James Miller

10/8/2014
Housing Prices and the Financial Crisis
The early 2000s were a great time for banks. The FED was keeping interest rates low, with the
intent of keeping unemployment down. As a result, banks were willing to make more loans, such as
mortgages. In addition, housing prices were increasing rapidly. A rapid increase in the price of a house
will make the real value of the loan lower, allowing banks to make riskier loans without necessarily
incurring huge costs to themselves. Additionally, several techniques for increasing return on
investment were gaining popularity. Mortgage Based Securities (MBSs) bundled together thousands of
mortgages, making them a safer investment than individual mortgages. Collateralized Debt
Obligations (CDOs) enabled financial insitutions to bundle together loans to draw investors at multiple
interest rates. Senior holders of CDOs got paid first, but at lower rates. If the investment financed by
the CDO was profitable enough, the Junior holders got paid as well at their respective interest rate, and
so on. This was great for banks, because, like an MBS, a CDO allowed investors to put their money in
a supposedly diversified pool, rather than a single all-or-nothing investment. However, as we will
see later, CDOs were often not as diversified as they should have been.
Around 2006, housing prices stopped increasing and began to decline. This created a huge
problem within the loan market. The risky, or subprime, mortgages that banks had been issuing had
been even riskier than they originally thought. As the value of homes decreased, many homeowners
found themselves in possession of homes worth less than their mortgages. Others simply defaulted on
their loans, since they were issued in such a way as to draw the borrower in. The mortgage had a low
initial interest rate, but was variable and sharply rose a few months or years later, resulting in borrowers
being simply unable to pay. These defaults decreased the value of MBSs and CDOs held by banks and
investors. However, due to the size and complexity of these CDOs (some were MBSs within CDOs
within CDOs), it was extremely difficult to accurately assess which CDOs contained subprime
mortgages and which did not. Consequently, investors became unwilling to invest in CDOs containing
MBSs or the financial institutions which held those MBSs.
Faced with a rapid decrease in the value of their assets, banks began slipping dangerously close
to bankruptcy. They had not anticipated this downturn and had implemented several policies which
made its effects even more severe. They encouraged managers to take high risk high reward chances
by rewarding them for high returns. So, they found creative solutions, such as increasing the bank's
leverage by dumping high risk assets into virtual daughter companies, which were not legally required

to have a percentage of their liabilities on hand in liquid capital. This made the bank's potential profits
higher, but the decrease in asset value brought banks closer to bankruptcy much faster than they had
anticipated. Additionally, wholesale funding, designed to allow banks to purchase assets by borrowing
from other institutions, presented yet another point of possible failure. As more and more banks
approached bankruptcy, the remainder became increasingly unwilling to provide short-term loans.
When the struggling banks' creditors demanded their money, they had no choice but to sell assets for
much less than they were worth, decreasing the value of similar assets across all financial institutions,
and making the problem spiral even further out of control.
In devising a solution to this downward spiral, we must consider its ongoing causes: extremely
low capital-to-asset ratios, and a general distrust among financial institutions and investors. The first
can be countered by folding the imaginary banks into their real parents, and requiring the bank to keep
enough capital on hand for ALL its assets. The federal regulations were there to prevent this kind of
spiral, and the banks' circumvention of that safety feature contributed to the downward spiral.
Additionally, the government may need to supply some initial fund of liquid money to halt the
immediate downturn in essence, increase government spending by printing more money. This would
not affect any real values besides private saving, but since all the money is going to banks, it increases
total investment by more than private savings would decrease. On the fiscal side of policy, they could
decrease the interest rate on treasury bills to make investment in banks the only profitable option.
Increasing interest payments on reserves would also help encourage banks to keep more capital on
hand, though by the time the policy is implemented, I think most banks would have realized that they
needed to hold on to more capital. The trust issue would also likely be resolved by the above policies.
As long as the banks' stores of capital increase to a reasonable amount, people will no longer suspect
that they are about to fail, and will be more willing to invest in the bank.
As it turns out, the Federal Government responded very similarly to the plan outlined above.
They had banks take on their imaginary child banks' assets and debts, and loaned the banks large
amounts of money to stop them from going bankrupt. They decreased the value of a treasury bill.
Something they did that I did not think of was to increase the value of deposit insurance from $100k to
$250k. This would have also helped encourage people to invest more money in banks, since it would
be insured by the government.