USA Crisis 2008

8/2/2019 USA Crisis 2008

1/31

THE ECONOMIC CRISISOF 2008

Rupesh Chandra

BBA VIth TermSBS

8/2/2019 USA Crisis 2008

2/31

U.S. housing policies are the root cause of the current financial crisis.

Other players-- greedy investment bankers; foolish investors;

imprudent bankers; incompetent rating agencies; irresponsible housing

speculators; short sighted homeowners; and predatory mortgage

brokers, lenders, and borrowers--all played a part, but they were onlyfollowing the economic incentives that government policy laid out for

them.

- Peter J. Wallison

School of Business Studies, Sharda University, Greater Noida, U.P, India

8/2/2019 USA Crisis 2008

3/31

KEY EVENTS LEADINGUPTOTHE CRISIS

Housing price increase during 2000-2005, followed by a levelling off and pricedecline

Increase in the default and foreclosure rates beginning in the second half of

2006

Collapse of major investment banks in 2008

2008 collapse of stock prices


8/2/2019 USA Crisis 2008

4/31


Source: www.standardpoors.com, S and P Case-Schiller Housing Price Index.

Housing prices were relatively stable during the 1990s, but they began to risetoward the end of the decade.

Between January 2002 and mid-year 2006, housing prices increased by awhopping 87 percent.

The boom had turned to a bust, and the housing price declines continuedthroughout 2007 and 2008.

By the third quarter of 2008, housing prices were approximately 25 percent belowtheir 2006 peak.

HOUSE PRICE CHANGE

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

Annual Existing House Price Change

8/2/2019 USA Crisis 2008

5/31


Default Rate

Source: mbaa.org, National Delinquency Survey.

1979

1980

1981

1982

1984

1985

1986

1987

1989

1990

1991

1992

1994

1995

1996

1997

1999

2000

2001

2002

2004

2005

2006

2007

0%

1%

2%

3%

4%

5%

6%

The default rate fluctuated, within a narrow range, around 2 percentprior to 2006.

It increased only slightly during the recessions of 1982, 1990, and2001.

The rate began increasing sharply during the second half of 2006

It reached 5.2 percent during the third quarter of 2008.

THE DEFAULT RATE

8/2/2019 USA Crisis 2008

6/31

FORECLOSURE RATE

Housing prices were relatively stable during the 1990s, but they began to risetoward the end of the decade.

Between January 2002 and mid-year 2006, housing prices increased by awhopping 87 percent.

The boom had turned to a bust, and the housing price declines continuedthroughout 2007 and 2008.

By the third quarter of 2008, housing prices were approximately 25 percent below

their 2006 peak.


Foreclosure Rate

Source: www.mbaa.org, National Delinquency Survey.

1979

1980

1981

1982

1984

1985

1986

1987

1989

1990

1991

1992

1994

1995

1996

1997

1999

2000

2001

2002

2004

2005

2006

2007

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

8/2/2019 USA Crisis 2008

7/31

STOCK MARKET RETURNS


Total Return

Source: www.standardpoors.com

1950

1953

1956

1959

1962

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

As of mid-December of 2008, stock returns were down by 37percent since the beginning of the year.

This is nearly twice the magnitude of any year since 1950.

This collapse eroded the wealth and endangered the retirementsavings of many Americans.

8/2/2019 USA Crisis 2008

8/31School of Business Studies, Sharda University, Greater Noida, U.P, India

Why did housing prices rise rapidly and then fall?

Why did the mortgage default and housing foreclosure rates begin toincrease more than a year before the recession of 2008 started?

Why the default and foreclosure rates were so much higher during 2007-

2008?

Why did investment banks like Bear Stearns and Lehman Brothers run

into financial troubles so quickly?

KEY QUESTIONS ABOUTTHE CRISISOF 2008

8/2/2019 USA Crisis 2008

9/31

WHAT CAUSEDTHE CRISISOF 2008?

FACTOR 1: Beginning in the mid-1990s, government regulations beganto erode the conventional lending standards.

Fannie Mae and Freddie Mac hold a huge share of American mortgages.

Beginning in 1995, HUD regulations required Fannie Mae and FreddieMac to increase their holdings of loans to low and moderate incomeborrowers.

HUD regulations imposed in 1999 required Fannie and Freddie to accept

more loans with little or no down payment. 1995 regulations stemming from an extension of the Community

Reinvestment Act required banks to extend loans in proportion to theshare of minority population in their market area. Conventional lendingstandards were reduced to meet these goals.

Slide9 of31

SchoolofBusinessStudies,Shard

a

University,

GreaterNoida,U.P,Ind

ia

8/2/2019 USA Crisis 2008

10/31

EXHIBIT 4: FANNIE MAE/FREDDIE MAC SHARE

The share of all mortgages held by Fannie Mae and

Freddie Mac rose from 25 percent in 1990 to 45 percent in2001.

Their share has fluctuated modestly around 45 percentsince 2001.

Slide10 of

31

SchoolofB

usinessStudies,Shard

a

University,

GreaterNoida,U.P,Ind

ia

Freddie Mac/Fannie Mae Share of Outstanding Mortgages

Source: Office of Federal Housing Enterprise Oversight, www.ofheo.gov.

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

20%

25%

30%

35%

40%

45%

50%

8/2/2019 USA Crisis 2008

11/31

EXHIBIT 4.1: SUBPRIME MORTGAGES

Subprime mortgages as a share of total mortgagesoriginated during the year, increased from 5% in 1994 to

13% in 2000 and on to 20% in 2004-2006.

Slide11 of

31

SchoolofB


a

University,

GreaterNoida,U.P,India

Subprime Mortgage Originations as a Share of Total

Source: Data from 1994-2003 is from the Federal Reserve Board while 2001-2007 is from the Joint Center for Housing Studies at Harvard University

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

Subprime (FRB) Subprime (JCHS)

8/2/2019 USA Crisis 2008

12/31

EXHIBIT 4.2: SUBPRIME, ALT-A, AND HOME EQUITY

Like subprime, Alt-A and home equity loans haveincreased substantially as a share of the total since 2000.

In 2006, subprime, Alt-A, and home equity loansaccounted for almost half of the mortgages originatedduring the year.

Slide12 of

31

SchoolofB


a

University,


Subprime, Alt-A, and Home Equity as a Share of Total

Source: Data from 1994-2003 is from the Federal Reserve Board while 2001-2007 is from the Joint Center for Housing Studies at Harvard University

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

0%

10%

20%

30%

40%

50%

Subprime (FRB) Subprime (JCHS) Subprime + Alt-A Subprime + Alt-A + HomeEquity

8/2/2019 USA Crisis 2008

13/31


FACTOR 2:The Feds manipulation of interest rates during 2002-2006

Fed's prolonged Low-Interest Rate Policy of 2002-2004 increased demandfor, and price of, housing.

The low short-term interest rates made adjustable rate loans with lowdown payments highly attractive.

As the Fed pushed short-term interest rates upward in 2005-2006,adjustable rates were soon reset, monthly payment on these loans

increased, housing prices began to fall, and defaults soared.

Slide13 of

31

SchoolofB


a

University,


8/2/2019 USA Crisis 2008

14/31

EXHIBIT 5: SHORT-TERM INTEREST RATES

The Fed injected additional reserves and kept short-terminterest rates at 2% or less throughout 2002-2004.

Due to rising inflation in 2005, the Fed pushed interest ratesupward.

Interest rates on adjustable rate mortgages rose and the defaultrate began to increase rapidly.

Slide14 of

31

SchoolofB


a

University,


Federal Funds Rate and 1-Year T-Bill Rate

Source: www.federalreserve.gov and www.economagic.com

1995

1995

1996

1996

1997

1997

1998

1999

1999

2000

2000

2001

2002

2002

2003

2003

2004

2004

2005

2006

2006

2007

2007

2008

0%

1%

2%

3%

4%

5%

6%

7%

8%

Federal Funds 1 year T-bill

8/2/2019 USA Crisis 2008

15/31

EXHIBIT 5.1: ARM LOANS OUTSTANDING

Following the Fed's low interest rate policy of 2002-2004,Adjustable Rate Mortgages (ARMs) increased sharply.

Measured as a share of total mortgages outstanding,ARMs increased from 10% in 2000 to 21% in 2005.

Slide15 of

31

SchoolofB


a

University,


ARM Loans Outstanding

Source: Office of Federal Housing Enterprise Oversight, www.ofheo.gov.

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

0%

5%

10%

15%

20%

25%

8/2/2019 USA Crisis 2008

16/31


FACTOR 3: An SEC Rule change adopted in April 2004 led to highlyleverage lending practices by investment banks and their quick demise

when default rates increased.

The rule favored lending for residential housing.

Loans for residential housing could be leveraged by as much as 25 to 1,and as much as 60 to 1, when bundled together and financed withsecurities.

Based on historical default rates, mortgage loans for residential housingwere thought to be safe. But this was no longer true because regulationshad seriously eroded the lending standards and the low interest rates of2002-2004 had increased the share of ARM loans with little or no downpayment.

When default rates increased in 2006 and 2007, the highly leveragedinvestment banks soon collapsed.

Slide16 of

31

SchoolofB


a

University,


8/2/2019 USA Crisis 2008

17/31

EXHIBIT 5.2: LEVERAGE RATIOS

The leverage ratios of loans and other investments to capitalassets for various financial institutions are shown here.

When Bear Stearns was acquired by JP Morgan Chase itsleverage ratio was 33 to 1. Note, this was not particularlyunusual for the GSEs and large investment banks.

Slide17 of

31

SchoolofB


a

University,


Leverage Ratios (June 2008)

Source: The Rise and Fall of the U.S. Mortgage and Credit Markets: A Comprehensive Analysis of the Meltdown, Milken Institute

Credit unions

Commercial banks

Savings institutions

Brokers/hedge Funds

Fannie Mae

Freddie Mac

0 20 40 60 80

67.9

21.5

31.6

9.4

9.8

9.1

8/2/2019 USA Crisis 2008

18/31


FACTOR 4: Doubling of the Debt/Income Ratio of Households since themid-1980s.

The debt-to-income ratio of households was generally between 45 and 60percent for several decades prior to the mid 1980s. By 2007, the debt-to-income ratio of households had increased to 135 percent.

Interest on household debt also increased substantially.

Because interest on housing loans was tax deductible, households had an

incentive to wrap more of their debt into housing loans. The heavy indebtedness of households meant they had no leeway to deal

with unexpected expenses or rising mortgage payments.

Slide18 of

31

SchoolofB


a

University,


8/2/2019 USA Crisis 2008

19/31

EXHIBIT 6A: HOUSEHOLD DEBTASA SHAREOF INCOME

Between 1950-1980, household debt as a share of disposable(after-tax) income ranged from 40 percent to 60 percent.

However, since the early 1980s, the debt-to-income ratio ofhouseholds has been climbing at an alarming rate.

It reached 135 percent in 2007, more than twice the level of themid-1980s.

Slide19 of

31

SchoolofB


a

University,


Household Debt to Disposable Personal Income Ratio

Source: www.economagic.com

1953

1955

1958

1960

1963

1965

1968

1970

1973

1975

1978

1980

1983

1985

1988

1990

1993

1995

1998

2000

2003

2005

2008

20%

40%

60%

80%

100%

120%

140%

8/2/2019 USA Crisis 2008

20/31

EXHIBIT 6B: DEBT PAYMENTSASA SHAREOF INCOME

Today, interest payments consume nearly 15 percent of

the after-tax income of American households, up fromabout 10 percent in the early 1980s.

Slide20 of

31

SchoolofB


a

University,


Debt Payments to Disposable Personal Income Ratios

Source: www.economagic.com

1980

1981

1982

1983

1985

1986

1987

1988

1990

1991

1992

1993

1995

1996

1997

1998

2000

2001

2002

2003

2005

2006

2007

6%

8%

10%

12%

14%

16%

Total Debt Mortgage

8/2/2019 USA Crisis 2008

21/31

EXHIBIT 7A: FORECLOSURE RATESON SUBPRIME

Compared to their prime borrower counterparts, the

foreclosure rate for subprime borrowers is approximately10 times higher for fixed rate mortgages and 7 timeshigher for adjustable rate mortgages.

There was no trend in the foreclosure rate prior to 2006 foradjustable rate or fixed rate mortgages.

Starting in 2006, there was a sharp increase in theadjustable rate mortgage foreclosure rate.

Slide21 of

31

SchoolofB

usinessStudies,Sharda

University,


Foreclosure Rates on Subprime Mortgages

Source: Liebowitz, Stan J., Anatomy of a Train Wreck: Causes of the Mortgage Meltdown, Ch. 13 in Randall G. Holcombe and Benjamin Powell, eds, Housing America: BuildingOut of a Crisis(New Brunswick, NJ: Transaction Publishers, 2009 (forthcoming) We would like to thank Professor Liebowitz for making this data available to us.

1998

1998

1999

1999

2000

2000

2001

2001

2002

2002

2003

2003

2004

2004

2005

2005

2006

2006

2007

2007

0%

1%

2%

3%

4%

5%

6%

Fixed Adjustable

8/2/2019 USA Crisis 2008

22/31

EXHIBIT 7B: FORECLOSURE RATESON PRIME

While the foreclosure rate on fixed rate mortgages was

relatively constant, the foreclosures on adjustable ratemortgages began to soar in the second half of 2006.

This was true for both prime and subprime loans.

Slide22 of

31

SchoolofB


University,


Foreclosure Rates on Prime Mortgages

Source: Liebowitz, Stan J., Anatomy of a Train Wreck: Causes of the Mortgage Meltdown, Ch. 13 in Randall G. Holcombe and Benjamin Powell, eds, Housing America: BuildingOut of a Crisis(New Brunswick, NJ: Transaction Publishers, 2009 (forthcoming) We would like to thank Professor Liebowitz for making this data available to us.

1998

1998

1999

1999

2000

2000

2001

2001

2002

2002

2003

2003

2004

2004

2005

2005

2006

2006

2007

2007

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

Fixed Adjustable

8/2/2019 USA Crisis 2008

23/31

FIXEDVS. VARIABLE RATE MORTGAGES

Default and foreclosure rates on fixed interest rate mortgages did not risemuch in 2007 and 2008. This was true for loans to both prime and sub-

prime borrowers.

In contrast, the default and foreclosure rates on adjustable rate

mortgages soared during 2007 and 2008 for both prime and sub-prime

borrowers.

The combination of lower lending standards, adjustable rate loans, and

the Fed's interest rate policies of 2002-2006 was disastrous.

Incentives matter and perverse incentives created the crisis of 2008.

Slide23 of

31

SchoolofB


University,


RE E EADED OWARD NOTHER REAT

8/2/2019 USA Crisis 2008

24/31

RE E EADED OWARD NOTHER REATDEPRESSION?

Are the current conditions unprecedented?

How do the current conditions compare with the Great Depression?

Slide24 of

31

SchoolofB


University,


EXHIBIT 8A: UNEMPLOYMENT IN RECENT SEVERE

8/2/2019 USA Crisis 2008

25/31

EXHIBIT 8A: UNEMPLOYMENTIN RECENT SEVERERECESSIONS

At the end of January 2009, the unemployment rate was

7.6 percent and it will surely go higher. This is notunprecedented.

The unemployment rate rose to 9.6 percent during the1974-75 recession, and to 10.8 percent during the 1980-1982 recession.

Even during the relatively short recession of 1990-1991,the unemployment rate rose to nearly 8 percent and itremained at, or near, 7 percent for almost two years.

Slide25 of

31

SchoolofB


University,


Peak Monthly Unemployment Rates in Recent Severe Recessions

Source: www.bls.gov

1973-75 1980-82 1990-91 2007-?

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

9.0%

10.8%

7.8% 7.6%

8/2/2019 USA Crisis 2008

26/31

EXHIBIT 8B: GREAT DEPRESSION UNEMPLOYMENT

The unemployment rate soared to nearly 25 percent

during 1933. The unemployment rate was 14 percent or more every

year throughout 1931-1939.

Slide26 of

31

SchoolofB


University,

GreaterNoida,U.P,Indi

a

Unemployment Rates During the Great Depression

Source: Bureau of the Census, The Statistical History of the United States from Colonial Times to the Present (New York: Basic Books, 1976)

1930 1931 1932 1933 1934 1935 1936 1937 1938 1939

0%

5%

10%

15%

20%

25%

30%

9%

16%

24%25%

22%20%

17%

14%

19%17%

8/2/2019 USA Crisis 2008

27/31

LESSONS FROMTHE GREAT DEPRESSION

Avoid these policies:

Monetary contraction Trade restrictions

Tax increases

Constant changes in policy; this merely creates uncertainty and delays

private sector recovery.

Slide27 of

31

SchoolofB


University,GreaterNoida,U.P,India

8/2/2019 USA Crisis 2008

28/31

THIS RECESSIONIS LIKELYTOBE LENGTHY

It will take time for the malinvestments to be corrected and for householdsto improve their personal financial situation.

Various types of stimulus packages are not likely to be very effective.

Danger: Frequent policy changes will retard recovery. The recent policies

of the Bush Administration illustrate this point.

Slide28 of

31

SchoolofB



8/2/2019 USA Crisis 2008

29/31

WHAT NEEDSTOBE DONE?

1. The keys to sound policy are well-defined property rights, monetary andprice stability, open markets, low taxes, control of government spending,

and above all, neutral treatment of both people and enterprises.2. Monetary policy is way off track. Since the late 1990s it has been on a

stop-and-go course that generates instability. The Fed needs toannounce it will follow a stable course in the future. There will be norepeat of the Great Depression, but neither will there be a repeat of the

1970s.3. President Obama and Congress should announce that:

i. The mistakes of the 1930s will not be repeated, including theuncertainty generated by the frequent policy changes thatcharacterized the New Deal.

ii. In the future, government spending will be controlled and the deficitreduced.

Slide29 of

31

SchoolofB



8/2/2019 USA Crisis 2008

30/31

CRISISOF MARKETSORA CRISISOF POLITICS?

Are the current conditions unprecedented?

Both the Great Depression and the current crisis are the result ofperverse policies.

During the Great Depression era, disastrous policies led to a huge

expansion in the size and role of government. Will the same thing

happen this time? The answer to this question will determine the future

economic status of Americans.

Slide30 of

31

SchoolofB



8/2/2019 USA Crisis 2008

31/31

END

Slide31 of

31

SchoolofB



USA Crisis 2008

Documents