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 Market2. Stock Market3. Foreign Exchange Market4. 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).http://yadayadayadaecon.com/clip/23/

Function of Financial Markets1. Allows transfers of funds from person or business without investment opportunities to one who has them2. 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

• http://www.youtube.com/watch?v=r-S6rZ18KKk

Putting It All Together

Towers of Debt Were Established by Investment

BanksMortgagesCommercial loansCredit card debtCar loansStudent loansAnd 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 2000-2005, 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.

1979

1980

1981

1982

1984

1985

1986

1987

1989

1990

1991

1992

1994

1995

1996

1997

1999

2000

2001

2002

2004

2005

2006

2007

0%

1%

2%

3%

4%

5%

6%

Foreclosure Rates Increased

Source: www.mbaa.org, National Delinquency Survey.

1979

1980

1981

1982

1984

1985

1986

1987

1989

1990

1991

1992

1994

1995

1996

1997

1999

2000

2001

2002

2004

2005

2006

2007

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

Large U.S. Financial Institutions Were Shaken

• Activity in the market for credit defaults swaps had accelerated between 2003 and 2008.

• 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

Causes of the Financial Meltdown

• Erosion of conventional lending standards.

• Low interest rate policies of the Federal Reserve System during 2002-2006.

• 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 2004.

• Subprime loans totaled $330 billion in 2001.• 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 2001.

• Their share has fluctuated modestly around 45 percent since 2001.

Freddie Mac/Fannie Mae Share of Outstanding Mortgages

Source: Office of Federal Housing Enterprise Oversight, www.ofheo.gov.

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

20%

25%

30%

35%

40%

45%

50%

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 2004-2006.

Source: Data from 1994-2003 is from the Federal Reserve Board while 2001-2007 is from the Joint Center for Housing Studies at Harvard University

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 20070.0%

5.0%

10.0%

15.0%

20.0%

25.0%

Subprime (FRB) Subprime (JCHS)

What Caused the Financial Meltdown?

FACTOR 2: The Fed under Greenspan’s chairmanship followed a low interest rate policy during 2002-2006.

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 2003.

• 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: www.federalreserve.gov and www.economagic.com

1995

1995

1996

1996

1997

1997

1998

1999

1999

2000

2000

2001

2002

2002

2003

2003

2004

2004

2005

2006

2006

2007

2007

2008

0%

1%

2%

3%

4%

5%

6%

7%

8%

Federal Funds 1 year T-bill

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 2006.

• The demand for houses and other durable goods decreased and prices declined 33% from a peak in July 2006.

Subprime, Alt-A, and Home EquityLoans

Subprime, Alt-A, and Home Equity as a Share of Total

Source: Data from 1994-2003 is from the Federal Reserve Board while 2001-2007 is from the Joint Center for Housing Studies at Harvard University

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 20070%

10%

20%

30%

40%

50%

Subprime (FRB) Subprime (JCHS) Subprime + Alt-A Subprime + Alt-A + Home Equity

ARM Loans Outstanding

Source: Office of Federal Housing Enterprise Oversight, www.ofheo.gov.

ARM Loans Outstanding

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

0%

5%

10%

15%

20%

25%

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 2002-2004 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: www.economagic.com

1953

1955

1958

1960

1963

1965

1968

1970

1973

1975

1978

1980

1983

1985

1988

1990

1993

1995

1998

2000

2003

2005

2008

20%

40%

60%

80%

100%

120%

140%

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?