The Federal Reserve and the Bush administration could have prevented the 2008 financial crisis. But they ignored the early warning signs.
First Signs of the Crisis
In April 2006, the first leading indicator revealed trouble. The total value of building permits for single-family homes was 9% lower than the year before. That meant new home sales would slump for the next nine months.
No one could believe that home values would continue falling. It hadn't happened since the Great Depression.
In May, the value of single-family home permits was down 2%. By December, it had dropped 26%.
The Fed remained optimistic. In the November Beige Book report, the Fed seemed to indicate the economy was strong enough to pull housing out of its slump. It pointed to strong employment, low inflation, and increasing consumer spending.
In July 2006, the Fed ignored the second clear sign of economic distress. That was the inverted yield curve for U.S. Treasurys. The yield on the two-year note was 5.12% -- higher than the 5.07% yield on the 10-year note.
An inverted yield curve happens when short-term Treasury note yields are higher than long-term yields.
In a healthy yield curve, short-term yields are lower than those for long-term notes. Investors need a higher return for tying up their money for longer. In a downturn, they'd prefer the protection of a long-term bond. The yield curve had also inverted before the recessions of 2001, 1991, and 1981.
Economists ignored this sign because interest rates were lower than in prior recessions. Most of them thought housing prices would rise once the Fed lowered interest rates even more. The economy had plenty of liquidity to fuel growth.
As late as August 2007, the Fed still thought the economy would continue to expand despite the housing market decline. In fact, 2007 GDP growth came in at 1.9%.
Real Cause of the Crisis
Economy-watchers didn't realize how the combination of banking deregulation, derivatives, and the subprime mortgage market had created instability in the overall economy.
In 1999, the Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act, repealed the Glass-Steagall Act of 1933. The repeal allowed banks to use deposits to invest in derivatives.
The following year, the Commodity Futures Modernization Act exempted credit default swaps and other derivatives from regulations.
After Congress lifted regulations, banks were free to use deposits to invest in derivatives. They repackaged mortgages into derivatives called mortgage-backed securities and sold them to outside investors.
The banks hired sophisticated "quant jocks" to create the new securities. The "quants" wrote computer programs that further repackaged these MBS into high-risk and low-risk bundles. The high-risk bundles paid higher interest rates, but were more likely to default. The low-risk bundles paid less but were safer investments.
The programs were so complicated that no one understood what was in each package. They had no idea how much of each bundle were subprime mortgages.
When times were good, it didn't matter. Everyone bought the high-risk bundles because they gave a higher return. As the housing market declined, everyone knew that the products were losing value. Since no one understood them, the resale value of these derivatives was unclear.
Since banks sold the mortgages on the secondary market, they were not careful about the credit-worthiness of borrowers.
Unregulated mortgage brokers made loans to people who weren't qualified.
The derivatives were so profitable, banks needed more loans to underwrite them. Banks pushed exotic loans, like interest-only loans, to attract borrowers.
Many first-time homeowners snapped up these loans to get lower monthly payments. As mortgage rates reset at a higher level, these homeowners could not pay the mortgage. Then housing prices fell and they couldn't sell their homes for a profit. As a result, they defaulted.
How Subprimes Destabilized the Economy
Many of the purchasers of these MBS were not just other banks. They were individual investors, pension funds, and hedge funds. That spread the risk throughout the economy.
Hedge funds used these derivatives as collateral to borrow money. That created higher returns in a bull market but magnified the impact of any downturn. The Securities and Exchange Commission (SEC) did not regulate hedge funds, so no one knew how much of it was going on.
The Fed Intervenes
Throughout the summer, banks became unwilling to lend to each other. They were afraid that they would receive bad MBS in return.
Bankers didn't know how much bad debt they had on their books. No one wanted to admit it. If they did, then their credit rating would be lowered
Then, their stock price would fall, and they would be unable to raise more funds to stay in business. The stock market see-sawed throughout the summer, as market-watchers tried to figure out how bad things were.
By August, credit had become so tight that the Fed loaned banks $75 billion. It wanted to restore liquidity long enough for the banks to write down their losses and get back to the business of lending money. Instead, banks stopped lending to almost everybody.
The downward spiral was underway. As banks cut back on mortgages, housing prices fell further. That made more borrowers go into default, which increased the bad loans on banks' books. That made the banks lend even less.
Over the next eight months, the Fed lowered interest rates from 5.75% to 2%. It pumped billions of dollars into the banking system to restore liquidity. But nothing could make the banks trust each other again.
An Ounce of Prevention
Two things could have prevented the crisis. The first would have been regulation of mortgage brokers, who made the bad loans, and hedge funds, which used too much leverage. The second would have been recognized early on that it was a credibility problem. The only solution was for the government to buy bad loans.
But the financial crisis was also caused by financial innovation that outstripped human intellect. The potential impact of new products, like MBS and derivatives, were not understood even by the quant jocks who created them.
Regulation could have softened the downturn by reducing some of the leverage.
It couldn't have prevented the creation of new financial products. To some extent, fear and greed will always create bubbles. Innovation will always have an impact that isn't apparent until well after the fact.