Financial Crisis.

Name

10/26/11

Bus 254: Macroeconomics

1b.       Question1b: (20 points) Financial Crisis.

During the early 21^st century easy access to credit along with low rates on mortgages gave more people the possibility of owning a home. After the recession of 2001 the Federal Reserve enacted a policy aimed at stimulating the economy which leads to the lower mortgage rates. With easy credit and low rates people bought houses, causing home prices to rise and for new house construction to reach all time highs. From 2000 – 2006 U.S. home prices rose 10% a year on average.

            The securitization of mortgages had helped fuel the housing boom due to its rapid growth. Securitization of mortgages is the act of bundling of mortgages into securities that then are sold to investors and traded in financial markets. Securitization of low-risk mortgages has existed for many years and has expanded the market, making it easier for investors to hold mortgages. Unfortunately in the early 2000s riskier mortgages were securitized in huge amounts. The riskier mortgages included subprime mortgages; a subprime mortgage is made to borrowers with low credit scores. When subprime borrowers defaulted on their mortgages during the housing boom the lender could easily refinance or sell the property to avoid a default. With high profits and low defaults investors and lenders became complacent in the mortgage-backed securities market. With increased compliancy underwriting standards dropped lenders demanded little or no down payment or documentation. Ratings agencies gave investors reassurance by rating mortgage-backed securities as low risk.

            As new houses came into the market people realized that home prices could no rise forever. In 2006 home prices began to falter than fell sharply. With home prices falling sales and construction came to an immediate halt. For new home owners and people who refinanced their home value fell below what they currently owed on their mortgage. Subprime borrowers began to fall behind in mortgage payments which eventually this spread to prime mortgages made to people with high credit scores.

            As delinquencies started to increase it became clear that residential mortgages were much more volatile than people had assumed. As the market imploded the level of expected losses rose dramatically. Due to the millions of U.S. mortgages repackaged as securities the losses spread around the world. In the early part of the housing bust the International Monetary Fund estimated worldwide losses to be $240 billion, in April 2009 that estimate climbed to $1.4 trillion.

            As estimates for mortgage-related losses rose, investors and financial institutions became nervous over their risk as well as the risk of others. Anxiety increased because of the difficulty to determine the value of many loans and mortgage-backed securities. The complexity of financial instruments increased the vulnerability of financial institutions to losses. Businesses became reluctant to lend to each other. In 2007 fears about the financial health of other firms led to huge disruptions in lending. Institutions used the lending market to fund day-to-day needs for cash. With firms reluctant to lend rates on short-term loans increased sharply compared to overnight federal funds rate.

            The fall of 2008 saw the failure of two large financial institutions Lehman Brothers and Washington Mutual. American Insurance Group as well as several others also threatened to fail. With some many institutions connected in a large complex web the failure of one could start a cascade of losses all through the financial system. A large money market mutual fund incurred sizeable losses which extended the crisis to a section of the financial system thought to be safe. The losses lead investors to pull their money out of the market. Short-term debt securities for corporations froze due to declining confidence. With confidence in the financial sector heading south the stock prices of financial institutions around the world fell off a cliff. The global financial system found itself on the brink of a meltdown.

            The Federal Reserve took action to prevent a full meltdown of the financial system. With short-term markets freezing up the Federal Reserve expanded its own collateralized lending to financial institutions to make sure there was access too much needed funding for day-to-day operations. Under normal conditions the Federal Reserve only loans to institutions that take deposits through a process known as discount lending. During the collapse of confidence in 2008 investment banks also had difficulty in obtaining short-term funding making them vulnerable to credit cutoffs resembling bank runs. In March 2008 the Federal Reserve created two programs to provide short-term secured loans to primary dealer similar to discount-window loans.

            Bear Stearns in 2008 was close to failure, its failure would have created a domino effect that would have disrupted the markets severely. The Federal Reserve attempted to contain the damage by facilitating the purchase of Bear Stearns by JP Morgan Chase. The Reserve provided loans backed by specific Bear Stearns assets. Within several months the investment bank Leman Brothers collapsed due to no private company willing to acquire the troubled investment bank. The Federal Reserve did not issue direct loans to Lehman due to a lack of collateral. The failure of Lehman resulted in a financial panic which threatened to spread to several key financial institutions, including American International Group which is a large insurance company. AIG was central to guaranteeing financial instruments its failure could have lead to a cascading effect of failures and cause a meltdown of the global financial system. To protect the global financial system the Federal Reserve provided secured loans to AIG.

            In response to the financial crisis the U.S. government passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. The reform act establishes the Bureau of Consumer Financial Protection; the bureau has authority over a range of financial services providers. The mission is to ensure that people are treated in a fair and transparent way in the financial marketplace. The bureaus director will be appointed by the President and confirmed by the Senate, the bureau will be autonomous within the Federal Reserve.

            The financial reform legislation requires regulators to focus on the entire interconnected system instead on individual firms. This new perspective is known as a macro-prudential view. The legislation gives the Reserve the power to act when a group of institutions practices create risk within the financial system. In order to properly understand the possible risks regulators need to collect accurate and up-to-date information on the interconnections of financial firms.

            In recent decades there has developed a banking system that is less rigorously regulated. During the crisis this unregulated system was vulnerable to panics and was a major source of credit-market disruption. The Dodd-Frank legislation attempts to remove regulation gaps by focusing oversight on how the firm functions and its level of risk to the economy. The act creates a Financial Stability Oversight Council to watch the overall risks within the financial system and the broad economy. Federal Reserve has been given authority to regulate all systemically important financial institutions, even non-banks.