The Current EconomicandFinancial 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 mortgageloans
•Lenders loaned NINJA loans, et. al.
•Lenders “bundled” these loans and sold themas MBSs
•Sub Prime loans – interest only, low interestand balloon payment
Housing Market
•Easy credit increased demand forhomes.
•Housing prices increased
•Supply increases overtake demandincreases.
•Prices fell
•Speculators demand decreased
•Prices fell further
Housing Market (2)
•Easy payments ended, interest ratesrose, many found themselves “upsidedown.”
•Excess capacity caused housing pricesto decline further.
•Upside down homeowners walk awayfrom their homes, housing pricesdecline further.
Mortgage Market
•“Creative” mortgages worked well as long ashousing prices rose. Borrowers expectedincreases to continue; many did well buyinglow and selling high.
•Sales of MBSs takes risk away from bundlers.Incentives to sellers
•Some buy MBSs and bundle them intoCollateralized 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 awayfrom their loans, the value of bundledpackages fell.
•The value of highly leveraged bank’sassets dropped dramatically, causingfailures and inability and unwillingnessto make new loans.
•Credit freeze
Main Street
•C + I + G + (X-M)
•Fall in home equity reduces borrowing, Cfalls.
•Slow housing demand reduces construction,and durable goods production and sales – Cand I fall
•Construction and other businesses lay offworkers, employment falls, income falls –Cfalls.
•Wealth effect
Main Street (2)
•Credit freeze decreased demand forautomobiles. Workers in autos and relatedindustries laid off.
•Businesses, large and small, unable toborrow to finance inventories, workers laidoff.
•Decreased employment causes decreasedincome, causes decreased spending, causesdecreased employment.
Main Street (3)
•Consumer confidence falls further.
•State and local governments have lessrevenue, G falls.
•The multiplier worsens the situation.
•Loss of jobs, loss of income – inducedconsumption falls.
•Low consumer confidence, lack of credit, highdebt – autonomous consumption falls.
Wall Street
•Largely dependent on expectations
•No reason to be confident
•Temptation to dump stocks and moveinto 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 industrialcapacity stood idle.
MB/MOC AnalysisUpside Down Mortgage
•You owe more than the value of the home. Ifyou sell the home, you won’t have enough topay off the mortgage.
•Three alternatives
–Sell the home for less than you owe
–Keep making payments that you may not be ableto afford. Maybe no food or shoes for the kids.
–Walk away; default on the loan. You end up withno home and bad credit.
Housing Market Test(S or D, I or D)
•Easy credit
•Government policies to encouragelenders to lend to low incomeborrowers.
•Inability of construction to keep up withdemand.
•Speculation that housing prices wouldcontinue to increase
Housing Market Test (2)
•Builders overbuild
•Credit tightens
•Borrowers default
•Speculators and others loseconfidence
C, I, G, X, or M?
1.Lower housing values, negative wealtheffect.
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