essay 4 - outline

Intro:

·         The Fed didn't start lowering rates until January 2001, and lowered them about 1/2 point each month, resting at 1.75% in December 2001. This kept interest rates high when the economy needed low rates for cheap business loans and mortgages.

One of the causes of the 2008 recession was that the Fed was also slow to raise interest rates when the economy started to boom again in 2004. Low interest rates in 2004 and 2005 helped created the housing bubble. Irrational exuberance set in again as many investors took advantage of low rates to buy homes just to resell. Others bought homes they couldn't afford thanks to interest-only loans. – (amadeo)

·         Throughout the mid 2000s, we all heard the ads on the radio; get a mortgage for no money down. Lending standards were lowered and lowered until people with no jobs, no income, no assets and no credit rating were able to get huge mortgages for no money down and no proof of income. (Montana)

·         Deregulation and stability had afforded Wall Street traders a self-confidence that encouraged them to take significant risks, many centered on America’s growing number of homeowners, who took advantage of relaxed credit restrictions and a market wide open to lending. Subprime mortgages (high-risk home loans) began to take their toll on the economy as homeowners defaulted or fell behind on payments.- (“Recession”)

·         . In 2006, the bubble burst as housing prices started to decline. This caught many homeowners off guard, who had taken loans with little money down. As they realized they would lose money by selling the house for less than their mortgage, they foreclosed. An escalating foreclosure rate panicked many banks and hedge funds, who had bought mortgage-backed securities on the secondary market and now realized they were facing huge losses. – (amadeo)

·         These mortgages were securitized or turned into mortgage backed securities that people could invest in. For example, take a 10 block area around your home. Put all those mortgages into an envelope. You don’t know the credit worthiness of those mortgages. Cut up the envelope into smaller pieces all holding all kinds of mortgages and then sell those pieces to investors. These pieces were called tranches.

These were called collateralized debt obligations (CDOs). Those who owned them would get paid when each person in that certain tranche paid their mortgage and did not get paid when the mortgages were not paid and the defaults and foreclosures started.

There was such a huge demand for these CDOs and not enough mortgages that the banks invented CDOs, these were called synthetic CDOs.

Two big problems caused the banks to live in their dream world during this housing “bubble”. How they listed their assets on their books. They listed these CDOs at inflated prices when in reality they were dropping like a rock. When they had to list them properly at current market value, everyone could see the banks didn’t have nearly the assets they claimed to have.

The second problem was leverage. Many of these banks had leverage of 30 or more to 1. Meaning for every dollar of their own they invested in these mortgages, they used $30 borrowed dollars to invest.

Other bank problems that led to the Great Recession include shadow banking, the unregulated derivatives market and the repo market or repurchase agreements. – (Montana)

·         In the summer of 2008, both institutions were on the verge of collapse. A $300 billion credit line was extended to stabilize Fannie Mae and Freddie Mac, but ten days later Lehman Brothers, an international financing firm, declared bankruptcy, the largest in U.S. history. The next day, the federal government authorized an $85 billion buyout of A.I.G. Financial Products, an insurance group closely related to Goldman Sachs, another financial behemoth specializing in investments. Citigroup, Merrill Lynch, and other companies teetered on the brink of bankruptcy and were forced to radically restructure. A general alarm sounded as the healthy financial institutions shut down credit lines and less-fortunate companies scrambled for economic security through mergers, buyouts, and federal bailouts. (“recession”)

·         Bush signed the Troubled Asset Relief Program (TARP) on 3 October, authorizing $700 billion in rescue funds to beleaguered banking firms. More than $17 billion was carved out to save the auto industry. (“recession”)

·         By December 2008, employment was declining faster than in the 2001 recession. – (amadeo)

Thesis: the 2008 recession could have been avoided if the Federal Reserve had better regulated new financial instruments, if the government hadn’t kept interest rates and lending standards so low, and if finance companies hadn’t taken on a large amount of risky securities.

First Section: The major cause for the 2008 recession was massive deregulation by the government because they failed to notice the risky actions being taken by financial institutions

·         The 2008 financial crisis was an “avoidable” disaster caused by widespread failures in government regulation, - (Chan)

·         The commission that investigated the crisis casts a wide net of blame, faulting two administrations, the Federal Reserve and other regulators for permitting a calamitous concoction: shoddy mortgage lending, the excessive packaging and sale of loans to investors and risky bets on securities backed by the loans.

“The greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done,” the panel wrote in the report’s conclusions, which were read by The New York Times. “If we accept this notion, it will happen again.” – (Chan)

·         The majority report finds fault with two Fed chairmen: Alan Greenspan, who led the central bank as the housing bubble expanded, and his successor, Ben S. Bernanke, who did not foresee the crisis but played a crucial role in the response. It criticizes Mr. Greenspan for advocating deregulation and cites a “pivotal failure to stem the flow of toxic mortgages” under his leadership as a “prime example” of negligence. – (Chan)

·         It also criticizes the Bush administration’s “inconsistent response” to the crisis — allowing Lehman Brothers to collapse in September 2008 after earlier bailing out another bank, Bear Stearns, with Fed help — as having “added to the uncertainty and panic in the financial markets.” – (Chan)

·         The pithiest explanation I've seen comes from New York Times columnist and Nobel Laureate Paul Krugman, who noted in one interview: "Regulation didn't keep up with the system." In this view, the emergence of an unsupervised market in more and more exotic derivatives—credit-default swaps (CDSs), collateralized debt obligations (CDOs), CDSs on CDOs (the esoteric instruments that wrecked AIG)—allowed heedless financial institutions to put the whole financial system at risk. "Financial innovation + inadequate regulation = recipe for disaster is also the favored explanation of Greenspan's successor, Ben Bernanke, who downplays low interest rates as a cause (perhaps because he supported them at the time) and attributes the crisis to regulatory failure. – (Weisburg)

·         Deregulation and stability had afforded Wall Street traders a self-confidence that encouraged them to take significant risks, many centered on America’s growing number of homeowners, who took advantage of relaxed credit restrictions and a market – (“Recession”)

Second Section: Low interest rates because of the 2001 recession led to lowered lending standards, which caused the housing bubble to grow until it peaked in 2008.

·         Most analysts find former Fed Chairman Alan Greenspan at fault, though for a variety of reasons. Conservative economists—ever worried about inflation—tend to fault Greenspan for keeping interest rates too low between 2003 and 2005 as the real estate and credit bubbles inflated. This is the view, for instance, of Stanford economist and former Reagan adviser John Taylor, who argues that the Fed's easy money policies spurred a frenzy of irresponsible borrowing on the part of banks and consumers alike. – (Weisburg)

·         High interest rates are also a cause of recession. That's because it limits liquidity, or the amount of money available to invest. In spite of the stock market decline in March 2000, the Federal Reserve continued raising interest rates to a high of 6.25% in May 2000. The Fed didn't start lowering rates until January 2001, and lowered them about 1/2 point each month, resting at 1.75% in December 2001. This kept interest rates high when the economy needed low rates for cheap business loans and mortgages.

·         One of the causes of the 2008 recession was that the Fed was also slow to raise interest rates when the economy started to boom again in 2004. Low interest rates in 2004 and 2005 helped created the housing bubble. Irrational exuberance set in again as many investors took advantage of low rates to buy homes just to resell. Others bought homes they couldn't afford thanks to interest-only loans. – (amadeo)

Third section: even though all financial institutions felt the impact of the recession, the few that went under lost because they unwisely bought large amounts of mortgage backed securities that were extremely risky.

·         Though the report documents questionable practices by mortgage lenders and careless betting by banks, one striking finding is its portrayal of incompetence.

It quotes Citigroup executives conceding that they paid little attention to mortgage-related risks. Executives at the American International Group were found to have been blind to its $79 billion exposure to credit-default swaps, a kind of insurance that was sold to investors seeking protection against a drop in the value of securities backed by home loans. At Merrill Lynch, managers were surprised when seemingly secure mortgage investments suddenly suffered huge losses.

By one measure, for about every $40 in assets, the nation’s five largest investment banks had only $1 in capital to cover losses, meaning that a 3 percent drop in asset values could have wiped out the firm. The banks hid their excessive leverage using derivatives, off-balance-sheet entities and other devices, the report found. The speculative binge was abetted by a giant “shadow banking system” in which the banks relied heavily on short-term debt. – (Chan)

·         Other analysts look to the underlying mindset that supported the meltdown. People like to say that the crisis was caused by shortsightedness, stupidity, and greed. But those are weak explanations, unless you think human nature somehow changed in the final decades of the 20th century to make people greedier or more foolish than they were previously. This isn't impossible, but it's hard to support. A subtler psychological argument is that the economy fell prey to recurring delusions about risk and bubbles, which economists Carmen Reinhart and Kenneth Rogoff describe in their book This Time Is Different. – (Weisburg)

·         Countrywide and a host of other mortgage companies started lending money for homes to anyone and everyone, regardless of their income or credit rating. Throughout the mid 2000s, we all heard the ads on the radio; get a mortgage for no money down. Lending standards were lowered and lowered until people with no jobs, no income, no assets and no credit rating were able to get huge mortgages for no money down and no proof of income.

Mortgage writers were not checking the information on mortgage applications and even encouraged applicants to lie on the mortgage applications. These loans were known as sub-prime, Alt-A and NINJA loans (No income, no job or assets). These mortgages came with low initial teaser rates and were ARMs (Adjustable Rate Mortgages) and in two years they would reset to a much higher payment. Some people were actually defaulting on their first mortgage payment.

The thinking was home prices would never go down and continue upward. This caused increased speculation with people buying numerous houses. Flipping was buying a home, waiting a short amount of time and selling it for a profit while others were buying numerous homes and renting them.

Mortgage companies didn’t really care since they sold most of these mortgages they wrote, so they would not be on the hook if these mortgages defaulted. – (Montana)

·         These mortgages were securitized or turned into mortgage backed securities that people could invest in. For example, take a 10 block area around your home. Put all those mortgages into an envelope. You don’t know the credit worthiness of those mortgages. Cut up the envelope into smaller pieces all holding all kinds of mortgages and then sell those pieces to investors. These pieces were called tranches.

These were called collateralized debt obligations (CDOs). Those who owned them would get paid when each person in that certain tranche paid their mortgage and did not get paid when the mortgages were not paid and the defaults and foreclosures started.

There was such a huge demand for these CDOs and not enough mortgages that the banks invented CDOs, these were called synthetic CDOs.

Two big problems caused the banks to live in their dream world during this housing “bubble”. How they listed their assets on their books. They listed these CDOs at inflated prices when in reality they were dropping like a rock. When they had to list them properly at current market value, everyone could see the banks didn’t have nearly the assets they claimed to have. – (Montana)

The second problem was leverage. Many of these banks had leverage of 30 or more to 1. Meaning for every dollar of their own they invested in these mortgages, they used $30 borrowed dollars to invest.

Other bank problems that led to the Great Recession include shadow banking, the unregulated derivatives market and the repo market or repurchase agreements.- (Montana)