Causes Of The 2007 Financial Crisis Finance Essay
An Analysis of the 2007 Financial Crisis and Its Impact on China
FIN 635 Capital and Money Markets
Dr. Kwok-Fai M. Wong
April 25, 2012
Causes of the 2007 Financial Crisis………………………………………………………………………….. Page 4
The U.S. Housing Bubble………………………………………………………………………………..Page 4
Subprime Mortgage Lending………………………………………………………………………….Page 5
Securitization: Mortgage-Backed Security……………………………………………………..Page 6
Rating Agencies……………………………………………………………………………………………..Page 7
Risky investment and excessive borrowing…………………………………………………… Page 8
Crisis Response………………………………………………………………………………………………………… Page 9
Impact on China …………………………………………………………………………………………………………Page 11
Appendix : Figures……………………………………………………………………………………………………...Page 13
Appendix: Works Cited……………………………………………………………………………………………….Page 19
The 2007 financial crises began in the summer of 2007 as a subprime mortgage crisis that triggered by the collapse of the American housing market. The 2007 financial crisis is considered to be the worst financial crisis since the Great Depression of the 1930s. In the U.S., because the use of high leverage ratio and risky investment in mortgages, banks and other financial institutions become victims of the burst of the housing bubble and would lose hundreds of billions of dollars.
With crisis gradually increased in intensity, caused a series of major financial institution failed which includes, Bear Stearns, Countrywide Financial IndyMac , Fannie Mae and Freddie Mac failed (U.S. Department of the Treasury, about TRAP). After Lehman Brothers one of the largest investment bank in the U.S. files for Chapter 11 bankruptcy protection on September 15,2008, ( Federal Reserve Bank of St.Louis,The Financial Crisis),the crisis quickly transformed into a global financial crisis and many financial institutions all over the world were pushed to the edge of bankruptcy. The U.S. government and the Federal Reserve undertook a series of emergency actions to prevent the collapse of the financial system.
There are various causes triggered this crisis, in this paper I will analyze some major causes of the 2007 financial crisis and how government responses to the crisis. I will also evaluate the impact of the 2007 financial crisis on China’s economy.
Causes of the 2007 Financial Crisis
The U.S. Housing Bubble
The U.S. housing bubble is an economic bubble that has a huge impact on the United States housing market. An economic bubble occurs when "trade in high volumes at prices that are considerably at variance with intrinsic values" (Ronald R, Vernon L, Arlington W., and Mark V).
U.S. house price increase substantially since 1988, the Standard Poor’s Case-Shiller Home Price Indices shows a significantly larger increase in house price that starting in 1988 and it peaked in 2006. Between 1997 and 2006, U.S. house price increased by 124% ("Economist",2007).
There are Lots of things help to bring up the house price. Under the increasing pressure from the government to expand mortgage loans among low income family, Fannie Mae started to encourage financial institutions to offer home loans even to people who do not qualify for traditional loans( STEVEN A,1999 ). The Taxpayer Relief Act 1997 offer tax relief for people on the profit gained from the sale of their house and the passes of the American Dream Down Payment Act which provide funds for down-payment and closing cost to fist-time low-income homebuyers("American Dream Downpayment Initiative",2003) which further stimulate the home ownership. As the result, People start spending more and borrowing more, speculators start investing in second homes and investment properties. A report from Bureau of Economic Analysis indicate that saving rate is steadily declining(figure 1) and the consumer and mortgage debts increase to 133% of annual disposable income in 2008(figure 2). According to the United States Census Bureau, U.S. homeownership rate reaches 66.1% during 2007-2011("State & County QuickFacts", 2013).
After 2006, house price began to decline to its present level and housing bubble start to burst. According to the Department of Commerce, in 2007 the sales of new house declined by 26.4 % to 774,000("Associated Press",2008). By September 2008, the house price declined by more than 20% from the 2006 peak (figer 3). This unexpected decline caused some borrowers have zero or negative equity in their houses which means the value of the mortgage loans are less than the house value. About 23% total U.S. mortgage holders their house worth less value than the mortgage loan (Louis, 2010).
Under this situation the probability that borrowers might default on their mortgages increased. Realty Trac TM U.S. Foreclosure Market Reports, there are about 846,982 properties entering some stage of foreclosure in 2005 and more than 1.2 million foreclosure filings were reported nationwide in 2006 which means for every 92 U.S. households there is one foreclosure filing(White, 2013). The burst of the U.S. housing bubble triggered the subprime mortgage crisis which led to the 2007 financial crisis and subsequent recession.
Subprime Mortgage Lending
Increased in high risk subprime mortgage loans during the housing bubble is one of the major causes of the subprime mortgages crisis. With the low interest rates, innovative financing option and the support of the government, mortgages qualification becomes more and more loosely. Banks lend money to the borrowers without concern for whether they have the ability to repay the loans. According to a National Association of Realtors report, during the housing bubble period, 43% of first time home buyers purchased their house with a zero down payment loans (Knox, 2006 ).
Income verified assets loans (SIVA) makes people easier to get a mortgage loan. In order to get SIVA, borrowers only need to verbally state their income status. No income, verified assets loan (NIVA) makes borrowers no longer need to be in employment as long as borrowers show some proofs that they have money in their bank account. No Income No Asset (NINA) loans provide loan to borrowers without proof or even state anything, except a credit score.
Adjustable rate mortgage (ARM), the most popular loan. ARM is a mortgage with an interest rate and monthly payment adjust annually in response to changes in the market conditions. (Kidwell, Blackwell, Whidbee, and Sias 274).ARM has a lower starter rates and interest-only ARM even allows the borrower pay only the interest during an initial period.
American CoreLogic study shows that one-third of ARMs taken out between 2004 to 2006 began with a rate below 4% and payments on these loans will double on average (Arnold, 2007). ARM was initially designed to borrower who will live in their homes for few years and then sell at a profit or refinance. Now these loans were made to borrowers with poor credit with higher interest rates to compensate for the risks. A study shows in 2005, almost 23% of all mortgage originated were interest-only ARMs (Arnold, 2007).
In 2006, the percentage of subprime loan to the total mortgage originations had increased to about 25% ("2007 Annual Report • The Subprime Mortgage Market" 8). There are about 7.75 million outstanding subprime mortgage loans in later 2007 which counted 14% of the overall mortgage market (Kroszner, 2007). From 1994 to 2006, the value of subprime lending increased from $35 billion to $600 billion which counts 20 percent of total value of family mortgage originations Figure 3. (Bernanke, 2008).
Under such loose mortgages qualification, some borrowers grabbed this opportunity of cheap credit to take on debt that they don’t have the ability to repay. With the housing bubble burst, value of their houses became less compared to the value of their mortgages. This created extremely high default rates in the subprime mortgages market compared to the prime market (figure 5). As the result, more than 3.6 million outstanding subprime ARMs were seriously delinquent and 1.5 million foreclosures were initiated by lenders in 2007(Bernanke, 2008).
Behind the slump of the U.S housing market, growing subprime mortgage market and significant increased delinquencies and foreclosures, a financial crisis gradually formed.
Securitization: Mortgage-Backed Security
Fannie Mae and Freddie Mac were two government-sponsored enterprises are the major players in mortgage-backed security market. The following is the history of Fannie Mae and Freddie Mac:
In 1934, Congress passed the National Housing Act, which created the Federal housing Administration (FHA) to provide insurance for mortgage which made by approved lender. In order to develop a secondary market for mortgages, Federal National Mortgage Association (FNMA) was created in 1938. (Kidwell, Blackwell, Whidbee, and Sias 283).
In 1968, Federal National Mortgage Association (FNMA) was split into two entities, the Government National Mortgage Association(GNMA-Ginnie Mae) and the Federal National Mortgage Association(FNMA-Fannie Mae) (Kidwell, Blackwell, Whidbee, and Sias 283). GNMA does not originate or purchase mortgages. As a government agency, it provides guarantees on the timely payment of principal and interest payments on MBS issued by approved lender (Kidwell, Blackwell, Whidbee, and Sias 283). FNMA was established as a private hold corporation after 1968. It still considers as a government agency by investors and investers believe federal government will rescue if it became insolvent (Kidwell, Blackwell, Whidbee, and Sias 284).
Like FNMA, Federal Home Loan Mortgage corporation (FHLMC was established by Congress in 1970 to assist savings and loan association and other mortgage lenders to attracting funds and provide competition for FNMA. FNMA and FHLMC there were all referred to as government- sponsored enterprise (GSE ). Until June 30, 2008, there are 1.5 trillion mortgage assets (loans and MBS) held by Fannie Mae and Freddie Mac(Jickling, 2008).
Here is a simply example shows how mortgage-backed security works. Banks, mortgage companies or other originators who do not want to wait until the loans been repaid will sell their mortgage loans to the government agencies, GSEs or private entity. Then the government agencies, GSEs or private entity will repackage the entire mortgage they purchased into a pool and then issue securities that claim on the principal and interest payments made by borrowers on the loans in the pool ("Mortgage-Backed Securities").
Financial institutions use securitization as a source of long-term fund which also helps reduce risk of fluctuations in interest rates. Securitization also transferred the loan specific risk such as the default risk of the mortgages from the originator to the buys of collateralized securities. However, the buys or investors of the MBS have less information about the mortgage market which makes them bear most default risk. In order to make MBS attractive to investors, some well capitalized financial institution, government agencies or GSEs provides a guarantee for qualified MBS.
With the mortgage origination start to drop after the slump of the U.S. housing market, the securitization rates keep increasing as financial institutions use securitization as a source of funding. Figure 6 shows that as the mortgage origination volume fell in 2007 and 2008, securitization rates keep increasing and reached 85% in 2009(Simkovic, 2011). There were estimated $6.5 trillion in MBS outstanding which make it as large as the Treasury market at that time (Fabozzi , Bhattacharya, and william S 72).
figure 7 shows in 2000, value of non agency (investment banks, commercial banks) mortgage-backed security starts increasing rapidly and overtaking agency mortgage-backed security in 2005(Simkovic). Investment banks pooled risky subprime loans and sold them as nonagency MBS which did not meet the qualification of the GSEs such as Fannie Mae. In order increase liquidity and split the risk of a loan pool, structured finance was created. Structured finance which divided MBS into tranches and investors who purchased these bonds will receive a portion of cash flow from the pool (Olender C3). The creation of the collateralized debt obligations further spread the risks to the entire financial market.
With the housing bubble burst, due to the extremely increased market value and high default rates of subprime mortgages, value of the MBS and CDOs declined caused the collapsed of private non GSE securitizes. Fannie Mae and Freddie Mac were placed into the conservatorship of the Federal Housing Finance Association on September 7, 2008. (Kidwell, Blackwell, Whidbee, and Sias 284).
Three large U.S. credit rating agencies, Standard poor’s, Moody’s and Fitch should take responsible for the cause of the financial crisis. These three rating agencies provided favorable ratings on the mortgage-backed securities that made by subprime mortgage loans. During 2000 to 2007, Moody’s gave Aaa rating to almost 45,000 mortgage-related securities and 83% of the mortgage securities that received an Aaa rating been downgraded eventually ("Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States" xxv). The market is heavy reliance on ratings, many regulations and laws require using ratings as a criterion for permissible investments. (Jickling 6). Many major firms and private investors blindly use rating as a guide when making investment decisions. Investors bought the high risk mortgage-backed securities and the CDOs which rated as Triple-A by rating agencies and believed they were put money in the low risk investments. As the result of extremely increased market value and high default rates for subprime mortgages, value of securitized subprime mortgage collapsed, private investors and financial institutions which heavily invested in those securities suffered huge losses.
Inherent conflict of interest that ratings agencies presented is the primary cause of the problem. Rating agencies are paid by their clients to rate their securities and bonds.In order to attract investors, investment banks paid huge fees to the rating agencies to obtain a desired ratings. For rating agencies, their revenues are closed related to the performance of those securities they rated.
According to the financial crisis inquiry report, during 2005 to 2007 about half of Moody’s rating revenues come from the rating of structured finance products such as mortgage-backed securities, Moody’s net income rose from $298 milliom in 2002 to $745 million in 2007("Economist", 2007 ).
This crisis could be avoided if the rating agencies do the right job. According to the U.S. Securities and Exchange Commission, on December 3, 2008, SEC approves a series of measures to increase transparency and accountability at credit rating agencies. "These comprehensive rules touch every aspect of the credit rating process – from conflicts of interest, to publication of ratings methodologies, to disclosure of ratings track records," said SEC Chairman Christopher Cox. ("SEC Approves Measures to Strengthen Oversight of Credit Rating Agencie")
Risky investment and excessive borrowing
Many financial institutions and private investors become vulnerable to this financial crisis since they were highly leveraged. Excessive debt leverage that allowed financial institutes such as banks and hedge funds to create assets composed of corporate and mortgage-backed securities.
During 2003 to 2007, many financial firms heavily borrowed funds and invested in mortgage backed securities and they believed that house price would continue to go upward.
In 2007, the five major investment banks-Goldman Sachs, Bear Stearns, Merrill Lynch, Lehman Brother and Morgan Stanley were reported have total $4.1 trillion in debt which counts 30% of USA nominal GDP (Duthel 87).
In 2007, two government-sponsored enterprises Fannie Mae and Freddie Mac have the highest leverage ratio which reached 75 to 1. At the same period, the five major investment banks were also operating with extraordinarily thin capital, their leverage ratio was as high as 40 to 1 which mean for every $40 in assets, there was only $1 in capital to cover losses. A 3% decline in value of total assets could destroy these firms. ("Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States" xix and xx).
The high leverage ratio by some financial institutions was deteriorated by the risky assets these firms were acquiring. For example, by the end of 2007, Lehman had cumulated $111 billion in risky assets which counted more than four times of its total equity, these risky assets includes the commercial and residential real estate holdings and mortgage-backed securities("Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States" xx).
Within the current financial system, due to the lack of transparency, the risks of heavy debt taken were magnified. These heavy borrowing activities were held off-balance sheet and in derivatives positions in order to hide from both investors and regulators. ("Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States" xx).
When the housing bubble busted, high leverage ratio, risky assets taken and lack of regulations pushed financial institutions to the edge of bankruptcy.
The exposure to subprime mortgage market loans and high leverage ratio make investment banks and other financial institutions face the serious consequence that they would lose billions of dollars and bankruptcy. The failure of these banks and financial institution could pose huge risk to broader economy and create a greater calamity for the country. In order to prevent that outcome and help ease the crisis, U.S. Government and Federal Reserve undertook various actions.
During the crisis, all the efforts and actions that the Federal Reserve made are following two principles which are increasing liquidity and maintaining the market functioning and using monetary policy to pursuit macroeconomic objective (Bernanke, 2008).
At the beginning stage, the Federal Reserve expanded its lending to address the significant strains in short-term money market by cut the discount rate by 0.5 %. The Federal Reserve also extended the maximum term for borrowing to 30 days in 2007 and further extended to 90 days in 2008 and could be renew at the request of the borrower (Bernanke, 2008).
Loans though discount window are different from the traditional open market operations which against government and agency securities with a limited set of dealers, loans though discount window are made directly to individual banks and against much wild range of collateral (Bernanke). However, many banks are unwilling to borrow thought discount window because these banks fear it would be seen as a negative sign about their financial condition (Bernanke, 2008).
In order to provider long term liquidity and meet the demands for term funding more directly, The Federal Reserve Board announced the creation of a Term Auction Facility (TAF). Under the TAF, The Fed auctioned 28 days or 84 days loans to depository institutions to provide term funds to a border range of counterparties ("Term Auction Facility (TAF)").
In March 11, 2008, after the collapse of Bear Stearns, The term Securities Lending Facility was created which will lend $200 billion of Treasury securities for 28-day terms to increase liquidity in Treasury and other collateral markets ( Federal Reserve Bank of St.Louis,The Financial Crisis) ("Term Securities Lending Facility").
In the same month, the Federal Reserve establishes the Primary Dealer Credit Facility (PDCF).The purpose of PDFC is to provide an overnight loan to primary dealers in exchange for a range of eligible collateral ("Primary Dealer Credit Facility").
Market Investor Funding Facility(MMIFF), Asset-Backed Commercial Paper Money Mutual Fund Liquidity Facility(AMLF) and Money Commercial Paper Funding Facility(CPFF), were established with the Term Asset-Backed Securities Loan Facility (TALF) to promote liquidity directly to investors and borrowers in key credit market("Federal Reserve's response to the financial crisis and actions to foster maximum employment and price stability").
With the creation a series of new tools and facilities, the Federal Reserve also expended its traditional tool of open market operations to support and maintain the functioning of credit markets. The Fed put downward pressure on long term interest rates and purchase of long term securities for the Federal Reserve’s portfolio to make broader financial condition more accommodative ("Federal Reserve's response to the financial crisis and actions to foster maximum employment and price stability").
After the bankruptcy of the Lehman Brother, both investment banks and commercial banks had received estimated $300 billion from the Federal Reserve though the Primary Dealer Credit Facility (PDFC) and Term Securities Lending Facility (TSLF) ("Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States" 371).
However this $300 billion only promote liquidity, it could not fill the huge capital loss of these financial institutions. The market filled with uncertainty and Investors have no idea about which financial institutions could survive this crisis. It is very important that keeps capital markets open and lender continue to lend. Under this situation, Troubled Asset Relief Program (TARP) was created to stabilize the financial market("Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States" 371).
TARP was authorized by Congress through the Emergency Economic Stabilization Act of 2008 and is overseen by the office of Financial Stability at the U.S. Department of the Treasury(U.S. Department of the Treasury, about TRAP).TARP allows government bailout of the U.S. financial system by purchase illiquid assets and equity from financial institutions to make them survive the crisis. It’s encouraging banks to resume lending activities. $700 billion was originally authorized to TARP program. According to the Congressional Budget Office only $431 billion will be ultimately disbursed. This $431 billion includes $417 billion that has been disbursed and $14 billion in additional project disbursements ("Report on the Troubled Asset Relief Program—October 2012").
Undeniable Troubled Asset Relief Program played a key role in settle this financial crisis and obtained the expected result. However, TARF program is a double blade, because it allowed government funds into the U.S. banking system to stabilize the financial market, it created a moral hazard. Government bailouts create a signal to financial institutions that if it collapses will cause a chain reaction and will sufficient affect entire financial market, government will provide support. The concept of "Too big to fail" creates an incentive for large financial institutions to take more risk, because the government and taxpayer will bear the loss.
Impact on China
The 2007 financial crisis accelerated the pace of economic contraction in the U.S. By December 2008, unemployment rate in the U.S. hit the 7.2% up from 4.4% before recession (Amadeo). The unemployment rate continues growth under the aftershock of the crisis and reached the 10% in October 2009 which is the highest rate in the past 26 years ("Bureau of Labor Statistics")
Although financial innovation and diversification such as asset-backed securities, collateralized debt obligations and other derivatives reduce some risks, but it created more uncertainty and spread risks worldwide.
With the crisis become more and more severe, most countries in the world are affected by the crisis. China is one of these countries hit by the blast wave of the crisis.
Due to the lack of transparency of China investment Banks and some financial institutions, it is difficult to get enough data to figure out what kind of level these financial institutions involved in the U.S mortgage-back securities market. Since China government put heavy regulations on the domestic financial institutions which engage in offshore credit derivatives trading, the amount of U.S. MBS that these financial institutions held are not enough to cause any huge damage to the firms. But the total losses for the banks and financial institutions still not a small number. According to The U.S. department of housing and urban development, until June 2006, China held 107.5 billion in U.S. MBS, up from $3 billion in 2003 and the number only include securities offered by Fannie Mae, Freddie Mac and Ginnie Mae (Lau, 2007) The total number should be higher if add the subprime and alternative A-paper that held by China investment banks and other financial institutions.
The impact on china stock market is huge, according to Bank of America, in October 2008, the collapse in U.S. subprime housing market led a 7.7 trillion loss in global stock market (Burgess, 2008). Average stock markets have a 7.83% declined in developed countries. For China there is a 21.4% declined in the stock market ("XINHUANET", 2008). Huge declined in China stock market caused the turmoil in domestic market which further threatens the stability of China financial market.
U.S. subprime crisis also reduced china’s export volume. In the fourth quarter of 2007, China’s export growth fall by 6% compared with the first three quarter ("XINHUANET", 2008). China’s export has a large percentage of the GDP, the declined of China’s exports has a direct impact on China’s economic growth.
As response, on November 9, China government starts to loosen credit conditions, cut tax and introduce a 4 trillion (647 billion U.S. dollar) yuan stimulus package to boost economy and help sustain the global economic growth (Li, and Wong, 2008). A considerable amount of 4 trillion yuan flowed into China housing market poured oil on the already overheated house price. As the result, the house price increased roughly 40% in Shanghai and Beijing. A famous financial commentator Tan Ye said "the growth rate of China house price are 5 times the GDP growth rate." A China housing bubble gradually formed. The burst of bubble is only a matter of time.
In order to prevent the occurrences of another financial crisis, China government starts to put more restrictions on China housing market, such as substantially increased down-payment for purchasing second house, implement a 20% capital gains tax on sales of second houses (Fung A12) A series restrictions and tighten credit regulations for home purchasing weaken the house price but also slowed the construction industry which will cause a decline in economic growth of China. It becomes a challenge for China government to balance the house price and development of the construction industry.
Although the financial crisis 2007 caused certain damages to China economy, I think the opportunities that this crisis brings to China cannot be ignored.
The aftershock of the U.S subprime crisis still has it impact on developed countries, the development and growth of some largest financial institutions and banks limited by the capital loss and lack of confidence of investors. It gives China financial industry an opportunity to shorten the gap between the world’s leading financial institutions. According to the Forbes Global 2000, JPMorgan Chase, the world’s largest company in 2011 moves down to No.3, instead Industrial & Commercial Bank of China moves up to No.1 as the world’s biggest company for the first time. China Construction Bank moves up to No.2. And Agricultural Bank of China is on No.8(DeCarlo, 2013).
The 2007 finical crisis provides a good opportunity for China to learn from the world’s leading developed countries by analyze their crisis responses and monetary policy. With the increased strength of China financial industry, it will lead a transformation of China’s economic structure.