The September 11, 2001, terrorist attacks on the United States accelerated the economic slowdown that began in early 2001. Immediately, the U.S. central bank, the Federal Reserve (FED), stepped in and began lowering interest rates. Soon, interest rates were at 40-year lows and market participants reacted they borrowed.
The low interest rates allowed more Americans to qualify for mortgages, causing home prices to rise. Rising prices encouraged speculators to jump in as “returns” on homes exceeded those on other investments and low interest rates increased the demand for second homes, fueling the upward pressure on prices.
As rising prices pushed borrowers out of the market, financial institutions reacted by offering a variety of mortgage instruments that eased standards for loan qualification. In addition, loan officers were often compensated based on the number and the size of the mortgages they wrote, not based on the likelihood that the borrowers could repay.
To satisfy the demand for loans, lenders sold the mortgages they originated to Wall Street banks and other investors, and lenders used those funds to finance additional mortgages. The purchasers of the mortgages pooled them and sold bonds backed by the pools to hedge funds, insurance companies, and other investors.
Credit Default Swaps
Institutions used credit default swaps (CDS) to insure against default of the mortgage-backed securities. A credit default swap is a contract in which the buyer makes a series of payments to the seller. In exchange, the buyer receives the right to a payoff if a credit instrument goes into default, or if some event such as bankruptcy or restructuring occurs. Originally a form of “insurance” against bad debt, CDS became an instrument for speculation after the Commodity Futures Modernization Act of 2000 when the market exploded, peaking at $62 trillion for this derivative. Warren Buffett called these instruments “financial weapons of mass destruction” in the 2002 Berkshire Hathaway Annual Report, and many of the problems during the past year can be traced back to CDS.
The Cracks Begin to Show
The FED began increasing short-term interest rates in June 2004. By mid-2005, mortgage defaults and delinquencies in the subprime category, while still low, began to grow. The housing market continued to flourish until early 2006, when cracks began to show. The upward march of housing prices slowed, and the inventory of unsold homes increased as buyers took to the sidelines anticipating price cuts. Slowing prices dampened speculation and higher interest rates reduced second-home purchases, decreasing the demand for homes.
To exacerbate the problem, adjustable-rate mortgages that closed two to three years earlier began to reset. In the past, many subprime borrowers continually refinanced their homes with loans featuring low teaser rates to postpone large jumps in payments. However, rising delinquencies caused lenders to tighten standards, limiting the ability of subprime borrowers to refinance. In addition, falling home prices and slowing demand limited their ability to sell their homes.
By January 2007, 14.3 percent of subprime loans were at least 60 days late, up from 8.4 percent in January 2006. For Alt-A loans, which fall between subprime and prime, the late payment rate rose to 2.6 percent, up from 1.3 percent in January 2006. Foreclosures continued to climb, and by March 31, 2008, 2 percent of single-family homes were in foreclosure and 6.4 percent of all mortgages were delinquent by 30 days or more. Fifty percent of the mortgages that went into foreclosure in the first quarter of 2008 were subprime, but a startling 42 percent were prime loans.
U.S. Financial System Begins to Unravel
The first U.S. victim of the subprime debacle was the investment bank Bear Sterns. Its troubles began when two of its hedge funds failed in July 2007. As its losses from subprime bets mounted, Bear Sterns’ financial condition continued to deteriorate until a takeover bid by JPMorgan Chase in March 2008 was orchestrated with the FED’s assistance. The fire sale of the institution resulted in the demise of the 85-year-old firm and the loss of approximately 60 percent of Bear Sterns’ 14,000 jobs. The FED immediately extended the privilege of borrowing at the discount window to other Wall Street banks, providing needed liquidity and temporarily reducing the fear of more failures.
Lenders continued to tighten borrowing standards, but change did not occur fast enough for financial institutions not to feel the heat. Wells Fargo announced a drop of 11 percent in first quarter 2008 net income because of mortgage defaults. Countrywide Financial Corporation, once the largest mortgage lender in the United States, lost $2.5 billion over a nine-month period and agreed to be bought by Bank of America Corporation in January 2008. Merrill Lynch acknowledged almost $25 billion worth of asset write-downs and charges, while Citigroup recognized over $22 billion.
Credit Crisis Turns Global
The pain was not limited to U.S. institutions. UBS, the Swiss banking giant, announced in May 2008 that it would issue $15 billion worth of common stock shares its second trip to the equity market in three months to restore capital depleted by mortgage losses. Additionally, UBS announced that it would lay off 5,500 employees, mainly in the United States and Britain. While UBS was the hardest hit, banks globally have written off more than $330 billion in losses since the summer of 2007. Even the Bank of China acknowledged that it held $9.7 billion of securities backed by U.S. subprime mortgages.
The bad news continued with the downfall of IndyMac Bancorp, which acknowledged large losses in its subprime portfolio. Senator Charles Schumer expressed concern that the bank might fail; soon after there was a run on the bank, causing a shortage of cash and forcing the Federal Deposit Insurance Corporation to seize it. IndyMac has the dubious distinction of being the second largest federally insured institution to fail, but it was certainly not the last.
Failure of Freddie and Fannie
Banks and mortgage lenders were not the only institutions to be hurt by the subprime debacle and credit crunch. Two government-sponsored institutions, Freddie Mac and Fannie Mae,* saw their stock prices plummet as they recorded huge losses. In mid-July, the FED provided a short-term solution to liquidity worries by allowing the two institutions to borrow at the discount window. The Bush administration proposed and Congress approved a longer-term solution, which could inject up to $300 billion into the two institutions through investments and loans. However, even this did not restore public confidence in the two institutions, and the government placed them in conservatorship in early September.
(*Editor’s Note: Click here for the authors’ analysis of what went wrong with Freddie Mac and Fannie Mae)
The Crunch Continues
Mortgage debt is not the only worry for consumers and financial markets. U.S. credit card debt stands at $915 billion, a 435 percent increase since 2002 and approximately the same size as the subprime mortgage debt. Additionally, about 45 percent of credit card loans have been packaged in pools that have been sold to banks and other institutional investors. Delinquencies of over 90 days on credit card debt have increased by 50 percent, and credit card companies have written off approximately five percent of payments. Is this the next ticking time bomb?
Troubles exist across the board. Distressed debt has affected industries beyond the typical sick sectors (airlines and automobile) or industries related to the real estate sector (home builders, mortgage lenders etc.). Banks are reluctant to lend money and investors have no appetite for risk. According to Standard & Poor’s, about two-thirds of non-financial firms carry a junk credit rating.
The Bailout Bill
The FED reacted to the meltdown in the mortgage markets and the ensuing credit crunch by lowering interest rates. In September 2007, the discount rate and target for the FED fund rate stood at 5.25 percent and 5.0 percent, respectively. Decreases continued until the rates stood at 2.25 and 2.0 percent, respectively, in June 2008. The decline in interest rates helped lower the rates at which many adjustable rate mortgages reset, thus lowering potential payment increases for many borrowers. However, the lower rates also increased the risk of inflation; therefore, they had only modest impact on the rate of 15- and 30-year mortgages.
Financial markets stumbled along until late September 2008, when a fast and furious series of events occurred. In a five-day period, Lehman Brothers, the 158-year-old investment firm, declared bankruptcy; the insurance giant American International Group (AIG) required a FED bailout; Warren Buffett invested $5 billion in Goldman Sachs to keep it afloat; JPMorgan Chase purchased Washington Mutual; and Bank of America purchased Merrill Lynch.
In response, the Bush Administration sent U.S. Treasury Secretary Henry M. Paulson, Jr., to Congress with a three-page plan that granted the Treasury Department authority to spend up to $700 billion to purchase soured mortgage-backed securities from banks to relieve the pressure. After tense negotiations, the U.S. House of Representatives considered a bill that added oversight and accountability, restrictions on executive compensation, and mortgage workouts; however, the bill was rejected.
On September 29, 2008, the Dow Jones Industrial Average responded by falling 7 percent or 777.68 points in one day. The Standard & Poor’s 500 Index plunged 8.8 percent and the Nasdaq Composite Index plummeted 9.1 percent. A total of $1.3 trillion in wealth disappeared in less than 24 hours. Markets around the world followed the downward slide.
The U.S. Senate acted quickly to get the bill passed by adding “sweeteners” to entice reluctant legislators to approve it. These included raising the limit on federally insured bank deposits from $100,000 to $250,000, which had broad-based support. In addition, the new bill included tax breaks, tax benefits and tax credits for domestically produced films and TV shows, natural disaster victims, “clean” coal and renewable energy, and research and development costs. The bill also revised the Alternative Minimum Tax, which under the U.S. tax code disallows several deductions and exemptions allowable in computing tax liability. The revisions added more than $100 billion to the plan, and the three-page plan exploded to 451 pages. On October 3, the House passed the bill and President Bush immediately signed it.
The passage of the bailout package did not stop the hemorrhaging in financial markets and the financial contagion spread worldwide. On October 6, the Dow Jones Industrial Average dropped below 10,000 points for the first time since 2004. In Europe, London’s FTSE 100 suffered its worst one-day drop in history, and stock markets in Germany, France, and Italy declined by between 4 and 5 percent. Russia halted trading on its stock market three times and ended with a 20 percent decline. In Latin America, stock markets slid as much as 17 percent. Even Japan’s Nikkei stock market index lost more than 3 percent.
Supporters warn that it will take time for the bailout to stabilize banks and loosen credit. Critics claim that the bailout is too little, too late. At best, it will serve as the first step in re-establishing trust in the global financial markets.
Erosion of Faith
Trust is the foundation on which the U.S. financial system rests U.S. financial institutions were considered to be highly regulated and, therefore, their products were assumed to be safe. Unfortunately, recent events have shaken faith and confidence as institutions worldwide have recognized losses from securities backed by pooled U.S. subprime mortgages. What seemed to be a containable problem in the subprime market is becoming a comprehensive financial crisis.
An international backlash appears to be growing as the credit crunch continues to affect the global financial system. Trillions of dollars in paper wealth have evaporated in global stock markets. Central banks around the world have been injecting liquidity into the system to maintain some sense of stability, with limited success thus far. Hamid Varzi, in an article written for the International Herald Tribune, summarized world opinion: “The U.S. economy, once the envy of the world, is now viewed across the globe with suspicion.”
As the crisis deepens, the criticism grows. Russian Prime Minister Vladimir Putin sharply criticized the United States for its economic failures, which have negatively impacted the Russian economy. Russian President Dmitry Medvedev noted that the financial crisis signaled the end of U.S. global economic dominance. This sentiment was echoed by Peter Steinbruck, the German finance minister, who declared that the United States was “the source . . . and the focus of the crisis” and was no longer the world financial superpower.
World confidence in the United States is important because we depend on the rest of the world to finance our debt. U.S. government debt is at a record $10 trillion. U.S. household debt hovers at $14.5 trillion, while U.S. savings rates remain at historic lows. Foreign investment has offset this imbalance, attracted by fairly competitive interest rates, financial security, and economic stability. More importantly, Asian economies, with their export-led growth models, purchased U.S. Treasury securities to keep their exchange rates stable by protecting their currency against the depreciating dollar.
With the events of the last year and the danger of a global recession, it is likely that the world will find a new world financial order; one the United States may no longer head. Dubai and Shanghai have been touting themselves as the next financial centers and market participants may start believing them if U.S. markets do not stabilize soon.
In May 2008, the stock markets seemed to stabilize, the corporate credit spreads narrowed, and the price of gold dropped. Treasury Secretary Paulson announced that the worst was behind us. But recent events demonstrate there are still plenty of concerns.
Banks continue to tighten credit standards and report losses. Bailouts and mergers to prevent bankruptcy seem to be announced daily not only in the United States, but around the world. Credit card debt continues to be a concern. Home prices continue to decline, and defaults and foreclosures in the housing market are still on the rise. Small businesses are finding short-term loans, their lifelines, expensive or unavailable.
Following one of the biggest credit crises of all time, when will the worst be over for the financial sector, the stock market, the housing industry, and the global economy? Home prices need to stabilize and confidence must return before markets will rebound, but rebound they will. Markets are probably approaching the bottom, but growth will likely be sluggish for the remainder of 2008. In the words of Winston Churchill, “…this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”
 For a complete discussion of the subprime meltdown, please see “Will the Sub-prime Meltdown Burst the Housing Bubble” by Peggy J. Crawford and Terry Young, Graziadio Business Report, 11, no. 3 (2007).
 Maura Reynolds, “Mortgage Troubles Hit Record Highs” The Los Angeles Times, June, 6, 2008, at C3.
 Bloomberg News, “Wells Fargo Home Loan Policies Get Tougher” The Los Angeles Times, May, 23, 2008, at C4.
 David Jolley, “After Losses UBS Seeks to Raise $15 Billion” The New York Times, May, 23, 2008, at C5.
 Danny Schechter, “House of Cards” LA CityBeat, June 25, 2008.
 Andrew E. Kramer, “Russia Sees in Credit Crisis End of U.S. Domination” International Herald Tribune, October 2, 2008.
 “World on the Edge” The Economist, October 2, 2008.
 Winston Churchill, “The End of the Beginning” Lord Mayor’s Luncheon, Mansion House, London, November 10, 1942.