Download Section 2B - Financial Crisis of 2008

Section 2B
Financial Crisis of 2008
1
Overview
• Key events of the economic crisis
• The four causes of the economic crisis
• 3 lessons we should learn from economic
crisis
2
Key Events of the Economic Crisis
This economic downturn was characterized
by:
•
•
•
•
The boom and bust of the housing market
Rising default and foreclosure rates
Sharp downturn in the stock market
Soaring energy prices
3
Boom and bust of the housing
market
20
15.7
15
Percent Change
12.1
10
7.5
8.6
7.4
9.3
11.5
8.0
4.8
4.3
5
8.6
10.6
2.7
1.2
1.7
2.4
2.8
0.2
0
-2.1
-2.8
-5
-10
-11.2
-15
-20
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
-18.8
2007
4
Mortgage Default Rates
6
5
Percent
4
3
2
1
0
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
5
Foreclosure Rates
1.4
1.2
Percent
1
0.8
0.6
0.4
0.2
0
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
6
Sharp downturn in the Stock
Market
1,800
1,600
S and P 500
1,400
1,200
1,000
800
600
400
200
0
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
7
What caused the economic crisis of
2008?
1. Regulations that lowered mortgage
lending standards
2. Prolonged low interest rate policy of the
Fed during 2002-2004
3. Increased debt to capital ratio of lending
institutions
4. High and growing debt to income ratio of
American households
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1. Regulations Lowered Lending
Standards
A. Government Sponsored Enterprises
(GSE’s): Fannie Mae and Freddie Mac
B. Department of Housing and Urban
Development (HUD) required them to
extend loans to low and moderate
income households
C. Community Reinvestment Act (CRA)
also pushed banks to extend loans to
high risk borrowers
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1. Regulations Lowered Lending
Standards
Subprime loans: loans made to borrowers
with a blemished credit history
Alt-A loans: loans extended to borrowers
with a poorly documented credit history
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1. Regulations Lowered Lending
Standards
Share of Mortgages Originated (percent)
40
35
30
25
20
15
10
5
0
1994
1995
1996
1997
1998
1999
2000
Subprime + Alt-A
2001
2002
2003
2004
2005
2006
2007
Subprime
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2. Low interest rate policy of the
Fed
•
The Fed kept interest rates low in 20022004 to stimulate the economy.
– This increased the attractiveness of
Adjustable Rate Mortgages (ARM loans)
•
The Fed pushed interest rates back up in
2005-2006 to combat inflation.
12
2. Low interest rate policy of the
Fed
Interest Rate (percent)
8
7
6
5
4
3
2
1
0
1995
1996
1997
1998
1999
2000
2001
Federal Funds
2002
2003
2004
2005
2006
2007
2008
1 year T-bill
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2. Low interest rate policy of the
Fed
When interest rates on ARM loans increased, so did the
foreclosure rates (for both subprime and prime loans)
14
2. Low interest rate policy of the
Fed
When interest rates on ARM loans increased, so did the
foreclosure rates (for both subprime and prime loans)
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3. Increased Debt to Capital Ratio
A. In 2004, SEC regulations allowed banks to
leverage their capital and extend more loans
B. So banks bundled mortgages together into
“AAA” securities.
C. This led to the collapse of investment banks
and other financial institutions
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3. Increased Debt to Capital Ratio
17
4. High and growing debt to income
ratio of American households
A. The debt to income ratio of households
has risen sharply since the early 1980s.
18
4. High and growing debt to income
ratio of American households
Debt to Disposable Personal Income Ratio
(percent)
140
120
100
80
60
40
20
1953
1958
1963
1968
1973
1978
1983
1988
1993
1998
2003
2008
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4. High and growing debt to income
ratio of American households
B. Because mortgage and home equity
loans are tax deductible, but other forms
of debt are not, household debt is
concentrated in housing assets
C. As a result, housing is hit especially hard
when economic conditions weaken
20
Lessons from the Financial Crisis
1. Be careful with regulations: They can
create perverse incentives.
2. Monetary policy should focus on price
stability, rather than trying to stimulate or
slow the economy.
3. American households should probably
carry less debt relative to their income
21
Review
1. Know the key events surrounding the
2008 economic crisis.
2. Know the four causes of the economic
crisis.
3. Understand the lessons we should take
from the mistakes made leading up to
the economic crisis (and don’t repeat
them).
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