• 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.
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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