Econ435TermPaper

Greg Crist
Econ 435
Term Paper
How the 2007 Crisis, Recession and Recovery are Unique.
The financial crisis of 2007-2008 was an event unlike any other recessions in
the history of the United States or even the world. To the uneducated eye the reason
for this crisis was the collapse of the housing bubble. There are other factors that
led to this collapse however. In this paper we will look at these specific factors that
unique to this kind of crisis and recession. This event could be called a balance
sheet-financial crisis. This paper will show how the 2007-2008 financial crisis, a
balance sheet-financial crisis, is different from a standard recession. This type of
recession can stem from many things from unconventional monetary policy to lack
regulation responsibility. The structure of this paper will first look at what caused
the crisis of 2007-2008 and how these align with characteristics of a balance sheet-
financial crisis. Then we will explore what the effects of this crisis have been and
why the recovery is unconventionally slow compared to the standard
recession/recovery. I will also present some possible solutions to speeding up the
recovery and ways this deep recession could have been possibly avoided. First let
us look at the events that led up to this devastating crisis many years before it
actually occurred.

Causes
For policy reasons that we will talk about also in this paper, the cause of the
housing crisis was the fact that many sub prime fixed rate and sub prime adjustable
rate mortgages were being issued due to banks having relaxed standard on
borrowing requirements. These were the first mortgages that would be in a
foreclosure crisis. Beginning in 2007 the rate of house in any point of foreclosure on
sub prime adjustable rate mortgages exploded from 5 percent to 25 percent of loans
in that class in a matter of only 2 years. Other loans followed suit, not to that
extreme, a few months later when prime mortgages started to have increased
foreclosure rates. The sub prime mortgage crisis in a way caused the prime
mortgage crisis by causing higher levels of unemployment and people with normally
high credit losing their jobs. This mortgage crisis kicked off the financial crisis of
2007-2008 and the effects are still lingering around in the recovery. Homes just
entering foreclosure also exploded in 2007 especially in the subprime category.
The mortgage crisis itself did not cause the recession, rather it sparked of a
financial crisis. These two crises are the reason however that this recession has
been so deep and so long. This financial crisis was directly part of the mortgage
crisis since an expansion of securitized lending and capital ratio requirements of
zero made it very attractive to large banks to grow sub-prime mortgage backed
securities and other securitized assets. This brought in a whole new crop of
financial products such as credit default swaps, collateralized debt obligations,

collateralized loan obligations. These new products very extremely complex and it
was extremely hard to understand the risk associated with them. Institutions could
not accurately calculate the risk associated with mortgage based products because
by the time the mortgages were collected and bundled there was no way for them to
go through every single mortgage in the product and assess the individual risk of
each mortgage. Along with risk uncertainty, there were extremely poor regulations
for these new products. This lack of regulation was because these products were
not created within traditional banking structures and regulations. The problem
with these products, which are called credit derivatives, is that there is a lack of
knowledge of the risk associated with them. For example a credit default swap is
technically when a bank who hold a loan takes out an ’insurance’ policy by paying a
premium to another bank who ‘insures’ the product in case the loan is defaulted on.
Some people will say that this spreading of the risk injected the financial crisis
throughout the whole economy while the defenders of credit default swaps will say
that this spreading of risk actually is a safeguard against a financial shock.
When problems started rising with these new financial products many
institutions began faltering to the point where the government thought they needed
to step in. The government did this quickly because they thought right away that
this was a banking crisis. The Federal Reserve Board and the Treasury Secretary got
Congress to pass the Troubled Asset Relief Program or more commonly known as
TARP. This program consisted of 700 billion dollars to buy these assets from failing
financial institutions. These funds were forced into many banks and financial
institutions with about 111 billion dollars being requested banks. Citigroup and

Bank of America ended up requesting an additional 20 billion dollars each on top of
the money the FED forced on them when TARP started. Sub prime securities had
caused Citigroup to write down their balance sheet by 5.9 billion dollars and the
forced resignation of their CEO. TARP ended up rolling out 417 billion dollars with
over half of the funds going to Commercial banks. Funds also went to auto
companies, insurance companies and investment banks. 187.4 billion dollars also
went to Fannie Mae and Freddie Mac but were not included in the TARP rollout.
Some blame has even been put on the credit rating agencies. These agencies
were suppose to assess these financial products and advise would be buyers about
the risk level associated with them. These agencies have been accused of keeping
the rating of sub prime mortgage backed securities favorable even when the
mortgage crisis was emerging in the market. These credit rating agencies were
accused of the same thing in 2001 when they gave Enron’s bonds a very good rating
right until the company collapsed. These rating companies are in a strange situation
however with these ratings since if they do not rate the securities well then the
securities will not sell and that rating company will no longer get any business.
Many of the financial failures and large losses came from large investment
banks like Lehman Brothers and institutions that dealt heavily in mortgages like
Washington Mutual. These investment bank failures can be blamed on the fact that
after 2004 the capital level was near zero as compared to a regular bank who had a
large capital base after regulations put in place after the Savings and Loan Crisis.
The same was true for government-sponsored enterprises like Fannie Mae and
Freddie Mac who also had a capital level near zero. These failures would be felt

around world since about half of the losses stemming from mortgage based
products happened overseas, which turn this in to a global financial crisis.
The Savings and Loan Crisis occurred at the end of the 1980’s. This crisis is
often called a ‘bank-centered financial crisis and is used to compare against the
latest financial crisis. The comparison can be made of bank experience between
these two crises. In the Savings and Loans crisis four times more banks failed than
during the 5 years between 2007 and 2012, which was 465. This is where the
common term ‘too big to fail’ comes in. There is much argument if the TARP funds
saved many banks or worsened the landscape of the recession. The question of
whether this financial crisis was in fact a banking crisis is debatable. In comparison
to the Savings and Loans crisis this would have been a very mild banking crisis.
There has to be a reason that banks and financial institutions were able to get
into this mess without being stopped. That’s where policy is involved. There is a lot
of evidence that points to bad policy and poor regulation as being a large factor for
the financial crisis and Great Recession.
The case can be made that preceding the recession poor monetary policy was
practiced. Starting in 2003 the Federal Reserve kept unusually low federal funds
rates compared to the suggested rate from the Taylor rule, which was closely
followed in the 1980’s and 1990’s. The federal funds rate in 2003, 1 percent, was
also below the inflation rate, 2 percent. This was highly unlike previous policy,
which had the federal funds rate higher than the inflation rate as in the 1980’s and
1990’s. These unusually low interest rates could have easily contributed to the
housing crisis.

With the interest rates held uncommonly low the Federal Reserve was in fact
encourages risk taking in the housing market. These low interest rates can lower
fixed rate mortgage rates and the expectations of those mortgage rates. What
contributed even more was that these low rates made for very low teaser rates for
adjustable rate mortgages. These low interest rates allowed people to buy houses
they could not usually afford. This caused housing prices to continuously climb
which boosted the whole economy until 2006. This increase in sub prime
mortgages meant that a larger and larger fraction of mortgages in bundled securities
were become more risky and financial institutes ability to sustain risk with these
bundled securities weakened. During the time right before the housing bust the
amount of adjustable rate mortgages grew 200 percent because of these low rates
and accounted for 20 percent of new mortgages written in 2005. This in turn
increased inflation rates on housing prices leading to the bust. These problems
could be seen around the world especially in Europe where too low of interest rates
caused housing booms and busts in some countries.
After the crisis the Federal Reserve went into liquidity mode. They increased
reserve balances and keep liquidity up during the panic. After the panic subsided
logical monetary policy would have had the Federal Reserve decrease reserves and
liquidity. However the Federal Reserve expanded liquidity to start quantitative
easing programs. These programs included massive purchases of mortgage-backed
securities and long-term Treasury bonds. Through quantitative easing the reserve
went to 2,400 billion dollars as compared to jus 10 billion dollars before the panic.

These massive increases in reserves obviously did not follow any previous policy
that used to be followed.
Why did no one stop the banks from all this risk taking and leveraging? It’s
not that there were not regulations in place but that regulators allowed these
financial institutions to take excessive risks and terrible levels of capital. This was
most obvious through the actions that regulators allowed Fannie Mae and Freddie
Mac to take such as high risk and low capital levels. The government pretty much
forced these risky investments with such low housing interest rates, which were
trying to promote affordable housing. In April 2004 the Security and Exchange
Commission started allowing financial institutions to calculate their own risk and
capital ration levels.
As stated previously this crisis was initially diagnosed as a banking crisis or
liquidity problem. The bailout actions taken by the Federal Reserve were in an
effort to fix liquidity. These bailouts were seen by some as illegal since bankruptcy
laws seemed to just be ignored in many of these bailout cases. These bailouts were
seen as very discretionary since the bailout of Bear Stearns made it seem like
Lehman Brothers, who were in a similar situation, would have been bailed out as
well. It came as a shock when Lehman Brothers was allowed to fail. The TARP
bailout made equity prices skydive which was shown because the S&P 500 was
higher after Lehman Brothers’ failure than right before the failure.
The fall of Bear Stearns came when two of their prominently profitable hedge
funds, worth 1.5 billion dollars in 2006, were busting since these hedge funds were
mainly comprised of mortgage-backed securities. By July 2007 one of these funds’

value had dropped 91 percent and the other fund had become pretty much
worthless. These losses were blamed on drastic devaluations in prime securities
ratings, which were at one point either AA or AA rated investments. The bailout of
Bear Sterns was technically just a forced buyout by their rival JP Morgan. The
Federal Reserve forced JP Morgan to acquire Bear Stearns for a very low price of 2
dollars per share. When it came to the risky investment portfolios, that had landed
Bear Stearns in this position, it should some extra incentive for JP Morgan to take
control of these in the form of 29 billion dollar loan from the Federal Reserve. Many
critics of this move called it a gift to the richest people in the country while many
people in the country were foreclosing on their homes. The Federal Reserve
chairman at the time defended his actions since the effects from the collapse of Bear
Stearns would have affected the whole country’s economy.
By letting these banks increase their leverage was just putting them farther
up river without a paddle. Increasing leverage makes an increase with how much
an institution will be affected by a shock to the economy. These shocks are felt so
much harder because the growth before a financial crisis is so much more rapid, in
this case due to credit booms. The prevalence of credit spikes in the economy is a
factor that has been playing a larger and larger role in modern macroeconomics.
After World War II there has been a 38.4 percent increase in expansion amplitude
due to high excess credit. There is also much evidence that expansions with large
credit spikes have worse recessions and much slower, sluggish recoveries. Real
GDP Recovery paths for a normal recession do not dip anywhere near as deep as a
financial recession and a normal recession recovers much more rapidly than the

path of a financial recession. On average a financial recession takes about 5 years to
return to the previous levels. A normal recession does this on average in only 2
years. Also the actual fall of the GDP per capita is much greater in a financial crisis, 3
percent below pre-recession levels, while the normal recession only dips half as
much, 1.5 percent. The same effects can be seen in the investment per capita during
recessions. Investment falls five percent in normal recessions and it falls four times
as much in financial recessions.
Effects
The initial effect of this crisis was for the government to make policy changes
to stop the bleeding and furthermore prevent this kind of disaster from repeating
itself.
Along with the initial two TARP bailouts the government started stimulus
programs to try to kick-start an economy wide boost. There were two stimulus
packages, one in 2008 and the next again in 2009. While these packages did
increase disposable income across America it did not significantly boost aggregate
consumption in either of the subsequent years. The government also started a Cash
for Clunkers program, which does provide a boost to the economy through spending
but does little to help the recovery sustain a faster pace.
The problem with regulation problems is also addressed after the crisis. The
government increased the amount of regulation workers by 30 percent from 2006
to 2012. The Federal Reserve also temporarily opened up lending to investment

banks on overnight loans at a rate of 2.5 percent, a privilege that was usually only
reserved for commercial banks. They also diversified the kinds of securities that
investment banks could use for collateral on these overnight loans. This program
was set to only last for 6 months and was used for a solution for the investment
banks’ current liquidity problem. The amount investment banks were borrowing
daily peaked at 38.1 billion dollars in the beginning and dwindling down to 18.6
billion dollars. While commercial banks actually needed to borrow less and less,
11.6 billion dollars at the same time the investment banks borrowing was
decreasing.
The financial sector begins fortifying itself by making moves to raise capital
to increase confidence in the banking sector. Citi Group and JP Morgan Chase held
multi billion dollar stock offerings to help strengthen their balance sheets; each firm
individually raised 6 billion dollars and Bank Of America raised 4 billion dollars.
Between the U.S. and European banks over 200 billion dollars was acquired in a few
months. This helped the banks make up for their losses and acquire capital for
when the economy started back into an up swing. This massive capital acquirement
was also pressure by regulators who were forcing banks to repair their balance
sheets.
While the financial sector was rebuilding there was still problems in the
consumer market. There was less money to be loaned out for businesses and
homeowners. This problem could cause all the work the financial sector was doing
to become obsolete since without a strong consumer market the financial sector
cannot properly recover and operate. This problem could not be technically

addressed by the Federal Reserve but was a problem that the Treasury would need
to try to correct. This problem with consumer credit is exactly what would lead to a
long, sluggish recession and recovery.
Conclusion
There is still much debate on what kind of remedy is needed to speed up the
current recovery. This is due to the fact that many economists and politicians still
disagree about what kind of crisis and recession actually took place. A common
analogy for this problem is if you have pneumonia you might think you have a bad
cold and not correctly treat the symptoms. The idea that this recession is like
previous post war normal recessions is starting to seem more and more inaccurate.
The steps that have been taken through bailouts and policy changes have not shown
the desired effects in helping the economy recover. This crisis is not a normal
recession rather a financial crisis induced recession only comparable to the Great
Depression. This was denoted by some, Milton Friedman, as the Great Contraction,
which would make the current situation the Second Great Contraction. According to
Friedman the idea of a contraction looks past output and employment problems like
a normal recession and also looks at debt and credit. This seems fitting since the
crisis could be called a credit crisis due to over leveraging and the sub prime
collapse. This deleveraging could take a much longer time to correct than a normal
recession. In a standard recession if growth returns the economy can usually catch
up to its long run trend and return to normality, this recovery can sometimes take

place in under a year. A financial crisis is not like this at all. After a financial crisis it
could take many years just for the economy to get back to where it was prior to the
crisis. The measures taken to correct this recession would have been correct if this
was a normal recession. The right size bail outs and stimulus would have been able
to correct it. With a contraction the first problem is not output but rather debt. So
the actions taken through stimulus packages are actually adding to the problem in
the form of government debt. This effort would have been much more efficiently
asserted in attempts to minimize debt rather than to spend more. Roghoff will
argue that a way to shorten recovery time and deleverage would be to boost
inflation. He claims that this will happen sooner or later, naturally or induced. This
theory is seem by some as the opposite way to fix a recession but that is because this
type recession is extremely rare and there is not a lot of previous examples to
compare against.
This crisis could have been seen as a normal banking crisis except for the
extent of the effect of the crisis. The way this crisis began through sub prime
securities made the effects become felt far outside the banking sector of the
economy. The overleveraging of banks’ balance sheets set them up to not be able to
handle this crisis and let the crisis spread outside their control and into other
sectors of the economy. Had banks’ balance sheets been strengthened through more
practical capital levels then there would not have been a problem with liquidity
initially.

This crisis was what I would call the perfect storm of crisises. All factions of
this crisis could be held somewhat responsible for letting it occur. Fiscal policy,
monetary policy, credit, and even consumers can be blamed.
The serious lack of regulation by governing bodies of the banking sector is
almost troubling to think about. A complete disregard of rules seemed to take place
in the early 2000’s and maybe even the late 1990’s. Regulators stood by and let
financial institutes overleverage and take excessive risks that have never before
been seen. Then there was the fact that when the introduction of credit derivatives
and mortgage back securities products entered markets there was no call for a
investigation of what regulations should be placed on these products. How no red
flags were raised when financial sector profits were booming and most banks
involved in the boom were far overleveraged is utterly astounding.
The policies taken to try to correct the course as soon as the panic hit were
highly misguided as well. The wrongful diagnosis of what was happening may have
even worsened the conditions for the economy to recover. The injection of liquidity
through federal reserves seemed to not bring stability to the economy but rather
make it worse by creating more debt without creating a increase in spending and
consumption.
The financial sectors actions were extremely irresponsible leading up to the
crisis. Due to the lack of enforcement of regulations regarding risk and leveraging
these banks could be compared to small children having the run of the playground
without anyone supervised and punish them. However these firms have one goal
and one goal only, and that goal is to earn profits for clients and shareholders. They

saw this new market for credit derivatives and securities as a way to increase
profitability. The blame then shifts to the credit rating agencies that were giving
these risky securities favorable investment ratings. To me this seems to be quite a
conflict of interest since the financial institutions who were trying to sell these
products were the ones paying the rating companies to do so. There seemed to be
no checks and balances in this emerging market of non-financial debt.
Then the problem comes down to the consumer. Since the average Joe who
wants to buy a house does not know that interest rates have been too low for too
long and that situation makes for increased volatility. So average Joe sees this as a
great opportunity to get the nice house he could never afford before and use that
house equity as capital. Pretty soon these people are stuck with a giant interest rate
on a mortgage that has more owed on it than the new value of the house after the
collapse of the market. So maybe the real enemy here was the mortgage brokers
pushing these loans with plenty of knowledge that the grass is not going to be very
green on the other side for sub prime adjustable rate mortgages.
In conclusion, was this financial crisis like anything that we have ever seen?
My answer is no, this situation was unique to our day and age of a global economy,
technology, debt, and credit. This was a balance sheet crisis among other things.
The environment for overleveraging made this into a balance sheet crisis. This is
because of a lack of regard for a need of capital to work with such large amounts of
investments. Through dismal policy enforcement and misinformation this crisis
stemmed from weak balance sheets. As this paper has shown, these kinds of crises
do not behave like normal recessions because the underlying issues are not the

same. The largest issues here are debt and overleveraging due to a time period of
unrestrained growth due to low interest rates. The recovery time for this kind of
recession or contraction could take a long time to rebuild consumer confidence and
properly regulated financial and non-financial markets.
Sources
1. Ansell, Ben. "Assets in Crisis: Housing, Preferences and Policy in the Credit
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Analysis: An International Journal 29.6 (2009): 785-792. Business Source Complete.
3. Holt, Richard P. F., and Daphne T. Greenwood. "Negative Trickle-Down and the
Financial Crisis of 2008." Journal of Economic Issues 46.2 (2012): 363-70. ProQuest.
4. Jost, Kenneth. "Financial Crisis." CQ Researcher (2008). Print.
5. Kapan, Tümer, and Camelia Minoiu. "Balance Sheet Strength and Bank Lending
During the Global Financial Crisis." IMF Working Paper (2013). Print.
6. Marcia Millon Cornett, Jamie John McNutt, Philip E. Strahan, Hassan Tehranian,
Liquidity risk management and credit supply in the financial crisis, Journal of
Financial Economics, Volume 101, Issue 2, August 2011, Pages 297-312
7. Reinhart, Carmen M., and Kenneth S. Roghoff. "GROWTH IN A TIME OF
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8. Tatom, John A. "Crises and the Great Recession." Business Economics 48.3 (2013):
175-81. ProQuest.
9. Taylor, John B. "The Role Of Policy In The Great Recession And The Weak
Recovery." American Economic Review 104.5 (2014): 61-66. EconLit. Web.
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Responses. Paris: Organisation for Economic Cooperation and Development (OECD),
2012. ProQuest.

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