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Chapter 33 - Financial crisis. After studying this chapter you will be able to understand: What role irrational expectations and leverage play in financial crises? What role mortgage-backed securities and tranching played in the rise of subprime lending? How to analyze the factors that lead to the housing bubble and increased household debt?...
Chapter 33 Financial Crisis © 2014 by McGraw-Hill Education What will you learn in this chapter? • What role irrational expectations and leverage play in financial crises • What role mortgage-backed securities and tranching played in the rise of subprime lending • How to analyze the factors that lead to the housing bubble and increased household debt • How the housing bubble collapse created a credit crisis and drop in output • What tools are used to stimulate the economy when interest rates hit the zero lower bound © 2014 by McGraw-Hill Education The origins of financial crises • Two interconnected concepts lie at the heart of many financial crises Irrational expectations: The price of an asset can become so inflated that it is unclear why it should be so valuable – Herd instinct may push investors to buy because everyone else is – Recency effect is a cognitive bias that causes humans to overvalue recent experience when trying to predict the future Leverage: The practice of using borrowed money to pay for investments – This allows people to make investments that are larger than the amount they own – Leverage is not necessarily dangerous, so long as it is limited and investors understand the risks well © 2014 by McGraw-Hill Education Active Learning: Determining Irrationality Determine whether or not each of the following scenarios is an example of irrational expectations A CEO proclaims that the company will indefinitely remain profitable, similar to the last five years The SEC cracks down on an investment bank’s fraudulent trading The bank’s stock falls 15% Given a mild winter, the prices of snow shovels is lower © 2014 by McGraw-Hill Education The South Seas Bubble • The South Seas Company participated in the London’s Exchange Alley in the 1600s • The price of the company’s stock jumped significantly after it was granted a government trade monopoly between England and South America – It was never clear how the company was going to earn enough to justify such jumps in the stock price • Investors cashed in when prices were high • Parliament enacted the Bubble Act to regulate publically-traded companies © 2014 by McGraw-Hill Education The Great Crash of 1929 • The Great Crash of 1929 is arguably the most infamous stock market crash in history • After WWI, returning soldiers boosted production – The value of the stock market more than tripled • On October 24, 1929—“Black Thursday”—the leading index of stock prices dropped 9% – Once prices started to drop, everyone tried to sell their stocks before prices dropped further © 2014 by McGraw-Hill Education The Great Recession: A financial-crisis case study • In the 1930s, Congress passed several laws to prevent similar crises • The Glass-Steagall Banking Act of 1933 – Required the separation of investment and commercial banks – Established the Federal Deposit Insurance Corporation (FDIC) to insure deposits against bank failures • The Securities and Exchange Act of 1932 • Formed the Securities and Exchange Commission (SEC) to regulate the securities industry • These reforms contributed to a long period of relative stability in financial markets © 2014 by McGraw-Hill Education The Great Recession: A financial-crisis case study • There are several origins of the most recent financial crisis • The world’s governments had extraordinary monetary and fiscal responses using financial and macroeconomics concepts • To understand how the U.S economy collapsed so suddenly, the interrelated components of the U.S economy must be analyzed: – Subprime lending – The housing and mortgage market – The broader world of consumer debt © 2014 by McGraw-Hill Education Subprime lending • People who cannot obtain a traditional mortgage loan may still become homeowners through subprime mortgages – A subprime mortgage is a loan made to a borrower with a low credit score • Subprime mortgages became available due to securitization – Securitization is the practice of packaging individual debts into a single uniform asset – Investment banks created mortgage-backed securities, which were tradable assets made up of individual mortgages • Banks created tranches by dividing debt packages by risk and return characteristics – Low-risk mortgages could be sold to more risk-averse investors – High-risk subprime mortgages could be sold to risk-loving investors – Investors relied on the reassuringly high AAA ratings given to many of these assets • Credit-rating agencies were overly optimistic when rating securities, to attract business and keep Wall Street happy © 2014 by McGraw-Hill Education Subprime lending • Traditionally, new subprime mortgages comprised less than 10% of all new mortgages • In 2004, the rate of new subprime mortgages more than doubled Percentage 25 20% 20 20% 18% 15 10 8% 7% 7% 2001 2002 8% 2003 2004 2005 2006 2007 © 2014 by McGraw-Hill Education 10 The housing bubble The housing bubble was created through a series of actions of banks and homeowners • The sudden explosion of cheap and readily available mortgages encouraged people to buy bigger and better homes • Securitization transferred risk away from lenders, which misaligned incentives – Down payment requirements got smaller and loans got cheaper – Banks issued mortgages even when people couldn’t repay them • Homeowners became more and more leveraged – Some people bought houses solely on the expectation that they would continue to go up in value, even though they couldn’t afford them • The run-up in housing prices represented a classic market bubble © 2014 by McGraw-Hill Education 11 The housing bubble The housing bubble can be observed by the rapid rise in U.S home prices and the number of new housing starts Housing starts (thousands of units) 2,500 Case-Shiller housing price index (Jan 2000 = 100) 250 200 2,000 150 1,500 1,000 100 National composite 50 500 Housing starts 1999 2001 2003 2005 2007 2009 2011 • Rapid increase of housing prices from 1999 to 2006 • Prices peaked in early 2007 and then quickly plummeted © 2014 by McGraw-Hill Education 12 Buying on credit • Flush with the feeling of wealth from their inflated home values, consumers began saving less and spending more – Many used the value of their homes to secure loans and higher limits on their credit cards – This caused overall debt levels in the U.S to increase – Growth in household debt accelerated as the housing market took off • The debt service of consumers was sustainable only as long as interest rates remained low and home values remained high – Debt service is the amount that consumers have to spend to pay their debts – Often expressed as a percentage of disposable income © 2014 by McGraw-Hill Education 13 Buying on credit Since the 1960s, total debt in the United States has more than doubled its share of GDP Historical debt trends in the United States Percent of GDP 400 Total debt 350 300 Financial debt 250 Personal debt 200 150 Corporate debt 100 Federal debt 50 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 © 2014 by McGraw-Hill Education 14 Buying on credit • Household debt has risen considerably over time • Debt payments have not increased much, because interest rates have kept the price of debt low Debt payments and total debt Household financial obligations as a percent of income 20 Household debt as a percent of income 140 19 130 18 120 17 110 16 100 15 90 14 80 Household financial obligations 70 Household debt 60 13 12 11 10 1980 50 1985 © 2014 by McGraw-Hill Education 1990 1995 2000 2005 2010 15 Active Learning: Securitization Determine which is riskier: A $1,000,000 loan with a 17% probability of default A mortgage-backed security worth $1,000,000 with the following risk profile Number of loans Probability of default Weighted risk 40 1.5% 1% 20 5% 1% 25 25% 6% 15 50% 8% © 2014 by McGraw-Hill Education 16 Active Learning: Securitization What would the probability of default on the lowest risk loans in the mortgage-backed security have to be to make the probability of default on the security equal to 18%? Number of loans Probability of default Weighted risk 20 5% 1% 25 25% 6% 15 50% 8% 40 © 2014 by McGraw-Hill Education 17 A brief timeline of the crisis The collapse began in the subprime mortgage market When housing prices stopped rising, consumers were unable to refinance Faced with large debt service, a massive wave of defaults occurred An increase in foreclosed properties increased the supply of housing Housing values decreased as supply increased, leaving many homeowners “underwater.” The result was a vicious cycle of defaults and falling prices © 2014 by McGraw-Hill Education 18 A brief timeline of the crisis The collapse continued through the financial markets Risky real estate investments became worthless – Banks lost trillions of dollars Mortgage-backed securities made it difficult to tell which banks were in trouble, causing the lending market to halt – Many businesses were suddenly unable to access credit for their day-to-day needs Large institutions and companies that had deposited money with Wall Street’s banks withdrew funds – This led to a run on bank assets The reduction in consumption and investment spending shifted the aggregate demand curve to the left © 2014 by McGraw-Hill Education 19 A brief timeline of the crisis • The financial sector performed well in the years leading up to the crisis • Banks announced that they held toxic assets • Prices of stocks throughout the financial sectors plummeted Price per share ($) 90 80 70 Bank of America 60 Lehman Brothers 50 Citigroup 40 30 20 10 2006 2007 2008 2009 2010 © 2014 by McGraw-Hill Education 20 A brief timeline of the crisis The financial crisis can be understood using the AD–AS model Price level SRAS2 SRAS1 P1 P2 AD1 AD2 Y2 Y1 Real GDP © 2014 by McGraw-Hill Education • The housing-market crash caused both AD and AS to shift to the left • This put the economy at a new equilibrium – Lower prices – Reduced output 21 The immediate response to the crisis • Policy-makers used monetary and fiscal policy tools to try to avoid a catastrophic economic collapse • The goal of the 2008 policies was to “unstick” frozen credit markets – Concerned that any attempt to stimulate demand without any supply would be dangerous – This attempts to avoid stagflation, which is when high inflation occurs despite low economic growth and high unemployment © 2014 by McGraw-Hill Education 22 The immediate response to the crisis The Fed attempted to stabilize the financial market by buying up toxic assets The Federal Reserve’s balance sheet Millions ($) 2,500,000 Other assets Loans 2,000,000 1,500,000 1,000,000 Central bank liquidity swaps Term auction credit Net portfolio holdings of Commercial Paper Funding Facility LLC Mortgage-backed securities 500,000 Federal agency debt securities U.S Treasury securities Jan 2008 May 2008 Oct 2008 Feb 2009 Jul 2009 Dec 2009 © 2014 by McGraw-Hill Education 23 The immediate response to the crisis • The U.S Treasury bailed out banks that were considered “too big to fail.” – “Too big to fail” refers to banks so large that banking regulators allow these banks to keep operating despite insolvency – This refers to banks that are large in terms of assets and customers, or ones that are historically important • These bailouts were short-term loans under the Troubled Asset Relief Program (TARP) • Once the financial market started to unfreeze, fiscal policy was introduced to stimulate demand © 2014 by McGraw-Hill Education 24 The immediate response to the crisis The responses of the Fed and Treasury can be understood using the AD–AS model Fed and Treasury intervention • The economy enters into the financial crisis SRAS2 • The Federal Reserve and the Treasury restore aggregate SRAS1 = SRAS3 supply to its original level • Lower interest rates slightly stimulate demand • Sluggish aggregate demand AD causes: Price level P2 P3 AD AD Y2 Y3 Y1 Real GDP – Lower prices – Output to increase (but not to original levels) © 2014 by McGraw-Hill Education 25 Stimulus at the zero lower bound • The Fed engaged in expansionary monetary policy to lower interest rates and encourage borrowing and investment • The Treasury engaged in stimulus spending to increase aggregate demand • Spending stayed weak, so the Fed cut interest rates until they were close to zero, or the zero lower bound • The Fed took extra measures, known as quantitative easing policies, which directly increase the money supply by a certain amount © 2014 by McGraw-Hill Education 26 Summary • Financial crises usually arise from a combination of irrational expectations and leverage • Crises have been around since the first financial markets, and governments have regulated markets to avert crises • The most recent financial crisis occurred when innovations in the subprime lending market led to a dramatic increase in housing prices – Securitization in the mortgage loan market increased the supply of subprime lending © 2014 by McGraw-Hill Education 27 Summary • Securitization increased the demand for housing and pushed up home values • As housing values increased, people felt more wealthy and took on more debt • This bubble popped and many borrowers defaulted on their debt • As households faced a negative shock to wealth, consumers began saving more and consuming less • These actions led to a decrease in aggregate demand and lending, which resulted in a recession â 2014 by McGraw-Hill Education 28 Summary ã The federal government acted quickly to stabilize the financial system – The Fed offered short-term financing to banks – The Treasury bailed out several large banks – The government passed stimulus measures to increase aggregate demand • The Fed engaged in quantitative easing to increase the money supply © 2014 by McGraw-Hill Education 29 10 ... relative stability in financial markets © 2014 by McGraw-Hill Education The Great Recession: A financial- crisis case study • There are several origins of the most recent financial crisis • The world’s... further © 2014 by McGraw-Hill Education The Great Recession: A financial- crisis case study • In the 1930s, Congress passed several laws to prevent similar crises • The Glass-Steagall Banking Act... timeline of the crisis The financial crisis can be understood using the AD–AS model Price level SRAS2 SRAS1 P1 P2 AD1 AD2 Y2 Y1 Real GDP © 2014 by McGraw-Hill Education • The housing-market crash