Subprime Mortgage Crisis: Causes and Government Response

Introduction: A Complex Systemic Crisis

What caused the subprime mortgage crisis, and what was the result of the Treasury's and Federal Reserve's response to it? Most people are familiar with the broad outline of events leading up to 2008. They may have seen the film The Big Short, which helped the public understand collateralized debt obligations (CDOs) and credit default swaps (CDSs). However, there is far more to the story than any one film could tell.

The reality is that the subprime mortgage crisis was caused by a complex variety of systemic factors, and the response to it—rather than addressing those systemic issues—ensured that a similar crisis would occur again down the road. That crisis materialized in 2020.

Overview of Causes: Fair Value Accounting and the FASB

The Financial Accounting Standards Board (FASB) was a significant contributing factor to the crisis. The FASB had the opportunity to restrict the use of mark-to-market accounting—that is, fair value accounting practices—in the 1990s, yet it did not. This was the type of accounting used by Enron and facilitated by Arthur Andersen, the accounting firm whose high standards had once set the bar for the industry. If Andersen could promote fair value accounting consultancy services, others would follow—and that is precisely what happened (Healy, Palepu & Serafeim, 2009; Laux & Leuz, 2010; Young, 2008).

Not every researcher agrees this was a problem (Posen, 2009). Some argue that fair value accounting helps companies maintain a more accurate system of bookkeeping because it allows them to show the value of their assets based on the going rate in the market. Traditional historical cost bookkeeping simply records the price paid for an asset; a loss or profit is not recorded until the asset is sold. Fair value recording allowed companies to book profits—or losses—without ever having actually sold the asset. It was an accounting practice the FASB failed to curtail, and the case of Enron demonstrates just how badly it could get out of control.

The 2008 economic implosion, however, is the more instructive illustration. When the housing bubble burst and the market crashed, every company using mark-to-market accounting was forced to book substantial losses as asset prices plummeted. Because every company uses leverage, margin calls came quickly and fiercely; selling begat more selling, and a vicious cycle resulted. Companies were compelled to offload assets because their books reflected a loss of capital—even though they had not actually lost anything through a completed sale.

The appeal of fair value accounting is easy to understand when asset prices are rising: companies can increase their leverage, borrow more, and buy more. It becomes a sudden liability when the market turns and asset prices decline. That is precisely what happened when demand for mortgage-backed securities collapsed as subprime borrowers began defaulting on their mortgages. Banks like Lehman Brothers and Bear Stearns felt the full brunt of fair value accounting principles coming back to bite them. As Flegm (2008) points out, historical cost accounting is more reliable than fair value accounting. Had firms used the historical cost approach, they would not have suffered the same forced liquidations when the crisis hit—though neither would they have benefited as greatly from leverage on the way up.

Relaxed Lending Standards and the MBS Market

Relaxed lending standards were another significant contributor to the crisis. Under the Clinton Administration, the goal of enabling subprime borrowers to achieve homeownership—fulfilling the American Dream—was proposed and implemented. Lending standards were relaxed, and borrowers found it easier than ever before to obtain a loan for a home, or even multiple properties (Lewis, 2010). Previously, lending standards had been more restrictive, as they would again become after the crisis. Lenders were required to verify that borrowers could actually repay their loans. During the housing bubble, however, loan originators were incentivized to lend to virtually anyone, profiting on each commission with little concern for repayment risk.

These loans were then bundled together and sold as mortgage-backed securities (MBS) to investors in search of yield. Since the Dot-Com implosion of 2000, the Federal Reserve had suppressed interest rates to encourage investment in riskier assets. Traditional savings accounts and Treasury bonds did not provide the returns that institutional investors required; insurance funds and pension funds, for example, depend on a high return on investment to meet their payment obligations. They therefore gravitated toward whatever offered the best yield with the least apparent risk. MBS appeared to be a safe and attractive option, but this perception was mistaken, and few noticed (Lewis, 2010). Companies like Countrywide Financial saw a lucrative opportunity in the subprime market and recognized that they could offload the associated risk through MBS sales. With housing demand artificially inflated by relaxed lending standards, the arrangement seemed advantageous for all parties.

Conclusion

The main causes of the subprime market crisis of 2008 were, first, the FASB's decision to permit fair value accounting. This may not appear to be a critical detail, but it was—because it meant that firms using this accounting method were forced to liquidate or face margin calls as their books reflected the declining value of assets the market was rejecting in 2008. For firms holding MBS or CDOs, book value collapsed suddenly even if the firm had made no sales. Historical cost accounting would not have produced this outcome; those firms could have held their positions and waited for the market to recover. Fair value accounting created an entirely different dynamic, one in which falling asset prices triggered forced selling that accelerated further price declines.

Nevertheless, firms would not have been in that position in the first place had lending standards not been relaxed. Those who argue that fair value accounting was not the primary culprit point instead to the transformation of lending practices, and they are also correct. Borrowers were required to demonstrate almost nothing to qualify for loans. Companies like Countrywide Financial rushed to originate loans because a ready market existed for offloading them as MBS. And that market for MBS existed because the Federal Reserve had suppressed interest rates, driving yield-hungry funds toward riskier assets. Those who argue that the Federal Reserve bears primary responsibility for the crisis are therefore correct as well. The reality is that all of these explanations are valid simultaneously—each piece of the puzzle was essential, and none can be removed without the broader picture falling apart.

The response by the federal government through TARP and by the Federal Reserve through QE did not merely sanction the end of moral hazard—it actively laid the groundwork for a future crisis. The Treasury bailed out too-big-to-fail firms including AIG and the banks left holding worthless MBS, which were ultimately offloaded onto the Federal Reserve's balance sheet. CDSs could only be honored because the insurer was rescued by taxpayers. Why AIG was not forced to liquidate is a question only Goldman Sachs can fully answer, given that it made billions from the bailout. Regardless, the market was backstopped, interest rates were suppressed further, and inflation spread across asset classes—from housing to precious metals to equities to food costs.

With the United States—and much of the world—now operating under a system in which central planners ensure that asset prices perpetually rise and that institutions are shielded from the consequences of their own risk-taking, the fundamental question is how long such a system can be sustained. The Soviet Union ultimately collapsed under the contradictions of its planned economy. It is reasonable to ask whether a similar reckoning awaits the current system. That uncertainty may itself be one factor driving nations to reposition themselves geopolitically at an accelerating pace. The policy response to 2008 did not resolve the underlying vulnerabilities of the financial system; it deferred and amplified them, ensuring that the next crisis would arrive sooner, and at greater cost.

Bibliography

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