The Mortgage Meltdown

Policy Backgrounders | Economy

No. 179
Tuesday, September 29, 2015
by Chanan Steinhart

The 2008 financial crisis was one of the most severe economic breakdowns in the history of the world.2 The crisis was a classic financial bubble with all the classic attributes thereof: greed, misallocations, malinvestment and irrationality. This bubble and the subsequent financial meltdown is a story about the U.S. housing market.

Creating a Bubble

Although many people, organizations, policies and regulations contributed to the creation of the housing bubble and the ensuing 2008 crash, the overriding issue, or the “original sin,” involved the incredible availability of cheap money for housing purchases. The abundance of money dedicated to housing fueled the bubble and enabled Wall Street’s dubious behavior.

Interest Rates. The story of this bubble starts at the end of the previous one. The dot-com bubble, created after years of speculative investing in internet businesses, burst around 2000. After the collapse of the dot-com bubble, the U.S. economy fell into a recession. The federal government, however, aimed to avoid recessions and corrections at almost any price. To avoid a necessary economic correction, the Federal Reserve came to the rescue and reduced a key interest rate (the rate banks charge each other to borrow funds overnight, called the federal funds rate) 11 times throughout 2001. The rate eventually dropped to 1.75 percent, the lowest in almost 50 years. By November 2002, the interest rate dropped to 1.25 percent. This reduction tried to encourage “liquidity,” that is, borrowing, and with it, economic activity.

Mortgage interest rates also fell significantly. These low mortgage rates and the Fed near-zero interest rates created a rush by Wall Street firms to lend money. Looking for better yields, these firms started pushing money into the mortgage market. This money, however, was not only U.S. money. Many countries had significant dollar surpluses in their trade balances and thus were looking to invest in dollar-denominated assets. To them and to other international investors, nothing seemed more lucrative and safe than investing in U.S. mortgages backed by collateral as solid as U.S. homes.

The Fed’s low interest rates encouraged new debt-money creation, which, in the eyes of the Fed, meant economic stimulation. The Fed believed the housing market would replace dot-com businesses as a generator of wealth. The rise in home prices would encourage not only more home building, but would also incite people to take loans out against their homes and use these loans for consumption, which would further stimulate the economy.

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