The subprime mortgage crisis threatened to drag the economy into a recession. In early 2008, the U.S. Government, together with the U.S. Federal Reserve Board, undertook policy measures to tackle this issue. However, policy-makers were debating on what the best solution is and its implications globally.
Laura Alfaro and Renee Kim
Harvard Business Review (708036-PDF-ENG)
March 28, 2008
Case questions answered:
- What were the precipitating factors associated with the 2008-2011 crisis in subprime mortgages in the U.S.? How do you allocate blame for the crisis?
- Describe the reaction of the Federal Reserve to the late-2000s economic crisis and to the downturn in housing and commercial real estate. Be specific as regards the tools of monetary policy, describing Fed utilization of both standard and unconventional policy instruments.
- Enumerate and discuss the FRB monetary policy actions in the wake of the 2020 COVID-19 pandemic. Provide an opinion as regards the appropriateness and effectiveness of Fed actions at the time of COVID onset and in the current environment as we emerge from the pandemic.
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U.S. Subprime Mortgage Crisis: Policy Reactions (A) Case Answers
1. What were the precipitating factors associated with the 2008-2011 crisis in subprime mortgages in the U.S.? How do you allocate blame for the crisis?
There are a few precipitating factors associated with the 2008-2011 crisis in subprime mortgages in the U.S. The Federal Reserve maintained a low-interest rate after the 2001 recession.
Fearing a recession did not materialize, it kept the low-interest rate for a long time despite the growth in output and asset prices and acted too slowly to raise the federal fund’s target, leading to inflation and later a dramatic rise (bubble) of housing prices.
Mortgage Originators and Brokers: They had little incentive to perform due diligence and monitor borrow creditworthiness. Compared to traditional mortgages, they lent loans to those who had difficulty obtaining prime loans and required less documentation, based only on state income rather than proof of income or property appraisals, while refusing to remind borrowers that they were under the conditions of higher interest rate and ensure they were manageable to repay.
What’s worse, the incentive compensation system aggravated this phenomenon, it was mainly focused on the volume of loans originated while neglecting the negative consequences of the default risk.
Borrowers: Since Americans have the dream of house ownership, many of them played an extremely risky game by buying houses and taking on mortgages they could barely afford. They were able to make these purchases with those risky subprime mortgages such as 2/28 mortgages. Their hopes lay in housing price appreciation, which would have allowed them to refinance and take the equity out of the home for use in another spending.
However, the burst of the housing bubble led them unable to repay their high-interest-rate mortgages. Also, some reckless borrowers with low credit used this invention to borrow money for other expenditures.
Rating Agency: They should have foreseen the high default rates for subprime borrowers with deep monitors on the raw data and monitors the raw data and they should have given these CDOs much lower ratings than the AAA rating given to the higher quality tranches. If the ratings were more accurate, fewer investors would have bought into these securities, and the losses could be controlled.
Besides, a conflict of interest arose since the rating agencies were paid by clients, and regulation limits competition, resulting in the rating of structured products being a very profitable business for the agency. Some were enticed to give better ratings to continue receiving service fees instead of giving an unbiased assessment of risk.
Investment banks: The increased use of the secondary mortgage market by lenders added to the number of subprime loans lenders could originate. Instead of holding the originated mortgages on their books, lenders were able to simply sell off the mortgages in the secondary market and collect the originating fees.
A lot of the demand for these mortgages came from the special investment vehicle – a creation of assets pooling mortgages together into a security, such as a collateralized debt obligation (CDO). Since the CDO offers a higher yield with a Triple-A rating, in this process, investment banks would buy the mortgages from lenders and securitize them into bonds, which were sold to investors through CDOs, fueling the sub mortgage market.
The practice of financial compensation system evaluated the bonus of employees on the short-term performance regardless of the banking losses, advocating the trend to treat risk-taking as value-creation.
Central Banks: It had federal supervision over commercial banks but not over investment banks, hedge funds, and other firms involved in complex financial products such as CDOs.
Half of the subprime loans were…
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