Holt 7525-9 S15_IT

Fed policies caused short-term interest rates to be extremely low from 2002 to 2004. The low
short-term interest rates contributed to the housing bubble by; (1) encouraging the use of
adjustable rate mortgages, and (2) encouraging leveraging. The use of adjustable rate mortgages
made monthly mortgage payments temporarily affordable for more buyers and thus contributed to
rising home prices. Leveraging increased the financing available for mortgage lending and thus
contributed to rising home prices.
In the mid 1990s, new governmental policies were enacted that contributed to a relaxing of
standards for mortgage loans. Greater competition in the mortgage industry contributed to
relaxed mortgage standards. As irrational exuberance caused the housing market to overheat,
lenders relaxed their mortgage standards even further.
Irrational exuberance played a key role in the housing bubble. All the participants who contributed
to the housing bubble acted on the assumption that home prices would continue to rise. Home
prices kept rising for a long time, rewarding those who contributed to the bubble.
When the housing bubble burst, mortgage default rates began to rise. Falling home prices meant
that ARMs could not be refinanced, which reinforced the continuing fall in home prices. Most of
the losses caused by the bursting of the housing bubble fell not on homeowners but on the
financial system, especially mortgage lenders, investment banks, foreign investors, and insurance
companies. The bursting of the housing bubble sent a shock through the entire financial system,
increasing the perceived credit risk. The increased perceived credit risk decreased investment
spending.
When the credit crisis arose, the federal government began to intervene in the economy in
unprecedented ways. The Fed lowered the federal funds rate and greatly increased the money
supply. The Fed loaned billions of dollars to financial institutions. The Fed provided loans to
facilitate the purchase of Bear Stearns and to prevent the bankruptcy of AIG. The federal
government placed Fannie Mae and Freddie Mac into conservatorship and injected new capital
into the GSEs. The federal government enacted four economic stimulus plans, in February of
2008, in October of 2008, in February of 2009, and in December of 2010.
The one essential cause of the housing bubble was irrational exuberance. The housing bubble
would not have occurred without the widespread belief that home prices would continue to rise.
Questions for Chapter 11
Fill-in-the-blanks:
1. The Federal Reserve System is the U.S. ______________________ bank.
2. The most important function of the Fed is controlling the ______________________
______________________ .
3. The ______________________ ______________________ rate is the interest rate one
bank charges another bank to borrow reserves.
4. The ______________________ rate is the interest rate the Fed charges banks that
borrow reserves from it.
5. ______________________ is investing with borrowed money.
6. ______________________ mortgages are home loans given to persons who are considered
a poor credit risk.
FOR REVIEW ONLY - NOT FOR DISTRIBUTION
7. ______________________ ______________________ is a heightened state of speculative
fervor.
11 - 13 The Federal Reserve System