Fiscal Hour

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 Remedial Measures
• The U.S. Federal Reserve and central banks around the world have taken
steps to expand money supplies to avoid the risk of a deflationary spiral
• Governments have enacted large fiscal stimulus packages. The U.S. executed
two stimulus packages, totaling nearly $1 trillion during 2008 and 2009.
• During the last quarter of 2008, these central banks purchased US$2.5 trillion
of government debt and troubled private assets from banks. This was the
largest liquidity injection into the credit market, and the largest monetary
policy action, in world history.
• The governments of European nations and the USA also raised the capital of
their national banking systems by $1.5 trillion, by purchasing newly issued 
preferred stock in their major banks.
• Governments have also bailed-out a variety of firms like AIG, Fannie Mae,
Freddie Mac.
 Genesis of this Crisis
• The role of US govt.
• Reasons for the crisis have been stated as greedy investment bankers,
incompetent CEO’s and even market innovations like credit default swaps.
However the main cause of the financial crisis is the US govt itself.
• Policies that first created the housing bubble, removed the equity in homes
and the capital in the banking system. The govt. tried to use the banking and
financial system to expand home ownership. it imposed the Community
Reinvestment Act (CRA) on insured banks in 1977 which helped them lower
their lending standards.It also came out with an "affordable housing" mission
on Fannie Mae and Freddie Mac in 1992.
• Similarly, under regulations of the Department of Housing and Urban
Development (HUD), Fannie Mae and Freddie Mac were required to make
affordable housing more plentiful. Fannie and Freddie began to purchase and
guarantee larger and larger numbers of subprime and other non traditional
loans in order to meet HUD's stringent requirements.
• Lenient Mortgage Norms

Under prevailing mortgage market policies, homeowners were permitted to

refinance their homes without any penalty--a benefit rarely available in
commercial lending--so that as home values increased and homeowners
accumulated equity in their homes they were able to draw out this equity
through refinancing. This activity, known as " cash-out refinancing," made
possible the purchase of cars, boats, vacations and other consumer goods--and
even drove the stock market to new highs--but inevitably reduced the amount
of equity in homes that should have been backing mortgages.
• Loose taxation policies
Homeowners were encouraged to borrow against their home equity--in
effect to use their homes as savings accounts--because government tax policy
made interest on home equity loans tax deductible while interest on credit
cards and other consumer loans was not.
Incentive to Indulge in Residential mortgages:
• Bank regulations specified a lower capital requirements of 4% for residential
mortgages as compared to 8% for commercial loans. In addition, by converting
their mortgages to mortgage-backed securities banks could reduce the capital
charge to 1.6 percent, further enhancing this preference.
• From 2000 to 2003, the Federal Reserve lowered the federal funds rate target
from 6.5% to 1.0%. An increase in loan incentives such as easy initial terms and
a long-term trend of rising housing prices had encouraged borrowers to assume
difficult mortgages in the belief they would be able to quickly refinance at more
favorable terms. However, once interest rates began to rise and housing prices
started to drop moderately in 2006–2007 in many parts of the U.S., refinancing
became more difficult. Defaults and foreclosureactivity increased dramatically
as easy initial terms expired
• Inflow of  foreign capital 
The trade deficit of USA increased from 1.5% to 5.8% of GDP. USA borrowed
large funds from abroad to finance these deficits. Hence, emerging economies in Asia
and oil-exporting nations started  financing these deficits. This created demand for
various types of financial assets. Financial institutions started investing foreign funds in
MBS as it was giving high returns. 
• High Risk Lending
“Subprime” refers to the credit quality of particular borrowers, who have weakened
credit histories and a greater risk of loan default than prime borrowers. Subprime
mortgages remained below 10% of all mortgage originations until 2004, when they spiked
to nearly 20% and remained there through the 2005-2006 peak of the 
United States housing bubble. A proximate event to this increase was the April 2004
decision by the U.S. Securities and Exchange Commission (SEC) to relax the net
capital rule, which encouraged the largest five investment banks to dramatically increase
their financial leverage and aggressively expand their issuance of mortgage-backed
securities. This applied additional competitive pressure to Fannie Mae and Freddie Mac,
which further expanded their riskier lending. Subprime mortgage payment delinquency
rates began to increase rapidly, rising to 25% by early 2008.
• Weak Regulatory Environment
The regulatory framework did not keep pace with financial innovation. In
2004, the Securities and Exchange Commission relaxed the net capital rule, which
enabled investment banks to substantially increase the level of debt they were
taking on, fueling the growth in mortgage-backed securities supporting subprime
mortgages. Regulators and accounting standard-setters allowed depository banks
such as Citigroup to move significant amounts of assets and liabilities off-balance
sheet into complex legal entities called structured investment vehicles.
• Excess Leverage
• USA household debt as a percentage of annual 
disposable personal income was 127% at the end of 2007, versus 77%
in 1990.
• U.S. home mortgage debt relative to gross domestic product (GDP)
increased from an average of 46% during the 1990s to 73% during
2008, reaching $10.5 trillion.
• In 1981, U.S. private debt was 123% of GDP; by the third quarter of
2008, it was 290%.
• From 2004-07, the top five U.S. investment banks each significantly
increased their financial leverage (see diagram), which increased their
vulnerability to a financial shock
• Toxic financial instruments
The adjustable-rate mortgage; the bundling of subprime mortgages into 
mortgage-backed securities (MBS) or collateralized debt obligations (CDO) for
sale to investors, a type of securitization; and a form of credit insurance called 
credit default swaps(CDS).  
 
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