Ten Years After

For financial market participants, the ten-year anniversary of the financial crisis will bring back a lot of bad memories, chiefly among them is the failure of Lehman Brothers (Sept. 15, 2008). In the weeks ahead, we’ll see retrospectives on the events that led to the crisis, the failure to predict how bad things would get, and how we should prevent a similar setback.

Prior to the crisis, the U.S. economy had experienced just two minor recessions in 25 years. The belief was that the business cycle had been tamed. Former Fed Chairman Alan Greenspan called it the Great Moderation. Monetary policy would be able to counter economic downturns, limiting the scope of the damage. Technology had improved the flow of information. Bar codes and scanners, for example, streamlined the inventory process. As a consequence, firms could respond more rapidly to changing conditions.

We tend to think of the financial crisis as the bursting of the housing bubble, but it was much more than that. The U.S. had experienced a number of regional housing bubbles over the years (defined as home prices rising faster than median household income). As one of these regional housing bubbles burst, home prices tended to fall somewhat, but then stabilized, flattening over time as incomes caught up. We had never seen a housing bubble on a national scale. Alan Greenspan, the chair of the Federal Reserve likened the housing market to a glass of beer – a lot of small bubbles – and downplayed the risks.

During the housing boom, a lot of homeowners used their homes as ATMs. In major metropolitan areas, companies ran TV commercials offering to free up extra cash to pay bills, take a vacation, or buy that new boat or motorcycle. At its peak, the extraction of home equity was huge, totaling more than 10% of the level of personal income. That extraction funded a wide range of consumer spending, especially motor vehicle sales, but the support to spending evaporated as home prices declined.

As a rule, debt doesn’t matter until it does. High debt levels are never a catalyst for a recession, but can make an economic downturn worse. Household debt had risen sharply ahead of the financial crisis, but so had home prices, leaving household balance sheets in generally good shape – that is, until home prices began falling. Some had feared that a resetting of adjustable-rate mortgages would trigger a downturn in spending, but this doesn’t seem to have been a major issue.