Transcript What Caused This Mess? Bad Laws Built Up Over Time

What Caused The ‘08-’09 Recession?
Laws That Encourage Weak Loans
We Could Not See the Forest for the Trees
1938—Law put more risk of mortgage default on the
government through Fannie Mae (Federal National
Mortgage Association). Charted by Congress. It issues
bonds; revenues used to buy mortgage from savings and
loans, thereby insulating them from mortgage risk.
1968: Ginnie Mae (Government National Mortgage Assn.)
created—it guarantees mortgage-based securities based
on loans to government employees and veterans.
1970: Freddie Mac (Federal Home Loan Mortgage Corp.)
created as private corporation in 1970 by Congress to
encourage more loans.
Congress at Work
Fannie, Freddie and Ginnie are “GovernmentSponsored Enterprises.” Only Ginnie is government
guaranteed, but people presumed all safe.
Fannie privatized in 1968. Freddie a competitor.
Both issue bonds to get cash to buy mortgages that
are packaged and resold (securitized) to investors.
Both do same thing; Fannie larger and older.
1977—Community Reinvestment Act—banks forced
to expand loans to higher-risk areas. Later tied into
mortgage-making rules.
Congress Adds Fuel to the Fire
• 1992—Congress sets targets for Fannie and
Freddie via HUD. Put into company charters: “an
affirmative obligation to facilitate the financing
of affordable housing for low- and moderateincome families.” HUD: “Lack of credit history
should not be seen as a negative factor.”
• By 2006, 20% of all mortgages were sub-prime
(up from 4.5% in 1994)—and 81% of the subprimes were securitized. Not so in Canada or EU.
• 74% of sub-primes held by Fannie and Freddie.
Fuel to the Fire
• Lurking in the background since the ’30s is the
FHA (Federal Housing Admin.) Part of HUD.
• It provides insurance for mortgages. Pretends
to be real insurance company, but taxpayers are
on the hook when it goes under.
• When Fannie and Freddie crashed in ’08, FHA
began to provide mortgage money—one third
of all mortgages now are FHA money.
• FHA now (‘12) underwater—taxpayer bailout.
Some Lenders Greatly Expand Loans
• Lenders (Countrywide) focused on loans to
people who could not traditionally qualify.
• Fannie & Freddie securitized $1 trillion subprime loans. Both declared bankrupt in ‘08. Fed
bailout.
• Many people buy homes who could not before
(ownership rises from 65% up to 70% of
families); and existing owners trade up; high
demand pushes prices up; builders happy to
build more homes; lenders happy to make
loans and collect a fee.
Easy Money
• Government forces/encourages lenders to make
risky loans, but government “guarantees” loans.
• Mortgage brokers encourage people to buy
houses or trade up to more expensive house. No
down payment needed!
• Bush Admin had easy money policy—low interest
rates—housing bid up 65% from 2001-2006.
• Adjustable rate mortgages—ARMs—first year or
two, very low rate, then rises to market. People
thought they would cash out before then.
• When prices drop & owner can’t afford higher
payment—default.
Then Reality – and Fear – Sets In
By 2007, the problem becoming clear and prices begin
to fall in summer. Weakest markets fall hardest and
fastest—
10 million+ bad
mortgages
No one sure
Less Trouble in Texas
Housing Prices Down;
Trillions in Equity Evaporated
Where Are the Mortgages Now?
Few banks keep mortgages—most are bundled together and
sold as securities for years. “Special Investment Vehicles”
(SIVs) sold to creditors all over the world. Mortgages
“backed” by Fannie—so why worry? China holds $375
billion worth of Fannie Mae backed loans.
Insurance companies, AIG, insure the purchase of the SIVs
and other mortgage products by “credit default swaps.”
No loss possible!
Hedge funds take positions on mortgages—derivatives.
Those on the wrong side took huge losses. Lehman
bankrupt overnight in ‘08.
Almost impossible to sort out who has what mortgage.
TARP: Troubled Asset Relief Program (‘08)
Most important is liquidity in banking sector—keep
credit flowing to strong businesses or they must
contract and make recession far worse.
TARP guaranteed bank and financial firm solvency.
Almost all money repaid. Moral hazard problem?
Get cash into banks for lending purposes, not to
guarantee their weak assets—that is just a bailout,
not a solution to liquidity problem.
• But—none of the laws behind this have changed.
Who does Congress blame?
TARP then the “Stimulus” - Private Bailout
Ends; Government Bailout Begins
The Recession
The recession and financial meltdown was
triggered by the housing crisis.
Why should crisis in one area hurt whole
economy? One-sixth of whole economy related to
construction, which essentially stopped.
Obama Administration:
Need Stimulus to Get Economy Going
Keynesian Stimulus
How do you finance massive federal deficits?
1.Raise taxes—kill incentives; capital flees. Capital
is investment; investment means jobs, growth.
What Does Capital Investment Mean?
Greater Worker Productivity; Wages Rise
Another Way to Finance Deficit
2. Sell bonds.
Market cannot absorb $1 trillion plus year after
year.
Chinese government used to buy half of federal
debt, but too big now for them or anyone else.
If government borrows private savings, then
little left for private sector, which again makes
capital scarce, so hard to grow.
Last Way to Finance Deficit
3. Treasury borrows more from Fed.
Common practice around the world—the central
bank gives the government new money. What
happens to the value of money?
Falls as inflation takes hold.
But, this time the money the Fed has created
just sits in reserves of banks. Little interest in
borrowing.
Stimulus
Administration economists estimated multiplier to be 1.54.
First stimulus, an extra $787 billion debt, would generate an
additional $425 billion in economic activity.
Nothing happened—so double down and run up $5 trillion.
But no Keynesian “multiplier”—that is, $1 government
spending does not generate $1.54 in economic activity.
Later work showed at most it was 96¢ for $1—but less
efficient than $1 of voluntary spending, so even worse.
By 2010 return fell to estimated 48¢ per $1.
Where does the money come from? Future generations.
The day of reckoning will come.