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Ohio Wesleyan University Goran Skosples 12. The Great Recession

Ohio Wesleyan University Goran Skosples 12. The Great Recession. The 2008-09 Financial Crisis & Recession Causes of the Crisis Macroeconomic consequences Policy responses. CASE STUDY The 2008-09 Financial Crisis & Recession. 2009-2010: Real GDP fell, u-rate hit 10%

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Ohio Wesleyan University Goran Skosples 12. The Great Recession

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  1. Ohio Wesleyan UniversityGoran Skosples12. The Great Recession

  2. The 2008-09 Financial Crisis & Recession • Causes of the Crisis • Macroeconomic consequences • Policy responses

  3. CASE STUDYThe 2008-09 Financial Crisis & Recession 2009-2010: Real GDP fell, u-rate hit 10% Important factors in the crisis: early 2000s Federal Reserve interest rate policy sub-prime mortgage crisis bursting of the housing price bubble, rising foreclosure rates falling stock prices failing financial institutions declining consumer confidence, drop in spending on consumer durables and investment goods

  4. Potential GDP

  5. Unemployment

  6. Origins • Global savings glut • high saving rates in emerging markets (Asia) • rising _____ markets: • Great Moderation • low ______, low ____________, rising ______ prices • Banking industry • “originate and distribute model” - ____________ • collateralized debt obligations (CDOs), mortgage-backed securities (MBSs), asset-backed commercial paper • lending to the ___________ market • short-term borrowing to finance assets

  7. Major US Stock Market Indexes

  8. US Housing Market • Trigger for the Crisis • US housing prices decline • Why did house prices increase so much? • low interest rates • lending to subprime borrowers • Fannie Mae and Freddie Mac – GSE (Government Sponsored Enterprises) • IndyMac • Government’s goal to increase homeownership

  9. Interest rates and house prices

  10. Homeownership Rate

  11. Inflation

  12. Federal Funds Rate

  13. Crisis • adjustable-rate mortgages (ARMs) reset to higher rates • mortgage delinquencies increased • decline in the price of houses • lower ability to borrow (indebtness, source) • oversupply of housing • Mortgage losses cannot explain overall losses • amplification • leverage • complexity • liquidity

  14. Increasing level of debt

  15. Subprime Mortgages

  16. U.S. Residential Mortgage Delinquencies

  17. House price change and new foreclosures, 2006:Q3 – 2009Q1 Nevada Illinois Florida Ohio Michigan California Georgia New foreclosures, % of all mortgages Colorado Arizona Rhode Island Texas New Jersey S. Dakota Hawaii Oregon Wyoming Alaska N. Dakota Cumulative change in house price index

  18. Bank A Bank A Bank B Bank B Assets 100 Assets 90 Liabilities 80 Capital 20 Liabilities 80 Capital Assets 100 Assets 90 Liabilities 95 Capital 5 Liabilities 95 Capital Leverage • Capital ratio = capital/assets (20% vs 5 %) • Leverage ratio = assets/capital (5 vs 20) • Ex. Suppose 10% of assets go bad

  19. Leverage • Small losses can lead to bankruptcies • Why leverage so high? • Ex. Suppose assets pay an expected 5% and liabilities cost an expected 4% • Expected return of capital • A: (100*5% - 80*4%)/20 = ____% • B: (100*5% - 95*4%)/5 = ____% • But, higher leverage also carries higher risk

  20. Leverage • Reasons? • Banks underestimated risks they were taking • Compensation and bonus system favored high _______-term return • ______ banking system • banks kept risky assets off-balance (Structured Investment Vehicles – SIVs) • relatively small losses in the mortgage markets prompted huge losses of SIVs • by 10/2008, no SIVs left

  21. Complexity • rise of new financial instruments - securitization • MBS: ________________ securities • CDO: ________________ obligation • CDS: ________________ swap • allowed for diversification of risk • Uncertainty of how leveraged banks are through the shadow banking system • When underlying mortgages started collapsing, hard to value securities  ______ assets

  22. Liquidity • What is liquidity and why was it so important? • in 1990s and 2000s, banks relied on new sources of funding to fund investments • borrowing from other banks or other investors • short-term funding • wholesale funding (especially SIVs) • gave banks flexibility and more funds • problems if other banks/investors unwilling to lend • lack of funds  need to __________ assets • ______ sales further decline in capital • modern version of a bank run

  23. Origins of the Crisis • February 2007 • an increase in defaults in the subprime market • Freddie Mac announces it will not lend to most risky subprime borrowers anymore • April 2007 • New Century Financial Corporation files for bankruptcy • the largest lender to subprime borrowers • May 2007 • UBS’s hedge fund closed after $125m losses

  24. Origins of the Crisis • June 2007-July 2007 • rating agencies start downgrading mortgage-backed assets • Bear Sterns liquidates two MBS related hedge funds • Countrywide warns of large losses • August 9, 2007 • BNP Paribas closes three investment funds • money market participants become very reluctant to lend to each other • inability to _______ short-term debt

  25. Global Issuance of ABSs and CDOs

  26. Source of short-term funding

  27. Hoarding Liquidity

  28. Risk Premium

  29. CDS Premia

  30. Origins of the Crisis • The Fed’s response • lower the discount rate by 0.50% to 5.75% • broadening of collateral banks can post • lengthening the lending horizon to 30 days • lower target for the federal funds rate 5.254.75 • September 2007 • Northern Rock helped by the Bank of England • bank run  collapse

  31. Interbank funding liquidity

  32. Origins of the Crisis • October 2007 • write-downs by banks and wealth funds • November 2007 • revision of mortgage losses upward from $200b • banks had to write-down further • December 2007 • Fed cuts the discount and the federal funds rate • creation of _________________ (TAF) • January 2008 • downgrading of “monoline insurers” credit rating • federal funds and discount rates reduced twice

  33. Origins of the Crisis • March 2008 • spread between Treasury and _______ bonds (issued by Fannie/Freddie) widened • Carlyle Group’s collateral liquidated after failing to meet a margin call • Bear Sterns • heavily invested in agency bonds • creditor to Carlyle • Term Securities Lending Facility • swap agency/other MB-related bonds for Treasuries • interpreted as difficulty of investment banks

  34. Origins of the Crisis • cont. • Bear Sterns • viewed as too leveraged and in most difficulty • unable to get funding on the repo market • Fed negotiated a sale to JPMorgan Chase for $10 per share ($150 per share less than a year before) • Fed opened Primary Dealer Credit Facility • discount window for investment banks • eased funding for other investment banks (Lehman) • April-August 2008 • worsening conditions for the MBSs • the Housing and Economic Recovery Act of 2008

  35. Origins of the Crisis • September 2008 • Fannie and Freddie put into conservatorship • Lehman Brothers • did not raise enough capital since March • Korea Dev’t Bank backed out of a deal to purchase Lehman  shared plunged • Bank of America and Barclays potential new buyers • Treasury and Fed officials decline a guarantee • 9/15 Lehman files for bankruptcy • AIG (the largest insurer of CDSs) • 9/16: shares fall by 90% • rescue package of $85b for 80% equity because it is too interconnected  _________________

  36. Summary of Macroeconomic Shocks • Demand shock • housing market decline • and subsequent problems in the financial markets • decline in both consumer and business confidence • Supply shock • Oil Price • in July 2008, $147.30 per barrel • demand from the emerging markets • supply growth slowdown • speculation

  37. Oil Price

  38. Crisis • Bank failures and sales • Washington Mutual, Wachovia • Stock markets plunged • Problems spilled over from Wall Street to Main Street • credit for firms and local governments dried up • fall in consumer and business confidence

  39. Dow Jones Industrial Average

  40. U.S. bank failures by year, 2000-2009 * * as of April 9, 2010.

  41. Consumer sentiment and growth in consumer durables and investment spending

  42. Real GDP growth and Unemployment

  43. Macroeconomics Shocks r P LM1 r1 IS1 Y Y Y1 P1 SRAS1 AD1 Y1 • Demand Shock: • _ in house prices • _ uncertainty • _ consumer & business confidence • IS & AD shift __ Supply Shock: • _ in price of oil •  SRAS and LM shift __

  44. Federal Funds Rate

  45. Monetary Base

  46. Money Multiplier

  47. Liquidity

  48. LM1 r IS1 Y Y Liquidity Trap • Negative shock to the IS curve: • IS curve shifts __ • where does the new IS curve cross the LM curve? • Fed’s response? Y1 • it may be that the necessary interest rate is below __

  49. Liquidity Trap and Deflation • Liquidity trap is when individuals are not willing to borrow to finance spending and investment • Borrowing depends on the real rate of interest (r ) • Fisher equation: r = i – π • i cannot be ________ (_______________) • suppose 3% deflation  r = 0 – (–3) = • Deflation worsens the situation • creating inflation lowers the real interest rate • Traditional monetary policy may be useless

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