Causes of the Subprime Mortgage Crisis A

CAUSES OF THE SUBPRIME MORTGAGE CRISIS

A THESIS

Presented to

The Faculty of the Department of Economics and Business

The Colorado College

In Partial Fulfillment of the Requirements for the Degree

Bachelor of Arts

Jackson Currier

May 2011

CAUSES OF THE SUBPRIME MORTGAGE CRISIS

Jackson C Currier

May 2011

Economics

Abstract

In 2006, the most extreme housing bubble the United States has ever faced popped, rocking financial industries to their knees. Losses were expected to be contained to the subprime sector but the losses due to defaults were massive as exposure to mortgage default proved to permeate the balance sheets of investors globally. This paper strives to illuminate the causes of how such a catastrophic market came to pass.

KEYWORDS: (Subprime Mortgages, Government Sponsored Enterprises, Mortgage Backed Securities, Collateralized Debt Obligations)

TABLE OF CONTENTS

ABSTRACT ii 1 INTRODUCTION 1

2 History 5

3 Crisis 16

4 Literature Review 18

5 Methodology & Predictions 33

6 Results 39

7 Proposed Solutions 44

8 Conclusion 49

9 Appendix

10 References

LIST OF FIGURES

1.1 U.S. Foreclosures 10

1.2 Foreclosures by State 45

2.1 Federal Funds Rate and 1-Month LIBOR 70

2.2 CDO Structure.

4.1 Share of MBS Issuance

4.2 Securitization Flow Chart

4.3 CDO vs. Underlying Asset Ratings

5.1 Robert Shiller’s Home Price Index

5.2 Regression output

6.1 Home Prices vs. Mortgage Debt Held by Pools of Assets

CHAPTER I

INTRODUCTION

Nobody likes to use the „D Word‟, but the Great Depression is the only

episode in American History comparable to our current financial crisis. Not since

the Depression‟s resulting 25% GDP decrease between 1929 and 1933 have

Americans faced such staggering losses.1 For many US citizens the effects of this

„recession‟ have hit extremely close to home, specifically, it has hit their home

mortgages. The housing bubble has definitely popped. Total household wealth

suffered a record $10.9 trillion loss in 2008 due to falling property values and

investment losses.2 Foreclosures have been skyrocketing since the second quarter

of 2006. Real estate values have plunged dramatically since their 2006 record

high, dragging equity values and government property tax revenue along for the

ride. There is no question that the tightening of credit caused by the housing

market collapse has been strangling our economy.

1 Louis D. Johnston and Samuel H. Williamson, “What was the U.S. GDP then?” MeasuringWorth, 2008

2 Tami Luhby, Americans‟ Wealth drops $1.3 trillion, CNNMoney.com, 2009, http://money.cnn.com/2009/06/11/news/economy/Americans_wealth_drops/?postversion=2009061113

(accessed September 26, 2010)

The most stinging blows, however, are the foreclosure notices dealt to

underwater homeowners. In the second quarter of 2008, 739,714 foreclosures

were filed, and the continuing trend is unfavorable to say the least.3

In 2010, analysts predicted that as many as 5 million homes were headed

towards foreclosure.4 Which begs the question: Why? Finger pointing never

solves anything but it is central to the issue to find out where the system has failed.

Certainly there is fault to be had by all implicated parties; irresponsible borrowing

can be just as detrimental as predatory lending to the collective welfare of all

involved. However, the mortgage industry has evolved far beyond the simple

borrower-lender relationship normally associated with a home loan, and an

acquaintance with all relative parties is necessary in order to trace this catastrophic

market failure to its root causes.

3 Realty Trac Staff, “Foreclosure Activity Up 14% In Second Quarter,” RealtyTrac.com, July 26, 2008, http://www.realtytrac.com/content/press-releases/foreclosure-activity-up-14-percent-in-second-quarter-

4142 (accessed September 20, 2010).

4 UPI.com, “Study says 5 million foreclosures imminent,” Business News, February 16, 2010, http://www.upi.com/Business_News/2010/02/16/Study-says-5-million-foreclosures-imminent/UPI-

78201266333128/ (accessed September 8, 2010).

Figure 1.1 U.S Foreclosures

Source: Mike Larson, “February foreclosures up 60% YOY,” Interest Rate

Roundup, March 13, 2008, http://interestrateroundup.blogspot.com/2008/03/february-foreclosures-up-60- yoy.html (accessed September 20, 2010).

Figure 1.2 Foreclosures by State

Source: Michael Lang, “One Solution to the Home Foreclosure Epidemic,” The

Lang Report, 2010, http://www.thelangreport.com/political-commentary/one-

solution-to-the-home-foreclosure-epidemic/ (accessed September 12, 2010).

CHAPTER II

HISTORY

The first home mortgages ever issued date as far back as 1190 in England.

The word itself derives from the Latin „mort‟ meaning „dead‟ and „gage‟ meaning

„pledge.‟ The „Dead pledge‟ refers to either the death, or forfeiture, of the property

in the case of default and to the death, or termination, of the pledge itself once the

loan has been repaid. English settlers brought their mortgage system to colonial

America. In these original mortgages, the loan was issued, the borrower paid a

large down payment, often 50% of the entire loan, and then made interest

payments for four to six years until the principal was repaid.5 This mortgage

model remained effectively unchanged for centuries.

The Great Depression, Fannie Mae & The Secondary Market

During the Great Depression this model became ineffective. Banks began to

fail, causing panicky account holders to withdraw their funds. These bank runs

were further exacerbated by the Federal Reserve‟s inactive monetary policy at the

time, which allowed currency in circulation to shrink by a third. Cash shortage

coupled with increasing default by struggling borrowers, victims of the depression,

5 Gareth Marples, “The History of Home Mortgages – A „Dead Pledge,‟” TheHistoryOf.net, September 11,

2008, http://www.thehistoryof.net/history-of-home-mortgages.html (accessed November 3, 2010).

turned loan origination into an extremely risky practice. Lenders became timid

and unwilling to invest in a housing market recovery. To combat this collapse, the

government instituted the Federal Housing Administration (FHA) with the

National Housing Act of 1934 to regulate loan origination and help banks lower

their risk of defaults. The FHA then created a Government Sponsored Enterprise

(GSE) called the Federal National Mortgage Association (Fannie Mae) on in

1938.6 Fannie Mae originally acted as a private enterprise, purchasing FHA

insured mortgages and then selling claims to the future cash flows of a pool of

these mortgages in a secondary market. A novel market was created along with

Mortgage Backed Securities (MBS), a brand new product. The market for MBSs

created a new source of income for banks and granted them the liquidity to issue

new loans. It also eased the fiduciary responsibility of FHA loan originators by

transferring the loans and the risk to Fannie Mae‟s balance sheet. An MBS, being

issued and insured by the government, was a very safe investment. The liquidity

provided by this secondary market and the insurance provided by the FHA

revitalized the housing market and caused banks to issue more mortgages. The

government‟s active role in creating the secondary mortgage market helped pull

the United States out of the worst depression it has ever faced.

Ginnie Mae

6 Fannie Mae, “About Fannie Mae > Our Charter,” http://www.fanniemae.com/aboutfm/charter.jhtml

(accessed November 3, 2010).

When World War II ended numerous veterans returned home and began

using their service credit to apply for home loans. To deal with the rapid growth of

these very specific loan applications the Government National Mortgage

Association (Ginnie Mae) was split off from Fannie Mae in 1968 to deal

specifically, though not exclusively, with mortgages secured by the Veterans

Administration (VA) and Farmers Home Administration (FmHA).7 Fannie Mae

remained a private corporation whereas Ginnie Mae is publicly financed,

controlled by the Department of Housing and Urban Development (HUD) and

backed by the full faith and credit of the U.S. government.

Freddy Mac

Ginnie Mae and Fannie Mae, successfully managed the volume of

mortgages but they encountered some financial strain when the recession of the

late sixties brought about more defaults due to tighter credit and higher interest

rates for borrowers. The Emergency Home Finance Act of 1970 created another

GSE, the Federal Home Loan Mortgage Corporation (Freddy Mac).8 Freddy Mac

was created to help absorb default risk and to act as competition for Fannie Mae,

expanding the secondary mortgage market.

7 Ginnie Mae, “About Ginnie Mae,” http://www.ginniemae.gov/about/history.asp?Section=About

(accessed November 3, 2010).

8 Freddy Mac, “Freddy Mac – Company History,” http://www.fundinguniverse.com/company- histories/Freddie-Mac-Company-History.html (accessed November 3, 2010).

Freddy, Fannie, and Ginnie are all subject to government regulations

concerning matters such as equal loan opportunity, loan size, credit and federal tax

history, and employment. Loan originators are required to send all applications to

an underwriter for FHA approval.

Deregulation and The Savings & Loan Crisis

Until the 1980s essentially all mortgage loans were issued through the

three aforementioned enterprises. A few privately owned Thrifts competed with

the GSEs but they were virtually all wiped out in 1973 when the ceiling on loan

rates, established by Regulation Q in 1970, was pushed down to a quarter percent

over the thirty year bond rate on prime loans.9 Thrifts mostly issued loans to

individuals who could not meet FHA qualifications and therefore represented

higher risk. The .25% they could add to their rates was not fully able to cover the

added risk and usually was barely sufficient in covering processing costs. This

ceiling on rates made Thrifts more attractive to borrowers but squeezed out profit

margins so severely that most Thrifts failed.

The few surviving Thrifts found their niche alongside savings and loan

associations and private, unregulated mortgage banks. Savings and loan

associations, many of which were not-for-profit, upheld the ideal of helping

working class men, women, and families save at higher rates in hope of qualifying

for a future mortgage. In 1979 oil prices spiked, triggering a crisis in the already

9 Bert Ely, “Savings and Loan Crisis,” Library of Economics and Liberty, 2008, http://www.econlib.org/library/Enc/SavingsandLoanCrisis.html (accessed November 3, 2010).

struggling industry. In response to the 747 enterprise casualties of the Savings and

Loan Crisis, the government passed a series of regulatory measures in 1980 such as the Depository Institutions Deregulation and Monetary Control Act as well as approving a $124.6 Billion bailout. Most notably these acts subjected all banks, public and private, to Federal Reserve regulations, allowed small mortgage banks to spread risk nationally by selling loans into the federal banking system, and removed all price ceilings on risk rates by tossing out Regulation Q.

Types of Loans

In addition to subprime mortgages, the private sector also issues jumbo and nearprime or alternative A-paper loans. Jumbo loans are simply mortgages that exceed the FHA established maximum. Nearprime loans are issued to borrowers who have adequate credit and employment history fail to qualify for

FHA approval, usually due to improper documentation or similar technicalities.

Since 1980 and the loosening of private sector lending regulation other specialty loans have matured into specific market niches, but the majority of mortgages issued fall into the subprime, nearprime, prime, or jumbo category.

The Subprime Boom

Although the Savings and Loan industry never staged the dramatic full recovery George H Bush hoped for, new regulation set the stage for the explosive emergence of the subprime mortgage onto Wall Street. The elimination of

Regulation Q allowed private banks to provide riskier loans at higher and usually

unfixed rates. Roughly 80% of all subprime mortgages today are Adjustable Rate

Mortgages (ARMs). New regulation also enabled private lenders to sell mortgages

to federal banks, spreading their risk nationally. In 1992 the cash-on-hand and net

income requirements were relaxed, making the national secondary mortgage

market further accessible to private lenders. Subprime mortgages quickly became

immensely popular among borrowers for their lower standards and as well as a

lucrative trade for lenders as the secondary mortgage market was beginning to take

off, demanding more MBSs. Some underwriters even began to approve subprime

ARMs obviously doomed to fail in a practice called predatory lending. Borrowers

were drawn in by loans requiring no initial down payment, no proof of income, or

interest-only payments. After collecting some small initial payments for a few

years, the lenders would reset the rates much higher, forcing the borrowers into

default. The lenders, having already sold the loans into the secondary market,

suffered no losses. The holder of the mortgage debt would receive the initial

payments as well as the revenue from the foreclosure. By 2006 subprime

mortgages accounted for 20% of total mortgage origination value.10

In response to the 2001 recession, following the September 11th attacks,

the Enron scandal, and the dotcom bubble popping, the Federal Reserve dropped

interest rates to 1% in 2003, allowing for lower mortgage rates nationally. These

exceptionally low rates attracted throngs of borrowers, initiating the historic

housing boom, which would peak in 2006. In addition to boosting borrowing

10 Ask.com, “2007 subprime mortgage financial crisis,” January 16, 2011, http://www.ask.com/wiki/2007_subprime_mortgage_financial_crisis (accessed January 16, 2011).

incentives, the recession disenchanted investors with more volatile markets, turning them towards the safety of MBSs. By this time it had become common practice for securitizers to bundle their purchased MBSs with subprime and other

FHA nonconforming mortgages, as well as corporate bonds and loans, credit card debt and auto loans, and even movie revenues, creating tradable bonds called Asset

Backed Securities (ABS) or Collateralized Debt Obligations (CDO).

Figure 2.1 Federal Funds Rate and 1-Month LIBOR

Source: Ben Borden, “Get Rid of Your 30 Year Mortgage,” The Virginia

Mortgage Report, 2008, http://bbmteam.com/get-rid-of-your-30-yr-mortgage-in-just-10- years/ (accessed September 12, 2010).

CDOs

CDOs, MBSs, and ABSs, are all divided into ranked tranches based on the

credit risk of the underlying assets. These tranches are then sold individually to

investors. The Equity tranche is the lowest and is retained by the CDO issuer. It is

often equivalent in value to the predicted losses of the entire asset pool. If there

are fewer losses than anticipated the equity tranche can potentially realize the

highest yields. The tranches then increase in confidence as they gain seniority, moving up through the BBB, BBB+, and AAA Super Senior, tranches. As payments are made on the underlying assets, cash flow is distributed to the tranches in order of seniority. If the assets incorporated in the CDO should fail to perform as expected or if the underlying loan holders decide to pay off their balances early to reduce their total interest payments, losses are incurred on the pool. The Equity tranche will absorb the first losses until it has been entirely wiped out. The next tranche will absorb any further losses, followed by the next tranche, etc. Senior tranches are therefore the safest investments since the junior tranches will suffer any depreciation of the CDO. They accordingly receive the lowest return on investment. Senior tranches are safe investments as long as the

CDO retains a significant percentage of its original value.

Figure 2.2 CDO Structure

Source: Jefrey Kramer, “Mortgage Backed Securities (Part 2): Structure and

Failure,” Economic Outlook, October 13, 2009, http://www.econoutlook.com/2009/10/mortgage-backed-securities-part-2.html

(accessed January 4, 2011).

CDSs

The credit default swap, a type of derivative, is a Wall Street creation that resembles an insurance policy; it entitles the holder to compensation if there is any default in the underlying assets in return for small premium payments. The main difference between CDSs and insurance is that the holder does not actually have to

own the underlying assets. Also, CDS issuers are not required to disclose factors

of possible risk nor are they required to hold reserved capital to cover any potential

losses. CDSs allow investors to gamble on the likelihood of default in a wide

range of market sectors. CDSs were first introduced in the early 1990s and since

1996 the market has almost doubled each year.11 Credit default swaps on MBSs

and CDOs grew drastically starting in 2003. AIG held the largest market share for

CDS origination, selling both to securities issuers who wanted to hedge their stakes

in mortgage securities and by the few savvy investors who astutely bet against the

inflated housing market.

11 Kaushik Choudhury, “Credit Default Swaps: Development, Pricing And Correlation To Default Risk”

(Dissertation presented at CRISIL Young Thought Leaders 2006).

CHAPTER III

CRISIS

On February 7th, 2007 the first cause for concern surfaced when HSBC

Finance publicly acknowledged unanticipated losses to do subprime defaults in the

US. As the first and, at the time, only allusion to the impending chaos, this notice was largely disregarded. But no degree of industry optimism could freeze the economic gears already in motion. Two months later, New Century Financial, after weeks of significant downsizing and refusal of all new loans, filed for bankruptcy court protections and fired 54% of its remaining employees. Subprime defaults continued to wreak havoc on Wall Street, inflicting sizeable losses to

Merrill Lynch, JPMorgan Chase, Citigroup, Goldman Sachs, and to the Californian lender, IndyMac. On July 11th, 2008 the Federal Deposit Insurance Corporation took the helm of IndyMac in an attempt to quell the rapidly approaching reality of complete bankruptcy. By September 6th the government also held conservatorship over the GSEs, Fannie Mae and Freddy Mac. With the GSEs back on the federal balance sheet, the Capitol found itself staring down fiduciary responsibility for an additional $5 trillion in mortgages. On September 15th financial giant Lehman

Brothers announced bankruptcy, causing the largest single day drop in the Dow

Jones since September 17th, 2001, the day the markets reopened after the

September 11th terrorist attacks as a national credit crunch as anyone holding

Leman Brothers debt was left empty handed.

With the luxury of hindsight, it is painfully obvious that the GSE structure was a futile risk mitigation tool for the government. The same day Fannie Mae and Freddy Mac came under federal conservatorship, the Treasury Department consented to shell out $200 Billion in loans to struggling mortgage-funding firms; chump change compared to the $700 Billion George W Bush committed to bailouts 27 days later to buy failing securities, or, the $110 Billion in tax breaks, incentives, and measures such as supplementing FDIC deposit coverage that the senate tacked on five days later. Ideally that $700 Billion would add enough liquidity to the industry to allow mortgage issuers the freedom to negotiate fiscally manageable loan modifications with their struggling homeowners. Sadly, the bulk of the balance will be used to reimburse secured MBS and CDO holders in the secondary capital market, while defaulted borrowers will remain homeless, with tarnished credit, and most likely impoverished after struggling to make their monthly payments and pay the fees leading up to the seizure of their properties.

Home loan regulation and GSEs were originally established with the noble intentions of getting Americans into their dream homes and protecting the government from shouldering the entirety of the associated risk. At some stage in the evolution of the policy the dynamic shifted to protect private interests even at the cost of the federal government and its citizens.

CHAPTER IV

LITERATURE REVIEW

Many different potential causes are cited as instigators and escalators of the crisis and in all likelihood each one played some contributing role to the financial turmoil. One overtly detestable cause of a number of defaults was the disheartening prominence of predatory lending practices. Lack of industry transparency allowed for high risk credit lines to permeate pools of secured commodities, concealing or at least obscuring, actual risk. The Federal Reserve is also at fault for instituting monetary policy that prompted irresponsible borrowing, increasing both corporate and personal debt, tightening credit and spurring the inflation of the housing bubble. The steady increase of the London Interbank

Offered Rate between 2004 and 2007 is also a direct cause of rising rates for

ARMs throughout the period, undoubtedly placing numerous homeowners beyond their means to fulfill their monthly payments. Of course there is also fault to be had by irresponsible borrowers who simply took advantage of lenient lending standards and bit off more than they could chew. Some borrowers are even guilty of falsifying their credentials in order to obtain loans they would eventually default on. The natural human propensity towards overreaction led to inefficient levels of speculation and overbuilding during the housing boom as well as hyper-cautious investing since the onset of the crisis, further devaluing the net worth of the secondary market. Finally, there is a dubious degree of moral hazard sitting at the

core structure and framing policy of the entire industry. Borrowers, originators,

underwriters, servicers, rating agencies, investors, the Federal Reserve, and

congressional policymakers, every link in the mortgage chain, can be criticized for

playing some role in “The Great Housing Bubble.”12 Since the default problems

began manifesting in 2007 an incredible amount of evidence has surfaced

implicating blame on behalf of all parties involved.

Author Lawrence Roberts states in an article for the Irvine Housing Blog:

“The root causes of the Great Housing Bubble can be traced back to four

interrelated factors:

1. Separation of origination, servicing, and portfolio holding in the lending

industry.

2. Innovation in structured finance and the expansion of the secondary mortgage

market.

3. The lowering of lending standards and the growth of subprime lending.

4. Lower FED funds rates as an indirect and minor force.”13

Borrowers and mortgage brokers both are guilty of taking advantage of the

low lending standards concerning required documentation and income. Between

1997 and 2005, the Financial Crimes Enforcement Network witnessed a 1,411

percent increase in Suspicious Activity Reports of mortgage fraud. Borrowers are

12 Lawrence Roberts, The Great Housing Bubble: Why Did House Prices Fall (Monterey Cypress

Publishing, 2008).

13 Lawrence Roberts, “The Credit Bubble - Part 1,”Irvine Housing Blog, February 21, 2010, http://www.irvinehousingblog.com/blog/comments/the-credit-bubble-part-1/ (accessed November 9, 2010).

not only culpable but mortgage brokers are known to have steered clients towards more exotic and risky types of mortgages in order to increase their commissions as well as pressuring immigrant and low-income clients to take out subprime loans for amounts beyond their means. However, the predatory lending and borrowing issues were greatly exacerbated by pressure from the secondary market to increase business volume.

Certainly the evolution of the mortgage market chain led to an increase in lending. This was, after all, the intent of the federal government when it created the secondary mortgage market during the Great Depression, to increase liquidity, lower risk for originators, and stimulate the industry to provide more loans. The issue inherent in the structure is that since risk is passed along to the investors, there is no incentive for the originators and servicers to uphold their due diligence. The other players still hold a stake in the actual mortgages being repaid. Their profits are realized as small percentages of the interest payments.

However the investors will bear the brunt of the losses. Originators were incentivized to issue greater quantities of loans. Consequently, quality suffered, especially as more unregulated private loan originators began to encroach on the

GSEs market share of loan origination and MBS issuance. Some critics believe that the crisis could have been preemptively detected and quelled if the government had acknowledged the reality of this trend. As the GSEs lost market share, despite relaxing their standards to incorporate more low-income loans into their balance sheets, they should have realized that the reason for this was the growing issuance of nonconforming, subprime loans by the private sector,

Roberts‟ third point. Despite the downward trend in the overall quality of loans,

the spread between prime and subprime rates shrank as subprime lenders sought

to attract more borrowers.

Source: Nick Timiraos, “White House Plans to Revamp Mortgage Market,”

WSJ.com, February 9, 2011,

http://online.wsj.com/article/SB1000142405274870398950457612840363069434

0.html (accessed February 23, 2010).

The „innovation in structured finance‟ that Roberts mentions is what

author George Soros refers to as „the alchemy of finance.‟14 It is undeniable that

the overall quality of outstanding loans was much lower than perceived. The

14 George Soros, The Alchemy of Finance (John Wiley & Sons, Inc, 1994).

invention of the CDO certainly allowed for risk to be concealed. Many people who are not directly involved in structured finance (and even some who are) believe that the securitzation process is deliberately perplexing in order to mislead investors. One look at a securitization flowchart and this theory does not seem too farfetched.

Source: Sam Glover, “Mortage Securitization Flowchart,” Caveat Emptor, January

11, 2011, http://caveatemptorblog.com/mortgage-securitization-flowchart/

(accessed February 23, 2011)

Much of the „alchemy‟ that occurred was able to take place because the

credit rating agencies‟ incentives pushed them to report inaccurately, if not

downright dishonestly. Moody‟s, Fitch, and Standard & Poor‟s were all being

compensated for each deal by the institutions whose products they were rating.

Their profits were tied to the volume of business they conducted with securities

issuers. They were pressured to give out high ratings like candy to keep the

secondary market and their profits growing. There was also the fact that securities

issuers could „shop‟ around the different agencies in search of the most favorable

evaluations, pitting the members of the rating oligarchy against each other to push

the marks even higher.15

Author Michael Lewis describes how securitizers, who were already

receiving the benefit of padded ratings, would repackage the unsold tranches of

their securities into new securities, which would be rerated and sold to investors.

This resulted in lower rated tranches to be given higher ratings in the new security

simply for being slightly better than the other bad tranches with which they were

repackaged. The rating agencies simply reviewed each MBS or CDO they were

15 Efraim Benmelech, “NBER Reporter 2010 Number 1: Research Summary: The Credit Rating Crisis,”

National Bureau of Economic Research, January 2010, http://www.nber.org/reporter/2010number1/benmelech.html (accessed February 12,2011).

given individually and rated a proportion of the top tranches AAA, regardless of

how the it, as a whole, compared to other securities.

Efraim Benmelch, a faculty researcher for the National Bureau of

Economic Research (NBER), uncovered evidence that suggests the rating agencies

even provided issuers with their own models so that they could further manipulate

the commonly used rating systems. He writes:

“Thus, the rating agencies may have served not just as monitors and

evaluators of existing structures, but rather as architects and creators of new

securities. Providing such models to issuers potentially led to the creation of

CDOs with the minimum possible collateral needed to obtain an AAA credit

rating.”16

The result of all this shopping, reshuffling, and collaboration was an

astounding disparity between ratings and reality.

16 IBID

Source: Efraim Benmelech, “NBER Reporter 2010 Number 1: Research

Summary: The Credit Rating Crisis,” National Bureau of Economic Research,

January 2010, http://www.nber.org/reporter/2010number1/benmelech.html (accessed

February 12,2011).

On March 10, 2010, Connecticut‟s Attorney General, Richard Blumenthal filed a lawsuit against Moody‟s and S&P claiming that they actually participated in

a conspiracy to inflate ratings, violating public trust. The agencies responded by

citing the first amendment, that it is a violation of free speech to sue them for their

reports. The trial is still ongoing.17

There are some who believe the innocence plea of the rating agencies.

Raymond McDaniel, the CEO of Moody‟s, has stated that his agency “had simply

failed to foresee the severity of the nationwide housing collapse” and he has been

defended by famed investor Warren Buffett who simply stated: “I was wrong on

it, too.”18 The rating agencies best defense in the matter is to restate that their

ratings are not infallible. Everyone is responsible for investing responsibly and

developing their own understanding of where their information comes from,

especially if it could be inaccurate. However, no matter how you spin it, the rating

agencies are guilty of not performing their mandated task appropriately whereas

investors are only guilty of not recognizing the error.

The CDS market, another „innovative‟ financial instrument, was meant to

help smooth out any unanticipated market movements by allowing investors with

large stakes in mortgage securities to hedge against default risk in their holdings.

17 Shepherd Smith Edwards & Kantas, “Moody‟s, Fitch, and Standard and Poor‟s Were Exercising Their 1st

Amendment Rights When They Gave inaccurate Information,” Institutional Investor Securities Blog,

December 30, 2010, http://www.institutionalinvestorsecuritiesblog.com/2010/12/moodys_fitch_and_standard_and.html

(accessed January 4, 2011).

18 Paul Wiseman, “Buffett comes to defense of credit-rating agencies,” USA Today, June 2, 2010, http://www.usatoday.com/MONEY/usaedition/2010-06-02-fcic-ratings-agencies-hearing_NU.htm

(accessed November 3, 2010).

However the actual effect of the CDS market was to exacerbate the credit crunch.

The premiums were much lower than they should have been since default risk was

perceived to be much lower than it actually was and the payouts when tranches

began to default were enormous due to the overvaluation of housing and the

consequent size of the pooled loans. Fannie Mae and Freddy Mac issued default

swaps on their MBSs but it was AIG‟s Financial Products division that was most

exposed to these CDSs, betting against defaults while not being required to hold

any capital in reserve to cover their risk of being wrong. A report by the Geneva

Association states:

“In summary, AIG FP had bet more than twice the market value of AIG in

credit default swaps, and, according to AIG‟s 2007 annual report, failed to hedge

or otherwise protect itself against collateral calls.”19

AIG‟s near failure was a huge contributor to the mayhem of the credit

crunch and required two government bailouts of $85 billion and $37.8 billion to

keep the institution, deemed „too big to fail,‟ from doing exactly that.

Although Lawrence Roberts cites the federal funds rate as a „minor‟ cause,

there are many critics who blame the Federal Reserve‟s ex-chairman, Alan

Greenspan for „engineering‟ the housing bubble, through his implementation of the

1% interest rate. In 2001, Pimco economist, Paul McCulley stated:

“There is room for the Fed to create a bubble in housing prices, if necessary,

to sustain American hedonism. And I think the Fed has the will to do so, even

19 The Geneva Association, “Systematic Risk in Insurance: An analysis of insurance and financial stability”

(Special report of The Geneva Association Systematic Risk Working Group, March 2010).

though political correctness would demand that Mr. Greenspan deny any such

thing."20

Worse perhaps than over-stimulating the housing market was the fact

that the Federal Reserve allowed unregulated origination to go unchecked as

loan quality clearly began decreasing. Edmund Andrews of the New York

Times writes:

“Mr. Greenspan, along with most other banking regulators in Washington, also

resisted calls for tighter regulation of subprime mortgages and other high-risk

exotic mortgages that allowed people to borrow far more than they could afford.

The Federal Reserve had broad authority to prohibit deceptive lending practices

under a 1994 law called the Home Owner Equity Protection Act. But it took little

action during the long housing boom, and fewer than 1 percent of all mortgages

were subjected to restrictions under that law.”21

The GSEs have also come under heavy scrutiny for their role in the

expansion of the secondary market. Between 1971 and 2003 Fannie and Freddy

went from holding or guaranteeing 6% of total outstanding mortgage debt to

20 Paul Krugman, “Running Out of Bubbles,” New York Times, May 27, 2005, htetp://www.nytimes.com/2005/05/27/opinion/27krugman.html?_r=1&scp=9&sq=housing%20bubble&st= cse (accessed December 4, 2010).

21 Edmund L. Andrews, “Greenspan Concedes Error on Regulation,” New York Times, October 23, 2008, http://www.nytimes.com/2008/10/24/business/economy/24panel.html (accessed November 18, 2010).

51%.22 Their daunting share in the secondary market is believed to have conveyed

the message to private institutions that the government would not allow the

industry to collapse, giving them the confidence to continue their risky practices

and further exacerbating the bubble.

Economist Paul Krugman, however, offers the following defense of the

GSEs:

“Fannie and Freddie had nothing to do with the explosion of high-risk

lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact,

Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the

scene during the height of the housing bubble.

Partly that's because regulators, responding to accounting scandals at the

companies, placed temporary restraints on both Fannie and Freddie that curtailed

their lending just as housing prices were really taking off. Also, they didn't do any

subprime lending, because they can't: the definition of a subprime loan is

precisely a loan that doesn't meet the requirement, imposed by law, that Fannie

and Freddie buy only mortgages issued to borrowers who made substantial down

payments and carefully documented their income.”23

Although they did not participate in subprime securitization, Fannie and

Freddy began to relax their standards as they started losing market share to private

22 James Hamilton, “Did Fannie and Freddy Cause the Mortgage Crisis?” Seeking Alpha, July 16, 2008, http://seekingalpha.com/article/85146-did-fannie-and-freddie-cause-the-mortgage-crisis (accessed

November 18,2010).

23 IBID

institutions. They began offering documentation relief and low-doc programs

through automated underwriting systems, which were just a slight step above

subprime loan quality. They also began purchasing the highest rated tranches from

subprime lenders, which were perceived to be safe but would haunt them once the

defaults began occurring at alarming rates.

A small but very interesting factor pointed out by chairman of the House

Committee on Financial Services, Barney Frank is the fact that CDO structure

actually creates a loophole in the cardinal rule of mortgage lending that

foreclosures hurt everyone. Senior tranches can actually benefit from foreclosures

of distressed homes.24 The junior tranches will absorb all of the losses associated

with a foreclosure, imposing zero loss on the senior tranches. But if the loan is

successfully modified and the rate is lowered, as is usually the case in a

restructuring, the lower rate will reduce cash flow to every tranche in the pool. As

long as total credit default in the mortgages and other credit lines that comprise the

CDO doesn‟t exceed the top tranche‟s lower risk absorption limit, the senior

tranche holder would prefer to see foreclosures rather than mortgage

modifications. However, this effect is negated when entire pools default

simultaneously. Restructuring will salvage more value than a foreclosure, which is

likely to benefit the senior tranches in cases of extreme default rates.

24 The Implementation of the Hope for Homeowners Program and a Review of Foreclosure Mitigation

Efforts, Hearing before the Committee on Financial Services, U.S. House of Representatives, One Hundred

Tenth Congress, Second Session, September 17, 2008, U.S. Government Printing Office, Washington,

2009.

Everyone involved seems to have believed, as Alan Greenspan did, “that

housing prices had never endured a nationwide decline and that a bust was highly

unlikely.”25 Every model in use forecasted that only a small proportion of

mortgages in a pool would ever default. When entire pools of mortgages began

defaulting at once, defying all predictions, everyone lost.

Esteemed economist Joseph Stiglitz has claimed that the United States no

longer exemplifies a capitalist economy but rather has evolved into an ersatz

capitalist economy, in which “you socialize the losses and privatize the gains.”26

He claims that he still believes in a market economy but that it can only work if the

right rules are enforced. The current system creates a huge degree of moral hazard

and allows Wall Street investors to gamble under the conditions of heads they win,

tails the taxpayers lose. The fact that financial executives and money managers

receive huge salaries and bonuses but never suffer the losses when things go

poorly is also addressed in the movie Inside Job, which goes as far as to link the

economic crisis to the Wall Street culture of prostitution and cocaine use.

However polarizing the movie‟s message may be, it raises an interesting point

when highlighting the fact that those responsible for losing trillions of dollars of

other people‟s money bear almost zero accountability under the existing corporate

structure.

25 Edmund L. Andrews, “Greenspan Concedes Error on Regulation.”

26 CNBC.com, “US Does Not Have Capitalism Now: Stiglitz,” CNBC.com, January 19, 2010, http://www.cnbc.com/id/34921639/US_Does_Not_Have_Capitalism_Now_Stiglitz (accessed January 4,

2011).

CHAPTER V

METHODOLOGY & PREDICTIONS

In order to illuminate the factors surrounding the crisis this composition will include a multivariable linear regression analysis with Yale Professor Robert

Shiller‟s historical home price index as the dependent variable. Dr. Shiller‟s home price index does a remarkable job of demonstrating the gross overvaluation of housing values throughout the recent bubble and therefore serves as perfect dependent variable for determining the causes of the dramatic increase in prices and the inevitable correction that caused the recent recession.

Figure 5.1 Robert Shiller‟s Home Price Index

Source: Robert Shiller, Irrational Exuberance 2nd Edition, Princeton University

Press 2005.

The analysis will include up to 34 different variables that are all potentially linked to the behavior of Dr. Shiller‟s home price index. Some

variables may be omitted from the final regression if they are deemed entirely insignificant or compromise the results of the analysis.

X1 – Construction Cost: Dr. Shiller‟s work includes a historical home construction cost index, which will be used in this regression. It is predicted to have a positive correlation with the Y variable since construction costs is reflected in the final sale value of any structure.

X2 – Land Costs: Land cost data provided by the Lincoln Institute of Land Policy is expected to have a positive correlation as well since the cost of land is also reflected in the final sale vale of properties.

X3 – Long Rate: The Federal Reserve‟s long-term interest rate is also provided in

Dr. Shiller‟s work. As the benchmark of loan rates and a factor of national money supply it is expected to have a negative correlation to home prices. Lower rates correspond to greater loan availability, which increases competition for houses and drives up prices.

X4 – Population: Population data is provided by the U.S. Census Bureau. It is expected to be positively correlated with home prices because as population increases it should increase competition for homes and increase prices.

X5 – GDP: GDP data is provided by the Bureau of Economic Analysis. It is expected to be positively correlated to home prices since property sales are included as a factor of GDP. Also, as America‟s wealth increases, demand for homes should increase.

X6 – Minimum Wage: Data is provided by the United States Department of Labor

Bureau of Labor Statistics. Minimum wage is expected to be positively correlated

to home prices. When workers earn more they can move from renting to owning homes or to more expensive homes, increasing demand.

X7 – Rental Vacancy Rate: Data is provided by the U.S. Census Bureau. Rental vacancy could be either positively or negatively correlated to home prices considering there are two opposing reasons for rental vacancy: either renters have upgraded to become home owners or they have become entirely homeless.

X8 – Unemployment: Data is provided by the Bureau of Labor Statistics.

Unemployment is expected to be negatively correlated to home prices since most unemployed persons are unable to afford houses.

X9 – S&P 500 Stock Prices: Data is provided by Robert Shiller. Stock price is expected to be positively correlated to home prices both as a sign of national economic health and due to the degree of exposure to the secondary mortgage market by major investment firms.

X10 – Total Consumer Credit: All consumer credit data is provided by the Federal

Reserve Statistical Release. Outstanding consumer credit figures exclude mortgage debt. The correlation to home prices could be either positive or negative.

In some cases, institutions may have to reduce its outstanding consumer credit in order to issue more mortgage debt. However, higher home prices are a sign of a thriving economy, which could correlate to more outstanding credit as individuals and institutions gain confidence in markets. The following consumer credit variables all come from the same Federal Reserve Statistical Release.

X11 – Consumer Credit, Commercial Banks

X12 – Consumer Credit, Finance Companies

X13 – Consumer Credit, Credit Unions

X14 – Consumer Credit, Federal Government

X15 – Consumer Credit, Savings Institutions

X16 – Consumer Credit, Nonfinancial Business

X17 – Consumer Credit, Pools of Securitized Assets

X18 – Total Mortgage Debt: Total outstanding mortgage debt data is provided by the U.S. Census Bureau. Outstanding mortgage debt should have a strong positive correlation to home values across all sectors

X19 – Mortgage Debt, Household Sector

X20 – Mortgage Debt, Nonfinancial Corporate Business

X21 – Mortgage Debt, Nonfarm Noncorporate Business

X22 – Mortgage Debt, State and Local Government

X23 – Mortgage Debt, Federal Government

X24 – Mortgage Debt, Commercial Banking

X25 – Mortgage Debt, Savings Institutions

X26 – Mortgage Debt, Credit Unions

X27 – Mortgage Debt, Life Insurance Companies

X28 – Mortgage Debt, Private Pension Funds

X29 – Mortgage Debt, State and Local Government Employee Retirement Funds

X30 – Mortgage Debt, Government-Sponsored Enterprises

X31 – Mortgage Debt, Agency and GSE Backed Mortgage Pools

X32 – Mortgage Debt, Asset Backed Securities Issuers

X33 – Mortgage Debt, Finance Companies

X34 – Mortgage Debt, Real Estate Investment Trusts

Y = c+c1x1+c2x2+c3x3+c4x4+c5x5+c6x6+c7x7+c8x8+c9x9+c10x10+c11x11+c12x1

2+c13x13+c14x14+c15x15+c16x16+c17x17+c18x18+c19x19+c20+20+c21x21+c

22x22+c23x23+c24x24+c25x25+c26x26+c27x27+c28x28+c29x29+c30x30+c31x

31+c32x32+c33x33+c34x34

CHAPTER VI

RESULTS

Total Consumer Credit and Total Mortgage Debt were both omitted from the final regression because they are each just a summation of their respective „by sector‟ variables. Minimum wage was also omitted because quite frankly, people who earn minimum wage cannot afford to own their own home and the model became much stronger after the variable‟s omission. Ten variables were found to be significant at the 95% confidence level. An additional four were found to be significant at the 90% level as well as five more at the 85% and 80% confidence levels. A few of these will be briefly discussed.

Number of obs = 54 F( 31, 22) 121.89 Model 23030.6808 31 742.925186 Prob > F 0

Residual 134.092614 22 6.09511884 R-squared 0.9942 Adj R-squared 0.9861 Total 23164.7734 53 437.071196 Root MSE 2.4688 y Coef. Std. Err. t P>t [95% Conf. Interval] x1 0.671212 .276234 2.43 0.024 .0983378 1.244086 x2 0.0043265 .0195497 0.22 0.827 -.0362171 0.04487 x3 0.0291935 .6594323 0.04 0.965 -1.338385 1.396772 x4 -1.991481 .7287128 -2.73 0.012 -3.502739 -0.4802229 x5 0.0275352 .0092812 2.97 0.007 .0082872 0.0467833 x7 -0.3376242 .9927052 -0.34 0.737 -2.396369 1.72112 x8 1.508172 .8255396 1.83 0.081 -.2038927 3.220236 x9 -0.0067089 .009039 -0.74 0.466 -.0254546 0.0120368 x11 0.0002338 .0001162 2.01 0.057 -7.10e-06 0.0004748 x12 -0.0003661 .0001604 -2.28 0.032 -.0006987 -0.0000335 x13 -0.0002524 .000467 -0.54 0.594 -.0012209 0.0007161 x14 0.0006435 .0004816 1.34 0.195 -.0003554 0.0016424 x15 -0.0000836 .0002328 -0.36 0.723 -.0005664 0.0003993 x16 0.0001394 .0003205 0.43 0.668 -.0005252 0.000804 x17 -0.0002938 .0000996 -2.95 0.007 -.0005004 -0.0000872 x19 0.082619 .1404189 0.59 0.562 -.2085919 0.3738299 x20 0.3535434 .2375188 1.49 0.151 -.1390405 0.8461272 x21 -0.599225 .6668087 -0.90 0.379 -1.982101 0.7836516 x22 -1.113647 .4113226 -2.71 0.013 -1.966678 -0.2606164 x23 -0.5070825 .3368525 -1.51 0.146 -1.205672 0.1915068 x24 -0.1465498 .0723477 -2.03 0.055 -.2965897 0.0034901 x25 0.0589926 .02591 2.28 0.033 .0052585 0.1127267

x26 0.5325596 .3912854 1.36 0.187 -.2789166 1.344036 x27 1.729931 .5906989 2.93 0.008 .5048964 2.954965 x28 1.244084 1.177134 1.06 0.302 -1.197141 3.68531 x29 5.331106 2.317549 2.30 0.031 .5248039 10.13741 x30 0.0146953 .032572 0.45 0.656 -.0528548 0.0822454 x31 0.0139121 .0184192 0.76 0.458 -.0242869 0.0521112 x32 0.0472954 .0314994 1.50 0.147 -.0180304 0.1126211 x33 0.4771457 .1209471 3.95 0.001 .2263168 0.7279747 x34 -0.4007682 .1976868 -2.03 0.055 -.8107455 0.009209 _cons 344.2841 73.9729 4.65 0.000 190.8737 497.6945

At 95% significance, construction cost, GDP, state and local government

mortgage debt, savings institution mortgage debt, life insurance companies

mortgage debt, state and local government employee retirement funds mortgage

debt, and finance companies mortgage debt were all found to be positively

correlated with home prices. Population, finance companies consumer credit, and

pools of securitized assets consumer credit were found to be negatively correlated.

Construction cost and home prices have an obvious relationship. The

more expensive it is to build new homes, the more expensive the homes must sell

for the vendor to realize a profit.

GDP also has a clear relationship to home prices considering that

Americans can only purchase homes with the wealth they create.

It is interesting that state and local governments were found to have a

more significant relationship with inflated housing prices than the federal

government. In fact, the federal government‟s holdings of mortgage debt were

actually shown to have a negative correlation to home prices with 85%

significance. These facts cannot attest to the involvement of the GSEs, but it

seems, at least, that federal government tried in earnest to stay out of the dangerous game being played by investors.

The correlation between outstanding mortgage debt held by savings institutions may be the most interesting relationship unveiled by this model.

Apparently they did not learn their lesson from their earlier fiasco. This could also be interpreted as an argument for moral hazard. The savings institutions were bailed out once before and were therefore more confident that the government would cough up another bailout if things went sour once again.

The correlation between home prices and life insurance companies and state and local government employee retirement funds is a tragic indication of how honest citizens were blindsided by losses as the crisis hit. These investors were drawn in by the AAA ratings of mortgage bonds, seeking a secure account to fall back on in old age or to aid their families in the event of their passing. As risk was passed down the line through the mortgage market chain it eventually landed on the heads of innocent working class citizens.

Finance companies can be judged more harshly for their stake in the bubble market. It is their job to evaluate bonds and recognize when assets are over or under valued. The demand for mortgage bonds by finance companies probably served to exacerbate the crisis. The fact that their consumer credit holdings is negatively correlated with home prices most likely indicates that they shifted their focus towards mortgage bonds as the market was inflating.

The negative correlation between population and home prices could possibly be explained by the fact that population growth tends to occur in poorer

sectors. This would increase demand for cheaper housing options, which would lower the national average of home prices that Dr. Shiller uses. Also, the variable

GDP per capita was omitted in lieu of the two separate variables, but negative population correlation and positive GDP correlation both correspond to a strongly positive, predictable correlation between GDP per capita and home prices.

The negative correlation between mortgage debt held by pools of securitized assets and home prices appears to be a total fluke, probably due to the fact that until 1988 the total dollar amount of mortgage debt held by asset pools was 0. A scatter plot of home prices and asset pools mortgage debt reveals that the true relationship is indeed positive.

Mortgage debt held by credit unions and ABS issuers were also found to be positively correlated to home prices with 85% significance.

250.0000

200.0000

150.0000

100.0000

Series1 Home Prices Home

50.0000

0.0000 0 200000 400000 600000 800000 Mortgage Debt Held by Pools of Securitized Assets

CHAPTER VII

SOLUTIONS & PREVENTATIVE MEASURES

In response to the crisis there have been a number of proposed and actualized measures to assist in the United States‟ recovery as well as prevent future crises. Federal corrective action began during the presidency of George

Bush with the implementation of the first bailout to prevent a complete crash of the national financial system. Discussion over additional preventative measures will likely continue for years to come.

Although the bailouts may have been entirely necessary they were certainly the least desirable result of the housing bubble. As Joseph Stiglitz affirmed, they undermine the founding principles of capitalist theory. Although the reality is that certain institutions are vital to the day-to-day operations of the national economy, true capitalism requires institutional casualties in order to weed out bad business practices and allow for more efficient institutions to come into being; natural selection drives evolution, innovation, and progress. It is also just morally detestable to monetarily reward institutions that misled investors, bet against the very products they were selling, and still somehow managed to completely fail what they do. The Savings & Loan Crisis should have been the last and only straw. Instead, the government allowed financial institutions to repeat the same mistakes on a much larger scale.

Although president Barack Obama instituted a Hope for Homeowners

program and the American Recovery and Reinvestment Act of 2009 included a

$75 billion Homeowner Affordability and Stability plan, the number pales in

comparison to financial relief provided for major institutions such as the $185

billion of financial relief given to AIG.27 Also, a significant portion of struggling

homeowners will never be able to qualify for government assistance programs and

more still will be unable to restructure their loans due to restrictions by the

secondary market. In order to amend the terms of a mortgage a homeowner must

contact their bank to reach an agreement and draft a proposal. The bank will then

pass the proposal to the servicer of the loan who will pass it on to their master

servicer to get approval from a trustee, appointed and compensated by the loan‟s

securitizer. The trustee is legally obligated to precisely enforce the terms of the

contract between the servicer and securitizer, which will be determined by the

securitizer‟s obligation to their bond holders. In many cases these contracts will

not allow loan rates to drop below a specific minimum. The sad reality is that

homeowners lost big, and they will not be bailed out.

The other immediate measure taken by the government was to take

conservatorship of selected institutions and its sponsored enterprises, holding itself

accountable for further losses incurred from junk assets. There are some who

believe that the government should have bailed out or taken conservatorship of

Lehman Brothers to prevent its collapse, or at least to allow its failure to occur in a

27 The White House, “Homeowner Affordability and Stability Plan: Executive Summary,” Washington

February 18, 2009.

more orderly fashion. Others believe that the government should have allowed all

failing institutions to do so despite the harsh repercussions it would have on the

economy. What actually occurred was an inconsistent response by the

government, but probably an appropriate one. There were bound to be casualties

of the crisis. The government allowed the free market to impose its will to the

greatest extent possible while preventing an utter collapse of all financial

institutions. However, it would be extremely frightful if a similar situation were

ever to occur in the future, forcing the government to play favorites again.

The Federal Reserve also played a very active role in easing the transition

through the crisis by buying toxic assets from struggling institutions in order to

provide them with liquidity. The government and Fed have basically taken the

lion‟s share of the losses on themselves in order to keep Wall Street solvent. The

big issue is that financial institutions were so heavily leveraged that the losses the

government now has to stomach vastly outweigh the total value of the institutions

they are saving. Although economists Eric Dinallo, Alan Greenspan, and Joseph

Stiglitz have all proposed stricter capital requirements in order to prevent future

leverage issues, the Dodd-Frank Wall Street Reform and Consumer Protection Act

only requires that regulators impose counter-cyclical leverage limits, which seems

a bit open-ended and soft.28

For some time after the crisis there was dialog about establishing a Good

Bank/Bad Bank system, an idea that was developed during the Great Depression

and briefly revisited during the Savings and Loan Crisis. The theory is that the

28 Dodd-Frank Wall Street Reform and Consumer Protection Act, Washington, January 5, 2010.

government and private sector would collectively support a Bad Bank, holding

only toxic assets, as it unwound itself in a tidy style. It seems that the government

has simply taken this role of Bad Bank upon itself.

Economist Jeffrey Sachs has proposed that in the event of a future crisis,

the government should impose „haircuts‟ to bondholders and counterparties in lieu

of fully compensating them with taxpayer bailout money.29 This seems like a

much more appropriate response to such an event. The parties who actively invest

in overvalued bonds, even in ignorance, are certainly guiltier by association than

the average taxpayer, and should have the value of their foolish investments

written down.

A similar proposition pertaining specifically to home mortgages is that

lenders be required to write down the total principal balances of loans in exchange

for equity of the house, which would allow them to reap the benefit of any future

increase in the home‟s value. These equity swaps would properly realign

incentives for lenders to issue loans that better reflect real home value, knowing

that if the prices were to fall drastically, the debt owed to them would be

appropriately lowered by the government. However the government is highly

squeamish when it comes to unprecedented imposition of regulation.

Unfortunately, the dramatic polarization of United States politics hinders the

29 Jeffrey Sachs, “Our Wall-Street-Besotted Public Policy,” Real Clear Politics, March 31, 2009, http://www.realclearpolitics.com/articles/2009/03/making_rich_guys_richer.html (accessed January 5,

2011).

ability of the policymakers to take unconventional measures as well as causing

them to behave hyper-cautiously, especially concerning the big issues.

Other proposed measures include breaking up larger institutions into

smaller entities that could be allowed to fail harmlessly, reinstating the separation

of commercial and investment banking that was repealed by the Gramm-Leach-

Bliley Act of 1999, require minimum mortgage down payments and income

statements, impose more regulation on businesses that “act like banks,” reforming

executive pay to be more dependent on long term success, implement more

counter-cyclical regulation to correct for humanity‟s pro-cyclical nature, stricter

regulation, new regulatory bodies, and nationalizing insolvent banks.30 All are

viable options and would be steps in the positive direction. Most people with

decent economic sense would agree that the measures that have been taken to date

have not been sufficient in altering the fundamental structures of the financial

world. The recent crisis definitely demonstrates a significant need for evolutionary

steps to be taken in U.S. markets.

30 Paul Krugman, “The Return of Depression Economics and the Crisis of 2008,” W.W. Norton Company

Limited, 2009.

CHAPTER VIII

CONCLUSION

The subprime mortgage crisis has definitely proven to be greatest

American financial tragedy since the Great Depression. Home prices have fallen so drastically since 2006 that many homeowners have simply walked away from their mortgages in disgust of how much they overpaid. Retirement funds, life insurance policies, pensions, education funds, any type of fund that was established with the intention of being a safe account to rely on in the future has probably been exposed to the mortgage euphoria. You can blame it on greed, but greed is the benchmark in world of finance. Every entity simply acted in its own interest, to the disservice of all. The structure was flawed, the incentives amiss, and Federal Reserve, the body with the power to detect and deter the crisis, intentionally spurred the market onward.

Moving forward we can only hope that the powers that be take strong action to protect us from yet another crisis. Clearly the market structure needs to evolve to move us out of an ersatz capitalist economy, even if just to get back to true capitalism where failure is accepted and the government has no need to involve itself. If it takes more government involvement to get us there, so be it.

The issue at hand is not political in nature. It is a clear-cut case of a system unable to hold itself accountable. But instead of doling out discipline, the government

doled out more bailouts, repeating its trend of rewarding bad behavior. Savings institutions have now been at the center of two national crises of which the taxpayers had to pay the cost. The government tried to reduce its role in the industry through deregulation, but it is safe to say now that there is no smooth retreat for the government from a market it is not only solely responsible for creating but of which its entities are the dominant shareholder. As home prices return to their historic trend of slight linear, not exponential growth, new opportunities will emerge for research and reform. Hopefully the future of mortgage lending can escape the tumultuous cycle of its past.

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