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The Financial Crisis of 2008The Financial Crisis of 2008

Bradley UniversityBradley University’’s Economics Departments Economics Department

Presented by Presented by Dr. Joshua J. Lewer & Dr. Robert C. ScottDr. Joshua J. Lewer & Dr. Robert C. Scott

Some Recent Financial CrisesSome Recent Financial Crises

Theme: Bad LoansTheme: Bad LoansU.S. Savings and Loans U.S. Savings and Loans -- 1985 to 19891985 to 1989JapanJapan’’s Banking Crisis s Banking Crisis –– 1989 to present1989 to presentMexican Banking Crisis of 1995Mexican Banking Crisis of 1995Asian Flu of 1997Asian Flu of 1997--98 98 –– The The ““ContagionContagion””Russian Implosion of 1998Russian Implosion of 1998Argentina 2001Argentina 2001

Functions of the Financial SystemFunctions of the Financial System

Essential for overall economic performance, see Essential for overall economic performance, see King and Levine (1993)King and Levine (1993)

Credit markets funnel savings to borrowersCredit markets funnel savings to borrowersHousingHousingInvestmentInvestmentExchange assets across generationsExchange assets across generationsShort term needs Short term needs –– Baltimore steel framer storyBaltimore steel framer story

The Roots of the Current Problem The Roots of the Current Problem

The current crisisThe current crisisA crisis in financial institutionsA crisis in financial institutions

Collapse of a speculative bubble in the housing Collapse of a speculative bubble in the housing marketmarket

Triggered a credit crunch Triggered a credit crunch →→ Recession since Dec Recession since Dec ‘‘0707

The Housing Bubble The Housing Bubble

ShillerShiller’’s Housing Value Index s Housing Value Index

0.0

50.0

100.0

150.0

200.0

250.0

1985 1990 1995 2000 2005 2010

Note: Shiller Index Adjusted for Inflation and Based on 1998

Benchmark = 110

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ShillerShiller’’s Housing Value Index s Housing Value Index

0.0

50.0

100.0

150.0

200.0

250.0

1985 1990 1995 2000 2005 2010

Note: Shiller Index Adjusted for Inflation and Based on 1998

Benchmark = 110

Peak = 220 (May 2006)

ShillerShiller’’s Housing Value Index s Housing Value Index

0.0

50.0

100.0

150.0

200.0

250.0

1985 1990 1995 2000 2005 2010

Note: Shiller Index Adjusted for Inflation and Based on 1998

Benchmark = 110

Peak = 220 (May 2006)

Now = 158 (Aug 2008)

Housing OutliersHousing Outliers

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50

100

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250

300

350

400

1985 1990 1995 2000 2005 2010

U.S.

Housing Outliers Housing Outliers

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50

100

150

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300

350

400

1985 1990 1995 2000 2005 2010

U.S.

Los Angeles

Note: Tri-county area has observed a 4.85% average annual increase from 2004-2008 (3q).

Source: Illinois Association of Realtors

Why Do ManiaWhy Do Mania’’s Like This Occur?s Like This Occur?

The truth isThe truth is……we donwe don’’t knowt know

Investors as PigeonsInvestors as Pigeons……we just fly in circleswe just fly in circles

Pigeon investor theory suggests we watch each other rather than focus on fundamentals

Major Housing Boom FactorsMajor Housing Boom Factors

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The Savings TsunamiThe Savings Tsunami

Savings glut in Asia Savings glut in Asia →→ global interest rates low global interest rates low since 1991since 1991

Low interest rates stimulate the demand for housingLow interest rates stimulate the demand for housing

Other factorsOther factorsHistoric low federal funds rateHistoric low federal funds rateFederal policies that promoted homeownershipFederal policies that promoted homeownershipGreed, speculation, and the lack of personal Greed, speculation, and the lack of personal responsibilityresponsibility

Enter Subprime Enter Subprime

““SubPrimeSubPrime”” ---- a loan under conditions which a loan under conditions which make the risk higher than make the risk higher than ““primeprime””

Some ExamplesSome ExamplesThe borrower could be more risky than one who The borrower could be more risky than one who would get the usual 20% down, 30would get the usual 20% down, 30--year fixed rateyear fixed rateThe borrower could get a 0% down mortgageThe borrower could get a 0% down mortgageGrandma Tesch storyGrandma Tesch story

Subprime Issuance and Ratings 2005Subprime Issuance and Ratings 2005--07 07 U.S.$ BillionsU.S.$ Billions

494970701341341,1341,1341,4211,421

BBBBBB

(3.5%)(3.5%)

AA

(5.0%)(5.0%)

AAAA

(9.6%)(9.6%)

AAAAAA

(80.8%)(80.8%)

All All SubprimeSubprime(100%)(100%)

Source: Greenlaw et al. (2008), Inside Mortgage Finance

Note: 2000-2007 subprime issuance total is $2.71 trillion, before this - minimal

Percentage of Loan OriginationsPercentage of Loan Originations

Source: Greenlaw et al. (2008), Inside Mortgage Finance

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60

2000 2001 2002 2003 2004 2005 2006 2007

5 of

Orig

inat

ions

by

Prod

uct (

Tota

l) ARMs

Subprime

From Wall Street to Main Street: From Wall Street to Main Street: How has the Financial Crisis How has the Financial Crisis Impacted the Real Economy? Impacted the Real Economy?

Impact 1Impact 1Credit Markets have Seized UpCredit Markets have Seized Up

The reduced availability of liquidityThe reduced availability of liquidity1.1. Interest rate premiumsInterest rate premiums

U.S.: Banks not lending to each otherU.S.: Banks not lending to each otherROW: London Interbank Offered Rate (Libor) ROW: London Interbank Offered Rate (Libor)

Libor is used to set rates on the $360 trillion Libor is used to set rates on the $360 trillion of financial products worldwide.of financial products worldwide.Three month Libor set an all time high in Three month Libor set an all time high in October at 5.34%. Dec. 7October at 5.34%. Dec. 7thth 2.18%2.18%

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Housing loan premiums Housing loan premiums 250 basis point gap over 30250 basis point gap over 30--Year TreasuriesYear TreasuriesHistorical average is 100 basis pointsHistorical average is 100 basis points

Corporate bond issuance premiums Corporate bond issuance premiums CAT paid an allCAT paid an all--time high premium of time high premium of roughly 500 basis points over comparable roughly 500 basis points over comparable Treasuries (Dec. 2Treasuries (Dec. 2ndnd))

NonNon--profit bond issuance premiumsprofit bond issuance premiumsMethodist Hospital delaying the last two Methodist Hospital delaying the last two stages of itstages of it’’s $400 million expansion. NPO s $400 million expansion. NPO bond rates at 8%bond rates at 8%

2.2. Banks have implemented selective lending Banks have implemented selective lending practices practices

More difficult for companies to obtain shortMore difficult for companies to obtain short--term term funding funding –– Baltimore steel framer storyBaltimore steel framer story

3.3. Commercial paper market has fallen off Commercial paper market has fallen off dramatically as companies are unable to find dramatically as companies are unable to find buyers for shortbuyers for short--term debt (e.g. money market term debt (e.g. money market buyers have dried up)buyers have dried up)

Higher interest rates and the lack of liquidity Higher interest rates and the lack of liquidity reduce economic activity and technological reduce economic activity and technological progressprogress

Impact 2Impact 2Financial Institutions Financial Institutions

Decapitalization and FailuresDecapitalization and Failures

Banks and other financial intermediaries exposed to:Banks and other financial intermediaries exposed to:virtually untradeable MBSvirtually untradeable MBSrisky loans (e.g. 1 in 10 mortgages)risky loans (e.g. 1 in 10 mortgages)

have seen their net worth declinehave seen their net worth decline

In the rush to recapitalize their balance sheets, we have In the rush to recapitalize their balance sheets, we have seen what Irving Fisher called seen what Irving Fisher called ““a stampede to liquidatea stampede to liquidate””and and ““debt deflationdebt deflation””

Financial ConnectionsFinancial Connections

Impact 3Impact 3Household Bankruptcy and Household Bankruptcy and

Foreclosure RatesForeclosure Rates

BankruptcyBankruptcyThe number of Americans filing for consumer The number of Americans filing for consumer bankruptcy increased by nearly 40 percent in 2008.bankruptcy increased by nearly 40 percent in 2008.

Foreclosure RatesForeclosure RatesA record 1 in 10 American homeowners were either A record 1 in 10 American homeowners were either at least a month behind on their payments or in at least a month behind on their payments or in foreclosure at the end of September. foreclosure at the end of September.

Foreclosure Rates in U.S.Foreclosure Rates in U.S.

Source: RealtyTrac U.S. Foreclosure Market ReportRealtyTrac U.S. Foreclosure Market Report

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Appreciation Rates in U.S.Appreciation Rates in U.S.

Source: RealtyTracRealtyTrac

Impact 4Impact 4Consumer Sentiment Near All Time LowConsumer Sentiment Near All Time Low

Monthly Data

Impact 5Impact 5Job CreationJob Creation

The lack of available credit has weakened The lack of available credit has weakened business activity considerably business activity considerably -- and thus job and thus job creationcreation

The Bureau of Labor Statistics (BLS) The Bureau of Labor Statistics (BLS) Job losses every month in 2008Job losses every month in 2008533,000 in November and 1.91m total533,000 in November and 1.91m total

Unemployment rate has increased to 6.7%Unemployment rate has increased to 6.7%

Unemployment RateUnemployment Rate

Monthly Data

The Bailout: The Bailout: The $700b Paulson/Bernanke PlanThe $700b Paulson/Bernanke Plan

Ben Bernanke

Aka: “Bailout Ben”

Emergency Economic Stabilization Act of 2008

Allows the federal government to:Buy and sell MBSBuy and sell MBSBuy and sell illiquid whole loansBuy and sell illiquid whole loansServe as an insurer of troubled assetsServe as an insurer of troubled assetsCapital purchase program Capital purchase program –– buy preferred stocksbuy preferred stocks

GoalsGoals1.1. ““Provide stability or prevent disruption to the Provide stability or prevent disruption to the

financial markets or banking system.financial markets or banking system.””2.2. ““Protecting the taxpayer.Protecting the taxpayer.””

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Does it Fix the Problems?Does it Fix the Problems?With concurrent Federal Reserve actions,With concurrent Federal Reserve actions,……

Lowering the Federal Funds rate to 1.00%Lowering the Federal Funds rate to 1.00%Using MBS as collateral for Term Auction Facility (TAF) Using MBS as collateral for Term Auction Facility (TAF) loans loans -- $900B by end of year.$900B by end of year.Buying commercial paper Buying commercial paper -- $275B since August$275B since AugustBuying MBS Buying MBS -- $500B starting in Nov.$500B starting in Nov.Buying the spectrum of Treasuries to keep longBuying the spectrum of Treasuries to keep long--term interest term interest rates low and increase liquidity rates low and increase liquidity -- $600B$600B

……capitalization and liquidity in the financial sector has capitalization and liquidity in the financial sector has been significantly enhanced, butbeen significantly enhanced, but……

……credit access still remains a problem in some areas.credit access still remains a problem in some areas.

Risk Indicators ImprovingRisk Indicators Improving

1. TED spread 1. TED spread –– the difference between the yield on the 3the difference between the yield on the 3--month Treasury Bill and the 3month Treasury Bill and the 3--month month LiborLibor

Indicator of health of global credit marketsIndicator of health of global credit marketsExcellent measure of fear banks have when lendingExcellent measure of fear banks have when lendingSpread was 465 basis points in October, Dec 7Spread was 465 basis points in October, Dec 7thth at 217at 217Normalized credit conditions spread would be 100 Normalized credit conditions spread would be 100

2. Yield curve 2. Yield curve –– the tenthe ten--year treasury less federal funds rateyear treasury less federal funds rateCurrently at (1.71% = 2.71%Currently at (1.71% = 2.71%--1.00%)1.00%)Recovery spread would be above 2.50%Recovery spread would be above 2.50%

We Still Have a Ways to GoWe Still Have a Ways to Go

Consensus NABE 4Consensus NABE 4thth quarter 2008 economic numbers quarter 2008 economic numbers look very weaklook very weak

Real GDP growth estimates at Real GDP growth estimates at --3% (worst quarter was 13% (worst quarter was 1stst

quarter 1980 = quarter 1980 = --7.8%)7.8%)December job loss estimated at 300,000December job loss estimated at 300,000

Consensus 1Consensus 1stst quarter 2009 economic estimates also look quarter 2009 economic estimates also look negativenegative

Real GDP growth estimates Real GDP growth estimates --1.3%1.3%

Unemployment expected to peak at 7.7% 3Unemployment expected to peak at 7.7% 3rdrd quarter quarter ’’0909

The Sky Has Fallen.The Sky Has Fallen.The Sun Also Rises.The Sun Also Rises.

What Will Drive the Recovery?What Will Drive the Recovery?

Thawing of the credit markets Thawing of the credit markets Steady decline in the Steady decline in the LiborLibor (Oct. at 5.34% (Oct. at 5.34% -- Dec. 7Dec. 7thth 2.18%)2.18%)BankBank--toto--bank and bankbank and bank--toto--customer lending has improvedcustomer lending has improved

Keynesian Economics Keynesian Economics Massive stimulus packages by Massive stimulus packages by ObamaObama and rest of worldand rest of worldPublic works projects for country (and Peoria)Public works projects for country (and Peoria)

Lower oil and commodity pricesLower oil and commodity pricesStimulates aggregate supplyStimulates aggregate supply

ExportsExportsExports are at an allExports are at an all--time high, and are growing faster than importstime high, and are growing faster than imports

The Future The Future

RecessionRecession……but how long?but how long?Depression Depression –– (<1%) (<1%) Lost decade Lost decade –– looking Japanese (25%) looking Japanese (25%) Controlled landing Controlled landing –– bottom out second half of 2009 bottom out second half of 2009 (65%) (65%) –– longest recession since WWIIlongest recession since WWIIEasy bounce Easy bounce –– no lasting effects (10%)no lasting effects (10%)

Keys to recovery: housing prices stabilize & Keys to recovery: housing prices stabilize & consumer confidence reboundsconsumer confidence rebounds

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Visibility of RecessionVisibility of Recession’’s Ends End

The 2The 2ndnd Quarter of 2009 has the potential to be Quarter of 2009 has the potential to be the initial quarter of the next economic recovery.the initial quarter of the next economic recovery.

The second half of 2009 should see the The second half of 2009 should see the economy on the recovery track.economy on the recovery track.

Projected 2009 GDP growth at 0.7%Projected 2009 GDP growth at 0.7%

Policy PrescriptionsPolicy Prescriptions

Delay Delay ObamaObama’’ss tax increases on hightax increases on high--income income AmericansAmericansSupport open trade...not the time for a trade warSupport open trade...not the time for a trade warCombine fiscal and monetary policies effortsCombine fiscal and monetary policies efforts

Like pharmaceuticals, the potency is enhancedLike pharmaceuticals, the potency is enhanced

Provide shortProvide short--term support to American families term support to American families behind on their mortgagesbehind on their mortgagesReduce startReduce start--up costs and red tape for up costs and red tape for entrepreneursentrepreneurs

End of PresentationEnd of Presentation

Parking Lot SlidesParking Lot Slides

Additional ConsiderationsAdditional Considerations

Increased regulation and government involvement in Increased regulation and government involvement in the financial sector (looking more Japanese)the financial sector (looking more Japanese)

Increase in moral hazard (downside punishment is not Increase in moral hazard (downside punishment is not enforced)enforced)

Potential reaction in antitrust practicesPotential reaction in antitrust practices““Too big to failToo big to fail””Why do we let firms become too big to failWhy do we let firms become too big to fail

Costlier to operate in financial markets Costlier to operate in financial markets

1010--Year Treasury YieldYear Treasury Yield

Monthly Data

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James Galbraith InterviewJames Galbraith InterviewInterviewer:Interviewer: ““But there are at least 15,000 professional But there are at least 15,000 professional economists in this country, and youeconomists in this country, and you’’re saying only two or re saying only two or three of them foresaw the mortgage crisis?three of them foresaw the mortgage crisis?””Galbraith:Galbraith: ““Ten or 12 would be closer than two or Ten or 12 would be closer than two or three.three.””Interviewer:Interviewer: ““What does that say about the field of What does that say about the field of economics, which claims to be a science?economics, which claims to be a science?””Galbriath:Galbriath: ““ItIt’’s an enormous blot on the reputation of the s an enormous blot on the reputation of the profession. There are thousands of economists. Most of profession. There are thousands of economists. Most of them teach. And most of them teach a theoretical them teach. And most of them teach a theoretical framework that has been shown to be fundamentally framework that has been shown to be fundamentally useless.useless.””

Federal Funds RateFederal Funds Rate

Monthly Data

19921992---- Congress pushed Fannie Mae and Freddie Mac Congress pushed Fannie Mae and Freddie Mac (F&F) to increase mortgages going to low/moderate (F&F) to increase mortgages going to low/moderate income borrowers.income borrowers.

HUD gave F&F percentage targets of their mortgage HUD gave F&F percentage targets of their mortgage financing going to low/moderate incomefinancing going to low/moderate income

1996 1996 –– 46%46%2000 2000 –– 50%50%2005 2005 –– 52%52%

19951995---- Community Reinvestment Act (CRA) of 1977Community Reinvestment Act (CRA) of 1977commercial bankscommercial banks increase loans to low/moderate income increase loans to low/moderate income households. households. This doubled the number of bank loans to that category in This doubled the number of bank loans to that category in ten years. ten years.

19971997----The Taxpayer Relief Act of 1997 increased the The Taxpayer Relief Act of 1997 increased the demand for higher value propertiesdemand for higher value properties

The capitalThe capital--gains exclusion increased from $125,000 to gains exclusion increased from $125,000 to $500,000$500,000Capital gains exclusion for most rental propertiesCapital gains exclusion for most rental properties

Overall, public policies increased the demand for Overall, public policies increased the demand for housinghousing

Payroll EmploymentPayroll Employment

Monthly Data, -250,000(p) October

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OversightOversight

There be two oversight committees over the There be two oversight committees over the Troubled Assets Relief Program of the Act.Troubled Assets Relief Program of the Act.

1.1. Congressional oversight panelCongressional oversight panelFive members appointed by House and Senate Five members appointed by House and Senate leadership from both parties.leadership from both parties.

2.2. Financial Stability BoardFinancial Stability BoardReports to Congressional PanelReports to Congressional PanelMade up of Made up of ---- Fed Chair, SEC Chair, Fed Home Fed Chair, SEC Chair, Fed Home Fin Dir, HUD Sec, Treasury SecFin Dir, HUD Sec, Treasury Sec