PDF Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008

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The kindling for the fire that consumed Wall Street and nearly the entire economy was mortgages that should never have been taken out in the first place. Homeowners figured the more house the better, whether or not their income could support the monthly payment, while greedy banks and middlemen were all too happy to encourage them. When the bubble burst, the bedrock investment for many families was wiped out by a combination of falling home values and too much debt.

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The damage done to the middle-class psyche is impossible to price, of course, but no one doubts that it was vast. Banks were hurt, too, but aside from the collapse of Lehman Brothers, the pain proved transitory. Bankers themselves were never punished for their sins. Like the bankers, shareholders and investors were also bailed out.

By cutting interest rates to near zero and pumping trillions — yes, you read that right — into the economy, the Federal Reserve essentially put a trampoline under the stock market. The subsequent bounce produced a windfall, but only for a limited group of beneficiaries. Sometimes, eviction came in the form of marshals with court orders; in other cases, families quietly handed over the keys to the bank and just walked away. Although home prices in hot markets have fully recovered, many homeowners are still underwater in the worst-hit states like Florida, Arizona and Nevada.

Meanwhile, more Americans are renting and have little prospect of ever owning a home. Worsening the picture, the post-crisis era has been marked by an increased disparity in wealth between white, Hispanic and African-American members of the middle class. Not only were both minority groups harder hit by foreclosures, but Hispanics were also twice as likely as other Americans to be living in Sun Belt states where the housing crash was most severe. In , net worth among white middle-income families was 19 percent below levels, adjusted for inflation.

But among blacks, it was down 40 percent, and Hispanics saw a drop of 46 percent. For many, old-fashioned hard work has simply not been a viable path out of this hole. After unemployment peaked in the fall of , it took years for joblessness to return to pre-recession levels. Slack in the labor market left the employed and unemployed alike with little leverage to demand raises, even as corporate profits surged.

Maybe it was inevitable that when half the population watches its wages stagnate while the other half gets rich in the market, the result is President Donald Trump and Brexit. Swonk, who is chief economist at Grant Thornton in Chicago. It also made inequality and the One Percent an urgent topic, and made unlikely celebrities of wonky intellectuals such as the economist Thomas Piketty. Piketty argued that the decades after World War II, when the divisions between the classes narrowed and opportunities to move up the economic ladder expanded — that is, when the middle class as we knew it was formed — may actually have been an aberration.

Society, Mr. Piketty wrote, risks a return to the historical norm of a yawning gap between rich and poor. Whether or not he is right, the concentration of wealth that is a legacy of the financial crisis will make itself felt far into the future. Younger Americans, in particular, will be marked by the experience of much as the Crash of and the Great Depression haunted the generations who lived through it in the last century. Not only were they unable to accumulate assets in the lean years of the early recovery, but they also missed out on the recent stock market rally that benefited their older and richer peers.

A recent study by the Federal Reserve Bank of St.


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For those fortunate enough to still possess wealth after the crisis, the future looks very different. With the security provided by assets, rather than just income, they and especially their children are on a glide path for a gilded financial future. Pfeffer, a sociologist at the University of Michigan. A wealthy person who loses a job can afford to be more choosy and wait for an opportunity suited to his or her skills and experience. The risk of going to an expensive college and taking on debt is lower when there is parental wealth to fall back on.

Timothy Smeeding, who teaches public affairs and economics at the University of Wisconsin, put it more bluntly. Ten years have passed since the trauma of , the nerves are still raw, and the pain still has a way of flaring up. And once people start to become concerned about a bank's solvency, it becomes very hard to prevent the loss of counterparty confidence that can bring that insolvency on. When Lehman failed, it triggered a further increase in risk aversion. There was a flight to the safety of government bonds, and away from emerging market and other assets.

Yield spreads on traditionally risky assets widened further, as well as those on newer kinds of derivatives and securities such as credit default swaps or collateralised debt obligations. Those newer classes of assets were especially affected by the increase in the price of risk. They didn't have much history to use to measure their riskiness in the upswing, so the subsequent surprise factor in the downswing was greater. Also weighing on confidence is the fact that it is not clear if those asset classes can even survive.

When markets are very liquid and risk premiums are low, the financial system can approach the textbook, complete-markets ideal, where every possible pattern of pay-offs can be created and every individual risk can be hedged. But when risk appetite returns to a more normal, lower level, markets become less complete again.

Some of the more exotic structured products might not survive as viable asset classes outside of a credit-market boom. When risk aversion rises like this, the macroeconomic consequences can be severe. Since at least Keynes' day, it has been recognised that economies run in large part on confidence. When firms and consumers no longer feel confident, they pull back from spending.

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When banks and other financial institutions no longer feel confident, they pull back from lending. Projects that seemed likely to be profitable in the good times suddenly seem risky and less attractive. Bank regulation and behaviour might explain how a US mortgage crisis propagated into essentially a North Atlantic banking crisis. But trade and confidence effects explain why that North Atlantic banking crisis has escalated into a global problem.

The intensification of the current crisis following the Lehman failure in September saw the deterioration of many macroeconomic indicators. Industrial output contracted sharply in much of the world. Commodity prices had been booming earlier in the year, but declined significantly towards the end of the year. There was a sudden contraction in the volume of world trade. In this environment, forecasters have had to scale down their forecasts for output growth repeatedly.

As Graph 12 shows, the IMF is now forecasting that global output will contract in This would be the first annual contraction in output since at least the Second World War.


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  6. The weak global macroeconomic outlook implies that borrowers have become riskier. Some are likely to face greater difficulty servicing their debts. Bad loans normally rise relative to total lending when economies turn down, and the current global downturn will be no exception to this pattern. In the current environment, this could weigh on the profitability of already weakened banking sectors in the major economies.

    The Australian financial system has withstood the shocks coming from overseas better than many others. Australian-owned banks have recorded solid profits over the past year. Unlike banks in many other countries, they have been able to raise additional capital where required from private investors, at only modest discounts to the market price of their equity at the time. There are a number of reasons for their relatively good performance during a period of considerable turbulence.

    One of these is that they had not previously accumulated large exposures to the kinds of tradable securities in which losses at other banks have been concentrated. Rather, Australian banks were focused on their domestic lending business. Australia usually runs a current account deficit, so our banks were seeking offshore funding for their domestic activities, not casting around for foreign assets in which they could invest their domestic surpluses.

    Another reason is that housing and mortgage markets did not become as over-extended as in the United States. For a start, the underlying position of the household sector was better in Australia. Graph 13 shows two aspects of this point. First, in the left panel, the real earnings of average Australian workers were growing much faster than in the United States.

    Second, in the right panel, the total incomes of typical Australian households have been further boosted by the tight labour market. The employment-to-population ratio has been rising here; by contrast, in the United States, it never really recovered from its recession. The housing market in Australia also wasn't so over-extended, and in any case it had already had its boom. As the left panel of Graph 14 shows, the truly rapid growth rates in national housing prices had ceased around the end of , especially for apartments.

    The Australian market was going through a period of consolidation when the US market melted down. Prices were still rising in Australia, especially in Perth and other areas affected by the mining boom. But unlike in the United States, housing supply had not boomed in the same way for the past five years. There simply has not been an overhang of supply built up that would subsequently weigh on prices. In thinking about the sustainability of a particular level of housing prices, we must take many things into account. Theory and experience suggest that average inflation, credit constraints, tax rates and the distribution of income all matter to the so-called user cost of housing, and thus equilibrium housing prices.

    Just looking at one thing — say the ratio of prices to household incomes — is really not enough. In addition, looking at one type of housing in isolation — say, detached houses — gives only a guide about movements, not a level that can be compared across countries. So it's best to use prices of all dwellings, houses and apartments together, and assess the whole market. The right-hand panel of Graph 14 shows overall dwelling prices as a ratio to post-tax income. This is not a measure of sustainability or equilibrium housing prices, because all those other determinants of equilibrium user cost also change over time.

    But even taking this crude measure as a guide, since , dwelling prices have been rising more slowly than household incomes in Australia.

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    Another reason the Australian housing market was less over-extended was that lending standards did not ease as much as in the United States. Sitting on the other side of the world, it's easy to lose sight of just how far lending standards did decline in the US mortgage market.

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    Low-doc loans exist in Australia but they are less common. And in contrast to common practice in the United States, low-doc didn't mean providing no documentation at all. No-deposit mortgages are also less common in Australia than they were in the United States over the boom period. One reason for the more moderate easing in standards here is that the regulatory arrangements concerning mortgage lending are different. For example, Australia's prudential regulator, APRA, raised capital requirements on certain kinds of riskier mortgage products.

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    There are also important differences in consumer protection laws concerning lending, and in the way foreclosure law affects lenders' decisions, as was detailed in the Bank's Financial Stability Review , released last month. The tax systems also differ between the two countries. Many Australian households pay off more than they have to. In doing so, they accumulate potential redraws that serve both as precautionary saving and an additional buffer of equity against falls in housing prices. Partly as a result of these tax and regulatory differences, Australian households by and large have more of a financial buffer against falls in housing prices than their American counterparts did.

    Timely data are hard to come by, but we can look at current loan-to-valuation ratios based on households' own assessments of their mortgage balance and the current value of their home, using the HILDA survey. The distribution of these loan-to-valuation ratios, as seen in Graph 15, saw an increase in the proportion of households with high ratios between and Overall, though, that proportion remained low compared with the United States.

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    It seems that relatively few households in Australia face going into negative equity, even if housing prices do fall somewhat. As the crisis has unfolded, there are signs that Australian banks and other lenders have become more risk-averse and they have tightened lending criteria somewhat. However, it appears that good quality borrowers can still obtain and roll over credit. The Australian household and business sectors have also become much more risk-averse than in recent years.

    Some indicators of this change include higher household saving, and a shift from debt to equity funding by some firms. Their demand for credit has weakened as they have become more cautious. Together with those tighter lending standards, this has contributed to a slowdown in credit growth. At this stage, policy-makers around the world are focusing on solving the immediate problems in the banking system. Governments and central banks are also providing macroeconomic stimulus through fiscal and monetary policy easing.

    Restoring the global banking system to health is a precondition for a recovery in credit supply and economic activity. As such, it has to take priority over longer-term reforms. In this environment, the need for credible steps to restore the health of the financial system is crucial. Governments in the most-affected countries have provided substantial support to financial institutions and markets, especially since the Lehman failure. Most have ensured banks' access to funding by guaranteeing wholesale debt issuance; some have injected capital into banks; and a few have helped banks to reduce the risk in their balance sheets.

    There are several ways of undertaking this de-risking of balance sheets. Governments can buy the assets outright and place them in an entity separate to the bank; they can insure assets remaining on banks' balance sheets against losses; or, they can invest in joint investment funds that buy the assets. Each of these approaches has been used in at least one country in the recent crisis. At this stage it is hard to say if there is one right way to deal with these issues.

    The important thing is that they are dealt with. Despite these considerable efforts, confidence in the financial system remains fragile. Some market-based indicators of confidence have nonetheless improved in recent weeks. Money market spreads have retraced much of the increase that occurred following the Lehman failure. Equity markets have also staged a partial recovery, especially after the US Government released further details about its own programs for de-risking bank balance sheets.

    On top of these efforts to deal with the immediate problems, there is also considerable focus on reforms to the financial system architecture, to prevent a similar crisis from occurring again. Policy initiatives under discussion include changes to the regulation of credit rating agencies, the pay incentives faced by financial institutions and their staff, and the regulation of bank capital and liquidity.

    Many of these initiatives have been developed under the auspices of international groupings of central banks and bank regulators, such as the Financial Stability Forum, now known as the Financial Stability Board, and the Basel Committee on Bank Supervision. Both groupings have expanded their memberships in the past few weeks, in particular to include major emerging economies. Australia was already represented on the Financial Stability Forum, and is one of the countries that have just joined the Basel Committee.

    Central banks and other authorities around the world are working together to deal with the crisis and finalise these initiatives. Some of the reforms being considered will take a couple of years to be introduced. The global financial system is therefore facing a period of change. The present financial crisis has followed a period in which the price of risk was unusually low and conducive to the build-up of excesses in credit markets.

    These easier conditions are unlikely to return any time soon. What happens over the next few years, at least, is highly uncertain. For the time being, credit conditions will probably still be tighter than had been the case a few years ago. There will probably be less financing available for asset acquisition.