Categories: Financial/Economic

The Current Financial Crisis

TASA ID: 1258

The United States has been in the midst of a financial crisis since mid-2006 that resulted from residential real estate foreclosures.  The foreclosures caused severe pressures in subprime mortgage markets and ultimately in global money markets.  As a result of stricter accounting standards and downgrades by credit rating agencies, various complex mortgage-backed financial instruments had to be written down on financial institution balance sheets.  As housing prices declined, financial institutions worldwide faced severe losses that threatened their survival.  By September 2008, severe credit tightening was becoming evident.  In response to these events, Congress passed legislation authorizing the Secretary of the Treasury to spend up to $700 billion to purchase troubled financial assets.  

The financial crisis originated in the low interest rates set by the Federal Reserve in response to a recession that began in 2001.  The low interest rate environment stimulated the U.S. economy, and in particular the residential real estate market.  As measured by the Case-Schiller composite index of real estate prices, residential real estate prices in the United States more than doubled between 2001 and 2006.

An additional factor was a change in lending practices by financial institutions.  Banks began to issue mortgages so that the mortgages could be sold to other financial institutions, which would then combine the mortgages in order to issue securities that were backed by the pooled mortgages.   The ultimate purpose of pooling the mortgages was to transfer the risk of loan default from the original issuer of the mortgage to the purchaser of the mortgage backed securities.  These new mortgage backed securities were then pooled again and new mortgage backed financial instruments were created again.  Unfortunately, these various financial instruments seemed to ignore the higher risk of loan default that was associated with subprime mortgages when securities backed by these mortgages were priced in the marketplace.

As the housing boom continued through 2006, buyers of mortgage backed securities continued to ignore the higher risk of loan defaults associated with subprime mortgages and this fueled a demand for these financial instruments.  As a result, banks reduced their lending standards when originating mortgages in order to increase the supply of mortgages and meet the demand for new mortgage backed financial instruments.  Although banking institutions are regulated by Federal regulators, including the Federal Deposit Insurance Corporation and the Federal Reserve, regulators either did not understand what was happening or ignored the lowered lending standards in response to the risk of loan default being transferred from regulated banking institutions to relatively unregulated nonbank financial institutions.  In other words, the view of regulators was that the risk had been transferred from the regulated originators of mortgages (banks) to the ultimate holders of mortgage backed securities who were beyond the boundaries of regulatory control.   However, regulators did not recognize the spillover effects of the lack of regulatory oversight which began to set the seeds of a financial crisis after housing prices began to decline in the United States.

By mid-2006, housing prices were reaching their peak in most locations in the United States.  When signs began to appear of a slowing American economy and a potential financial crisis, housing prices began their decline in mid-2006.  As housing prices declined, there were increased mortgage foreclosures.  In early 2007, losses at financial institutions began to become apparent.  In February 2007, HSBC Financial reported over $10 billion in losses from its mortgage lending business.  In April 2007, New Century Financial, one of the largest mortgage lenders in the subprime market, filed for bankruptcy.  In August 2007, Countrywide Financial, the largest mortgage lender in the United States, became illiquid as a decline in the value of securities backed by its mortgages caused Countrywide's depositors to withdraw their deposits.  On January 11, 2008, Countrywide was bought by Bank of America for $4 billion.

The next major crisis occurred when losses related to mortgage backed securities led to the collapse in March 2008 of Bear Stearns, the then fifth largest investment bank.   In order to avoid the bankruptcy of Bear Stearns, JP Morgan Chase purchased Bear Stearns with guarantees on Bears Stearns liabilities by the Federal Reserve.

Another major event in the last quarter of 2008 was the placement of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) under federal government receivership.  Fannie Mae and Freddie Mac were government sponsored entities (GSEs) that bought mortgages from banks and repackaged them as mortgage backed securities.  The role of Fannie Mae and Freddie Mac was to guarantee the repayment of principal and interest of the underlying pooled mortgages.  Prior to being placed under federal government control the net worth of Fannie Mae and Freddie Mac had declined precipitously as mortgage foreclosures, particularly on subprime loans, increased.        

By September 30, 2008, three investment banks had failed: Merrill Lynch, Lehman Brothers and Bear Stearns.  In addition, some major commercial banks, including the banking operations of Wachovia, Washington Mutual and IndiMac had failed as a result of runs on deposits and rapid declines in the value of troubled mortgage portfolios.  The result was a credit crisis in which financial institutions with little idle cash and declining net worth as a result of problem mortgages began to stop lending to consumers and businesses.  The Bush Administration began to fear that without major intervention by the federal government, an economy that has shown signs of entering a recession could contract rapidly leading to a prolonged period of economic stagnation.  Many observers pointed to the example of Japan in the early 1990s that went through a decade of economic stagnation following the collapse of major financial institutions.    In this environment and after extensive debate and deliberation, Congress enacted a $700 billion financial rescue plan.  The plan involves the purchase of up to $700 billion in weakened assets from financial institutions, increased federal deposit insurance on bank deposits from a maximum of $100,000 to $250,000 and to limit compensation to executives of financial services firms that sell troubled assets to the Federal Government.

As things now stand, it is not yet clear what the impact will be of the federal government's financial rescue plan.  In particular, there is no certainty that the rescue will lead to financial institutions having sufficient funds to again lend to consumers and businesses so that there is not a severe economic collapse instead of a recession. 

This article discusses issues of general interest and does not give any specific legal, medical, or business advice pertaining to any specific circumstances.  Before acting upon any of its information, you should obtain appropriate advice from a lawyer or other qualified professional.

This article may not be duplicated, altered, distributed, saved, incorporated into another document or website, or otherwise modified without the permission of the author, who will be contacted by TASA.

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