Was the U.S. Was the U.S. Government Bailout in Government Bailout in

the 2008 Economic the 2008 Economic Meltdown a Good Idea?Meltdown a Good Idea?

Using Economic Concepts to Explain a Using Economic Concepts to Explain a Real Economic IssueReal Economic Issue

By R. Mahoney – York Mills CIBy R. Mahoney – York Mills CI

THE VIDEOTHE VIDEO

BACKGROUNDBACKGROUND

Cheap LoansCheap Loans

Financial institutions make cheap loans Financial institutions make cheap loans available (available (subprime loanssubprime loans) below ) below “reasonable” interest rates“reasonable” interest rates

NINJA loans (no income/no job/no assets)NINJA loans (no income/no job/no assets)

People able to purchase homes with little People able to purchase homes with little or no down paymentor no down paymentSubprime loans went from $35 billion in Subprime loans went from $35 billion in 1994 to $600 billion in 2006 1994 to $600 billion in 2006 (Bernanke)(Bernanke)

Home Prices IncreaseHome Prices Increase

Cheap loans mean more people qualify for Cheap loans mean more people qualify for mortgages for homeownership.mortgages for homeownership.

Also provides opportunity for speculators or Also provides opportunity for speculators or “home flippers” to participate in the housing “home flippers” to participate in the housing market more easilymarket more easily40% of purchases were not primary in 2006 40% of purchases were not primary in 2006 (vacation, rental investment or flipping) (vacation, rental investment or flipping) (Christie)(Christie)

Both of these factors push up Both of these factors push up demanddemand for homes for homes creating a “real estate bubble”creating a “real estate bubble”

Impact of Increased Demand for Impact of Increased Demand for Homes on Home PricesHomes on Home Prices

House PricesS1

D1

P2

Q1

P1

D2

Q2

SHORTAGE

Quantity of Homes

Impact of Increased Demand?Impact of Increased Demand?

Home prices increase by 124% between Home prices increase by 124% between 1997 and 2006 1997 and 2006 (“CSI:Credit Crunch”)(“CSI:Credit Crunch”)

The increased value also meant people The increased value also meant people took out second mortgages to finance took out second mortgages to finance home expansion or often home expansion or often consumer consumer spendingspending on goods such as cars and on goods such as cars and electronicselectronics

Second MortgagesSecond Mortgages

House valued at $200,000 bought with House valued at $200,000 bought with $10,000 down and a $190,000 mortgage.$10,000 down and a $190,000 mortgage.

Value increases to $300,000Value increases to $300,000

Take out a line of credit or second Take out a line of credit or second mortgage to the tune of $50,000mortgage to the tune of $50,000

Now owe $240,000, but the house is worth Now owe $240,000, but the house is worth $300,000 ($60,000 in equity instead of $300,000 ($60,000 in equity instead of $10,000)$10,000)

Financial Markets ComplicateFinancial Markets Complicate

Institutions parcel off and re-sell mortgages to Institutions parcel off and re-sell mortgages to other institutions (so called “credit default other institutions (so called “credit default swaps” and “toxic loans”)swaps” and “toxic loans”)

Margins (or returns) on the mortgages get Margins (or returns) on the mortgages get smaller and smaller.smaller and smaller.

Mortgages are based on property values that Mortgages are based on property values that are artificially too high because of cheap loans are artificially too high because of cheap loans and speculatorsand speculators

Few buyers/investors understand the real risksFew buyers/investors understand the real risks

New HomesNew Homes

Speculators also cash in through the Speculators also cash in through the building of new homes.building of new homes.This begins to increase the This begins to increase the supplysupply of of homeshomesAn increasing number of “bad loan” An increasing number of “bad loan” customers begin defaulting on loans customers begin defaulting on loans causing banks to foreclose and put more causing banks to foreclose and put more homes on the market.homes on the market.These two factors “pop the bubble”These two factors “pop the bubble”

Impact of More Homes on the Impact of More Homes on the Housing MarketHousing Market

House PricesS1

P2

D2

Q2

S3

P3

Surplus

Q3 Quantity of Homes

More ForeclosuresMore Foreclosures

Housing prices decrease by 20% between Housing prices decrease by 20% between 2006 and 2008 2006 and 2008 (“A Helping Hand”)(“A Helping Hand”)

Nervous banks call in more loans and are Nervous banks call in more loans and are quicker to foreclose (take a person’s quicker to foreclose (take a person’s house from them to sell it and recover the house from them to sell it and recover the loaned money)loaned money)Foreclosures went from 717,000 in 2006 Foreclosures went from 717,000 in 2006 to 1.3 million in 2007 to 1.3 million in 2007 (“Number of foreclosures”)(“Number of foreclosures”) and 2.3 and 2.3 million in 2008 million in 2008 (Armour)(Armour)

So why did banks collapse?So why did banks collapse?

The loans were backed by artificially high The loans were backed by artificially high housing priceshousing pricesIn 2008 11% of homeowners had “zero or In 2008 11% of homeowners had “zero or “negative” equity “negative” equity (Andrews and Uchitelle)(Andrews and Uchitelle)

Negative equity???Negative equity???

Remember the $200,000 home that Remember the $200,000 home that increased in value to $300,000?increased in value to $300,000?

The owner had $240,000 in loans based The owner had $240,000 in loans based on that value.on that value.

Say the increased house supply reduced Say the increased house supply reduced its value to $210,000.its value to $210,000.

If the bank foreclosed and sold the home it If the bank foreclosed and sold the home it would still lose $30,000would still lose $30,000

Negative Equity and the Financial Negative Equity and the Financial SectorSector

Total home equity in the US in 2006 was Total home equity in the US in 2006 was $13 trillion$13 trillion

By 2008 it had fallen to $8.8 trillionBy 2008 it had fallen to $8.8 trillion

““Free cash” from home equity extraction Free cash” from home equity extraction was $427 billion in 2001was $427 billion in 2001

This went up to $1.4 trillion by 2005 (and This went up to $1.4 trillion by 2005 (and totaled about $5 trillion over those 5 years)totaled about $5 trillion over those 5 years)

(“Spending Boosted”)(“Spending Boosted”)

Impact on Impact on Money SupplyMoney Supply

Huge mortgage losses frightened depositors that Huge mortgage losses frightened depositors that banks did not have a way to replace banks did not have a way to replace reservesreserves to to pay them backpay them backWithdrawals changed in one week from $7 Withdrawals changed in one week from $7 billion to $145 billion billion to $145 billion (Gullapalli)(Gullapalli)

Potential to shrink Potential to shrink money supplymoney supply by $1.4 trillion by $1.4 trillion (with a (with a 10% reserve ratio = money multiplier of 10% reserve ratio = money multiplier of 1010))Banks couldn’t replace cash reserves fast Banks couldn’t replace cash reserves fast enough (even with foreclosures)enough (even with foreclosures)

GDP = C + G + I + (X-M)GDP = C + G + I + (X-M)

THE IDEATHE IDEA

The Stimulus PackageThe Stimulus Package

Very Very KeynesianKeynesian in nature in nature A tax rebate package - $168 billion to A tax rebate package - $168 billion to stimulate stimulate ConsumptionConsumption and and InvestmentInvestment (“Bush signs”)(“Bush signs”)

$505 Billion in new $505 Billion in new government spendinggovernment spending - - energy, education, health care and energy, education, health care and infrastructure infrastructure (Teslik)(Teslik)

Boost US Boost US deficitdeficit to $1.2 trillion in 2009 to $1.2 trillion in 2009 (Teslik)(Teslik)

The Bank BailoutThe Bank Bailout

318 US banks collapse between 2007 and 318 US banks collapse between 2007 and 2010 2010 (United States)(United States)

Big scare was failure of Fannie Mae and Big scare was failure of Fannie Mae and Freddie Mac in 2008 which owned or Freddie Mac in 2008 which owned or guaranteed 50% of the $12 trillion guaranteed 50% of the $12 trillion mortgage market in the US mortgage market in the US (Duhigg)(Duhigg)

Bailout of $700 billion (boosting reserves) Bailout of $700 billion (boosting reserves) to prevent banks from further collapseto prevent banks from further collapseAlso prevents shrinkage of money supply Also prevents shrinkage of money supply

GDP = C + G + I + (X-M)GDP = C + G + I + (X-M)

AD3

Economic GoalsEconomic GoalsThe actions of the Federal Reserve The actions of the Federal Reserve

and the US government were and the US government were designed to promote the goals of:designed to promote the goals of: economic growtheconomic growth full employmentfull employment

BUT contradicted the goal of:BUT contradicted the goal of: reduced public debtreduced public debt

WAS IT A GOOD IDEA?WAS IT A GOOD IDEA?

Was it a Good Idea?Was it a Good Idea?

““The White House says the multiyear $814 The White House says the multiyear $814 billion stimulus program passed by billion stimulus program passed by Congress in 2009 boosted employment by Congress in 2009 boosted employment by 2.5 million to 3.6 million jobs and raised 2.5 million to 3.6 million jobs and raised the nation's annual the nation's annual economic outputeconomic output by by almost $400 billion. A recent study by two almost $400 billion. A recent study by two prominent economists generally agrees, prominent economists generally agrees, crediting the pump-priming with averting crediting the pump-priming with averting "what could have been called Great "what could have been called Great Depression 2.0."” Depression 2.0."” (Lynch)(Lynch)

U.S. Unemployment RateU.S. Unemployment RateYearYear Unemployment RateUnemployment Rate

20062006 4.24.2

20072007 4.24.2

20082008 5.25.2

20092009 8.58.5

20102010 8.88.8

20112011 8.28.2

20122012 8.18.1United States. United States Department of Labour. Bureau of Labour Statistics. Labor Force Statistics from the Current Population Survey. Bureau of Labour Statistics, 23 Nov. 2012. Web. 23 Nov. 2012. <http://data.bls.gov/timeseries/LNS14000000>.

U.S. Real GDP Growth RateU.S. Real GDP Growth RateYearYear Real GDP Growth RateReal GDP Growth Rate

20062006 2.7%2.7%

20072007 1.9%1.9%

20082008 -0.3%-0.3%

20092009 -3.1%-3.1%

20102010 2.4%2.4%

20112011 1.8%1.8%

20122012 2.0% (32.0% (3rdrd Q) Q)

United States. U.S. Department of Commerce. Bureau of Economic Analysis. Table 1.1.1. Percent Change From Preceding Period in Real Gross Domestic Product. Bureau of Economic Analysis, 26 Oct. 2012. Web. 23 Nov. 2012. <http://www.bea.gov/iTable/iTable.cfm?ReqID=9>.

U.S. Annual Inflation RateU.S. Annual Inflation RateYearYear Inflation RateInflation Rate

20062006 2.5%2.5%

20072007 4.1%4.1%

20082008 0.1%0.1%

20092009 2.7%2.7%

20102010 1.5%1.5%

20112011 3.0%3.0%

20122012 2.2% (Oct.)2.2% (Oct.)

United States. United States Department of Labour. Bureau of Labour Statistics. Table Containing History of CPI-U for United States. Bureau of Labour Statistics, 16 Nov. 2012. Web. 23 Nov. 2012. <ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt>.

YearYear Unemployment Unemployment RateRate

Real GDP Real GDP Growth RateGrowth Rate

Inflation RateInflation Rate

20062006 4.2%4.2% 2.7%2.7% 2.5%2.5%

20072007 4.2%4.2% 1.9%1.9% 4.1%4.1%

20082008 5.2%5.2% -0.3%-0.3% 0.1%0.1%

20092009 8.5%8.5% -3.1%-3.1% 2.7%2.7%

20102010 8.8%8.8% 2.4%2.4% 1.5%1.5%

20112011 8.2%8.2% 1.8%1.8% 3.0%3.0%

20122012 8.1%8.1% 2.0% (32.0% (3rdrd Q) Q) 2.2% (Oct.)2.2% (Oct.)

Was it a Good Idea (cont’d)Was it a Good Idea (cont’d)

““economists at Goldman Sachs, IHS Global economists at Goldman Sachs, IHS Global Insight, JPMorgan Chase and Macroeconomic Insight, JPMorgan Chase and Macroeconomic Advisers….say the stimulus boosted Advisers….say the stimulus boosted gross gross domestic productdomestic product by 2.1% to 2.7%.” by 2.1% to 2.7%.” (Lynch)(Lynch)

““The fiscal stimulus created 2.7 million jobs and The fiscal stimulus created 2.7 million jobs and added $460 billion to added $460 billion to gross domestic productgross domestic product. . Unemployment Unemployment would be 11% today [instead of would be 11% today [instead of 9%] if the stimulus hadn't been passed and 9%] if the stimulus hadn't been passed and 16.5% if neither the fiscal stimulus nor the 16.5% if neither the fiscal stimulus nor the banks' rescue had been enacted, according to banks' rescue had been enacted, according to Zandi and Blinder.” Zandi and Blinder.” (Lynch)(Lynch)

SourcesSources

““A helping hand to homeowners.” A helping hand to homeowners.” The Economist.The Economist. 23 October 2008. 28 September 2009 23 October 2008. 28 September 2009 <http://www.economist.com/businessfinance/displayStory.cfm?story_id=12470547><http://www.economist.com/businessfinance/displayStory.cfm?story_id=12470547>

Andrews, Edmond L. and Louis Uchitelle. “Rescues for Homeowners in Debt Weighed.” Andrews, Edmond L. and Louis Uchitelle. “Rescues for Homeowners in Debt Weighed.” New York TimesNew York Times. 22 . 22 February 2008. 28 September 2009 <http://www.nytimes.com/2008/02/22/business/22homes.html?_r=1>February 2008. 28 September 2009 <http://www.nytimes.com/2008/02/22/business/22homes.html?_r=1>

Armour, Stephanie. “2008 foreclosure filings set record.” Armour, Stephanie. “2008 foreclosure filings set record.” USATODAY.com.USATODAY.com. 14 January 2008. 14 January 2008. USA TODAY.USA TODAY. 28 28 September 2009 <http://www.usatoday.com/money/economy/housing/2009-01-14-foreclosure-record-September 2009 <http://www.usatoday.com/money/economy/housing/2009-01-14-foreclosure-record-filings_N.htm>filings_N.htm>

Bernanke, Ben S. “Fostering Sustainable Homeownership.” Speech. 14 March 2008. Bernanke, Ben S. “Fostering Sustainable Homeownership.” Speech. 14 March 2008. United States Federal United States Federal ReserveReserve. . 28 September 2009 28 September 2009 <http://www.federalreserve.gov/newsevents/speech/bernanke20080314a.htm><http://www.federalreserve.gov/newsevents/speech/bernanke20080314a.htm>

"Bush Signs Stimulus Package into Law." Msnbc.com. Msnbc.com, 13 Feb. 2008. Web. 3 May 2012. "Bush Signs Stimulus Package into Law." Msnbc.com. Msnbc.com, 13 Feb. 2008. Web. 3 May 2012. <http://www.msnbc.msn.com/id/23143814/ns/business-stocks_and_economy/t/bush-signs-stimulus-<http://www.msnbc.msn.com/id/23143814/ns/business-stocks_and_economy/t/bush-signs-stimulus-package-law/#.T6MkZMXwCSo>. package-law/#.T6MkZMXwCSo>.

Christie, Les. Christie, Les. “Homes: Big drop in speculation.” “Homes: Big drop in speculation.” CNNMoney.com.CNNMoney.com. 30 April 2007. 28 September 2009 30 April 2007. 28 September 2009 <http://money.cnn.com/2007/04/30/real_estate/speculators_fleeing_housing_markets/index.htm><http://money.cnn.com/2007/04/30/real_estate/speculators_fleeing_housing_markets/index.htm>

““CSI: credit crunch.” CSI: credit crunch.” The Economist.The Economist. 18 October 2007. 28 September 2009 18 October 2007. 28 September 2009 <http://www.economist.com/specialreports/displaystory.cfm?story_id=9972489><http://www.economist.com/specialreports/displaystory.cfm?story_id=9972489>

Sources (cont’d)Sources (cont’d)Duhigg, Charles. “Loan-Agency Woes Swell From a Trickle to a Torrent.” Duhigg, Charles. “Loan-Agency Woes Swell From a Trickle to a Torrent.” NYTimes.comNYTimes.com. 11 July 2008. 28 September 2009 <. 11 July 2008. 28 September 2009 <

http://www.nytimes.com/2008/07/11/business/11ripple.html?_r=1>.>.

Lynch, David J. "Economists Agree: Stimulus Created Nearly 3 Million Jobs." USAToday.com. USA Today, 30 Aug. 2010. Web. Lynch, David J. "Economists Agree: Stimulus Created Nearly 3 Million Jobs." USAToday.com. USA Today, 30 Aug. 2010. Web. 3 May 2012. <http://www.usatoday.com/money/economy/2010-08-30-stimulus30_CV_N.htm>. 3 May 2012. <http://www.usatoday.com/money/economy/2010-08-30-stimulus30_CV_N.htm>.

““Number of foreclosures soared in 2007.” Number of foreclosures soared in 2007.” msnbc.com.msnbc.com. 29 January 2009. 28 September 2009 < 29 January 2009. 28 September 2009 <http://www.msnbc.msn.com/id/22893703/>.>.

Shell, Adam. “Stock market losses take a personal toll on investors.” Shell, Adam. “Stock market losses take a personal toll on investors.” USATODAY.comUSATODAY.com. 23 March 2009. . 23 March 2009. USA TODAYUSA TODAY. 28 . 28 September 2009 < September 2009 < http://www.usatoday.com/money/markets/2009-03-23-investor-pain_Nhtm>.>.

"Spending Boosted by Home Equity Loans: Greenspan| Reuters." "Spending Boosted by Home Equity Loans: Greenspan| Reuters." Business & Financial News, Breaking US & International News | Business & Financial News, Breaking US & International News | Reuters.comReuters.com. Reuters, 23 Apr. 2007. Web. 04 Nov. 2010. <http://www.reuters.com/article/idUSN2330071920070423>.. Reuters, 23 Apr. 2007. Web. 04 Nov. 2010. <http://www.reuters.com/article/idUSN2330071920070423>.

Teslik, Lee H. "The U.S. Economic Stimulus Plan." The U.S. Economic Stimulus Plan. Council on Foreign Relations, 18 Feb. Teslik, Lee H. "The U.S. Economic Stimulus Plan." The U.S. Economic Stimulus Plan. Council on Foreign Relations, 18 Feb. 2009. Web. 03 May 2012. <http://www.cfr.org/united-states/us-economic-stimulus-plan/p18348>. 2009. Web. 03 May 2012. <http://www.cfr.org/united-states/us-economic-stimulus-plan/p18348>.

United States. Federal Deposit Insurance Corporation. Failed Bank List. 25 Mar. 2011. Web. 05 Apr. 2011. United States. Federal Deposit Insurance Corporation. Failed Bank List. 25 Mar. 2011. Web. 05 Apr. 2011. <http://www.fdic.gov/bank/individual/failed/banklist.html>.<http://www.fdic.gov/bank/individual/failed/banklist.html>.