ECN201 Grantham University Housing Collapse Great Recession Paper Housing Collapse Paper After reading Special Topic 5, write a 2-page paper answering the

ECN201 Grantham University Housing Collapse Great Recession Paper Housing Collapse Paper

After reading Special Topic 5, write a 2-page paper answering the following:

Why did housing prices rise rapidly during 2002 – 2005?

Why did the mortgage default rate increase so sharply during 2006 and 2007 even before the 2008 – 2009 recession began?

What did the Community Reinvestment Act have to do with the housing bubble and collapse?

Special Topic 5 is below:

Chapter Introduction

Why did housing prices rise rapidly during 2001–2005 and then fall in the years immediately following? Did regulation play a role? Did monetary policy contribute to the housing boom and bust?
What caused the Great Recession of 2008–2009?
Has the crisis changed the structure of the U.S. economy?

U.S. housing policies are the root cause of the current financial crisis. Other players—“greedy” investment bankers; foolish investors; imprudent bankers; incompetent rating agencies; irresponsible housing speculators; shortsighted homeowners; and predatory mortgage brokers, lenders, and borrowers—all played a part, but they were only following the economic incentives that government policy laid out for them. —Peter J. Wallison

The headlines of 2008 were dominated by falling housing prices, rising default and foreclosure rates, failure of large investment banks, and huge bailouts arranged by both the Federal Reserve and the U.S. Treasury. The Great Recession of 2008–2009 substantially reduced the wealth of most Americans and generated widespread concern about the future of the U.S. economy. This crisis and the response to it may well be the most important macroeconomic event of our lives. Thus, it is vitally important for each of us to understand what happened, why things went wrong, and the lessons that need to be learned from the experience.

ST05-1 Key Events Leading up to the Great Recession

The housing boom and bust during the first seven years of this century are central to understanding the economic events of 2008. As Exhibit 1 shows, housing prices were relatively stable during the 1990s, but they began to increase rapidly toward the end of the decade. By 2002, housing prices were booming. Between January 2002 and mid-year 2006, housing prices increased by a whopping 87 percent. This translates to an annual growth rate of approximately 13 percent. But the housing boom began to wane in 2006. Housing prices leveled off, and by the end of 2006, they were falling. The boom had turned to a bust, and the housing price decline continued throughout 2007 and 2008. By year-end 2008, housing prices were approximately 30 percent below their 2006 peak.

Exhibit 1Annual Change in the Price of Existing Houses, 1987–2008

Housing prices increased slowly during the 1990s, but they began rising more rapidly toward the end of the decade. Between January 2002 and mid-year 2006, housing prices increased by a whopping 87 percent. But the boom turned to a bust during the second half of 2006, and the housing price decline continued throughout 2007–2008.

Source: www.standardpoors.com, S&P Case-Schiller Housing Price Index.

Exhibit 2 part (a) presents data on the mortgage default ratemortgage default rateThe percentage of home mortgages on which the borrower is late by ninety days or more with the payments on the loan or it is in the foreclosure process. This rate is sometimes referred to as the serious delinquency rate. mortgage default rate The percentage of home mortgages on which the borrower is late by ninety days or more with the payments on the loan or it is in the foreclosure process. This rate is sometimes referred to as the serious delinquency rate. from 1979 through 2008. (Note: The default rate is also known as the serious delinquency rate.) As these figures illustrate, the default rate fluctuated, within a narrow range, around 2 percent prior to 2006. It increased only slightly during the recessions of 1982, 1990, and 2001.

Exhibit 2Mortgage Default and Housing Foreclosure Rates, 1979–2008

As part (a) shows, the mortgage default rate fluctuated within a narrow range around 2 percent for more than two decades before 2006. It increased only slightly during the recessions of 1980, 1982, 1990, and 2001 but started to increase in the second half of 2006 and soared to more than 5 percent in 2008. As part (b) shows, the foreclosure rate followed a similar pattern. It ranged between 0.2 and 0.5 percent before 2006, before soaring to 1.2 percent in 2008.

Source: http://mbaa.org, National Delinquency Survey.

However, even though the economy was relatively strong and unemployment low, the default rate began to increase sharply during the second half of 2006. By the fourth quarter of 2007, it had already risen to 3.6 percent, up from 2.0 percent in the second quarter of 2006. The increase continued and the default rate reached 5.2 percent in 2008.

As Exhibit 2 part (b) illustrates, the pattern of the housing foreclosure rateforeclosure rateThe percentage of home mortgages on which the lender has started the process of taking ownership of the property because the borrower has failed to make the monthly payments. foreclosure rate The percentage of home mortgages on which the lender has started the process of taking ownership of the property because the borrower has failed to make the monthly payments. was similar. It fluctuated between 0.2 and 0.5 during 1978–2005. The recessions of 1980, 1982, 1990, and 2001 exerted little impact on the foreclosure rate. However, like the mortgage default rate, the foreclosure rate started to increase during the second half of 2006, and it tripled over the next two years.

During 2008, housing prices were falling, default rates were increasing, and the confidence of both consumers and investors was deteriorating. These conditions were reinforced by sharply rising prices of crude oil, which pushed gasoline prices to more than $4 per gallon during the first half of the year. Against this background, the stock market took a huge tumble. As Exhibit 3 shows, the S&P 500 index of stock prices fell by 55 percent between October 2007 and March 2009. This collapse eroded the wealth and endangered the retirement savings of many Americans.

Exhibit 3Changes in Stock Prices, 1996–2009

Stock prices as measured by the Standard & Poors 500 are shown here. Note how stock prices fell by approximately 55 percent between October 2007 and March 2009. This collapse eroded the wealth and endangered the retirement savings of many Americans.

Source: www.standardpoors.com.

ST05-2 What Caused the Great Recession?

Why did housing prices rise rapidly, then level off, and eventually collapse? Why did the mortgage default and housing foreclosure rates increase rapidly well before the start of the recession, which did not begin until December 2007? Why are the recent default and foreclosure rates so much higher than the rates of earlier years, including those of prior recessions? Why did large, and seemingly strong, investment banks like Bear Stearns and Lehman Brothers run into financial troubles so quickly? Four factors combine to provide the answers to all of these questions.

ST05-2a Factor 1: Change in Mortgage Lending Standards

The lending standards for home mortgage loans changed substantially beginning in the mid-1990s. The looser lending standards did not just happen. They were the result of federal policy designed to promote home ownership among households with incomes below the median. Home ownership is a worthy goal, but it was not pursued directly through transparent budget allocations and subsidies to homebuyers. Instead, the federal government imposed a complex set of regulations and regulatory mandates that forced various lending institutions to extend more loans to low- and moderate-income households. To meet these mandates, lenders had to lower their standards. By the early years of the twenty-first century, it was possible to borrow more (relative to your income) and purchase a house or condo with a lower down payment than was the case a decade earlier.

The Federal National Mortgage Association and Federal Home Loan Mortgage Corporation, commonly known as Fannie Mae and Freddie Mac, played a central role in this relaxation of mortgage lending standards. These two entities were created by Congress to help provide liquidity in secondary mortgage markets. Fannie Mae, established by the federal government in 1938, was spun off as a government-sponsored enterprise (GSE) in 1968. Freddie Mac was created in 1970 as another GSE to provide competition for Fannie Mae.

Fannie Mae and Freddie Mac were privately owned (for-profit) businesses, but because of their federal sponsorship, it was widely perceived that the government would back their bonds if they ever ran into financial trouble. As a result, Fannie and Freddie were able to borrow funds at 50 to 75 basis pointsbasis pointsOne one-hundredth of a percentage point. Thus, 100 basis points are equivalent to one percentage point. basis points One one-hundredth of a percentage point. Thus, 100 basis points are equivalent to one percentage point. cheaper than private lenders. This gave them a competitive advantage, and they were highly profitable for many years. However, the GSE structure also meant that they were asked to serve two masters: their stockholders, who were interested in profitability, and Congress and federal regulators, who predictably were more interested in political objectives.

As a result of their GSE structure, Fannie Mae and Freddie Mac were highly political. The top management of Fannie and Freddie provided key congressional leaders with large political contributions and often hired away congressional staffers into high-paying jobs lobbying their former bosses. Between the 2000 and 2008 election cycles, high-level managers and other employees of Fannie Mae and Freddie Mac contributed more than $14.6 million to the campaign funds of dozens of senators and representatives, most of whom were on congressional committees important for the protection of their privileged status.

The lobbying activities of Fannie Mae and Freddie Mac were legendary. Between 1998 and 2008, Fannie spent $79.5 million and Freddie spent $94.9 million on congressional lobbying, placing them among the biggest spenders on these activities. They also set up “partnership offices” in the districts and states of important legislators, often hiring the relatives of these lawmakers to staff these local offices. The politicians, for their part, and the regulators who answered to them fashioned rules that made very high profits possible for the GSEs, at least in the short run. Although it was a relationship that reflected political favoritism (some would say corruption), members of Congress, particularly those involved in banking regulation, were highly supportive of the arrangement.

Fannie Mae and Freddie Mac did not originate mortgages. Instead, they purchased the mortgages originated by banks, mortgage brokers, and other lenders. Propelled by their cheaper access to funds, Fannie Mae and Freddie Mac grew rapidly during the 1990s. As Exhibit 4 shows, the share of all mortgages held by Fannie Mae and Freddie Mac jumped from 25 percent in 1990 to 45 percent in 2001. Their share fluctuated around 40 percent during 2001–2008. Their dominance of the secondary mortgage marketsecondary mortgage marketA market in which mortgages originated by a lender are sold to another financial institution. In recent years, the major buyers in this market have been Fannie Mae, Freddie Mac, and large investment banks. secondary mortgage market A market in which mortgages originated by a lender are sold to another financial institution. In recent years, the major buyers in this market have been Fannie Mae, Freddie Mac, and large investment banks. was even greater. During the decade prior to their insolvency and takeover by the federal government during the summer of 2008, Fannie Mae and Freddie Mac purchased about 90 percent of the mortgages sold in the secondary market. Because of this dominance, their lending practices permitted them to exert a huge impact on the standards accepted by mortgage originators.

Exhibit 4The Share of Total Outstanding Mortgages Held by Fannie Mae and Freddie Mac, 1990–2008

Fannie Mae and Freddie Mac dominated the mortgage market for many years. Because of their government sponsorship, they were able to obtain funds cheaper than private firms. They held 45 percent of all mortgages in 2001, up from 25 percent in 1990. During 2001–2008, their share fluctuated around 40 percent. Their dominance of the secondary market, where loans are purchased from originators, is even greater. In July 2008, they were declared insolvent and taken over by the U.S. Treasury.

Source: Office of Federal Housing Enterprise Oversight, www.ofheo.gov.

Responding to earlier congressional legislation, the Department of Housing and Urban Development (HUD) imposed regulations designed to make housing more affordable. The HUD mandates, adopted in 1995, required Fannie Mae and Freddie Mac to extend a larger share of their loans to low- and moderate-income households. For example, under the HUD mandates, 40 percent of new loans financed by Fannie Mae and Freddie Mac in 1996 had to go to borrowers with incomes below the median. This mandated share was steadily increased to 50 percent in 2000 and 56 percent in 2008. Similar increases were mandated for borrowers with incomes of less than 60 percent of the median. Moreover, in 1999, HUD guidelines required Fannie Mae and Freddie Mac to accept smaller down payments and permitted them to extend larger loans relative to income.

The policies of Fannie Mae and Freddie Mac exerted an enormous impact on the actions of banks and other mortgage lenders. Recognizing that riskier loans could be passed on to Fannie and Freddie, mortgage originators had less incentive to scrutinize the creditworthiness of borrowers and more incentive to reduce the required down payment, in order to sell more mortgages. After all, when the mortgages were soon sold to Fannie or Freddie, the risk was transferred to them also. The bottom line: Required down payments were reduced and the accepted credit standards lowered.

Modifications to the Community Reinvestment Act (CRA) in 1995 also loosened mortgage-lending standards. These changes required banks to meet numeric goals based on the low-income and minority population of their service areas when extending mortgage loans. In order to meet these requirements, many banks, especially those in urban areas, were forced to reduce their lending standards and extend more loans to borrowers who did not meet the conventional credit criteria.

The lower standards resulting from the GSE and CRA regulations reduced lending standards across the board. Lenders could hardly offer low-down-payment loans and larger mortgages relative to housing value on subprime loanssubprime loansA loan made to a borrower with blemished credit or one who provides only limited documentation of income, employment history, and other indicators of creditworthiness. subprime loans A loan made to a borrower with blemished credit or one who provides only limited documentation of income, employment history, and other indicators of creditworthiness. , without offering similar terms to prime borrowers. As the regulations tightened, the share of loans extended to subprime borrowers steadily increased. Exhibit 5 illustrates this point. Measured as a share of mortgages originated during the year, subprime mortgages rose from 4.5 percent in 1994 to 13.2 percent in 2000 and 20 percent in 2005 and 2006. (Note: Bank examiners consider a loan to be subprime if the borrower’s FICO scoreFICO scoreA credit score measuring a borrower’s likely ability to repay a loan. A person’s FICO score will range between 300 and 850. A score of 700 or more indicates that the borrower’s credit standing is good. FICO is an acronym for the Fair Isaac Corporation, the creators of the FICO score. FICO score A credit score measuring a borrower’s likely ability to repay a loan. A person’s FICO score will range between 300 and 850. A score of 700 or more indicates that the borrower’s credit standing is good. FICO is an acronym for the Fair Isaac Corporation, the creators of the FICO score. is less than 660.) When the Alt-A loansAlt-A loansLoans extended with little documentation or verification of the borrowers’ income, employment, and other indicators of their ability to repay. Because of this poor documentation, these loans are risky. Alt-A loans Loans extended with little documentation or verification of the borrowers’ income, employment, and other indicators of their ability to repay. Because of this poor documentation, these loans are risky. , those extended without full documentation, were added to the subprime, a third of the mortgages extended in 2005–2006 were to borrowers with either poor or highly questionable credit records.

Exhibit 5Subprime and Alt-A Mortgages as a Share of the Total, 1994–2007

Both subprime and Alt-A mortgages reflect loans to borrowers with a weak credit history. Note how the share of loans to borrowers in these two cate-gories jumped from roughly 10 percent in 2001–2003 to 33 percent in 2005–2006.

Source: The data for 1994–2000 are from Edward M. Gramlich, Financial Services Roundtable Annual Housing Policy Meeting, Chicago, Illinois (21 May 2004), www.federalreserve.gov/boarddocs/speeches/2004/200…. The data for 2001–2007 are from the Joint Center for Housing Studies of Harvard University, The State of the Nation’s Housing 2008, www.jchs.harvard.edu/son/index.htm.

As the mortgages extended to those with weak credit soared, so too did the number with little or no down payment. Exhibit 6 shows both the number of loans issued by Fannie Mae and Freddie Mac and the share extended to borrowers with 5 percent or less down payment. Note how the number of new loans financed by the government sponsored corporations increased from less than one hundred thousand in the late 1990s to more than six hundred thousand in 2007. At the same time, the share of mortgages to borrowers making a down payment of 5 percent or less rose from 4 percent in 1998 to 12 percent in 2003 and 23 percent in 2007. Thus, Fannie Mae and Freddie Mac were flooding the market with low-down-payment loans extended to borrowers with weak credit. Meanwhile, conventional loans for which borrowers were required to make at least a 20 percent down payment fell from two-thirds of the total in the early 1990s to only one-third in 2005–2006.

Exhibit 6Growth of Low-down-payment Loans Extended by Fannie Mae and Freddie Mac

Following the 1999 HUD guidelines encouraging Fannie Mae and Freddie Mac to extend more low-down-payment loans, the GSEs both increased the number of their mortgages (left frame) and the share extended with a down payment of 5 percent or less. As the right frame shows, the share of these low down payment mortgages extended by Fannie Mae and Freddie Mac increased from 4 percent in 1998 to 12 percent in 2003 and 23 percent in 2007.

Sources: Russell Robert’s, Gambling With Other Peoples Money, Mercatus Center, http://mercatus.org/publications/gambling-other-pe….

The shift from conventional loans to “creative finance” and “flexible standards,” as the regulators called the new criteria, is highly important because the default and foreclosure rates for subprime loans ranges from seven to ten times the rate for conventional loans to prime borrowers. This differential is even greater in the case of mortgages with little or no down payment. Initially, this easy credit policy increased demand and pushed housing prices upward. But, the policy was not sustainable and it was predictable where it would lead. Eventually, the growing share of low-down-payment loans extended to those with weak credit would result in substantially higher default and foreclosure rates. This is precisely what happened.

ST05-2b Factor 2: Prolonged Low Interest Rate Policy of the Fed During 2002–2004

Following the high and variable inflation rates of the 1970s, Federal Reserve policy focused on keeping the inflation rate low and stable. By the mid-1980s, the inflation rate had been reduced to 3 percent. Throughout 1985–1999, the Fed kept the inflation rate low and avoided abrupt year-to-year changes. In turn, the relative price stability reduced uncertainty and created an environment for both strong growth and economic stability.

However, beginning in 1999, Fed policy became more erratic. Monetary policy was expansionary just before 2000, restrictive prior to the recession of 2001, and then highly expansionary during the recovery from that recession. As Exhibit 7 shows, the Fed kept short-term interest rates at historic lows throughout 2002–2004. These extremely low short-term rates increased the demand for interest-sensitive goods like automobiles and housing.

Exhibit 7 Fed Policy and Short-Term Interest Rates, 1995–2009

Here we show the federal funds and one-year Treasury bill interest rates. These short-term rates are reflective of monetary policy. Note how the Fed pushed these rates to historic lows (less than 2 percent) throughout 2002–2004 but then increased them substantially during 2005–2006. The low rates provided fuel for the housing price boom, but the rising rates led to higher interest rates and monthly payments on adjustable rate mortgage (ARM) loans, which helped push the mortgage default and foreclosure rates upward beginning in the second half of 2006.

Sources: www.federalreserve.gov and www.economagic.com.

The Fed’s artificially low short-term rates substantially increased the attractiveness of adjustable rate mortgages (ARMs)adjustable rate mortgages (ARMs)A home loan in which the interest rate, and thus the monthly payment, is tied to a short-term rate like the one-year Treasury bill rate. Typically, the mortgage interest rate will be two or three percentage points above the related short-term rate. It will be reset at various time intervals (e.g., annually), and thus the interest rate and monthly payment will vary over the life of the loan. adjustable rate mortgages (ARMs) A home loan in which the interest rate, and thus the monthly payment, is tied to a short-term rate like the one-year Treasury bill rate. Typically, the mortgage interest rate will be two or three percentage points above the related short-term rate. It will be reset at various time intervals (e.g., annually), and thus the interest rate and monthly payment will vary over the life of the loan. to both borrowers and lenders. As Exhibit 8 shows, adjustable rate mortgages jumped from 10 percent of the total outstanding mortgages in 2000 to 21 percent in 2005. The low initial interest rates on adjustable rate mortgages made it possible for homebuyers to afford the monthly payments for larger, more expensive homes. This easy credit provided fuel for the housing boom. But the low rates and ARM loans also meant that as short-term interest rates increased from their historic low levels, home buyers would face a higher monthly payment two or three years in the future. Unsurprisingly, this is precisely what happened.

Exhibit 8 Adjustable Rate Mortgages (ARMs) as a Share of Total Outstanding Mortgages, 1990–2008

The interest rate and monthly payment on ARMs are tied to a short-term interest rate (e.g., the one-year Treasury bill rate). The Fed’s low-interest rate policy of 2002–2004 increased the attractiveness of ARMs. Note how ARM loans increased as a share of total mortgages from 10 percent in 2000 to 21 percent in 2005.

Source: Office of Federal Housing Enterprise Oversight, www.ofheo.gov.

By 2005, the expansionary monetary policy of 2002–2004 was clearly placing upward pressure on the general level of prices. The Fed responded with a shift to a more restrictive monetary policy, which pushed interest rates upward (see Exhibit 7). Many who purchased houses with little or no down payment and adjustable rate loans when interest rates were low during 2002–2004 faced substantially higher monthly payments as interest rates rose and the monthly payments on their ARM loans were reset during 2006 and 2007. These owners had virtually no equity in their homes. Therefore, when housing prices leveled off and began to decline during the second half of 2006, the default and foreclosure rates on these loans began to rise almost immediately (see Exhibits 1 and 2). Some owners with little or no initial equity simply walked away as their outstanding loan exceeded the value of their house.

Essentially, the small down payment and ARMs combination made it possible for homebuyers to gamble with someone else’s money. If housing prices rose, buyers could reap a sizable capital gain without risking much of their own investment capital. Based on the rising housing prices of 2000–2005, many of these homebuyers expected to sell the house for a profit and move on in a couple of years. There were even television programs and investment seminars pushing this strategy as the route to riches.

Exhibit 9 shows the foreclosure rates for fixed interest rate and ARM loans for both subprime and prime loans. Compared to their prime borrower counterparts, the foreclosure rate for subprime borrowers was approximately ten times higher for fixed rate mortgages and seven times higher for adjustable rate mortgages. These huge differentials explain why the increasing share of loans to subprime borrowers substantially increased the default and foreclosure rates.

Exhibit 9 The Foreclosure Rate of Fixed and Adjustable Rate Mortgages for Subprime and Prime Borrowers, 1998–2008

The foreclosure rates on fixed and adjustable interest rate mortgages are shown here for both subprime (part a) and prime (part b) borrowers. Note how the foreclosure rate was generally seven to ten times higher for subprime loans than for those to prime borrowers. As housing prices leveled off and declined in 2006–2008, the foreclosure rate on fixed interest rate mortgages did not change much. In contrast, the foreclosure rate for ARM loans soared beginning in the second half of 2006, and this was true for ARM loans to both subprime and prime borrowers. Clearly, the increasing share of both subprime and ARM loans during 2000–2005 contributed to the boom and bust of the housing market.

Source: Stan J. Liebowitz, “Anatomy of a Train Wreck: Causes of the Mortgage Meltdown,” Ch. 13 in Randall G. Holcombe and Benjamin Powell, eds, Housing America: Building Out of a Crisis (New Brunswick, NJ: Transaction Publishers, 2009). We would like to thank Professor Liebowitz for making this data available to us.

As Exhibit 9 shows, there was no upward trend in the foreclosure rate on fixed interest rate loans for either prime or subprime borrowers during 2000–2008. On the other hand, the foreclosure rate on ARMs soared for both prime and subprime loans during 2006–2008. In fact, the percentage increase in foreclosures on ARM loans was higher for prime than subprime borrowers. This is highly revealing. It illustrates that both prime and subprime borrowers played the low-down-payment, mortgage casino game.

The loan default problem is often referred to as the subprime mortgage crisis. This is true, but it is only part of the story. It was also an ARM loan crisis. Fed policy encouraging ARM loans, the increasing proportion of these loans as a share of the total, and their higher default and foreclosure rates also contributed substantially, first to the housing boom and then to the bust. The combination of the mortgage lending regulations and the Fed’s artificially low interest rate policies encouraged decision-makers to borrow more money and make unwise and inefficient investments.

ST05-2c Factor 3: The Increased Debt-to-Capital Ratio of Investment Banks

A rule change adopted by the Securities and Exchange Commission (SEC) in April 2004 made it possible for investment banksinvestment banksAn institution that acts as an underwriter for securities issued by other corporations or lenders. Unlike traditional banks, investment banks do not accept deposits from, or provide loans to, individuals. investment banks An institution that acts as an underwriter for securities issued by other corporations or lenders. Unlike traditional banks, investment banks do not accept deposits from, or provide loans to, individuals. to increase the leverage of their investment capital, which eventually led to their collapse. A firm’s leverage ratioleverage ratioThe ratio of loans and other investments to the firm’s capital assets. leverage ratio The ratio of loans and other investments to the firm’s capital assets. is simply the ratio of its investment holdings (including loans) relative to its capital. Thus, if a firm had investment funds that were twelve times the size of its equity capital, its leverage ratio would be 12 to 1. Prior to the SEC rule change, this was approximately the leverage ratio of both investment and commercial banks.

Essentially, the SEC applied regulations known as Basel I to investment banking. These regulations, which have been adopted by most of the industrial countries, require banks to maintain at least 8 percent capital against assets like loans to commercial businesses. This implies a leverage ratio of approximately 12 to 1. However, the Basil regulations provide more favorable treatment of residential loans. The capital requirement for residential mortgage loans is only 4 percent, which implies a 25 to 1 leverage ratio. Even more important, the capital requirement for low-risk securities is still lower at 1.6 percent. This means that the permissible leverage ratio for low-risk securities could be as high as 60 to 1.

Key investment banking leaders, including Henry Paulson who was CEO of Goldman Sachs at the time, urged the SEC to apply the higher leverage ratio to investment banks. Ironically, Paulson later became Secretary of the Treasury and was in charge of the federal “bailout” of the banks that got into trouble because of the excessive leveraging of their capital.

Following the rule change, large investment banks, like Lehman Brothers, Goldman Sachs, and Bear Stearns, expanded their mortgage financing activities. They bundled large holdings of mortgages together and issued securities for their finance. Because of the diversity of the mortgage portfolio, investment in the underlying securities was thought to involve minimal risk. If the security-ratingsecurity-ratingA rating indicating the risk of default of the security. A rating of AAA indicates that the risk of default is low. security-rating A rating indicating the risk of default of the security. A rating of AAA indicates that the risk of default is low. firms provided the mortgage-backed securitiesmortgage-backed securitiesSecurities issued for the financing of large pools of mortgages. The promised returns to the security holders are derived from the mortgage interest payments. mortgage-backed securities Securities issued for the financing of large pools of mortgages. The promised returns to the security holders are derived from the mortgage interest payments. with a AAA rating, then the investment banks could leverage them up to 60 to 1 against their capital.

The mortgage-backed securities, financed with short-term leveraged lending, were highly lucrative. The large number of mortgages packaged together provided lenders with diversity and protection against abnormally high default rates in specific regions and loan categories. But it did not shield them from an overall increase in mortgage default rates. As default rates increased sharply in 2006 and 2007, it became apparent that the mortgage-backed securities were far more risky than had been previously thought. When the risk of these mortgages became more apparent, the value of the mortgage-backed securities plummeted because it was difficult to know their true value. As the value of the mortgage-backed securities collapsed, the highly leveraged investment banks faced massive short-term debt obligations with little reserves on which to draw. This is why the investment banks collapsed so quickly. In fact, when the Fed financed the acquisition of Bear Stearns by JPMorgan Chase, the leverage ratio of Bear Stearns was an astounding 33 to 1, about two and a half times the historical level associated with prudent banking practices.

Why didn’t key Wall Street decision makers see the looming danger? No doubt, they were influenced by the low and relatively stable default rates over the past several decades (see Exhibit 2). Even during serious