FINANCIAL CRISIS OF 2007–2010 in the USA
Dnipropetrovsk State agrarian university
Demchuk N.I., dubrova N.P.
The financial crisis of 2007–2010 has been
called by leading economists the worst financial
crisis since the Great
Depression of the 1930s. It contributed to the failure of key
businesses, declines in consumer wealth estimated in the trillions of U.S.
dollars, substantial financial commitments incurred by governments,
and a significant decline in economic activity. Many causes have been proposed,
with varying weight assigned by experts. Both market-based and regulatory
solutions have been implemented or are under consideration, while significant
risks remain for the world economy over the 2010–2011 periods.
Although this economic period has at times been referred to as "the Great
Recession," this same phrase has been used to refer to every
recession of the several preceding decades.
The collapse of
a global housing bubble, which peaked in the U.S. in
2006, caused the values of securities tied to real estate pricing to plummet thereafter,
damaging financial institutions globally. Questions regarding bank solvency,
declines in credit availability, and damaged investor confidence had an impact
on global stock markets, where securities suffered large
losses during late 2008 and early 2009. Economies worldwide slowed during this
period as credit tightened and international trade declined. Critics argued
that credit rating agencies and investors
failed to accurately price the risk
involved with mortgage-related
financial products, and that governments did not adjust their regulatory
practices to address 21st century financial markets. Governments and central banks
responded with unprecedented fiscal
stimulus, monetary policy expansion, and institutional bailouts.
Low interest
rates and large inflows of foreign funds created easy credit conditions for a
number of years prior to the crisis, fueling a housing construction boom and
encouraging debt-financed consumption. The combination of easy credit and money
inflow contributed to the United States housing bubble. Loans of
various types (e.g., mortgage, credit card, and auto) were easy to obtain and
consumers assumed an unprecedented debt load. As part of the housing and credit
booms, the amount of financial agreements called mortgage-backed securities (MBS) and collateralized debt obligations
(CDO), which derived their value from mortgage payments and housing prices,
greatly increased. Such financial innovation enabled institutions
and investors around the world to invest in the U.S. housing market. As housing
prices declined, major global financial institutions that had borrowed and
invested heavily in subprime MBS reported significant losses. Falling prices
also resulted in homes worth less than the mortgage loan, providing a financial
incentive to enter foreclosure. The ongoing foreclosure epidemic that began in
late 2006 in the U.S. continues to drain wealth from consumers and erodes the
financial strength of banking institutions. Defaults and losses on other loan
types also increased significantly as the crisis expanded from the housing
market to other parts of the economy. Total losses are estimated in the
trillions of U.S. dollars globally.
While the
housing and credit bubbles built, a series of factors caused the financial
system to both expand and become increasingly fragile, a process called financialization.
Policymakers did not recognize the increasingly important role played by
financial institutions such as investment
banks and hedge funds, also known as the shadow banking system. Some experts
believe these institutions had become as important as commercial (depository)
banks in providing credit to the U.S. economy, but they were not subject to the
same regulations.
These
institutions as well as certain regulated banks had also assumed significant
debt burdens while providing the loans described above and did not have a
financial cushion sufficient to absorb large loan defaults or MBS losses. These
losses impacted the ability of financial institutions to lend, slowing economic
activity. Concerns regarding the stability of key financial institutions drove
central banks to provide funds to encourage lending and restore faith in the commercial
paper markets, which are integral to funding business operations.
Governments also bailed out
key financial institutions and implemented economic stimulus programs, assuming
significant additional financial commitments.
Between 1997
and 2006, the price of the typical American house increased by 124%. During the
two decades ending in 2001, the national median home price ranged from 2.9 to
3.1 times median household income. This ratio rose to 4.0 in 2004, and 4.6 in
2006. This housing bubble resulted in quite a few
homeowners refinancing their homes at lower interest rates, or financing
consumer spending by taking out second
mortgages secured by the price appreciation.
In a Peabody Award
winning program, NPR correspondents argued that a
"Giant Pool of Money" (represented by $70 trillion in worldwide fixed
income investments) sought higher yields than those offered by U.S. Treasury
bonds early in the decade. Further, this pool of money had roughly doubled in
size from 2000 to 2007, yet the supply of relatively safe, income generating
investments had not grown as fast. Investment banks on Wall Street answered
this demand with the MBS and CDO, which were assigned safe ratings
by the credit rating agencies. In
effect, Wall Street connected this pool of money to the mortgage market in the
U.S., with enormous fees accruing to those throughout the mortgage supply
chain, from the mortgage broker selling the loans, to small banks that funded
the brokers, to the giant investment banks behind them. By approximately 2003,
the supply of mortgages originated at traditional lending standards had been
exhausted. However, continued strong demand for MBS and CDO began to drive down
lending standards, as long as mortgages could still be sold along the supply
chain. Eventually, this speculative bubble proved unsustainable.
The CDO in
particular enabled financial institutions to obtain investor funds to finance
subprime and other lending, extending or increasing the housing bubble and
generating large fees. A CDO essentially places cash payments from multiple
mortgages or other debt obligations into a single pool, from which the cash is
allocated to specific securities in a priority sequence. Those securities
obtaining cash first received investment-grade ratings from rating agencies. Lower
priority securities received cash thereafter, with lower credit ratings but
theoretically a higher rate of return on the amount invested. By September
2008, average U.S. housing prices had declined by over 20% from their mid-2006
peak. As prices declined, borrowers with adjustable-rate mortgages could not
refinance to avoid the higher payments associated with rising interest rates
and began to default. During 2007, lenders began foreclosure proceedings on
nearly 1.3 million properties, a 79% increase over 2006. This increased to 2.3
million in 2008, an 81% increase vs. 2007.
By August 2008, 9.2% of all U.S. mortgages outstanding were either delinquent
or in foreclosure. By September 2009, this had risen to 14.4%.
Additional
downward pressure on interest rates was created by the USA's high and rising current
account (trade) deficit, which peaked along with the housing bubble
in 2006. Ben Bernanke explained how trade deficits
required the U.S. to borrow money from abroad, which bid up bond prices and
lowered interest rates.
The term
subprime refers to the credit quality of particular borrowers, who have
weakened credit histories and a greater risk of loan default than prime
borrowers. The value of U.S. subprime mortgages was estimated at $1.3 trillion
as of March 2007, with over 7.5 million first-lien subprime mortgages
outstanding.
In addition to
easy credit conditions, there is evidence that both government and competitive
pressures contributed to an increase in the amount of subprime lending during
the years preceding the crisis. Major U.S. investment
banks and government sponsored enterprises
like Fannie Mae
played an important role in the expansion of higher-risk lending.
Subprime mortgages remained below
10% of all mortgage originations until 2004, when they spiked to nearly 20% and
remained there through the 2005-2006 peak of the United States housing bubble.
A proximate event to this
increase was the April 2004 decision by the U.S. Securities and Exchange
Commission (SEC) to relax the net capital
rule, which permitted the largest five investment banks to
dramatically increase their financial leverage and aggressively expand their
issuance of mortgage-backed securities. This applied additional competitive
pressure to Fannie Mae
and Freddie Mac,
which further expanded their riskier lending. Subprime mortgage payment
delinquency rates remained in the 10-15% range from 1998 to 2006, then began to
increase rapidly, rising to 25% by early 2008.