The default rate leapt up because:

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1 The financial crisis What led up to the crisis? Short-term interest rates were very low, starting as a policy by the federal reserve, and stayed low in partly due to policy, partly to expanding funds from outside US (China, India had high growth rates and high saving rates and lent to US borrowers). Short-term interest rates were much lower than long-term interest rates. This caused banks to borrow short-term and lend long-term to take advantage of an arbitrage opportunity. One long-term loan they made was for mortgages. Long-term interest rates were low but not extraordinarily so like the short term interest rates. So the banks and other institutions that were lending would lend long-term like a mortgage to get the higher interest rate, but in order to do it would borrow at a short-term interest rate (banks always do this borrow at a low interest rate and lend out at a higher interest rate). Due to the increased desire of banks to make long-term loans, there was an increased opportunity for everyone to borrow to buy houses, even people with bad credit or low income. There was a housing boom from (prices started taking off faster then, had been rising since 1994) along with rapid expansion in home construction. Speculation in the housing market occurred because of rising prices (people bought houses with the intention of selling them at a higher price). At the same time new financial contracts had come into existence: securities backed by collections of mortgages. The backing for these securities were the mortgage payments of thousands of homeowners. These securities were getting traded among banks and getting sold to foreign inexperienced investors who didn t realize what the risk was. In fact, it was difficult for even experts to know the riskiness of these securities because they were so complicated. Thus, buyers of the securities didn t know well the default risk for the mortgages. Because of that mortgage agents could get people to buy houses, taking out loans even though they didn t have a good chance of repaying them. The mortgage agents could sell the mortgages to companies, which would then bundle them with other mortgages and sell these bundles again. Normally in the past in order to get a loan to buy a house, people would have to go to a bank, get their credit history, income, assets and debts checked 1

2 and only then maybe get a loan. But here, not only were long-term interest rates somewhat lower than usual, but also with these securities the mortgage would get packaged with many other mortgages, and even if a particular mortgage was not secure (low-income and bad credit history subprime) the money would be lent. Because the mortgage would be sold anyway as it would be bundled with many other, maybe better, mortgages. Many of these people bought houses with adjustable rate mortgages. That means that the initial interest rate would be very low, often around zero for the first year. But the interest rate would increase after that. Some people may have expected that housing prices would continue to rise, so that they would be able to refinance their house when the interest rate for them rose. However, at some point housing prices stopped rising and even fell. People making lending contracts were getting commissions for each contract they got signed. That gave them the incentive to get as many contracts signed as possible. However, housing prices couldn t keep going up indefinitely. By 2006 the rise in prices stopped on average. In 2007 average housing prices started to fall a little. The default rate leapt up because: 1. People had borrowed almost the whole value of the house. If they borrowed, say, 200,000 and paid 5000, and bought a house for 205,000, and then the market value of the house goes down to 90,000, it would make it less attractive for them to stay in the house. They would have to pay more than the value of the house, and would prefer to default and leave. 2. Also, many speculators had borrowed to buy houses, hoping to earn a profit by selling the house at a higher price. Many of these speculators also defaulted. 3. For the average low-income person who lost their house, it was because of the interest rate that they had to pay going up. This could be because of short-term interest rates rising or long-term interest rates rising, or just because of the adjustable rate mortgage they had signed. They may have expected to refinance to pay for the higher interest rate, but with a lower value of the house, they couldn t get the refinancing loan. There was a much higher rate of default than ever in history except during 2

3 the great depression. Due to falling housing prices the number of prime mortgages defaulting also began to increase. How did that lead to a financial crisis in markets that seem totally different from the housing market? There is the whole financial system, and the part of the financial system that takes in savings and lends it to individuals or to businesses (mostly to businesses). Those lenders need to have assets called bank capital that are at least some fraction of the money they lend (banks are required by law to hold a certain amount of bank capital, other lenders want it in order to not go out of businesses if borrowers default). Banks are allowed to lend at least 4 times the value of their capital. The biggest lenders to relatively big businesses are the ones who have had the most difficulty with foreclosures. In usual times, the default rate on subprime mortgages is about constant at 3 to 4%. In the subprime market it went up to about 70%. Subprime mortgages are mortgages where the owner has low income relative to the size of the loan and few assets other than the house being bought. If they default, in normal times the house is collateral, but now the value of the house has fallen a lot (because of the housing bubble bursting) so the value of the mortgage has fallen. Why did financial markets collapse after the short-term interest rate rose in 2005? Nobody expected the default rate to be this high. This is because expected default rate was calculated from models using the past default rates as a basis. However, the expansion in the number of subprime loans and decrease in their quality were not taken into account. The arbitrage opportunity had made it so that there were many more risky borrowers. The mortgage part of banks lending had expanded very fast and also suddenly had a very high default rate. That meant that 1. they were getting lower income than expected on their loans. 2. the value of their bank capital decreased, forcing them to lend out less money to keep the fraction constant. 3. Enormous expansion in uncertainty about who are trustworthy borrowers among other banks, businesses. This is because for the banks a large part of their assets were these mortgage-backed securities which could become worthless. 3

4 Why is that such a big problem? Because businesses need loans constantly to expand operations or replace used capital. The amount of available credit has dried up because the capital for the whole banking sector has fallen so much. Each bank had assets of the other banks. Many different members of the banking sector had these securities (bundled mortgage contracts), bundles of those types of securities, and insurance on other securities. Credit default swap is an insurance on bundles of bundles of mortgages or other loans. They had contracts with other members of the sector related to buying securities from others or insuring them. Then as soon as one of these banking-type institutions (first was Bear-Stearns) had its income fall by a certain percentage, they would make losses from those contracts. But this time, the profits were so large and so many institutions were not regulated in the amount of capital they would have to hold that they would borrow a very large amount compared to the amount they would lend out. This is called high leverage. They would borrow from some other banks and foreign lenders. The problem with that was that a lot of the loans at the high interest rate were going to default they were either bad mortgages or loans to other financial institutions that themselves had bad mortgages. In short 1. Due to low interest rates, people were able to borrow to buy houses. 2. Due to financial innovation (including an expansion of mortgage-bundling and existence of insurance on mortgage bundles) people with high risk of default were able to borrow to buy houses. 3. Bad mortgages were bundled with good mortgages and sold to other banks and financial institutions. 4. Speculation in the housing market made prices of houses rise. That made it seem like it wasn t risky to lend to people with high risk of default in case of default the owner of the mortgage would get the house as collateral. 5. Banks made big profits by borrowing at the lower short-term interest rate and lending at the higher long-term interest rate. They got and sold mortgages. 6. Then short-term interest rates rose. The housing price rise stopped. Many homeowners couldn t meet the higher interest rate payments and had to default. But due to the lower than expected house prices, the owners of these 4

5 mortgages lost money. 7. The owners of mortgages had to repay short-term debts at higher interest rate. So they started defaulting. 8. This caused bank capital to shrink, preventing them from making loans to other businesses. This is the real problem for the main part of the economy. What is the bailout plan? Paulson s original rescue plan asked Congress for 700 billion to buy mortgagebacked securities whose value had fallen a lot or which had become impossible to sell from companies. The government would pay prices based on an estimate of what the asset would be worth once the crisis had passed. The idea of this was to give capital to financial institutions and restore consumer confidence in them. The original proposal was rejected by Democrats and Republicans in Congress and many economists opposed it. They objected to the fact that the plan gave authority over the bailout entirely to Paulson with no oversight by Congress or any other agency. They also demanded that the government receive an ownership share in the companies it bailed out. Paulson and Bush agreed to that and to limits on executive pay during the bailout. The plan was finally accepted by Congress after 150 billion in tax provisions were added on by the Senate. 5