How Did We Get Here?
The news came in a seemingly bottomless and never-ending ticker, like some kind of wicked messenger smacking us upside the head with the proverbial two-by-four. Through September, October and most of November, we watched stunned and amazed as Wall Street’s venerable financial institutions bled and government officials scurried around, frantically searching for a tourniquet.
But the news of the unfolding financial crisis and the certainty of an imminent credit crisis did not surprise everyone. Many months before the mid-September firestorm of bankruptcies, bank failures, buyouts and bailouts, the effect of which deepened an already disturbing mortgage market crisis and further propelled the United States into severe financial trouble, researchers in the Sam M. Walton College of Business monitored the developments that contributed to current financial woes.
Although they view the crises from slightly different perspectives, they agree that the U.S. economy won’t recover anytime soon. It could take months, perhaps years to climb out of the recession. The researchers also agree that there are many unknowns, because the U.S. economy historically has not experienced aspects of the current crisis, so there really isn’t a blueprint for how to fix it.
“One thing we know for sure is that changes will be made so that this particular kind of crisis doesn’t happen again,” says Tim Yeager, associate professor of finance in the Walton College. “But we’ll have to struggle for a while. It’ll work out over time. That’s just the nature of the capitalist system. Every so often, we go on these credit binges. It’s been happening for hundreds of years, and we haven’t yet figured out a way to change it.”
How did we get in this mess?
Today’s problems did not materialize over night, despite the sudden and dramatic events of mid-September and the subsequent runaway train of bank failures and ultra-volatile stock market. Yeager and his colleagues say the roots of the financial crisis go back at least five, maybe eight years. The causes are complex but can be explained.
It may help to describe the crisis as not one, but three distinct, yet interrelated crises in housing, finance and credit. Market forces and trends within each crisis helped create or aggravate other crises, the researchers say. Also, in the era of economic globalization — a time in which countries and people, especially investors, have never been more interconnected — the problem cannot be fully understood without looking beyond U.S. borders.
For example, several years before Americans ever heard terms such as mortgage-backed securities and credit-default swaps, demand for the U.S. dollar, primarily by Asian economies but also foreign investors in general, rose sharply, says Javier Reyes, assistant professor of economics. Reyes studies international trade networks and financial “contagion,” which is the transmission and impact of financial crises.
In the 1990s, Reyes says, these foreign countries built large monetary reserves to avoid the negative effects of sudden stops in capital and to protect themselves against contagion. The countries were eager to invest large sums in American companies, U.S. treasuries and commercial paper, which they did. The effect of this investment generated unprecedented liquidity in U.S. banks.
The housing bubble
The massive influx of capital from abroad pushed interest rates down and motivated banks to promote credit, says Kathy Deck, director of the Center for Business & Economic Research. One of Deck’s primary tasks is monitoring housing, construction and real estate in general. She focuses on Arkansas but also pays close attention to national trends.
The housing bubble, Deck says, played a major role in the current economic crisis. In short, Americans built and bought too much house. The combination of immense bank liquidity, low interest rates and credit promotion, including innovative financing mechanisms (which will be addressed later) created a real-estate bonanza like none other, except perhaps the housing boom immediately following World War II. From the late 1990s to about 2006, commercial and residential construction exploded. Appreciation rates soared.
“Developers looked out there and said ‘I can make a ton of money right now because money’s cheap, and everybody wants a nice house, and I’m going to build it,'” Deck says. “So you had this overinvestment, and at the same time an explosion in the ability of people to get financing. This combination caused us to get exuberant, and we put ourselves in a situation where we had to have ever-rising housing prices for the economy to work. That was the bubble. And, of course, it burst. We just couldn’t sustain that kind of growth.”
As little as a decade ago, if you wanted a home loan, you went to a local bank, and a loan officer offered two choices, a 15- or 30-year, fixed-rate loan. What happened, Deck says, is that the real-estate mortgage industry changed and began offering a variety of products — no money down, adjustable-rate mortgages, interest-only mortgages and others — to choose from. Only later did government officials, investors and consumers discover that many of these products were not sound.
How and why did this happen? Yeager says these questions can be answered by looking at the evolution of the financial system behind mortgage lending. Banks were flush, and many could not resist the urge to use their liquidity to earn even greater sums of cash. The high profits earned by early subprime lenders — financial institutions that provided credit to high-risk borrowers — and fueled by lax federal regulation drove even more lenders into the market.
Banks began bundling these high-risk, subprime loans into pools, otherwise known as mortgage-backed securities, and backed the securities with something called credit-default swaps, a sort of cooked-up, industry-manufactured euphemism for insurance, which were not subject to insurance regulation. Banks then sold these loans to foreign countries and investors who were hungry for alternative investment opportunities in a low-interest-rate environment.
So greed played a role, but that’s only part of the explanation, a fact that disappoints angry citizens who can’t understand how the federal government could step in today and save these financial institutions from ruin. Borrowers, federal agencies and even Congress must accept culpability as well, says John Dominick, also a professor of finance. Dominick says consumers did not invest enough energy or time to learn about mortgage-loan characteristics. So they bought more than they could afford, made possible by these bad loans that, in many cases, more than doubled monthly payments when the housing bubble burst and interest rates went up.
Also, under pressure from the mortgage industry, Fannie Mae and Freddie Mac, the federal mortgage agencies, relaxed underwriting standards, which allowed firms to package even more bad mortgages. And members of Congress, motivated by a social imperative to make home ownership available to all Americans, pressured Fannie Mae and Freddie Mac to provide expanded approval to many risky consumers.
“The emphasis was ‘get them in a house,'” Dominick says, “but I don’t guess (members of Congress) cared whether they could afford that house or not.”
The financial crisis
Combined, these factors — foreign investment, bank liquidity, creative financing and packaging of subprime loans, poor investment-banking regulation and lax underwriting — created the financial crisis.
“So all of these things mixed in led to an impossible situation,” Yeager says. “And then you just add gasoline in terms of low interest rates and high housing prices, and the whole thing is bound to burst into flames.”
The inferno included a barrage of defaults, which at first weren’t harmful to banks because they could still sell houses at a profit. But then demand for housing went down — because plumbers and teachers could not afford a $1.2 million house in Sacramento — so property started to depreciate significantly. Then Wall Street banks and Fannie and Freddie woke up and found themselves sitting on a mountain of worthless assets.
“All of a sudden, it became clear that these subprime mortgages were trash,” Yeager says. “Losses were high and nobody wanted to buy anymore. So the loans sat on the banks’ books like perishable fruit, degrading in value until they were rotten. Banks had to write off billions of dollars in loans, which took a direct hit on their capital, because when the market value of your assets keeps falling, then the market value of your equity falls too. So share prices plummeted.”
We need a bailout!
It started in the spring of 2008 with the collapse of Bear Stearns. The government stepped in to arrange a buyout by JP Morgan, with the Fed picking up a large share of potential losses. The crisis spread over the summer with Fannie Mae and Freddie Mac. Officials at both organizations, which then were still shareholder-owned corporations rather than part of the Treasury, saw the storm coming and cried for help.
“They had a couple hundred billion in debt coming due,” Dominick says. “They had defaults on these loans, and like all good children do, they ran home to mommy and daddy and said ‘we need a bailout,’ and, of course, they got it.”
Then came Lehman Brothers and American International Group, or AIG. In mid-September, about a week after the Treasury took over Fannie and Freddie, discussions among government and finance officials to prevent bankruptcy at Lehman broke down, and the company failed. On Sept. 16, the Federal Reserve bailed out AIG with an $85 million infusion of cash. But the deal did not keep the company’s stocks from falling.
After much debate and one rejected plan, the big bailout came on Oct. 1, when Congress approved the Troubled Asset Relief Program, or TARP, which freed up $700 billion in government funds. Initially, officials at the Federal Reserve and Treasury talked about using the money to purchase troubled assets, a plan that Yeager argued would have been a disaster and waste of taxpayer money. Instead, Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson settled on a “capital injection” program in which the federal government has poured billions of dollars into banks in exchange for equity shares or partial ownership stakes.
A crisis of credit
Despite government intervention, the combined impact of the housing and financial crises created a more disturbing crisis, one that has corrosive, pervasive and potentially long-term effects on the real economy, says Raja Kali, associate professor of economics.
“What we have now,” Kali says, “is a crisis of credit, which is causing the economy to seize up. People are worried about what they don’t know, and this is not good for an economy that depends on credit and the trust that inherently accompanies it. Right now, no one is willing to loan money, and this is a real problem because the functioning of the economy critically depends on the flow of credit.”
This dynamic is much broader and deeper than the simple act of consumers using credit cards to purchase Christmas gifts. Lack of credit affects virtually every business transaction, and repercussions reverberate and trickle down to all kinds of relationships, not only between consumers and merchants but also business to business and business to employee.
For example, business investment and inventory depend on short-term credit because of lags between expenditures and receipts. In this situation, when credit is cut off, businesses cut back not only on investment and inventory but also employment. They can’t make payroll, so they lay off workers.
Paulson, Bernanke and every economist worth the price of their education all know this, and it is exactly why the Federal Reserve and Treasury have deposited massive funds into these banks — to thaw the credit market, to get money flowing, to prevent the economy from seizing up. So far — before the end of the 2008 — it hasn’t worked. In an effort to stabilize their balance sheets, banks are holding on to the money and waiting for the fear to subside and a modicum of trust to return.
This will take time, says Kali, because relationships have been damaged, and trust, the essential ingredient of the credit market, won’t return overnight.
Where do we go from here?
For certain, the U.S. economy is in recession, which Kali and others say was coming anyway. What isn’t certain is how deep it will dive and how long it will last. But all of the researchers agree that the economy’s problems will not be solved anytime soon. Instead, they will likely worsen before the country starts to climb out of the recession.
To be sure, Americans will suffer. Unemployment, a critical economic indicator, will continue to rise. Yeager guesses that it might peak somewhere between 7.5 and 8 percent this spring — high when compared to 5 percent rates over the past 15 or more years, but a far cry from unemployment seen during the Great Depression.
Manufacturing, which suffered before the crisis, will cut back even more. Retail workers will get laid off because people are spending less on luxury items. The recession has and will continue to significantly affect construction, insurance and real estate jobs. Yeager says that the safest areas, those least affected, are government, education and health care.
Officials at the Federal Reserve and Treasury have taken necessary steps to prevent the crisis from worsening, says Kali. But only time will tell if the intervention will work as is hoped.
“A similar financial crisis hit Scandinavian countries in the early 1990s,” he says. “In that case, Sweden and Finland took up equity stakes in banks and gave quick injections of cash, just as the Fed and Treasury are doing now. And it worked; the financial system recovered, cash and credit flowed, the banks recovered and eventually the governments were able to sell their equity stakes at a profit. And none of this passed much burden to the taxpayer. That’s kind of the ideal scenario, a justification for intervention. Maybe we don’t like it, but probably the best thing to do is hold our noses and just do it.”