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Chicago Association of Realtors Member Outreach October 2008. From uncertainty to certainty: a recession is upon us. The Fed has taken extreme measures to prevent collapse of financial markets
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Chicago Association of Realtors Member Outreach October 2008
From uncertainty to certainty: a recession is upon us • The Fed has taken extreme measures to prevent collapse of financial markets • They have been successful in preventing catastrophe, but not preventing a recession (not that they can stop a recession!) • Credit quality and availability, real estate, oil prices, and creation of new jobs have been the center of attention throughout
Let’s look for a turning point • Business cycle analysts use four important indicators in addition to GDP to determine the business cycle turning points: • Industrial production • Labor markets, mainly jobs created • Retail sales • Personal Income
Housing is a disaster: everything moving in the wrong direction! • Construction: Down • Prices: Down • Sales: Down • Permits: Down • Foreclosures: Up • Inventories: Up
The bail out: some basics, as of today at least • The initial idea: stop the weakness in the financial markets from taking the rest of the economy with it • The key word is restore: • Restore liquidity • Restore confidence • Restore common economic sense
The sources of the problem set up a house of cards • Subprime mortgages • Alt-A mortgages • Fannie and Freddie lose their minds + market assumes an implicit government guarantee • Credit Default Swaps: insuring loss with no sense of the risk of these promises • A housing bubble (we now know in retrospect)
What brought the house of cards down? • The housing bubble burst • Without rising house prices, many mortgages that may have survived went bad • The holders had to mark the assets to market, which took firms that are cash-flow solvent to insolvent, or at least cautious • Banks, holding all the bad paper, stop lending: hold the dollars to back up bad loans, worry about counter-party risk
Lending stops: how do we know? • TED (Treasury versus LIBOR), and LIBOR versus OIS (Overnight index swaps) moved from a few basis points to 300-400 basis points; thank goodness the spreads are falling • This reflects the level of counter-party risk – you will not lend if you worry that the other side of the loan will default, even if it is a bank
So what to do? The Fed • Initially the Fed stepped in through its role of lender of last resort • The role was expanded well beyond banks, and it involved collateral that would normally not be accepted • Now moved into the commercial paper market • Moves were bold, necessary, and stopped a total collapse, but they were not yet enough
So what to do? The Treasury • Initial plan was to buy up the bad mortgage paper, removing it from the banks’ balance sheets frees up the money to be loaned • Now the government will inject capital directly by buying preferred shares, recapitalizing the banks and freeing up money to be lent
Role for bank insurance • European countries began to expand dramatically their promise to insure bank deposits • The FDIC followed by raising the limit to $250,000; more may be necessary • FDIC has been given unlimited borrowing power at the Treasury in the case of disaster
Do many hate everything that was done? You bet! • Currently: the US government owns an insurance company, will own banks, will set up a terrible moral hazard problem, and there are no guarantees that banks will lend to boot • Then why do it? The alternative would be worse
What should happen • Credit will begin to flow between banks, and then to the deserving public • This will hasten the reduction in the excess inventory in housing • Equity markets may stabilize, allow banks to get capital from private sources • Both will raise household wealth, which can help stimulate the economy
View from the top • As Bernanke said Monday, the damage has been done; we are in for a two- to three-quarter recession • He recommends a second stimulus package by congress that should be targeted, efficient, well timed, and that has no long-term negative effects
Sources of data and contact information • Mike Miller: mmiller@depaul.edu Data Sources: • Bureau of Economic Analysis: bea.gov • Bureau of Labor Statistics: bls.gov • Federal Reserve Beige Book: http://www.federalreserve.gov/fomc/beigebook/2008/20080903/default.htm • FRED: http://research.stlouisfed.org/fred2/
Recommended reading • The testimony on Monday by Fed Chairman Ben Bernanke is an excellent summary of the current situation and future outlook for financial markets and the economy: http://www.federalreserve.gov/newsevents/testimony/bernanke20081020a.htm