Friday, May 9, 2014

Chicago And The Causes Of The Great Recession

This study of mortgage origination in Chicago during the run up to the Great Recession, shows that the poorest zip codes in Chicago had the highest incidence of new mortgages.  They also had the highest incidence of foreclosures.  Theses zip codes also had the lowest rate of new car auto purchases during the recovery.  The article concludes that over leveraged households provides a better explanation for the Great recession than the collapse of Lehman Brothers.

Its very clear that households took on more debt than they could afford in this period.  Its also clear that highly indebted households are not good prospects for new cars.  Its not clear, however, that the financial sector was not the proximate cause of the Great Recession.  Those mortgages would never have been originated if the investment banks had not packaged them into securities which they sold to investors.  The originators had no skin in the game, since they sold the mortgages to the investment banks.  Investment banks, like Lehman, believed that they could borrow money short term using the securities that they created as collateral.  When the money market funds lost confidence in the value of the collateral provided by Lehman, they demanded a higher interest rate for the short term loans, or they refused the collateral on offer.  Lehman lost its source of short term funding and it was stuck with toxic mortgage backed securities which it could no longer sell.  Lehman was both illiquid and insolvent.

The fall of Lehman signaled the collapse of the system that had been put in place by the investment banks.  The global economy was faced with two huge problems: Lehman was not the only bank in trouble.  Central banks were forced to rescue the failed banks in order to prevent a total collapse of the banking system.   It took years for the banks to recover and credit became scarce for all but the least risky borrowers.  The rapid rise in foreclosures also led to a decline in home prices.  Many households, which were servicing their debt, discovered that their homes were worth less than the value of their mortgages.  This led to an increase in distressed sales which caused home prices to fall even further.  It did not take long for real estate developers to get into trouble.  New home construction, which had been a bright spot in the economy during the boom, collapsed, and many banks which had loaned money to real estate developers discovered that they were at risk.

In short, its too simple to trace the cause of the Great Recession to poor households in Chicago that bought homes that they could not afford.  They would not have been put in that position if the investment banks had not created the system that enabled mortgage originators to make bad loans.

No comments:

Post a Comment