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ABSTRACT
Asset‐market bubbles occur dependably in laboratory experiments and almost as reliably throughout economic history—yet they do not usually bring the global economy to its knees. The Crash of 2008 was caused by the bursting of a housing bubble of unusual size that was fed by a massive expansion of mortgage credit—facilitated, in turn, by the longest sustained expansionary monetary policy of the past half century. Much of this mortgage credit was extended to people with little net wealth who made slender down payments, so that when the bubble burst and housing prices declined, their losses quickly exceeded their equity. These losses were transmitted to the financial system—including banks, investment banks, insurance companies, and the institutional and private investors who provided liquidity to the mortgage market through structured securities. It seems that many of these institutions became insolvent; it is certain that they became illiquid. Liquidity loss and solvency fears created a feedback cycle of diminished financing, reduced housing demand, falling housing prices, more borrower losses, and further damage to the financial system and eventually the stock market and the real economy. There are important parallels with the housing and financial‐market booms that led up to the Crash of 1929 and the Great Depression.
Notes
1. Price/rent ratios are calculated from data compiled and analyzed in Davis, Lehnert, and Martin Citation2008.
2. These data are taken from 2003 and 2004 monthly CPI news releases archived at https://www.bls.gov/schedule/archives/cpi_nr.htm
3. We use the Case‐Shiller twenty‐city index when possible because of its broader coverage than the ten‐city index. Karl Case and Robert Shiller initiated their twenty‐city index in January 2000, so we use their ten‐city index for earlier periods. The twenty‐city index covers metropolitan areas that are home to over 90 million Americans, and includes many cities that had a severe bubble, as well as many that had a moderate one. Since the mortgage defaults that cascaded into the financial system originated in cities with severe bubbles, it is useful to examine price paths there, rather than broader national indices such as the Median Sales Price of Existing Homes (from the National Association of Realtors) or the Conventional Mortgage Home Price Index (from Freddie Mac: http://www.freddiemac.com/finance/cmhpi/). Case‐Shiller data are available at http://www2.standardandpoors.com/spf/pdf/index/CSHomePrice_History_022445.xls. Case‐Shiller tiered price indices are at http://www2.standardandpoors.com/spf/pdf/index/cs_tieredprices_022445.xls
4. Even in 2005, the average federal‐funds rate was lower than in every year between 1964 and 2001, with the single exception of 1993. The rate was increased so slowly starting in May 2004 that monetary policy remained lax (until late 2005) by the standards of the past half century.
5. These figures on serious delinquency (defined as mortgage payments over 90 days past due plus foreclosures in process) are taken from the third‐quarter 2006 and fourth‐quarter 2006 National Delinquency Survey, published by the National Association of Realtors.
6. Goldman was not the only firm that made extensive bets against the subprime market. Pittman Citation2007 recounts the steps taken by J. Kyle Bass of Hayman Capital Partners to trace down the source of some of the worst subprime loans and bet against them with synthetic Collateralized Debt Obligations. Lewis Citation2008 tells a similar story for FrontPoint Partners. Weiss Citation2009 describes the bets made by John Paulson against both subprime mortgages and the firms that wrote them.
7. These figures are taken from Inside Mortgage Finance Publications Citation2008, vol. II: 149–50.
8. By 2006, the characteristics and performance of many of these securities were extremely poor. For example, on 17 August 2006, Goldman Sachs issued a security, GSAMP Trust 2006‐S5, which consisted of 5,321 second‐lien mortgages totaling $330,816,621. The loan‐to‐value ratio in the pool was 98.7 percent, the average fico score of the borrowers was 666, and the average loan term remaining on these second‐lien mortgages at the time the security was issued was 25.25 years. The two top tranches of the bond, A1 and A2, were rated AAA by Moody's and S & P. These tranches amounted to $231,571,000. Thirty‐nine days later, in the 25 September 2006 Distribution Report filed with the S.E.C., $26,129,089 of the loan pool was delinquent. By the end of 2006, over $40 million was delinquent. On 12 September 2008, Standard and Poor's “Revised Projected Losses for 2005–2007 Vintage U.S. Closed‐End Second Lien RMBS Transactions” estimated that total losses on GSAMP Trust 2006‐S5 would reach 68 percent.
9. By betting against the market, Goldman Sachs, Hayman Capital Partners, FrontPoint Partners, and Paulson & Co. made tens of billions of dollars, but their bets drove the cost of insurance on new mortgage‐backed securities up to a level that deterred the flow of capital into these securities. These firms have been criticized for making money from the economic collapse, but their actions arguably stanched the hemorrhaging of capital into this destructive housing‐market bubble.
10. A.I.G. Financial Products stopped writing credit‐default swaps on RMBSs “in late 2005 based on fundamental analysis and based on concerns that the model was not going to be able to handle declining underwriting standards,” according to A.I.G.F.P. risk management consultant Gary Gorton (quoted in O'Harrow et al. Citation2008). Curiously, A.I.G. saw the problems more than a year before Goldman Sachs, but did nothing during an eighteen‐month period when they could have taken steps to reduce their exposure.
11. Lehman went into bankruptcy. Bear Stearns, Merrill, and Wachovia were all taken over by other firms in the face of imminent collapse. Washington Mutual was seized by the Office of Thrift Supervision and placed into receivership with the F.D.I.C. in late September, filed for bankruptcy, and had major assets taken over by J. P. Morgan Chase. Citigroup and A.I.G. became wards of the state.
12. The data in Figure come from the Federal Reserve Flow of Funds historical data table F.218 (Home Mortgages). The data are available at http://www.federalreserve.gov/releases/z1/Current/data.htm in the file utabs.zip. Table F.218 is in the file utab218d.prn. The net flow of mortgage funds is in the third column.
13. Negative equity figures are taken from the First American CoreLogic Negative Equity Report for the fourth quarter of 2008: http://www.loanperformance.com/loanperformance_hpi.aspx#NegEqReport
14. We follow the convention of calling even the weakest borrowers “homeowners,” even though “high‐margin speculators” more accurately describes their activities.
15. The equity value figure for the first quarter of 2000 is taken from Table L.213, line 1 in the fourth‐quarter 2000 Federal Reserve Flow of Funds document; the equity figure for the third quarter of 2002 is taken from Table L.213 in the fourth‐quarter 2003 Flow of Funds document.
16. In nominal terms, the BKX index rose slightly during a period when the stock market lost 49 percent of its value.
17. Residential real‐estate values are taken from Table B.100, line 4 in the third‐quarter 2008 Flow of Funds document.
18. The International Swaps and Derivatives Association publishes summary data on outstanding derivatives contracts at http://www.isda.org/statistics/pdf/ISDA-Market-Survey-historical-data.pdf
19. The Concept Release press statement is available at http://www.cftc.gov/opa/press98/opa4142-98.htm; the release itself is available at http://www.cftc.gov/foia/fedreg98/foi980512a.htm
20. See http://www.treas.gov/press/releases/rr2426.htm for the joint statement from Treasury Secretary Rubin, Federal Reserve Board Chairman Greenspan, and S.E.C. Chairman Levitt.
21. Summers—who spearheaded opposition to the regulatory review of the derivatives markets that was proposed by the C.F.T.C., and who was the apparent architect of derivatives‐market deregulation—nonetheless said, in an interview with George Stephanopoulos on 15 March 2009, that “there are a lot of terrible things that have happened in the last eighteen months, but what's happened at A.I.G. … the way it was not regulated, the way no one was watching … is outrageous.”
22. The decline after 1929 was severe, but occurred after Persons's paper was published in Citation1930. Grebler, Blank, and Winnick (Citation1956, Table B‐3) shows that residential construction expenditures in 1930 were 53 percent of their 1929 level, and by 1932 they were 12.5 percent of their 1929 level and a mere 7.5 percent of their 1925 level.
23. Automobile production figures are from NBER Macrohistory production data, series m01107a, available at http://www.nber.org/databases/macrohistory/rectdata/01/m01107a.dat
24. According to the Motor Vehicle Manufacturers Association, by 1932 auto sales were only 25 percent of 1929 sales. See MMVA, Facts and Figures, various years.
26. Cecchetti Citation2009, 55 discusses reasons that banks may be reluctant to borrow at the discount window.
