1. What accounts for the subprime financial turmoil which burst onto the scene in the summer of 2007? Who is most to blame for this mess? A number of interrelated factors can be pointed to in accounting for the subprime mortgage crisis and resulting credit crunch that exploded in the summer of 2007. Overly loose monetary policy, poor regulation of financial markets, the overexpansion of the subprime mortgage market and accompanying housing bubble, and the rapid growth of complex financial derivatives based on pooled mortgage loans all played significant roles in bringing about the crisis.
Looking back at the actions of the Federal Reserve in the aftermath of the 2001 recession, it is evident that the Fed made a fundamental error in ignoring soaring asset prices in their decisions to keep lowering interest rates through 2003 to a low of 1%, even as the economy recovered, and then to keep rates at historically low levels through the first half of 2004. The Fed justified its actions by pointing out that relatively low inflation during the period leading up to the crisis, as measured by the Consumer Price Index (CPI), led them to see no need to raise interest rates and stifle the economic recovery underway.Unfortunately, instead of bidding up the prices of goods and services included in the CPI, the excess money supply created by extremely low interest rates found its way into assets—homes and commercial real estate—and helped to create the housing bubble. While it is clear that monetary policy errors played a foundational role in creating the economic environment that enabled and accelerated the housing bubble, the greatest responsibility for the catastrophic extent of the crisis rests with the managers of mortgage lenders and financial institutions.Irresponsible lending practices, unrealistic expectations about future home values, the euphoria over high returns from mortgage backed securities (CDOs), along with the inaccurate pricing of risk, are some of the primary reasons that so many investors and financial institutions worldwide were overly exposed to the risks inherent in the subprime mortgage market.
The advent of the modern mortgage model, where banks make loans to prospective homeowners and then sell them to large institutional investors, incentivized lax lending standards on the part of bank managers, as they were no longer concerned with the loan applicant’s ability to repay so much as with the commission they would earn from selling the mortgage.That CDOs and other mortgage backed securities, which included large proportions of subprime loans, were able to earn “AAA” or higher credit ratings points to poor risk assessment and conflicts of interest on the part of ratings agencies that were paid by the very institutions whose financial instruments they were rating. Prior to 2007 the default rate on subprime loans, though higher than that of prime and near prime loans, were not so high as to lead investors to believe that CDOs were riskier than their high credit ratings indicated.It seems that investors, financial institutions, and ratings agencies failed to realize that comparatively low subprime default rates were dependent upon rising home prices and low interest rates and based their assessment of the riskiness of mortgage backed securities on the unrealistic assumption that home prices would continue rise and interest rates remain low indefinitely. 2.
What has the Fed done with regard to monetary policy to address the economic downturn resulting from the subprime crisis?What is your assessment of how Ben Bernanke has handled the situation? After the housing bubble burst in the summer of 2007 and the credit crunch set in, the Fed began a series of interest rate cuts in the fall of 2007 in an attempt to stimulate lending, arguing that the downside risks to the economy outweighed concerns over rising inflation. The Fed also pursued a strategy based on injecting capital into financial markets to provide troubled institutions with much needed liquidity beginning with a $35 billion injection on August 10, 2007.Continuing financial woes and tight credit markets persisted, however, prompting the Fed to step up the pace and degree of interest rate cuts, slashing the Federal funds rate on January 22, 2008 by three quarters of a percentage point to 3. 5%, the largest cut since 1982.
Rate cuts continued throughout 2008, settling at 0. 25% by December. Overall, Ben Bernanke has done admirable job in handling the subprime crisis, acting swiftly to lower interest rates to loosen tightening credit markets and standing up to critics that accused him of irresponsibly ignoring the threat of rising inflation posed by his policies.He clearly recognized the grave implications of the subprime crisis for the global economy and did not dither when it came to policy actions to stimulate lending in the financial markets.
Despite criticisms that the Fed’s capital injections contributed to moral hazard on the part of bank managers, these measures were necessary to prevent the possible collapse of the global financial system, which would have had disastrous consequences for the world economy. 3. What fiscal policy actions have been taken to address the economic downturn?What additional fiscal policy actions should be taken? The Bush administration launched a $150 billion fiscal stimulus package in early summer 2008 comprised of tax cuts for businesses and tax rebates for households and individuals. Many experts argued that the stimulus was not timely enough to address the crisis, and others pointed out that early surveys revealed most potential recipients did not intend to spend their rebates, but rather planned to save them or use them pay off bills.The Bush stimulus did cause an uptick in consumer spending in the second and third quarters of 2008, though it was short-lived and seemed to do little alter the downward course of the economy.
Clearly, given the severity of the economic downturn and the seeming impotence of monetary policy, a more expansive fiscal stimulus is necessary, one that incorporates increased government spending along with tax cuts aimed directly at stimulating consumption, such as tax-incentives for home improvements and new car and home purchases. . If you were advising top lawmakers in Washington about potential policy responses to the subprime mortgage crisis and ensuing recession, what advice would you offer? If the link does not work, copy the address below and paste into your browser. http://www. time.
com/time/specials/packages/article/0,28804,1877351_1877350,00. html
