The 2007-2008 mortgage crisis

The actions of central banks worldwide have serious ramifications on the economies of
countries. In the build-up to the 2007-2008 financial crisis, several economic and non-economic
instigating activities happened. One key event was the terrorist attack on September 11, 2001
(Posner & Vermeule, 2008). This attack led to the collapse of the capital markets as prices of
stocks plummeted. There was a period of economic uncertainty as organizations reduced their
spending activities, which led to a financial decline. Since the 1900s, the housing market has
been on a steady increase. In their quest to realize the American dream, many individuals had
created a demand for homes, prompting increased investment activities in homes. Increased
investment in homes led to increased money commitment to the residential sector. Further
encouragement for investing in the residential sector was prompted by increased economic
performance, such as increased private-sector job creation that was attributable to housing and
housing-related sector.
The Federal reserve evaluated the economic climate and reviewed the interest rates
downwards from 6.5% to 1% in June 2003. The economic response to this move was to increase
the circulation of money in the economy. Before the revision of the rates, individuals who
wanted to own homes through mortgages had to have a good credit rating and the ability to
service the mortgages at the 6.5% rate. Following the reduction, many individuals could now
afford to enter into mortgage arrangements with lenders (Laeven et al., 2008). Sensing a
booming business, financial institutions increased their lending appetite to benefit from a large
influx of customers.
This created a demand for homes, and dealers increased home prices to reap maximum
benefits from the increased demand. The Federal Reserve held the low-interest rates for a long

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time, and there was a continued investment in the housing sector. The capital market also grew
significantly from the rise in mortgage loans after banks packaged the mortgage loans and sold
them to Wallstreet banks as collateralized debt obligations (CDOs). With such growth came an
increased risk due to the availability of cheap credit as a result of reduced interest rates.
Therefore, a significant amount of money was held in the real estate sector by way of investment
and in the secondary market prior to the drop in home prices in 2007.
By 2007, the federal bank had already readjusted the interest rates, which at the time
were at 5.25% from 1% in 2003 (Covitz et al., 2012). Home prices reached a peak and began to
fall in the second quarter of 2007. This meant that many mortgaged homes reduced in value for
most Americans, and at the same time, subprime mortgage loans became non-performing (Covitz
et al., 2012). The market shocks meant that most owners could not liquidate their homes even
when they could afford to pay the down payment. Subprime lenders filed for bankruptcy.
The effect on the money was that there was a reduction in the supply of money. This
occurred because people were unable and unwilling to purchase loans due to the crash of
subprime lenders. The uncertainty created in the property market and mortgage-related financial
securities meant that property investment was reduced, and the compounding effect reduced the
circulation of money in the economy. In the housing boom between the 1990s and 2007, many
financial institutions had offered subprime mortgages and subprime mortgage-backed securities,
which were reduced in value over time. Banks reviewed their policies and halted further
investments in such securities and mortgages.

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Actions taken by the Federal Reserve to reduce the effects
The federal reserve had to take steps to reduce the liquidity crisis and offer a lifeline since
many financial organizations had already gone under. The government provided an incentive for
lenders that negotiated mortgage payments with mortgage holders. This was meant to reduce the
increasing trend of foreclosures, especially for mortgages where the value of homes dropped
lower than the value of mortgages. Mortgage restructuring was meant to encourage mortgage
holders to honor their agreements, in effect increasing the supply of money in the economy.
The federal reserve also provided an incentive in the form of tax credits for home buyers.
This was meant to encourage more people to purchase homes. Tax credits would reduce the tax
liability and increase demand for homes to avoid further decline in the prices of homes. The
increased commitment to purchase homes increased the money circulation in the economy.
One reason that had led to the decline of the housing market was the increase in interest
rates. The Federal Reserve acted by reducing the interest rates both short term and long term to
encourage economic activity. The Federal reserve also creates money inflow into the economy
by buying prime mortgage-backed securities. This was done to protect the value of mortgage-
backed securities, increase demand for mortgage transactions and reduce the number of unsold
homes in the market. The federal government additionally purchased distressed assets through
the Troubled Asset Relief Program (Nguyen & Enomoto, 2011). The effect was increased
liquidity in the market as the government invested $442.6 billion (Nguyen & Enomoto, 2011).
The secondary effect which also had an effect on the circulation of liquidity in the market
was the recovery of the construction industry. Such recovery was instrumental in stabilizing the

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housing prices and spurring new construction, and in effect, increasing the circulation of money
in the economy through production and employment.
The housing recession had serious ramifications on the two principal mortgage banks in
the United States; Fannie Mae and Freddie Mac (Pelouz, 2009). The government committed to
purchasing both institutions to protect the value of the housing assets held in the books of both
firms and avoid the fate that had befallen other notable names such as IndyMac Bank and
Lehman Brothers. The Federal Reserve invested approximately US $ 187 billion to bail out
Fannie and Freddie (Pelouz, 2009).
Other actions were taken in the form of law. The Dodd-Frank Act was enacted to
empower the Federal Reserve to have increased oversight of the operations of large banks in the
United States (Musilek, 2010). This was done in an effort to protect large financial institutions
from adverse effects in case of another financial crisis. The housing crisis led to the downfall of
many banks that had traded large volumes of subprime mortgage offerings. Through the Dodd-
Frank Act, the Federal Reserve increased the requirements of large firms to hold higher cash
reserves. The actions of large financial institutions are now closely monitored. The Policy
requirements also reduced the probability of large banks dealing in predatory lending that causes
many financial institutions to offer subprime mortgages.

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References

Covitz, D. M., Liang, N., & Suarez, G. (2012). The Evolution of a Financial Crisis: Collapse of
the Asset-Backed Commercial Paper Market. SSRN Electronic Journal.
https://doi.org/10.2139/ssrn.1364576
Laeven, L. A., Igan, D., & Dell’Ariccia, G. (2008). Credit Booms and Lending Standards:
Evidence from the Subprime Mortgage Market. SSRN Electronic Journal.
https://doi.org/10.2139/ssrn.1153728
Musílek, P. (2010). Financial Crises and Their Responses in the Institutional Reforms: Glass-
Steagall Act versus Dodd-Frank Act. Český Finanční a Účetní Časopis, 2010(2), 6–17.
https://doi.org/10.18267/j.cfuc.63
Nguyen, A. P., & Enomoto, C. E. (2011). The Troubled Asset Relief Program (TARP) And The
Financial Crisis Of 2007–2008. Journal of Business & Economics Research (JBER),
7(12). https://doi.org/10.19030/jber.v7i12.2369
Pelouze, F. A. (2009). Fannie Mae and Freddie Mac and the 2008 Financial Crisis. SSRN
Electronic Journal. https://doi.org/10.2139/ssrn.1424456
Posner, E. A., & Vermeule, A. (2008). Crisis Governance in the Administrative State: 9/11 and
the Financial Meltdown of 2008. SSRN Electronic Journal.
https://doi.org/10.2139/ssrn.1301164