Question

In less than 2 pages, use the concepts/terminology developed up to this point in the course to:

1. Describe, in economic terms what happened in the lead-up to the Financial Market Crisis in 2007 (both at a micro and macro level). As part of your answer discuss what some people feared would happen if no action was taken.
2. Characterize the major steps taken by Federal Reserve Bank/ US Department of the Treasury to minimize the impact of the financial crisis.
3. Define moral hazard. Explain how it applies to this situation.
4. As part of your answer, briefly discuss whether or not you think the policies were “good” (make sure this is written as an evaluation in terms of economic efficiency and equity implications).

Answer 1

The 2007 financial crisis is the breakdown of trust that occurred between banks the year before the 2008 financial crisis. It was caused by the subprime mortgage crisis, which itself was caused by the unregulated use of derivatives. This timeline includes the early warning signs, causes, and signs of breakdown. It also recounts the steps taken by the U.S. Treasury and the Federal Reserve to prevent an economic collapse. Despite these efforts, the financial crisis still led to the Great Recession.

March 2007, the housing slump had spread to the financial services industry. Business Week reported that hedge funds had invested an unknown amount in mortgage-backed securities. Unlike mutual funds, the Securities and Exchange Commission didn’t regulate hedge funds. No one knew how many of the hedge fund investments were tainted with toxic debt.

Since hedge funds use sophisticated derivatives, the impact of the downturn was magnified. Derivatives allowed hedge funds to borrow money to make investments. They did this to earn higher returns in a good market. When the market turned south, the derivatives then magnified their losses. In response, the Dow plummeted 2 percent on Tuesday, the second largest drop in two years. The drop in stocks added to the subprime lenders’ miseries.  

On April 17, 2007, the Federal Reserve suggested that the federal financial regulatory agencies should encourage lenders to work out loan arrangements, rather than foreclose. Alternatives to foreclosure included converting the loan to a fixed-rate mortgage and receiving credit counseling through the Center for Foreclosure Alternatives. Banks that worked with borrowers in low-income areas could have received Community Reinvestment Act benefits.

In addition, Fannie Mae and Freddie Mac committed to helping subprime mortgage holders keep their homes. They launched new programs to help homeowners avoid default. Fannie Mae developed a new effort called “HomeStay." Freddie modified its program called "Home Possible." It gave borrowers ways to get out from under adjustable-rate loans before interest rates reset at a higher level, making monthly payments unaffordable. But these programs didn't help homeowners who were already underwater, and by this time that was most of them.

RealtyTrac reported that the rate of foreclosure filings in December 2007 were 97 percent higher than in December 2006. The total foreclosure rate for all of 2007 was 75 percent higher than 2006. This means that foreclosures were increasing at a rapid rate. In total, 1 percent of homes were in foreclosure, up from 0.58 percent in 2006.

The Center for Responsible Lending estimated that foreclosures would increase by 1 million to 2 million over the next two years. That's because 450,000 subprime mortgages reset each quarter. Borrowers couldn't refinance as they expected, due to lower home prices and tighter lending standards.

The Center warned that these foreclosures would depress prices in their neighborhoods by a total of $202 billion, causing 40.6 million homes to lose an average of $5,000 each.

Home sales fell 2.2 percent to 4.89 million units. Home prices fell 6 percent to $208,400. It was the third price drop in four months.​

The housing bust caused a stock market correction. Many warned that, if the housing bust continued into spring 2008, the correction could turn into a bear market, and the economy could suffer a recession.

The Federal Reserve responded aggressively to the financial crisis that emerged in the summer of 2007, including the implementation of a number of programs designed to support the liquidity of financial institutions and foster improved conditions in financial markets. These programs led to significant changes to the Federal Reserve's balance sheet.

While these crisis-related special programs have expired or been closed, the Federal Reserve continues to take actions to fulfill its statutory objectives for monetary policy: maximum employment and price stability. Over recent years, many of these actions have involved substantial purchases of longer-term securities aimed at putting downward pressure on longer-term interest rates and easing overall financial conditions.

The first set of tools, which are closely tied to the central bank's traditional role as the lender of last resort, involve the provision of short-term liquidity to banks and other depository institutions and other financial institutions. The traditional discount window falls into this category, as did the crisis-related Term Auction Facility (TAF), Primary Dealer Credit Facility (PDCF), and Term Securities Lending Facility (TSLF). Because bank funding markets are global in scope, the Federal Reserve also approved bilateral currency swap agreementswith several foreign central banks. The swap arrangements assist these central banks in their provision of dollar liquidity to banks in their jurisdictions.

A second set of tools involved the provision of liquidity directly to borrowers and investors in key credit markets. The crisis-related Commercial Paper Funding Facility (CPFF), Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), Money Market Investor Funding Facility (MMIFF), and the Term Asset-Backed Securities Loan Facility (TALF) fall into this category.

As a third set of instruments, the Federal Reserve expanded its traditional tool of open market operations to support the functioning of credit markets, put downward pressure on longer-term interest rates, and help to make broader financial conditions more accommodative through the purchase of longer-term securities for the Federal Reserve's portfolio. For example, starting in September 2012, the FOMC decided to increase policy accommodation by purchasing agency-guaranteed mortgage-backed securities (MBS) at a pace of $40 billion per month in order to support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate. In addition, starting in January 2013, the Federal Reserve began purchasing longer-term Treasury securities at a pace of $45 billion per month. Starting in January 2014, the FOMC reduced the pace of asset purchases in measured steps, and concluded the purchases in October 2014

Moral hazard is the risk that a party has not entered into a contract in good faith or has provided misleading information about its assets, liabilities, or credit capacity. In addition, moral hazard also may mean a party has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles. Moral hazards can be present any time two parties come into agreement with one another. Each party in a contract may have the opportunity to gain from acting contrary to the principles laid out by the agreement.

Moral hazard became a significant factor during (and after) the financial crisis that began in 2007. There are two ways to think about moral hazard and loans.

Lenders: Lenders were eager to approve loans before the mortgage crisis. Some mortgage brokers encouraged “subprime” borrowers to lie on loan applications, or they altered documents to make it appear that borrowers were able to afford loans that they really couldn’t afford. For example, sometimes they reported inaccurate income numbers, or they did not require documentation that would demonstrate a borrower’s ability to repay the loan.

Why would lenders hand out money when they don’t really know if the borrower can afford the payments—especially if they have to commit fraud to get the loans approved? In many cases, the lenders were only originating (or selling) the loans. After approving and funding loans, lenders would sell the loans to investors, who eventually suffered losses. In other words, the lender took little or no risk. But lenders had an incentive to keep making new loans because that's how originators generate revenue.

When things turned sour, lawmakers and the public got scared. They worried that if major banks collapsed (some of them were loan originators, while others held risky investments), they would bring down the U.S. economy—not to mention the global economy. Because these banks were considered “too big to fail,” the U.S. government provided funding to help some of them weather the economic storm. If those banks suffered significant losses, the government promised to protect deposits (in some cases through the FDIC).

Of course, taxpayers fund the U.S. government, so the taxpayers were ultimately bailing out the banks.

To restate the previous sentence: Lenders and investment banks took risks that had consequences for taxpayers and others (or potential impacts, for those who didn’t actually lose money or suffer).