The Current Economic and Financial Crises

How did we get here? Background Housing Market Mortgage Market Main Street Wall Street

Background World money markets awash with savings ($72 trillion) Rates on T bills too low, looked to mortgage loans Lenders loaned NINJA loans, et. al. Lenders “bundled” these loans and sold them as MBSs Sub Prime loans – interest only, low interest and balloon payment

Housing Market Easy credit increased demand for homes. Housing prices increased Supply increases overtake demand increases. Prices fell Speculators demand decreased Prices fell further

Housing Market (2) Easy payments ended, interest rates rose, many found themselves “upside down.” Excess capacity caused housing prices to decline further. Upside down homeowners walk away from their homes, housing prices decline further.

Mortgage Market “Creative” mortgages worked well as long as housing prices rose. Borrowers expected increases to continue; many did well buying low and selling high. Sales of MBSs takes risk away from bundlers. Incentives to sellers Some buy MBSs and bundle them into Collateralized Debt Obligations (CDOs). Thought to be as good as cash. As long as housing prices continued to rise, all was well.

Mortgage Market (2) As upside down borrowers walked away from their loans, the value of bundled packages fell. The value of highly leveraged bank’s assets dropped dramatically, causing failures and inability and unwillingness to make new loans. Credit freeze

Main Street C + I + G + (X-M) Fall in home equity reduces borrowing, C falls. Slow housing demand reduces construction, and durable goods production and sales – C and I fall Construction and other businesses lay off workers, employment falls, income falls –C falls. Wealth effect

Main Street (2) Credit freeze decreased demand for automobiles. Workers in autos and related industries laid off. Businesses, large and small, unable to borrow to finance inventories, workers laid off. Decreased employment causes decreased income, causes decreased spending, causes decreased employment.

Main Street (3) Consumer confidence falls further. State and local governments have less revenue, G falls. The multiplier worsens the situation. Loss of jobs, loss of income – induced consumption falls. Low consumer confidence, lack of credit, high debt – autonomous consumption falls.

Wall Street Largely dependent on expectations No reason to be confident Temptation to dump stocks and move into other assets (bonds, commodities) Fear of the President’s bill

Is this another depression? What caused the depression? –Perverse monetary policy –Perverse fiscal policy –Smoot Hawley Tariff 25% unemployment, 50% of industrial capacity stood idle.

MB/MOC Analysis Upside Down Mortgage You owe more than the value of the home. If you sell the home, you won’t have enough to pay off the mortgage. Three alternatives –Sell the home for less than you owe –Keep making payments that you may not be able to afford. Maybe no food or shoes for the kids. –Walk away; default on the loan. You end up with no home and bad credit.

Housing Market Test (S or D, I or D) Easy credit Government policies to encourage lenders to lend to low income borrowers. Inability of construction to keep up with demand. Speculation that housing prices would continue to increase

Housing Market Test (2) Builders overbuild Credit tightens Borrowers default Speculators and others lose confidence

C, I, G, X, or M? 1.Lower housing values, negative wealth effect. 2.Purchase of durable goods fell. 3.Expenditure multiplier as a result of (1) and (2) 4.Construction declines. 5.Consumer confidence falls.

C, I, G, X, or M 6.Credit crunch 7.Increased federal spending 8.Decreased federal taxes 9.Decreased state and local spending 10.Increased state and local taxes