How the Subprime Mortgage Crisis Caused the Recession
In November 2006, the Department of Housing and Urban Development warned that new home building permits were 26% lower than the year before. At this point, the mortgage crisis could have been prevented. But the Bush administration and the Federal Reserve did not realize how grave those early warning signs were. They ignored declines in the inverted yield curve. Instead, they thought the strong money supply and low interest rates would restrict any problems faced by the real estate industry. They didn’t realize how reliant banks had become on derivatives, or contracts whose value is derived from another asset. Banks and hedge funds sold assets like mortgage-backed securities (MBS) to each other as investments. But they were backed by questionable mortgages. These interest-only loans were offered to subprime, high-risk borrowers who were most likely to default on a loan. The banks offered them low interest rates. But these “too-good-to-be-true” loans reset to a much higher rate after a certain period. Home prices fell at the same time interest rates reset. Defaults on these loans caused the subprime mortgage crisis. When home prices started falling in 2007, it signaled a real estate crisis that was already in motion. Essentially, banks had sold more mortgage-backed securities than what could be supported by good mortgages. But they felt safe because they also bought credit default swaps (CDS), which insured against the risk of defaults. But when the MBS market caved in, insurers did not have the capital to cover the CDS holders. As a result, insurance giant American International Group almost went belly-up before the federal government saved it. This financial catastrophe quickly spilled out of the confines of the housing scene and spread throughout the banking industry, bringing down financial behemoths with it. Among those deemed “too big to fail” were Lehman Brothers and Merrill Lynch. Because of this, the crisis spread globally.
2007: The Fed Didn’t Do Enough to Prevent the Recession
On April 17, 2007, the Federal Reserve announced that the federal financial regulatory agencies that oversee lenders would encourage them to work with lenders to work out loan arrangements rather than foreclose. Alternatives to foreclosure included converting the loan to a fixed-rate mortgage and receiving credit counseling through the Center for Foreclosure Solutions. Banks that worked with borrowers in low-income areas could also receive Community Reinvestment Act benefits. In September, the Fed began lowering interest rates. By the end of the year, the Fed funds rate was 4.25%. But the Fed didn’t drop rates far enough, or fast enough, to calm markets.
The Recession Underway
July 2008: The Recession Began
The subprime crisis reached the entire economy by the third quarter of 2008 when GDP fell by 2.1%. But for early observers, the first clue was in October 2006. Orders for durable goods were lower than they had been in 2005, foreshadowing a decline in housing production. Those orders also measure the health of manufacturing orders, a key indicator in the direction of national GDP.
August 2008: Fannie and Freddie Spiraled Downward
Mortgage giants Fannie Mae and Freddie Mac were fully succumbing to the subprime crisis in the summer of 2008. The failure of the government-backed companies that insured mortgages signaled that the bottom was dropping out. The Bush administration announced plans to take over Freddie and Fannie in order to prevent a full collapse.
September 2008: The Stock Market Crashed
On Sept. 29, 2008, the stock market crashed. The Dow Jones Industrial Average fell 777.68 points in intra-day trading. Until 2018, it was the largest point drop in history. It plummeted because Congress rejected the bank bailout bill. Although a stock market crash can cause a recession, in this case, it had already begun. But the crash of 2008 made a bad situation much, much worse.
Efforts Towards Recovery
October 2008: $700 Billion Bank Bailout Bill
On Oct. 3, 2008, Congress established the Troubled Asset Relief Program, which allowed the U.S. Treasury to bail out troubled banks. The Treasury Secretary lent $115 billion to banks by purchasing preferred stock. It also increased the Federal Deposit Insurance Corporation limit for bank deposits to $250,000 per account and allowed the FDIC to tap federal funds as needed through 2009. That allayed any fears that the agency itself might go bankrupt.
February 2009: The $787 Billion Stimulus Package
On Feb. 17, 2009, Congress passed the American Recovery and Reinvestment Act. The $787 billion economic stimulus plan ended the recession. It granted $212 billion in tax cuts and $575 billion in outlays, including $311 billion for new projects such as health care, education, and infrastructure initiatives. On Feb. 18, 2009, Obama announced a $75 billion plan to help stop foreclosures. The Homeowner Stability Initiative was designed to help 7 to 9 million homeowners before they got behind in their payments (most banks won’t allow a loan modification until the borrower misses three payments). It subsidized banks that restructured or refinanced their mortgage. However, it wasn’t enough to convince banks to change their policies.
March 2009: Making Home Affordable Launched
Making Home Affordable was an initiative launched by the Obama Administration to help homeowners avoid foreclosure. The program generated more than 1.7 million loan modifications in its lifespan. The Homeowner Affordable Refinance Program (HARP) was one of its programs. It was designed to stimulate the housing market by allowing up to two million credit-worthy homeowners who were upside-down in their homes to refinance and take advantage of lower mortgage rates. But banks only selected the best applicants.
The Role of the Banks in a Sluggish Recovery
August 2009: Obama Asked Banks to Modify Loans
By August, foreclosures kept mounting, dimming hopes of an economic recovery. Banks could have, but didn’t, prevent foreclosures by modifying loans. That’s because it would further hurt their bottom line. But record foreclosures (360,149 in July) only made things worse for them as well as American families. July’s foreclosure rate was the highest since RealtyTrac, a real estate information firm, began keeping records in 2005. It was 32% higher than in 2008. Foreclosures continued rising as more adjustable-rate mortgages came due at higher rates. More than half of foreclosures were from just four states: Arizona, California, Florida, and Illinois. California banks beefed up their foreclosure departments, expecting higher home losses. The Obama administration asked banks to double loan modifications voluntarily by November 1.
October 2009: Banks Weren’t Lending
In October 2009, unemployment peaked at 10%, the worst level since the 1982 recession. Almost 6 million jobs were lost in the 12 months prior to that. Employers were adding temporary workers as they grew too wary of the economy to add full-time employees. But the fields of health care and education continued to expand. One reason the recovery was sluggish was that banks were not lending. Lending was down 15% from the nation’s four biggest banks: Bank of America, JPMorgan Chase, Citigroup, and Wells Fargo, according to The Huffington Post’s analysis of federal data. Between April and October of 2009, these banks cut their commercial and industrial lending by $100 billion. Loans to small businesses fell sharply during the same period as well. Lending from all banks surveyed showed the number of loans made was down 9% from October 2008. But the outstanding balance of all loans made went up 5%. This meant banks made larger loans to fewer recipients. The banks said there were fewer qualified borrowers thanks to the recession. Businesses said the banks tightened their lending standards. But if you looked at the 18 months of potential foreclosures in the pipeline, it looked like banks were hoarding cash to prepare for future write-offs. In other words, banks were sitting on $1.1 trillion in government subsidies. In December of 2009, Bank of America pledged to President Obama that it would increase lending to small and medium-sized businesses by $5 billion in 2010. But that was only after drastically slashing lending in 2009.
Why Not Let the Banks Go Bankrupt?
People are still angry about the $350 billion in taxpayer dollars that were used to bail out the banks. Many people feel that there was no oversight and that the banks just used the money for executive bonuses. In this case, people thought banks should not have been rescued for making bad decisions based on greed. The argument goes that, if we had just let the banks go bankrupt, the worthless assets would be written off. Other companies would purchase the good assets and the economy would be much stronger as a result. In other words, let laissez-faire capitalism do its thing. In fact, that is what Former Treasury Secretary Hank Paulson attempted to do with Lehman Brothers in September. The result was a market panic. It created a run on the ultra-safe money market funds, which threatened to shut down cash flow to all businesses, large and small. In other words, the free market couldn’t solve the problem without government help. In fact, most of the government funds were used to create the assets that allowed the banks to write down about $1 trillion in losses. The other problem is that there were no “new companies,” i.e. other banks that had the funds to purchase these banks. Even Citigroup—one of the banks that the government had hoped would bail out the other banks—required a bailout to keep going.
Why Didn’t Obama Do More To End the Recession?
President Obama was dealing with more than just the recession as he looked toward the midterm elections. He launched sorely needed but sharply criticized healthcare reform. He also supported the Dodd-Frank Wall Street Reform Act. That and new Federal Reserve regulations were designed to prevent another banking collapse. They also made banking much more conservative. As a result, many banks didn’t lend as much, because they were conserving capital to conform to regulations and write down bad debt. But bank lending was needed to spur the small business growth needed to create new jobs.
The Dangers of Derivatives
The cause of the meltdown was the deregulation of derivatives that was so complicated that even their originators didn’t understand them. Banks became so quick to resell mortgages on the secondary market that they felt immune to the dangers of taking riskier and riskier mortgages. Other aggressive moves by banks to sell more collateralized debt obligations (CDOs) and corporations to sell more asset-backed commercial paper helped to push the economy toward a bubble. These derivatives were designed to increase liquidity in the economy, but that liquidity drove housing prices and debt to unmanageable levels.
How the Bailout Affects You
The Dodd-Frank Act stopped the bank credit panic, allowed LIBOR interest rates to return to normal, and made it possible for everyone to get loans. Without the credit market functioning, businesses were not able to get the capital they need to run their day-to-day business. Without the bill, it would have been impossible for people to get credit applications approved for home mortgages and even car loans. In a few weeks, the lack of capital would have led to a shutdown of small businesses, which couldn’t afford the high interest rates. Also, those whose mortgage rates reset would have seen their loan payments jump. This would have caused even more foreclosures. The Great Recession would have become a depression. That gives us hope because we learned more about how the economy works and became smarter about managing it. Without that knowledge, we would be in much worse shape today.
