A Calm Analysis of the Panic of 2008

Published in Law & Liberty.

It makes sense that the 2008 bailouts inspired a lot of emotion, rhetoric, and hyperbole. Hundreds of billions of dollars had just been lost, the government was rescuing arguably undeserving institutions and their creditors, and the financial system seemed to be wavering on the edge of an abyss. Sixteen years after the panic, though, Todd Sheets manages to stay calm, analytical, and generally convincing in his new book discussing the Great Housing Bubble, its causes, its acceleration, its collapse, and the costly aftermath. 2008: What Really Happened dispassionately reviews the actions of key parts of the US government that were central to creating each stage of the bubble and bust over a decade.

In the early 2000s, Sheets tells us, he “had a growing concern that the Fed’s cheap-money policies were destined to end badly.” Then came the first financial crisis of the then-new twenty-first century. This disaster, we should remember, arrived shortly after we were assured by leading central bankers that we had landed safely in a new age of “The Great Moderation.” In fact, we landed in a great overleveraged price collapse.

In economics, the future is unknowable, we are usually confused by the present, and we can easily misinterpret the past. Sheets believes that “historical review reveals … a lengthy delay from an economic crisis to an understanding of what really happened.” He tells us that the book is a result of deciding, while reflecting on the crisis, that “I was confused about big-picture economic matters I had long taken for granted and realized it was time for a new self-study program … focused on financial history.”

Five Phases of the Bubble

Sheets’ study has resulted in an instructive historical framework for understanding the development from growing boom to colossal bust. He proposes five principal stages:

1. The pre-Bubble era, pre-1998: This era is now 26 years, or a whole generation, away from today. Sheets emphasizes the long historical period when average house price increases approximately tracked general inflation. “In the century preceding the housing bubble, house prices more or less tracked inflation,” he writes, “increases in real house prices were negligible.” He believes this is historical normalcy. One might argue that the average real increase in US house prices had been more like 1 percent per year (as I did at the time in graphing the Bubble’s departure from the trend), but that does not alter the fundamental shift involved.

2. Liftoff, 1998–2001: “Beginning in 1998, housing prices suddenly departed from these long-term historical trends,” Sheets notes. In other words, the Bubble starts inflating ten years before the final panic. “Real home prices suddenly begin to increase at an average annual rate of 4.7% during Liftoff.” Why did they? We will discuss below Sheets’ proposals for the principal cause of each phase.

3. Acceleration, 2002–2005: In this phase, “the rate of real home price appreciation began to accelerate even more rapidly”—it “shot up again, to an average annual rate of 8.3%, reaching a peak of 10.4% in 2005.” Remember that Sheets is always dealing always in real price increases—those on top of the general rate of inflation. At this point, it seemed to many people that buying houses with the maximum amount of mortgage debt was a sure-fire winning bet. From 1998 to 2006, Sheets calculates that in real terms, house prices “appreciated over 10 X the level of cumulative appreciation in the 100 years before the bubble.”

4. Deceleration, 2006: “The rate of increase in real house prices slowed dramatically” in the transition year of the inflation turning into deflation of the bubble.

5. Crash, 2007-2012: Home mortgage debt had by now become much more important to the US economy than before, surging strikingly, as Sheet’s table of mortgage debt as a percent of GDP shows:

A lot of people had made a lot of money on the way up, but any potential mortgage debt losses now had a much bigger potential negative impact than before. How much bigger? We were about to discover. Then, “beginning in 2007, real house prices declined … eventually falling about one-third.” Indeed, house prices fell for six years, until 2012. Between 1998 and 2012 we thus approximated the biblical seven fat years followed by seven lean years. There were vast losses to go around, defaults, failures, continuing bad surprises, and a constant cry for government bailouts, as inevitably happens in financial crises.

Sheets helpfully divides Phase 5, the Crash, into four component stages. For many of us, he reenergizes memories that may have been fading by now, and for those younger without the memories, provides a concise primer. Thus:

5(a) Awareness, June 2007-October 2007: “Hedge funds managed by Bear Stearns and BNP Paribas that were heavily concentrated in US home mortgages announced significant write-downs.” Oh-oh, but there was still much uncertainty about the implications for wider problems. “The markets still had no idea of just how precipitously housing prices would fall.” The Federal Reserve embarrassingly and mistakenly opined that the problems were “contained.” The stock market rose until October 2007. Showing some earlier awareness of looming problems, in March 2007 the American Enterprise Institute had a conference on “Implications of a Deflating Bubble,” which I chaired. We were pessimistic, but not pessimistic enough.

5(b) Stress, November 2007-August 2008: “A steady procession of substantial mortgage-related write-downs and losses were announced by a wide swath of financial institutions.” Two of my own favorite quotations from this time epitomize the growing chaos. “Hank,” the chairman of Goldman Sachs told the Secretary of the Treasury, Henry Paulson, “it is worse than any of us imagined.” And as Paulson himself summed it up: “We had no choice but to fly by the seat of our pants, making it up as we went along.”

In July 2008, “the Fed invoked special emergency provisions that enabled it to supply bailout financing” to Fannie Mae and Freddie Mac, the dominant mortgage companies. Fannie and Freddie are called “GSEs,” or government-sponsored enterprises. Their creditors believed, even though the government denied it, that “government-sponsored” really meant “government-guaranteed.” The creditors were correct. In the same July, “President Bush signed a bipartisan measure to provide additional funds” to Fannie and Freddie. These two former titans of the mortgage market, the global bond market, and US politics were tottering. But Sheets stresses a key idea: “Markets found additional reassurance in the idea that federal authorities would continue to intervene,” as they did when Fannie and Freddie went broke but were supported by the US Treasury in early September. In a financial crisis, the universal cry becomes “Give me a government guarantee!”

5(c) Panic, September 2008-February 2009: The Treasury and the Fed provided government guarantees and bailed out the creditors of Bear Stearns, Fannie Mae, and Freddie Mac. But on September 15, 2008, “the authorities unexpectedly allowed Lehman Brothers to fail.” Whereupon “the money markets lurched into a state of panic,” their confidence in bailouts punctured. As Sheets relates, this was followed by a series of additional, giant government guarantees and bailouts to try to stem the panic.

5(d) Recovery, March 2009-forward: “What the [panicked] short-term financing markets were looking for,” Sheets concludes, “was unconditional assurance that none of the remaining critical institutions—Citigroup, Merrill Lynch, or Bank of America—would become the next ‘Lehman surprise.’ The final bailout package for these critical institutions was announced in mid-January of 2009.” In 2009 bank funding markets stabilized and the stock market recovered. That is where Sheets’ history concludes, but we should remember that house prices did not finally stop falling until 2012, and the Fed’s abnormally low interest rates resulting from the Crash continued for another decade—through the financial crisis of 2020 and until 2022. But that is another story.

What were the fundamental causes of the ten-year drama of the housing bubble and its end in disaster? “A plausible theory of causation must explain the sudden onset and the distinct phases of the bubble,” Sheets sensibly argues, thus that different phases had different main causes. As he identifies the principal cause of each phase, it turns out that the US government, in various manifestations, is the prime culprit.

“The Liftoff phase of the bubble in 1998 was triggered by the rapid expansion undertaken by Fannie Mae and Freddie Mac,” Sheets concludes. The timing fits: “The sudden acceleration of GSE growth coincided with the onset of the housing bubble.” And the magnitudes: “88% of the excess growth in mortgages outstanding relative to the Base Period originated from the GSEs.”

Fannie and Freddie could have so much impact because they were the dominant competitors, had key advantages granted by the Congress, had deep political influence and allies—but most importantly—operated with a government guarantee. This was only “perceived” and “implied” it was said, but it was nonetheless entirely real. That enabled their debt obligations to be sold readily around the world, as they set out to and did expand rapidly, notably in riskier types of mortgages, seeking political favor as well as more business.

Fannie and Freddie’s rapid expansion was linked to the push of the Clinton Administration to expand homeownership through “innovative” (i.e. risky) mortgages. This was a perfect combination of factors to launch a housing bubble. Sheets correctly observes that Fannie and Freddie’s role was “aided and abetted by federal housing policy.”

He sympathetically discusses Franklin Raines, Fannie’s CEO from 1999–2004, whose “move back to Fannie Mae coincided almost exactly with the onset of the housing bubble.” This section should also have considered James Johnson, CEO from 1991–1998, the real architect of Fannie’s risky, politicized expansion. Both of them combined politics at the highest level in the Democratic Party with housing finance, a combination which produced, as Sheets says, “just the opposite of what was intended.”

Sheets’ conclusions are consistent with those of Peter Wallison’s exhaustive study, Hidden in Plain Sight, which states, “There is compelling evidence that the financial crisis was the result of the government’s own housing policies.” So that no one misses the point, Sheets reiterates, “We can safely conclude that the Liftoff phase of the housing bubble was caused by the GSEs, with the support of the federal government.”

In the acceleration phase, Sheets writes that “the Federal Reserve became the driving force behind the further escalation of real housing price appreciation” by suppressing interest rates to extremely low levels, including negative real interest rates. This made mortgage borrowing seem much cheaper, especially as borrowers shifted to adjustable-rate mortgages.

“The Fed dramatically lowered short-term interest rates in order to deal with the collapse of the Internet stock bubble in 2000 and then held rates at historically low levels. … The Fed pushed the real fed funds rate down to an average of minus 0.6% during the Acceleration phase.” And “Where did the stimulus go? Into housing.”

Sheets notes that after the Internet stock bubble burst in 2000, the Fed lowered short-term interest rates and held them at historic lows. That stimulus, he says, went into housing. I call this the “Greenspan Gamble,” after the famous Fed chairman of the time, who was then admired as “the Maestro” for his timely monetary expansions. As Sheets says, the Fed ended up with the housing bubble instead—which cost Greenspan his “Maestro” title.

After the Fed started increasing rates again in 2005–2006, the housing bubble decelerated, and then collapsed in 2007. House prices started to go down instead of up, the start of the six-year fall. Subprime mortgage defaults went up. Specialized subprime mortgage lenders went broke. The problems spread to leading, household-name financial institutions. In the fourth quarter of 2007, “Citigroup, Bank of America, and Wachovia announced steep profit declines due to mortgage write-downs, … Merrill Lynch announced the largest quarterly loss in the firm’s history, … Citigroup revealed [huge] pending write-downs … [and there was] the steady drumbeat of massive mortgage write-downs, historic losses, and jettisoned CEOs”—all this showed the bust had arrived, just as it had so many times before in financial history, and it kept getting worse.

When Fannie and Freddie went down in September 2008, it provided an affirmative answer to the prescient question posed by Thomas Stanton way back in his 1991 book, A State of Risk: “Will government-sponsored enterprises be the next financial crisis?” That took the crash to the brink of its panic stage. As discussed above, the panic began when the funding market’s expectation that Lehman Brothers would be bailed out by the government was surprisingly disappointed. Peak fear with peak bailouts followed.

Sheets believes this no-bailout decision for Lehman was a colossal mistake, describing the date of Lehman’s bankruptcy as “a day that will forever live in financial infamy.” He provides a summary of internal government debates leading up to the failure, considers the argument that the Treasury and the Fed had no authority to provide a bailout, and finds it unconvincing: “I believe that they could have chosen to bail out Lehman if given sufficient political backing, and that such a step would have averted the Panic stage of the crisis.”

Wallison relates that the decision seems to have originated as a negotiating position of Treasury Secretary Henry Paulsen, who explained that he thought “we should emphasize publicly that there could be no government money … this was the only way to get the best price.” Paulsen also “declared that he didn’t want to be known as ‘Mr. Bailout.’” Wallison is a former general counsel of the Treasury Department and thinks, like Sheets, that authority to rescue Lehman was available: “Paulsen and [Fed chairman] Bernanke … telling the media and Congress that the government didn’t have the legal authority to rescue Lehman … was false.”

What would have followed if there had been a bailout of Lehman, since the deflation of the housing bubble would still have continued? That is a great counterfactual issue for speculation.

2008: What Really Happened ends a good read with two radical thoughts about politically privileged institutions:

Given the understanding of the bubble set forth here, the keys to preventing a similar crisis in the future are relatively straightforward: Eliminate the role of the GSEs in the national housing markets. Eliminate or dramatically curtail the ability of the Federal Reserve to inflate asset bubbles.

Great proposals, with which I fully agree. But Sheets, like the rest of us, does not expect them ever to happen, so he does expect, and so do I, that we will get more bubbles and busts.