Causes and consequences of the financial crisis of 2007-2009.

• Author: Poole, William

By the early fall of 2009, the business contraction that began in December 2007 appeared to be ending, (1) but the outlook, remained hazy. Despite a number of "green shoots," as Federal Reserve Chairman Ben Bernanke liked to put it, (2) the data were not decisive enough to declare the end of the contraction. Employment was still falling through September 2009. (3) Although in October 2009 it certainly seemed that the economy was near the bottom, it was not safe to say that the crisis was history. (4) Nevertheless, much is already known about the causes of the financial crisis and government responses to it, permitting a much more than speculative review. David Wessel has provided a superb blow-by-blow account of events during the crisis; (5) there is no point in repeating that account here.

Nevertheless, a brief chronology of the phases of the financial crisis should help to organize the discussion.

1. CHRONOLOGY OF THE FINANCIAL CRISIS

   The crisis broke in mid-August 2007, when the market suddenly cut off funding to several financial entities. (6) The Federal Reserve's initial response in August was to reduce the discount rate--the interest rate the Fed charges on loans to banks--in the hope that banks could provide funds to firms cut off by the market. (7) In mid-September 2007, the Fed began to cut its main policy interest rate, the federal funds rate. The rate had stood at 5.25% from June 2006 through August 2007. (8) Although the Fed ordinarily changes its fed funds rate target in steps of twenty-five basis points, the first reduction in September was by fifty basis points. (9) As financial strains grew and the economy gradually weakened, the Fed continued to reduce its fed funds target rate, reaching 3% in late January 2008. (10)

   In mid-March 2008, financial strains intensified as the market cut off funding to Bear Stearns, a large New York investment bank. (11) To prevent Bear Stearns from failing, the Federal Reserve provided an emergency loan and assumed the credit risk on some Bear Stearns assets, which persuaded JP Morgan Chase to buy Bear Stearns. (12) A few days later, the Federal Reserve cut its federal funds rate target by seventy-five basis points, down to 2.25%. (13) The Bear Stearns bailout marked the end of the first phase of the financial crisis.

   In April the Fed lowered its funds rate target another notch to 2%, which it held until September. (14) During this second phase of the crisis, the economy was drifting downward, but not at an alarming pace. This phase ended with the Lehman crisis. The Fed did not bail out Lehman Brothers, an investment bank twice the size of Bear Steams, and Lehman declared bankruptcy on September 15. (15) Lehman's collapse marked the beginning of phase three of the crisis, when market strains went from serious to calamitous. The Fed bailed out American International Group (AIG), a huge insurance company, the day after Lehman failed. (16) In October 2008, the Fed cut its target funds rate in two steps to 1% and further to near zero in December. (17)

   The flight to safety was so intense that in November and December 2008 the market bid the yield on Treasury bills literally to zero on some days. (18) Credit strains were severe and economic activity declined sharply. There is no particular date or event to mark the end of phase three of the crisis; markets gradually improved and the economy transitioned to phase four, in which credit conditions became more settled and credit began to flow again.

   The financial crisis was worldwide, with European banks and markets as severely affected as those in the United States. (19) Asian banks were stronger than U.S. and European banks, but Asia could not escape the effects of the crisis. (20) Output and employment fell around the world.

2. CONDITIONS LEADING TO THE CRISIS (21)

   After the stock market peak in 2000 and to resist the 2001 recession, the Fed reduced its target federal funds rate in steps, eventually reaching 1% in 2003. (22) With interest rates low and memories of the dot-com stock crash fresh, investors searched for higher yielding investments. They thought that they had found the perfect vehicle in collateralized debt obligations (CDOs) backed by subprime mortgages. The CDOs were structured obligations, with several tranches of differing risk characteristics. The senior tranche had first claim on the mortgage interest and principal paid by the subprime mortgages in the mortgage pool backing each CDO issue. The senior tranches were rated triple-A by the rating agencies. (23)

   As the decade proceeded, underwriting standards for subprime mortgages deteriorated. Mortgage brokers, who originated the subprime mortgages, lent to households without adequate income or assets to service the mortgages. (24) Income and asset documentation was weak or nonexistent. (25) Some of the mortgage borrowers were investors anticipating quick resale of the properties they purchased--the "flippers." (26) Nevertheless, the market was so hungry for yield that investment banks found that they could easily package subprime mortgages into CDOs and peddle them to investors. Too many investors, unfortunately, took the triple-A ratings at face value and loaded their portfolios with the CDOs.

   Citigroup is a good, but by no means unique, example. Citi had formed structured investment vehicles (SWs) as off-balance-sheet entities to hold CDOs. (27) Because mortgages return principal gradually over a period of years, these CDOs were inherently long-term assets for the SIVs. The SIVs financed their purchases mostly with borrowed funds, not equity. (28) Moreover, the borrowed funds were often in the form of short-maturity, asset-backed commercial paper. (29) Commercial paper is simply a corporate IOU, and the asset backing for each commercial paper issue was a package of CDOs. The commercial paper was short term, with maturities of thirty days, sixty days, or even overnight.

   When the financial crisis broke in August 2007, commercial paper investors no longer rolled over their maturing paper. (30) They demanded to be paid in cash instead. In the case of the Citigroup SIVs, Citi could have let the SIVs default, but instead brought the assets onto its own balance sheet and repaid the maturing commercial paper. (31) Doing so put great strain on Citigroup itself.

   The federal government encouraged growth of the subprime mortgage market in an attempt to increase the percentage of families owning their own homes. (32) Congress and the Bush Administration pushed the giant mortgage intermediaries, Fannie Mae and Freddie Mac, to accumulate subprime mortgages. (33) Previously, Fannie and Freddie had dealt only in prime mortgages with a maximum loan-to-value ratio of eighty percent. (34) The main business of these government-sponsored enterprises (GSEs) was to securitize prime mortgages into mortgage-backed securities, some of which they sold into the market and some of which they held in their own portfolios. Other federal policies also encouraged home ownership and growth of the mortgage market.

   House construction led the way to faster economic growth after the 2001 recession. (35) Federal policies that encouraged housing and an increase in house prices fed the boom. (36) Mortgages, both prime and subprime, appeared to be reasonably safe investments because a borrower in distress could refinance or sell the property for enough to repay the mortgage. As house prices leveled off in 2006, and adjustable-rate mortgages taken out in the low interest rate environment of 2003-2004 began to adjust up, the music stopped. (37) Defaults began to rise, and in mid-2007, some firms had trouble financing their positions. (38)

   Analysts continue to argue about how much responsibility for the financial crisis belongs to the federal government. My view is that the federal government was a supporting actor but the responsibility rests primarily with the private sector. The government did not make or even directly encourage Bear Steams to sponsor hedge funds investing in subprime CDOs--hedge funds that collapsed in July 2007. Citigroup was not compelled to form its SIVs holding subprime assets. It did so in part to take assets off its balance sheet to escape bank capital requirements.

   Nor do I fault lax regulation. The fundamental problem was a failure of economic analysis in both the private sector and among regulatory agencies. Neither market participants nor federal agencies thought that a significant decline in the national average of house prices could occur. The failure to understand fully the risks of subprime mortgages and to foresee the decline in house prices might be an honest mistake of portfolio managers and federal authorities alike. Building portfolios with risky long-maturity assets financed with little equity capital and short-maturity liabilities, however, is an inexcusable mistake. The federal government pursued policies to encourage home ownership, but that fact cannot justify the portfolio policies that crashed. The private-sector managers of firms that built such portfolios bear the responsibility for building houses of cards.

3. THE FEDERAL GOVERNMENT'S MANAGEMENT OF THE CRISIS

   Although the National Bureau of Economic Research did not officially identify the cycle peak in December 2007 until a year later, (39) after August 2007 the financial stress was obvious, as were signs of a weakening in the general economy. The Federal Reserve was the first responder to the crisis; fiscal policy responses came later.

   To understand the Fed's management of the crisis, it is important to distinguish monetary policy from credit policy. Monetary policy involves central bank control over interest rates and the aggregate quantity of central bank funds in the system. The Fed's main monetary policy instrument is the federal funds interest rate, which is the rate on overnight loans between banks. Traditionally, the Fed controls this rate through purchases and sales of...