Download Section 2A: Economic Crisis of 2008

Section 2B: Economic Crisis of 2008
Slide 3: Key Events of the Economic Crisis
The economic downturn was headlined by:
 The boom and bust of the housing market: Housing prices soared until about 2005
and then started to turn down again.
 Rising default and foreclosure rates:
1. Mortgage Default Rates: The percentage of home mortgages on which the
borrower is late by ninety days or more with the payments on the loan or it is in
the foreclosure process.
2. Foreclosure Rates: The percentage of home mortgages on which the lender has
started the process of taking ownership of the property because the borrower has
failed to make monthly payments.
 Sharp downturn in the stock market: The S&P 500 fell by more than 55% between
October 2007 and March 2009. This collapse eroded the wealth and endangered the
retirement savings of many Americans
 Soaring energy prices: Gas prices were rising at this time
Slide 4: Boom and Bust of the housing market
 Housing prices were relatively stable during the 1990s, but they began to rise toward
the end of the decade. Between January 2002 and mid-year 2006, housing prices
increased by a whopping 87%.
 In late 2006, the boom turned to a bust and housing prices declined throughout 20072008. By year-end 2008, housing prices were approximately 30% below their 2006
peak
Slide 5: Mortgage Default Rates
 The default rate fluctuated within a narrow range (around 2%) prior to 2006. It
increased only slightly during the recessions of 1982, 1990, and 2001.
 The rate began increasing sharply during the second half of 2006. It reached 5.2%
during the third quarter of 2008.
Slide 6: Foreclosure Rates
 The foreclosure rate followed a similar path as the default rate. Prior to mid-year
2006, the foreclosure rate fluctuated between 0.15% and 0.50%. But in 2007-2008, it
increased sharply and moved to the highest level in decades
Slide 7: Sharp downturn in the stock market
The S&P 500 fell by more than 55% between October 2007 and March 2009. This
collapse eroded the wealth and endangered the retirement savings of many Americans
Slide 8: What caused the economic crisis of 2008
 This is just an over view slide, we are going to talk about each one of these in turn
 The four main causes of the current economic recession:
1. Regulations that lowered mortgage lending standards
2. Prolonged low interest rate policy of the Fed during 2002-2004
1
3. Increased debt to capital ratio of lending institutions
4. High and growing debt to income ratio of American households
Slide 9: Regulations Lowered Lending Standards (1)
A. The Role of Government Sponsored Enterprises (GSE’s): Fannie Mae and Freddie
Mac:
a. These two Government Sponsored Enterprises (GSEs) were set up as “for profit”
firms by the federal government.
b. Because of their GSE status and the perceived government backing of their bonds,
they could borrow funds at 50 to 75 basis points cheaper than other lenders.
c. The GSEs were highly political: their top management provided key
congressional leaders with large contributions and often hired away congressional
staffers into high paying jobs lobbying former bosses
d. They dominated the secondary mortgage market. The share of mortgages held by
them rose from 25% in 1990 to 45% in 2001.
B. Department of Housing and Urban Development (HUD) required them to extend
loans to low and moderate income households.
a. The HUD mandates required Fannie and Freddie to extend 40% of their new
loans to borrowers with incomes below the median in 1996. This mandated share
was increased to 50% in 2000 and 56% in 2008.
b. In 1999, HUD guidelines required Fannie and Freddie to accept smaller down
payments and extend larger loans relative to income
c. In order to meet HUD mandates, the GSEs accepted more subprime loans.
Mortgage originators were willing to make subprime and other high risk loans
because they could be passed on to the GSE’s. This resulted in the deterioration
of lending standards
C. Community Reinvestment Act (CRA) also pushed banks to extend loans to high risk
borrowers.
a. Mortgage loans to subprime borrowers soared as a result of these regulations.
Slide 10: Regulations Lowered Lending Standards (2)
 Subprime loans: loans made to borrowers with a blemished credit history
a. This is important because the foreclosure rate on subprime loans is 7 to 10 times
higher than for prime loans (The intent was to promote affordable housing, but
the regulations eroded lending standards, fueled the housing price boom and bust,
and the defaults and foreclosures that followed.)
 Alt-A loans: loans extended to borrowers with a poorly documented or incomplete
credit history:
a. Alt-A loans are those extended with incomplete documentation and verification.
Both subprime and Alt-A loans are risky
Slide 11: Regulations Lowered Lending Standards (3)
These loans rose from 10% of the total in 2001-2003 to 33% in 2005-2006
2
Slide 12: Low interest rate policy of the Fed (1)
 Consistent with the idea of Keynesian Economics, the Fed kept interest rates low in
2002-2004 in an effort to try and stimulate the economy. These low interest rates
increased the attractiveness of Adjustable Rate Mortgages (ARM) loans and added to
the housing boom. Measured as a share of total mortgages outstanding, ARMs
increased from 10% in 2000 to 21% in 2005
 But, as inflation increased during 2005-2006, the Fed increased interest rates to slow
down the economy and this helped turn the housing boom to a bust.
Slide 13: Low interest rate policy of the Fed (2)
The Fed kept interest rates really low for the year 2002-2004. Then in an effort to slow
the economy down and combat inflation, the Fed allowed interest rates to rise in 2005,
which made the interest, and consequently, the amount of people’s house payments
skyrocket, leading to increased foreclosures.
Slide 14: Low interest rate policy of the Fed (3)
 The foreclosure rates increased for ARM subprime loans (foreclosure rates on fixed
rate loans did not change that much)
Slide 15: Low interest rate policy of the Fed (4)
 The foreclosure rates on ARM prime loans also increased (again, fixed rate loans
were not significantly affected).
 Note, the foreclosure rate was 7 to 10 times higher for subprime than prime loans
(look at the difference in the vertical axis on the two graphs).
Slide 16: Increased Debt to Capital Ratio (1)
A. SEC regulations
 A regulation adopted by the SEC in April 2004, permitted investment banks to
leverage their capital by a larger amount and thereby extend more loans.
 Banks were required to maintain 8% capital against commercial loans, but only
4% against residential housing loans, and only 1.6% against low-risk (AAA rated)
securities.
B. Financial institutions bundled mortgages together into what they thought were low
risk securities (they were low risk in the past, but lending standards had been eroded)
 Major investment banks and many commercial banks bundled mortgages together
and received AAA ratings for the securities backing the mortgages
 These highly leveraged securities generated large profits for investment and
commercial banks and the GSEs (Fannie and Freddie) during the housing boom
C. As housing prices leveled off in the latter half of 2006, default rates increased and the
value of the highly leveraged mortgage-backed securities plummeted.
 This led to the collapse of investment banks like Bear Stearns and Lehman
Brothers, and serious problems for other financial institutions
Slide 17: Increased Debt to Capital Ratio (2)
This article illustrates how ridiculous and obvious this disaster was in hindsight.
3
Slide 18: High and growing debt to income ratio of American households (1)
Americans have been carrying larger amounts of debt relative to their income compared
to before. A significant amount of debt was contained in housing.
Slide 19: High and growing debt to income ratio of American households (2)
 Between 1953-1980, household debt as a share of disposable (after-tax) income
ranged from 40% to 65%.
 Since the early 1980s, the debt-to-income ratio of households has risen at an alarming
rate.
 It reached 135% in 2007, more than twice the level of the mid-1980s
Slide 20: High and growing debt to income ratio of American households (3)
 Because mortgage and home equity loans are tax deductible, but other forms of debt
are not, household debt is concentrated against housing assets
 As a result, housing is hit hard when economic conditions weaken
Slide 21: Lessons from the Financial Crisis
1. Limit government regulations: Think twice about the secondary effects involved.
2. Monetary Policy should focus only on price stability and worry less about controlling
economic fluctuations.
3. American households should probably carry less debt. Don’t buy more than you can
afford.
Slide 22: Review
1. Know the key events surrounding the 2008 economic crisis.
A. The boom and bust of the housing market
B. Rising default and foreclosure rates
C. Sharp downturn in the stock market
D. Soaring energy prices
2. Know the four causes of the economic crisis.
A. Regulations that lowered mortgage lending standards
B. Prolonged low interest rate policy of the Fed during 2002-2004
C. Increased debt to capital ratio of lending institutions
D. High and growing debt to income ratio of American households
3. Understand the lessons we should take from the mistakes made leading up to the
economic crisis (and don’t repeat them).
A. Be careful with regulations: They can create perverse incentives.
B. Monetary policy should focus on price stability, rather than trying to stimulate or
slow the economy.
C. American households should probably carry less debt relative to their income
4