Economic Avalanche
What caused the boom/bust and what's on the horizon?

An interview with Abdul B. Pathan, professor of economics. Photos by Larry Kauffman.

The downturn/recession in our economy started in December of 2007.

The main reason for this current economic crisis is the bursting of the housing bubble, which was caused by high default rates on mortgage loans.

In 2004, homeownership which historically was very low
rose to 70 percent.

This downturn caused the unemployment rate to rise. The number of unemployed Americans exceeded the total population of our home state. (The population of Pennsylvania is about 12.4 million.) What happened?

How the bubble grew and burst

Homeownership is a major goal in our country. The government, through tax incentives, encourages people to buy houses. In 2004, homeownership – which historically was very low – rose to 70 percent.

Abdul B. Pathan, professor of economics, discusses current issues in economics in the classroom.During the late ’90s and earlier this decade, house value was appreciating fast. People were buying more houses because the interest rate was so low. Borrowers were offered adjustable-rate mortgages and interest-only mortgages. An adjustable-rate mortgage has an interest rate that changes based on market factors, and as a result, the payment increases when interest rates rise. Interest-only mortgages are set up so that during the first several years of the mortgage, the borrower pays no principle, so initial payments are low. It’s like a bait, to hook you into taking a higher mortgage than you could afford otherwise. Overall, more than 40 percent of borrowers took adjustable-rate mortgages, which had lower initial interest rates.

Banks started lending to subprime borrowers who otherwise would not qualify. According to some estimates, 25 percent of lending was subprime.

The banks were willing to lend. Since home value was appreciating, they didn’t care much about default, because they thought borrowers could refinance or sell their houses and be able to repay. This created a housing-construction boom. The lowering of mortgage underwriting standards, faulty credit rating, lack of government oversight on some of the financial institutions and other risky behavior on their part played a big role in this housing boom, and that created a peak in home prices.

During the middle of 2006, when the Federal Reserve Board started raising the interest rate, forcing banks to raise mortgage interest rates, some borrowers started to default, and as a result, house values started to fall. People simply could not make payments on their adjustable-rate mortgages as rates started to go up. Many borrowers – some estimate as many as 10.5 million in December 2008 – started to owe more money to banks than the actual market price of their houses. So literally, it was easier for them to walk out of the house. Foreclosures shot up to more than 3 million in 2008.

Some of those borrowers, while house values were appreciating, built some fake equity in their houses, so they took home-equity loans to lead lavish lives. When house values dropped, they not only owed more on their mortgages than their houses were worth, they also owed the home-equity money. It’s unfathomable. People were borrowing against their houses as if they were ATMs.

Another contributing factor to this bubble is financial innovation. As a practice, lending institutions do not keep the mortgages they issue. They sell those mortgages in the secondary market. This innovation is called securitization. Examples are collateralized debt obligation and mortgage-backed securities (CDO and MBS).

This process shifted the credit default risk to other investors and institutions from the initial mortgage lenders. One estimate found that, of the $10.6 trillion worth of U.S. residential mortgages, as of November 2008, $6.6 trillion were held by mortgage pools and only $3.4 trillion by traditional depository institutions.

The two largest issuers of mortgage-backed securities are the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). They are institutions called government-sponsored enterprises, meaning that they are privately owned with links to government. Both of them own or guarantee almost $5 trillion worth of mortgages, which is half of all mortgages.

The lending institutions, when they sold those mortgages to Fannie and Freddie, didn’t worry about the default risk, because it’s all passed on. And Freddie and Fannie, in turn, sold those securities to private investors.

There were other issuers of mortgage-backed securities, such as Morgan Stanley, Lehman Brothers and investment banks like Merrill Lynch.

Hedge funds also buy mortgage-backed securities. Hedge funds are privately owned investment funds dealing with large investors. They are not regulated. They didn’t have to declare quarterly reports, unlike mutual funds. Some estimates put the total value of assets of these hedge funds at $3 trillion in 2008. When hedge investors move their funds around, they affect the value of the mortgage-backed securities, stock prices, and commodity prices, creating a lot of volatility in the economy.

Some estimate that, in December 2008, as many as 10.5 million borrowers started to owe more money to banks than the actual market price of their houses.

As subprime defaults rose, the prices of securities backed by subprime mortgages plummeted. Losses by Merrill Lynch, Citi, Bank of America, Bear Stearns and Lehman Brothers mounted. Lehman Brothers went bankrupt. The Fed intervened in the Bear Stearns takeover by J.P. Morgan and the Merrill Lynch takeover by Bank of America.

The MBS and CDO investors bought credit default swap, which is sort of an insurance – if someone defaults, the investors receive payment. Some estimates put the volume of credit-default swap at $47 trillion. That was one reason insurers like AIG got in trouble. AIG lost $62 billion during the last quarter of 2008 alone, because it was insuring all these securities, and defaults were climbing.

This intermixing of risks is now called systemic risk. What that means is that previously, these risks were borne by different people. Now, they became correlated, affecting the entire financial system. The credit market froze, affecting many industries. The stock market index dropped, people’s savings in 401(k) and other retirement funds dropped, consumer spending dropped, and the auto industry, relying on bank credit, began suffering immensely. Tax revenues of states and local authorities plummeted, which caused cutbacks in many programs, raising unemployment along with other side effects we are now seeing, like an increase in violence and other crimes.

Intervention

Since the problem was so enormous, the government tried to intervene as much as it could. During this turbulent time, it took specific measures.

To protect banking customers, the Federal Reserve Board raised the Federal Deposit Insurance Corp. insurance limit from $100,000 to $250,000 per account. It also made several moves to ease the credit of financial institutions, including lowering the federal funds rate – the rate at which one bank can borrow funds from another bank – from 5 percent to near zero, and infusing money under several programs.

The Fed gave $600 billion to Fannie and Freddie to purchase mortgage-backed securities. AIG got a loan of $175 billion in 2008 to help lower mortgage rates. The Fed also lowered the 30-year mortgage rate below 5 percent by investing money into various programs and – on March 18 – announcing another $1.2 trillion to buy long-term government bonds and mortgage-backed securities.

The federal government, through the Treasury Department, also stepped in.

On Feb. 13, 2008, President George W. Bush signed into law a $168 billion economic stimulus package in the form of income tax rebate checks mailed directly to taxpayers. Then came the $700 billion Emergency Economic Stabilization Act of 2008/Troubled Asset Recovery Program that was signed Oct. 3. It was intended to purchase from financial institutions large amounts of mortgage-backed securities and collateralized debt obligations, or toxic assets. In reality, the Treasury injected half of that money into the banks, buying dividend-paying, non-voting preferred stocks. In effect, we – as citizens – own Citi and other institutions. Some of the money was spent for the auto industry, too.

On Feb. 16, President Barack Obama signed the American Recovery and Reinvestment Act of 2009, a $787 billion stimulus bill in the form of tax cuts and spending. This was designed after former President Franklin Delano Roosevelt’s New Deal program. On Feb. 18, Obama announced a $75 billion program to help 9 million homeowners to avoid foreclosures.

Household net worth dropped by $11 trillion in the U.S. in 2008 and $50 trillion globally.

The government also established task forces to monitor the activities – including CEO pay and benefits – of institutions taking government money, like the auto and banking industries.

In late March, Treasury Secretary Timothy Geithner announced a $500 billion private/public partnership to buy out toxic assets to clean up banks’ balance sheets and make them stronger. Government is trying to ensure more transparency from the banks, big and small. The Treasury Department also tried to help big banks to assess their liquidity needs by running stress tests.

How has it helped?

The goal of all government action is to:

  • Restore liquidity of the banking system so credit can flow again for all kinds of economic activities.
  • Restore people's confidence about the economy so they can go on with their normal spending habits.
  • Revive corporate sectors, the housing sector, the auto industry, the appliance sector and other manufacturing industries so they can start hiring and earn profits, which will revitalize the stock market, allowing investors to regain confidence and start investing again.

The Dow Jones index dropped to less than 8,000 from its high of 14,000 in July of 2007, wiping out the perceived wealth of a lot of people from their retirement funds, which further impacted people’s spending, causing a downward spiral. Consumer spending constitutes 70 percent of our gross domestic product. Household net worth dropped by $11 trillion in the U.S. in 2008 and $50 trillion globally.

The massive bailout plans will take time to take effect. Many economists predict it may take a couple more years for the economy to rebound. Lack of action would be more disastrous. As we learned from the Great Depression of the ’30s, people trusting classical theory were hesitant to support bold action on the part of the government.

With this additional government spending, our annual deficits will run around $1.5 trillion, and our total national debt will approach $12 trillion. This may cause high inflationary trends and high interest rates, and possibly a falling value of the dollar. That is why government has to be very careful in taming the deficit by cutting unproductive government expenditures and giving the tax cuts that will create the most jobs.

The government is taking the right steps, I would say, by trying to get rid of toxic assets so the banks can start lending.

The Fed should be given more regulatory power to oversee other financial institutions, and once-secretive hedge funds should be required to be more transparent to the public about their investment vehicles. Credit-rating agencies should be monitored for any wrongdoing on issues of conflict of interest.

Most big banks are in shaky positions – most smaller ones are OK so far – because of huge losses, falling value of their stocks and their inability to raise private-equity capital due to public fear that they may be nationalized. So government should make a clear pronouncement regarding their bold action to reassure public confidence and dispel any rumor. The surplus inventory of unsold houses should be disposed of before building new ones. New job creation programs should be encouraged, and government should give financial incentives to laid-off workers to get retraining from colleges like ours.

What do we do now?

We should be patient. Our current economic slide – I’ll compare it with a tidal wave or a big avalanche – will need a huge barrier to be stopped and prolonged time and effort to be stabilized. I believe it will get better slowly with the proper handling of the economy. People may be advised not to do anything drastic and get caught in the frenzy. A lot of people try to sell and get out of their 401(k)s, but that is never a wise decision. Most economists believe we have reached the bottom, and the economy will start to rebound by the last quarter of this year.

In a market economy, we are bound to see booms and busts: the oil boom in the ’70s, the savings and loan crisis in the ’80s, the dot-com boom in the ’90s, and the recent housing boom and subsequent bust. It has taught us to be cautious and make money the hard, honest way. We should not buy something we cannot afford, and we should not rely on others to bail us out. We should be prudent in our economic decisions. ■

Abdul Pathan, professor of economics, holds a doctorate from the University of Houston and master's degrees from Williams College in Massachusetts and Dhaka University in Bangladesh. He has taught at Penn College since 1987. He serves on the Board of Directors for the Pennsylvania Economic Association and is a frequent presenter at economics and economics education conferences.

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