The Cascading Financial CrisisTHE CASCADING FINANCIAL CRISIS
I. Fannie and Freddie Play with Fire
Prior to 2007
For many years, AEI scholars have been observing and warning about the giant government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. But as the economy boomed, few wanted to deal with the risks the GSEs posed to taxpayers and the financial system. Scholars at AEI were arguing that Fannie and Freddie posed systemic risk to the financial system, but policymakers would not listen. Congress routinely ignored calls for GSE reform. According to Peter J. Wallison and Charles W. Calomiris, in 2003-2004, when Fannie and Freddie went through multibillion-dollar accounting scandals, they wiggled their way out of these scandals by signing onto one of Congress's pet causes: increasing the stock of affordable housing. Fannie and Freddie used their massive size to steer the U.S. housing market toward subprime and Alt-A home buyers--that is, toward borrowers with the poorest credit records. But Fannie and Freddie did not pay a price for their risky financial behavior, because, as always, those who purchased their debt assumed that the GSEs enjoyed the backing of the federal government.
- Wallison is the coauthor or editor of several prophetic AEI Press books on Fannie and Freddie, including Privatizing Fannie Mae, Freddie Mac, and the Federal Home Loan Banks: Why and How, Serving Two Masters, Yet out of Control: Fannie Mae and Freddie Mac, and Nationalizing Mortgage Risk: The Growth of Fannie Mae and Freddie Mac. All of these volumes are available as Adobe Acrobat PDFs.
- The AEI Press has also published Government-Sponsored Enterprises: Mercantilist Companies in the Modern World, by Thomas H. Stanton.
- In December 2007, GSE regulator James Lockhart spoke at AEI about the urgent need for GSE reform legislation--which came too little, too late, in the summer of 2008.
- Wallison's March 2008 Financial Services Outlook underscored the need for urgent action on Fannie and Freddie. The Financial Services Outlook is no stranger to discussions of the GSEs: Wallison proposed privatizing Fannie and Freddie in 2004 and, in 2005, he made the case that they should be heavily regulated to protect taxpayers from their risky behavior.
- In a November 2006 Economic Outlook, John H. Makin discussed the connection between the housing sector and U.S. recessions.
- View AEI scholars' work on the housing GSEs.
II. Subprime: Not So Sublime
Fueled by low interest rates, easy credit, and a host of unorthodox financing mechanisms like adjustable-rate mortgages, the U.S. housing market took off between 2000 and 2006. Bad credit or a lack of a down payment did not hinder many home buyers, and lenders overlooked these subprime borrowers' poor credit, counting on home values to rise. From 2005 to 2007, 20 percent of mortgages originated were subprime.
But beginning in early 2007, the U.S. housing bubble began to deflate. As home prices leveled off or began to decline, borrowers began to default, followed by big subprime lenders going bust. Credit dried up for the most risky borrowers, but the rest of the financial sector seemed to hold.
- AEI held the first installment of its Deflating Mortgage Bubble conference series, featuring Desmond Lachman, John H. Makin, Alex J. Pollock, Nouriel Roubini, R. Christopher Whalen, and Thomas Zimmerman.
- Lachman wrote several essays on the collapse of the housing market, including on on the "housing market blues."
- Pollock also wrote several articles on the crisis, including these for American.com and the Wall Street Journal.
- Makin's March Economic Outlook focused on the fallout from the subprime bust.
III. How Subprime Hit Primetime
The subprime crisis could not remain isolated for long. One recent financial innovation was securitization of mortgages. Mortgages--including the huge number of those that were subprime--were packaged into securities and sold to investors throughout the financial system. All of the major investment banks' balance sheets had large swathes of mortgage-backed securities (MBS). While these were a hot option in a rising real estate market, a bursting bubble made them loss leaders. But even worse, financial institutions could not properly value their MBS, and their counterparties could not accurately assess their exposure to bad mortgage loans. Credit began to dry up across the board as financial institutions sought to adjust their balance sheets and avoid risk.
For strapped borrowers, many of whom were already suffering in the slowing economy and seeing their homes' values sink below the purchase price, foreclosure became a grim option. Alex J. Pollock proposed a one-page mortgage form to ensure that all home buyers are aware of their obligations and the terms of their loans. This form would be incorporated into congressional legislation and adopted by local communities, including the District of Columbia.
- Pollock, Representative Patrick McHenry (R-N.C.), John S. Allison, Christopher Cruise, and Kurt Pfotenhauer spoke at a conference to assess the one-page mortgage form idea.
- Desmond Lachman and others continued to comment on the depth of the housing bust.
- John H. Makin's April Economic Outlook explored the risk of recession later in 2007.
IV. The Infection Spreads
Summer and Fall 2007
In the summer of 2007, the fallout from subprime mortgage losses spread to the big financial houses. Credit began to contract in the global economy, and the Federal Reserve began acting to counteract the fears of anxious investors. Even as they worried about a liquidity crisis, banks remained reluctant to borrow through the Federal Reserve's discount window to shore up their own liquidity. Doing so would have required them to "discount" the collateral for these loans--the very instruments whose value was questionable and on which they would face steep losses if forced to declare their value. The Treasury got involved, creating a "superconduit" by which a group of banks would purchase troubled mortgage-related assets and speed up the process of discovering the assets' actual value. And not a moment too soon, or so it seemed: several leading banks declared huge subprime-related losses in the fall and going into 2008. As the losses mounted, would a major financial house go under?
- John H. Makin wrote two Economic Outlooks on tightening credit and its consequences. That fall, he wrote one about how the credit crisis resulting from the housing bust would result in a painful global economic rebalancing. In December 2007, he addressed a question that would resound throughout 2008: "Why do financial firms take too much risk?"
- Peter J. Wallison defended the Treasury's superconduit in a Wall Street Journal essay, but Makin's November Economic Outlook claimed that the Treasury's involvement only underscored the depth and seriousness of the problems in the financial markets.
- Charles W. Calomiris took a more optimistic view in an AEI paper, arguing that we had not yet reached a "Minsky moment" in which tightening credit triggers an economic contraction.
- Makin, Desmond Lachman, Alex J. Pollock, Nouriel Roubini, R. Christopher Whalen, and Thomas Zimmerman met in October for the second Deflating Mortgage Bubble conference.
- The position of ratings agencies, which so many financial institutions relied on in making spurious investments, was the subject of a November conference at AEI.
- Pollock floated a Depression-era institution--the Home Owners' Loan Corporation--as a possible housing solution in his December Financial Services Outlook. This idea was picked up by members of Congress and would pop up throughout 2008.
- Five AEI economists--Calomiris, Lachman, Makin, Kevin A. Hassett, and Vincent R. Reinhart--met in December to discuss Calomiris's paper and debate the extent of the problems that the credit crunch would pose for the economy.
V. Bear Necessities
Bear Stearns was known to be exceptionally exposed to subprime-related losses--in the summer of 2007 it spent more than $3 billion bailing out two of its hedge funds' related losses--but in one weekend in March, Bear came perilously close to collapse. Treasury Secretary Henry M. Paulson engineered an unprecedented takeover, with Bear selling itself to JPMorganChase at a fire-sale price and the Fed taking $30 billion of Bear's riskiest assets onto its balance sheet. The financial policy world was in an uproar over the introduction of moral hazard. Although Peter J. Wallison rejected the notion that Bear was "too big to fail," the firm may indeed have been too interconnected to fail. Regardless, Vincent R. Reinhart, a former senior Fed official, regarded the Fed's decision to intervene as "the worst policy decision in a generation."
- After the Bear bailout, Wallison wrote a Financial Services Outlook arguing that regulating securities firms tightly still did not make sense. He had previously written about the relative problems of banks--a heavily regulated industry--compared to the lightly regulated hedge funds.
- John H. Makin's April 2008 Economic Outlook offered his perspective on the Bear bailout.
- In a special On the Issues, Reinhart, Allan H. Meltzer, Amity Shlaes, and John L. Chapman commented on the Fed's actions in the Bear Stearns case.
VI. The Future Shape of Regulation
On March 31, Paulson unveiled a major overhaul of U.S. financial regulation. His report, which began as an effort to respond to concerns about the competitiveness of U.S. companies, was instead a far more ambitious blueprint for change. In an interview with the Wall Street Journal describing the effort, the secretary said that everywhere he looked, the "plumbing hasn't changed to meet the realities." One of the proposals would expand the role of the Fed in overseeing the financial system. Congress declined to act on Paulson's proposals, but Peter J. Wallison had written about regulatory and litigation burdens facing Americans firms and has urged an optional federal charter for insurance companies, all components of the Treasury plan. Wallison was particularly critical of the weakness of the Securities and Exchange Commission, an agency slated in the Treasury plan to be merged with the Commodity Futures Trading Commission.
- Wallison criticized the Treasury's proposals as ill-equipped to respond to its original--and broader--concerns about U.S. financial market competitiveness.
- Wallison addressed the future of financial regulation in his June Financial Services Outlook. In two installments in the fall of 2007, he outlined priorities that the Treasury should adopt in future regulation.
- Wallison moderated a conference with the head of the Financial Services Roundtable in January 2008 on the future of financial regulation.
- As Congress considered regulation, Vincent R. Reinhart explored how securitization is involved in the mortgage mess.
- Wallison, Reinhart, and Allan H. Meltzer--the nation's leading historian of the Federal Reserve--contributed to a July On the Issues about the Fed's role in the proposed changes to financial and securities-firm regulation.
VII. The Great Recession Debate
Figures showed that the U.S. economy grew by only 0.6 percent in the first quarter of 2008, identical to the final quarter of 2007. The official figures did not meet the classic criteria for a recession--two or more quarters of negative GDP growth--but they made it clear that the economy was slumping. Wages and compensation grew by 0.7 percent in the first quarter, less than expected, and consumer spending grew by its lowest rate since 2001. The Federal Reserve, battling the twin specters of recession and inflation, cut interest rates by a quarter of a point while promising to watch inflation closely. Although "economic stimulus" payments began flowing to taxpayers in April, they provided only a phantom boost to the economy that was expended by summer's end, when the economy became extremely dicey.
- AEI's economists from the previous credit crunch conference returned in April, joined by Allan H. Meltzer, to discuss the outlook for the economy. Their perspectives ranged from fair to grim.
- John H. Makin's Economic Outlook addressed recession prospects in 2008. In June 2008, he warned that the economic situation was growing more dire.
- Panelists returned for a third installment in AEI's Deflating Mortgage Bubble conference series.
- Bill Thomas and Alex Brill urged Congress to avoid economic gimmicks in the stimulus package it was weighing.
VIII. The Gathering Storm
In the summer of 2008, financial news rarely hit the headlines, as Americans focused instead on the presidential election and other summertime diversions. But bubbling underneath were several troubling developments. In July, Paulson approved a lifeline for Fannie Mae and Freddie Mac, granting them access to the Fed's discount window and allowing the Treasury to purchase GSE stock. Although they provided temporary relief, they took away the government's room to maneuver and limited its policy options. Late July saw Congress pass a housing bill focused on Main Street worries. It authorized the Federal Housing Administration to insure up to $300 billion in fixed-rate mortgages for homeowners in trouble and established, too late, a strong regulator for the GSEs. Later in the summer, as Americans prepared to tune into the Olympics, Merrill Lynch wrote down $30 billion in mortgage-related assets. Even a firm thought to be in good financial shape still faced huge mortgage exposure. Bear was only the beginning.
- Vincent R. Reinhart, Peter J. Wallison, and Allan H. Meltzer's July On the Issues continued to resonate as Congress decided how to respond to the housing collapse.
- Desmond Lachman argued that the credit crunch was more than a liquidity dilemma and that it would not be resolved until the housing market stabilized--a lesson realized by top policymakers later that year.
- Reinhart wrote about the scary messages sent by Merrill Lynch's write-downs.
- Lawrence B. Lindsey said that the housing bill spares Fannie and Freddie any real hardship while increasing risks for taxpayers.
- Kevin A. Hassett addressed "fair-weather capitalism" in the wake of the housing crisis.
IX. Fannie and Freddie's Day of Reckoning
The weekend was the new weekday in 2008, with many of the unusual financial interventions being negotiated and announced in time for Monday's trading. And over the weekend of September 6-7, Fannie Mae and Freddie Mac were nationalized. Paulson made clear that the winking federal guarantee of the GSEs' debts was real. The companies entered "conservatorship" under the newly created Federal Housing Finance Agency, sparing debt holders but pinning the companies' $5 trillion in liabilities on U.S. taxpayers. Paulson banned the companies from lobbying and fired their CEOs.
Shortly before the nationalization, Peter J. Wallison reviewed the options and suggested that the best course from the standpoint of taxpayers would have been to allow the GSEs to go into receivership, which would have allowed the management to wipe out shareholders and minimize taxpayers' losses, unlike the conservatorship, which Wallison characterized as "a gift" to shareholders. Furthermore, Wallison argued, bailing out Fannie and Freddie without reforming them means that a future Congress or administration can easily make the same errors and allow the GSEs to repeat their mistakes.
- Wallison wrote in the Wall Street Journal that Paulson's approach to the GSEs neglects the systemic risk they cause, and he called the rescue "a major disappointment."
- Alex J. Pollock, a historian of banking and former president of the Federal Home Loan Bank of Chicago, wrote that the "most radical part" of the GSE bailout is that the Treasury will become directly involved in mortgage finance. He called for the taxpayers' commitment to Fannie and Freddie to be defined and codified.
X. We All Fall Down
A week later, Fannie and Freddie were all but forgotten as America awakened Monday to what was to be called "the week that changed American capitalism." Paulson declined to bail out Lehman Brothers, long teetering on the edge due to its exposure to bad mortgages. Lehman, finding no one else interested in rescuing it, declared bankruptcy. Merrill Lynch, not as weak but unlikely to survive on its own, sold itself over the weekend to Bank of America. "This was the right time for the government to draw the line," Vincent R. Reinhart said of the Treasury's lack of action.
That was all changed a day later, when the insurance giant AIG faltered suddenly. Reversing its position, the U.S. government lent AIG $85 billion in exchange for an 80 percent equity stake. The financial world was stunned that the U.S. government had effectively nationalized an insurance company--what would come next? Stocks fell freely in the confusion, and by Thursday, even "safe" money market funds lost money. Even worse, the credit markets--the "lifeblood" of the U.S. financial system--seized up in midweek. To calm the markets and avert further losses, Paulson took urgent action.
- Reinhart praised the Treasury's inaction on Lehman, but after Paulson agreed to bail out AIG, Reinhart said that the Treasury had unleashed the possibilities for bailouts.
- R. Glenn Hubbard emphasized the need to prevent mortgage-related problems from spreading to the rest of the economy.
- Desmond Lachman argued that the Treasury needed to intervene in unorthodox ways to put a floor under the housing market, lest Wall Street's troubles spread quickly to Main Street.
XI. The Mother of All Bailouts
On Friday, September 19, Paulson announced the framework of a bailout of the entire financial industry. The U.S. financial system's exposure to mortgage-related losses had not been effectively mitigated by the previous weeks' actions, and the subprime shadow continued to haunt Wall Street. The trauma continued as the last two independent investment banks standing, Goldman Sachs and Morgan Stanley, reorganized as bank holding companies able to take deposits and subject to the Fed's regulation.
Under Paulson's proposal, backed by the rest of the Bush administration, the Treasury would spend "hundreds of billions" of dollars--perhaps as much as $1 trillion--buying illiquid assets from financial institutions. The assets would be managed and disposed of with an eye toward minimizing taxpayer losses, and firms would be able to resume raising capital once freed from the bad assets on their balance sheets.
Stocks rallied upon news of the plan, but the following week brought a mixed response as Congress pushed back on the plan. It drew criticism from both right and left for its sheer size and for its lack of oversight: "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency." Congressional Democrats sought to add their own provisions to the bailout, such as allowing bankruptcy judges to modify mortgages, placing executive compensation limits on companies participating in the bailout, and increasing funding for affordable housing.
- Kevin A. Hassett pinned the origins of the financial crisis on bad policy, especially Congress's inaction on Fannie and Freddie.
- Peter J. Wallison and Charles W. Calomiris echoed this criticism in the Wall Street Journal, arguing that the same politicians who in September 2008 were decrying the lack of intervention to stop excess risk-taking were the very ones who blocked the only legislative efforts that could have stopped it.
- According to Calomiris, the decline of independent investment banks was inevitable, but he worried about the dearth of risk-taking innovators in the financial markets.
- Vincent R. Reinhart said in the New York Times that government action should focus on immediate financial market problems.
- Newt Gingrich criticized the speed with with Paulson and the administration wanted to rush the massive bailout plan through Congress, and he urged open deliberations on the measures.
XII. Obama Wins and Prepares to Govern
The economic panic probably mortally wounded the already-underdog McCain-Palin campaign, and Barack Obama swept to a major victory, with 53 percent of the popular vote and 365 electoral votes. Obama unveiled his transition team, announcing a key player in the bailouts of the fall--New York Fed president Timothy Geithner--as his treasury secretary nominee. Obama also named Paul Volcker to chair his Economic Recovery Advisory Board.
In a sign of further interventions to come, executives from Ford,Chrysler, and General Motors came to Washington in November 2008 toseek massive infusions of taxpayer cash in order to stay afloat. Speaking at AEI, President Bush said that he did not want to leave the automakers collapsing as his successor took office, so he approved the bailouts.
The transition was punctuated in early December by the declaration from the National Bureau of Economic Research that the U.S. economy had entered recession in December 2007. With the recession officially declared, the financial crisis had morphed into a wider economic crisis that was engulfing the entire world. Political leaders worldwide began debating the merits of fiscal versus monetary stimulus and the extent to which the latter was even possible in struggling eurozone economies like Ireland and Hungary.
This summary ends with the official declaration of recession. To follow the latest economic developments, visit AEI.org's section on Economic Policy Studies.