The Modern Recession September/October 2008

Good Times Housing market was strong for years Lenders offered loans to almost anyone People took on a lot of debt Housing Market was strong for years prior to the collapse. People would take on a lot of debt to buy a house since the market had been stable for so long. Banks would lend to people beyond their means. Why? They had to. Banks need to acquire assets (loans) because the more assets they have the more appealing their stock was. Thus people would buy their stock forcing the stock price up. Maintaining a higher stock price made it more difficult for that bank to be acquired by another bank. So all the banks were doing this and if your bank didn’t then you were at risk. Even though the loans were risky, the economy was good and the banks felt people would tighten their financial belts to make these higher payments because they were able to get their dream house. Also, if there was a default the bank at least had the house as an asset and housing had been holding its value for a long time. Not to mention, these banks did not plan to keep a high percentage of these loans – they would bundle and sell They didn’t see the crash coming

Mortgage Life Cycle Banks (like Amtrust) lend money for mortgages They sell most mortgages to investment banks (Bear Stearns – Goldmann Sachs) These banks would then bundle mortgages from several of their customers and sell them off to other financial institution. Each bundle would contain mortgages of similar ratings (AAA being the best, B being high risk) Investment banks sell them to investors like … Northwestern Mutual or US Government Pension Fund or China

Debt Insurance AIG – was a Top 5 insurance company in the world Some Insurance companies got in this game Times were good, so risk seemed low AIG – was a Top 5 insurance company in the world Some companies began to offer debt insurance on mortgage loans that they would offer to the buyers of loans. Buyers of loans were now more apt to take on riskier loans. When the crash happened insurance companies couldn’t handle all of the claims. A.I.G. was one of these companies (they sold life, property/casualty, annuities, but they also offered debt insurance as a small part of the business) – global company Top 5 insurance company in the world Government deemed them too big to fail and took them over. AIG was eventually split up and sold off to various buyers after being crushed by this

The Collapse Collapse of housing market Credit market freeze Companies need loans to operate Collapse began with bad loans – too many people were unable to pay mortgage because they foolishly borrowed more than they could afford. They begin defaulting. Federal regulations require that banks have a certain amount of cash on hand or they could be seized, so when the market collapses all banks are holding some bad loans and it prevents them from lending much if at all since their cash position is weak. The credit market will come to a stand still Some companies need loans to operate. They will borrow money for everyday operations like raw materials or payrolls. When these companies could not get the money they needed it threatened them (GM laid off 100,000 and eventually was deemed “too big to fail”) Harley Davidson found themselves in this predicament

Issues with Companies Wall Street Journal Headline: “GM Collapses Into Government's Arms: Second-Largest Industrial Bankruptcy in History; Obama Defends Intervention” Most companies must tighten belts Layoffs Hiring freezes

Financial Collapse When the market tanks, they are left holding the bag with all sorts of bad loans Bear Stearns was a top 10 investment firm in the world Lehman Brothers may have been the 2nd biggest. Lehman Brothers was allowed to fail, but it will have a ripple effect throughout the economy since they were such a big financial player. Bear Stearns -- JP Morgan Chase Fannie mae/freddie Mac - Federal Government Merrill Lynch  Bank of America AIG  US Government Lehman Brothers  Split Divisions (Barclays from England, Nomura Holding from Japan) Wachovia  Wells Fargo National City - PNC

Real Risk Banks were collapsing No one wanted to lend With no credit Companies and banks would collapse Fear of FDIC collapsing People’s life savings would be wiped out Could have led to a depression of 1929 magnitude

Immediate Fixes TARP Loans - Troubled Asset Relief Program October 2008 $800 million in federal loans To banks and businesses To allow banks to survive Fed Lowered Interest Rates Banks too will lower rates to spark borrowing Referred to as a bailout, but it was actually loans Initiative of the Bush administration Lent about $800 million Really bad banks didn’t get TARP loans – they were bought by stronger banks This stuff helped to save companies from failing, but now they live with the realities of staying afloat in a sever recession. Meaning they had fewer buyers for products/services and must lay off. Companies will be slow to trust again. Hiring employees will be the last indicator of an improved economy.

American Recovery & Reinvestment Act Obama Stimulus Package (2009) Keynesian in nature approximate cost estimated to be $787 billion Primary objective: save and create jobs Secondary objective: investment in federal programs Primary objective for ARRA was to save and create jobs almost immediately. Secondary objectives were to provide temporary relief programs for those most impacted by the recession and invest in infrastructure, education, health, and ‘green’ energy. Including unemployment benefits and social welfare programs The approximate cost of the economic stimulus package was estimated to be $787 billion at the time of passage. The Act also included many items not directly related to economic recovery such as long-term spending projects (e.g., a study of the effectiveness of medical treatments) and other items specifically included by Congress (e.g., a limitation on executive compensation in federally aided banks The rationale for ARRA was from Keynesian macroeconomic theory which argues that, during recessions, the government should offset the decrease in private spending with an increase in public spending in order to save jobs and stop further economic deterioration.