most significant factor in the subprime crisis was the irresponsible lowering of interest rates to provide excessive stimulus to the economy in the early 2000s, coupled with the rapid rise in rates in the middle part of the decade.

The Buildup

Although financial theory is predicated on the notion that investors are perfectly rational, the rational investor is a construct of academia rather than a market reality. Market volatility can often be directly attributed to investor irrationality. In the late 1990s, Internet stocks became the subject of an irrational stock market bubble. This bubble inevitably burst as investors realized that buying 50lb bags of dog food online from the computer terminal installed in one's refrigerator was not actually the future of global commerce.

The stock market was viewed as having crashed, when in reality assets were being returned to their normal, rational values. When 9/11 happened, the economy was already turning south and the terrorist attacks only exacerbated the situation. The economy needed a boost, just a little something to tide it over until things got better.

Subprime Mortgages

Subprime mortgages are mortgages given to investors who for one reason or another do not qualify for a "prime" mortgage. Prime mortgages are offered at the bank's prime rate, while subprime mortgages carry a higher rate of interest. Prior to the Fed lowering rates in the early 2000s, subprime mortgages were a relatively small category of the overall mortgage industry. While the interest rates charged for such loans were enticing, the risks were higher as well. Subprime mortgages, however, grew rapidly during the early 2000s (Chomsisengphet & Pennington-Cross, 2006).

The rapid rise in subprime loans boils down to basic economic fundamentals. The banks were so flush with cash that they lowered their lending standards in order to invest it all. Consumers were enticed by mortgages because in a low interest rate environment, even subprime loans are not that expensive.

Securitization

By their nature, subprime loans are riskier than prime loans. A 2004 report from the Mortgage Bankers Association of America showed that 4.48% of subprime mortgages were in default, compared with 0.42% of prime mortgages. In order to address this risk, banks bundled these mortgages along with prime mortgages, the theory being that a bundle of mortgages would have sufficient diversification to reduce risk. That diversification only reduces asset-specific risk and not total market risk was evidently not given sufficient thought. These securitized mortgage backed securities were sold to financial institutions both domestically and internationally. Institutions from both groups were eager to not only cash in on the booming U.S. housing market, but were flush with cash because of two years' worth of below equilibrium interest rates from the Federal Reserve.

The Housing Market

The housing market bubble was created by interest rate policy, and so it was destroyed by it as well. The bubble was speculative. Demand was high because prices (interest rates) were so low. With high demand, buyers assumed that they could sell, quickly, at higher than purchase price if need be.

However, the Fed had already begun to increase interest rates. Understanding that the economy was likely to overheat if rates stayed low for much longer, the Fed began to raise rates quickly between June 2004 and June 2006. Suffice to say, the rapid rise in interest rates had the desired effect of cooling the economy.

As the cost of mortgages increased rapidly, the demand curve shifted downwards. With willing buyers drying up, sellers could not sell their properties in order to meet the payments. Worse, subprime lending had focused on rate structures that emphasized low rates in the early years, jumping to high rates thereafter. Homeowners found themselves unable to make payments, and were forced to sell. The buyers, however, had dried up. Housing inventories increased. The housing market bubble burst.

The Fed had failed to accurately gauge the impacts of its interest rate policies. It likely made the right moves with respect to timing and direction, but the intensity of its moves was very high. The demand for housing skyrocketed then plummeted, in virtual lockstep with the cost of a mortgage.

Enter the Fed, Yet Again

Unable to understand that rapid interest rate moves create shocks to the market, resulting in distortions in supply and demand, the Fed dealt with the bursting of the housing bubble by lowering interest rates rapidly, this time to next to nothing. This response was intended to stimulate the economy. In 2001, the rate decreases were also intended to stimulate the economy, but they mainly stimulated one sector. The Fed's goal with the most recent round of drastic rate cuts is to stimulate lending. The rate cuts came when the scope of the crisis was just becoming apparent. The rapid reaction this time was met with skepticism from markets. Where before there was at least one strong sector in which to invest excess capital, this time there were none. Worse, the mistakes of the past few years had put banks in a position where they could not reasonably lend out their money. Many bank executives simply did not trust their lenders and tightened restrictions severely. The result of this was a credit crunch, as the liquidity the Fed was trying to inject into the banking system was either being used to cover losses on subprime loans and collateralized debt obligations or was simply not lent.

The Money Supply and Savings Rates

The money supply typically refers to the total amount of money in the economy at a point in time. The money supply (M2) consists of money that is readily available for spending (M1) plus money in savings deposits, time deposits and individual money market accounts. The objective of the Fed's interest rate decreases was to ensure sufficient money supply in the economy. For the most part, that strategy worked. While money supply growth was slow, it only receded once, during August 2008 (Federal Reserve, 2009). Yet, growth in the money supply did not equate to growth in the economy.

One of the contributors to M2 of course are savings accounts. In April 2008, the savings rate was zero. Americans, buoyed by a surging stock market, still with high real estate values, and not yet fully aware of the impending financial crisis, were spending as much as they made. Low savings rates were also reflected in high rates of consumer spending. With the onset of the crisis, this changed.

Investors, once confident about the future, had that confidence shaken by the realization that not only was the housing market bust but that the stock markets were set to tank, and quickly. Consumers began to save. As the subprime crisis blossomed into the global financial crisis, savings rates only increased, such that by May 2009, just one year after the savings rate hit zero, it was at 6.9% (Miller & Sider, 2009). While this is likely good for the overall economy, particularly in China's savings rates come down, it is bad for businesses that rely on consumer spending.

Consumer Spending

Consumer spending is the largest component of the Gross Domestic Product. Although some dispute the inclusion of certain components such as health care programs that should be included as government spending, consumer spending is considered to be roughly 70% of the GDP (Mandel, 2009). Even without government health care funding, consumer spending is the largest portion of the GDP. It also provides 60% of total employment in the U.S. economy (Toossi, 2002).

During the real estate bubble and stock market increase, savings rates dropped while consumer spending increased. This increase fueled substantial profits, which fueled strong stock markets. Consumer spending, however, has gone into a tailspin as a result of the lingering effects of the subprime crisis. In addition to the aforementioned increase in the savings rate, consumer spending has been hampered by the lack of credit. Despite the Fed's efforts and the efforts of Congress to inject liquidity into the banking system, consumer spending remains suppressed.

The intensity of the subprime crisis is ultimately dependent on consumer spending. With the category accounting for 60% of domestic employment, job losses were inevitable as consumer spending fell. However, as unemployment increases, consumer spending should fall further. This cycle perpetuates recession. With savings rates still increasing and consumer spending still suppressed, it is expected that unemployment will remain high for the foreseeable future as well.

Stimulus

With consumer spending suppressed, the federal government took the view that the best way to improve aggregate demand was injecting money into the economy. The stimulus package was signed into and law monies were pumped into the economy over the subsequent months. The third quarter spike in GDP has been attributed to the stimulus package.

The main test for the stimulus, however, is not the short-term surge in GDP, but whether that stimulus promotes spending growth on the part of consumers, which in turn would allow businesses to start making investments again. Government spending, therefore, is being used as a catalyst to prop up the ailing economy.

Insufficient time has elapsed from the stimulus to make this determination. However, the impact of this stimulus relates to a pair of factors. The first is the savings rates. With a higher than usual savings rate, some of the stimulus from the government will go into private savings. The other factor is business investment. Although the economy as a whole performed well as a result of the stimulus package, individual businesses are unlikely to have seen a substantial positive impact. Thus, they are unlikely to make the decision to invest strictly based on the stimulus provided by government. This situation is compounded by the credit environment, which remains tight.

Conclusion

The subprime crisis has caused by high volatility in liquidity in both the U.S. And overseas economies. This liquidity, which was above its equilibrium point as the Fed suppressed interest rates in order to stimulate economic growth, was put to poor use in the subprime mortgage market.

The housing bubble burst, again as a direct result of interest rate policy, which constricted money supply and reduced demand for new homes. The move also forced many into foreclosure. The risk was spread throughout the financial system, causing a credit crunch. As credit dried up, so did consumer spending. Savings rates increased by the GDP began to decrease.

Ultimately, responsibility for the crisis falls to the Federal Reserve. They managed the money supply poorly, injecting too much liquidity into the system too quickly, and then removing that liquidity from the system just as quickly. The markets reacted poorly to this volatility, at which point a multitude of macroeconomic factors lend support to the emerging recession -- increase savings, decreased spending, decreased business investment and lower aggregate demand as the global impacts of the crisis affected exports.

Works Cited:

Knowledge @ Wharton: Inside the Subprime Crisis website, various pages. (2008). Wharton School of Business. Retrieved December 2, 2009 from http://knowledge.wharton.upenn.edu/special_sections/subprime/

Bureau of Economic Analysis. (2009). Gross domestic product: Third quarter 2009. BEA. Retrieved December 2, 2009 from http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

Shiller, R. (2005). Origin of the Term. Irrational Exuberance. Retrieved December 2, 2009 from http://www.irrationalexuberance.com/definition.htm

Boeri, T. & Guiso, L. (2007). Subprime crisis: Greenspan's legacy. Vox EU. Retrieved December 2, 2009 from http://www.voxeu.org/index.php?q=node/488

Chomsisengphet, S. & Pennington-Cross, A. (2006). The evolution of the subprime mortgage market. Federal Reserve Bank of St. Louis. Retrieved December 2, 2009 from http://research.stlouisfed.org/publications/review/06/01/ChomPennCross.pdf

Federal Reserve Statistical Release. (2009). Money stock measures. Federal Reserve. Retrieved December 2, 2009 from http://www.federalreserve.gov/releases/h6/Current/

Miller, R. & Sider, A. (2009). Surging U.S. savings rate reduces dependence on China. Bloomberg. Retrieved December 2, 2009 from http://www.bloomberg.com/apps/news?pid=20601103&sid=aMl2N_xsMPT4

Mandel, M. (2009). Consumer spending is *not* 70% of GDP. Business Week. Retrieved December 2, 2009 from http://www.businessweek.com/the_thread/economicsunbound/archives/2009/08/the_retail-impo.html

Toossi, M. (2002). Consumer spending: An engine for U.S. job growth. Monthly Labor Review. November 2002.