Lessons Learned from the Financial Crisis: Beginnings of the Most Severe Financial Crisis since the Great Depression

September 11, 2011

In 2008, this country started to experience the “most severe financial crisis since the Great Depression,” according to Federal Reserve Chairman Ben Bernanke. Julie Stackhouse explains the factors that led up to the crisis, including the housing bubble and its causes.

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Julie Stackhouse: So let's step back for a moment and look at where we were three years ago. And it is September of 2011. It was just September of 2008 that this country experienced what most, in fact Chairman Bernanke has characterized as the most severe financial crisis since the Great Depression. For those of you that saw the 60 Minutes episode, probably about two years ago now, where Bernanke talked about what it felt like to be chairman of the Federal Reserve at that point in time, he offered a couple of observations.

The first observation is that there were many decisions that had to be made and it was a matter of choosing from a group of undesirable decisions the best choice. So the best of what he didn’t want to have to do.

The second thing he observed is that he did not want to be chairman of the Federal Reserve during the second Great Depression. And so this quote from the Congressional Oversight report for the Troubled Asset Relief Program, also known as TARP, summarizes a little bit of where we were. We did in fact have an asset bubble in housing. It was transformed, and we'll talk about that later, and to mortgages. The mortgages had issues with them. They were put into a different form. They were sold to investors across the world and panic ensued. And our financial markets clearly felt the impact.

So let's step back for just a minute and break that apart a little bit, because it's not very understandable just to take that quote and try to comprehend what it all means. So this is a little schematic of the mortgage market. What I've tried to show here is sort of how mortgages, the volume of mortgages that originate look if you put in picture form. And, you know, not too surprising, I know Patty is a realtor. There's a big refinancing boom in the early part of the 2000s. Interest rates were low. It was a chance to go out to refinance at a lower rate, take advantage of rates that had not been seen for quite some time.

But as we approached the latter part and the middle part of the decade, the volume trailed off just slightly. But, again, not necessarily anything that would catch your eye.

But let me show you another picture. This picture shows what was happening underneath the surface. So the schematic here is just that part of mortgage originations that were the type that were called sub-prime or Alt-A. Now without getting very technical, let me preface it this way, which is to say these were mortgages that all had higher risk than a mortgage that you would likely get if you have a good credit rating and you can put down a down payment. They tended to be mortgages to either investors who didn’t necessarily want to show financial information the way you probably would if you took out a mortgage. Or they may have been mortgages to individuals that had lower than, lower credit capabilities, so they couldn't qualify for a typical mortgage.

What's meaningful is how big—hmm—that I'm going to let someone else figure that out—how big this volume got. About $1 trillion in 2005 and 2006. So if we look at the total amount of mortgages that were out there, the numbers are coming off a little bit. If we look at this piece, I'm not going to use that pointer anymore, if we look at this piece related to the sub-prime market you can see that it was actually growing and very significant by the middle part of the 2000s.

So here's some of the characteristics that today because the data is there, the mortgages are made, we can step back and look and see what was, you know, if you peel back the onion a little bit, what did these mortgages look like inside? And this is what's really amazing. If you take a look at the mortgages, a good threequarters of the mortgages had adjustable rates. So this, of course, is something where if your income is flexible and if rates go up you can afford to pay the mortgage, it can be a great thing. In fact, if you plan to live in your home for a short period of time, say five or seven years, that may be exactly the right mortgage for you, because interest rate may vary, but probably not enough that you're going to worry about it.

On the other hand, and the example I used in Susan Scarpinato's class a few years ago, if you are on a fixed income and mortgage rates can go up, there may reach a point where the rate of that mortgage exceeds what you can afford to pay. And it's at that point, and the students told me this, you're better off going with a mortgage that maybe costs a little bit more but has a fixed rate, so you always know what your payment is.

Okay, let's put the two facts together that I just talked about. The first was that sub-prime or Alt-A mortgages often went to individuals that had problems with their credit. A second fact was that many of these mortgages had rates that adjusted. And in some cases adjusted well above what they could afford to pay. And it's not necessarily that people were mis—well, maybe misinformed. But also may not have expected that they would be in a situation where they would ever see that rate go up. Because, remember, back in 2005 and 2006, it's easy to refinance a home. So if you get two or three years out and you find that the rate starts to go up, housing prices always go up, right? And so you can always refinance. And therein laid one of the fallacies. So here we had a good chunk of higher risk mortgages with variable rates.

The second part of it, a good 40 percent of the mortgages, had limited or reduced documentation. So for those that read back about sub-prime mortgages a few years ago, you may have seen the term ninja loan, no income, no job. You know, there were many terms that were out there. And I love to use this. I need to see, is there a banker in the room? Raise your hand, it's okay. Okay, right there. You're it. So here's the question. As a banker, remember, I'm the regulator, if you make a—get this right. If you make a loan to a commercial customer, do you usually ask for documentation? Yes, okay. The answer is right, yes. Good. Whew. I'm always relieved when I hear that. So generally when we look at banks and bank lending we expect banks to do things like verify income, to verify assets, to have all documentation in good order. We just expect it, because as a course of business, things can go wrong, and if you don't get the documentation right up front you're going to have a problem down the road because it gets much harder if something goes wrong.

Well, in this case these higher risk mortgages, about 40 percent had reduced or limited documentation. So as we talk today about some of the challenges with loan modifications, the reduced documentation certainly comes into play because if that actually reflected a fact where maybe there weren't as many assets as perceived, or as much income as reflected, then certainly when you try to modify a loan it's a huge challenge.

The next one I also find to be kind of fascinating. So these loans on average, when you take a loan that was put on as a second, often a loan to finance the down payment, at the time the loan was made the average amount of the loan, both the first loan and a piggyback loan, the second loan, was about 98 percent of the value of the home. So think about that.

Okay, just a real quick live poll. When you bought your first home, if you are homeowners, how many of you put 5 percent or more down on your loan? Can you raise your hand? Yeah, just about everybody in the room. You know, that was sort of the way we did things back in the old days. You did it for a couple of reasons. One, because it was obviously required of you when you got the loan. But you also saved up or you may have gone to your parents, but you had some skin in the game, and that certainly made that investment very real to you.

So a high value like this, if housing prices go up, might work, right? If you start with a very high amount of debt and the value of your asset, your dominator goes up, then you might be okay. But think about it. When housing prices go down. Later on I'm going to show you a chart that shows the decline in housing prices in Las Vegas, Nev., among other cities. And they're off about 58, 59 percent from their peak. When you start at this ratio and you lose that much value in housing prices, you can imagine how quickly the value of that home, your major asset, has now affected your balance sheet.

Other things that were characteristic, it wasn't unusual to see that these mortgages also had some cash out as part of the refinancing. I'm going to show you a chart that looks at the cash taken out. And, again, remember the advertisements? Consolidate your debt in a mortgage. You know, very, very popular back at that point in time. And so taking cash out, reducing the amount of equity was not uncommon.

And finally, most of the mortgages were originated through a wholesale means, which translated largely means mortgage brokers. Now my brother-in-law is a mortgage broker, so I speak fondly of some mortgage brokers. But we know now that were many who chose for purposes of maximizing their own income, incented or encouraged borrowers to take out mortgages that they couldn't afford. But, of course, it was the American dream to own a home, and so therein laid the risk.

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