Introduction

            In 2007, the United States began to face one of the largest financial crises in the country’s history. The stock market suffered from significant losses, financial industry leaders filed for bankruptcy, and Americans watched as the country’s economic health diminished in front of their eyes. The economy continued to disintegrate until early 2009. As the United States economy hit what seemed to be its “post-crisis low,” approximately $30 trillion, the U.S. historic average of investment gain through a decade, had been lost.

The overall economic health of the United States is supported by numerous financial institutions such as banks, mortgage companies, and Wall Street firms. Between February 2007 and July 2009, almost each one of these contributing institutions experienced serious hardship. The financial crisis of 2008 is often discussed as a moment in time or a specific instant. In retrospect though, the crisis had been building up for decades. Though numerous factors contributed to the crisis, the housing market is at the center of the story.

Financial Crisis of 2008

            Prior to 2008, many Americans believed that the housing market would continue to grow unimpeded. Slight hiccups might, occur, but these could be corrected fairly quickly through a functioning market. Historically, there was much support for this belief due to the relatively consistent pattern of increases in housing prices over the last several decades. Because of this stability, the United States’ financial industry has benefited enormously, relying on the stability of mortgages and assets tied to home values to earn profits and build up their balance sheets.

In the latter part of the 20^th century, financial firms welcomed stability and good profits. But because these firms became unsatisfied in their constant search for higher returns and lower risk, they began creating and selling relatively new, sophisticated financial instruments which were directly related to housing prices. When housing prices fell significantly in late 2007, however, the entire economy experienced a major financial disaster largely because of these new securities which turned out to have substantial risk. The historical rise and then precipitous drop in housing prices is shown in the graph below.

Figure 1: Historic Housing Prices

After housing prices fell in the United States, the economy tried to absorb the major decline in wealth, which in normal economic times would be possible, but due to the relatively new relationship the housing market had to the financial industry, not one person or entity could contain the major damages done by the loss on investments within the financial and housing markets. Because, prior to the drop in housing prices, banks assumed that these prices were incapable of falling, the mortgage-backed-securities that they held were leveraged[1] at historically high levels.[i] If banks’ assumptions about housing prices had been correct, the high leveraging would not have been an issue. Because the housing market collapsed, however, the already leveraged securities lost value which heightened the risk of default on such securities. Unlike previous recessions and economic collapses, Wall Street and the financial industry had now become interwoven with the housing market. This caused the Financial Crisis of 2008 to be unprecedented and problematic to the entire United States economy.

Contributors to the Crisis

The duration of the financial crisis revealed to the United States that even such a strong economy can be devastated by a combination of individual, independent decisions. The events can be traced back to decisions made 50 years ago.  Throughout these years, separate financial and political entities had been making decisions and carrying out their business with the belief that they were doing what was right for the firms and the country. As detailed in this paper, some of these decisions contributed directly to the financial crisis of 2008. Because these entities were independent and separate, their individual decisions were not examined in regards to their effects on the rest of the economy. Though the scope of the financial crisis is huge, in this paper, we will focus our attention on these three areas: the Federal Reserve Bank, political initiatives regarding housing, and the financial industry’s reliance on mortgage-backed securities.

The Federal Reserve Bank

Congress created the Federal Reserve (the Fed) in 1913 “to provide the nation with a safer, more flexible, and more stable monetary and financial system.”[2] Since the Great Depression, the Federal Reserve has expanded its purpose within the United States economy. One of the most important purposes is the Federal Reserve’s goal to “[conduct] the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.”[3] To pursue the Federal Reserve’s mission, Chairmen of the Board of Governors have been targeting interest rates and influencing lending and borrowing practices for decades.

Monetary Policy in the United States

Depending on the economy, the monetary policy led by the Chairman of the Federal Reserve Board of Governors differs greatly. When the economy is in a state of high inflation, interest rates are set high to offset the inflationary effects. In the same nature, when unemployment is high, interest rates are set low to encourage bank lending when the flow of money is low. The Fed influences interest rates by targeting the Federal Funds Rate[4]. This rate guides the ease or difficulty of lending and borrowing in the United State which in turn influences consumer and business spending which, in turn, influences the economy. [ii]

The Federal Reserve attempts to set the Federal Funds rate at the “natural rate of interest[5].” This rate cannot be found in a book or through a calculation.[iii] The natural rate of interest is essentially the equilibrium rate of interest. [iv] The natural rate of interest changes constantly through the different decisions made within financial markets. The natural rate of interest cannot be too low because it could cause inflation. If the rate is too high, the economy could suffer from high unemployment.

Determining the proper Federal Funds Rate is the most intrinsically important decision the Federal Reserve makes due to its lasting effects on the economy. As mentioned before, the Federal Funds Rate is set low by the Fed to help offset unemployment. With a lower interest rate, businesses and consumers can borrow money at a lower cost; therefore, they are motivated to spend more which in turn expands the economy as a whole. When interest rates are set lower than average, the Fed is said to be promoting an expansionary monetary policy.

Alan Greenspan: Chairman of the Board of Governors

When Alan Greenspan took the position as Chairman of the Board of Governors at the Federal Reserve in August 1987, unemployment[6] was hitting an 8-year low of 5.8%.[v] The United States perception of Greenspan was positive. Greenspan was known for his support of anti-inflationary policy and it was believed that he would concentrate on fighting inflation. With unemployment seemingly under control, Greenspan’s next move appeared to be predictable: if inflation increased, he would raise interest rates, if unemployment increased, he would lower interest rates.

Through the 1990’s, the U.S. generally experienced strong economic growth and low unemployment without high inflation. Greenspan led the Fed through this strong economic time, but in the late 1990’s and early 2000’s, the United States experienced two major hits to the economy: the dot com bubble[7] and bust and the terrorist attacks of 9/11/2001. These events struck the U.S. economy at its center by hurting confidence. The economy struggled to recover and was experiencing deflation[8]. Greenspan attempted to spur the economy and combat the deflation by lowering interest rates. In 1999, interest rates were set at 6.5%. Two years later, after both economic disasters, the rate had been reduced to 1.75%. Greenspan and the Fed believed that the best way to revive the economy was to cut interest rates to make it more appealing to spend money. The financial market became reliant on Greenspan’s consistency to cut rates anytime the economy began to slip. This tendency became known as the “Greenspan put.”[vi]

Throughout the early 2000’s, the economy continued to struggle. Greenspan and many others believed that a stronger housing market would have economic benefits. New initiatives to increase home ownership in the United States had been introduced in the 1990’s and were continued through the 2000’s. To accomplish this along with many other objectives, Greenspan lowered the interest rates to 1% and kept it at that level until 2004. Interest Rates in the United States had not been that low since before the 1950’s. His plan to increase consumer spending through housing stimulation and other spending categories such as business investment is called the “wealth effect[9]” and has been used by numerous Chairman to accomplish economic growth.

With the aid of historically low interest rates, the economy began to respond. Consumer spending and confidence in the economy increased. Wall Street rebounded strongly for the first time in years and home ownership climbed. After the lowest rate was achieved in mid-2004, Greenspan began to raise the rate slowly to return the economy to its natural state. Note in the graph below that by the time Greenspan retired in 2006, the interest rates had been reset to a normal level which according to the “Taylor Rule” is approximately 4%.[vii] [viii]

Figure 2: Historic Federal Funds Rate

Greenspan’s plan to initiate the wealth effect in the United States appeared to work in the efforts to grow the economy. This plan benefitted from housing initiatives implemented by President Bill Clinton and the U.S. Department of Housing and Urban Development that paralleled the low interest rates. When home ownership increases, consumer spending and overall economic morale increase and vice versa. This theory helps policy makers guide the direction of the economy; however, the initiatives set forth by the Federal Reserve and HUD combined created a major housing bubble[10] in the early 2000’s.[ix]         

Politics of Housing

            Historically, one of the most prominent assets owned by consumers in America has been a home. Homeownership has guided individual and government decision making in the United States from the beginning. Because a home is one of the largest investments someone makes in their life, housing market health and policies regarding housing have huge effects on the United States’ economy. Due to the wealth effect, when housing prices increase, a vast population of people in the United States perceives an increase in wealth and they spend more. President Bill Clinton capitalized on this concept throughout his terms as the President.

When Bill Clinton began his first term as the President on the United States of America in January 20, 1993, his platform for his presidency concentrated on domestic issues. One of the most prominent issues Clinton emphasized during his terms was homeownership. Due to his emphasis on homeownership, Clinton worked very closely with the U.S. Department of Housing and Urban development (HUD).

President Bill Clinton and HUD

            President Bill Clinton believed, “there is no more crucial building block for a strong community and a promising future than a solid home.”[x] Clinton regularly emphasized that if every American could own a stable home, all of the other domestic issues in the United States would resolve. He was quoted numerous times including in his Record of Progress saying things such as, “[Our] administration is dedicated to making the dream of homeownership a reality for all Americans.”[xi]

Historically, homeownership has been an option for Americans with a steady income and strong credit. As we will discuss, however, increasing homeownership required, in part, changing financial requirements to qualify for a mortgage. Changing these criteria encouraged new, permissive lending practices. Certainly, there is more wide-spread homeownership. But, as we discuss below, the permissive lending had the potential to cause detrimental circumstances for the financial industry and housing market.

               In order for Clinton’s goals for the housing sector to be achieved, he believed something drastic in the market needed to change.[xii] He enlisted many private and public sector organizations to contribute to his National Homeownership Strategy[11] which gave more Americans the chance to own a home. [xiii] One specific initiative passed through HUD and Clinton’s administration was the Urban Homestead Initiative[12]. With the help of HUD, Clinton announced he would increase homeownership “by cutting mortgage closing costs, helping police officers buy homes, using rental subsidies for home purchases and cracking down on housing discrimination.”[xiv] The Urban Homestead Initiative was one of many acts passed by Clinton’s administration. Another one of the most prominent initiatives from Clinton’s presidency is the National Homeownership Strategy. With this strategy, Clinton announced 100 Actions[13] to help promote homeownership. Within this message from the President, 100 items are highlighted to show the steps Clinton’s administration and HUD were taking to increase homeownership.[xv] Clearly administration policy was focused on increasing homeownership. The financial implications were either not considered or were a minor concern.

               In August 1995, the Urban Development Brief presented by HUD wrote, “Although research on some key points remains inconclusive, the preponderance of the existing scholarship confirms the validity of many of the benefits popularly attributed to homeownership.” To summarize, Clinton’s HUD was not sure about long-term effects, but because, in the past, the housing market has been a steady market and homeownership has shown benefits, the administration believed every American should be able to own a home. 

               The Fed and political powers in the United States spent much of the 1990’s and early 2000’s setting the environment to enable homeownership and consumer spending. As we can see in the above graph, through Clinton and HUD’s initiatives and lower interest rates the housing market began to experience a large boom.  Homeownership levels in the United States reached historic levels in 1996 at 66.3 million households.[xvi] More Americans owned their own home than ever before in history. This was largely due to the new initiatives set forth by Clinton and HUD but, financing for mortgages needed to change in order to accommodate the new housing policies. This included lower interest rates and more flexible lending requirements. A discussion on the role of financial institutions pertaining to the financial crisis will follow.

Financial Industry

            Numerous companies and organizations such as banks, insurance companies, credit unions, investment funds, and government sponsored enterprises make up the financial industry. This group of companies comprises a large portion of the major corporations in the United States. Financial institutions made up about 20% of the Standard & Poor’s 500[14] in 2004.[xvii]

            Because the financial industry is such a large sector of the American economy and because financing affects nearly every business, changes in its structure and/or disruptions in the flow of funds can have huge effects on the health of the economy.  As mentioned, fundamental changes, particularly regarding housing and mortgages, were taking place in the 1980’s and 1990’s.

Subprime vs. Prime Mortgage Backed Securities

Since the 1980’s and 1990’s, mortgage lending practices had been historically subjective and varied from one financial institution to another. Traditionally, basic mortgage lending had strict guidelines and specific levels of credit required for each level of loan value issued. Loans issued in this manner were considered prime mortgages[15]. Prime mortgages not only protected the borrower from serious consequences of default, but allowed to banks to lend money with high levels of confidence that the loans would be repaid. This high level of confidence allowed lower, fixed interest rates which in turn historically grew the mortgage market at a slow, stable rate.

Prime borrowers were rare and far in between within the mortgage market because people who had the means to borrow money for a mortgage had already done so. Past standards in lending practices included analyzing the risk of default by a borrower by tracking credit ratings, debt, and assets. In the 1980’s, the financial industry was seeking ways to grow this market further. Since all ‘ideal’ or prime borrowers already had a mortgage. Ways to tap the next tier of borrowers were explored. These new borrowers became known as ‘subprime’ borrowers.

These new lending practices increased risk for both the banks and the borrowers. Unlike historic lending processes, these new, subprime borrowers were not held to precedents set by prime borrowers. New borrowers no longer were required to have a 20% down payment and credit checks. Historically unqualified borrowers were now being viewed as qualified and receiving approval for a massive amount of money through mortgages. Subprime borrowers began emerging in the 1980’s. Subprime borrowers typically have a lower credit score and smaller amounts of assets; therefore, he or she is seen as being riskier than prime borrowers due to the higher probability of default on the mortgage. Because they are riskier, banks would charge subprime borrowers higher interest rates providing the bank with higher yields.

From the late 1980’s until the early 2000’s, new and different investment options became very popular to financial firms.[xviii] One of these was mortgage-backed securities. A mortgage backed security is a type of bond financed through the principle and interest payments of a mortgage. As more investors bought these securities, the number of homebuyers approved for loans increased due the newly presented demand. Because investors relied on the mortgage holder to repay the mortgage in order to receive the return on investment, the mortgage holder is said to “control the cash flows.”

Changes in lending practices in the financial sector lead to new trends in the asset-backed security markets which allowed for a buildup of investments tied to the housing market. When the housing market was experiencing growth, mortgage backed securities were considered a low-risk, high-return investment. Therefore as the housing market continued to grow until the middle to end of 2008, mortgage-backed securities became more and more popular.[xix] Banks noticed that the demand for this type of investment was increasing. To feed this growth banks and mortgage companies began approving mortgages for people who due to historical regulation were never considered adequate to secure a home loan in the past. This meant that people who once would have been denied due to lack of qualification for a mortgage were suddenly being approved without a change in their financial status. Because an increasing number of people who had never had access to such an investment were taking out larger values of mortgages, the banks were reaping the benefits of a massive supply of mortgages to the mortgage backed security market.[xx] This was important for the market’s success because the banks required higher yields to provide greater returns to their depositors in a market with low interest rates and minimal returns. These types of assets spread to a wider market due to changes in regulation within the financial industry. Since the Great Depression in the 1930’s, commercial banks had been restricted to holding deposits and lending, but due to regulatory changes, these restrictions were removed.

Regulation and Deregulation of the Financial Industry

In 1933, the United States Government passed the Glass-Steagall Act of 1933 in response to the failure of approximately 5,000 banks during the Great Depression. This law prohibited commercial banks and investment banks from being consolidated into one company. Regulations were applied to the banks at this time in direct response to questionable bank practices such as a creation of artificial markets due to security underwriting between commercial and investment banks.

            In 1999, the Gramm-Leach-Bliley Act or GLBA was passed to restructure the financial system. GLBA repealed the portion of Glass-Steagall that dealt with mergers of commercial and investment banks.[xxi] The intention behind repealing Glass-Steagall was to allow for larger banks to form with more capability to cater to growing markets and to be able to compete with the global financial sectors. In retrospect, GLBA allowed for riskier decisions made within banks because it allowed more complicated business practices with the promise FDIC still ensuring deposits up to a certain amount. GLBA became a major issue because it allowed the investment department of banks to invest in securities backed by loans[16] that they held on their commercial department’s balance sheets. This widened the scope of the number and type of investors investing in the mortgage backed securities market.

The Flow of Disaster

            As we discussed throughout the paper thus far, numerous changes were taking place simultaneously. Each decision contributed to the sequence of events leading up to and through the Financial Crisis of 2008. The first event was the bursting of the housing bubble. Due to the unprecedented number of homes being purchased the market grew at an aggressive rate. This growth was not sustainable and did not reflect the intrinsic values of the homes. Because of this, prices in the housing market could not withstand the large amount of growth and the bubble burst.

            After the housing bubble burst, asset-backed securities tied to the housing market lost a majority of their value. This can be contributed to the large increase in defaults due to the rapid decrease in home values. When a mortgage is defaulted, securities backed by such mortgages become worthless. This is what happened during the Financial Crisis. Wide spread declines in securities wrecked the financial firms. When all of these securities failed, bank assets declined quickly leaving large amounts of liabilities with very few assets to cover the bank’s obligations.

            Not only did the structure of both the housing market and the financial sector collapse, but consumers also took notice of the failures. Levels of wealth dropped tremendously due to major losses on investments. When the financial sector and the housing market deteriorated, the American population lost confidence in the economy. Along with the decline in confidence in the United States, the economy fell to pieces.

Looking Back at the Financial Crisis of 2008

When examining the financial crisis of 2008, many experts and critics have placed blame within the hands of politicians, the Federal Reserve, or even the financial industry as a whole. Through this research, we would argue that not one person is at fault, but instead it is the sum of the effects of numerous idly, individual events and decisions. If any of the previously discussed decisions or events were changed or removed for the history prior to 2008, the financial crisis would not have been as severe or even happened.

            When forming this conclusion, we removed each of the controversial topics discussed in this paper one at a time and followed the pattern of causes and effects. For example, if Greenspan hadn’t lowered interest rates to historic levels, banks would not have been searching for investment options with greater returns. Without Clinton and HUD pushing wide-spread homeownership at the same time of lower interest rates, the housing market would not have boomed the way it did. These new homeownership initiatives, gave way banks searching for new borrowers which in turn created a new subprime mortgage market.

Also, if banks wouldn’t have been looking for higher returns; mortgage-backed securities would not have become such an investment staple in the market. Without this strong tie between the housing and financial industries due to the increase demand of mortgage-backed securities, the markets would not be so dependent on one another; therefore, the burst of the housing bubble would not have destroyed the financial institutions who held risky subprime mortgage-backed securities which in turn forced the financial markets into a collapse. And even if all of this had happened, without the repeal of the Glass-Steagall Act of 1933 the scope of the deterioration of the economy would not have been so wide spread.

            This exact cause and effect concept can be applied to any of the decisions and events discussed in the paper. All would lead to the same conclusion. The financial market either would not have crashed or the crash would not have been so detrimental to the U.S. economy without the combination of homeownership initiatives supported by Clinton, low interest rates contributed from Greenspan, deregulation of the financial structure, and the new tie between housing markets and the financial industry which was tightened due to Subprime and Prime Mortgage Backed Securities.

            One of the most commonly asked questions on this topic is whether or not we learned our lesson. While only time will tell, I think it is important to recognize the mistakes made and the steps necessary to not make repeated mistakes. I am not convinced that the United States has learned their lesson, but again there is no way to tell. I think to prevent such crises in the future it is important to be aware and realistic of future effects decisions may have.