The root cause of the financial crisis was the housing bubble, going back to Clinton’s repeal of Glass Steagall and looting at FNMA, but – what was the trigger? Understanding the chain of events helps us to evaluate the policy response, and also suggests what to look for the next time.
The nadir, as everyone knows, was the S&P 500 touching 666 in March 2009, before its rescue by Chairman Bernanke. Lehman Brothers had failed in September 2008, precipitating the crash in October, but the market had peaked a full year earlier.
The NBER identified December 2007 as the recession’s start, and it’s not surprising that the market peaked a few months ahead. It is generally a leading indicator for the economy. Mortgage lending, with its new ecosystem of boiler rooms and dodgy paper, had been shaking out all year. This is variously attributed to a dip in housing prices, declining demand for mortgage backed securities, and rising mortgage interest rates.
… the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not – FCIC
So, among the proximate causes, which was the trigger? Did the Fed pop the bubble by raising rates? Probably not. Fed funds had ramped steadily throughout the bubble, but had been flat at 5.25% since July 2006. That’s an indication the Fed was trying not to spoil the party.
Mortgage rates peaked in July 2006 and so, roughly, did the Case-Shiller home price index. The chart shows rates following the price trend up, and then following it back down.
It’s reasonable to suppose that the recession started and then people couldn’t make their mortgage payments, but the timing doesn’t support that. The recession was not a cause of the bust, nor was it obviously an effect. Delinquent mortgage payments, especially for Miami condos, had been on the rise throughout 2006. This chart is from the Financial Crisis Inquiry Commission.
These were flippers running out of people to flip to, like punters at the end of a chain letter, plus some poor fools actually occupying the homes and trying to make the payments. The trough of the rate trend was around 2003. If you had signed an ARM then, your interest rate had just about doubled by 2006.
- Delinquencies start to rise in 2006.
- Home prices peak, June 2006.
- Mortgage rates peak, July 2006.
- Mortgage bonds downgraded, July 2007.
- Stock market peaks, October 2007.
- Recession starts, December 2007.
- Stock market crashes, October 2008.
Right up until the crash, this reads like a normal business cycle recession. David Stockman argues that main street banks were never in danger from the housing market, because they had been run out of it by big investment banks. On this reasoning, policies like TARP, ARRA, and QE were a response to Wall Street, not the recession.
If you had been alert, you could have predicted when the housing bubble would burst simply by looking at the timing of the 5-year ARMs. Stanley Druckenmiller knew that risk premiums were too low in 2004, but it took him another a year to identify the housing bubble.
When you have zero money for so long, the marginal benefits you get through consumption greatly diminish, but there’s one thing that doesn’t diminish, which is unintended consequences.
We are in a similar phase now. Everyone knows that six years of ZIRP have planted a bomb somewhere in the economy, but no one knows for sure where it is.