The Current Economic and Financial Crises
Jan 02, 2016
The Current Economic and
Financial Crises
How did we get here?
• Background
• Housing Market
• Mortgage Market
• Main Street
• Wall Street
Background
• World money markets awash with savings ($72 trillion)
• Rates on T bills too low, looked to mortgage loans
• Lenders loaned NINJA loans, et. al. • Lenders “bundled” these loans and sold them
as MBSs• Sub Prime loans – interest only, low interest
and balloon payment
Housing Market
• Easy credit increased demand for homes.
• Housing prices increased• Supply increases overtake demand
increases.• Prices fell• Speculators demand decreased• Prices fell further
Housing Market (2)
• Easy payments ended, interest rates rose, many found themselves “upside down.”
• Excess capacity caused housing prices to decline further.
• Upside down homeowners walk away from their homes, housing prices decline further.
Mortgage Market
• “Creative” mortgages worked well as long as housing prices rose. Borrowers expected increases to continue; many did well buying low and selling high.
• Sales of MBSs takes risk away from bundlers. Incentives to sellers
• Some buy MBSs and bundle them into Collateralized Debt Obligations (CDOs). Thought to be as good as cash.
• As long as housing prices continued to rise, all was well.
Mortgage Market (2)
• As upside down borrowers walked away from their loans, the value of bundled packages fell.
• The value of highly leveraged bank’s assets dropped dramatically, causing failures and inability and unwillingness to make new loans.
• Credit freeze
Main Street
• C + I + G + (X-M)• Fall in home equity reduces borrowing, C
falls. • Slow housing demand reduces construction,
and durable goods production and sales – C and I fall
• Construction and other businesses lay off workers, employment falls, income falls –C falls.
• Wealth effect
Main Street (2)
• Credit freeze decreased demand for automobiles. Workers in autos and related industries laid off.
• Businesses, large and small, unable to borrow to finance inventories, workers laid off.
• Decreased employment causes decreased income, causes decreased spending, causes decreased employment.
Main Street (3)
• Consumer confidence falls further.• State and local governments have less
revenue, G falls.• The multiplier worsens the situation.• Loss of jobs, loss of income – induced
consumption falls.• Low consumer confidence, lack of credit, high
debt – autonomous consumption falls.
Wall Street
• Largely dependent on expectations
• No reason to be confident
• Temptation to dump stocks and move into other assets (bonds, commodities)
• Fear of the President’s bill
Is this another depression?
• What caused the depression?– Perverse monetary policy– Perverse fiscal policy– Smoot Hawley Tariff
• 25% unemployment, 50% of industrial capacity stood idle.
MB/MOC AnalysisUpside Down Mortgage
• You owe more than the value of the home. If you sell the home, you won’t have enough to pay off the mortgage.
• Three alternatives– Sell the home for less than you owe– Keep making payments that you may not be able
to afford. Maybe no food or shoes for the kids. – Walk away; default on the loan. You end up with
no home and bad credit.
Housing Market Test(S or D, I or D)
• Easy credit• Government policies to encourage
lenders to lend to low income borrowers.
• Inability of construction to keep up with demand.
• Speculation that housing prices would continue to increase
Housing Market Test (2)
• Builders overbuild
• Credit tightens
• Borrowers default
• Speculators and others lose confidence
C, I, G, X, or M?
1. Lower housing values, negative wealth effect.
2. Purchase of durable goods fell.
3. Expenditure multiplier as a result of (1) and (2)
4. Construction declines.
5. Consumer confidence falls.
C, I, G, X, or M
6. Credit crunch
7. Increased federal spending
8. Decreased federal taxes
9. Decreased state and local spending
10. Increased state and local taxes