Teaching Financial Crises lessons Common elements of financial

Teaching Financial Crises lessons: � Common elements of financial crises worldwide throughout history Lesson 1 – compares 1907 & 2007 crises Lesson 2 – compares 2007 crisis with: (emphasis on reading eco. Data) ▪ ▪ ▪ Recession of 2001 Recession of 1990 -1991 Recession of 1981 -82 Recession of 1973 -75 Great Depression 1929 -38 (Dot-Com bubble burst, Enron, Worldcom, et. ) (oil price shock due to Gulf War) (tight money to control inflation) (stagflation; OPEC oil embargo spiked oil prices) (stock market crash; falling demand) Lesson 3 – a historical look at five bubbles & panics: ▪ ▪ ▪ Tulipmania in the Dutch Republic – 1630’s The South Sea Bubble – Great Britain 1711 -1721 The Roaring 20’s Stock Bubble – 1920’s Japan’s Bubble Economy – 1985 -90 The Dot-Com Bubble – 1990’s Lesson 4 – comparison to Lost Decade in Japan 1

PANDEMONIUM IN THE MARKETS THE PANIC OF 1907 THE FINANCIAL CRISIS OF 2007

THE FINANCIAL CRISIS OF 2007 THE WORLD MADE HUGE INVESTMENTS IN THE U. S. HOUSING MARKET ………. AND LOST!! � By ignoring risk, remaining irrationally optimistic, and forgoing transparency through an array of fantastically complicated investment vehicles, the world’s financial markets were extremely dependent on housing prices. � The underlying assumptions were (1) that housing prices never fall and (2) homeowners almost always pay their mortgages.

THE ORIGINS OF THE CRISIS STRONGLY PROMOTED HOMEOWNERSHIP FORMER PRESIDENT GEORGE BUSH � “We can put light where there’s darkness, and hope where there’s despondency in this country. And part of it is working together as a nation to encourage folks to own their own home” –President Bush, October 15, 2002.

CAUSES OF THE CRISIS HIGHLY COMPLEX FORMS OF FINANCING The momentum behind the expansion of homeownership led the government to reduce regulations and capital requirements for making loans. � This led to a dizzying number of innovative ways to get less-qualified borrowers a mortgage and seemed to reduce risk for the lender. � Mortgages could be bundled and sold around the world as securities. � THIS WAS TOO TEMPTING FOR THE FINANCIAL INSTUTIONS

CAUSES OF THE CRISIS TRUSTED AGENCIES FAILED TO WARN INVESTORS � Mortgage-backed securities were constructed of mortgages of differing quality levels. � The obligations of solid and subprime borrowers were mixed in a manner that made it very difficult for experts to calculate risk. � The assumption that U. S. housing prices would continue to rise and incentives to provide good ratings led agencies to rate these securities as AAA, lowering investors’ concerns. RISK-RATING AGENCIES

EFFECTS OF THE CRISIS THE PERFECT STORM WHAT WERE WE THINKING? � � � � Homeownership peaks in early 2005 at 70% of households. The Fed raises interest rates. Home prices fall. Higher adjustable interest rates increase payments for borrowers. Borrowers default in waves. Dozens of subprime lenders file for bankruptcy. Mortgage-backed securities lose value as investors question their contents. Financial institutions struggle to find buyers for the MBSs.

“FINANCIAL WEAPONS OF MASS DESTRUCTION” Financial institutions could purchase credit default swaps. A CDS is a private insurance contract that paid off if the investment failed. One did not actually have to own the investment to collect on the insurance. These promises were unregulated, and the sellers did not have to set aside money to pay for losses.

THE FINANCIAL CRISIS OF 2007 -2009 � � � Bank failures: 183 (2%) 12/072/10 (No deposits lost) Unemployment rate: 10. 1% (10/09) Economic decline: -4. 1% (4 Q 2007 -2 Q 2009) Biggest drop in DJIA: -53. 8% (12/07 -3/09) Emergency spending and tax reduction programs: 2. 5% of GDP in 2008 and in 2009 Aggressive increase in monetary stimulus by the Fed

THE FINANCIAL CRISIS OF 2007 -2009 6. 7 million jobs lost in 2008 and 2009 Capital investment levels lowest in 50 years Domestic demand declines 11 consecutive quarters Industrial production down worldwide: Japan 31%, South Korea 26% , Russia 16% , Brazil 15% , Italy 14%, Germany 12%

The federal government unleashed a series of remedies in an attempt to limit the contagion. Massive sums of bank reserves were created to ease fears. In the process, the taxpayers took over or funded several familiar financial and nonfinancial companies. This time the government bails out the economy and business leaders and bankers are criticized.

What do all of the explanations show? � The rise in housing prices represented a bubble. � A price bubble is a situation where increases in price are not justified by fundamental factors affecting supply or demand, and therefore not sustainable. � A price bubble is often caused by contagion, which is prices increasing because people observe them going up and think they will continue to go up. At one point, people who couldn’t pay their mortgages were taking out home equity lines of credit and using the cash to pay the mortgages! They could do this because equity in homes rose as home prices rose, and “personal bankers” were pushing home equity lines of credit. � This causes people to purchase houses with the expectation that they will be able to sell them for a higher price in a relatively short time. � It was a speculative bubble. � When the bubble burst in 2006, house prices tumbled. 12

A Look at Historical Homeownership - USA 13

How does home ownership in the US compare to the world? U. S. Homeownership rate: 2000 2004 2010 67. 4% 69. 0% 66. 9% 14

Mortgage-backed securities: � Positives: Spreads risk. Not all eggs in one basket. Diversified. Made a liquid investment from an illiquid investment. Allowed smaller investors to invest in housing. Meant more money flowed into mortgage markets. � Negatives: Reduced the incentive for investors to be concerned about the creditworthiness of borrowers. Reduced the incentive for banks and mortgage brokers to be concerned with creditworthiness. Exported the risk around the world because the MBS securities were stamped AAA by the ratings agencies and sold worldwide. 15

Lesson 3 – Manias, Bubbles, and Panics in World History ▪ Tulipmania in the Dutch Republic – 1630’s ▪ The South Sea Bubble – Great Britain 1711 -1721 ▪ The Roaring 20’s Stock Bubble – 1920’s ▪ Japan’s Bubble Economy – 1985 -90 ▪ The Dot-Com Bubble – 1990’s � http: //www. library. hbs. edu/hc/historicalreturns/fb/movie. html 16

What is a bubble? � Hyman Minsky’s phases of a bubble: Displacement ▪ Boom ▪ A few insiders begin to take profits and get out, and price increases begin to level out. Panic ▪ People take more risk as more credit is offered. High profits repeat the cycle, and at some point rational decision-making succumbs to manic behavior. Profit-taking ▪ Rapid rise in prices of a financial or physical asset as investors and speculators earn profits Euphoria ▪ Crisis begins with an outside shock to the system—war, new invention, political event, etc. The failure of a large institution, the realization of a swindle, or an increase in the supply of the asset bring everyone back to their senses. People scramble to sell as the price falls. Bailout (not a part of Minsky’s description) ▪ ▪ A central bank may expand the money supply to salvage essential financial institutions. Rationale: don’t make the whole economy pay for the actions of a few. Negative externality: the anticipation of a bailout may indirectly add to the problem because people may take greater risks if they know there is a safety net—this is known as a moral hazard. John Kenneth Galbraith suggests investors have a short financial memory and investors have a tendency to attribute greater intelligence to individuals who have higher income or control more wealth. 17

The Next Bubble? ? ? 18

The Last 5 Years: GDP 19

The Last 10 Years: Unemployment 20

The Last 5 Years: Stock Markets 21

The Last 25 Years: Housing Prices The Case-Schiller Price Index represents the real price of housing throughout the country, so it is inflation-adjusted. The index equals 100 for the price of housing in 1980. Prices peaked in 2006. 22

Fall, 2007 – Trouble on the Horizon � In the fall of 2007, the “subprime crisis” was a concern, and we began to realize the real estate bubble had burst. (Home prices peaked in 2006. ) � However, the stock market peaked, and GDP in the 2 nd & 3 rd quarters of 2007 was especially strong. � Generally, people deeply involved in finance began to talk about problems in the credit markets and a lack of liquidity. 23

From Business. Week, 9 -3 -07 24

From Business. Week, 9 -24 -07 25

2008: The Year It All Fell Apart December, 2007 Dec. 11 – Fed begins lending to banks for longer than overnight. (By October 2008, many banks are on Fed life support. ) � January Jan. 12 – Bank of America agrees to buy Countrywide Financial, the largest mortgage lender, and casualty of the mortgage-default crisis. � February Feb. 8 – Congress approves a $168 billion economic stimulus plan. Feb. 29 – Dollar hits record low against euro. � March 17 – Bear Stearns, which traded at a share price of nearly $90 per share in January, sells itself to J. P. Morgan Chase for $2 per share, with the Fed providing special financing. Mortgage-backed securities took them down. � 26

2008, The Year It All Fell Apart � April 18, 19 – Merrill Lynch posts a $1. 96 billion loss; Citigroup posts a $5. 1 � � � billion quarterly loss. April 30 – Countrywide Financial posts a $893 million loss. May 9 – AIG posts $7. 8 billion quarterly loss. June 9 – Average price of gasoline in U. S. first hits $4 a gallon. June 21 – Bond insurers MBIA and Ambac lose AAA ratings from Moody’s. July 12 – Regulators seize Indy. Mac bank. July 14 – Treasury and Fed place Fannie Mae and Freddie Mac under govt. control. July 31 – Pres. Bush signs a housing-rescue bill. 27

September 2008: The Month Wall Street Died � August 7 – Freddie Mac posts an $821 million loss; AIG reports a $5. 4 billion loss. � September – Wall Street Journal calls Sept. 14 – 21, “The Week That Wall Street Died” Sept. 7 – Govt. seizes Fannie and Freddie; Treasury replaces CEOs and buys $1 billion of preferred shares in each. Sept. 14 – Merrill Lynch sells itself to Bank of America. Sept. 15 – Lehman Brothers files for bankruptcy. Fed and Treasury choose to let Lehman fail. (In hindsight, probably a disastrous decision. ) Sept. 16 – Banks stop lending to each other. Sept. 17 - Govt. seizes control of AIG, makes $85 billion loan and receives warrants in exchange. Sept 21 – Fed converts the last two major investment banks, Morgan Stanley and Goldman Sachs into traditional bank-holding companies. Sept. 24 – Goldman Sachs gets $5 billion investment from Warren Buffett. Sept. 26 – Feds seize Washington Mutual and sell it to J. P. Morgan Chase—largest bank failure in U. S. history. Sept. 30 – Citigroup agrees to acquire Wachovia, and Wells Fargo makes higher bid. Congress passes the bailout bill. 28

2008, The Year It All Fell Apart � October Oct. 4 - President Bush signs $700 billion bailout bill. Oct. 8 – Fed says it will lend directly to U. S. corporations for the first time since the Great Depression. Oct. 9 – World Central Banks coordinate lowering of short-term rates. Dow down 14% in October, worst month in % terms in 10 years. � November Nov. 10 – Govt. scraps $123 billion deal with AIG and replaces it with a $150 billion package on better terms. Govt. injects $20 billion into Citigroup and guarantees $300 billion of its troubled assets. � December Dec. 9 – On this date, only Mc. Donald’s and Walmart in the Dow have higher stock prices that this date last year. Dec. 12 – Fund advisor Bernie Madoff is arrested by federal agents in a $50 billion Ponzi scheme. Dec. 17 – Fed funds rate cut to 0 -. 25%. Dec. 17 – Goldman Sachs posts $2. 12 billion loss, first since going public in 1999. Dec. 20 – White House agrees to lend GM and Chrysler $17. 4 billion. 29

2008 – Winners & Losers Sample of Bankruptcy filings in 2008: Sharper Image Lillian Vernon Aloha Airgroup, ATA Airlines, Skybus Airlines, Frontier Airlines Linens ‘N Things Tropicana Entertainment (casino operator) Circuit City Pilgrim’s Pride (chicken processor) Tribune (newspaper publisher) 30

How did major players survive 2008? 31

How did major players survive 2008? 32

How did major players survive 2008? One of the very few beneficiaries of the Recession 33

Fed’s Effort to Stimulate the Economy Unintended consequence of low rates since 2009: when interest rates are low, corresponding investment yields are low and investors move to riskier assets trying to find yield. 34

Statistics Based on Indicators 1. Misery Index: The sum of the unemployment rate and the inflation rate. 2. Real Per Capita GDP Growth Rate: The percentage change in real GDP person

Activity 8. 2 Economic Indicators for Presidential Election Think, Pair, Share 1. 1. What do you see on the chart? 2. 2. What year since 1957 has the unemployment rate been the highest? 3. 3. What year had the highest inflation rate? 4. What year had the highest Misery Index?

Which election was hardest to predict and why? Do economics play a role in presidential elections?