Economics_in_Us

Economic Crisis in Our Backyard By Mark Davis All around us is evidence of economic heartache, as I sit and write this paper I hear the fear in the people on the television. Christmas is near and times are tougher now than anyone remembers, lay-offs, stock market crashing, bailouts and so much more have infected our lives. We are suffering from a near depression, if we can’t consider ourselves in a depression. Our economic status is shaky at best, with no end in sight. And the government solution “bailout”. To understand the current economic turbulence in the United States, it is necessary to study the two credit institutions which played a decisive role in its creation: Fannie Mae and Freddie Mac. The business of Fannie Mae consists of underwriting loans granted by other credit agencies. The Federal Home Loan Mortgage Corporation, Freddie Mac for short, was created in 1970 with the same basic structure and purpose as Fannie Mae. The two institutions were taken over by the federal authorities on 7 September 2008, as both of them were very badly hit by the crisis to which they had largely contributed. It should be mentioned that these institutions in the preceding months had been in charge of 70% of the mortgages in the United States, which provides an indication of their decisive role in the market where the crisis first occurred. Prior to being taken over by the federal government, these institutions had a very peculiar design. Fannie Mae and Freddie Mac were on one hand government entities with political goals for which they received substantial subsidies; on the other hand, they were private businesses seeking to maximize shareholder value. At the same time, the Federal Reserve has for a long time kept a very low federal funds rate. In 2003, the interest rate for 3 month treasury bills were as low as 1%. Above all, from 2003 to 2005 the Federal Government maintained the interest rates below the expected inflation rate and thus strongly subsidized loaning. This created a housing bubble. Since the mid-1990s a market for subprime mortgages has evolved. This concerns loans granted to borrowers with insufficient credit worthiness to qualify for ordinary bank loans. The development of these mortgages has been strongly encouraged on the political level through subsidies. There have even been regulations which in some cases forced banks to extend mortgages. The subprime mortgages have played an important role in pushing the share of US home-owning households from 65% to 69% between 1995 and 2006. In total, more than seven million American households had subscribed to a subprime mortgage at the end of 2007. The value of these mortgages at that time amounted to $1,300 billion, four times more than in 2003. In 2005 alone, subprime mortgage contracts were signed at a value of $600 billion. The high-risk subprime loans coincided with a general overheating of the market. The government created the crisis to a great extent, but excessive lending contributed to its corruption. U.S. politicians increased risk taking on a market which was already highly prone to risk, and the crisis soon emerged. When the economy turned around and housing prices started stagnating, low-income households increasingly found it difficult to reimburse and renew their mortgages. “During the third quarter of 2007, subprime contracts represented 13% of the US mortgage market, but also 55% of the foreclosures initiated during this period.”( Henning,p.23) A number of American credit institutions specializing in subprime mortgages were then in deep crisis. For instance, the shares of New Century Financial Corporations and Novastar Financial plunged by 90%. The crisis then spread throughout the overheated financial sector and soon hit credit institutions outside the United States. “In March 2008, Bloomberg reported that more than 34,000 jobs had been cut in various Wall Street quoted banks. In April 2008, the IMF warned repeatedly that the crisis could lead to a global recession.” (economyincrisis.com) The organization even said that it could be “the greatest financial shock since the Great Depression”. The US subprime mortgage crisis has become a global problem. Around the world, small and large savers and investors alike fear losing their assets. A number of the world’s best-known banks have gone bankrupt, been bought by other banks, taken over by the government or saved by public credits. This ranges from “Bear Sterns, Merrill Lynch and the 119-year old Washington Mutual in the United States, to Northern Rock, Bradford & Bing and HBOS in the UK.”( Varadarajan) Internationally there is great uncertainty on which banks are rife for bankruptcy, which is why banks are reticent to lend to each other. Since many banks are dependent both on lending and borrowing, even those surviving are in dire straits. The US government has spent $ 700 billion on a rescue package to calm the markets and transfer funds to the banks, granting them a margin for renewed lending. The capital is to be used in part to buy back bad loans, for instance bank mortgages. Around Europe, other methods – with the same purpose – have been applied. Governments have pledged guarantees for bank deposits in several countries. “In the UK the government has swapped capital transfers to banks against equity”( Varadarajan), to facilitate a return of taxpayers’ money in the future – as was the case in Sweden in 1992. Perhaps the most remarkable feature of the crisis is that it was all but inevitable. In fact some experts foresaw this development as early as 1999, but their warnings were not heeded by governments. The political objective was to push down the cost of subprime mortgages, using public subsidies. The latter in effect served to directly disable market risk analysis by artificially deflating the mortgage costs. They focused on increasing the subprime mortgages whose beneficiaries triggered the crisis by defaulting on their payments. One reason why Fannie Mae and Freddie Mac controlled such a large share of the market is that they also used the subsidies to expand their activities. A 1996 Congressional Budget Office study showed that Fannie Mae and Freddie Mac received some $ 6.5 billion in subsidies in 1995. They both retained more than 40% of these funds, rather than using them to subsidize mortgages. Unsurprisingly, the companies thus enjoyed very large profit margins. A survey from the US Treasury Department from the same year confirms this impression. Fannie Mae and Freddie Mac not only benefited from the government subsidies. The financial sector clearly perceived that the federal government backed these organizations and that it was very unlikely that it would let them fail – a hypothesis which proved accurate on 7 September 2008. Thus, profits were privatized and losses socialized. The advantages granted by the politicians to Fannie Mae and Freddie Mac enabled them to grow rapidly and crowd out the ordinary credit institutions on the free market. In July 2008 the New York Times reported that “the two institutions granted or underwrote approximately half of the mortgage market, representing $12,000 billion.”(NYT Website) One reason why financial crises originating in the United States superficially may be interpreted as a crisis for the free economy is that we enjoy a high degree of economic freedom. There are naturally parts of the US economy which are not free. In terms of financial markets, the economic freedom in the US is on par with that of many European countries. Economic freedom has continually risen in the world over the past 20 years. This is not the case everywhere and where the rate has improved, it has not been constant all the time – nevertheless, the trend is clear. In recent years however, “the US has stagnated and even experienced a loss of economic freedom, resulting among other things from new regulations hitting industry, as well as increased public expenditure.”( Soros, p.47) The crisis has therefore occurred in the United States with regulated financial markets and in recent years decreasing economic freedom. It thus suddenly seems less reasonable to assume that widespread deregulation is the cause of the crisis. References 1. George Soros. “The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means.” PublicAffairs, 2008 2. James Jay Carafano, Richard Weitz. “Mismanaging Mayhem: How Washington Responds to Crisis.” Greenwood Publishing Group, 2008 3. C. Randall Henning. “Accountability and Oversight of US Exchange Rate Policy.” Peterson Institute, 2008 4. Michael Spence. “What Can We Do To Halt The Crisis'” Forbes Magazine 11/14/2008 5. Tunku Varadarajan. “The Financial Crisis, From A-Z.” Forbes Magazine 11/14/2008 6. http://www.economyincrisis.org 7. http://www.newsweek.com/id/161649 8. http://www.nytimes.com/2008/07/11/business/11fannie.html