A Plague of Subprimes
Part II: Provenance
Five Factors:
1) Interest Rates
In a complex crossfire of pointed fingers on the issue of what caused the subprime mortgage mess, there are a few elements of common agreement. One factor, however, is on everyone’s list: The whole thing would never have gotten started were it not for the profound and historic relaxation of interest rates by the Federal Reserve from 2001-03. The collapse of the great tech-stock bubble in March 2000, followed by the turmoil of the presidential election eight months later, had put stock markets into a freefall unmatched since the catastrophe of 1929. Fed Chairman Alan Greenspan and several other members of the Board of Governors (including Greenspan’s successor and current chairman, Ben Bernanke) believed there was an imminent danger of the general economy again following the stock market into a full-scale depression.
In January 2001, the Federal Reserve’s Open Markets Committee began a series of cuts that by August 21 had cut 300 basis points from the Fed Funds, putting it at relatively accommodating 3.5 percent. That might have been taken as a logical resting point, or even a terminus, for the relaxation policy, but for the fact that 21 days later terrorists destroyed the World Trade Center and attacked the Pentagon. Suddenly, the threat of chaos was not only imminent, but very palpable. The financial system, coming off a complete shut-down and still lying partially in ruins, was skittish in the extreme. The OMC responded by cutting the Fed Funds rate four more times (to 1.75%) by year’s end. Another cut came in November 2002 (to 1.25%) and again in November 2003 (to 1%).
This was the lowest absolute level for Fed Funds since 1958, and the lowest rate ever in “real” (net of inflation) terms. The real interest rate in fact was negative on short-term Treasury bonds, meaning buyers of T-bills had to pay to hold them, as if renting a virtual safe deposit box. The 1% rate remained in force for a year and five days, and was regarded