The Financial Crisis: Miss-Diagnosis and Reactionary Responses
Eisenbeis, Robert A., Atlantic Economic Journal
The financial crisis that began in the fall of 2007 continues well into 2010, and has proved to be one of the longer lasting periods of financial disruption in decades. The policy responses to the crisis can be divided into three distinct phases. Phase I was a period of misdiagnosis in which policy makers viewed the crisis as a traditional liquidity crisis and they attempted to treat it as such. That misdiagnosis cost the economy almost a year of recovery. Phase II was a period of triage as it became clear that there were significant solvency problems in many of the country's largest financial institutions and in those of other countries as well. However, the policy responses also created significant uncertainty in financial markets and arguably exacerbated the recession. Finally, Phase III can be characterized as a period of extreme monetary policy ease as the Federal Reserve has resorted to extraordinary efforts to stem the declines that have taken place in the housing market and real economy more generally. The result has been an explosion of the Federal Reserve's balance sheet and likely has interjected the Fed into incomes policy.
This paper describes the financial market conditions that characterized each of the three phases. It details the policy responses in each phase and attempts to sort out what we have learned and not learned from this crisis.
Phase 1--The So-Called Liquidity Problem
During the first phase of the financial crisis which lasted from approximately August 2007 to the end of September 2008, the press was filled with reports from policy makers that financial markets had frozen up. They pointed to widening credit spreads and developments in the asset-backed commercial paper markets were of particular concern. Chart I shows the TED spread which is the difference between 3 month London Interbank Borrowing Rate (LIBOR) and the 3 month Treasury Bill rate from January 2007 through August 2008. The vertical line is where the first signs of a significant problem appeared. Through April of 2007 the spread averaged approximately 25 basis points, and then in May it nearly doubled to about 50 basis points.
The roots of this widening of credit spreads in the short term markets where many large banks were obtaining short term funding lay in what was happening in the housing market, and in the sub prime mortgage segment in particular, which requires a bit of a digression. Chart 2 shows that U. S. new and existing home sales had begun to decline from their peak in mid-2005. The housing slowdown was no doubt triggered in part by the increase in interest rates that resulted from the monetary tightening that the Federal Reserve had initiated in July of 2004 (shown in Chart 3). From July 2004 through July of 2006 the Federal Reserve had executed a series of seventeen 25 basis point increases in interest rates, such that the Fed Funds target rate was already up by some 400 basis points by the time the housing market had started to decline. So by the end of 2005 and throughout 2006 we had entered a period of declining housing sales. The housing decline continued and by the beginning of 2007 the housing market was at pre-2001 recession levels. Construction also stalled as the excess supply of housing relative to demand increased and homes stayed on the market longer and longer.
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But it was in 2006, well after the housing decline was underway. That sub prime lending and the securitization of those loans accelerated. Chart 3 shows the explosion in issuance of Residential Mortgage Backed Securities (RMBS) backed by sub prime loans from 2000 through the third quarter of 2007. (1) By 2006, issuance was more than double that in 2003 and accelerated in 2005 and 2006, long after the housing market had begun its decline. Three things are noteworthy in Chart 3. First, the main issuers were U.S. investment banks followed by foreign institutions including large complex UK and European financial institutions. …