A Perfect Storm: A Summary and Analysis of the Financial Crisis of 2008

Name: Scott Dorfman

Class: IDP4U101 – 2009/2010 – Honours Thesis

Date: Thursday December 17, 2009

Teacher: Rob Cotey

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Living in a capitalist society means that there will be inevitable periods of time

when the economy is weak. It can be seen in history many times; most specifically in

the last century. One of the strongest examples was the great depression that began in

1929. The economy was devastated and it took many years for a full recovery. In 1973,

an oil crisis led to a serious fall in the economy.1 In addition to these situations, there

were countless others that occurred in the 1900’s.

With the number of economic collapses throughout history, one wonders why it

isn’t easy to predict them. There are several varying factors that differentiate each of

these unique situations. In 1973, there was a drastic increase in the price of oil2 that

was a major cause of the recession. Towards the end of the 1950’s the U.S. entered a

recession that was a result of a major change in Federal Reserve policy.3 The US

Government reduced the money supply which led to higher interest rates and slowed

spending.4

It seems almost ironic that the crash of 2008 came at a time when the economy

was said to be very strong.5 This made it particularly difficult to predict and many

experts failed to do so. Federal Reserve Board Governor Donald Kohn said in 2005:

A couple of years ago I was fairly confident that the rise in real estate prices

primarily reflected low interest rates, good growth in disposable income, and

1 The OPEC Oil Crisis: Forcing up World Oil Prices. Government of Canada, 4 May 2007. Web. 22 Nov. 2009 <http://www.canadianeconomy.gc.ca/english/economy/1973opec.html>.2 Trumbore, Brian The Arab Oil Embargo of 1973-74. Buy & Hold, 16 Apr. 2002. Web. 22 Nov. 2009 <http://www.buyandhold.com/bh/en/education/history/2002/arab.html>.3 Late 1950's Recession | RECESSION.ORG. RECESSION.ORG United States Economy & Global Economic Recession. Web. 23 Nov. 2009. <http://recession.org/history/late-1950s-recession>.4 Ibid.5 Greenspan, Alan. Testimony of Chairman Alan Greenspan. The Federal Reserve Board, 3 Nov. 2005. Web. 23 Nov. 2009 <http://www.federalreserve.gov/BoardDocs/Testimony/2005/20051103/default.htm>.

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favorable demographics. Prices have gone up far enough since then relative to

interest rates, rents, and incomes to raise questions; recent reports from

professionals in the housing market suggest an increasing volume of

transactions by investors, who... may be expecting the recent trend of price

increases to continue. Even so, such a distortion would most likely unwind

through a slow erosion of real house prices, rather than a sudden crash.6

His evaluation of the state of the market was that even if the US economy began to fail,

it would be a slow fall, instead of an instant crash. In 2007, the Federal Reserve

chairman Benjamin Bernanke stated, “The impact on the broader economy and the

financial markets of the problems in the subprime markets seems likely to be

contained”.7 His assessment of the economy was that any problems that had arisen had

already been dealt with. There were others however, who foresaw the crash of 2008

and were attacked for it. Economist Peter Schiff predicted the crash in April 2007, when

he said, “We're just at the beginning of the housing slump. Housing is going to collapse,

and when it does it's going to take the rest of the economy with it”.8

Although it seemed unlikely at the time, Schiff was right, and the United States

was devastated. Millions of jobs have been lost9 and consumer spending dropped

6 Kohn, Donald L. Remarks by Governor Donald L. Kohn. The Federal Reserve Board, 22 Apr. 2005. Web. 30 Nov. 2009 <http://www.federalreserve.gov/boarddocs/speeches/2005/20050422/default.htm>.7 Sorkin, Andrew R. Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System- and Themselves. New York, NY: Penguin Group, 2009. Print.8 Isidore, Chris Economic Growth Slowest in Four Years. CNNMoney, 27 Apr. 2007. Web. 12 Nov. 2009 <http://money.cnn.com/2007/04/27/news/economy/gdp/index.htm>.9 US Economy Has Lost Almost 7m Jobs Since Recession Began, Fresh Figures Show. Telegraph Media Group, 4 Sep. 2009. Web. 23 Nov. 2009 <http://www.telegraph.co.uk/finance/financetopics/recession/6138478/US-economy-has-lost-almost-7m-jobs-since-recession-began-fresh-figures-show.html>.

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significantly.10 The recession has even spread to other countries. Moody’s Analytics

recently reported that there were more than 15 countries in a recession, and at least 22

countries that were in the process of recovering, including Canada and the United

Kingdom.11

The many different factors that led to the destruction of the economy made it

hard to predict, but also challenging to place blame on any specific individual or

organization. The long chain of events that occurred gave many different impressions

as to who was responsible, but by the time the economic recession had devastated the

world it was clear who was at fault. As a result of financial institutions ignoring common-

sense lending practices, creating complex and repackaged investments, and utilizing

adjustable rate mortgages in combination with discounted interest rates, the American

financial institutions were directly responsible for causing the economic crisis.

It is argued that there are a number of parties who all hold some responsibility for

causing the economic recession; ranging from the Government, to the consumers, to

the financial institutions.

One party that is always quick to be blamed is the Government. This case is no

exception. In response to the recession that began in 2000 (caused by the bursting of

the technology bubble) George Soros argues:

10 7 Recession Effects of the Recession Cycle. Khera Communications, Inc., 2 Apr. 2009. Web. 23 Nov. 2009 <http://www.morebusiness.com/7-effects-economic-cycle>.11 Global Recession Status. Moody's Analytics, 2009. Web. 24 Nov. 2009 <http://www.economy.com/dismal/map/default.asp>.

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...the Fed continued to lower rates-all the way down to 1 percent...Cheap money

engendered a housing bubble...When money is free, the rational lender will keep

on lending until there is no one else to lend to.12

After the Government lowered interest rates to stimulate the economy, credit became

easily available. Soros explains that financial institutions (lenders) were just doing what

any organization would do under the circumstances.

Although it is easy to point blame at the Government and financial institutions,

often times it is a lack of common sense that is at fault. Most people know that one

should not buy things one cannot afford. A decrease in interest rates should have led to

lower payments, rather than purchasing larger and more expensive homes. Paul

Krugman, a Nobel Prize winner in Economics blames the consumer for this situation:

Low interest rates should have changed the mortgage payments associated with

a given amount of borrowing, but not much else. What actually happened,

however, was a complete abandonment of traditional principles...this was driven

by the irrational exuberance of individual families who saw house prices rising

ever higher and decided that they should jump into the market, and not worry

about how to make the payments.13

Others however, contend that financial institutions are to blame for the crisis of

2008. In their article “The Ratings Charade”, Bloomberg writers Richard Tomlinson and

David Evans assess the validity of financial investment instruments such as

12 Soros, George. The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means. New York, NY: Public Affairs, 2008. Print.13 Krugman, Paul. The Return of Depression Economics and the Crisis of 2008. New York, NY: W. W. Norton & Company Inc., 2009. Print.

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Collateralized Debt Obligations (CDOs)14. They say that “it's nearly impossible to find

out exactly what's in a CDO, and CDOs aren't regulated”.15 It is also noted that “U.S.

banks have invested as much as 10 percent of their assets in CDOs”.16 The conclusion

that can be drawn from this is that banks (and other financial institutions) were putting a

significant amount of their money into investments that were very risky.

USA Today writer Adrienne Lewis also lays blame on financial institutions. She

observes that having realized their mistake, banks have returned to more traditional

types of loans. “Gone are loans for people who have trouble paying their bills on time.

Gone are mortgages for 100% of the home price. Gone are loans requiring no proof of

income or assets.”17

The willingness of American financial institutions to loan their money to anyone

who wanted it caused a string of events that was a direct cause of the economic crisis.

After thousands of consumer mortgage defaults, other people were scared of losing

their houses and stopped spending money. Many retailers went bankrupt and laid off

their employees. There became less money to spend and more businesses failed.

Beginning in 1991, housing prices in the United States began to increase

steadily.18 From 1997 onward, Robert Shiller - creator of the Case-Shiller home price

indices - found that housing prices in the US were increasing significantly faster than

14 Collateralized Debt Obligations will be explained further later in this essay15 Tomlinson, Richard & David Evans. The Ratings Charade. Bloomberg, July 2007. Web. 3 Dec. 2009 <http://www.bloomberg.com/news/marketsmag/ratings.html>.16Tomlinson, Richard & David Evans. The Ratings Charade. Bloomberg, July 2007. Web. 3 Dec. 2009 <http://www.bloomberg.com/news/marketsmag/ratings.html>.17 Lewis, Adrienne. "Many Face Final Financial Straw, but There's Hope." USAToday 4 Jan. 2008: 2B. Print.18 S&P/Case-Shiller Home Price Indices. Standard & Poor\'s, 29 Oct. 2009. Web. 12 Nov. 2009 <http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us---->.

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household incomes, population growth, or building costs (refer to figure 1).19 It quickly

became clear that housing prices would continue to increase and financial institutions

began to take advantage of the situation. They realized that they could afford to begin

taking risks on clients because if a loan was not repaid, the bank could seize the client’s

house and sell it at a profit. Risk-Management experts Robert & Don Tapscott explain,

“Banks and brokers were lending against a greater estimated ‘future market value’ that

never materialized”.20 Though it was a risk on the part of the financial institution it ended

up affecting consumers as well.

On the other side of the spectrum, consumers needed additional funds to afford

more expensive homes. The average price of a house in the US rose from

approximately $200,000 in 2000 to $275,000 in 2005.21 There were many Americans

who were unable to afford a house, and because they had a low credit rating they were

unable to get a traditional mortgage. Instead, consumers got what was known as a

subprime mortgage.

Subprime mortgages are useful because many people who could not get into the

housing market were given a chance to do so. The risk however, is that there is a larger

chance of the borrower not paying back the loan in full.

Subprime mortgages have proven to be extremely dangerous. Initially they were

not used except in rare cases; however in the early 90’s subprime mortgages became

19 Shiller, Robert J. Irrational Exuberance. Princeton, New Jersey: Princeton U, 2005. Print.20 Tapscott, Robert, and Don Tapscott "Overcoming the Current Financial Crisis and Restoring Stability and Prosperity with a New Perspective on Risk." Risk Management 2.0 (2008): 1-18. Web. 22 Sep. 2009. <http://wikinomics.com/content/Risk_Management_2_0.pdf>.

21 US: Average Price of Houses Actually Sold. Economagic, 23 Nov. 2009. Web. 24 Nov. 2009 <http://www.economagic.com/em-cgi/pdf.exe/cenc25/c25q07>.

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more common.22 Then, in 2004, the use of subprime mortgages skyrocketed.23

Subprime mortgages accounted for 20% of all mortgages in 2005 and 2006.24 Although

it seemed very risky to have one-fifth of all mortgages as subprime mortgages, the

banks looked at it as a money making opportunity. After all, they could just repossess

the higher-valued home.

Banks were not considering what might happen if house prices decreased. As

mentioned earlier, the average price of a house in the US rose by $75,000 in just five

years. If that trend continued, banks would gain from repossessing a house. However,

the true dangers of subprime mortgages were revealed when housing prices began to

decline. In the first quarter of 2008, only 12% of mortgages given in the US were a type

of subprime mortgage, yet they accounted for approximately 50% of home

foreclosures.25

In addition to using subprime mortgages, banks began to advocate re-financing.

Many families who were well on their way to paying off their mortgage opted to re-

finance because they wanted a new car or a boat. Author and Economist George Soros

notes the ability of banks to convince clients to refinance:

22 Gramlich, Edward M. Remarks by Governor Edward M. Gramlich. The Federal Reserve Board, 21 May 2004. Web. 24 Nov. 2009 <http://www.federalreserve.gov/boarddocs/speeches/2004/20040521/default.htm#table1>.23 Lee, Mara Subprime Mortgages: A Primer. National Public Radio, 23 Mar. 2007. Web. 24 Nov. 2009 <http://www.npr.org/templates/story/story.php?storyId=9085408>.24 Ibid.25 Delinquencies and Foreclosures Increase in Latest MBA National Delinquency Survey. Mortgages Bankers Association, 5 June 2008. Web. 24 Nov. 2009 <http://www.mbaa.org/NewsandMedia/PressCenter/62936.htm>.

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From 1997-2006, consumers drew more than 9 trillion dollars in cash out of their

home equity and home equity withdrawals were financing 3% of all personal

consumption.26

The particularly disturbing part is that re-financing was used for personal expenditures.

Often consumers re-finance out of necessity, to pay their bills. Re-financing a home

proved to be extremely dangerous later on as house prices began to drop.

Banks were lending as much as they could to anyone who wanted their money.

Soros states, “Towards the end of the bubble houses could be bought with no money

down, no questions asked”.27 Soros notes that banks began to give out mortgages

equal to the full cost of the house. This was a major cause of the recessions as it led to

defaults on homes that were worth less than the price of the mortgage, causing a

substantial loss for the loan giver.

For example, an individual wants to purchase a house for $100,000. The

financial institutions chose to loan the individual the full $100,000, regardless of whether

or not there was a good chance of being repaid. If the price of the house went up, the

bank either got paid by the individual, or the individual defaulted on their mortgage and

allowed the bank to take over their higher-valued house. However, if the price of the

house went down and the individual defaulted on the loan, the bank would lose

thousands of dollars. It wasn’t uncommon for loans to have a value greater than that of

the house. With a higher supply of homes on the market, prices went down. To put it

26 Soros, George. The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means. New York, NY: Public Affairs, 2008. Print.

27 Ibid.

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simply, initially subprime loans were not an issue, but as they became more widespread

they caused a huge problem for financial institutions.

Some will argue that the government is at fault because they failed to enforce

strict regulations. While this argument appears valid, it is important to note that three

highly influential positions in the US Federal Government were held by former Goldman-

Sachs (a major US financial institution) employees.28 It is logical that decisions of the

Government would be heavily swayed in favour of banks when they were influenced by

former bank employees. In addition, the fact that regulations were loosened did not

force financial institutions to give out these kinds of loans. Common-sense should have

been used to understand that if a large number of people have subprime mortgages,

there will be a larger number of people defaulting, thus increasing supply and

decreasing price.

Others argue that by lowering interest rates the Government created the

problem. It was easier for financial institutions to give out big loans with a small interest

rate. The low interest rate argument can be proven false by comparing the Canadian

and American economies. At its lowest point, interest rates in the United States were

only 1% less than that of Canada.29 Canada’s economy however, fared much better

than the United States’. Even well into 2008, housing prices in Canada continued to

rise,30 suggesting a demand for houses. The true cause of this problem was the number

28 Foley, Stephen How Goldman Sachs Took over the World. The Independent, 22 July 2008. Web. 25 Nov. 2009 <http://www.independent.co.uk/news/business/analysis-and-features/how-goldman-sachs-took-over-the-world-873869.html>.29 MacGee, James Why Didn’t Canada’s Housing Market Go Bust? 4 Dec. 2009. 8 Dec. 2009 <http://advisoranalyst.com/glablog/2009/12/04/why-didn%e2%80%99t-canada%e2%80%99s-housing-market-go-bust/>.30 Ibid.

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of subprime mortgages given. James MacGee, a researcher at the Federal Reserve

Bank of Cleveland writes:

While subprime mortgages accounted for less than 5 percent of mortgage

originations in the U.S. in 1994, a fifth of all mortgages originated between 2004–

2006 were subprime…But while subprime lending also increased in Canada, the

subprime market remains much smaller than in the U.S. The most cited estimate

is that subprime lenders had a market share of roughly 5 percent in 2006.31

This difference of over 15% was caused by financial institutions that were greedy and

attempted to give out overvalued subprime mortgages.

The banks made a fatal error in assuming that housing prices would continue to

rise. They took advantage of rising house prices to lend out as much money possible

and in the end it backfired. Even though the government did not intervene by tightening

regulations, the blame still lies on the financial institutions for their use of subprime

mortgages.

The second reason that financial institutions are to blame for the economic crisis is

because they manipulated bond investment ratings in such a way that they depicted an

inaccurate rating of the bond’s risk. These inaccurate ratings led to poor judgement

when investing and caused many unnecessary financial losses.

Before this argument can be made clearly, it is necessary to define a Collateralized

Debt Obligation (CDO). To quote the BBC’s Business Editor, Robert Peston, CDOs are,

31 Ibid 9.

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“bonds created out of other bonds”.32 Much like bonds, CDOs are given ratings based

on the amount of risk they hold. These ratings can range from AAA (the safest

investments) all the way to B.33 Often times a CDO is made up of several different loans

or mortgages put together.34

The problem with CDOs is that the risk they hold is unknown. Many times they are

created from thousands of subprime mortgages.35 As outlined above, subprime

mortgages are very risky and ended up creating a huge problem for banks.

The banks were able to repackage these risky loans to appear as if they were more

secure investments by grouping large numbers of loans together. They would then sell

the rights to this package of loans to different investors based on a hierarchy of the

likelihood of default. The first mortgages to default would be considered lower rated

investments, while the higher rated investments would be those that defaulted only after

all the other loans had failed. The problem behind this theory is that it was believed that

the likelihood of the majority of the loans in a pool defaulting at the same time was low.

However, when the majority of the loans pooled together were high risk, it did not

prevent them from defaulting.

One would think that the rating system would help separate the good investments

from the bad ones but this proved to be false. Millions of dollars were being spent on

investments that were unrated. It was found that:

32 Peston, Robert Liars’ Loans. BBC, 20 Aug. 2007. Web. 2 Dec. 2009 <http://www.bbc.co.uk/blogs/thereporters/robertpeston/2007/08/liars_loans.html>.33 The bond rating system is considerably more complex than presented, but for the simplicity of this essay, AAA, AA, A, BBB, BB, and B are the only terms that will be used.34 Ibid.35 Ogg, Jon CDOs and the Mortgage Market. Investopedia, 2009. Web. 3 Dec. 2009 <http://www.investopedia.com/articles/07/cdo-mortgages.asp?viewed=1>.

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...the California Public Employees’ Retirement System, the nation’s largest public

pension fund, has invested $140 million in such unrated CDO portions, according to

data Calpers provided in response to a public records request. Citigroup Inc., the

largest U.S. bank, sold the tranches36 to Calpers.37

In just 5 years, over $500 million has been spent on equity tranches (unrated CDOs) by

pension funds.38 Why would banks sell unrated CDOs worth over $500 million, to a

pension fund, something that can not afford risk?

It is true that credit rating agencies such as Standard & Poor’s, Fitch, and Moody’s,

are responsible in creating many of these false ratings, but they hold less of the blame

than the banks. The credit rating agencies recognize themselves as a guide to help

investors, rather than as a decision making tool. “What we're saying is that many people

have the tendency to rely on it, and we want to make sure that they don't,” says the

senior managing director at Moody’s, Noel Kirnon.39 Due to the complex nature of

CDOs, it is extremely hard to be accurate when classifying them and rating agencies do

their best to act as a guide. Financial institutions however, are responsible for creating

the CDOs,40 as well as selling them.

When assigning ratings for CDOs, it must be understood that the first mistake was

not made by the rating agencies. As an example, assume that a CDO is made up of

1000 subprime mortgages. It is true that some of those mortgages are safer than

36 A tranche is a section of the CDO. As an example the AAA rating is one tranche.Ibid. 11 37 Evans, David The Poison in Your Pension. July 2007. 3 Dec. 2009 <http://www.bloomberg.com/news/marketsmag/pensions.pdf>.38 Ibid.39 Tomlinson, Richard & David Evans. The Ratings Charade. Bloomberg, July 2007. Web. 3 Dec. 2009 <http://www.bloomberg.com/news/marketsmag/ratings.html>.40 Ibid.

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others, but ultimately, they are all subprime, meaning they are all dangerous. The

complexity of these investments made it hard to assess what was actually being

purchased. Robert and Don Tapscott note:

Senior management, who authorized placing hundreds of billions of dollars at

risk, often were completely unaware of how risky some bets were, let alone how

these risks aggregated across their institutions, or against their counterparties.41

This was a major problem because many of the people who were responsible for

purchasing certain types of investments had no idea what they were buying. As a result

they bought risky investments believing they were safe.

Perhaps the strongest example of the complexity of CDOs comes from Alan

Greenspan, the Chairman of the Federal Reserve for 17 years. Greenspan’s term

ended in 200642, just before the crash of the markets. After Greenspan had finished with

the Federal Reserve, he stated:

I’ve got some fairly heavy background in mathematics, but some of the

complexities of some of the instruments that were going into CDOs bewilders

me. I didn’t understand what they were doing or how they actually got the types

of returns out of the mezzanines43 and the various tranches of the CDO that they

did. And I figured if I didn’t understand it and I had access to a couple hundred

PhDs, how the rest of the world is going to understand it sort of bewildered me.44

41 Tapscott, Robert, and Don Tapscott "Overcoming the Current Financial Crisis and Restoring Stability and Prosperity with a New Perspective on Risk." Risk Management 2.0 (2008): 1-18. Web. 22 Sep. 2009. <http://wikinomics.com/content/Risk_Management_2_0.pdf>. 42 Alan Greenspan. NNDB, 2009. Web. 11 Dec. 2009 <http://www.nndb.com/people/164/000023095/>.43 A mezzanine is one of the middle level tranches in a CDO44 Sorkin, Andrew R. Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System- and Themselves. New York, NY: Penguin Group, 2009. Print.

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This led to what is known as a credit freeze, a situation in which it is near

impossible to obtain any form of credit. Professor John Hull explains, “Markets are

frozen because investors have no real idea of what they are buying/have bought”.45

Since investors were unsure of what they were purchasing, it was not safe to buy many

investments. This uncertainty caused the markets to freeze because the risk of losing

money was too high for investors.

In addition to using dangerous CDOs, banks manipulated other banks by

repackaging loans. These repackaged loans caused problems worldwide. Evidence of

this comes from Charles Kindleberger’s examination of the Minsky model. One of the

basis’ of the Minsky model is the concept of overtrading. Kindleberger says that

overtrading “may involve pure speculation for a price rise, an overestimate of

prospective returns, or excessive ‘gearing’”.46 To further explain this, overtrading

involves the trading, buying, or selling of assets that often hold an expected, but

unrealized value. It is also assessed by Kindleberger that “overtrading has historically

tended to spread from one country to another”.47 In the case of the crash of 2008, it is

the trading of repackaged loans and other mortgage-backed assets48 that caused

problems on a worldwide scale.

45 Tapscott, Robert, and Don Tapscott "Overcoming the Current Financial Crisis and Restoring Stability and Prosperity with a New Perspective on Risk." Risk Management 2.0 (2008): 1-18. Web. 22 Sep. 2009. <http://wikinomics.com/content/Risk_Management_2_0.pdf>. 46 Kindleberger, Charles P. Manias, Panics, and Crashes: A History of Financial Crises. New York, NY: John Wiley & Sons, Inc., 1996. Print.47 Ibid.48 Asset-backed mortgages are investments that rely on mortgages. These were dangerous because during the 2000’s they often relied on subprime mortgages.

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Through the creation of CDOs and repackaged loans, financial institutions have

not only caused the American recession but the worldwide one as well. Their concept of

repackaging risky loans into safe ones failed and spread further than the United States.

By utilizing adjustable rate mortgages and discounted interest rates – tools

designed to convince consumers that they can borrow more than they can afford –

financial institutions unfairly took advantage of individuals that did not fully understand

the terms of the loans they were taking.

Adjustable Rate Mortgages (ARMs) are mortgages that have varying interest

rates, compared to a fixed mortgage where the rate stays the same throughout49. ARMs

are often more attractive to consumers because their initial interest rate is lower than a

fixed-rate mortgage. The reason for the lower interest rates is because the risk that the

interest rates will change in the future transfers from the bank to the consumer. Usually

the payments on an ARM are smaller for the first few years, often with only interest

being paid. After this “interest only” period, the loan payment will usually increase for the

remainder of the mortgage.

This is extremely dangerous because many people are not ready for the jump in

the payment.50 If they were barely making ends meet beforehand, it would be

impossible for them to make the higher payment. The situation however, was extremely

attractive to many homeowners because of the difference in payments between a 30

year fixed-rate mortgage and a 5/1 (5 years of fixed payments, followed by variable

49 Consumer Handbook on Adjustable-Rate Mortgages. The Federal Reserve Board, 6 Aug. 2009. Web. 27 Nov. 2009 <http://www.federalreserve.gov/pubs/arms/arms_english.htm#arm>.50 What Are the Dangers of Adjustable Rate Mortgages? Mortgage QNA, 2009. Web. 27 Nov. 2009 <http://www.mortgageqna.com/adjustable-rate-mortgage/dangers-of-adjustable-rate-mortgages.html>.

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payments) ARM mortgage. In 2005, the difference in fixed payments between the two

was approximately three-quarters of 1%.51 On a $200,000 30 year fixed-rate mortgage,

the borrower might pay an average of $1199.10 per month, compared to the $954.83 in

the first year of an ARM (at $200,000, 30 years), $1165.51 in the sixth year, and

$1389.51in the seventh year.52 This sudden increase is too much for many homeowners

and is a cause of thousands of defaults.

To give some context to the danger of ARMs it must first be understood that their

interest rates generally change as a response to the index rate.53 Many of the common

indices used are set by the Federal Government. By the end of 2003, index rates were

lower than 1%.54 The government set the interest rates at a lower price because of the

recession caused by the burst of the technology bubble. Banks took advantage of this

by pushing for ARMs. Since individuals were rewarded for selling mortgages based on

the size of the mortgage,55 it was more effective to sell ARMs to clients when the index

rate was low. If the index rate is lower than the payments on the mortgage will be lower,

which makes it easier to convince clients that they can afford a more expensive house.

However, as soon as the interest rate goes back up, payments increase, causing a

huge problem. To blame this situation on the Federal Government would be absurd as

the lower interest rates were designed to stimulate the economy. The fact that banks

51 Graph Rate Trends. Bankrate Inc., May 2009. Web. 27 Nov. 2009 <http://www.bankrate.com/funnel/graph/Default.aspx?cat=2&ids=1,359&state=zz&d=1825&t=MSLine&eco=-1>.52 Consumer Handbook on Adjustable-Rate Mortgages. The Federal Reserve Board, 6 Aug. 2009. Web. 27 Nov. 2009 <http://www.federalreserve.gov/pubs/arms/arms_english.htm>.53 Ibid.54 Daily Treasury Yield Curve Rates - 2003. United States Department of the Treasury, 2004. Web. 1 Dec. 2009 <http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield_historical_2003.shtml>.55 Peston, Robert Liars’ Loans. BBC, 20 Aug. 2007. Web. 2 Dec. 2009 <http://www.bbc.co.uk/blogs/thereporters/robertpeston/2007/08/liars_loans.html>.

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chose to push larger loans instead of more affordable ones was a mistake on their part

and as such, they should be held accountable.

In addition to changing interest rates, many ARMs were accompanied by

discounted interest rates.56 The purpose of a discounted interest rate is to have lower

payments in the designated time period. To convince a consumer to take a mortgage

from a specific bank, that financial institution will often offer a discounted interest rate for

a limited period of time. Following the discount period, the interest rate will return to

either the fixed or varying rate depending on the type of mortgage. Much like the

problem of using low interest rates, discounted interest rates convince consumers that

they should take out a larger loan and enjoy a nicer home. The payments in the

designated time period are often considerably lower than those later in the life of the

mortgage. This runs a secondary risk when combined with an ARM because after the

discounted interest rate ends, the payments go up, but the index may have risen as

well, causing payments to be even higher. The accountability for this situation must also

fall on banks because after the approximate 1% interest rates of 2003, it should have

become clear that interest rates could only go up.

Understandably, some might argue that it is the consumers fault. After all, the

consumer signed on the mortgage. Banks however, made two more mistakes. First,

they made the assumption that many borrows would want to (and be able to) refinance

their homes. Wells Fargo suggests refinancing into a fixed-rate mortgage; another ARM,

or a special kind of “flex” mortgage which imposes a cap that could possibly lead to a

56 Consumer Handbook on Adjustable-Rate Mortgages. The Federal Reserve Board, 6 Aug. 2009. Web. 27 Nov. 2009 <http://www.federalreserve.gov/pubs/arms/arms_english.htm>.

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situation of negative amortization.57 One can wonder, why Wells Fargo would suggest

refinancing when each of the options could lead to a worse problem.

The first problem is that banks had already lent the full value of the home to

consumers, making refinancing difficult. Secondly, refinancing into a fixed rate mortgage

would increase the interest rate, which would increase the payments. Refinancing into

another ARM would continue to leave the consumer at risk of an interest rate increase.

Finally, refinancing into a “flex” mortgage could cause a situation where the borrower

owes more than they initially borrowed (called negative amortization58). All of these are

dangerous situations and it makes one wonder why a bank would suggest or even allow

refinancing in the first place. In this case it seems the combination of ARMs and

discounted interest rates is guaranteed to result in failure. The problem in this case is

that when the thousands of defaults happened on mortgages, it caused an increase in

the number of houses on the market. As basic supply and demand theory states, when

something is in great supply, the price for it goes down. When these housing prices

went down, many people were unable to refinance out of their ARM because their

house was worth less. It also caused millions of dollars of losses taken by banks when

they repossessed the homes.

The second fatal mistake made by the banks was the complexity of the ARMs.

Banks made several different types of ARMs that were challenging for the consumer to

understand. In addition to the regular 3/1, 5/1, 7/1, and 10/1 ARMs, there are also

interest only ARMs, payment option ARMs, hybrid ARMs, and possibly countless others

57 Considering Your Options. Wells Fargo, 2009. Web. 30 Nov. 2009 <http://https://www.wellsfargo.com/mortgage/refinance/learn/armoptions>.58 Negative Amortization. Business Dictionary, 2009. Web. 1 Dec. 2009 <http://www.businessdictionary.com/definition/negative-amortization.html>.

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that banks have schemed up.59 If any of these terms seem confusing, imagine what the

consumer would be thinking. Although the decision is up to the consumer, as an expert

in the field of finance, banks are expected to give professional advice and put the client

first, rather than themselves.

Looking past the dangers of ARMs, one must also consider the volume of ARMs

given out. The number of mortgages given out by financial institutions peaked in the mid

2000’s as many of the ARMs were reset in 2008 (refer to figure 2).60 ARM resets

gradually decrease until the fourth quarter of 2013, which is substantial proof that as the

dangers of ARMs were discovered, they became less common.

Although Adjustable Rate Mortgages have many advantages, they can easily be

abused. Using them in combination with discounted interest rates caused a problem for

the consumer who was already paying more than they could afford. Rather than

decrease payment levels, financial institutions took advantage of consumers by

convincing them to buy more expensive homes.

The financial crisis of 2008 was no accident. Financial institutions created a wave

of problems that led to the unfolding of the economy. By neglecting common-sense

lending practices, creating complex mortgage-backed assets, and combining

discounted interest rates with adjustable rate mortgages, the financial institutions in the

United States are responsible for having caused the financial crisis.

59 Consumer Handbook on Adjustable-Rate Mortgages. The Federal Reserve Board, 6 Aug. 2009. Web. 27 Nov. 2009 <http://www.federalreserve.gov/pubs/arms/arms_english.htm>.60 Lewis, Adrienne. "Many Face Final Financial Straw, but There's Hope." USAToday 4 Jan. 2008: 2B. Print.

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This situation was driven entirely by greed. Financial institutions were rewarded

for each mortgage given and attempted to hand out as many as they could. The use of

interest rates (in both fixed and adjustable rate mortgages) allowed financial institutions

to loan out more money. To take the risk off of themselves they created objects such as

collateralized debt obligations and sold them to unsuspecting investors.

Ultimately none of the actions by financial institutions were successful. The

combination of all of these actions led to what is known as a perfect storm, defined as “a

critical or disastrous situation created by a powerful concurrence of factors”.61 Had any

of these factors occurred without the others, it could be concluded that the financial

crisis would be nowhere near as serious as it turned out to be. If complex mortgage-

backed securities had never been created, the financial crisis would have remained

largely in the United States.

It is true that lowered interest rates caused by the Government were an integral

part of this “perfect storm”, but those alone were not enough to cause any financial

crisis. In fact, low interest rates are often introduced to stimulate the economy.

Greenspan responded to the decision to lower interest rates, “It was our job to unfreeze

the American banking system if we wanted the economy to function. This required that

we keep rates modestly low”.62 Lowered interest rates were not a problem, but rather a

contribution to the storm.

61 “perfect storm." Merriam-Webster Online Dictionary. 2009. Merriam-Webster Online. 10 December 2009<http://www.merriam-webster.com/dictionary/perfect storm>62 Sughrue, Karen Greenspan Defends Low Interest Rates. CBS News, 16 Sep. 2007. Web. 10 Dec. 2009 <http://www.cbsnews.com/stories/2007/09/13/60minutes/main3257567.shtml>.

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It is clear that the future calls for change. A banking and investment system that

had been posting record profits should not have failed. Perhaps the Government can no

longer afford to put any faith in the financial institutions. Rather than allow banks to

make the right decision, the Government must now regulate more heavily, and once

again re-invest more of their time and funds towards ensuring that the American

banking system does not collapse. This event must be looked at as one that proves the

dangers of capitalism. Greed can consume a mind and, in this case, destroy an

economy.

Figure 163

63 Shiller, Robert J. Irrational Exuberance. Princeton, New Jersey: Princeton U, 2005. Print.

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Figure 264

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