The Financial Crisis Of 2007

The Financial Crisis of 2007: A Multidisciplinary Approach Toward Its Understanding By Carlos Valera April 16, 2009

Defining the Financial Crisis of 2007 Collapse of Financial Markets and Banking System caused by Massive Rise in Defaults in Home Mortgages Underwriting of Debt, Decapitalization of Banks Credit Crunch Businesses Households Layoffs Less Available Income/Credit for Expenses Less Investment/Production Lower Consumption, Bigger Cash Savings Lower Gross Domestic Product for 2008 (1.1% growth)

Research Question Can economic rationale alone explain the hype built around the Housing Market, which led to the Financial Crisis of 2007?

Main Thesis Misleading economic information on housing and financial markets Conditioned by Greater socio-political Distorted speculative consumer and goal of Homeownership investor behavior Exacerbated by Low Federal Funds Interest Rates

Multidisciplinary Approach American Dream Concept Sociological Boost Homeownership rates, especially among Minorities Legislation Political Lenient Lending Standards Increased Demand for Housing Psychological Rising expectations of House Prices Creation of Profitable Excessive and Continuous Financial Instruments Mortgage Borrowing Economic Boosted by Low Interest Rates

Sociological Perspective

Life, Liberty, and The Pursuit of… “[The American Dream is] that dream of a land in which life should be better and richer and fuller for every man, with opportunity for each according to his ability or achievement…It is not a dream of motor cars and high wages merely, but a dream of a social order in which each man and each woman shall be able to attain to the fullest stature of which they are innately capable, and be recognized by others for what they are, regardless of the fortuitous circumstances of birth or position.” James Truslow Adams, “The Epic of America”

Political Perspective

Why is Homeownership important?

Homeownership as a Public Policy Goal “…I believe when somebody owns their own home, they're realizing the American Dream… The problem is we have what we call a homeownership gap in America. Three-quarters of Anglos own their homes, and yet less than 50 percent of African Americans and Hispanics own homes…So I've set this goal for the country. We want 5.5 million more homeowners by 2010 – (sic) President George W. Bush at million more minority homeowners by 2010. Five-and- Department of Housing and Urban a-half million families by 2010 will Development, Washington, D.C. own a home. That is our goal. It is June 18, 2002 a realistic goal.”

Legislation • Community Reinvestment Act (1977, last modified 1995) • Home Mortgage Disclosure Act (1975)

Lenient Lending Standards “If you had a pulse, we gave you a loan” Source: Richard Greenberg, Chris Hansen. Dateline NBC. March 22, 2009

Homeownership rates per State

Psychological Perspective

Speculation on Housing Prices

Economic Perspective

Profitable Financial Instruments: Mortgage-Backed Securities Mortgage-Backed Security Mortgage A Mortgage-Backed Mortgage Mortgage Pool Security B Mortgage-Backed Mortgage Security C Asymmetrical, More Risk Symmetrical, Less Risk

Low Interest Rates: A “Liquidity Party”?

Conclusions

What went wrong? American Dream Concept Sociological Boost Homeownership rates, especially among Minorities Legislation Political Lenient Lending Standards Increased Demand for Housing Psychological Rising expectations of House Prices Creation of Profitable Excessive and Continuous Financial Instruments Mortgage Borrowing Economic Boosted by Low Interest Rates

Policy Implication Challenge: Tradeoff between homeownership for all and return to stricter lending standards

Acknowledgements Dr. Stephen Quinn, Associate Professor of Economics, TCU Economics Department In Loving Memory of Nora Miriana Rios Suarez (1926 – 2009)

References Adams, James T. The Epic of America. United States: Boston, Little, Brown, and company, 1933. Print. Bureau of Economic Analysis. “Gross Domestic Product: Fourth Quarter (Preliminary).” http://www.bea.gov/newsreleases/national/gdp/2009/pdf/gdp408p.pdf Bush, George W. “Remarks by the President on Homeownership.” United States Department of Housing and Urban Development. http://www.hud.gov/news/speeches/presremarks.cfm BusinessDictionary.com. “Underwater Loan”. http://www.businessdictionary.com/definition/underwater-loan.html Callahan, Gene and Roger W. Garrison. Does Austrian Business Cycle Theory Help Explain The Dot-Com Boom and Bust? Ludwig von Mises Institute. http://mises.org/journals/qjae/pdf/qjae6_2_3.pdf

References Collins, Michael. Pursuing the American Dream: Homeownership and the Role of Federal Housing Policy. http://govinfo.library.unt.edu/mhc/papers/collins.pdf De Bondt, Werner F. M. and Richard H. Thaler. Financial Decision- Making in Markets and Firms: A Behavioral Perspective. http://www.nber.org/papers/w4777 Federal Reserve Bank of Boston. “Home Mortgage Disclosure Act.” http://www.bos.frb.org/commdev/hmda/index.htm Federal Reserve Bank of St. Louis. http://research.stlouis.org Federal Reserve Board. “Community Reinvestment Act.” <http://www.federalreserve.gov/dcca/cra/>

References Financial Times. “Counting on Greenspan.” 8 December 2000. Graph. www.geocities.com/peronet/120801-fed-complacency.pdf Frame, W. Scott and Lawrence J. White. Fussing and Fuming over Fannie and Freddie: How Much Smoke, How Much Fire? Federal Reserve Bank of Atlanta. http://www.frbatlanta.org/filelegacydocs/wp0426.pdf Gorton, Gary. The Panic of 2007. <http://www.nber.org/papers/w14358> Greenberg, Richard and Chris Hansen. “If you had a pulse, we gave you a loan”. Dateline NBC. March 22, 2009.<http://www.msnbc.msn.com/id/29827248/> Greenspan, Alan. “The Roots of The Mortgage Crisis.” The Wall Street Journal Online. <http://opinionjournal.com/editorial/feature.html?id=110010981%3C/ref%3E> ---. “The Economic Outlook.” 9 June 2005. Federal Reserve Board. <http://www.federalreserve.gov/BOARDDOCS/TESTIMONY/2005/200506092/default. htm>

References HSH Associates Financial Publishers. “Fed Funds: Poor Indicator of Mortgage Rates.” Graph. <http://library.hsh.com/?row_id=90> Investopedia.com. “Redlining.” <http://www.investopedia.com/terms/r/redlining.asp> Kendra, Kevin, and Fitch Ratings. Tranche ABX and Basis Risk in Subprime RMBS Structured Portfolios. <http://www.fitchratings.com/web_content/sectors/subprime/Basis_in_ABX_ TABX_Bespoke_SF_CDOs.ppt> Liebowitz, Stan. “The Real Scandal.” The New York Post. <http://www.nypost.com/seven/02052008/postopinion/opedcolumnists/the_r eal_scandal_243911.htm?page=0> National Bureau of Economic Research. “Determination of the 2007 Peak in Economic Activity.” <http://wwwdev.nber.org/cycles/dec2008.html>

References OFHEO. “House Prices.” Graph. <http://www.ofheo.gov/hpi.aspx> Shiller, Robert J. Irrational Exhuberance. 2nd ed. United States: Princeton University Press, 2005. Print. Sigalla, Fiona. “Residential Mortgage Delinquency Foreclosure Rates.” Graph. Federal Reserve Bank of Dallas. <http://www.dallasfed.org/research/swe/2007/swe0701b.cfm> Schwartz, Nelson D. and Julie Creswell. “What Created This Monster.” The New York Times. 23 March 2008. < http://www.nytimes.com/2008/03/23/business/23how.html> The Economist. “The Global Housing Boom.” 16 Jun 2005. <http://www.economist.com/displaystory.cfm?story_id=4079027> United States Census Bureau. “Homeownership Rates by Race and Ethnicity of Householder.” <http://www.census.gov/hhes/www/housing/hvs/annual08/ann08t22.xls>

The Financial Crisis Of 2007

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