Blackberry Panic of 2008
Bashir Safi
PLCY704: Economics and Public Policy
May 2022
Contents
Abstract..........................................................................................................................................1
What caused the financial crisis of 2008?......................................................................................1
Factor 1: Change in mortgage lending criteria...............................................................................2
Factor 2: Prolonging the Federal Reserve low interest policy of 2002-2004................................3
Factor 3: The increased debt to capital ratio of the banks..............................................................5
Factor 4: high debt/income ration of households...........................................................................6
Policy constrains to the federal government..................................................................................6
1. Legal constraints...................................................................................................................7
2. Political constraints...............................................................................................................8
3. External constraints..............................................................................................................9
Policy mistakes..............................................................................................................................9
a. Monetary Policy:..................................................................................................................9
b. Uncontrolled GSEs; Growth of Freddie and Fannie...........................................................10
c. Mark-to-Market Accounting Practice.................................................................................12
Conclusion...................................................................................................................................12
Bibliography.................................................................................................................................15
ii
1
Abstract: This paper reviews government response to the 2008 financial crises, and
evaluates decisions taken by the key government officials. The housing boom and collapse in the
seven years leading to the 2008 economic events played an important role. Housing prices were
relatively stable during the 1990s, but the market began to skyrocket rapidly in after 2002.
Between 2002 and 2006, housing prices increased by a gigantic 87 percent. But at the end of
2006 the market began to decline. The boom turned into a bust, and housing prices continued to
decline throughout 2007 and 2008. When panic hit the financial system in 2008, the housing
market lost its value by 30 percent from its peak in 2006. Although numerous responses were
made by the Bush administration in 2007 and 2008 to curb the crises, however, there was little
appetite in democratic-led Congress to work with President George W. Bush White House. This
unconstructive relation caused to delay the enactment of the government economic policies.
Ironically, it had an effect on 2008 stimulus package 1 and other policies until early in 2009.
Considering, the untrusted relationship between the Congress and executive branch, this paper
also reviews the constraints faced by the government agencies facing the policy application.
Those constraints were largely appeared in legal authority, political arena, and financial market.2
What caused the financial crisis of 2008?
There are four main factors discussed in this paper that according to the experts, have
caused the financial crises of 2008. 3 The changes in mortgage lending criteria, Feds low interest
policy of 2002-2004, the increased debt to capital ratio of the banks, and high debt/income ratio
1 Phillip Swagel, “The financial crisis: an inside view.” Brookings Papers on Economic Activity, Business
Insights (2009), 2-5.
2 Swagel, “The Financial Crisis,” 1.
3 Thomas Sowell, The Housing Boom and Bust (New York: Basic Books, 2009)
2
of the households are top factors that will be discussed in this paper. This paper analyses the
main four factors that contributed to the economic downfall of 2008.
Factor 1: Change in mortgage lending criteria
The lending criteria for home mortgage loans changed considerably in the early 1990s.
These standards were loosened as a result of federal policy to ease home ownership for low-
income households.4 This federal policy imposed a new set of laws to force lending institution to
allow low-income families to buy a house with easy requirements. Although, there were no
subseries to homebuyers and a transparent budget allocation.
In 1995, the administration designed a National Homeownership Strategy with a
goal of helping more American to buy homes. Since the establishment of this strategy, it
helped ten million Americans to become homeowners by the third quarter of 2000.5 This strategy
mandated lending institutions to lower their requirements for loans to the low-income
households. Everyone was able to purchase a house or a condo with relatively low income
compared to the previous requirement.
Fannie Mae and Freddie Mac, both privately owned businesses, played central role in
homeownership program. These enterprises were spun off as government-sponsored enterprises
(GSE) by the federal government.6 These GSEs were not loan originators, but they would
purchase loans from banks and sell them on the homebuyers on easy requirements. In 1990s they
become very political in Congress. Both enterprises hire lobbying groups and spent millions of
4 James D. Gwartney. Economics, Private and Public Choice. (New York: Academic Press, 2018)
5 Census Bureau, 10/26/00; FY 2001 Budget, p. 127; Department of Housing and Urban Development.
6 Gwartney, Economics, 622.
3
dollars on members of Congress to delay reforms and new regulations. Between 1998 and 2008,
both GSEs paid nearly $175 million on congressional lobby. 7
Fannie Mae and Freddie Mac facilitated the housing boom and switched largely
homeowners from conventional loans which carried high lending standards to “creative finance”
and “flexible standards,” as it was called the new strategy.
Initially, the easy credit score and low-down-payment policy increased demand and
triggered the housing boom, but in long run it was not sustainable. The weaker credit score
policy with low-down-payment shares, led to the higher default and foreclose rates when the
crises hit its peak.8 This was exactly what predicted.
Factor 2: Prolonging the Federal Reserve low interest policy of 2002-2004
The Federal Reserve policy was focused to keep interest rate low after the 1970s
inflation. In mid 1980s the rate was reduced to three percent and continued to stay low
throughout 1999. Purpose of maintaining low rate was to keep the market stable and avoid abrupt
changes.9 This stability created a calm environment for investments and economic growth. The
Fed usually changes rate year to year. This change is not intended to create an uncertainty in the
market, it keeps the investment and economic machinery awake and adoptable to changes. The
market was not used to adjust to year-to-year interest rate change.
However, in the beginning of 1999, the Federal Reserve policy became more erratic and
unstable. Later that year, Monetary policy became expansionary and continued few months into
early 2000. It changed back to more restrictive prior to the recession of 2001, and then changed
back to highly expansionary. Interest rates was dropped from 6.5% in May 2001 to 1% in June
7 Gwartney, Economics, 623.
8 Ibid., 626.
9 Ibid.
4
2003.10 This short-term low interest attractive rate increased demand for vehicle and housing
market. 11 The adjustable-rate mortgages (ARMs) became very popular to both lenders and
borrowers. Borrowers purchased expansive homes on initial lowest rates that was affordable.
The ARMs-fueled housing boom continued until 2005. Unsurprisingly, interest rates increased
from record lowest to a higher monthly payment.
In the biggening of 2005, the Feds changed monetary policy from expansionary to more
restrictive, rising the interest rate. When house market leveled off and booming market started to
decline. Homeowners, at this point were not able to pay monthly bills and walked away from
their home as defaults and foreclosure rate went upward. Finally, it was the Feds policy that
encouraged ARMs low rate causing the housing boom. Later, erotic changes in the ARMs rate
also caused to bust the housing market and sensationally contributed to the higher default and
foreclosure rate. 12
The default and foreclosure rate contributed to rise into early 2009, even after Congress
passed the Emergency Economic Stabilization Act in October 2008. This act provided the
resources to the government to put money into public foreclosure avoidance. This law was
finally implemented after President Obama was inaugurated in 2009. The foreclosure avoidance
program was designed as a form of an interest rate subsidy, which was according to the Secretary
of Treasury, a refinement of a proposal developed at the Treasury in October 2007.13
10 Federal Reserve. “Open Market Operations.” Federal Open Market Committee. Accessed 2020.
11 Gwartney, Economics, 627.
12 Ibid.
13 Swagel, “The financial crisis,” 4.
5
Factor 3: The increased debt to capital ratio of the banks
A policy change to the Securities Exchange Commission (SEC) in April 2004, which
allowed investment banks to increase leverage of their capital, contributed to the 2008 panic.
According to this policy change at the SEC, it made it possible for the investment banks to
increase their leverage on investments. An investment bank’s leverage ratio is simply the ratio of
its investment holding relative to its capital.14 Meaning, if a firm has invested twelve times the
size of its equity capital, they can keep a leverage of 12 to 1. Prior to this policy the leverage was
equally divided between the investment banks and commercial firms. 15
This policy of mortgage-backed securities was lucrative, and financial expert thought it
would be sustainable. Investment banks basically introduced this policy to help sustain defaults
and foreclosure rate at bay, but the very change eventually led to their collapse. When defaults
and foreclosure rate increased in 2006 and 2007, it was realized that this policy was not helpful,
but made the crisis worst.
Financial analysts argue that this lucrative policy failed because the lending terms made it
easy for the borrowers to boy home with low down payment and no stable income. Though it
was not predicted that low-rate securities would be free of risk if down payment limit was high,
and lending ability was restricted to subprime borrowers. This shortsighted policy, basically
suggested by the Wall Street, and adopted at the Securities Exchange Commission (SEC) became
a disaster. 16
14 Gwartney, Economics, 627.
15 Ibid.
16 Ibid.
6
Factor 4: high debt/income ration of households
From 1953 to 1984 the debt-to-income ratio remained 40-65 percent. This ratio grew to
historic 135 percent in 2007. This means, homeowner must keep its income ratio at 135 percent
to meet the interest payment. As economic situation weakened in 2007, household income was
dropped and ultimately led to the default and foreclosures. Homeowners were heavily indebted,
and that share was applied against their housing. This level of debt in the form of housing
mortgage against homeowners, contributed to the Great Recession. 17
The first five years of this century looked booming in the housing market. The
combination of the HUD regulation, Fed’s low-rate policy of 2002-2004, and low-down payment
made it easy for both subprime and AMR loans. In short term, these relaxations increased the
demand for housing, boom construction and eased the ability to purchase home. Initially, the
boom looked great, but in long term these policies were disastrous.
Policy constrains to the federal government.
Before highlighting broad policy matters and economic decisions by the federal
government, this is important to weigh in the legal and political constrains from Congress. When
democratic party took control of Congress, the federal government response was further delayed.
Following the events of August, the main focus shifted to housing and particularly to
prevent foreclosure. The Hope Now Alliance act was designed. Congress was not interested in
Treasury’s foreclosure prevention initiative. The Treasury wanted to have loan servicers to make
economic decisions to modify loans, the troubled homeowners could pay a smaller monthly
amount, in order to avoid foreclosures. This approach was not at the expense of the public
expenditure, but there was very little appetite in Congress for this initiative.
17 Gwartney, Economics, 631.
7
In October 2008, Congress passed the Emergency Economic Stabilization Act of 2008
(EESA). This law provided resources and authority to the Treasury to use public money into
foreclosure prevention program, but Bush administration was not able to implement it. it
eventually implemented by the Obama’s Treasury department in March 2009. EESA was
designed to in a form of an interest rate subsidy. This program was introduced October 2007 by
the Bush administration, but never passed. There were three policy constraints to the federal
government during the 2008 crisis.
1. Legal constraints
Throughout the crisis there were several legal challenges to the government. The Fed,
Treasury and other agencies operate in legal boundaries. Given legal constraints, some notions
were very helpful but not practical. There were two key examples that could help the federal
government curb the crises, however, there was no existing legal framework for the notion. The
Federal government had a proposal to force investor to run debt-for-equity swaps to overcome
overhanging debts.18 This notion would have allowed banks to accept government capital. Also,
federal government wanted to modify the loans, but it needed legislative actions.19
Federal government needed legislative support for new legal changes, but administration
ran into political hurdle with Congress. This was difficult when Democratic party took control of
both chambers in Congress. To avoid massive foreclosures and stabilize the housing market,
some proposals suggested to offer at risk homeowners a government loan that would be used to
reduce the principal on first-lien mortgages.20 Such loans were not suggested for those who were
18 Philippon, Thomas, and Philipp Schnabl. “Efficient Recapitalization.” The Journal of Finance 68, no. 1
(2013): 1–42.
19 Swagel, “The financial crisis.” 5.
20 Martin Feldstein. “How to Stop the Mortgage Crisis," The Wall Street Journal, March 7, 2008.
8
deep in the process of foreclosures, however it was intended to help to arrest potential defaults
and decline the housing market.
2. Political constraints
In 2008, federal government successfully negotiated with the Congress to pass legislative
actions. This would allow Treasury to use public money, as economy was slowed, and credit
crisis was at its peak. Even though government received legal authority and the resources, but
political constraints remained a factor that administration was not able to implement the act, until
President Obama administration was inaugurated in 2009. 21 Democratic Party controlled
Congress was not the only one to be blame for the political constraints. As matter of fact, the
Bush administration also put hurdles to the Congress initiated proposals. According to the Bush
administration Treasury official, Phillip Swagel22, the TARP act was first written at the Treasury
in March 2008: to buy assets, provide insurance, put capital into financial institutes or
introducing massive federally guaranteed mortgage refinance. The Treasury and the Feds never
presented the proposal to Congress, but the same proposal was enacted in Congress, but it was
too late. The Treasury never attested to Congress that crisis was coming. 23
3. External constraints
There were some external constraints. Time was one of them. Events leading to the 2008
crisis needed prompt responses, but it was delayed for the legal and political constraints.
Decisions has to be made rapidly to curb each problem before combining with another one. The
time calculation was very important for the legislation. TARP legislation was passed with great
21 Swagel, “The financial crisis,” 2.
22 Philip Swagel was US Assistant Secretary of the Treasury for Economic Policy from 2006 to 2009.
23 Swagel, “The financial crisis,” 2.
9
difficulties but never implemented on time. Other external constrains to the decision-making
process were self-imposed. There was little coordination between responding government
agencies. The Treasury itself, a leading policy maker agency was disorganized. Let alone
democratic controlled Congress, the Treasury had difficult working relation with the White
House as well.
Policy mistakes
The government policy making process was very slow. The mortgage-backed securities,
easy lending standards, and subprime mortgage lending were main problems that triggered panic
and economic crisis in 2008. Just like government policy mistakes greatly contributed to the
1980s crises, the panic of 2008 was also originated from 1990s and 2000s policy mistakes. 24
These are top policy mistakes, has the government implemented them could have prevented the
crisis between 1980s and the crisis of 2008:
a. Monetary Policy:
Many experts believe the Federal Reserve’s monetary policy played vital role in the crisis of
2008. The Fed has supplied large amount of money too fast and for too long in response to the
recession of 2001. In addition to that, the Fed pressed brakes too hard a few years later. Other
experts believe, the Feds failed to recognize the housing bubble too late. Federal rate was
dropped from 4.25 percent in December 2007 to zero percent by December 2008. The Fed’s
2007 policy had good intentions; to reduce unemployment and control inflation.
This policy would allow liquidity in the banking system.25 This monetary policy was
difficult to work in 2008, but now it has widely accepted in the market and infrastructure.26 It
24William M. Isaac, Senseless Panic: How Washington Failed America. (Somerset: Wiley, 2010), 45.
25 Robert L. Hetzel, “Monetary Policy in the 2008–9 Recession.” Economic Quarterly, 95:2, (2009): 212.
26 Hetzel, “Monetary Policy,” 213.
10
was the Fed’s restrictive monetary policy that further intensified the recession that began in the
summer of 2008. Economists believe, 27 deleveraging in financial markets would have been a
better approach to reduce unemployment and curb inflation. There was no contingency plan with
Fed’s policy to allow liquidity. Inflation, which was caused by the liquidity monetary policy,
triggered fragility in the market.28 The policy makers were concerned about lowering the federal
funds rate. It was widely predicted that with slow-paced economy, the lower funds rate would
lead to a rise in inflation. Accommodative monetary policy has limited ability to drive the
economy, but it will lead to inflation in the long run. 29
b. Uncontrolled GSEs; Growth of Freddie and Fannie
The uncontrolled expansion of Fannie Mae and Freddie Mac, the two GSEs, was another
policy mistake that set the country up for the 2008 crisis. In the 1990s both entities were
encouraged by both the Clinton Administration and Congress to allow lower lending standards
and reduce down payment requirements for low-income and weak credit borrowers.
Conservative observers opposed this initiative by the Clinton administration. It was called
Washington’s foolish obsession with promoting homeownership.30 David Stockman, a top cretic
of Fannie Mae and Freddie Mac expansion, calls both entities a true evil.31 He accepted that both
entities are saddled with inappropriate social policy. Though Stockman, as director of the Office
of Management and Budget in Reagan administration, failed to eliminate both entities.
27 Robert L. Hetzel, “The Monetary Policy of the Federal Reserve: A History.” Cambridge: Cambridge
University Press (2008): 17
28 Franklin Allen, and Elena Carletti. "The Role of Liquidity in Financial Crises.” Hole Economic Policy
Symposium, (2008): 1-36
29 Hetzel, The Monetary Policy of the Fed, 18.
30 David A. Stockman, The Great Deformation: The Corruption of Capitalism in America, (New York:
Public Affairs, 2013): 404.
31 Stockman, The Great Deformation, 407.
11
George H. W. Bush initially blamed Reagan administration for Fannie Mae and Freddie
Mac expansion, and he called it “voodoo economics”.32 In fact, when Bush left office in 1992,
the GSEs was reached $1.5 trillion. These entities were expanded in Clinton Administration to
promote his homeownership strategy and continued into the George Bush administration. Later
in 2002-2004, GSEs allowed borrowers with low lending standards and weaker credit which
caused the housing boom; the failure to properly regulate and control Fannie Mae and Freddie
Mac was a major factor in creating the crisis of 2008.33 Federal government believed that the
hosing GSEs will help the home ownership strategy, but according to economic experts, it
contributed little the housing finance system, yet it caused great risk for the economic system
that cannot be undo by regulation. 34
c. Mark-to-Market Accounting Practice
This accounting requires banks to tag a price to financial asset whatever they worth on
any given day. This accounting rule was abandoned and discredited in the 1980s crises. 35
However, Securities and Exchange Commission and the Financial Accounting Standards Board
(FASB), which regulate accounting rules choose to impose Mark-to-Market Accounting for the
financial industry. Mark-to-Market rule destabilizes the market with an exaggerated swings of
ups and downs. 36 This is inappropriate ways, according to the experts, to determine the value of
assets and loans. Among other policy mistakes the Deposit Insurance Premiums and Loan
Securitization were also main factor that, without questions, led to the financial panic of 2008.
32 Ibid., 406.
33 Isaac, Senseless Panic, 111.
34 Peter Willison, Thomas Stanton and Berty Ely, Privatizing Fannie Mae, Freddie Mac, and the Federal
Home Loan Banks: Why and How, (American Enterprise Institute, 2004): 9.
35 Isaac, Senseless Panic, 105.
36 Ibid., 106.
12
Conclusion
Taken as a whole, the policy mistakes and government response to the crisis of 2008,
suggest a conclusion. Many observers believe it was international capital flow and monetary
policy that caused the crisis of 2008. For others, flawed housing policy, and unregulated financial
institutions caused the panic.
The Financial Crisis Inquiry Report was published in 2011, which believed the top three
factors mainly contributed to the crisis. However, two dissenting opinions in the report argued
that not every regulatory step contributed to the panic. Peter Wallison and Arthur Burns, two
Commissioners of the inquiry report, in their dissenting argument concluded that “not every
regulatory change related to housing or the financial system prior to the crisis was a cause.”37
After studying the financial crisis of 1930s, the crisis of 1980s and the panic of 2008, we
can not rule out another similar panic. Most of the flawed policy that caused the crisis of 1980s,
such as unregulated GSEs, were further expanded in 1990s and continued into 2000s with less
regulations. The Feds later acknowledged that “the best response to the housing bubble would
have been regulatory, not monetary.” 38
From the biblical idea of covenant, power is shared, and we are accountable to one
another. 39As mentioned in the policy constrains, there was an episode of untrusted relationship
between the legislative and executive branch of government, which caused delay in government
response. Conservatives blamed the booming homeownership strategy an evil social policy,
which may not fit into the biblical world, as it said, “for I know the plans I have for you, declares
37The Financial Crisis Inquiry Report. (The Financial Crisis Inquiry Commission, Washington, 2011): 443.
38 Ben Bernanke. “Monetary Policy and the Housing Bubble” (Speech at American Economic Association.
Atlanta. Georgia 2010)
39 Fischer Kahlib, “Economic and Statesmanship” (video lecture in PLCY704, Liberty University,
Lynchburg, VA, May 14, 2022)
13
the Lord, plans for welfare and not for evil, to give you a future and a hope.” 40 There is not a
prescribed biblical form of economic system, but it does prescribe the principles to encourage
political, economic, and moral freedom.
As Stockman indicated that the American economic system, free market, and democracy
have been under long-term attack,41 he criticized Clinton administration for not curbing the
uncontrolled GSEs, but it will be unfair to walk away from his failure in same effort, which he
admitted in his book – failure to eliminate the uncontrolled GSEs. Both political parties criticized
each other for serving the interest of K Street rather than the interest of the people.
American public was very hopeful to President Bush second term, but the administration
could not curb the crisis. 42 Financial institution’s influence in Congress, and unregulated banking
sector for decades contributed to the 1980s and 2008 panic. The Fannie Mae and Freddie Mac,
the two GSEs, were expanded with no regulation and nearly no competitors. As Adam Smith
said, “to widen the market and to narrow the competition, is always the interest of the dealers…
The proposal of any new law or regulation of commerce which comes from this order, ought
always to be listened to with great precaution.”43
40 (Jeremiah 29:11, NIV)
41 Mary Whaley, “The Great Deformation: The Corruption of Capitalism in America,” Booklist, 109.15,
(2013): 8-9.
42 Philip A. Wallach, Embracing Adhocracy. Into the Edge: Legality, Legitimacy, and the Responses to the
2008 Financial Crisis (Brookings Institution Press, 2015): 43–78.
43 Adam Smith, The Wealth of Nations (England: Oxford Bibliomania Ltd, 2002): 267.
14
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