Fligstein and Adam Goldstein Assistant Professor at Princeton University 1 examine the history of bank action leading up to the market collapse, paying particular attention to why banks created and purchased risky mortgage-backed securities MBSs and collateralized debt obligations CDOs in the first place, and why they ignored early warnings of market failure in Conventional wisdom holds that the housing industry collapsed because lenders of subprime mortgages had perverse incentives to bundle and pass off risky mortgage-backed securities to other investors in order to profit from high origination fees.
The logic follows that banks did not care if they loaned to borrowers who were likely to default since the banks did not intend to hold onto the mortgage or the financial products they created for very long. Goldstein and Fligstein challenge this understanding. They find that financial institutions actually sought out risky mortgage loans in pursuit of profits from high-yielding securities such as an MBS or CDO , and to do so, held onto high-risk investments while engaging in multiple sectors of the mortgage securitization industry.
Until the early s, engaging with multiple sectors of the housing industry through a single financial institution was highly unusual; instead, a specialized firm would perform each component of the mortgage process i. This changed when financial institutions realized that they could collect enormous fees if they engaged with all stages of the mortgage securitization process. Large financial conglomerates including Bear Stearns, Lehman Brothers, Merrill Lynch, and Morgan Stanley became lenders of mortgages, creators of mortgage-backed securities and collateralized debt obligations rather than outside investors , underwriters of securities, and mortgage servicers.
They all also invested these securities on their own accounts, frequently using borrowed money to do this. This means that as financial institutions entered the market to lend money to homeowners and became the servicers of those loans, they were also able to create new markets for securities such as an MBS or CDO , and profited at every step of the process by collecting fees for each transaction.
Using annual firm-level data for the top subprime mortgage-backed security issuers, the authors show that when the conventional mortgage market became saturated in , the financial industry began to bundle lower quality mortgages—often subprime mortgage loans—in order to keep generating profits from fees. By , more than half of the largest financial firms in the country were involved in the nonconventional MBS market.
About 45 percent of the largest firms had a large market share in three or four nonconventional loan market functions originating, underwriting, MBS issuance, and servicing. As shown in Figure 1, by , nearly all originated mortgages both conventional and subprime were securitized. Financial institutions that produced risky securities were more likely to hold onto them as investments. Since these institutions were producing and investing in risky loans, they were thus extremely vulnerable when housing prices dropped and foreclosures increased in A final analysis shows that firms that were engaged in many phases of producing mortgage-backed securities were more likely to experience loss and bankruptcy.
In a working paper, Fligstein and co-author Alexander Roehrkasse doctoral candidate at UC Berkeley 3 examine the causes of fraud in the mortgage securitization industry during the financial crisis. Fraudulent activity leading up to the market crash was widespread: mortgage originators commonly deceived borrowers about loan terms and eligibility requirements, in some cases concealing information about the loan like add-ons or balloon payments.
Banks that created mortgage-backed securities often misrepresented the quality of loans. For example, a suit by the Justice Department and the U. The authors look at predatory lending in mortgage originating markets and securities fraud in the mortgage-backed security issuance and underwriting markets.
Residential investment peaked in , as did employment in residential construction. The overall economy peaked in December , the month the National Bureau of Economic Research recognizes as the beginning of the recession. The decline in overall economic activity was modest at first, but it steepened sharply in the fall of as stresses in financial markets reached their climax.
From peak to trough, US gross domestic product fell by 4. It was also the longest, lasting eighteen months. The unemployment rate more than doubled, from less than 5 percent to 10 percent. In response to weakening economic conditions, the FOMC lowered its target for the federal funds rate from 4. As the financial crisis and the economic contraction intensified in the fall of , the FOMC accelerated its interest rate cuts, taking the rate to its effective floor — a target range of 0 to 25 basis points — by the end of the year.
In November , the Federal Reserve also initiated the first in a series of large-scale asset purchase LSAP programs, buying mortgage-backed securities and longer-term Treasury securities. These purchases were intended to put downward pressure on long-term interest rates and improve financial conditions more broadly, thereby supporting economic activity Bernanke The recession ended in June , but economic weakness persisted.
Economic growth was only moderate — averaging about 2 percent in the first four years of the recovery — and the unemployment rate, particularly the rate of long-term unemployment, remained at historically elevated levels. In the face of this prolonged weakness, the Federal Reserve maintained an exceptionally low level for the federal funds rate target and sought new ways to provide additional monetary accommodation.
The FOMC also began communicating its intentions for future policy settings more explicitly in its public statements, particularly the circumstances under which exceptionally low interest rates were likely to be appropriate. For example, in December , the committee stated that it anticipates that exceptionally low interest rates would likely remain appropriate at least as long as the unemployment rate was above a threshold value of 6.
When the financial market turmoil had subsided, attention naturally turned to reforms to the financial sector and its supervision and regulation, motivated by a desire to avoid similar events in the future.
The Global Financial Crisis of is widely regarded as the worst financial catastrophe since the s Great Depression. It started in with the subprime mortgage crisis in the United States. The collapse of the major investment bank Lehman Brothers on September 15, , developed into a full-fledged international banking crisis. The collapse of the US housing bubble, which peaked in FY , was the primary and immediate cause of the financial crisis.
But it all began after the terrorist attacks of September 11, Investment banks in the United States became aware of the situation and began to apply some of their financial wizardries to mortgages. An MBS is a series of various mortgages geographically scattered to increase diversification and thereby lower risk. Investment banks use MBS to keep future returns from such investments as high as possible while lowering risk.
Although the subprime mortgage crisis was the immediate cause, multiple interconnected financial factors caused the specialized-industry bubble burst to ripple out, bankrupting firms, crashing the stock market, and hobbling the whole economy.
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Log out. Investment Assets. Investment Accounts. Investing Strategies. More Button Icon Circle with three vertical dots. It indicates a way to see more nav menu items inside the site menu by triggering the side menu to open and close. Anne Field. Table of Contents. The Great Recession by the numbers 1.
Immoderate investments and deregulation 2. Loose lending standards in the housing market 3. Risky Wall Street behavior 4. Weak watchdogs 5. The subprime mortgage crisis 6. Anne Field is an award-winning business journalist, covering entrepreneurship, impact investing, and financial services, among other topics. Known for her distinctive ability to make complex material lively and accessible, she has contributed to such web sites and publications as the New York Times, CNNMoney.
Understanding its causes and consequences can help investors prepare for a sudden, severe drop in share prices. Why the cost of goods rise over time and what it means for the value of your money.
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