About Subprime and the 2008 Financial Crisis

Recently, the financial crisis and its related terms have become buzzwords in their

own right. Terms such as 'Subprime', 'Lehman Brothers', 'Collaterised Debt

Obligations (CDOs)' and 'Mortgage Backed Securities (MBSs)' appear every day

in local newspapers, while experts of all stripes proffer various recommendations

on how to avoid the next financial crisis. But do we really understand what the

Financial Crisis is about? What caused the crisis? How did the government

respond? If it is a real event that has occurred, can a similar crisis be avoided in the

future? If so, what can be done to prevent a similar meltdown?

Definition and Key Characteristics

The recent Financial Crisis can be defined to be a series of events, starting in 2007

with the bursting of the US housing bubble and ultimately culminating in the freeze

in credit and short term money markets, which coincided with the drastic falls in

asset prices around the world.

Most financial crisis start with investors seeking a higher return on their capital.

Some would call it greed while others would label it as a maximisation of

individual utility. This time was no different.

In the years following the collapse of the dot-com bubble, the Federal Reserve

(Fed) lowered the Federal Funds rate (which corresponds to the rate at which banks

lend money to each other) from 6.5% to 1.0%. This was done to stimulate lending

and consumption, to mitigate the effects linked to the dot-com crisis and to prevent

the economy from slipping into a recession.

Apart from the Fed initiatives, interest rates also came under pressure from the

increase in the current account deficit, due to high government and private

expenditure.

Current Account (CA) + Non-Financial Account (NFA) + Official Reserves

Settlement (ORS) = 0

The basic balance of payments accounting schedule indicates that when current

account experiences a deficit, the change in the Non-Financial Account (NFA)

must be positive. Deficits must be financed with capital inflows and in this case,

the foreign entities invested in the US treasury bonds which ultimately reduced

yields and interest rates.

Ultra-low interest rates are a double edged sword. As debt servicing costs drop,

consumers have an added incentive to take on more debt. At the same time, the

return on saving deposits drop, and the savings rate decreases.

At what level should interest rates have been fixed?

In fixing interest rates, central bankers sometimes rely on the Taylor rule, a

monetary policy guideline developed by US Economist John Taylor which

prescribes the ideal nominal interest rate which should be used as deviations in

inflation and output are observed over time.

In its simplified version, the rule can be represented with the following equation:

I = T + R + a (T - T*) + b (Y - Y*)

where I is the nominal interest rate

T is the rate of inflation

T* is the targeted rate of inflation

Y is the actual Gross Domestic Product

Y* is the targeted Gross Domestic Product

a, b are parameters describing the sensitivity of central bank policy to

deviations in inflation and output

In the paper written by John Taylor, entitled 'The Financial Crisis and the Policy

Responses: An Empirical Analysis of What Went Wrong', the US Economist

argues that the Fed was overly aggressive in lowering interest rates.

John Taylor goes on to argue that the Fed, by lowering interest rates drastically to

stimulate the economy, inadvertently sell buy here pay here accounts provoked the Housing boom and its

subsequent bust.

However, had the central bankers followed the Taylor rule and had they lowered

interest rates in a less drastic manner, it is anyone's guess whether the economy

would have instead gone into a period of price deflation, as in the case of Japan in

the 1990s.

In his paper, John Taylor went on to study the correlation between the Fed funds

rate and the interest rates set by other Central Banks. He found that there was a

statistically significant relationship which indicated a certain degree of correlation,

and coordination between the Central Banks.

While he does not explain why this is so, it is easy to come up with some reasons.

Assuming that world Central Banks do not coordinate in the fixing of interest rates,

every bank would set her rates independently which would lead to frequent changes

in interest rate differentials. Countries would suffer destabilising inflows and

outflows due to speculative activity (like the Carry Trade), which is reason in itself

to pursue a coordinated monetary policy.

However, low interest rates alone cannot explain the reason why there was a

housing bubble or why a credit crunch occurred. To put things in perspective, we

also need to consider the role of Government Sponsored Entreprises (GSEs).

What are GSEs and what did they have to do with the crisis?

Government Sponsored Entreprises (GSEs), such as Fannie Mae and Freddie Mac

were originally created by the US government to further certain social goals, such

as increasing access to home ownership. GSEs do so indirectly by facilitating the

flow of credit. Typically, banks provide home loans to borrowers who are unable to

finance the entire purchase with the existing resources. However, the number of

loans that a given bank can grant is limited by the equity on its balance sheet and

national regulations. In order to encourage banks to lend more, GSEs purchase

loans on the loan book, thus providing the banks with cash to continue lending. By

facilitating the flow of credit and indirectly financing home loans, GSEs play in

key role in improving access to credit.

GSEs are only allowed to purchase conforming loans, which place a ceiling on loan

to value ratios. This ensures that borrowers within their means. For a loan to be

classified as 'Conforming', there are also restrictions on the minimum income

required and other administrative requirements.

In theory, such as system should function perfectly. However, in the US, these

entities were structured in such a way so as to create perverse incentives which led

to the subsequent development and collapse of the US housing bubble.

Take Fannie Mae for example. The Federal National Mortgage Association, also

known as Fannie Mae, started as a government institution in 1938 but was

converted into a private shareholder owned corporation in 1968. The organisation

was later listed on the stock exchange.

As a profit driven company with shareholders to answer to, Fannie Mae soon came

under pressure to increase its profit margins. However, it was restricted to buying

low yielding 'conforming loans'. Ceding to shareholder pressure, it began to relax

underwriting standards and started to purchase higher yielding sub-prime loans as

well. Loan to value restrictions began to slip.

With Fannie Mae purchasing lower quality loans, lending institutions were now

free to lend to a wide spectrum of borrowers, which include low or no income

individuals. With the easy access to credit, people began to commit to house

purchases with little regard to price and affordability. Housing prices began to

creep up.

With property prices increasing, people began to see housing as an investment

opportunity. Like the Tulip mania, the popular perception was that prices had no

way to go but up. People began to borrow to invest in property. The increased

demand caused prices to move up drastically. Between 1997 and 2006, the price of

a typical house in the US increased by 124%.

As the housing boom continued, people were able to use their houses to finance

their consumption as well, drawing cash out of their homes using Home Equity

Lines of Credit. The world began to observe a new era of monetary excess, with

Consumer Price Index (CPI) inflation, averaging 3.2% annually from 2005.

The role of securitization and how it is related to the low interest rate environment

When GSEs such as Fannie Mae purchase loans, they repackage them into

collaterised instruments such as Mortgage-Backed Securities (MBS). MBSs are

made up of a series of mortgages pooled together using a trust structure. These

MBS are later sold to investors. Owning an MBS represents a claim on the cash

flows from the underlying mortgages.

In the previous section, we argued how the privatisation of the GSEs led to an

increase in the number of sub-prime loans granted. As long as these loans are

serviced, they are highly profitable. Including a certain quantity of these loans in

any MBS would increase the MBS' yield.

Because MBS' often contained a certain percentage of sub-prime loans, MBS

marketers were able to offer high yields to attract investors. At the other end,

interest rates remained low, and investors began to look to higher yielding

instruments to generate better returns on their capital. Hedge funds, Pension funds,

Universities and other institutions began to purchase MBS' on a non-negligible

scale.

With investor appetite for MBS' came well known mortgage brokers like Lehman

Brothers, which generated significant revenue from fees generated by purchasing

mortgage loans, packaging them and reselling them to other investors.

Certain critics argue that Rating Agencies were complicit in the whole process.

These critics allege that the rating firms knew about the fundamental instability of

the MBS', but continued to award high ratings, often triple A, in return for high

fees from the MBS sponsors

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