The
roots of the United States’ financial crisis began during the Clinton
administration when banks Fannie Mae and Freddie Mac started encouraging
subprime loans to people who could not afford houses. Additionally, the government bailed out a
company called Long-Term Capital Management, which pioneered the development of
securities and credit derivatives. This
business plan failed eventually. When it
was bailed out, however, something insidious was signaled to the rest of the
industry. Namely, banks lost their
incentive to be fiscally responsible since they knew that they could be rescued
by the Federal Reserve in the event of a monetary emergency. The Reserve followed that action by bailing
out Bear Stearns, which only served to reinforce the policy. This assurance of safety allowed a trend to
form that ended up becoming the housing bubble.
Bubbles are not new, however. “Financial
bubbles, characterized by substantial rises in asset prices departing from
previous trends that are suddenly interrupted by a sharp fall, have been common
in economic history.”5 Real estate was targeted in America’s recent
crisis. As prices of housing began to
rise, people started to buy houses that they could not afford since they
believed that they could continue to make money on it. Unfortunately, many of these “sup-prime”
loans were destined for failure and borrowers declared bankruptcy en masse. A result of these bankruptcies that came in such
a high volume over a short duration was that the financial system in America
started to collapse as well. These
collapses manifested themselves as issues with insolvency and liquidity. When these “liquidity crises” start, they are
usually accompanied by damage to the economy as consumers lose confidence in
the financial system and begin to panic6.
Fannie Mae and Freddie Mac were
originally created and sponsored by the government to facilitate construction
and loans during the Housing and Urban Development program. Both contributed in
a unique way to the housing bubble that precipitated the crisis. Fannie Mae was started to securitize debt and
resell it as an investment. Initially
this process was only applied to safe (or “prime”) mortgages where the lender
was confident, based on some qualification matrix, that he would be
repaid. Eventually, however,
securitization was given to riskier ones (which are, “sup-prime”, or loans
where banks believed they had less of a chance of being repaid by the borrowers
due to low incomes or other factors) as well.
This was the result of the federal government’s increased requirements,
via the HUD program, for creating affordable housing. Suddenly Fannie and Freddie had a higher
quantity of loans to securitize. They
continued the securitization of sup-prime mortgages even during the crunch,
when loans began to default on a massive scale in 2007 and 2008. These government-supported enterprises had
internal issues as well. They were
fraught with corruption, mismanagement, and fraud. For these and other reasons, much of the
sub-prime lending that contributed to the housing bubble can be credited to the
irresponsibility and corruption within Fannie Mae and Freddie Mac7.
As banks began to fail at an
alarming rate, the government stepped in and gave them emergency funding under
a program called TARP, which stands for Troubled Asset Relief Program. The justification for these massive influxes
of cash was that the banks were “too big to fail”. This phrase became quite popular during the
latter 2000s. Essentially this
expression meant that if a bank were to go bankrupt, there would be serious
implications, unquestionably catastrophic ones, for the economy. Fisher’s 2010 article in the CATO Journal
speaks to the issue of whether or not an entity should be allowed to unravel if
such a thing would influence the downfall of other entities (financial
institutions in the case of the former and the American populace in the case of
the latter). Serious debate has been
sparked over the TARP, with staunch supporters of the bailout on one side and
those who oppose it with equal vigor on the other. Fisher suggests that there are two schools of
thought when dealing with institutions that are deemed “too big to fail”. The first states that large firms (especially
banks) are the lifeblood of the global economy and without them, there could
not be as much growth since they permit borrowers access to incredibly large
sums of money. Without the ability to
borrow this money, businesses would have to save their own money to be able to
invest in new projects. This would be
especially difficult if they were starting for the first time. So banks are necessary. The second school states that while banks are
a big part of society, society could still continue in their absence. Further, when a bank has reaches the status
of “too big to fail” and is guaranteed the bailout if they get in hot water,
they lose the incentive to be careful with their money, as mentioned above. This loss of responsibility is called a
“moral hazard”. A side effect that
accompanies this is the realization that when times are good, banks reap the
benefits of their actions. But when
times are bad, society is forced to pay the consequences twice, in the actual
bailout money that is used and in the loss to the value (purchasing power) of
their money because of inflation that results from the creation of new
money. Thus the bailout policy
encourages risky behavior in a two-fold manner.
The debate cannot be satisfactorily resolved, however, because there is
only one chain of events that actually happened (namely, the bailouts were
affected) and so there is no way of knowing if the economy would have been
better or worse without the stimulus spending9.
While the Federal Reserve was busy
bailing out 928 institutions with 652 billion dollars (as of April 18th,
2012)10, the Bank of England was doing the same with Northern Rock
and similar British firms. In fact, the
actions of both central banks mirrored each other quite closely in both the
bank bailouts and the quantitative easing that followed. “Quantitative Easing” is a technical term for
injecting liquidity (money) into the economy.
Both the Federal Reserve and Bank of England introduced huge amounts of
money into their respective economies.
Quantitative Easing is best described by the Bank of England’s Website:
“the Bank buys assets from private sector institutions…So the seller has more
money in their bank account, while their bank holds a corresponding claim
against the Bank of England…The end result is more money out in the wider
economy.”11 By purchasing
mortgages (as the “asset” in this case) from lending firms, both central banks
were able to stimulate the economy and rescue banks from their defaulted loans
simultaneously.
While the central banks’ responses
in fighting the crisis caused by unwise loans were similar, the responses of
each country’s populace differed. In
England, there was a run on Northern Rock when they announced their need for
emergency funding. In fact, a full five
percent of its entire holdings, over one billion pounds, were withdrawn over
the course of a day12. In
America, no runs were initiated, but the Occupy Wall Street movement was formed
to generally protest the actions of big banks and wealthy individuals. There were no other similar reactions to the
crisis since the goals of the Occupy Movement were broad enough to encompass
the objections of all disgruntled citizens.
As abuses of both borrowing and
lending power have been perpetuated on both sides of the Pond, the central
banks of England and the United States have been quick and responsive in
dealing with the new First World problems that societies face today. While there has been no shortage of debate on
the merits of “bailing out” banks and quantitative easing, there cannot be any
doubt that each country has learned many lessons for the future. Such wisdom will be valuable as other countries
develop, especially in Asia, and experience hard times of their own. With the benefit of hindsight, upcoming
crises may be truncated or remedied faster.
The benefit for the whole globe cannot be understated as humanity lives
in an age where the fate of each nation continues to be ever more inextricably
tied to the fates of the rest.
Sources
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Deepak. "The Great Crash Of 2008: Causes And Consequences." CATO
Journal 30.2 (2010): 265-277. Academic Search Premier. Web. 14 Apr.
2012.
Sánchez,
Manuel. "Financial Crises: Prevention, Correction, And Monetary
Policy." CATO Journal 31.3 (2011): 521-534. Academic Search
Premier. Web. 12 Apr. 2012.
Thompson,
Helen. "The Political Origins Of The Financial Crisis: The Domestic And
International Politics Of Fannie Mae And Freddie Mac." Political Quarterly
80.1 (2009): 17-24. Academic Search
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Reinhart,
C, and K Rogoff. This Time Is Different: Eight Centuries of Financial Folly.
Princeton, N.J.: Princeton University Press, 2009 pgs. (158-162)
Fisher,
Richard W. "Paradise Lost: Addressing Too Big To Fail." CATO
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ProPublica.
“Bailout Recepients.” New York: 18 April 2012. Web. <http://projects.propublica.org/bailout/list>
Bank
of England. Quantitative Easing Explained: Putting more money into our economy.
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Anonymous.
“Rush on Northern Rock Continues.” BBC News [London] 15 September 2007. Web. <http://news.bbc.co.uk/2/hi/business/6996136.stm>