In 2001, the economy faced a mild recession (GDP dropped by 0.3%) with unemployment remaining at a 30-year low (only 4%). Policy makers concluded that such a small drop was an end of a business cycle. The Federal Reserve, however, took measures to stimulate borrowing and spending and decreased interest rates multiple times throughout a year resulting in 40 years lowest 1.75%. The end of the recession and low-interest rates caused a rapid growth in housing and construction. The recovery was characterized by extremely small unemployment gains in all sectors of the economy except for construction.
In the following years, Fed kept its monetary policy resulting in significant decrease in mortgage interests. In 2003, fixed-rate mortgages had 5.2%, and that allowed to buy more expensive houses for the same price. Adjustable-rate mortgages also gained popularity (chosen by 4% of prime borrowers in 2001 compared to 10% in 2003). Among subprime borrowers, the increase was even greater, from 60% to 76%. People jumped in into the housing market and caused home prices to grow at even higher rates – 9.8% annually from 2000 to 2003. As a result, homeownership rates and housing value rose dramatically.
Low mortgage rates caused a wave of refinancing (more than 25% prime mortgages were refinanced). High access to home equity loans caused an invention of home equity line of credit which worked like a credit card. According to Fed, money received through home equity loans were spent on vacations, electronics, jewelry, cars, real estate, and home improvements. Overall the spending grew very fast, faster than the economy did, and in some years faster than the real disposable income did. The rapid growth of mortgage markets was thought to be the stabilizing force in the economy.
In the early 2000s, subprime lending regained its positions from its shakeout in 1990s. The subprime market was becoming the market of large companies (top 25 subprime lenders accounted for 93% of all subprime loans), biggest banks such as Citigroup, National City Bank, and others spent billions on creating new units and buying smaller companies to promote subprime lending. They adopted different models for growth – Ameriquest played aggressively and pursued volume in originating loans while Lehman and Countrywide followed a "vertically integrated" model. The employment of broker's services also was a widely used practice because it was cheap and allowed a rapid expansion. Brokers were the chain between lenders and borrowers and while they were thought by borrowers to pursue their interests, in reality, they were aiming solely for their own financial interests. Brokers offered borrowers expensive mortgages and received high premiums from both high-interest loan itself and a lender for selling a high-interest loan. This gave brokers the incentive to push the market as far as it ca bear in selling high-interest loans to unaware customers. Inflated appraisals were another issue that rose with the rapid growth of housing market. The deals have to be closed, so the appraisers were forced to raise their appraisals too high. By 2006, 90% of appraisers reported feeling pressure from brokers, lenders, and borrowers.
As subprime loans rose, Citigroup acquired Associates First, the second largest subprime lender, in 2000. Such a large merger caused a regulatory scrutiny on the company. Citigroup was accused of “systematic abusive and deceptive lending practices" and by 2004 charged of over $70 millions in penalties.
As a reaction to Citigroup acquiring Associates First, the Federal Reserve adopted the Home Ownership and Equity Protection Act (HOEPA) which protected borrowers from predatory lending. This act was, however, very conservative because Fed authorities did not want to slow down the subprime market. It was anticipated that the HOEPA will cover 38% of subprime loans but the lenders changed the terms of mortgages to avoid these regulations and, as a result, HOEPA covered only 1% of subprime loans. There were made numerous attempts to toughen the requirements for subprime loans and the supervision over subprime lenders which brought no real effect. Fed succumbed to high market growth and was unable to substantially reduce predatory lending. The states authorities however adopted own measures to confront predatory lending (established fee trigger, prohibiting repeated refinancing, etc.). The actions of states attorneys caused major subprime lenders to pay severe penalties and restitutions to customers. The market of loans to moderate- and low- income communities was stable during this period, and the bank's commitments towards community groups were kept and reinforced.
In October 2001, the Federal Reserve adopted the “Recourse Rule” which governed the capital a bank needs to hold against securitized assets. Following its rules, banks were encouraged to hold more AAA, and AA rated securities because they required to much lower capital than lower-rated securities did. This tendency made banks and regulators unprepared for large losses on high-rated mortgage-backed investments (Conczal, 2009). They were also unprepared to significant rating downgrades requiring banks to hold more capital which could not be acquired at the moment of market fall.
The Federal Reserve’s regulations can be considered too mild for the level of abusive and predatory lending which was present. The authorities, however, did not want to slow down the economy and bathed in the light of its rapid growth. The policy must always account for the worst case scenario and secure country from it, which was clearly not performed. It is a good lesson for us not to get blinded by the good and, therefore, not see the bad.
Conczal, M. (2009). Did Regulation Cause the Financial Crisis?. TheAltlantic.com. Retrieved 30 January 2016, from http://www.theatlantic.com/business/archive/2009/09/did-regulation-cause-the-financial-crisis/26880/