Chapter 33: Financial Crisis

11© 2014 by McGraw-Hill Education Chapter 33 Financial Crisis 2© 2014 by McGraw-Hill Education • What role irrational expectations and leverage play in financial crises. • What role mortgage-backed securities and tranching played in the rise of subprime lending. • How to analyze the factors that lead to the housing bubble and increased household debt. • How the housing bubble collapse created a credit crisis and drop in output. • What tools are used to stimulate the economy when interest rates hit the zero lower bound. What will you learn in this chapter? 3© 2014 by McGraw-Hill Education • Two interconnected concepts lie at the heart of many financial crises. 1. Irrational expectations: The price of an asset can become so inflated that it is unclear why it should be so valuable. – Herd instinct may push investors to buy because everyone else is. – Recency effect is a cognitive bias that causes humans to overvalue recent experience when trying to predict the future. 2. Leverage: The practice of using borrowed money to pay for investments. – This allows people to make investments that are larger than the amount they own. – Leverage is not necessarily dangerous, so long as it is limited and investors understand the risks well. The origins of financial crises 24© 2014 by McGraw-Hill Education Determine whether or not each of the following scenarios is an example of irrational expectations. 1. A CEO proclaims that the company will indefinitely remain profitable, similar to the last five years. 2. The SEC cracks down on an investment bank’s fraudulent trading. The bank’s stock falls 15%. 3. Given a mild winter, the prices of snow shovels is lower. Active Learning: Determining Irrationality 5© 2014 by McGraw-Hill Education • The South Seas Company participated in the London’s Exchange Alley in the 1600s. • The price of the company’s stock jumped significantly after it was granted a government trade monopoly between England and South America. – It was never clear how the company was going to earn enough to justify such jumps in the stock price. • Investors cashed in when prices were high. • Parliament enacted the Bubble Act to regulate publically-traded companies. The South Seas Bubble 6© 2014 by McGraw-Hill Education • The Great Crash of 1929 is arguably the most infamous stock market crash in history. • After WWI, returning soldiers boosted production. – The value of the stock market more than tripled. • On October 24, 1929—“Black Thursday”—the leading index of stock prices dropped 9%. – Once prices started to drop, everyone tried to sell their stocks before prices dropped further. The Great Crash of 1929 37© 2014 by McGraw-Hill Education • In the 1930s, Congress passed several laws to prevent similar crises. • The Glass-Steagall Banking Act of 1933 – Required the separation of investment and commercial banks. – Established the Federal Deposit Insurance Corporation (FDIC) to insure deposits against bank failures. • The Securities and Exchange Act of 1932 • Formed the Securities and Exchange Commission (SEC) to regulate the securities industry. • These reforms contributed to a long period of relative stability in financial markets. The Great Recession: A financial-crisis case study 8© 2014 by McGraw-Hill Education • There are several origins of the most recent financial crisis. • The world’s governments had extraordinary monetary and fiscal responses using financial and macroeconomics concepts. • To understand how the U.S. economy collapsed so suddenly, the interrelated components of the U.S. economy must be analyzed: – Subprime lending. – The housing and mortgage market. – The broader world of consumer debt. The Great Recession: A financial-crisis case study 9© 2014 by McGraw-Hill Education • People who cannot obtain a traditional mortgage loan may still become homeowners through subprime mortgages. – A subprime mortgage is a loan made to a borrower with a low credit score. • Subprime mortgages became available due to securitization. – Securitization is the practice of packaging individual debts into a single uniform asset. – Investment banks created mortgage-backed securities, which were tradable assets made up of individual mortgages. • Banks created tranches by dividing debt packages by risk and return characteristics. – Low-risk mortgages could be sold to more risk-averse investors. – High-risk subprime mortgages could be sold to risk-loving investors. – Investors relied on the reassuringly high AAA ratings given to many of these assets • Credit-rating agencies were overly optimistic when rating securities, to attract business and keep Wall Street happy. Subprime lending 410© 2014 by McGraw-Hill Education • Traditionally, new subprime mortgages comprised less than 10% of all new mortgages. • In 2004, the rate of new subprime mortgages more than doubled. Subprime lending 7% 7% 8% 18% 20% 20% 8% 0 5 10 15 20 25 Percentage 2001 2002 2003 2004 2005 2006 2007 11© 2014 by McGraw-Hill Education The housing bubble was created through a series of actions of banks and homeowners. • The sudden explosion of cheap and readily available mortgages encouraged people to buy bigger and better homes. • Securitization transferred risk away from lenders, which misaligned incentives. – Down payment requirements got smaller and loans got cheaper. – Banks issued mortgages even when people couldn’t repay them. • Homeowners became more and more leveraged. – Some people bought houses solely on the expectation that they would continue to go up in value, even though they couldn’t afford them. • The run-up in housing prices represented a classic market bubble. The housing bubble 12© 2014 by McGraw-Hill Education The housing bubble can be observed by the rapid rise in U.S. home prices and the number of new housing starts. The housing bubble National composite Housing starts Case-Shiller housing price index (Jan. 2000 = 100) Housing starts (thousands of units) 0 500 1,000 1,500 2,000 2,500 0 50 100 150 200 250 1999 2001 2003 2005 2007 2009 2011 • Rapid increase of housing prices from 1999 to 2006. • Prices peaked in early 2007 and then quickly plummeted. 513© 2014 by McGraw-Hill Education • Flush with the feeling of wealth from their inflated home values, consumers began saving less and spending more. – Many used the value of their homes to secure loans and higher limits on their credit cards. – This caused overall debt levels in the U.S. to increase. – Growth in household debt accelerated as the housing market took off. • The debt service of consumers was sustainable only as long as interest rates remained low and home values remained high. – Debt service is the amount that consumers have to spend to pay their debts. – Often expressed as a percentage of disposable income. Buying on credit 14© 2014 by McGraw-Hill Education Financial debt Since the 1960s, total debt in the United States has more than doubled its share of GDP. Buying on credit Total debt Personal debt Corporate debt Federal debt 0 50 100 150 200 250 300 350 400 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 Percent of GDP Historical debt trends in the United States 15© 2014 by McGraw-Hill Education • Household debt has risen considerably over time. • Debt payments have not increased much, because interest rates have kept the price of debt low. Buying on credit Household financial obligations Household debt 50 60 70 80 90 100 110 120 130 140 10 11 12 13 14 15 16 17 18 19 20 1980 1985 1990 1995 2000 2005 2010 Household financial obligations as a percent of income Household debt as a percent of income Debt payments and total debt 616© 2014 by McGraw-Hill Education Determine which is riskier: 1. A $1,000,000 loan with a 17% probability of default. 2. A mortgage-backed security worth $1,000,000 with the following risk profile. Active Learning: Securitization Number of loans Probability of default Weighted risk 40 1.5% 1% 20 5% 1% 25 25% 6% 15 50% 8% 17© 2014 by McGraw-Hill Education What would the probability of default on the lowest risk loans in the mortgage-backed security have to be to make the probability of default on the security equal to 18%? Active Learning: Securitization Number of loans Probability of default Weighted risk 40 20 5% 1% 25 25% 6% 15 50% 8% 18© 2014 by McGraw-Hill Education The collapse began in the subprime mortgage market. 1. When housing prices stopped rising, consumers were unable to refinance. 2. Faced with large debt service, a massive wave of defaults occurred. 3. An increase in foreclosed properties increased the supply of housing. 4. Housing values decreased as supply increased, leaving many homeowners “underwater.” 5. The result was a vicious cycle of defaults and falling prices. A brief timeline of the crisis 719© 2014 by McGraw-Hill Education The collapse continued through the financial markets. 1. Risky real estate investments became worthless. – Banks lost trillions of dollars 2. Mortgage-backed securities made it difficult to tell which banks were in trouble, causing the lending market to halt. – Many businesses were suddenly unable to access credit for their day-to-day needs. 3. Large institutions and companies that had deposited money with Wall Street’s banks withdrew funds. – This led to a run on bank assets. 4. The reduction in consumption and investment spending shifted the aggregate demand curve to the left. A brief timeline of the crisis 20© 2014 by McGraw-Hill Education • The financial sector performed well in the years leading up to the crisis. • Banks announced that they held toxic assets. • Prices of stocks throughout the financial sectors plummeted. A brief timeline of the crisis Bank of America Citigroup Lehman Brothers Price per share ($) 0 10 20 30 40 50 60 70 80 90 2006 2007 2008 2009 2010 21© 2014 by McGraw-Hill Education The financial crisis can be understood using the AD–AS model. A brief timeline of the crisis Y2 AD2 SRAS2 P2 AD1 SRAS1 Price level Real GDP Y1 P1 • The housing-market crash caused both AD and AS to shift to the left. • This put the economy at a new equilibrium. – Lower prices. – Reduced output. 822© 2014 by McGraw-Hill Education • Policy-makers used monetary and fiscal policy tools to try to avoid a catastrophic economic collapse. • The goal of the 2008 policies was to “unstick” frozen credit markets. – Concerned that any attempt to stimulate demand without any supply would be dangerous. – This attempts to avoid stagflation, which is when high inflation occurs despite low economic growth and high unemployment. The immediate response to the crisis 23© 2014 by McGraw-Hill Education The Fed attempted to stabilize the financial market by buying up toxic assets. The immediate response to the crisis Other assets Loans Central bank liquidity swaps Term auction credit Net portfolio holdings of Commercial Paper Funding Facility LLC Mortgage-backed securities Federal agency debt securities U.S. Treasury securities0 500,000 1,000,000 1,500,000 2,000,000 2,500,000 Jan 2008 May 2008 Oct 2008 Feb 2009 Jul 2009 Dec 2009 Millions ($) The Federal Reserve’s balance sheet 24© 2014 by McGraw-Hill Education • The U.S. Treasury bailed out banks that were considered “too big to fail.” – “Too big to fail” refers to banks so large that banking regulators allow these banks to keep operating despite insolvency. – This refers to banks that are large in terms of assets and customers, or ones that are historically important. • These bailouts were short-term loans under the Troubled Asset Relief Program (TARP). • Once the financial market started to unfreeze, fiscal policy was introduced to stimulate demand. The immediate response to the crisis 925© 2014 by McGraw-Hill Education The responses of the Fed and Treasury can be understood using the AD–AS model. The immediate response to the crisis Y2 Y1 3AD = SRAS3 P Y3 3 Price level Real GDP Fed and Treasury intervention • The economy enters into the financial crisis. • The Federal Reserve and the Treasury restore aggregate supply to its original level. • Lower interest rates slightly stimulate demand. • Sluggish aggregate demand causes: – Lower prices. – Output to increase (but not to original levels). AD2 SRAS2 AD1 P2 SRAS1 26© 2014 by McGraw-Hill Education • The Fed engaged in expansionary monetary policy to lower interest rates and encourage borrowing and investment. • The Treasury engaged in stimulus spending to increase aggregate demand. • Spending stayed weak, so the Fed cut interest rates until they were close to zero, or the zero lower bound. • The Fed took extra measures, known as quantitative easing policies, which directly increase the money supply by a certain amount. Stimulus at the zero lower bound 27© 2014 by McGraw-Hill Education • Financial crises usually arise from a combination of irrational expectations and leverage. • Crises have been around since the first financial markets, and governments have regulated markets to avert crises. • The most recent financial crisis occurred when innovations in the subprime lending market led to a dramatic increase in housing prices. – Securitization in the mortgage loan market increased the supply of subprime lending. Summary 10 28© 2014 by McGraw-Hill Education • Securitization increased the demand for housing and pushed up home values. • As housing values increased, people felt more wealthy and took on more debt. • This bubble popped and many borrowers defaulted on their debt. • As households faced a negative shock to wealth, consumers began saving more and consuming less. • These actions led to a decrease in aggregate demand and lending, which resulted in a recession. Summary 29© 2014 by McGraw-Hill Education • The federal government acted quickly to stabilize the financial system. – The Fed offered short-term financing to banks. – The Treasury bailed out several large banks. – The government passed stimulus measures to increase aggregate demand. • The Fed engaged in quantitative easing to increase the money supply. Summary