1. The Financial Crisis of 2008, Simplified (a lot)

2. Hollywood: Bank Run Scene From It’s A Wonderful Life (1946) http://www.youtube.com/watch?v=lbwjS9iJ2Sw http://www.youtube.com/watch?v=lbwjS9iJ2Sw

3. Real Life: Bank Run on IndyMac Bank July 2008 http://www.youtube.com/watch?v=IVRgZ9LizZQ http://www.youtube.com/watch?v=IVRgZ9LizZQ

4. The Financial Crisis as Dominoes 1.Housing Bubble 2.Housing Crisis 3.Credit Crisis 4.Stock Market Declines 5.Reduced Consumer Spending 6.Reduced Business Profits 7.Layoffs and Rising Unemployment

5. Housing Prices Rise

6. What is a house price index? In 1989 buy a house for $100,000 Index = 100 In 2005 the same house sells for $170,000 Index = 170

7. How to pay for the house? Traditional 30 year fixed rate mortgage with 20% down payment. For a $200,000 house, $40,000 down payment, $160,000 mortgage: If interest rates are 8% (2001), monthly payment is $1,174 If interest rates are 6% (2005), monthly payment is $960 If interest rates are a teaser 4%, monthly payment is $764 If interest only loan and 4% rate, $533 monthly

8. Borrower shows she is responsible by first saving $40,000 for a 20% downpayment on a $200,000 house. With a set monthly fee, borrower always knows how much she will pay each month for 30 years. -Banks also verified the income of borrowers to make sure they could handle the monthly payments. -Bank holds the mortgage so has an incentive to loan to credit worthy customers If the borrower can’t pay her mortgage the bank gets the house (foreclosure) to pay off the remaining mortgage (from the $160,000) -The borrower’s down payment ($40,000) protects the bank in case the house’s value goes down. -Foreclosure example: The house declines in value to $180,000 and the borrower owes $160,000 ---The bank sells the house, gets its $160,000, and the borrower gets back $20,000 (losing $20,000). Value of a traditional mortgage

9. In 2000, the housing bubble begins. Everyone knows housing prices only go up. The bubble is fed by:

10. 1. Fed Lowers Interest Rates

11. 2. Lenders provide easier terms “No money down” –Borrow 100% of the purchase price –(No protection for the bank if prices drop and buyer is foreclosed) No Income Verification Loans –To qualify for loans buyers need a certain income. –Now, banks don’t check if buyers really have that income. –NINJA loans (no income, no job, no assets) Interest Only loans –Low payments for the first few years of the mortgage –Then, monthly payments jump Generically called “subprime mortgages”

12. 3. Home Ownership as a Goal: Federal policies for HUD, Freddie Mac, Fannie Mae, bank regulations

13. 4. Regulatory policies Low capital requirements for certain bank products (MBS vs mortgages) Financial institutions choose their regulators Financial institutions get around regulations Sole source rating agencies (S&P, Moody’s)

14. Result: Increase in Housing Demand, Easier to Get Mortgages, Homeowners Feel Richer The house I bought for $200,000 is now worth $300,000. I am $100,000 wealthier! Maybe I should borrow more and buy an even bigger house (or two) before prices go up even further? Borrow against house equity to finance consumption Banks encourage this with easier access to home equity Leverage is great!

15. Leverage and a Homeowner House Price = $200,000 Paid with 20% down payment = $40,000 Leverage ratio of 200,000/40,000 = 5 Leverage: Value of Asset/Equity investment Mortgage amount = $160,000 What happens if price rises by 15% per year? YearHouse Value 1$200,000 2$230,000 3$264,500 4$304,175 5$349,801 6$402,271 7$462,612 8$532,004

16. How Fast Did Houses Appreciate?

17. What is your return on investment in one year if house price rises from $200,000 to $230,000 (15%) in one year? If you put a $40,000 (20%) down payment on the house? $30/$40 = 75% If you put a $20,000 (10%) down payment? $30/$20 = 150% If you put a $10,000 (5%) down payment? $30/$10 = 200% If you put a $0 down payment? $30/$0 = ∞ Impact of leverage is huge

18. Meanwhile, back on Wall Street…

19. Wall Street Bundles Subprime Mortgages into Bonds: Mortgage Backed Securities (MBS)

20. Mortgage Backed Securities Market MBS seen as low risk— many borrowers will surely not default at same time Sold to investors such as pension funds and Wall Street firms MBS’s are broken apart and repackaged to increase returns and reduce risk (!) Profitable business for investment banks Then housing prices stop rising and start falling The process works in reverse

21. Housing Bubble Turns into Housing Crash

23. Home Ownership Falls

24. What happens when prices fall? Homeowners are affected A family borrows $200,000 to buy a home with a no down payment mortgage (are they really a homeowner?). Now, the home is only worth $140,000. If the family defaults, the bank loses $60,000 If the family keeps paying the mortgage the decline in the value of the home has no effect on the bank, but the family feels poorer, and probably cuts their spending Spillover effects to other homeowners in the neighborhood

25. 40% Increase in Home Sales 2001 to 2005 (5m to 7m); then 40% decrease 2005 to 2009 (7m to 4m)

26. Defaults also cause problems for owners of debt (financial institutions): Credit markets impacted NYT Dec 5 2007

27. People Can’t Pay Their Monthly Mortgages and Credit Crisis Begins Since borrowers are defaulting the monthly payments to banks disappear- banks are now losing money! With default and foreclosure, the bond owners who are holding these toxic mortgages get paid the value of the homes with the defaulted mortgages But, the homes have declined in value and are worth much less than the amount borrowed. – What will they do with all those empty houses?

28. Good loans go bad

29. And subprime mortgages( the ones given to high risk buyers) even worse

30. Early Fall 2008: Credit Crisis and Trust Every day companies borrow money for short-term needs (such as payroll) Credit is the life blood of the financial system. But no one knows which financial firms are effectively bankrupt because they have invested in toxic mortgage bonds. So no one trusts anyone else Lending slows. The financial system is in danger of grinding to a halt

31. The financial crisis turns into an economic crisis in fall 2008:

32. Firms Shed Employees

33. Unemployment Rises

34. The stock market loses 50% of its value

35. Households lost $15 trillion in wealth

36. The Result: Bank Failures 2008-2011 (417 banks, $677b in assets) Note: in 1930s 9,000 banks failed

37. The Response

38. Fed lowers interest rates

39. The Fed’s Balance SheetThe Fed’s Balance Sheet: Quantitative Easing

40. Fiscal and other actions Bush stimulus plan spring 2008: $150 b Obama stimulus winter 2009 $830 b Bailout of financial institutions (really their creditors are bailed out) Bankruptcy and bailout of GM and Chrysler

41. Recent Federal Budget Balances ($ million) 2008$ -458,553 2009 $ -1,412,688 2010$ -1,294,373 2011$ -1,299,593 2012 $ -1,086,963 2013 $ -680,000

42. What went wrong? Federal policy to increase home ownership Low interest rates Poor regulatory policy Debt finance and excessive leverage Perverse incentives (too big to fail) A 21 st century bank run

43. Resources on the Crisis http://sffed-education.org/econanswers/portal.htm SF Fed http://sffed-education.org/econanswers/portal.htm http://timeline.stlouisfed.org/ St. Louis Fed timeline http://timeline.stlouisfed.org/ http://baselinescenario.com/financial-crisis-for-beginners/ A good list of resources around the web put together by Simon Johnson http://baselinescenario.com/financial-crisis-for-beginners/ Teaching Financial Crises, a book of lesson plans from The Council for Economic Education Teaching Financial Crises Federal Reserve Chairman Ben Bernanke’s 4-part lecture to an economics class at George Washington University on the Financial Crisis and the Fed’s reaction4-part lecture Giant Pool of Money and Bad Bank on This American Life (WBEZ Chicago) Giant Pool of Money Bad Bank Gambling With Other People’s Money by Russell Roberts Gambling With Other People’s Money