4.4 SOME NOTEWORTHY FINANCIAL CRISES
4.4.11 The Great Recession
The United States faced a deep and lengthy recession after the dot-com crisis and the consequent bear market. Allan Greenspan, then chairman of the Federal Reserve, through a succession of aggressive interest rate cuts, replaced one bubble – dot-com bubble - with another -real estate bubble. By considerably lowering the interest rates and standards of lending, the government of the United States escalated a colossal credit bubble which encouraged consumer spending and fueled rapid real estate price appreciation as well as the global economy, which eventually crashed and led to the worst financial crisis since the Great Depression (Knight, 2014).
According to Knight (2014), the seeds of the Great Recession were planted 80 years prior, during the Great Depression. Roosevelt’s administration acknowledged the importance of the housing industry to the whole economy. This is because of the fact a vibrant housing industry has a positive impact on other quarters of the economy namely: timber, consumer appliances, professional trades as well as the other services and materials needed for building and furnishing a home.
The Federal National Mortgage Association (FNMA), generally called “Fannie Mae” was established in 1938 in line with Roosevelt’s New Deal with a mandate to buy up mortgages from the banks, convert these mortgages into securities which are then sold to investors in the secondary public markets (Hagerty, 2012). The banks then could still have a decent cash reserve available for lending as opposed to it being locked up in a slow albeit continual stream of cash flow spanning a 3- year period. Fannie Mae was a government-sponsored entity (GSE), but it was also an independent corporation and became a publicly traded corporation in 1968.
Federal Home Loan Mortgage Corporation (“Freddie Mac”), another GSE was established in 1970 to buy mortgages from the secondary market, convert them into securities, and sell them as mortgage backed securities (MBS) (Acharya et al., 2011).
Page | 79 The United States federal government has a history of offering incentives for purchasing and owning homes. As an affirmation of policy, the government in 1992, stipulated that a portion of mortgage purchases by Fannie Mae and Freddie Mac be committed to purchasing affordable housing with the goal of helping low-income Americans who otherwise would not have qualified, to obtain mortgages. The government further directed a portion of mortgage purchases by the Department of Housing and Urban Development (HUD) should be committed to affordable housing. By 2008, Fannie Mae and Freddie Mac had committed 58% of mortgage purchases to affordable housing, up from 30% in 1992. The two institutions eventually had $5 trillion in low-income as well as minority loan commitments (Knight, 2014, Pezzuto, 2016).
Figure 4.3: US Mortgage Lending from 1997 - 2007
Source: U.S. Census Bureau and Harvard University (2008: 4)
Apart from mortgage interest qualifying for deduction for tax purposes, there was an additional benefit of tax-free capital gains included in the tax code for homeowners initially introduced in July 1978 which allowed up to $100,000 tax-free capital gain for people who are 55 years or older. The tax exemption increased to $250,000 and $500,000 for an unmarried person and for a married couple respectively in 1997 (Burman, 2010, Knight, 2014).
Page | 80 This ignited interest in investing in real estate. Falling interest rates also fuel the increase in mortgage loans which encouraged people to invest in real estate. Interest rates was above 18%
in 1982 for customers with some high creditworthy records. However, over the following three decades, interest rates declined persistently. After the dot-com crisis, the Federal Reserve adopted an assertive stance on reducing interest rates, and reduced its interest rate to 1%. As interest rates dropped mortgage payments became affordable (Knight, 2014).
Despite the economic slump in 2001—2002 the oil-producing countries, and the world in general still had lots of cash, and were seeking places to invest this wealth. Persistent decline in interest rates meant the $70 trillion invested in fixed-income vehicles were generating paltry rates of return. These monies were meant for safe, non-speculative reasons, and the managers were constantly seeking investments offering relatively higher yields as well as safety. The creative finance industry designed Credit Default Swaps (CDS) and Collateralized Debt Obligations (CDOs) which were made up subprime mortgages which in turn were given the blessings of the ratings agencies as high-grade securities. These monies seeking higher yields were poured into the creative investments although some underlying mortgages were classified as SIVA (Stated Income, Verified Assets) where the borrowers could declare any amount of income they pleased and only had to prove they had a job and cash in their bank accounts;
NIVA (No Income, Verified Assets) where only a proof of bank account was retired to secure a mortgage; NINA (No Income, No Asset) where no proof of assets or income was required to secure a mortgage (Knight, 2014).
With the Dot-com crises and the September 11 attacks now years away, and the United States economy performing very well, the Reserve Bank started making upward adjustments to interest rates which was at a historical low of 1%. This was done in small steps but consecutively for 17 times, increasing the Fed rate from 1% in 2004, to 5.25% in 2006 (Knight, 2014). Increasing interest rates implied increasing payments for mortgages all over the country, and majority of these had adjustable mortgage rates. The situation was even grimmer worse for those with subprime loans, as the low “teaser” rates, were replaced with even higher interest rate payments upon expiration (Knight, 2014).
Eventually, the safety of these investment vehicles was exposed when the default rates of the underlying mortgages began to increase triggering panic and eventually a crisis. The year 2008 was the severest stage of the mortgage meltdown and financial crisis, with trillions of dollars
Page | 81 wiped out in the United States. Several banks and other financial institutions heavily exposed to these securities collapsed or had to seek bailout form their governments. Notable among these banks and financial institutions were Lehman Brothers which was acquired by Nomura Holdings, Bear Stearns also acquired by JP Morgan Chase, Fannie Mae, Freddie Mac, which were bailed out by the United States government.