U.S.

Subprime Mortgage
Crisis: Policy Reactions

Abinash Mishra
B23005

10/25/2023
1. Case Background

U.S. Subprime Mortgage Crisis: Policy Reactions (A)

The US subprime mortgage crisis of the late 2000s was a pivotal event in the global financial
landscape. It was characterized by a housing boom, marked by low-interest rates and a surge
in housing prices, particularly in the early 2000s. The subprime mortgage market played a
significant role during this period. Subprime mortgages were loans offered to individuals
with poor or no credit histories, often at higher interest rates. The availability of these loans,
in combination with historically low-interest rates, led to a housing frenzy, with many
borrowers assuming they could refinance at favourable rates in the future. Financial
institutions seeking higher returns ventured into the subprime market and introduced
innovative financial products, such as "collateralised debt obligations" (CDOs), which
bundled these mortgages and were highly rated by credit agencies.
Hedge funds and international financial institutions actively engaged in this market, fueling
demand for these securities and exposing themselves to subprime-related products. However,
concerns about inflation led the US Federal Reserve to raise interest rates, reaching 5.25% by
mid-2006. This increase significantly burdened homeowners, especially those with subprime
mortgages, leading to a rise in mortgage defaults and home foreclosures.
The crisis began to unfold in 2007, with the bankruptcy of New Century Financial and the
shutdown of hedge funds at Bear Stearns heavily involved in subprime mortgages. Panic
spread globally as investors realised the magnitude of the subprime mortgage problem,
resulting in a credit crunch that affected significant Wall Street firms. The crisis prompted
unprecedented actions by central banks, including the US Federal Reserve and the European
Central Bank, injecting vast sums of money into the market. Despite these efforts, the crisis
persisted, forcing some major financial institutions to write off billions of dollars in
mortgage-related losses, leading to CEO resignations.
This economic report will delve deeper into the causes and consequences of the US subprime
mortgage crisis, examining the financial instruments, institutions, and policy responses that
shaped this significant event in economic history.

U.S. Subprime Mortgage Crisis: Policy Reactions (B)

By March 2009, a year had elapsed since the US Federal Reserve Board (commonly known
as the "Fed") had orchestrated JPMorgan Chase's acquisition of Bear Stearns, attempting to
mitigate the subprime mortgage crisis. However, the situation had deteriorated significantly.
Central pillars of America's financial system, such as Lehman Brothers and insurance giant
AIG, had faltered, plunging the United States into its most severe financial crisis and
recession since the Great Depression. With over five million jobs lost, a substantial wealth
erosion, and a profound decline in consumer confidence, the nation faced an unparalleled
economic challenge.
In response, the Bush administration launched efforts to rejuvenate the economy, including
advocating for a stimulus package and establishing lending programs to support debt-
burdened banks. The Fed had pushed interest rates to near zero and expanded its asset
purchase program to unlock credit markets and restore confidence. Yet, as the economy
displayed minimal signs of a swift recovery, the responsibility for charting a course forward
had fallen to newly inaugurated President Obama. One of his initial priorities was the rapid
pursuit of a massive $787 billion bailout package within a month of taking office.
As we delve into the second part of this economic report, we will scrutinise the efficacy of
various rescue plans. We will explore what must be done to address the beleaguered financial
system, whose woes originated in the subprime mortgage crisis that erupted in 2007.
Furthermore, we will examine the short- and long-term consequences of the new stimulus
measures, which generated intense debates about the rise of nationalism and protectionism.
This section will offer a comprehensive analysis of the monetary, fiscal, and other policies
implemented to confront the US subprime mortgage crisis, shedding light on their impacts
and the broader economic landscape.

2. Three critical Issues and challenges discussed:

The three most critical issues observed during the subprime US mortgage crisis are:

1. Financial Crisis Management: The primary challenge discussed in the case is

managing a financial crisis effectively. The 2008 subprime mortgage crisis and its
aftermath serve as a backdrop to this discussion. Managers faced the challenge of
responding to a rapidly deteriorating financial environment, including a credit market
freeze, bank failures, and a severe economic downturn. The critical issue was
navigating through this crisis, stabilising financial institutions, and preventing further
economic damage.
2. Government Intervention and Regulation: The role of government intervention and
regulation was a key challenge. The case discussed the Troubled Asset Relief
Program (TARP) and other government policies to stabilise the financial sector.
Managers needed to understand and adapt to changing government regulations and
procedures, as these could significantly impact their businesses. The challenge was to
align business strategies with government actions and requirements.
3. Economic Uncertainty and Risk Management: Managing in an economic
uncertainty and risk environment was a recurring theme. The case emphasised the
importance of risk management and the need for businesses to be prepared for various
economic scenarios. Managers had to grapple with risk assessment, financial stability,
and long-term planning issues. The critical challenge was making strategic decisions
and investments to bring business resilience in economic turbulence.
These critical issues and challenges reflect the complexities of managing during a financial
crisis and underscore the importance of adaptability, risk management, and adequate
decision-making in such turbulent times.
3. Case Analysis and Interpretation

U.S. Subprime Mortgage Crisis: Policy Reactions (A)

Anatomy of failure:
Key Issues Leading to the Subprime Mortgage Crisis:
1. Monetary Policy:
 Issue: Expansionary monetary policy during the early 2000s with prolonged
low-interest rates.
 Views:
 Some experts criticised the Federal Reserve for not raising interest
rates sooner, believing it could have prevented the housing bubble.
 Divergent opinions on whether the Fed's actions were justified, with
some arguing it was a response to economic challenges like potential
deflation.
 The "conundrum" of long-term interest rates not rising as expected
during rate hikes.
 Debate over the role of consumer expectations and the "global savings
glut" in shaping long-term rates.
 Disagreement on whether central banks should target asset prices to
prevent bubbles.

2. Financial Supervision:
 Issue: Poor regulation and oversight of financial institutions, particularly non-
traditional entities.
 Views:
o Critics highlighted the lack of regulation over investment banks, hedge
funds, and complex financial products.
o State-chartered mortgage companies wrote subprime loans with limited
supervision.
o Concerns about conflicts of interest in the rating agency industry.
o Debate on the effectiveness of regulatory attempts and whether more
regulation could have prevented the crisis.
o Observations on the prevailing belief in minimal regulation while financial
markets were profitable.

3. Compensation and Risk-Taking:

 Issue: The financial compensation system incentivising risk-taking.
 Views:
o Raghuram Rajan argued that compensating employees regardless of losses
encouraged risky behaviour.
o Observations that huge bonuses based on short-term performance created
incentives to disguise risk-taking as value creation.
These dimensions highlight the multifaceted nature of the subprime mortgage crisis, with
varying perspectives on the root causes, the actions of the Federal Reserve, the role of
financial supervision, and the impact of compensation systems on risk-taking. Differing
opinions reflect the complexity of the crisis and the ongoing debates about how to prevent
such events in the future.
Fighting the fire:
Potential Solutions Considered by the US Government for Handling the Various Crises:
Monetary Policy:
Solution No. 1:
 Merit: A lower interest rate would revive liquidity and encourage lending.
 Demerit: Loose monetary policy could lead to a weak dollar, potentially increasing
the current account deficit.
Solution No. 2:
 Merit: Focusing on inflation control preserves price stability.
 Demerit: Slower economic growth or recession could result.
Solution No. 3:
 Merit: Maintaining the commitment to price stability and anti-inflation efforts.
 Demerit: Prolonged and costly recessions may be the outcome.
Solution No. 4:
 Merit: Being cautious with liquidity injections helps prevent moral hazard.
 Demerit: Limits the effectiveness of liquidity support.
Solution No. 5:
 Merit: Carefully evaluating the government's role in financial institution rescues can
maintain financial stability.
 Demerit: This may encourage irresponsible financial practices if not appropriately
managed.

Fiscal Policy
Solution No. 6:
 Merit: Fiscal stimulus directly benefits households and individuals, mitigating the
risks associated with low-interest rates.
 Demerit: Challenges ensuring the stimulus is timely, targeted, and temporary.
Solution No. 7:
 Merit: Targeting fiscal aid at low-income consumers and unemployed workers
increases consumer spending and stimulates economic growth.
 Demerit: Potential disagreements over effectively targeting and distributing the aid.
Financial Regulation
Solution No. 8:
 Merit: Strengthening regulations enhance transparency in the financial sector.
 Demerit: This may lead to debates over government intervention in the free market.

Housing Sector Solutions

Solution No. 9:
 Merit: Addressing the root problems in the housing sector encourages consumer
spending and investment.
 Demerit: Risks creating additional bad loans and burdening taxpayers.
Solution No. 10:
 Merit: Allowing bankruptcy judges to alter mortgage terms and facilitating borrower
transitions to more affordable government-backed loans assists homeowners facing
foreclosure.
 Demerit: Opposition from those who argue it may bail out investors, lenders, or
speculators.
These potential solutions encompassed monetary and fiscal policy measures, financial
regulation, and housing sector-focused approaches. The government had to weigh their
respective merits and demerits to address the various crises effectively.

U.S. Subprime Mortgage Crisis: Policy Reactions (B)

Various Monetary Policy Tools Considered by the Federal Reserve for handling the crisis
were:
1 - Interest Rate Cuts:
 Description: Aggressively cutting interest rates, lowering the Fed funds rate by a
whole percentage point to 1%.
 Downsides: Risk of a weak dollar and inflation if not managed effectively. Limits
effectiveness once interest rates near zero.
2 - Quantitative Easing:
 Description: Implementing quantitative easing by directly buying government and
other bank assets, including mortgage-based securities.
 Downsides: The risk of inflation when growth resumes. Rapid action is needed to
withdraw the pumped money. Sceptics question limited effectiveness.
3 - Expanding Asset Purchases:
  Description: Expanding the types of assets purchased from financial institutions,
including debt, mortgage-backed securities, long-term bonds, and consumer loans.
 Downsides: Possible concerns about the assets' quality and valuation. Expanding the
balance sheet further carries potential risks.
4 - Term Auction Facility (TAF):
 Description: Implementing TAF to inject funds into depository institutions by
auctioning short-term, collateral-backed loans.
 Downsides: Potential moral hazard if financial institutions take excessive risks due to
low borrowing rates. Complexities in managing the TAF program.
5 - Term Asset-Backed Securities Loan Facility (TALF):
 Description: Establishing TALF to lend up to $200 billion to support new securities
backed by auto, student, or credit card loans.
 Downsides: Risk of moral hazard, potential burden on taxpayers, and complexities in
evaluating the quality of underlying assets.
6 - Long-Term Treasury Securities Purchase:
 Description: Announcing a plan to buy long-term Treasury securities to reduce yields
on long-term deposits.
 Downsides: Concerns about the Fed's balance sheet size and its impact on the
economy. Possible inflation risks.
Each monetary policy tool had its downsides and risks, including the potential for inflation,
challenges in managing the balance sheet, and concerns about moral hazard and the quality of
underlying assets. Sceptics also questioned the effectiveness of some tools, and the
unprecedented scale of the actions raised concerns about their long-term consequences.

Various Fiscal Policies Undertaken to Steady the US Economy:

1 - Troubled Asset Relief Program (TARP):
 Description: The US government initiated the TARP, a $700 billion financial bailout
program, to address the turmoil in the financial sector. The original intent was to
purchase troubled financial assets, but it later shifted to directly investing $250 billion
in banks by buying preferred shares.
 Downsides: Controversy arose over rewarding financial institutions for reckless
behaviour and a lack of conditions on fund usage. Some criticised the program for not
addressing housing market issues, massive foreclosures, or lousy bank balance sheet
loans. It was poorly executed, and its impact on lending was questioned.
2 - Support for Automakers:
 Description: The TARP program extended to provide financial assistance to
struggling US auto giants General Motors and Chrysler to prevent them from going
out of business.
 Downsides: Critics questioned why the auto industry received support and why more
was not done to help homeowners facing foreclosure or the average taxpayer. The
allocation of funds to automakers raised concerns about the program's direction.
Overall, the TARP program generated more criticism than praise, with questions about its
effectiveness, the allocation of funds, and the lack of conditions for the financial institutions
receiving assistance. Many believed the program should have focused more on addressing the
housing market issues, and its execution raised significant concerns.

The Nationalisation Debates:

The debate over nationalisation during the financial crisis of 2008 centred on whether the
U.S. government should take over struggling banks and financial institutions. Here are the
critical points in the debate:
Pros of Nationalization:
1. Swift Recapitalization: Proponents of nationalisation argued that it would allow for a
rapid recapitalisation of the banking sector. The government could quickly address
their financial problems by taking control of insolvent banks.
2. Fixing the Financial System: Nationalization was seen as a way to fix the financial
system itself, similar to the approaches countries like Sweden and Korea took during
their respective financial crises. It could enable the government to clean up banks'
balance sheets by taking over bad assets.
3. Restoring Confidence: Some believed that nationalisation would help restore
confidence in the banking sector. With the government taking control, depositors and
investors might regain trust in the financial institutions, reducing the risk of bank runs
and panic.
4. Greater Accountability: Advocates contended that nationalisation would create
better accountability and oversight over the use of funds. By owning the banks, the
government could ensure transparency and responsible management.
5. Use of the "Bad Bank" Model: The nationalisation approach could involve creating
a "bad bank," where the government would manage and eventually sell off bad assets
when market conditions improved. This approach has been successful in Sweden.
Cons of Nationalization:
1. Government Intervention: Critics argued that nationalisation would involve
unprecedented government intervention in the private sector, challenging the
principles of free-market capitalism. This level of intervention could stifle innovation
and entrepreneurship.
2. Moral Hazard: Nationalization might create moral hazard, encouraging risky
behaviour by banks in the future, as they could expect government bailouts if they run
into trouble.
3. Complexity and Political Influence: The U.S. financial sector was more extensive
and complex than Sweden or Korea, making nationalisation a more significant
challenge. There were concerns that politics and special interests could influence
government decisions.
4. Valuation and Finding Buyers: Determining banks' fair value and ensuring the
government did not over- or underpay for them was a challenge. Finding suitable
buyers quickly posed a risk of the government controlling banks for longer than
expected or necessary.
5. Nationalization vs. Temporary Control: There was debate about whether
nationalisation meant permanent government control or temporary control to stabilise
the banks. The government argued that it needed to seek complete nationalisation.
 6. Cultural Resistance: The U.S. banking culture and the long-standing embrace of
free-market capitalism made nationalisation a tough sell among financial institutions
and policymakers. There was resistance to a move typically associated with emerging
market economies.
In summary, the debate over nationalisation was contentious, with arguments for swift
government intervention to stabilise the financial system pitted against concerns about the
government taking over private-sector institutions. The decision ultimately led to various
strategies being employed to address the crisis, including the Troubled Asset Relief Program
(TARP), stress tests for banks, and government investments in financial institutions.

Obama Era Strategies

Strategies adopted by the Obama administration to deal with the subprime housing crisis and
the broader financial crisis:
1. Fiscal Stimulus Package: President Obama pushed for a massive fiscal stimulus
package approved in February 2009. This package was designed to provide a
significant boost to the economy. It included tax cuts, expanded unemployment
benefits, infrastructure spending, increased aid for health insurance, and additional
funding for education.
2. Tax Cuts: Approximately one-third of the stimulus package, or $787 billion,
consisted of tax cuts. This was intended to provide immediate relief to individuals and
businesses, potentially encouraging consumer spending and business investments.
3. Infrastructure Spending: Part of the stimulus package was allocated to building new
infrastructure. This aimed to create jobs and stimulate economic growth by investing
in public projects like roads, bridges, and other infrastructure improvements.
4. Increased Aid for Health Insurance: The package included provisions to support
healthcare by providing increased aid. This would help individuals and families
access healthcare services and maintain their well-being during the economic crisis.
5. Education Spending: The stimulus package also directed funds toward education.
This investment was intended to improve the quality of teaching and create jobs in the
education sector.
6. Payroll Tax Relief: The package included tax relief for low-income families—this
measure aimed to put more money into consumers' pockets, potentially boosting
spending.
7. Executive Compensation Caps: There were caps on executive compensation and
bonuses for companies that had received Troubled Asset Relief Program (TARP)
funds. This ensured financial institutions receiving government assistance would not
engage in excessive executive pay practices.
8. Job Creation Expectations: The Obama administration expected the stimulus
package to create 3.5 million jobs. The goal was to spend over two-thirds of the funds
by a specified date to maximise its economic impact.
The Obama administration also pursued other policies and measures, including helping
homeowners refinance their loans, proposing to cut the budget deficit, and working on
financial regulation and oversight to address lax laws and supervisory shortcomings in the
financial sector.

Macro-economic Theory/Tools used in case analysis

Some of the critical macroeconomic tools and concepts that were discussed or could be
relevant for case analysis include:
 Fiscal Stimulus: The passage discusses a fiscal stimulus package as a
macroeconomic tool. Fiscal stimulus involves government policies to increase
government spending and cut taxes to boost aggregate demand and stimulate
economic growth.
 Tax Cuts: Tax cuts are one of the fiscal tools the government can use to stimulate
economic activity by putting more money in the hands of individuals and businesses.
 Infrastructure Spending: Infrastructure spending refers to government investments
in public infrastructure projects like roads, bridges, and transportation systems. It is
often used as a tool for economic stimulus and job creation.
 Increased Aid for Health Insurance: This macroeconomic tool involves the
government providing additional support or aid for healthcare-related expenses. This
can be part of a broader strategy to address economic challenges and maintain
citizens' well-being.
 Education Spending: Government investments in education, such as funding for
schools, colleges, and other educational programs, are part of a macroeconomic
strategy to improve education and potentially create jobs in the education sector.
 Payroll Tax Relief: Reducing payroll taxes, especially for specific income groups, is
a fiscal tool that can put more money in consumers' pockets and stimulate spending.
 Executive Compensation Caps: Limiting executive compensation and bonuses for
companies that receive government assistance, like TARP funds, is a regulatory and
fiscal measure to address corporate excess and ensure accountability.
 Monetary Easing: While not explicitly mentioned in the passage, the Federal
Reserve's policy of reducing interest rates is a critical monetary tool for influencing
economic conditions. Lower interest rates can encourage borrowing and spending,
thus stimulating the economy.
 Regulatory Overhaul: The passage also mentions that the government considered
regulatory changes to address issues with the financial sector. Regulatory tools
involve establishing, revising, or enforcing rules and regulations governing various
aspects of the economy, including the financial industry.
These tools manage and influence macroeconomic variables, such as aggregate demand,
inflation, unemployment, and economic growth. They can be applied during financial crises
or downturns to help stabilise and support the economy.

4. Learnings from the case as a manager

Following are some of the Key learning which I feel are relevant to the case

1. Economic Context Awareness: Managers should have a solid understanding of the

broader economic context in which their businesses operate. This includes awareness
of monetary policy tools, fiscal policies, and their potential impacts on the business
environment.
 2. Adaptability: Economic conditions can change rapidly, and managers must adapt.
The case highlights the need for flexibility and the ability to adjust business strategies
in economic crises.
3. Policy Impacts: Economic policies, both monetary and fiscal, can have significant
effects on business operations. Managers should be attuned to government actions and
be prepared to respond to policy changes that affect their industries.
4. Risk Management: In uncertain economic times, risk management becomes crucial.
Managers should have strategies to mitigate financial risks and uncertainties,
including contingency plans for various economic scenarios.
5. Regulatory Compliance: The case underscores the importance of being aware of and
complying with government regulations, particularly in highly regulated sectors like
finance. Managers should ensure that their organisations meet all regulatory
requirements.
6. Leadership during Crises: Effective leadership is essential during economic crises.
Managers should provide clear guidance, inspire confidence, and maintain a steady
hand in turbulent times.
7. Long-Term Planning: Managers should plan long-term to ensure business resilience.
This may involve building financial buffers and diversifying business strategies to
weather economic storms.
8. Stakeholder Communication: Open and transparent communication with
stakeholders, including employees, customers, and investors, is vital during economic
crises. Managers should keep stakeholders informed about the situation and the steps
being taken.
9. Government Relations: In industries heavily influenced by government policies,
managers should cultivate relationships with government officials and be prepared to
engage in advocacy when necessary.
10. Learning from History: Managers can draw insights from historical financial crises
and the responses of governments and businesses to inform their strategies during
similar events.
Overall, the case illustrates the complexity of managing an economic crisis and the need for a
multifaceted approach to successfully navigate such challenges. Being informed, adaptable,
and prepared for various economic scenarios is essential for effective managerial decision-
making.