Keynesian Spirits


Role of Household Leverage in 2007 Recession

Below is the summary of a summary – the highly illuminating and rigourous work of Atif Mian (Berkeley) and Amir Sufi (Chicago) on the intersection of finance and macroeconomics, specifically on how household leverage influenced real economic outcomes:

1. From 2001 to 2007, household debt doubled, from $7 trillion to $14 trillion. The household debt-to-income ratio increased by more during these six years than it had in the prior 45 years. The household debt-to-income ratio in 2007 was higher than at any point since 1929.

2. Mortgage-related debt makes up 70 to 75 percent of household debt and was primarily responsible for the overall increase in household debt. The expansion of new mortgage originations was much larger in zip codes with a large fraction of low credit-quality households.

3. The fraction of home purchase mortgages that were securitized by non-GSE (government sponsored enterprise) institutions rose from 3 percent to almost 20 percent from 2002 to 2005. Non-GSE securitization primarily targeted zip codes that had a large share of subprime borrowers. In these zip codes, mortgage denial rates dropped dramatically and debt-to-income ratios skyrocketed. Expansion in mortgage credit did not reflect productivity or permanent income improvements for marginal borrowers.

4. The expansion in mortgage credit was more likely to be a driver of house price growth than a response to it.

5. From 2007 to 2009, foreclosures were responsible for 20 to 30 percent of the decline in house prices, 15 to 25 percent of the decline in residential investment, and 20 to 35 percent of the decline in auto sales.

6. Special interest pressure via campaign contributions from the financial industry influenced voting behavior on the financial rescue legislation that was designed to provide support to the banking sector in 2008. Similarly, constituent pressure from delinquent and under-water homeowners significantly influenced legislators to vote in favor of legislation that promoted mortgage modifications.

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NBER Research Summary

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The Wall Street Leviathan

Jeff Madrick has written a useful piece on the findings of the Financial Crisis Inquiry Commission (USA). Here are some of the most striking things he brings up:

“Bernanke told the FCIC: As a scholar of the Great Depression, I honestly believe that September and October 2008 was the worst financial crisis in global history, including the Great Depression…Out of maybe the 13, 13 of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two. “

“The single most stunning finding of the FCIC report is that if all Citigroup’s assets had been accounted for accurately, its ratio of assets to capital would have been forty-eight to one in 2007, not the twenty-two to one it had been reporting that year. The ratio of forty-eight to one was irresponsible—higher than the capital ratios at the most aggressive investment banks, such as Bear Stearns, and far higher than the capital ratios of other banks. The Fed apparently had no idea of this.”

“The legislation repealing Glass-Steagall, the Gramm-Leach-Bliley Act of 1999, had one other subtle but highly significant consequence, as the FCIC report explains. It diluted the government’s regulatory authority over the new financial conglomerates such as Citigroup. Under the legislation, the Fed, the strongest of the regulators when it did its job properly, now oversaw only bank holding companies, the umbrella organizations under which the bank subsidiaries operated. The 1999 act mandated that the Fed rely on the SEC to oversee bank subsidiaries that dealt in securities, and that the Office of the Comptroller of the Currency oversee commercial banks. The practical result was that much of importance thus fell through the cracks of the 1999 bill. The FCIC report refers to this stripped-down authority as “Fed-Lite.” The Fed failed to do its job in any case. It made no adequate analysis of the risky CDOs. As far back as 2005, a peer review by other Federal Reserve banks criticized the New York Fed, then under Tim Geithner, for inadequate oversight.”