What Caused The ‘08-’09 Recession?Laws That Encourage Weak Loans

We Could Not See the Forest for the Trees1938—Law put more risk of mortgage default on the

government through Fannie Mae (Federal National Mortgage Association). Charted by Congress. It issues bonds; revenues used to buy mortgage from savings and loans, thereby insulating them from mortgage risk.

1968: Ginnie Mae (Government National Mortgage Assn.) created—it guarantees mortgage-based securities based on loans to government employees and veterans.

1970: Freddie Mac (Federal Home Loan Mortgage Corp.) created as private corporation in 1970 by Congress to encourage more loans.

Congress at WorkFannie, Freddie and Ginnie are “Government-Sponsored Enterprises.” Only Ginnie is government guaranteed, but people presumed all safe.Fannie privatized in 1968. Freddie a competitor.Both issue bonds to get cash to buy mortgages that are packaged and resold (securitized) to investors. Both do same thing; Fannie larger and older.1977—Community Reinvestment Act—banks forced to expand loans to higher-risk areas. Later tied into mortgage-making rules.

Congress Adds Fuel to the Fire• 1992—Congress sets targets for Fannie and

Freddie via HUD. Put into company charters: “an affirmative obligation to facilitate the financing of affordable housing for low- and moderate-income families.” HUD: “Lack of credit history should not be seen as a negative factor.”

• By 2006, 20% of all mortgages were sub-prime (up from 4.5% in 1994)—and 81% of the sub-primes were securitized. Not so in Canada or EU.

• 74% of sub-primes held by Fannie and Freddie.

Fuel to the Fire• Lurking in the background since the ’30s is the

FHA (Federal Housing Admin.) Part of HUD.• It provides insurance for mortgages. Pretends

to be real insurance company, but taxpayers are on the hook when it goes under.

• When Fannie and Freddie crashed in ’08, FHA began to provide mortgage money—one third of all mortgages now are FHA money.

• FHA now (‘12) underwater—taxpayer bailout.

Some Lenders Greatly Expand Loans• Lenders (Countrywide) focused on loans to

people who could not traditionally qualify.• Fannie & Freddie securitized $1 trillion sub-

prime loans. Both declared bankrupt in ‘08. Fed bailout.

• Many people buy homes who could not before (ownership rises from 65% up to 70% of families); and existing owners trade up; high demand pushes prices up; builders happy to build more homes; lenders happy to make loans and collect a fee.

Easy Money• Government forces/encourages lenders to make

risky loans, but government “guarantees” loans.• Mortgage brokers encourage people to buy

houses or trade up to more expensive house. No down payment needed!

• Bush Admin had easy money policy—low interest rates—housing bid up 65% from 2001-2006.

• Adjustable rate mortgages—ARMs—first year or two, very low rate, then rises to market. People thought they would cash out before then.

• When prices drop & owner can’t afford higher payment—default.

Then Reality – and Fear – Sets In

By 2007, the problem becoming clear and prices begin to fall in summer. Weakest markets fall hardest and fastest—

10 million+ badmortgages

No one sure

Less Trouble in Texas

Housing Prices Down; Trillions in Equity Evaporated

Where Are the Mortgages Now?Few banks keep mortgages—most are bundled together

and sold as securities for years. “Special Investment Vehicles” (SIVs) sold to creditors all over the world. Mortgages “backed” by Fannie—so why worry? China holds $375 billion worth of Fannie Mae backed loans.

Insurance companies, AIG, insure the purchase of the SIVs and other mortgage products by “credit default swaps.” No loss possible!

Hedge funds take positions on mortgages—derivatives. Those on the wrong side took huge losses. Lehman bankrupt overnight in ‘08.

Almost impossible to sort out who has what mortgage.

TARP: Troubled Asset Relief Program (‘08) Most important is liquidity in banking sector—keep

credit flowing to strong businesses or they must contract and make recession far worse.

TARP guaranteed bank and financial firm solvency. Almost all money repaid. Moral hazard problem?

Get cash into banks for lending purposes, not to guarantee their weak assets—that is just a bailout, not a solution to liquidity problem.

• But—none of the laws behind this have changed. Who does Congress blame?

TARP then the “Stimulus” - Private Bailout Ends; Government Bailout Begins

The RecessionThe recession and financial meltdown was triggered by the housing crisis. Why should crisis in one area hurt whole economy? One-sixth of whole economy related to construction, which essentially stopped.

Obama Administration: Need Stimulus to Get Economy Going

Keynesian StimulusHow do you finance massive federal deficits?1.Raise taxes—kill incentives; capital flees. Capital is investment; investment means jobs, growth.

What Does Capital Investment Mean?Greater Worker Productivity; Wages Rise

Another Way to Finance Deficit

2. Sell bonds. Market cannot absorb $1 trillion plus year after year.Chinese government used to buy half of federal debt, but too big now for them or anyone else.If government borrows private savings, then little left for private sector, which again makes capital scarce, so hard to grow.

Last Way to Finance Deficit

3. Treasury borrows more from Fed.Common practice around the world—the central bank gives the government new money. What happens to the value of money?Falls as inflation takes hold.But, this time the money the Fed has created just sits in reserves of banks. Little interest in borrowing.

StimulusAdministration economists estimated multiplier to be 1.54. First stimulus, an extra $787 billion debt, would generate

an additional $425 billion in economic activity.Nothing happened—so double down and run up $5 trillion.But no Keynesian “multiplier”—that is, $1 government

spending does not generate $1.54 in economic activity. Later work showed at most it was 96¢ for $1—but less

efficient than $1 of voluntary spending, so even worse.By 2010 return fell to estimated 48¢ per $1.Where does the money come from? Future generations.The day of reckoning will come.