Principles of Macroeconomics

Macroeconomics, March 30, 2009, Martha Stuffler

Principles of Macroeconomics

Economic Crisis


HOW DID WE GET HERE

CHANGES

HAZARD

ACCOUNTABILITY

OVERSIGHT

SPECULATION


HOW DID WE GET HERE

Chaos Theory

Study of nonlinear dynamics, where seemingly random

events are actually predictable

ASK YOURSELF: Could this have been predicted?


HOW DID WE GET HERE

CHANGES IN BANKING LEGISLATION

Glass-Steagall Act (1932 & 1933)

Distinction between everyday banks and investment banks

Repealed in 1999


HOW DID WE GET HERE

Depository Institution Deregulation And Monetary Control Act 1980

Allowed banks to

both lend and invest


HOW DID WE GET HERE

1982 Garn St Germain & Alternative Mortgage

Transactions Parity Act

Allowed banks to offer: Adjustable Rate Loans

Interest Only Loans Balloon Payment Loans


HOW DID WE GET HERE

1982 Garn St Germain & Alternative Mortgage

Transactions Parity Act

Allowed banks to make: Adjustable Rate Loans

Interest Only Loans Balloon Payment Loans


HOW DID WE GET HERE

Gramm-Leach Bliley ACT (1999)

Banks, investments and insurance

under one umbrella


HOW DID WE GET HERE

EXAMPLES

JP Morgan buying Bear Stearns

Bank of America buying Merrill Lynch


HOW DID WE GET HERE

MORAL HAZARD

Behavioral change because something

is reducing our risk

We do not bear 100% of the risk


HOW DID WE GET HERE

MORAL HAZARD

Individuals who are

risk adverse

become more

tolerant or accepting of risk


HOW DID WE GET HERE

MORAL HAZARD

Seat Belts

FDIC Federal Deposit Insurance Corp. $250,000 per account


HOW DID WE GET HERE

MORAL HAZARD

Consumers and lenders

took on excessively

high levels of risk


HOW DID WE GET HERE

CONSUMERS

Sub Prime Mortgages

Low credit scores – high risk loans

Higher interest rates

Higher loan origination fees


HOW DID WE GET HERE

CONSUMERS

About 80% of the Sub-Prime loans

were Adjustable Rate or

Pick-A-Payment Loans


HOW DID WE GET HERE

CONSUMERS

Interest Only Loans

If unpaid, interest becomes part of the loan principal


HOW DID WE GET HERE

CONSUMERS

“Liar Loans” – lied about income

Fraud--False income claims

Worst Liar loans “NINJA LOANS”

No Income, No Job, No Assets


HOW DID WE GET HERE

CONSUMERS

Today, homeowners with “liar loans” are stuck -- no help

Did moral hazard only affect consumers?


HOW DID WE GET HERE

LENDERS

Encouraged people to take out loans they couldn’t afford

Believed housing P continue to rise, if default, pricey asset


HOW DID WE GET HERE

LENDERS

Moral Hazard

Government bailed out thrifts and loans and saving and loans in the 1980s

Government will do it again

Transferred risk from lenders to government


HOW DID WE GET HERE

LENDERS

Lenders didn’t have to keep the loans,

they could sell to investors

Sell to investors and get more

money to lend


HOW DID WE GET HERE

LENDERS

Risk is transferred from lenders

to investors

Not all lenders did this


HOW DID WE GET HERE

LENDERS

SECURITIZATION began 1970s: Banks pool mortgages into MBS (mortgage backed securities)

Sub-prime loans were securitized - packaged with high quality loans

Sold to investors as mortgage-backed securities


HOW DID WE GET HERE

LENDERS

Bad loans combined with good or high quality mortgage backed securities

Toxic Assets


HOW DID WE GET HERE

LENDERS

Faulty rating process that overrated sub prime loans for investment purposes

Ratings underestimated true risk of sub prime loans


HOW DID WE GET HERE

LENDERS

FANNIE MAE AND FREDDIE MAC

Government sponsored enterprises (GSEs) since 1968

Privately owned and operated


HOW DID WE GET HERE

LENDERS

Only lenders not required to report publicly their financial problems

Protected by US government


HOW DID WE GET HERE

LENDERS

Freddie Mac and Fannie Mae

Borrowed money at low interest rates

from foreign investors, if mortgage defaults,

US government would protect the investors


HOW DID WE GET HERE

LENDERS

FANNIE MAE AND FREDDIE MAC

Guaranteed “liar loans” from Countrywide and Indymac

Countrywide bought by BofA and Indymac taken over by FDIC


HOW DID WE GET HERE

LENDERS/INVESTORS

Carry trade, derivatives, hedge funds, credit

default swaps are not discussed here


HOW DID WE GET HERE

LENDERS

US top 5 banks control 96% of the derivatives

Assuming a great deal of risk if buyers stop buying real estate or interest rates rise

BofA, Citibank, JP Morgan chase, HSBC Bank USA, Goldman Sachs


HOW DID WE GET HERE

ACCOUNTABILITY

American Dream Homeownership

1970s political goal

Increase US homeownership rate


HOW DID WE GET HERE

ACCOUNTABILITY

Target low income groups

US homeownership rate increased from 64% in 1980 to 69.1% in 2005

Census Bureau estimate 4Q2008 is 67.5%


HOW DID WE GET HERE

ACCOUNTABILITY

1996 US Department of Housing and Urban Development (HUD) set a goal

for the US Treasury’s Financial Management Service (FMS)

At least 42% of the mortgages purchased must be for borrowers whose

household income was below the median income in their area


HOW DID WE GET HERE

ACCOUNTABILITY

2005: Target increased to 52%

At least 52% of the mortgages purchased must be for borrowers whose household income was below the median income in their area

By 2008 US Treasury FMS owned or through mortgage pools sponsored about 50% of all US mortgages


HOW DID WE GET HERE

ACCOUNTABILITY

Banks could be fined—not lending to “nontraditional customers” like those with no credit history

Down payment requirements became 2nd mortgages


HOW DID WE GET HERE

ACCOUNTABILITY

2003 White House and Alan Greenspan called for stricter controls on GSEs (government sponsored enterprises) and wanted limitations on the amount of their high risk investments


HOW DID WE GET HERE

ACCOUNTABILITY

From Terry Frieden: CNN Washington BureauFriday, September 17, 2004 Posted: 5:44 PM EDT (2144 GMT)

WASHINGTON (CNN) -- Rampant fraud in the mortgage industry has increased so sharply that the FBI warned Friday of an "epidemic" of financial crimes which, if not curtailed, could become "the next S&L crisis."


HOW DID WE GET HERE

ACCOUNTABILITY2004 US Congressional Hearings examined

fraudulent accounting practices within Fannie Mae and Freddie Mac

Highly publicized

Everyone should view the YouTube video or read the transcript of this hearing


HOW DID WE GET HERE

ACCOUNTABILITY2005 US Senate Banking Committee proposed a bill

for a new regulator who would be able to adjust the size of the GSEs' (government sponsored enterprises) portfolios.

Regulator would oversee GSEs to keep them from running into financial trouble and limit their risk.

Regulator would have increased power comparable to that of a bank regulator.


HOW DID WE GET HERE

ACCOUNTABILITY

2005 US Senate Banking Committee proposed bill was endorsed by Alan

Greenspan and the White House

BUT the proposed bill did not come to a vote


HOW DID WE GET HERE

ACCOUNTABILITY

Fed

Moral Suasion to ease lending

What Does Moral Suasion Mean?


HOW DID WE GET HERE

ACCOUNTABILITYPersuasion method when the Fed influences

or exerts pressure, but not force, banks into follow a policy

‘Moral’ is the idea of moral responsibility to operate in a way consistent with furthering the good of the economy

When Bernanke appears before Congress and discusses economic activity he can influence financial markets


HOW DID WE GET HERE

ACCOUNTABILITY

FedLow interest rates 2001-2004

Easy money-encourages risk taking

Raised interest rates during 2005-2006

Adjustable rate mortgage holders began to see rising monthly payments


HOW DID WE GET HERE

ACCOUNTABILITY

Securities Exchange Commission SEC did not regulate Wall Street securities rating industries

Securitized mortgages were overrated, not reflective of the true investment risk


HOW DID WE GET HERE

OVERSIGHT

Given the class discussions to date and what has occurred in the economy, what do you think about the issue of oversight?


HOW DID WE GET HERE

SPECULATION

“Irrational Exuberance”


HOW DID WE GET HERE

SPECULATION

People took out loans they could not afford

Why?

What went wrong?


HOW DID WE GET HERE

SPECULATION

Re-Fi mania took place

Why?

What went wrong?


HOW DID WE GET HERE

SPECULATION

Lenders made loans to everyone whether or not they were credit worthy

Why?

What went wrong?


HOW DID WE GET HERE

SPECULATION

Loans were securitized, packaged with high quality loans, sold to investors as mortgage-back securities

Why?

What went wrong?


HOW DID WE GET HERE

CHANGES

HAZARD

ACCOUNTABILITY

OVERSIGHT

SPECULATION


HOW DID WE GET HERE

WHAT IS GOING ON √

HOW DID WE GET HERE √

WHAT HAVE WE DONE

COST/BENEFIT ANALYSIS OF THE CHOICES BEING MADE

Documents

Principles of Macroeconomics