friedman (ed.) - what caused the financial crisis (2011)

[...]... because the more buyers there are in a bubble, the higher prices go— and the farther they fall when the bubble deflates; and because the 17852$ $CH1 0 9-1 7-1 0 11:13:57 PS PAGE 6 Capitalism and the Crisis 7 higher the price of a house, the larger the mortgage needed to buy it (Thus ‘‘jumbo’’ loans, too big for the GSEs, became more common as the decade continued.) The higher the mortgage, the more... paid before any other investors in the MBS; that tranche was rated AAA (Sometimes there were even tranches that were senior to the triple-A tranche; these were called ‘‘super-senior’’ tranches.) After senior investors had received all of the payments promised to them, income from the pool would flow down to the AA tranche, then the A tranche, then the BBB tranche 17852$ $CH1 0 9-1 7-1 0 11:13:58 PS PAGE... Brothers, the huge investment bank, declared itself insolvent The bailout of the GSEs was certainly expensive—upward of $382 billion (Timiraos 2010)—but this expense merely added to the growing fiscal deficit of the U.S government, which may cause a crisis in the future but did not cause the crisis of 2008 Indeed, the GSE bailout had the positive effect of removing the biggest risk that had been caused by the. .. of regulations The Subprime Bubble and Housing Policy The deflation of the subprime bubble in 2006–7 was the proximate cause of the collapse of the financial sector in 2008 So one might think that by uncovering the origins of subprime lending, the causes of the financial crisis would have thus been identified But as we shall 17852$ $CH1 0 9-1 7-1 0 11:13:54 PS PAGE 2 Capitalism and the Crisis 3 see, subprime... borrowers with better-than-subprime credit scores, such as ‘‘Alt-A’’ mortgagors, who barely missed the criteria for a ‘‘prime’’ loan (or whose income or assets were under-documented) In 2006, the aver- 17852$ $CH1 0 9-1 7-1 0 11:13:55 PS PAGE 4 Capitalism and the Crisis 5 age Alt-A LTV was 89 (Zandi 2009, 33) Such ‘‘nonprime’’ mortgages played a significant role in what is more loosely called the ‘‘subprime’’... it is central to understanding both how the housing crisis 17852$ $CH1 0 9-1 7-1 0 11:14:04 PS PAGE 18 Capitalism and the Crisis 19 turned into a financial crisis, and how the financial crisis turned into the Great Recession It is also a reason to believe that the public debate over the effect on the crisis of financial deregulation has been misinformed The economy relies on commercial banks to lend not... Jeffrey Friedman There was also an unrated equity tranche to provide extra safety to the investors; this was known as ‘‘overcollateralization.’’ The mortgages in the rated tranches were the collateral that ensured payments to the bondholders; but if any of the mortgagors were delinquent (late) in their payments, or if they defaulted by stopping payments altogether, the extra collateral would pick up the. .. monthly payment, half the average household’s after-tax income At 8 percent, the payment would be $1,250; at 6 percent, the cost drops to a very manageable $1,050 per month (Zandi 2009, 66) Obviously, then, low interest rates are good for the housing business—but they have a downside, from a mortgage-banker’s perspec- 17852$ $CH1 0 9-1 7-1 0 11:14:00 PS PAGE 10 Capitalism and the Crisis 11 tive If a... up, unless they put such a provision into the terms of the mortgage contract Hence the adjustable-rate mortgage It was obvious that the extremely low interest rates of the early 2000s would not last forever, so in 2004 banks began issuing a huge wave of ARMs with low two- or three-year teaser rates These low initial rates compensated the borrower for assuming the risk of future interest-rate hikes,... fulfill the numerous regulatory mandates for investment-grade and triple-A ratings that had proliferated since 1936 The net result was that, while the three rating ‘‘agencies’’ remained in private hands and could use whatever rating techniques they wished, their financial success did not depend on the ability of these techniques to produce 17852$ $CH1 0 9-1 7-1 0 11:14:02 PS PAGE 13 14 Jeffrey Friedman . What Caused the Financial Crisis PAGE i 17852$ $$FM 0 9-1 7-1 0 11:12:29 PS PAGE ii 17852$ $$FM 0 9-1 7-1 0 11:12:29 PS University of Pennsylvania Press Philadelphia · Oxford WHAT CAUSED THE FINANCIAL CRISIS Edited. Cataloging-in-Publication Data What caused the financial crisis / edited by Jeffrey Friedman. p. cm. Includes bibliographical references and index. ISBN 97 8-0 -8 12 2-2 11 8-3 (hardcover : alk. paper) 1. Financial. mortgages in the United States by the time the bubble burst (Table 7. 1). This is important because the more buyers there are in a bubble, the higher prices go— and the farther they fall when the bubble