The Collapse

Photo courtesy of wonderal (via flickr)

Photo courtesy of wonderal (via flickr)

Now that we have the context for the financial crisis, we can explain the crisis itself.  The financial crisis was the result of the collapse of a bubble in the US housing market which had formed in the early 2000s.

For at least a decade  prior to the crisis, the US housing market exhibited signs of a bubble:  exceptionally high growth, with housing prices rising more than 10% per year at the national level, which far exceeded the rate of inflation.1

The bubble was more pronounced in regions such as Florida, California and parts of the US northeast.

The housing bubble coincided with a period of substantial monetary easing by the Federal Reserve.  The federal funds rate declined from 6.5% in July 2000 to just under 1% in December 2003.  Over the same time frame, mortgage interest rates fell by roughly one third.  One can debate who was at fault, but it seems clear that the nation was awash in credit.2

The financial crisis began in early 2006 when the subprime mortgage market in the U.S. began to display an increasing rate of mortgage delinquencies, as is shown in the following figure.  In increase in mortgage foreclosures led, in late 2006, to a decline in US housing prices.

Source: Mortgage Bankers Association, National Delinquency Survey

Source: Mortgage Bankers Association, National Delinquency Survey

In retrospect, it is not surprising that many banks realized sharp increases in mortgage default rates beginning in 2006-this was roughly two years after the subprime market took off and when the first wave of teaser interest rates expired. When teaser rates associated with sub-prime ARMs expired, borrowers who now wished to refinance their mortgages at lower interest rates found they could no longer do so.  Meanwhile, banks responded to high mortgage default rates by raising interest rates at the same time as when the teaser rates expired.  When borrowers defaulted on their loans, banks began selling the foreclosed homes.  Placing these homes on the market created significant downward pressure leading to a decrease in home prices across the nation.  These factors led to a spiral of more defaults, foreclosures, and further diminished home values.  By late 2007, the prime mortgage markets were showing higher than normal default rates as well.  This process “popped” the housing bubble.

The prominent role played by collateralized mortgage obligations in subprime mortgage financing allowed these problems to spread from the mortgage market to other sectors of the economy, especially on financial markets as a whole.

As the value of mortgages fell due to increasing default rates, the value of these securities fell likewise.  The underlying rationale for the CMO model was broken as not enough mortgage payments came in to even pay the interest on the higher tranches, much less the middle or lower ones.  The result was twofold: first, the value of CMOs fell, but second, and perhaps more importantly, no one could be sure what those values were.

Image courtesy of BarryBar (via flickr)

Image courtesy of BarryBar (via flickr)

The problem was compounded by another financial product, the Credit Default Swap (CDS).   Credit Default Swaps were originally designed to be insurance contracts on CMOs (should they default).  Financial institutions sold CDSs for a fee.  American Insurance Group (AIG) was very heavily involved in this market.  CDSs then morphed into a type of speculative investment when the same “insurance” was sold to people who didn’t own the debt instruments, people who were betting on the collapse of CMOs.  As NPR’s Alex Blomberg explained it:  “There are $5 trillion worth of bonds [CMOs] issued in the world, but the total amount that people have bet on those bonds is $60 trillion. For every one person insuring a bond with a credit default swap, there are more than 10 people betting on it.”

Over time, sellers of CDSs bought matching CDSs to protect themselves against default risk until nearly all the players in the investment banking market were linked together by these liabilities.  On paper it appeared that the players had perfectly hedged their risk exposure, but that was only true if no one defaulted on the CDS.  If one CDS seller was unable to pay, though, the entire chain could go down.  And that is what happened.


[ next section: The Credit Crisis ]

Footnotes:

  1. This is a conservative estimate.  Others have put housing price inflation substantially higher.
  2. John Taylor argues that the Federal Reserve extended too much liquidity, while Alan Greenspan says that the liquidity was due to foreign capital inflows.  See http://economistsview.typepad.com/economistsview/2009/03/greenspan-the-fed-didnt-do-it.html
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