The Financial Crisis: Why Did the U.S. Economy Meltdown?

Overview A Refresher on Financial Markets The crisis step-by-step Four major factors contributing to the crisis Was this a crisis of capitalism or a case of primary and secondary effects?

Types of Financial Markets Financial Markets– markets in which funds are transferred from people who have excess funds to those that have a shortage. 1.Bond Market 2.Stock Market 3.Foreign Exchange Market 4.And some new ones?

Financial Markets Overcome Problems 1.Asymmetric Information—one party in a transaction knows more than another. 2.Adverse Selection—potential borrowers most likely to cause an adverse outcome seek loans (before the transaction). 3.Moral Hazard—borrower might engage in undesirable (immoral) activities after getting the loan (after the transaction).

Function of Financial Markets 1. Allows transfers of funds from person or business without investment opportunities to one who has them 2. Improves economic efficiency

Securitization Securitization: The process through which an issuer creates a financial instrument by combining other financial assets and then selling the repackaged instruments to investors. The process can encompass any type of financial asset and promotes liquidity in the marketplace.

Mortgage Backed Securities Mortgage Backed Securities (MBS): Debt obligations that represent claims to the income from pools of mortgage loans, most commonly home loans. – Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or a private entity. – The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization.

Government Sponsored Enterprises Government Sponsored Enterprises (GSE): A group of financial services corporations created by the U.S. Congress. Fannie Mae (Federal National Mortgage Association) was established in 1938 to provide banks with federal money to finance home mortgages to make homes more affordable. – It created a secondary market for home loans by allowing the issuing of MBS. – The federal government later authorized Fannie Mae to purchase private mortgages. Freddie Mac was created in 1970 to compete with Fannie Mae.

Credit Default Swaps Credit Default Swap(CDS): A credit default swap (CDS) can be thought of as a form of insurance. – If a borrower of money does not repay her loan, she "defaults." – If a lender has purchased a CDS on that loan from an insurance company, the lender can then use the default as a credit to swap it in exchange for a repayment from an insurance company. – Also used as a way to “short” or bet against subprime loans – Buyer is purchasing insurance in case the loans he made defaults (think cheap insurance for a pension fund, etc.) – AIG was a major supplier – A different kind of insurance  No capital requirements  “Insurable interest” is not required

Putting It All Together Towers, Tranches, and Mezzanines of Debt No transparent market — Individual deals cut by investment banks The Role of the Rating Agencies atch?v=r-S6rZ18KKk atch?v=r-S6rZ18KKk

Putting It All Together Towers of Debt Were Established by Investment Banks Mortgages Commercial loans Credit card debt Car loans Student loans And so forth Rated AAA by rating agencies Loaned by investment banks like Goldman Sachs to investors. Investors managing pension funds wanted to get in on the action. They bought credit default swaps to insure their risk. Securities were sold to investors

The Financial Crisis: Step-by-Step

Economic Crisis: Housing Prices Fall Housing price increased during , followed by a levelling off and price decline.

DJIA, S&P and Nasdaq Trends: Stock Wealth Evaporates

Average Real Disposable Income Was Increasing

Personal Savings Rates Fell

Household Debt Service Payments as a Percentage of Personal Disposable Income Increased

This Context Made It Harder to Adjust to a Serious Recession

Consequently, Default Rates Rose Default Rate Source: mbaa.org, National Delinquency Survey.

Foreclosure Rates Increased Source: National Delinquency Survey.

Large U.S. Financial Institutions Were Shaken Activity in the market for credit defaults swaps had accelerated between 2003 and Firms like JPMorgan sold credit default swaps to allow pension companies to lend to corporations, governments, and businesses in emerging markets at reduced risk. Other firms like AIG emerge in the CDS market. These markets were shaken when housing prices collapsed.

Emergency Economic Stabilization Act of 2008 Emergency Economic Stabilization Act of 2008 was passed in reaction to: – Tightening of credit – Reduced home values – Severe uncertainty in the stock markets Initially it authorized the United States Secretary of the Treasury to – Spend up to $700 billion to purchase distressed assets, especially mortgage-backed securities – Make capital injections into banks

Causes of the Financial Meltdown

Erosion of conventional lending standards. Low interest rate policies of the Federal Reserve System during Increased leverage lending of Government Sponsored Enterprises (GSE’s) and investment banks. Increased household debt to income ratio.

What Caused the Financial Meltdown? FACTOR 1: Beginning in the mid-1990s, government regulations change the conventional lending standards.

The Federal Government Pushed Aggressively for Homeownership Homeownership rate increased from normal 64 percent (which was the rate for 35 years) to 69 percent in Subprime loans totaled $330 billion in By 2004 they reached $1.1 trillion (37% of residential mortgages). By 2006 they were 48% of all mortgages.

Fannie and Freddie Fannie Mae and Freddie Mac held a huge share of American mortgages. – Beginning in 1995, HUD regulations required Fannie Mae and Freddie Mac to increase their holdings of loans to low and moderate income borrowers. – HUD regulations imposed in 1999 required Fannie and Freddie to accept more loans with little or no down payment. – 1995 regulations stemming from an extension of the Community Reinvestment Act required banks to extend loans in proportion to the share of minority population in their market area. – Conventional lending standards were reduced to meet these goals.

The share of all mortgages held by Fannie Mae and Freddie Mac rose from 25 percent in 1990 to 45 percent in Their share has fluctuated modestly around 45 percent since Freddie Mac/Fannie Mae Share of Outstanding Mortgages Source: Office of Federal Housing Enterprise Oversight, Fannie and Freddie

Subprime Mortgages Subprime mortgages as a share of total mortgages originated during the year, increased from 5% in 1994 to 13% in 2000 and on to 20% in Source: Data from is from the Federal Reserve Board while is from the Joint Center for Housing Studies at Harvard University

What Caused the Financial Meltdown? FACTOR 2: The Fed under Greenspan’s chairmanship followed a low interest rate policy during

A New World Scene In1989 Berlin wall falls. China and India deregulate. Expanded productive capacity puts a damper on inflation. Central banks increase money supply without much concern about inflation.

Reduced Interest Rates? In 2001, the Fed consistently lowered interest rate from 6.5% to 1.75 % and to 1.0 % by June Central banks around the world followed suit creating an unprecedented increase in the supply of credit.

Short-Term Interest Rates Federal Funds Rate and 1-Year T-Bill Rate Source: and

An Incentive to Borrow The low rates made borrowed money cheap and households and businesses responded as expected: they bought and bought. In the housing market, the Case-Shiller home price index increased 80% from January 2001 to December 2005.

What Happened? In mid-2004, the Fed reversed its interest policy -- the rate climbed to 2.25 % by December 2004 and reached 5.25% in The demand for houses and other durable goods decreased and prices declined 33% from a peak in July 2006.

Subprime, Alt-A, and Home Equity Loans Subprime, Alt-A, and Home Equity as a Share of Total Source: Data from is from the Federal Reserve Board while is from the Joint Center for Housing Studies at Harvard University

ARM Loans Outstanding Source: Office of Federal Housing Enterprise Oversight, ARM Loans Outstanding

What Caused the Financial Meltdown? FACTOR 3: A Securities and Exchange Commission (SEC) Rule change adopted in April 2004 led to highly leverage lending practices by investment banks and their quick demise when default rates increased as housing prices fell.

Where Were the Regulators? The rule favored lending for residential housing. Loans for residential housing could be leveraged by as much as 25 to 1, and as much as 60 to 1, when bundled together and financed with securities.

Where Were the Regulators? Based on historical default rates, mortgage loans for residential housing were thought to be safe. But this was no longer true.

Where Were the Regulators? Regulations had seriously eroded the lending standards and the low interest rates of had increased the share of ARM loans with little or no down payment. When default rates increased in 2006 and 2007, the highly leveraged investment banks soon collapsed.

What Caused the Financial Meltdown? FACTOR 4: The Debt/Income Ratio of Households since the mid-1980s doubles. Americas respond to the incentives before them.

Debt/Income Ratio of Households The debt-to-income ratio of households was generally between 45 and 60 percent for several decades prior to the mid 1980s. By 2007, the debt-to-income ratio of households had increased to 135 percent. Interest on household debt also increased substantially.

Debt/Income Ratio of Households Household Debt to Disposable Personal Income Ratio Source:

Responding to Incentives in Housing Because interest on housing loans was tax deductible, households had an incentive to wrap more of their debt into housing loans. The heavy indebtedness of households meant they had no leeway to deal with unexpected expenses or rising mortgage payments.

Conclusions Could the crisis have been avoided if regulators had done more? Less? Was this a crisis of capitalism? Was this a crisis of primary and secondary effects? – Businesses and households responding to distorted incentives created by government? – A result of the unintended consequences of well- intended monetary and fiscal officials?

Questions?