financial_crisis_of_2007-08_(b._modjathedi)

financial_crisis_of_2007-08_(b._modjathedi) - Financial...

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Page 1 of 41 Financial Crisis of 2007-08: Causes, Consequences, and Policy Options Preliminary Draft September 2009 B. Modjtahedi, Ph. D. Department of Economics University of California, Davis
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Page 2 of 41 Table of Contents Introduction The Causes of the Housing Bubble Low Interest Rates Trends in the Banking Industry The Originate and Hold Banking System Originate-and-Distribute Banking System Loan Securitization Slicing and Dicing the Mortgages The Agency Siblings and Pass-Through Securitization Pooling and Tranching Maturity Mismatch, Again Benefits of Securitization Economics of Mortgage Loans The Loan to Value Ratio Refinancing Negative Equity The 2007-08 Housing Crisis Global Nature of the Crisis Securitization and Loan Standards Interest Rate Resets and Subprime Defaults Decline in Home Prices Crisis Unfolds Amplification Mechanisms Appendices What is a (Financial) Bubble? Asymmetric Information Balance Sheet Amortized Loans Equity in your House Refinancing Calculating the Default Probabilities References
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Page 3 of 41 Introduction The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), a private non-profit organization that determines the peaks and troughs in U.S. economic activity, announced in November 2008 that the U.S. economic activity had peaked in December 2007. In other words a recession had started in January 2008. This date marks the end of an economic expansion that started in November 2001 (again according to NBER). As Figure 1 shows a distinguishing feature of this recession, compared to the previous ones, was the sharp reduction in the real GDP. Figure 2 shows that the unemployment rate in the second quarter of 2009 reached 9.27%, which was lower than the 10.67% observed at the bottom of the 1980-82 recession. However, if we focus on the cyclical unemployment rate, which is the excess of total over natural unemployment rate, the two rates are pretty close, see Figure 3. Another feature of the financial crisis of 2007-08 has been its complexity. Even policymakers and economists had been confused about the causes and consequences of the crisis and possible policy options to deal with it. At some point Henry Paulson, President Bush’s Secretary of Treasury, had to concede that the initial bailout plan proposed by the Administration had not been the correct remedy and that they had to modify it. As the recession of 2007-08 started, it became a well-known phrase that many of the people who were being laid off did not have a clue why they were losing their jobs. This paper will describe the causes of this financial crisis in the simplest words possible. This work is mostly a survey of the rather thin literature on the crisis. This literature, both academic and popular, is the basis of what we think we know about the crisis. It may not be surprising that even at this early stage there are some disagreements about various aspects of the crisis. For example, the popular press seems to have blamed the interest
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financial_crisis_of_2007-08_(b._modjathedi) - Financial...

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