Mo r ho lt |1

Michelle Eva Morholt Prof Wilson ECON 1010 July 24, 2012

Our House of Cards: Assessing the Recession of 2008-09

The global financial crisis that boiled over in September, 2008 has had systemic effects and catapulted economies around the world into recession. The foundations of this crisis were laid well before the domino effect of the bankruptcies suffered by American consumers and producers alike, as well as banks, municipalities, and government institutions. The resulting firestorm has had a far reaching effect that the world economy is still reacting to and recovering from. This weeks current events regarding the continuing LIBOR scandal1 only provides more evidence that we may very well still be in the heart of this debacle. In an attempt to understand this continuing whirlwind of this financial disaster, this report will summarize the major contributing factors of our ongoing global crisisthe American housing and credit bubbles and the practices of national and international banking institutions. Building Houses of Cards
Fig. 1. Harvard University State of the Nationss Housing Report 2008. Source: Data from US Census Bureau as reported by Harvard University. Web. July 19, 2012. http://www.census.gov/hhes/www/housing/hvs/historic/index.html

In an effort to stimulate the economy and encourage aggregate

London Interbank Offered Rate is determined by leading banks in London, namely Barclays. LIBOR is the average interest rate estimated that would be charged to banks if they borrowed money from other banks. A study conducted by the Wall Street Journal in May 2008 (Mollenkamp et al.) first reported the banks may be attempting to make the banking system appear healthier than it was. It has been proposed a blind eye was turned to these practices because many banks sought to make substantial profits on their large Libor interest linked portfolios.

Mo r ho lt |2

demand, our government has implemented Keynesian theory via fiscal and monetary policies over the past half century. Recently, the credit boom initiated by monetary policies of The Federal Reserve lowering interest rates peaked in mid-2007 and continued to historic lows by 2010 (Schiller, 243). This trend is continued today with mortgage rates at the time of this report ranging from all time lows of 2.3% to 3.25% for 15 to 30-year mortgages.2 With conditions that made it easy to obtain credit, banks began to issue large amounts of mortgages (Fig 1). The result of Americans obtaining low interest mortgages, which is essentially cheaper money, enabled Americans to accrue real assets and wealth (Fig. 2). Consequentially, this influenced housing prices to steadily rise every year from 2001 to 2006 (Schiller, 238). In an article entitled CSI: Credit Crunch, it was reported that between 1997 and 2006, the price of the typical American house increased by 124% (The Economist). This access to easy credit was not only taken advantage of by the average American. Financial institutions also over extenuated and over leveraged their balance sheets. Quite rapidly, Americans were taking on unprecedented debt loads.

Houses of Cards Collapse Our credit saturated economy

was further undermined by the

Fig. 2. Median and Average Sale Price of New Homes Sold in US. (2011). Source: United States Census Bureau. Web. July, 21, 2012. http://www.mediafire.com/view/?2rpufd8gvjwjz8k

Current 15 year refinance and 30 year home purchase mortgage rates as of July 20, 2012. http://www.mortgagenewsdaily.com/mortgage_rates/

Mo r ho lt |3

meltdown of subprime mortgages3 and securitized products. Suddenly, almost overnight, the real wealth and leverage to obtain credit for the over extenuated American consumer vanished. By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak (United States Department of Commerce). As prices declined, borrowers with adjustablerate mortgages4 could not refinance to avoid the higher payments associated with rising interest rates and began to default. Foreclosures on properties increased 79% from 2006 to 2007 involving nearly 1.3 million properties (RealtyTrac). But that was just the beginning. In 2008 another 2.3 million foreclosures occurred (RealtyTrac). From August 2008 to September 2009, U.S. mortgages that were either delinquent or in foreclosure had risen from 9.2% to 14.4% (Mortgage Bankers Association). The housing bubble did not merely pop, it exploded.

Financial Institutions Falter As the American dream of home ownership was crumbling, financial institutions began to show signs of
Fig 3. Source: Data is the 2007 Annual Reports (SEC Form 10K) for each firm. Web. July 22, 2012.

weakness. Highly leveraged banking firms were continually engaging in risky investments. The above visual (Fig.

3 4

A subprime mortgage refers to mortgages offered to less than creditworthy borrowers. Abbreviated as ARMs and also known as variable-rate mortgage, or tracker mortgage are mortgages where the interest rate is periodically adjusted based on an index that reflects the cost to the lender of borrowing on the credit markets.

Mo r ho lt |4

3) clearly depicts how rapidly and thoroughly banks engaged in this irresponsible behavior. Clearly we can see how each of the five largest investment banks5 took on greater risk leading up to the subprime crisis. A high leverage ratio6 indicates more risk. From 2003-2007, these firms drastically increased their leverage ratios. Typically, a conservative bank takes on a leverage ratio of 10-15. These firms had ratios approaching 30. The resulting concerns about the health of financial institutions became a full-blown banking panic following the failures of the three major US investing banks, Bear Sterns, Lehman Brothers and Merrill Lynch (Eatwell, 7). Subsequently, other major banking titans like Washington Mutual, Wachovia and Citigroup crumbled. Prominent financial investment institutions, Goldman Sachs and Morgan Stanley, in an effort to avoid similar fates converted to commercial banks (Eatwell, 8). Government takeovers of Fannie Mae, Freddie Mac, and AIG only further exasperated consumers and lenders alike. Although the panic subsided briefly after a variety of government fiscal and monetary actions to promote the liquidity and solvency of the financial sector, prices across most asset classes and commodities continued to fall drastically, the stock markets have severely suffered, the cost of corporate and bank borrowing rose substantially, and financial market volatility rose to levels that have rarely, if ever, been seen. The Aftermath A wide range of sources from the United States National Bureau of Economic Research, to popular news sources like Time Magazine, to President Obama; claim that the recession and financial crisis that erupted December 2007 was extinguished quickly. On January 27, 2010, in his State of the Union Address, President Barack Obama assured the American citizens the markets are now stabilized, and we've recovered most of the money we spent on the banks

5 6

Bear Sterns, Lehman Brothers, Goldman Sachs, Morgan Stanley, and Merrill Lynch. Leverage ratio is the ratio of total debt to total equity.

Mo r ho lt |5

(Obama). While economists and other policy makers have a greater understanding of the reasons for the recessions on 2008-09 and the necessary actions to remedy the subsequent financial crises that culminated after the housing market fell, the average American has yet to be convinced we have fully recovered. Although the latest consumer indexes have increased to 1.7% this June, a gain of almost 2% from the all-time low consumer confidence of -0.4 in 2009, Americans are still economically strapped and weary to spend (United States Census Bureau). Unemployment rates continue to disappoint, as we saw this past month, which reported that over 12.7 million Americans are unemployed5.4 million of which are considered to be long-term unemployed of 27 weeks or more. This June 80,000 jobs have been added to the employment sector, however unemployment rates have remained 8.2%, unchanged from the previous month (U.S. Bureau of Labor). In conclusion, the aftermath of the Recession of 2008-09 and the tactics of solving the financial crisis, has left a lot of Americans uncertain of the future and angry. Every American and world economy has been affected by the Recession 2008-09. As America diligently attempts to restore the prosperity we enjoyed in the late 90s, contentions continue to rise in the wake of scandals such as LIBOR7, response to bonuses paid to executive who represented companies that received government bailouts8, and occupy Wall Street. Perhaps fiscally we are on track to a full recovery of this recession. However, our emotional and mental psyches have yet to heal. Disillusion, mistrust, and a nation divided are other economic costs that remain to be remedied from this disaster.

It is the opinion of this author that there is no problem with banks making profits. However, one should make money off of the bet, not rigging the bet. 8 It is the opinion of this author that this practice has further disillusioned Americans. Who amongst us has ever been so exorbitantly rewarded for so thoroughly failing and disrupting world economies and individuals?

Mo r ho lt |6

Works Cited Annual Percent Changes From Prior Year in Consumer Price Indexes (CPI-U)--Selected Areas: 2010. (June 2010). United States Census Bureau. United States Department of Commerce. Web. July 23, 2012. http://www.census.gov/compendia/statab/2012/tables/12s0726.pdf CSI: Credit Crunch. (October 18, 2007). The Economist. Economist Newspaper Limited, London. Web July 21, 2012. http://www.economist.com/node/9972489?story_id=9972489 Delinquencies Continue to Climb in Latest MBA National Delinquency Survey. (November 19, 2009). Mortgage Bankers Association. Web. July 21,2012. http://www.mbaa.org/NewsandMedia/PressCenter/71112.htm Eatwell, John. 2008--Banking Crisis, 2011--Sovereign Debt Crisis: Two Sides Of The Same Coin?. JASSA: The Finsia Journal Of Applied Finance 4 (2011): 6-10. EconLit. Economist-A Helping Hand to Homeowners (October 23, 2008). The Economist. Economist Newspaper Limited, London. Web July 21, 2012. http://www.economist.com/finance/displaystory.cfm?story_id=12470547. The End of the Affair. (October 30, 2008). The Economist. The Economist Newspaper Limited, London. Web July 20, 2012. http://www.economist.com/node/12637090?story_id=12637090 Harvard University State of the Nationss Housing Report 2008. Image. Data from US Census Bureau as reported by Harvard University. Web. July 19, 2012. http://www.census.gov/hhes/www/housing/hvs/historic/index.html Median and Average Sales Prices of New Homes Sold in United States. (2006). United States Census Bureau, United States Department of Commerce. Web. July 19,2012. http://www.census.gov/const/uspriceann.pdf Median and Average Sale Price of New Homes Sold in US. (2011). Image. Source: United States Census Bureau. United States Department of Commerce. Web. July, 21, 2012. http://www.mediafire.com/view/?2rpufd8gvjwjz8k Moessner, Richhild and William A. Allen. "Banking Crises and the International Monetary System in the Great Depression and Now." Financial History Review 18, no. 1 (2011): 120. Web. July 19,2012. http://search.proquest.com/docview/856893828?accountid=14989 Mollenkamp, Carrick; Whitehouse, Mark (May 29 2008). Study Casts Doubt on Key Rate. The Wall Street Journal. Web. July 19, 2012. http://online.wsj.com/article/SB121200703762027135.html

Mo r ho lt |7

RealtyTrac Press Release 2008FY. RealtyTrac. (January 15, 2009). Web July 19,2012. http://www.realtytrac.com/content/press-releases/foreclosure-activity-increases-81percent-in-2008-4551?accnt=64847
Schiller, Bradley R. (2011). Essentials of Economics. 8th ed. Boston: McGraw-Hill/Irwin, Print.

State of the Union Address: President Barack Obama. (January 27, 2010). Web. July 23, 2012. http://photos.state.gov/libraries/ukraine/164171/pdf/state_union10.pdf US Economy Adds 80K Jobs in June, Unemployment holds at 8.2%. (June 6, 2012). TradingEconomics.com, U.S. Bureau of Labor. Statistics report of June 2012. Web. July 24, 2012. http://www.tradingeconomics.com/united-states/unemployment-rate US Foreclosure activity increases 75% in 2007. (January 29, 2008). RealtyTrac. Web. July 19, 2012. http://www.realtytrac.com/content/press-releases/us-foreclosure-activity-increases75-percent-in-2007-3604?accnt=64847