Download Chapter 13 The Federal Reserve System

Chapter 11 The Federal Reserve System and the Housing
Bubble and Subsequent Recession
The basic economic problem is scarcity. Human wants are unlimited. Resources are limited. The
basic goal in dealing with the problem of scarcity is to produce as much consumer satisfaction as
possible with the limited resources available. Achieving each of the three macroeconomic goals
(price level stability, full employment, and economic growth) will contribute toward reaching this
basic goal.
Proper control of a nation’s money supply is essential to achieving the macroeconomic goals. A
nation’s money supply is controlled by its central bank. Most nations have a central bank. Some
examples are; the Reserve Bank of Australia, the Bank of Canada, the Bank of England, the
Reserve Bank of India, the Bank of Japan, the Banco de Mexico and the Central Bank of the
Russian Federation. The central bank of the European Union is called the European Central
Bank.
The Federal Reserve System (commonly called the Fed) is the U.S. central bank. The Federal
Reserve System was created by the Federal Reserve Act in 1913. There are twelve Federal
Reserve District Banks in the Federal Reserve System.
The governing body of the Fed is the Federal Reserve Board of Governors. The seven members
of the Board are appointed by the President with the consent of the Senate. The Board is headed
by the Chairman of the Federal Reserve Board of Governors (Ben Bernanke, since February 1,
2006). The Chairman of the Federal Reserve Board is the key person in establishing monetary
policy in the U.S.
Functions of the Federal Reserve System
The Federal Reserve System performs a number of important functions in the U.S. economy.
Among the functions of the Fed are:
1. Control the money supply. This is the most important function of the Fed, and will be
discussed in more detail later in this chapter.
2. Supervise and regulate banking institutions. Regulations, such as the required-reserve
ratio, are established by the Board of Governors. Supervision, such as audits of bank lending
policies, is carried out by the Federal Reserve District Banks.
3. Serve as the lender of last resort. A bank in need of reserves can borrow reserves from
other banks or from the Fed. A bank in need of reserves will usually borrow reserves from
other banks through the federal funds market. But what if there is a shortage of reserves
throughout the financial system? In a fractional reserve banking system, it is possible for
widespread financial panic to occur. The creation of the Federal Reserve System was largely
motivated by the Panic of 1907. In a financial panic, many banks would need reserves, and
would be unable to borrow reserves from other banks. The Fed acts as the lender of last
resort.
4. Hold banks’ reserves. Banks are required to hold reserves (vault cash plus the bank’s
deposit with the Fed) to back up their checkable deposits. Most banks maintain a deposit with
the Fed as part of their reserves.
5. Supply the economy with currency. The Fed does not produce currency. Paper money
(Federal Reserve Notes) is printed by the Bureau of Engraving and Printing. Coins are
minted by the U.S. Mint. The currency is put into circulation through depository institutions by
the twelve Federal Reserve District Banks.
6. Provide check-clearing services. When Arlene writes a check on her account at Bank X to
pay her auto insurance, the money in her account has to move to the auto insurance
company’s account in Bank Y. The Fed is a large provider of check-clearing services in the
U.S. economy. The Fed handles about 18 billion checks per year.
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The Federal Reserve System
Monetary Base and the Money Supply
The primary function of the Fed is controlling the money supply. But the Fed does not directly
control the money supply. The Fed influences the money supply by changing the monetary base.
Monetary base – currency in circulation plus bank reserves (vault cash plus bank deposits with
the Fed).
When the Fed makes a purchase or a sale, the monetary base changes. (What the Fed primarily
buys and sells is U.S. government securities.) When the Fed makes a purchase, the monetary
base increases. When the Fed makes a sale, the monetary base decreases.
Example 1A: The Fed buys $250,000 of U.S. government securities in the open market. The
seller is Bank Y. The Fed pays Bank Y for the securities by increasing Bank Y’s deposit account
balance with the Fed by $250,000. Bank Y now has $250,000 in new reserves. Thus, there is a
$250,000 increase in monetary base.
Example 1B: The Fed sells $100,000 of its holdings in U.S. government securities. The buyer is
Bank Z. Bank Z pays for the securities by using some of its excess reserves. Bank Z now has
$100,000 less in reserves. Thus, there is a $100,000 decrease in monetary base.
The Actual Money Multiplier
When the monetary base changes, money creation or money destruction is triggered, and the
money supply changes by a multiplied amount. The actual money multiplier measures the change
in the money supply for a given dollar change in monetary base.
Actual money multiplier = Change in Money Supply ÷ Change in Monetary Base
Example 2: The Fed increases the monetary base by $150 million. The money supply increases
by $375 million. The actual money multiplier is 2.5 ($375 million ÷ $150 million = 2.5).
Tools for Controlling the Money Supply
The Fed has three major monetary policy tools available for controlling the money supply. The
most important monetary policy tool is open market operations. Open market operations refers to
the Fed buying and selling U.S. government securities in the open market.
The Federal Open Market Committee (FOMC) determines the policy for open market operations.
The voting members of the FOMC are the seven Federal Reserve Board Governors, the
president of the Federal Reserve Bank of New York, and four of the other eleven Federal
Reserve District Bank presidents, who serve on a rotating basis. The Chairman of the Board of
Governors also serves as the Chairman of the FOMC. Open market operations, along with the
other two monetary policy tools, are discussed below:
1. Open market operations. As discussed earlier in the chapter, when the Fed makes a
purchase or a sale, the monetary base changes. When the monetary base changes, the
money supply changes by a multiplied amount. What the Fed primarily buys and sells is U.S.
government securities. U.S. government securities are an attractive asset for the Fed to hold
for the same reasons (discussed in Chapter 10) that U.S. government securities are an
attractive asset for banks to hold.
If the Fed buys securities in the open market, bank reserves increase. When bank reserves
increase, banks have excess reserves, which they can loan out triggering the money creation
process. The money creation process leads to a multiplied expansion of the money supply.
The Federal Reserve System
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Example 3: The Fed buys $300,000 of U.S. government securities in the open market. The seller
is Bank X. The Fed pays Bank X for the securities by increasing Bank X’s deposit account
balance with the Fed by $300,000. Below is the updated balance sheet for Bank X from page 105. After Bank X sells the $300,000 of U.S. government securities to the Fed, Bank X’s holdings of
U.S. government securities decrease by $300,000 and its reserves increase by $300,000. Bank X
now has $300,000 in excess reserves, which it may loan out, triggering the money creation
process.
Bank X – Balance Sheet
Liabilities:
Checkable Deposits
$50,000,000
Assets:
Reserves;
Vault Cash
$500,000
Deposit with the Fed
$4,800,000 (+$300,000)
Loans Outstanding;
Mortgage Loans
$20,000,000
Business Loans
13,000,000
Personal Loans
11,000,000
U.S. Government Securities
700,000
(-$300,000)
Total Loans Outstanding
$44,700,000
Total Assets
$50,000,000
If the Fed wanted to reduce the money supply, it would sell U.S. government securities in the
open market. If the Fed sells securities in the open market, bank reserves decrease. When
bank reserves decrease, this leads to a multiplied contraction of the money supply. Open
market operations is the Fed’s most important tool for controlling the money supply.
2. Changing the reserve requirement. The Fed sets the required-reserve ratio. Lowering the
reserve ratio would give banks excess reserves. The excess reserves would allow the banks
to make new loans, which would trigger the money creation process. Thus, lowering the
reserve ratio will cause the money supply to increase. If the Fed raises the reserve ratio, the
money supply will decrease.
Example 4: Refer to Example 3. Initially the reserve ratio is 10%. Bank X has deposits of
$50,000,000, and is required to hold $5,000,000 in reserves. If the Fed lowers the reserve ratio to
9%, Bank X would be required to hold only $4,500,000 in reserves. Bank X would now have
$500,000 of new excess reserves, which it could loan out, triggering the money creation process.
3. Changing the discount rate. A bank in need of reserves can borrow reserves from other
banks or from the Fed. A bank can borrow reserves from other banks in the federal funds
market. The interest rate charged in the federal funds market is the federal funds rate.
Federal funds rate – the interest rate one bank charges another bank to borrow reserves.
A bank also can borrow reserves from their Federal Reserve District Bank. When a bank
borrows reserves from the Fed, the interest rate charged is the discount rate.
Discount rate – the interest rate the Fed charges banks that borrow reserves from it.
If a bank borrows reserves from other banks, the money supply is not changed. The
borrowing bank has more reserves, but the lending bank has fewer reserves. There is no
change in overall bank reserves. Thus, the money supply is not changed.
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The Federal Reserve System
If a bank borrows reserves from the Fed, the Fed is injecting new reserves into the financial
system and the money supply increases. To encourage borrowing from the Fed, the Fed
would lower the discount rate. Thus, lowering the discount rate will increase the money
supply. To discourage borrowing from the Fed, the Fed would raise the discount rate. Thus,
raising the discount rate will decrease the money supply.
The Housing Bubble and the Subsequent Recession
The economy entered into a recession in December of 2007. Real GDP was flat in 2008. Real
GDP decreased by 2.6% in 2009. Real GDP increased by 2.9% in 2010. The unemployment rate
increased from 4.7% in November of 2007 to 10.1% in October of 2009. Though the recession
officially ended in June of 2009, the unemployment rate was still at 9.0% in October of 2011. The
Dow Jones Industrial Average (DJIA) reached a peak of 14,279.96 on October 11, 2007, and
then fell to 6,440.08 on March 9, 2009, a drop of almost 55% from the peak. The federal budget
deficit increased from $161 billion in 2007 to $459 billion in 2008 and then to $1,413 billion in
2009. The deficit was $1,294 billion in 2010 and was $1,299 billion in 2011.
Most economists agree that the primary cause of the recession was the bursting of the housing
bubble and the subsequent credit crisis. Home prices nationwide were relatively flat throughout
most of the 1990s. According to the S&P/Case-Shiller Index, home prices increased by about
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8.3% from the 1 quarter of 1990 to the 1 quarter of 1997.
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Then home prices began a rapid increase, peaking in the 2 quarter of 2006, at over 132%
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higher than they had been in the 1 quarter of 1997. By the 1 quarter of 2009, home prices had
decreased by over 32% from their 2006 peak. However, home prices were still 57% higher than
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they had been in the 1 quarter of 1997. (See Example 5 below.) Why did the housing bubble
arise and why did its bursting cause a credit crisis leading to a severe recession? The four
primary causes of the housing bubble and the credit crisis arising from the bursting of the housing
bubble are discussed in this chapter.
Example 5: The graph below illustrates the Case-Shiller Index of home prices for the years from
1991 to 2009.
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170 150 CaseShiller 130 Index
110 90 70 z
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91
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Years (1st Quarter)
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Low Mortgage Interest Rates
Mortgage interest rates in the U.S. peaked at 18% in 1982, as the Federal Reserve drove interest
rates skyward in a successful attempt to squeeze inflation out of the economy. Mortgage interest
rates generally fell over the next twenty years, with the rate on a 30-year fixed mortgage falling
below 6% late in 2002. The rate stayed below 6% most of the time through 2005.
Example 6: Average 30-year fixed mortgage interest rates from 1982 to 2005
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14% 13% 12% -
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11% Mortgage
Rates
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6% 5% z
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82-84
85-87
88-90
91-93
94-96
97-99
00-02
03-05
Years
Mortgage interest rates were falling despite the low savings rate in the U.S. because of an influx
of savings entering the U.S. from other countries. Most of this savings came from countries with
high savings rates such as Japan and the United Kingdom and from countries with rapidly
growing economies such as China, Brazil, and the major oil-exporting countries. The net inflow of
foreign saving to the U.S. increased from about 1.5% of GDP in 1995 to about 6% in 2006.
Investors in these countries sought investments providing low risk and good returns. Initially, they
focused on U.S. government securities. Seeking better returns, they branched out into mortgagebacked securities issued by Fannie Mae and Freddie Mac, two enormous government-sponsored
enterprises (GSEs). Foreign investors assumed that these securities were low-risk because, if
trouble arose, the federal government would step in to bail out Fannie and Freddie. Eventually the
foreign investors grew bolder, investing in mortgage-backed securities issued by Wall Street
firms. These mortgage-backed securities appeared to be low-risk, since they had received
favorable ratings issued by highly respected credit rating agencies, such as Moody’s and
Standard & Poor’s. The low mortgage interest rates contributed to the housing bubble by keeping
monthly mortgage payments affordable for more buyers even as home prices rose.
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Low Short-term Interest Rates
The U.S. economy entered into a recession in March of 2001. Over the course of 2001, the
Federal Reserve lowered the federal funds rate eleven times, from 6.50% to 1.75%. When the
economic recovery proved sluggish and no sign of significant inflation appeared, the Fed
continued its low interest rate policy, lowering the federal funds rate to 1.25% in November of
2002 and to 1.00% in June of 2003. The Fed began gradually increasing the rate in June of 2004,
but the rate remained at 2.00% or lower for more than three years.
The low short-term interest rates contributed to the housing bubble in two primary ways. The low
short-term interest rates encouraged the use of adjustable rate mortgages (ARMs). As home
prices rose faster than household incomes, many prospective home buyers were unable to afford
house payments under fixed rate mortgages. But ARMs could provide the buyer with a lower
monthly payment initially, since short-term interest rates were lower than long-term interest rates.
Example 7: The monthly principal and interest payment on a $200,000 30-year fixed rate
mortgage with an interest rate of 6% would be about $1200. The monthly principal and interest
payment on a $200,000 30-year ARM with an initial interest rate of 4% would initially be only
about $950.
As the housing market heated up, mortgage lenders became more creative with ARMs,
developing “option” ARMs. With an “option” ARM, the borrower could choose to make standard
payments of both principal and interest (thus reducing the balance outstanding on the loan each
month), or could choose to make payments of interest only (thus not changing the balance
outstanding on the loan each month), or could choose to make payments of only a portion of the
interest due (thus increasing the balance outstanding on the loan each month).
ARMs made monthly mortgage payments temporarily affordable for more buyers and thus
contributed to rising home prices. When the interest rate on the mortgage adjusted upward
(typically after two years), the higher mortgage payments would prove unmanageable for many
home buyers.
The second way that low short-term interest rates contributed to the housing bubble was by
encouraging leveraging (investing with borrowed money). With short-term interest rates
extremely low, investors could increase their returns by borrowing at low short-term interest rates
and investing in higher yielding long-term investments, such as mortgage-backed securities.
Example 8A: XYZ Company invests $10 million in mortgage-backed securities paying 7%
interest. XYZ’s return on equity is 7%. If XYZ borrows $100 million on short-term loans at 4%
interest in order to invest an additional $100 million in mortgage-backed securities paying 7%
interest, XYZ is now leveraged at 10 to 1 ($10 in debt for every $1 in equity). XYZ’s return on
equity will now be 37% (profit of $3.7 million on equity of $10 million).
Leveraging increased the financing available for mortgage lending, thus contributing to rising
home prices. When the housing bubble eventually burst and home prices fell, the impact of the
bursting of the housing bubble was increased by the degree of leverage in the economy.
Example 8B: The bursting of the housing bubble led to increased mortgage foreclosures and
caused the value of mortgage-backed securities to fall. If the value of the mortgage-backed
securities held by XYZ Company from Example 8A falls by more than $10 million, XYZ Company
becomes insolvent and will be unable to obtain new short-term financing. XYZ is forced to
deleverage by selling some of its holdings of mortgage-backed securities. Many other highlyleveraged firms are going through the same deleveraging process, driving the price of mortgagebacked securities still lower.
The Federal Reserve System
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Relaxed Standards for Mortgage Loans
Standards for mortgage loans were fairly consistent in the decades prior to the housing bubble.
Most mortgages were 30-year fixed rate loans requiring a down payment of at least 20%, or
mortgage insurance if the 20% down payment requirement were not met. The borrower also had
to have sufficient income to ensure that the monthly mortgage payments would be manageable.
Governmental policies have long encouraged home ownership. The tax law has for decades
permitted the deduction of mortgage interest and real estate taxes. In 1997, the tax law was
changed to permit homeowners to exclude from taxation a gain of up to $500,000 from the sale of
a home.
In the mid 1990s, new governmental policies were enacted that contributed to a relaxing of
standards for mortgage loans. In 1995, the Community Reinvestment Act was modified to compel
banks to increase their mortgage lending to lower-income households. To meet the new
requirements of the Community Reinvestment Act, many banks relaxed their mortgage lending
standards. Beginning in 1996, the Department of Housing and Urban Development (HUD) began
to increase the percentage of mortgage loans to lower-income households that Fannie Mae and
Freddie Mac were required to hold in their portfolios. Fannie Mae and Freddie Mac are
government-sponsored enterprises that increase the funding available in the mortgage market by
purchasing mortgages from loan originators. Fannie and Freddie buy only mortgages that
conform to certain standards for down payment requirements and income requirements.
Historically, mortgages taken out by lower-income households often did not conform to these
strict standards. After HUD increased the percentage of mortgage loans to lower-income
households that Fannie and Freddie were required to hold in their portfolios, Fannie and Freddie
relaxed the standards that mortgages had to meet to be classified as “conforming” and thus
eligible for purchase by Fannie and Freddie. Down payment requirements and income
requirements were reduced.
With the internet came greater competition in the mortgage loan market. Home buyers were no
longer limited to borrowing locally, but could search nationally for the mortgage provider who
would offer the most favorable terms. This is exemplified by the reduction in the average fee paid
on a mortgage.
Example 9: According to the Federal Housing Finance Board, the average fee on a mortgage
loan fell from around 1% of the amount of the loan in 1998 to less than .5% from 2002 to 2007.
The greater competition in the mortgage industry contributed to relaxed mortgage standards.
Mortgage lenders who were willing to lower their standards gained market share. More
conservative mortgage lenders either had to lower their standards or lose market share.
As irrational exuberance caused the housing market to overheat, lenders relaxed their mortgage
standards even further. This was particularly true for loan originators who planned to quickly sell
their mortgages and thus felt little concern for the long-term credit-worthiness of the borrowers.
This practice (called “originate to sell” as opposed to the traditional practice of “originate to hold”)
became more common with the increasing purchases of mortgages by investment banks. The
investment banks were increasing their purchases of mortgages to enable them to issue more
and more of the highly profitable mortgage-backed securities.
The relaxing of mortgage standards is exemplified by the increase in subprime mortgages.
Subprime mortgages are home loans given to persons who are considered a poor credit risk.
Historically, subprime mortgages have had a foreclosure rate about ten times higher than prime
mortgages. Subprime mortgages charge a higher interest rate than conventional mortgages to
offset the greater risk of default. Subprime mortgages increased from 5% of new home loans in
1994 to 20% in 2006.
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Irrational Exuberance
As with all bubbles, irrational exuberance played a key role in the housing bubble. Robert
Shiller, who wrote a book titled “Irrational Exuberance”, defines the term as; “a heightened state
of speculative fervor”. The term became famous when, in a speech given on December 5, 1996,
Alan Greenspan hinted that stock prices might be unduly escalated due to irrational exuberance.
The Dow Jones Industrial Average fell 2% at the opening of trading the next day.
All the participants who contributed to the housing bubble (government regulators, mortgage
lenders, investment bankers, credit rating agencies, foreign investors, insurance companies, and
home buyers) acted on the assumption that home prices would continue to rise.
Example 10: Frank Nothaft, chief economist of Freddie Mac, was quoted in the June 22, 2005
issue of BusinessWeek magazine as saying, “I don’t foresee any national decline in home price
values. Freddie Mac’s analysis of single-family houses over the last half century hasn’t shown a
single year when the national average housing price has gone down.”
Since home prices had not fallen nationwide in any single year since the Great Depression, it
seemed reasonable to most people to assume that they would not fall.
Example 11: Government regulators did not try to slow rising home prices, which they did not
see as a bubble. Mortgage lenders continued to make more and more subprime and adjustable
rate mortgages. These mortgages would continue to have low default rates, if home prices kept
rising. Investment bankers continued to issue highly leveraged mortgage-backed securities.
These securities would perform well, if home prices kept rising. Credit rating agencies continued
to give AAA ratings to securities backed by subprime, adjustable rate mortgages. These ratings
would prove to be accurate, if home prices kept rising. Foreign investors continued to invest
heavily in highly-rated mortgage-backed securities. These securities would prove to deserve their
high ratings, if home prices kept rising. Insurance companies continued to sell credit default
swaps (a type of insurance contract) to investors in mortgage-backed securities. The insurance
companies would face little liability on these contracts, if home prices kept rising. And home
buyers continued to purchase homes even though the monthly payments would eventually prove
unmanageable. They expected to be able to “flip” the home for a profit or refinance the loan when
the adjustable rate increased. And this would work, if home prices kept rising.
And home prices kept rising for a long time. Warnings of a housing bubble were issued as early
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as 2002. By the 1 quarter of 2003, home prices had risen by about 59% from the 1 quarter of
1997. Should a wise homeowner have bailed out of the housing market at this point to avoid
being caught up in the housing bubble?
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Example 12: If the average homeowner had sold their home in the 1 quarter of 2003, for fear of
the housing bubble bursting, they would have sold it for 28% less than they could have received
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in the 2 quarter of 2007, one year after home prices peaked. The S&P/Case-Shiller Index was
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at 130.48 in the 1 quarter of 2003 and was at 183.16 in the 2 quarter of 2007.
The irrational exuberance that occurs during price bubbles is hard to recognize, hard to avoid,
and not necessarily good for an individual to avoid. Housing was a good investment up until just
before the peak of the housing bubble, the same way that stocks were a good investment up until
just before the dot-com bubble burst in 2000.
Example 13: At the time Alan Greenspan made his “irrational exuberance” comment, the Dow
Jones Industrial Average had risen by an incredible 364% over the previous nine years, and
stood at 6437.10. However, this would not have been a good time for an investor to bail out of the
stock market. The DJIA would increase by another 75% over the next three years.
The Federal Reserve System
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The Bursting of the Housing Bubble and the Credit Crisis
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Home prices reached their peak in the 2 quarter of 2006. They did not fall drastically at first.
Nonetheless, mortgage default rates began to rise as soon as home prices began to fall.
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Example 14: Home prices fell by less than 2% from the 2 quarter of 2006 to the 4 quarter of
2006. Foreclosure start rates increased by 43% over these two quarters, and increased by 75%
in 2007 compared to 2006.
Speculators who bought homes (often with no money down) simply walked away from the
property when the home price fell. Many never made even the first monthly payment.
Homeowners with adjustable rate mortgages found that they could not refinance, because the
decrease in home prices meant that they had negative equity in their homes. When their
mortgage interest rates adjusted upward, their monthly payment was no longer manageable.
Example 15: Foreclosure rates for adjustable rate mortgages increased much more than
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foreclosure rates for fixed rate mortgages. From the 2 quarter of 2006 to the end of 2007,
foreclosure rates for fixed rate mortgages increased by about 55% (prime) and about 80%
(subprime). During this same time period, foreclosure rates for ARMs increased by about 400%
(prime) and about 200% (subprime). (Information is from “Anatomy of a Train Wreck” by Stan J.
Liebowitz of the Independent Institute.)
Just as rising home prices reinforced the continuing rise in home prices, falling home prices
reinforced the continuing fall in home prices. The increase in foreclosures added to the inventory
of homes available for sale. This further decreased home prices, putting more homeowners into a
negative equity position and leading to more foreclosures. The increase in foreclosures also
decreased the value of mortgage-backed securities. This made it difficult for investment banks to
issue new mortgage-backed securities, eliminating a major source of financing for new mortgage
loans, and contributing to the continuing decline in home prices.
The bursting of the housing bubble led to enormous losses. Some of those losses were incurred
by homeowners, particularly those who bought their homes or who took out home equity lines of
credit against the value of their homes too close to the peak. Most of the losses were not incurred
by homeowners, but by the financial system. Large losses were incurred by:
1. Mortgage lenders. Since the housing bubble burst, a number of the largest mortgage lenders
have either been acquired (e.g. Countrywide Financial by Bank of America), have filed for
bankruptcy (e.g. New Century Financial), or have been liquidated.
2. Investment banks. Since the housing bubble burst, the five largest U.S. investment banks have
either filed for bankruptcy (Lehman Brothers), been acquired by other firms (Bear Sterns and
Merrill Lynch), or have become commercial banks subject to greater regulation (Goldman Sachs
and Morgan Stanley).
3. Foreign investors (mainly banks and governments) who had invested in mortgage-backed
securities.
4. Insurance companies (e.g. AIG) who had sold credit default swaps. Credit default swaps are a
type of contract that insures against the default of debt instruments, such as mortgage-backed
securities.
The bursting of any housing bubble would be expected to have a negative effect on the economy
for two reasons: First, home construction is an important economic activity and the decline in
home construction would reduce GDP. Second, the decrease in home prices would also reduce
household consumption due to the wealth effect. (See Example 1A on page 6-2.)
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The Federal Reserve System
But the bursting of this housing bubble caused more severe and widespread harm than would be
predicted from just these two reasons. As mentioned previously, most of the losses were suffered
by the financial system, not by the homeowners. The bursting of the housing bubble sent a shock
through the entire financial system, increasing the perceived credit risk throughout the economy,
as indicated by the TED spread. The TED spread is the difference between the interest rate on
three-month U.S. treasury bills and the interest rate on three-month interbank loans as measured
by the London Interbank Offered Rate (LIBOR).
Example 16: The TED spread is considered a good indicator of the perceived credit risk in the
economy. Historically, the TED spread has ranged between .2% and .5%. In August of 2007, the
TED spread jumped above 1% and generally stayed between 1% and 2% until mid-September of
2008, when it began spiking upward, reaching a record level of over 4.5% on October 10, 2008.
The TED spread finally fell back below .5% in June of 2009.
The increased perceived credit risk throughout the economy meant that not only would home
buyers find it more difficult to obtain financing, but so would commercial real estate investors,
corporations seeking financing for investment, municipalities seeking to issue new bonds, etc.
Example 17: Real investment spending decreased by 33% from the third quarter of 2007 to the
second quarter of 2009. By contrast, real consumption spending decreased by only 2% over this
time period.
Government Intervention
The bursting of the housing bubble did not immediately create widespread credit problems. The
TED spread did not significantly increase until August of 2007. When the credit crisis arising from
the bursting of the housing bubble became apparent, the federal government began to intervene
in the economy in unprecedented ways.
In September of 2007, the Federal Reserve began to take steps to attempt to ease the credit
crisis. On September 18, 2007, the Fed lowered the target for the federal funds rate from 5.25%
to 4.75%. Over the succeeding 15 months, the Fed would lower the rate nine more times,
eventually to a range of 0.00%-0.25% on December 16, 2008. In December of 2007, the Fed
began to lend billions of dollars directly to financial institutions (through such programs as the
Term Auction Facility) to enhance the Fed’s ability to provide liquidity to the financial system.
In February of 2008, the federal government enacted the Economic Stimulus Act of 2008. This
was a $168 billion stimulus plan, consisting primarily of tax rebates to individual taxpayers. The
act also increased the dollar size of mortgages eligible for purchase by Fannie Mae and Freddie
Mac.
In March of 2008, the Fed provided a $29 billion loan to facilitate the purchase of Bear Stearns,
an investment bank on the brink of bankruptcy, by JPMorgan Chase. From August of 2008 to
December of 2008, the Fed increased the money supply (M1) by more than 14%.
On September 7, 2008, the Federal Housing Finance Agency placed Fannie Mae and Freddie
Mac into conservatorship. With the conservatorship, the federal government committed to provide
up to $100 billion in additional capital to each of the GSEs.
On September 16, 2008, the Fed provided an $85 billion loan to AIG, the largest insurance
company in the world, to prevent its bankruptcy. The Fed received an 80% equity stake in the
company. The loans and lines of credit provided to AIG would eventually grow to over $180
billion. In October of 2008, the Fed introduced facilities to purchase highly rated commercial
paper and to provide backup liquidity for money market mutual funds. These actions were
intended to improve liquidity outside the financial sector.
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On October 3, 2008, the $700 billion Emergency Economic Stabilization Act of 2008 was
enacted. The initial plan was to buy up illiquid mortgage assets from banks. Instead, the bailout
money was used to make direct investments in financial institutions.
On November 25, 2008, the Fed announced a program to provide up to $200 billion to support
the issuance of asset-backed securities backed by newly and recently originated consumer and
small business loans. That same day the Fed announced another program to purchase up to
$100 billion in the direct obligations of Fannie Mae and Freddie Mac and to purchase up to $500
billion in mortgage-backed securities backed by Fannie Mae, Freddie Mac, and Ginnie Mae.
On February 17, 2009, the federal government enacted a $787 billion economic stimulus plan,
consisting mainly of new federal spending. On December 17, 2010, the federal government
enacted an $858 billion economic stimulus plan, consisting of tax cut extensions, new tax cuts,
and new federal spending.
The Essential Cause of the Housing Bubble
The severe recession that began in December of 2007 was caused by the bursting of the housing
bubble and the resulting credit crisis. Each of the four primary causes played an important role in
creating the housing bubble and the credit crisis. The combination of all four causes created a
type of “perfect storm” causing the housing bubble to be extreme and the resulting credit crisis to
be severe.
Three of the causes, though they contributed to the housing bubble, were not essential to the
development of the bubble. Low mortgage interest rates, low short-term interest rates, and
relaxed mortgage lending standards all contributed to the housing bubble. But the absence of any
of these three causes would not necessarily have prevented the housing bubble. For example, if
mortgage interest rates had not been at historically low levels, a housing bubble could still have
developed. A housing bubble occurred in the late 1980s at much higher mortgage interest rates.
Likewise, without low short-term interest rates or relaxed mortgage lending standards, there still
could have been a housing bubble, though it would have been less extreme.
The one essential cause of the housing bubble was irrational exuberance. The housing bubble
would not have occurred without the widespread belief that home prices would continue to rise.
And irrational exuberance contributed to the other three causes. Mortgage interest rates would
not have been so low if foreign investors and credit rating agencies had not believed that U.S.
home prices would keep rising. Low short-term interest rates would not have led to such
extensive use of ARMs and such a high degree of leveraging without irrational exuberance. And
relaxed standards for mortgage loans would not have led to such a large increase in subprime
mortgages without irrational exuberance.
Study Guide for Chapter 11
Chapter Summary for Chapter 11
The Federal Reserve System (Fed) is the U.S. central bank. The governing body of the Fed is the
Board of Governors, headed by the Chairman of the Board of Governors (Ben Bernanke). The
Fed performs a number of important functions, including; (1) control the money supply, (2)
supervise and regulate banking institutions, (3) serve as the lender of last resort, (4) hold banks’
reserves, (5) supply the economy with currency, and (6) provide check-clearing services.
The Fed influences the money supply by changing the monetary base, which is currency in
circulation plus bank reserves. When the Fed makes a purchase or a sale, the monetary base
changes. When the monetary base changes, the money supply changes by a multiplied amount.
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The Federal Reserve System
The actual money multiplier is equal to the change in the money supply divided by the change in
monetary base.
The Fed’s primary tool for controlling the money supply is open market operations; the Fed
buying and selling U.S. government securities in the open market. If the Fed buys securities in
the open market, bank reserves increase, which leads to money creation. To reduce the money
supply, the Fed would sell securities.
The Fed can also control the money supply by changing the reserve requirement or changing the
discount rate. Lowering the reserve ratio would increase the money supply. Lowering the discount
rate would increase the money supply.
The economy entered into a recession in December of 2007. The primary cause of the recession
was the credit crisis arising from the bursting of the housing bubble. The four primary causes of
the housing bubble were; (1) low mortgage interest rates, (2) low short-term interest rates, (3)
relaxed standards for mortgage loans, and (4) irrational exuberance.
Mortgage interest rates in the U.S. were kept low by an influx of savings from other countries.
Much of this saving was invested in mortgage-backed securities issued by Wall Street firms. The
low mortgage interest rates contributed to the housing bubble by keeping monthly mortgage
payments affordable for more buyers even as home prices rose.
Fed policies caused short-term interest rates to be extremely low from 2002 to 2004. The low
short-term interest rates contributed to the housing bubble by; (1) encouraging the use of
adjustable rate mortgages, and (2) encouraging leveraging. The use of adjustable rate mortgages
made monthly mortgage payments temporarily affordable for more buyers and thus contributed to
rising home prices. Leveraging increased the financing available for mortgage lending, thus
contributing to rising home prices.
In the mid 1990s, new governmental policies were enacted that contributed to a relaxing of
standards for mortgage loans. Greater competition in the mortgage industry contributed to
relaxed mortgage standards. As irrational exuberance caused the housing market to overheat,
lenders relaxed their mortgage standards even further.
Irrational exuberance played a key role in the housing bubble. All the participants who contributed
to the housing bubble acted on the assumption that home prices would continue to rise. Home
prices kept rising for a long time, rewarding those who contributed to the bubble.
When the housing bubble burst, mortgage default rates began to rise. Falling home prices meant
that ARMs could not be refinanced, which reinforced the continuing fall in home prices. Most of
the losses caused by the bursting of the housing bubble fell not on homeowners but on the
financial system, especially mortgage lenders, investment banks, foreign investors, and insurance
companies. The bursting of the housing bubble sent a shock through the entire financial system,
increasing the perceived credit risk. The increased perceived credit risk decreased investment
spending.
When the credit crisis arose, the federal government began to intervene in the economy in
unprecedented ways. The Fed lowered the federal funds rate and greatly increased the money
supply. The Fed loaned billions of dollars to financial institutions. The Fed provided loans to
facilitate the purchase of Bear Stearns and to prevent the bankruptcy of AIG. The federal
government placed Fannie Mae and Freddie Mac into conservatorship and injected new capital
into the GSEs. The federal government enacted four economic stimulus plans, in February of
2008, in October of 2008, in February of 2009, and in December of 2010.
The one essential cause of the housing bubble was irrational exuberance. The housing bubble
would not have occurred without the widespread belief that home prices would continue to rise.
The Federal Reserve System
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Questions for Chapter 11
Fill-in-the-blanks:
1. The Federal Reserve System is the U.S. ______________________ bank.
2. The most important function of the Fed is controlling the ______________________
______________________ .
3. The ______________________ ______________________ rate is the interest rate one
bank charges another bank to borrow reserves.
4. The ______________________ rate is the interest rate the Fed charges banks that
borrow reserves from it.
5. ______________________ is investing with borrowed money.
6. ______________________ mortgages are home loans given to persons who are considered
a poor credit risk.
7. ______________________ ______________________ is a heightened state of speculative
fervor.
Multiple Choice:
____ 1. The functions of the Fed include:
a. holding banks’ reserves
b. supplying the economy with currency
c. controlling the money supply
d. All of the above
____ 2. A bank in need of reserves:
a. will usually borrow reserves from other banks
b. as a last resort, may borrow from the Fed
c. Both of the above
d. Neither of the above
____ 3. Monetary base consists of:
a. currency in circulation
b. bank reserves
c. checkable deposits
d. Both a. and b. above
____ 4. If the monetary base increases by $200 million and the money supply increases by
$550 million, the actual money multiplier is:
a.
.36
b. 2.50
c. 2.75
d. 5.5
____ 5. Open market operations refers to the Fed:
a. acting as lender of last resort for banks
b. changing the required-reserve ratio
c. buying and selling U.S. government securities in the open market
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The Federal Reserve System
____ 6. If the Fed buys U.S. government securities in the open market:
a. bank reserves will increase
b. monetary base will increase
c. the money supply will increase by a multiplied amount
d. All of the above
____ 7. If the Fed lowers the reserve ratio:
a. banks will be short on reserves
b. the money supply will decrease
c. Both of the above
d. Neither of the above
____ 8. When a bank borrows from the Fed:
a. the interest rate paid is the discount rate
b. the Fed is injecting new reserves into the financial system
c. the money supply increases
d. All of the above
____ 9. The Fed can decrease the money supply by:
a. lowering the required-reserve ratio
b. selling U.S. government securities in the open market
c. lowering the discount rate
d. All of the above
____ 10. The Fed’s most important tool for controlling the money supply is:
a. printing more currency
b. changing the discount rate
c. open market operations
d. changing the required-reserve ratio
____ 11. During the recession caused by the bursting of the housing bubble:
a. Real GDP decreased by over 5% for the year 2008
b. the unemployment rate more than doubled from November of 2007 to October of
2009
c. Both of the above
d. Neither of the above
st
st
____ 12. From the 1 quarter of 1997 to the 1 quarter of 2009:
a. home prices increased by a steady 5% per year
b. home prices increased by over 132% and then decreased by over 32%
c. home prices increased by about 57%
d. Both b. and c. above
____ 13. During the housing bubble, mortgage interest rates were low:
a. because of the high savings rate in the U.S.
b. because of an influx of savings entering the U.S. from other countries
c. Both of the above
d. Neither of the above
____ 14. The low short-term interest rates from 2002 to 2004:
a. encouraged the use of adjustable rate mortgages
b. forced mortgage lenders to deleverage, thus triggering the bursting of the
housing bubble
c. Both of the above
d. Neither of the above
The Federal Reserve System
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____ 15. Leveraging:
a. increased the financing available for mortgage lending and thus contributed to
rising home prices
b. increased the impact of the bursting of the housing bubble because the
deleveraging contributed to falling home prices
c. Both of the above
d. Neither of the above
____ 16. Beginning in 1996, Fannie Mae and Freddie Mac:
a. were required to hold an increasing percentage of mortgage loans to lowerincome households in their portfolios
b. began to relax the standards that mortgages had to meet to be classified as
“conforming”
c. Both of the above
d. Neither of the above
____ 17. The greater competition in the mortgage market caused by the internet:
a. meant that home buyers were no longer limited to borrowing locally
b. led to an increase in the average fee on a mortgage loan
c. forced all mortgage lenders to adopt stricter standards for their loans
d. All of the above
____ 18. Subprime mortgages:
a. are home loans given to persons who are considered a poor credit risk
b. historically, have had a foreclosure rate almost twice as high as prime mortgages
c. charge a lower interest rate than conventional mortgages in order to encourage
home ownership by lower-income borrowers
d. All of the above
____ 19. The term “irrational exuberance” was first used by Alan Greenspan as he:
a. hinted in 1991 that a little irrational exuberance might help the economy recover
from the recession of 1991
b. hinted in 1996 that stock prices might be unduly escalated due to irrational
exuberance
c. hinted in 1999 that irrational exuberance would carry the economy to continued
rapid growth
d. described in 1997 how he felt about marrying the much-younger Andrea Mitchell
____ 20. If a homeowner could have foreseen the bursting of the housing bubble and had sold
their home in 2003:
a. they would have been better off than if they had sold their home in 2007, one
year after the bubble burst
b. they would have been worse off than if they had sold their home in 2007, one
year after the bubble burst
c. they would have been about as well off as they would have been if they sold their
home in 2007, one year after the bubble burst
____ 21. After Alan Greenspan made his “irrational exuberance” comment, the Dow Jones
Industrial Average:
a. fell 2% at the opening of trading the next day
b. went into a long-term decline
c. increased by another 75% over the next three years
d. Both a. and c. above
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The Federal Reserve System
____ 22. When the housing bubble burst and home prices began to fall:
a. the increase in foreclosures brought new buyers into the market, helping to slow
the fall in home prices
b. the increase in foreclosures decreased the value of mortgage-backed securities,
making it difficult for investment banks to issue new mortgage-backed securities
c. Both of the above
d. Neither of the above
____ 23. The bursting of any housing bubble would be expected to have an impact on the
economy because:
a. the decrease in home prices would free up more discretionary income leading to
an increase in consumption
b. the decline in home construction would reduce GDP
c. Both of the above
d. Neither of the above
____ 24. The increased perceived credit risk caused by the bursting of the housing bubble:
a. caused the TED spread to increase to a record level of over 10% in October of
2008
b. caused real investment spending to decrease by over 80% from the third quarter
of 2007 to the second quarter of 2009
c. Both of the above
d. Neither of the above
____ 25. In response to the recession caused by the bursting of the housing bubble, the federal
government:
a. has enacted four economic stimulus plans
b. has imposed strict import restrictions to protect domestic jobs
c. has created jobs programs employing millions of workers and has deported
millions of illegal immigrants
d. All of the above
____ 26. The essential cause of the housing bubble was:
a. greed and corruption among investment bankers
b. weak oversight by government regulators
c. irresponsible borrowing by speculative homebuyers
d. irrational exuberance
Problems:
1. Explain how the Fed buying U.S. government securities in the open market will increase the
money supply.
The Federal Reserve System
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2. List the four causes of the housing bubble.
3. List three factors that contributed to the relaxed standards for mortgage loans.
4. Explain how the increase in foreclosures after the bursting of the housing bubble led to further
increases in foreclosures.
Answers for Chapter 11
Fill-in-the-blanks:
1. central
2. money supply
3. federal funds
4. discount
Multiple Choice:
1. d.
2. c.
3. d.
4. c.
5. c.
6. d.
7. d.
8. d.
9. b.
5. Leveraging
6. Subprime
7. Irrational exuberance
10. c.
11. b.
12. d.
13. b.
14. a.
15. c.
16. c.
17. a.
18. a.
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19. b.
20. b.
21. d.
22. b.
23. b.
24. d.
25. a.
26. d.
The Federal Reserve System
Problems:
1. When the Fed buys U.S. government securities in the open market, bank reserves increase.
When banks have excess reserves, they make new loans. This triggers the money creation
process, leading to a multiplied expansion of the money supply.
2. The four causes of the housing bubble were:
(1) Low mortgage interest rates
(2) Low short-term interest rates
(3) Relaxed standards for mortgage loans
(4) Irrational exuberance
3. Three factors that contributed to the relaxed standards for mortgage loans were:
(1) Governmental policies aimed at fostering an increase in home-ownership rates,
particularly among lower-income households.
(2) Greater competition in the mortgage loan market.
(3) The irrational exuberance of all parties involved in the mortgage lending process.
4. The fall in home prices with the bursting of the housing bubble caused an increase in
foreclosures. The increase in foreclosures added to the inventory of homes available for sale.
This further decreased home prices, putting more homeowners in a negative equity position
and leading to more foreclosures.
The Federal Reserve System
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