An Economic Analysis of the Financial Collapse

1. An Economic Analysis of the Financial Collapse National Council for the Social Studies Vital Issues Session November 14, 2009

2. Presenters • Glen Blankenship Georgia Council on Economic Education • Mark Schug University of Wisconsin-Milwaukee • George Vredeveld University of Cincinnati • Richard MacDonald St. Cloud State University

3. Overview • How did the financial crisis affect us? • What are some likely hypotheses regarding the causes of the financial collapse? • What do today's banks do? Hint: Do they still follow the 3-6-3 rule? • Ideas for teaching about the financial crisis • Questions

4. How did the financial crisis affect us?

5. Average Real Disposable Income Was Rising

6. Savings Rates Were Falling

7. Household Debt to Disposable Personal Income Ratio Increases

8. Subprime, Alt-A, and Home Equity Loans Increase

9. Fall in Housing Prices

10. DJIA, S&P and Nasdaq Trends: Stock Wealth Evaporates

11. Default Rates Rise

12. Foreclosure Rates Increase

13. Recession

14. Unemployment

15. What are some likely hypotheses regarding the causes of the financial collapse?

16. What Happened? • In1989 Berlin wall falls. • China and India deregulate. • Expanded production capacity puts damper on inflation. Central banks now can increase money supply without much concern about inflation.

17. What Happened? • In 2001, the Fed consistently lowered interest rate from 6.5% to 1.75 % and to 1.0 % by June 2003.  • Central banks around the world followed suit creating an unprecedented increase in the supply of credit.

18. What Happened? • The low rates made borrowed money cheap and households and businesses responded as expected: they bought and bought. • In the housing market, the Case-Shiller home price index increased 80% from January 2001 to December 2005.

19. What Happened? • Federal government aggressively promotes home ownership • Homeownership rate increased from normal 64 percent (which was the rate for 35 years) to 69 percent in 2004 • Subprime loans totaled $330 billion in 2001 • By 2004 they reached $1.1 trillion (37% of residential mortgages) • By 2006 they were 48% of all mortgages.

20. What Happened? • In mid-2004, the Fed reversed its interest policy -- the rate climbed to 2.25 % by December 2004 and reached 5.25% in 2006. • The demand for houses and other durable goods decreased and prices declined 33% from a peak in July 2006.

21. Interest Rates and Lagged Housing Prices Housing prices Interest rates

22. Housing Bubble – Jan 92 to July 09source: S&P Case-Schiller National Home Price Index 1987-2008 - inflation adjusted

23. Leverage The magnitude of the current financial crisis has grown because of the amount of leverage used.

24. Leverage and Incentives • Investment banks were leveraged by a ratio of 30 to 1, government sponsored mortgage giants Freddie and Fannie were closer to 50 to 1. • When asset prices are rising, this system works like a dream.

25. What do today’s banks do?

26. WHAT DO BANKS DO? (source: http://www.fdic.gov/deposit/insurance/risk/2005_01/economy_fig14.html

27. Non-Interest income is increasing as a proportion of net operating revenue (source: Bank Management,6th edition.imothy W. Koch and S. Scott MacDonald 90% 90% 80% 80% 70% 70% Net Interest Income 60% 60% 50% 50% 40% 40% 30% Noninterest Income 30% 20% Actual Data Predicted 20% 10% 0% 10% 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

28. Composition of Noninterest Income by Bank Size as a Percentage of Total Assets, 2004 (source: Bank Management,6th edition.Timothy W. Koch and S. Scott MacDonald 0.8% 0.7% < $100M $100M-$1B 0.6% >$1B All Comm. Banks 0.5% 0.4% 0.3% 0.2% 0.1% 0.0% service Deposit charges activities Fiduciary Investment advisory, noninterest banking, brokerage, income Other other assets (losses) on Net gains Net servicing securitizations fees sales of loans (losses) on and other Net gains venture cap. Trading, and

29. Teaching about the financial crisis

30. THE 3 (oops—11) TOOLS OF MONETARY POLICY Open Market Operations Discount Policy Reserve Requirements Interest on Required Reserve Balances and Excess Balances Term Auction Facility Primary Dealer Credit Facility Term Securities Lending Facility ABCP MMMF Liquidity Facility Commercial Paper Funding Facility Money Market Investor Funding Facility Term Asset-Backed Securities Loan Facility

31. Teaching Financial Crises: A Resource for High School Teachers Upcoming publication of Council for Economic Education Planned Table of Contents Lesson 1 The Financial Crisis of 1907 and the Financial Crisis of 2007: A Comparison Lesson 2 Data Analysis: How the Numbers of U.S. Economic Performance in 2008 and 2009 Compare to Other Periods in History Lesson 3 Manias, Bubbles, and Panics in World History Lesson 4 The Japan Comparison: Japan in the mid-1980s through 1990s and the U.S. in the 2000s

32. Planned Table of Contents (cont.) Lesson 5 Monetary Policy in the Recent Financial Crisis Lesson 6 The Role of Housing in the Recent Financial Crisis Lesson 7 The Instruments and Institutions of Modern Financial Markets Lesson 8 Understanding Financial Markets in 2007 - 2009

33. Questions