U.S. Subprime Mortgage Crisis

In 2007, a strange financial crisis happened in the US and soon spreaded to every corner in the world. It is strange because unlike other recessions that happened before, it is not triggered by an event, such as external shocks or sudden policy adjustments. Nevertheless, the resulting economic recession was not any less than others, with a rippling effect that is probably longer than most.

The U.S. Housing market

House prices are constantly rising in major metropolitan areas in the US. The main reason is that people are experiencing unprecedented levels of mobility after World War II. The US, in particular, has attracted a steady infusion of immigrants with human capital from all over the world. There are only so many nice places in the US that are highly appreciated by home buyers, so homes in a good neighborhood are assets in scarcity; and the scarcity can only go up in time.

Since around 2001, after the tech bubble burst and the 9/11 terrorist attack, the US Fed has taken a drastic police reaction to stimulate the economy. The result was the interest rate was at an almost all-time low around 2004. The low mortgage rate further heated up the housing market and something called the subprime mortgage became very popular. A subprime mortgage is usually an ARM (adjustable rate mortgage) that has a very low introductory rate, that enables people who otherwise cannot afford to buy a house to buy one. Homebuyers wanted to take the risk because even if the homes turn out to be unaffordable in the long run, they can sell the houses for a profit then go back to renting. Well, only if home prices keep rising.

The low interest rate was only temporary as a short term policy to pull the economy out from the downturn. Starting from the lowest point in 2004, Fed was steadily raising the interest level back up. Many home buyers discovered that they really cannot afford the houses they got, so starting from 2007, foreclosure rates shot up, which put tremendous pressure on the house prices. Once house prices started falling, many new buyers with subprime mortgages realized that they have a negative asset in their houses so they became even more eager to foreclose their homes. The effect snowballed and by the middle of 2007, some major financial institutions were on the brink of bankruptcy. And this was merely the beginning.

At that time, the Fed still believed that “the housing market weakness did not appear to have spilled over to a significant extent.” Traditionally, the Fed has a line on the ground: inside the line there is commercial banking, which is heavily regulated. Outside the line are the investment bankers, which were not regulated nearly as much and took much more risks willingly for greater returns. The Fed believed that the firewalls on the line are strong enough so even if whatever outside the wall is burning, the inside shall survive largely intact.

The crisis

However, two factors effectively rendered this firewall null. One is the financial innovations such as CDOs that will easily spread credit risks across many financial institutions. The other is globalization, so foreign banks were also intimately connected to the US market and feel the subprime credit crunch just as much as the US banks. Effectively, everyone is on the same boat and if one goes down, so do everyone else.

Fed responded to the crisis in three ways:

Firstly, They used the traditional monetary and fiscal policy adjustments. Fed cut rate quickly, in fact, it was the fastest rate cutting in history. The US government also issued very large fiscal stimulus packages to stabilize the credit market.

Secondly, the Fed is directly involved in bailing out investment banks, such as Bear Steams, and underwrote a significant portion of the affected assets in the acquisition transactions. This was unprecedented in history.

Lastly, they strengthened the regulation on financial institutions in the areas such as information disclosure, liquidity management, and even attempted to regulate the investment banks. They also raised the loan limit of federal housing agencies.

The effects were controversial. We do not have enough information to judge those policies’ success because there was no counterfactual with which to compare. One thing we know for sure is: It was the actions or inactions of the Fed after the 2001 downturn that got us into this mess because there was no external shock to blame.

The aftermath

I am afraid history is repeating itself now:

• An large external shock (COVID-19) that triggered a recession
• Fed and the US government came up with very large and controversial policy reactions to stimulate the economy
• Unregulated financial activities (private equities) at an all-time high
• Financial innovations (crypto currencies) whose long term ramifications are unknown

Are we looking at a similar internal triggered recession a few years down the road?