The Great Recession that began in the fall of 2008 was caused by a series of complex and connected events.
These events were lined up like a set of dominos. The housing market began to turn down in the beginning of 2006 as house prices peaked and began to decline. By early 2007, this caused an increase in foreclosures, particularly for homeowners with subprime mortgages who were unable to refinance their mortgages and thus could not continue to pay their mortgages.
Over the next year and a half, the securities based on these mortgages came under increased scrutiny. The value of these securities began to drop, and it became increasingly difficult to sell them. This was a problem because most of these securities were bought using borrowed money. The contracts for borrowing that money included clauses that required financial institutions to put up more capital if the securities lost value.Many large financial institutions began to run through their capital, either because they had to repay the loans or because they had to increase their collateral. Since no one knew which banks held these securities, beginning with the collapse of Lehman Brothers on September 14, 2008, a full-blown panic effectively closed down the markets for short-term borrowing (what is called “shadow banking”) in the United States and abroad, especially in western Europe. This meant that many large financial institutions did not just experience a liquidity crisis (i.e., the inability to raise cash quickly enough to cover what they needed to add to that collateral) but were actually insolvent (i.e., bankrupt), as the cash they had quickly ran out as they had to pay back their borrowings and were not able to sell assets to pay off their debts. In the fall of 2008, the massive restriction of access to short-term borrowing caused nonfinancial corporations to lay off workers, and a recession ensued in many of the advanced industrial countries.
It is useful to remind ourselves what policymakers and economists were saying about the problem as US house prices began to decline in early 2006 and home foreclosures took off in 2007.
While the signs of a housing bust were mounting, regulatory authorities were not particularly concerned that a larger economic crisis was brewing. In a speech given in Chicago on May 27, 2007, Ben Bernanke, chair of the Federal Reserve, said, “Given the fundamental factors in place that should support the demand for housing, we believe that the troubles in the subprime sector on the broader housing market will be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system” (Bernanke, 2007).Bernanke's view was shared by most of his colleagues and the academic economists who were frequent contributors to discussions of the subprime market and Federal Reserve policies. For example, at their annual summer meeting of central bankers from around the world held in Jackson Hole, Wyoming, in the summer of 2007, Frederic Mishkin, at that time a governor on the Board of the Federal Reserve, remarked, “Problems in the subprime market have led to investors reassessing credit risk and risk pricing. Fortunately, the overall financial system appears to be in good health and the U.S. banking system is in good position to withstand stressful market conditions” (Mishkin, 2007).
As the housing market continued to deteriorate in the fall of 2007, the economics profession began to take notice. GDP growth estimates for 2008 were adjusted from somewhere around 3.5 percent to a consensus of about 2.5 percent, while expected unemployment rates were increased from 4.5 to 4.8 percent. These judgments and estimates did not foresee that the housing crisis would bring the financial system to its knees or that it would begin the most serious economic downturn since the Great Depression. How could they have been so far off? The economists making these predictions were making their best guesses based on their analysis of the significance of the housing downturn to the larger economy. The housing sector accounts directly for about 5 percent of GDP and indirectly for another 10 percent. Given the size of the market, macroeconomic models showed that even with a serious housing downturn, the effects on the larger economy were thought to be muted.
I think it is safe to say that the people who were in charge of trying to understand the mortgage crisis and how that crisis might spill over into the financial services industry were the people in the best position to understand how the housing market and the financial markets were connected. They held important positions in the government and business, and they had the training and access to information to know what was really happening. Yet they were all clueless about what was about to happen. What were they missing?