Origins of the Financial Market Crisis of 2008

I begin by describing the factors that contributed to the financial market crisis of 2008. I end by proposing policies that could have prevented the baleful effects that produced the crisis. Factors Contributing to the Financial Crisis At least three factors exercised significant influences on the emergence of the global financial crisis. Factor One: Expansive Monetary Policy The basic groundwork to die disruption of credit flows can be traced to the asset price bubble of the housing price boom. It bas become a cliche to refer to an asset boom as a mania. The cliche, however, obscures why ordinary folk become avid buyers of whatever object has become the target of desire. An asset boom is propagated by an expansive monetary policy that lowers interest rates and induces borrowing beyond prudent bounds to acquire the asset. The Fed was accommodative too long from 2001 on and was slow to tighten monetary policy, delaying tightening until June 2004 and then ending the monthly 25 basis point increase in August 2006. The rate cuts that began on August 10, 2007, and escalated in an unprecedented 75 basis point reduction on January 22, 2008, was announced at an unscheduled video conference meeting a week before a scheduled FOMC meeting. The rate increases in 2007 were too little and ended too soon. This was the monetary policy setting for the housing price boom. In the case of the housing price boom, the government played a role in stimulating demand for houses by proselytizing the benefits of home ownership for the well-being of individuals and families. Congress was also more than a bit player in this campaign. Fannie Mae and Freddie Mac were created as government-sponsored enterprises. Beginning in 1992 Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low- and moderate-income borrowers. In 1996, HUD, the department of Housing and Urban Development, gave Fannie and Freddie an explicit target: 42 percent of their mortgage financing had to go to borrowers with incomes below the median income in their area. The target increased to 50 percent in 2000 and 52 percent in 2005. For 1996, HUD required that 12 percent of all mortgage purchases by Fannie and Freddie had to be "special affordable" loans, typically to borrowers with incomes less than 60 percent of their area's median income. That number was increased to 20 percent in 2000 and 22 percent in 2005. The 2008 goal was to be 28 percent. Between 2000 and 2005 Freddie and Fannie met those goals every year, and funded hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans made to borrowers who bought houses with less than 10 percent down. Fannie and Freddie also purchased hundreds of billions of dollars worth of subprime securities for their own portfolios to make money and help satisfy HUD affordable housing goals. Fannie and Freddie were important contributors to the demand for subprime securities. Congress designed Fannie and Freddie to serve both their investors and the political class. Demanding that Fannie and Freddie do more to increase home ownership among poor people allowed Congress and the White House to subsidize low-income housing outside of the budget, at least in the short run. Unfortunately, that strategy remains at the heart of the political process, and of proposed solutions to this crisis (Roberts 2008). Fannie and Freddie were active politically, extending campaign contributions to legislators. Factor Two: Flawed Financial Innovations A second factor that influenced the emergence of the credit crisis was the adoption of innovations in investment instruments such as securitization, derivatives, and auction-rate securities before markets became aware of the flaws in the design of these instruments. The basic flaw in each of them was the difficulty of determining their price. Securitization substituted the "originate to distribute securities" model of mortgage lending in lieu of the traditional "originate to hold mortgages" model. …