The Economy: Crisis & Response
Federal Reserve Bank of San Francisco, November 30, 2009
What ignited the financial crisis?
The financial market turmoil that began in 2007 led to a severe global economic downturn. The causes of the crisis, the effects on global financial markets, and the spillover to the economy are examined here.
· Housing boom
During the early 2000s, low mortgage rates and expanded access to credit made homeownership possible for more people, increasing the demand for housing and driving up house prices. Low mortgage rates were a consequence of low interest rates around the world as well as Federal Reserve policy aimed at stimulating the economy following the 2001 recession. Home prices soared and construction of new houses reached all-time highs. According to one measure, U.S. house prices rose about 10 percent per year on average from 2000 to 2006, well outpacing gains in income. In some areas, the housing boom was even more dramatic, with prices rising by more than 15 percent per year.
Citations:
A View of the Economic Crisis and the Federal Reserve's Response, by Janet L. Yellen, President, Federal Reserve Bank of San Francisco, FRBSF Economic Letter 2009-22, July 6, 2009.
Four Questions about the Financial Crisis, speech by Ben S. Bernanke, Chairman, Federal Reserve Board of Governors, at Morehouse College, Atlanta, GA, April 14, 2009.
· Easy credit
The housing boom got a boost from increased securitization of mortgages—a process in
which mortgages were bundled together into securities that were traded in financial markets. Securitization of low-risk mortgages has been around for decades and has helped lower home loan rates by expanding the market of investors that hold mortgages. But, early this decade, securitization of riskier mortgages expanded rapidly, including subprime mortgages made to borrowers with poor credit records. During the boom years, defaults on these mortgages were rare because homeowners could easily refinance or sell their houses. High profits and low defaults made lenders and investors in mortgage-backed securities complacent. Underwriting standards became increasingly lax—including little or no down payment or documentation. Investors were reassured because rating agencies gave even subprime mortgage-backed securities high ratings.
Citations:
A Minsky Meltdown: Lessons for Central Bankers, by Janet L. Yellen, President, Federal Reserve Bank of San Francisco, FRBSF Economic Letter 2009-15, May 1, 2009.
· Housing bust and mortgage meltdown
Large numbers of new homes came onto the market and buyers began to realize that home prices could not rise indefinitely. House prices faltered in early 2006 and then started a steep slide. Home sales and construction fell sharply. For many people who had recently bought their homes or had taken equity out when refinancing, falling house prices meant that they owed more on their mortgages than their homes were worth. Starting with subprime mortgages, more and more homeowners fell behind on their payments. Eventually, this spread to prime mortgages as well.
Citations:
House Prices and Bank Loan Performance, by John Krainer, Senior Economist, Federal Reserve Bank of San Francisco, FRBSF Economic Letter 2009-06, February 6, 2009.
Why did the mortgage meltdown threaten the financial system?
· Mortgage-related losses skyrocket
The rising number of delinquencies on subprime mortgages was a wake-up call to lenders and investors that many residential mortgages were not nearly as safe as once believed. As the mortgage meltdown intensified, the magnitude of expected losses rose dramatically. In October 2007, shortly after the onset of the housing bust, the International Monetary Fund estimated that losses of financial institutions related to U.S. residential mortgages would total $240 billion. By April 2009, its estimate was nearly six times larger, exceeding $1.4 trillion. Because millions of U.S. mortgages were repackaged as securities, losses spread across the globe.
Citations:
The Mortgage Meltdown, Financial Markets, and the Economy, by Janet L. Yellen, President, Federal Reserve Bank of San Francisco, FRBSF Economic Letter 2008-35-36, November 7, 2008.
· Confidence erodes
As estimates of the magnitude of mortgage-related losses mounted, investors and financial institutions became increasingly nervous about their own exposure to risk and the financial health of firms with which they did business. In particular, it became very difficult to determine the value of many loans and mortgage-related securities. In addition, the widespread use of complex and exotic financial instruments made it even harder to figure out the vulnerability of financial institutions to losses. Institutions became increasingly reluctant to lend to each other. The situation reached a crisis point in 2007 when these fears about the financial health of other firms led to massive disruptions in the wholesale bank lending market that institutions use to fund their day-to-day needs for cash. As a result, rates on short-term loans rose sharply relative to the overnight federal funds rate.
Citations:
The Financial Markets, Housing, and the Economy, by Janet L. Yellen, President, Federal Reserve Bank of San Francisco, FRBSF Economic Letter 2008-13-14, April 18, 2008.
· Financial markets panic
In the fall of 2008, two large financial institutions failed: the investment bank Lehman Brothers and the savings and loan Washington Mutual. Several others threatened to go under. The extensive web of connections among major financial institutions meant that the failure of one could start a cascade of losses throughout the financial system, threatening many other institutions. Large losses at a big money market mutual fund extended the crisis to a part of the financial system previously regarded as safe, prompting investors to pull their money out. Short-term lending to corporations in the commercial paper market also froze. Confidence in the financial sector collapsed and stock prices of financial institutions around the world plummeted.
Citations:
Reflections on a Year of Crisis, speech by Ben S. Bernanke, Chairman, Federal Reserve Board of Governors, at the Federal Reserve Bank of Kansas City's Annual Economic Symposium, Jackson Hole, WY, August 21, 2009.
How did the financial crisis threaten Main Street?
· Credit crunch
The shock of massive losses in mortgage-related investments made financial institutions and investors much more wary of lending to households and businesses. Bad loans also eroded bank capital, the financial cushion these institutions maintain to cover losses. Moreover, banks were unable to sell most types of loans to investors because securitization markets had stopped working. As a result, banks and investors clamped down on many types of loans by tightening standards and demanding higher interest rates—a classic credit crunch.
Citations:
Four Questions about the Financial Crisis, speech by Ben S. Bernanke, Chairman, Federal Reserve Board of Governors, at Morehouse College, Atlanta, GA, April 14, 2009.
· Plummeting wealth
The financial crisis wiped out over 20 percent of American wealth. Plummeting house prices reduced the wealth of Americans by $4 trillion. Following the panic of late 2008 and the intensifying global recession, stock prices around the world crashed. In the United States, nearly one-half of stock market wealth was lost, a percentage decline that exceeded the 2000-2002 stock market crash. Foreign households didn’t fare any better, as stock markets around the world crashed.
Citations:
U.S. Household Deleveraging and Future Consumption Growth, by Reuven Glick, Group Vice President, and Kevin J. Lansing, Senior Economist, Federal Reserve Bank of San Francisco, FRBSF Economic Letter 2009-16, May 15, 2009.
· Recession
The credit crunch and loss of wealth were a one-two punch that sent the United States and many other economies into recession. Tight credit weakened spending on big-ticket items financed by borrowing: houses, cars, and business investment. The hit to household wealth was another factor causing people to cut back on spending as they struggled to rebuild depleted savings. With demand weakening, businesses canceled expansion plans and laid off workers. The U.S. economy entered a recession, a period in which the level of economic activity was shrinking, in December 2007. The recession had been relatively mild until the fall of 2008 when financial panic intensified, causing job losses to soar. •
Citations:
Issues Raised by the Credit Crunch and Global Recession, presentation by Janet L. Yellen, President, Federal Reserve Bank of San Francisco, to the Haas Business School, University of California, Berkeley, Berkeley, CA, May 5, 2009.
Jobless Recovery Redux?, by Mary Daly, Vice President, Bart Hobijn, Research Advisor, and Joyce Kwak, Research Associate, Federal Reserve Bank of San Francisco, FRBSF Economic Letter 2009-18, June 5, 2009.
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