Four interrelated factors are responsible for creating the ongoing [subprime mortgage] financial crisis that is raging in the United States today.
First, monetary policy. After the technology dotcom bubble burst in 2001 and brought about the March to November 2001 recession, the Greenspan Fed aggressively lowered the Federal Funds rate from 6.5% to 1% in 2004, the lowest it had been since 1958. it is considered now that this was excessive, and that the Fed should not have lowered the Federal funds rate below 2%, and that it should have begun to raise it sometime in 2002. Indeed, from 2002 to 2004, the American central bank pursued a monetary policy that was too expansionary.
Former Fed Chairman Alan Greenspan has argued to explain his policies that he was afraid of an onset of deflation, but few economists agree with him. Between 2002 and 2004, the Fed had no need to keep real short term interest rates so negative for so long, especially as the Bush administration was cutting tax rates and increasing military expenditures with its military invasion of Iraq.
Second, the housing boom. Abnormally low interest rates in the U.S., but also elsewhere because of the interconnections between money and capital markets, fed a housing boom world-wide which was unsustainable because partly based on price speculation. Indeed, mortgage rates in the U.S. remained low, even after the Fed started to raise the Federal funds rate from 1% in mid-2004 to 5.25% in June 2006. This was brought about by Americans borrowing huge amounts abroad. In 2006, the U.S. current account deficit even reached 6% of GDP. China, Japan and oil-producing countries were the main buyers of U.S. Treasury bills and bonds.
Third, new banking rules. With ever rising house prices, lending institutions relaxed their lending rules as the housing collateral behind the loans was gaining in value. Mortgage banks and other lenders began to accommodate subprime borrowers with dubious credit by extending mortgage loans to homebuyers who would not have qualified in other times. Nontraditional home loans were advanced to borrowers who had no documented incomes. Some loans were interest-only loans with down payments of 5% or less. Some were adjustable rate loans (ARMs), with low rates for one or two years to be reset later at much higher rates. In 2006, about 25 percent of American mortgages were subprime and close to 20 percent were adjustable rate loans.
Fourth, new financial instruments. With the demand for mortgage loans increasing, large banks resorted to some inventive financing of their own in order to economize their capital. They began repackaging loans and slicing them into some exotic new types of securities, and in so doing, shifted their lending risk to the buyers of such securities. Thus came into being a new class of securities – often rated AAA by credit rating agencies – that money market funds, insurance companies, pension funds and other investors could purchase.