Thesis on "Macroeconomic Explanation of the Sub-Prime Mortgage Crash"

Thesis 10 pages (2782 words) Sources: 10 Style: MLA

[EXCERPT] . . . .

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.

Enter the Fed

"But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs and price stability." - Alan Greenspan, 1996 (Shiller, 2005)

Mr. Greenspan unfortunately did not heed his own prescient words. The dot-com bubble was a classic financial asset bubble, exactly the type Greenspan had described in his 1996 "Irrational Exuberance" speech to the American Enterprise Institute. The assets were grossly overvalued by bankers and speculators who had no idea what they were buying. The evidence was rather clear -- every IPO was a moonshot because investors could not tell the difference between a strong business model and a glorified domain name with some venture capital behind it. Greenspan's prescription for the declining stock market should have been, had he followed his own advice, to do nothing.

Instead, the "central banker of the century" panicked. Beginning in May of 2001, Greenspan began lowering interest rates. The Fed funds rates dropped in 11 increments from 6.5% in May 2001 to 1.75% in December of the same year (Knowledge @ Wharton, 2008). That stimulus takes time to work never occurred to Greenspan, who seemed to be measuring the strength of the economy strictly by daily gyrations of the Nasdaq Composite Index.

It is true that the United States was in a recession, which began in March 2001, but the recession was minor. It only lasted until November, and was not sufficient enough to warrant such strong actions. The real economy, in Greenspan's words, was not genuinely impaired. It was merely going through a cycle that all free markets must go through at some point.

The excessive lowering of interest rates, before even having evidence of what past decreases would have on the economy, was only the beginning of what would become the subprime crisis. But it was the most significant factor. The Fed held interest rates below equilibrium for a significant amount of time, in order to stimulate investment. Short-term interest rates eventually dropped to 1%, injecting a tremendous amount of liquidity into the global monetary system (Boeri & Guiso, 2007). The rates were then held below equilibrium for two years.

This had two outcomes. The first was that the lower rates increased the money supply to the banks. The banks, now flush with cash, had to find ways to invest this excess cash in order to earn profits on it. The second outcome then was that investors, banks included, responded to the increase in money supply by pumping that money into the one sector of the economy that was performing well at the time -- real estate.

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… READ MORE

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