Subprime Mortgage Crisis in the United States, 2007-2009

The Great Recession in the United States lasted a year, from the second quarter of 2008 to the second quarter of 2009, which is linked to the 2007-2008 banking crash and the 2007-2009 subprime mortgage crisis in the United States (Mimir, 2016). Economists have proposed numerous reasons for the occurrences of the financial crisis, the most important of which is the various causes of shocks to the cost of financial intermediation among lending institutions in the United States.
The sources of these shocks came from housing programs in the United States. The repealing of the Community Reinvestment Act 1977 requires financial intermediaries in the housing sector to lend to borrowers below the 80% median class in the area of their operation. Overtime, this had, until the financial crisis, resulted into an accumulation of 27 million subprime and high risk weak mortgage loans throughout the United States ,out of a total 55 million at that time; the result of which is a crisis in subprime mortgages in 2007 (Wallison, 2015). This policy scenario has various potentials for causing shocks to the cost of financial intermediation;

First, these inferior types of loans are going to inflate the costs of the housing that people are going to purchase as a result of the higher than normal interest rates charged on them. If there is a weak financial system in terms of risk management, failure in regulation in excessive leverage and risk taking, then private lending institutions are going to exploit the subprime lending markets with the promise of higher profits on paper. Moreover and consumers of these high risk loans are also going to be lured into this market by the weak mortgage underwriting standards, which practically makes housing mortgage loans accessible to low income families, creating a spiraling demand for them. This leads to an unprecedented accumulation of excessively risky loans in the market. What this means is that, when the rise in the value of housing stagnate, as was seen in the great depression, then the chances of delinquencies are obvious. Cases of delinquencies, if widespread at about half of the total mortgages in the market, causes shocks to the entire economy through massive losses incurred by financial institutions (as well as insurance agencies); and this, on its own, is capable of sparking an economic recession.

Secondly, the high defaulting rates of low income borrowers means that the risks of losses through delinquencies to financial institutions always remain high. Housing bubbles always tend to suppress defaults in cases of Mortgage Backed Securities. But this is not always the case, as was seen in 2007, where nearly half all the mortgages in the United States were weak and of a high risk nature. Losses that can accrue as a result of delinquencies and defaults arising from over 27 million mortgages can shock financial systems and raise the cost of financial intermediation even further.

Moreover, failure of financial policies often results in cumulative impacts to the financial systems. The rationale of the affordable housing goals by the Department of Housing and Urban Development was to enhance the inclusivity of low and middle income borrowers, leading to the repealing of the Community Reinvestment Act 1977. The impacts of this policy to financial institutions cumulated overtime, until the final subprime meltdown occurred. Similarly, the Dodd-Frank Act must be continuously reviewed overtime and subjected to an improved monitoring program coupled with stronger financial regulation to avoid future recurrence of shocks to financial institutions and the economy.

A new classical perspective examines the shock to financial intermediation along three diagnostic sources of growth fluctuations. These are; effects on productivity, impacts on both physical and working capital, and finally, the labour market stress (encompassing employment).

Mass layoffs were one of the leading indicators in the financial crisis than gripped the United States. According to figure 1 below, Mass layoffs spiked continuously between 2007 and 2008.



Figure 1 Number of mass US layoffs from 2000 to 2008. Source: Bureau of Labour Statistics

One of the reasons that can be put forward to explain this trend is the extent to which the financial crisis impacted the ability of financial institutions to lend to businesses. Businesses and industries interact with financial intermediaries day by day to finance both their current operations and future investment plans, and therefore are more affected by the health of a financial system. The cost of obtaining external financing increased significantly during the financial crisis, affecting the ability of industries with a high dependence on external credits to finance their operations. The rising cost of credits was therefore a direct cause of the significant employment drop in those industries that are highly dependent on external financing. Small businesses and industries that could not access external financing through capital markets (and these account for over 20% employment rate in the United States) witnessed the most layoffs (Braun & Larrain, 2005).

During periods of shocks to financial intermediation, the capacity of banks to re-finance themselves is limited, and therefore they reduce lending to their clients, thereby impacting overall economic activity. In those sectors with high external capital dependence, the impact to production is more pronounced. Overall production reduces as the real economic activity of a business is reduced, and this overall reduction is driven by external capital constraints rather than shocks in demand or layoffs.

The New Classical model is put responsible for the low-interest rates in the economy. The period between 2007 and 2011 saw both inflation and interest rates on a general downward trend compared to periods before the financial crisis. This is because the new classical model balanced the interest rate on the basis of supply and demand of the market, giving rise to competitive interest rates offers by financial intermediaries. This made the Mortgage market very attractive to the consumers looking to purchase houses. In doing so, the model hedged the risk of future defaults making the crisis eminent in the economy; and because of heavy demand to acquire the loans, the money supply increased in the economy that gave rise to inflation. In my perspective, the model is responsible for the crisis, as it purely works on the supply and demand orientation of free markets with little government regulation, neglecting the precursors and elements that are supporting or affecting the functioning of the economy.

On the other hand, the model can also account for the low inflation witnesses in the financial crisis. In general, an upsurge in money usually induces an increase in consumption expenditure which, if not offset by a proportional rise in output, then inflation will result.

In as much as the presence of subprime financial intermediaries in the economy probably will result in a weakened channel that links financial growth and inflation in the consumer price, there is likelihood of these intermediaries reinforcing asset price channels. The pragmatic linkage between financial variables and asset values shows a significant effect in asset prices (particularly house values) with a growth of money and credit. Some studies have acknowledged bigger demand for assets that are a derivative of leveraged investments in addition to increased risk enthusiasm as chief influences in prices of assets (Meltzer, 1995). Therefore, instead of losing value during the mortgage meltdown, asset values still remained high as a result of active leverage management by financial intermediaries, and thereby boosting demand for assets that have been financed by incurrence of additional debt.

Both in the case of financial crisis and great Recession/depression, the model played a vital role, in which it facilitated the business cycle by stabilizing the supply and demand interplay in the mortgage market. The approach enhanced the buying power of an individual and the rationale to harvest great profits by fulfilling the utility demand in the market. In both cases, the model facilitated the markets to grow the horizon, leading to increase financial turnover for a particular period of time just before the financial crisis. However, financial intermediaries in the subprime loan market did not have a clear definition of their business cycle. It lead to continuous investments in the housing loan and imports (in Financial crisis and Great depression respectively) so much that that it did not make a complete business cycle by paying off the outcomes in order to start a new business cycle. The model also failed to identify and analyze the magnitude of the business cycle while lacking the information of the market to understand the upcoming market shifts.

The classical model, however, has certain weak premises in its explanation of the link between the financial crisis and the events in the great depression. First, the classical model is founded on the premise for self-regulating markets. What this means is that, the interest rates charged on mortgages were to be set by the market forces in play. This however was not the case. Interest rates of the subprime loans were set by the Community Reinvestment Act, making these subprime mortgages very expensive. Secondly, according to the classical model, the inter-temporal marginal rate of substitution of capital consumption and productivity needs to result into an accumulation of capital and a savings decision. The capital consumed in investments or through borrowing should be less than the capital produced through marginal output or repayment respectively. In the financial crisis however, the opposite was true. Delinquencies observed during the financial crisis accruing losses resulting from mortgage defaults shows deficits in capital productivity and consumption, and therefore the model cannot adequately address the events of the great depression.

The magnitude and complexity of the United States financial system has significantly increased since the 2007 financial crisis. This paper provides evidence that different sectors in the financial system are interlinked together to form a hub, which is the economy, and this increases the vulnerability of each of these sectors to stress if one or more other sectors are under stress. Here, the biggest role played by financial intermediaries is that of channeling money between lenders and borrowers who are not in the financial sector. Similarly, the players in the financial sectors, which include commercial banks, should play the role in fostering the foundations of deposit–taking as well as deposit-creating capacity, with the ability to grant loans and create money all together. The government should strengthen the measures aimed at restoring efficiency in the functioning of financial markets, as well as ensuring sustainability in the financial system in order to mitigate or avoid all together future financial crisis.

































Works Cited

Braun, M., & Larrain, B. (2005). Finance and the business cycle: international, inter‐industry evidence. The Journal of Finance, 60(3), 1097-1128.

Meltzer, A. H. (1995). Monetary, credit and (other) transmission processes: a monetarist perspective. The Journal of Economic Perspectives, 9(4), 49-72.

Mimir, Y. (2016). Financial Intermediaries, Credit Shocks and Business Cycles. Oxford Bulletin of Economics and Statistics, 78(1), 42-74. doi:10.1111/obes.12099

Wallison, P. (2015). Hidden in Plain Sight: What Really Caused the World's Worst Financial Crisis and Why It Could Happen Again: Encounter Books.