Page 28 - Accelerating out of the Great Recession

THE DAMAGED ECONOMY

The increase in U.S. house prices was underpinned by the
ready availability of debt, particularly after interest rates were
cut to 1 percent in order to stimulate a faltering economy in
the wake of the 9/11 terrorist attacks. From 2005 to 2007,
additional impetus was provided, first, in the form of aggres-
sive risk taking by highly leveraged financial institutions that
funded the unsustainable rise in house prices and, second, by
the promotion of artificially low-priced adjustable-rate mort-
gages. With high risk came high reward, at least initially. As
returns from mortgage lending increased, banks came to rely
on them to drive up their profits. In essence, this turned
banks from agents into principals: rather than fulfilling
demand in the market, banks were driving the supply of easy
credit.
Underlying all this were three widely held assumptions: that
the creditworthiness of borrowers was strong, that investors
were sophisticated, and that credit risk was widely distributed.
Unfortunately, these assumptions were seriously wrong.

The Creditworthiness of Borrowers Was Lower Than Expected

The first assumption—that borrowers’ creditworthiness was
strong—was based on the knowledge that credit losses had, in
fact, been relatively limited for years. There was, however, a
dangerous circularity to this logic. The belief—held by both
lenders and investors—in the creditworthiness of homeowners
drove spreads lower. This, in turn, caused marginal borrowers to
appear more financially attractive than they really were and
made it easier for lenders to justify giving them loans.
Many lenders also believed that the more financially con-
strained borrowers would not be a problem because they would
be sheltered by ever-rising home prices. The introduction of

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