Chapter 10 The Great Recession: A First Look Prepared by Emily Marshall, Dickinson College Copyright © 2018 W. W. Norton & Company 10.1 Introduction ◼ In this chapter, we learn: ❑ The causes of the financial crisis that began in the summer of 2007. ❑ The current state of the economy. ❑ How the current financial crisis compares to previous recessions. Introduction ◼ Financial crisis began in the summer of 2007 ◼ The financial crisis worsened in Sept. 2008 ◼ The worst recession since the Great Depression began in Dec. 2007 10.2 Recent Shocks to the Macroeconomy ◼ What shocks to the macroeconomy have caused the global financial crisis? ❑ Housing prices ❑ Global saving glut ❑ Subprime lending and rise in interest rates ❑ Previous financial turmoil ❑ Oil prices Housing Prices ◼ ◼ From1996 to 2006, ❑ Housing prices tripled ❑ “Housing bubble” From mid-2006 to the beginning of 2012, ❑ Housing prices plummeted by 36% ❑ The bubble “burst” Bursting Bubble in U.S. Housing Prices Subprime Lending and the Rise in Interest Rates—1 ◼ Mortgages were used to buy homes from 2000 to 2006 ◼ Low interest rates ◼ ❑ global savings glut ❑ low federal funds rate Many borrowers were “subprime” ❑ poor credit records ❑ high debt-to-income ratios The Global Saving Glut—1 ◼ Caused partly by prior financial crises ❑ Ben Bernanke, March 2005: “global saving glut” ❑ Excess of savings in developing countries The Global Savings Glut—2 ◼ Developing countries used savings to purchase assets ❑ increased demand for U.S. assets ❑ including the stock market and housing market Subprime Lending and the Rise in Interest Rates—2 ◼ ◼ Between 2004 and 2006 ❑ the Fed raised its interest rate from 1.25% to 5.25% ❑ higher interest rates (>teaser) for subprime debtors By August 2007, ❑ 16% of subprime ARMs were in default ❑ This led to a downward spiral of the housing market Fed Funds Rate The Financial Turmoil—1 ◼ ◼ Securitization ❑ Pooling a group of financial instruments, dividing them up, and selling in pieces ❑ Intended to diversify risk Bank lending standards decreased Securitization loans • Homeowners • Purchase home loans • Banks • Package loans loans • Third parties • Sell loans MBS • Investors • Repackage loans • Investors CDO or SIV The Financial Turmoil—2 ◼ August 2007: “flight to safety” ❑ Lenders put funds in T-bills S&P 500 Stock Price Index (Real) The Fed and the Treasury Department Respond—1 ◼ March 2008: ❑ The Fed made discount loans to primary dealers ❑ The Fed would loan up to $200 billion of Treasury securities in exchange for MBSs ❑ Helped JPMorgan Chase acquire Bear Stearns The Fed and the Treasury Department Respond—2 ◼ ◼ September 2008: ❑ Lehman Brothers went bankrupt ❑ Merrill Lynch was sold to Bank of America ❑ The Fed organized an $85 billion bailout of AIG October 2008: ❑ Troubled Asset Relief Program (TARP) Oil Prices—1 ◼ In addition, oil prices were extremely volatile Year Price 2002 $20 per barrel Summer 2008 $140 per barrel December 2008 $40 per barrel The Price of Oil Oil Prices—2 ◼ The oil price increase was caused by: ❑ Demands from China, India, and the Middle East ❑ Short-term supply disruptions ◼ The economic slowdown helped to alleviate oil demand pressures ◼ Price speculation also likely played a role 10.3 Macroeconomic Outcomes ◼ The recession, starting in December 2007, was first visible in unemployment ◼ By 2009: ◼ ❑ Output was 7% below potential ❑ Unemployment was more than 10% February 2010: ❑ 8.5 million jobs lost Nonfarm Employment in the U.S. Economy ෩ U.S. Short-Run Output, 𝒀 U.S. Unemployment Rate Changes in Key Macroeconomic Variables Inflation ◼ Unstable oil prices caused volatile inflation ◼ Core inflation has been much smoother Case Study: A Comparison to Other Financial Crises ◼ According to a study summarizing worldwide financial crises, the typical crisis sees ❑ unemployment rate increase of 7% for five years ❑ a doubling of government debt ❑ a 10% decline in real GDP Average Outcomes of 20thCentury Financial Crises The Rest of the World ◼ Global financial crisis ◼ 2009: world GDP fell for the first time in decades 10.4 Fundamentals of Financial Economics ◼ Balance sheet ❑ ❑ Accounting tool ◼ Left side: assets ◼ Right side: liabilities and net worth The two sides sum to the same value Balance Sheets ◼ Assets ❑ ◼ Liability ❑ ◼ Item of value that an institution owns An amount that is owed to someone else Equity (net worth or capital) ❑ Difference between total assets and total liabilities ❑ Represents the value of an institution to its shareholders or owners Banking Regulations ◼ Banks are also subject to financial regulations ◼ The reserve requirement ❑ ◼ Mandates that banks keep a certain percentage of deposits on reserve The capital requirement ❑ Mandates that capital be a certain fraction of assets Hypothetical Bank’s Balance Sheet Leverage—1 ◼ Leverage ❑ The ratio of total liabilities to net worth ❑ Magnifies any changes in the value of assets and liabilities ❑ This principle also applies to homeowners Leverage—2 ◼ ◼ If a bank is highly leveraged, it may have ❑ Large gains off a small increases in market prices ❑ Large losses off a small decrease in prices Insolvency ❑ ◼ Liabilities > assets Before the financial crisis, many investment banks were highly leveraged Bank Runs and Liquidity Crises—1 ◼ The Great Depression was caused in part by bank runs ◼ Bank run ❑ All depositors withdraw funds at once ❑ The bank cannot meet all requests Bank Runs and Liquidity Crises—2 ◼ In the recent crisis, a similar problem occurred on the liability side ❑ Financial institutions usually have large amounts of short-term debt ❑ After the collapse of Lehman Brothers, banks became worried about lending to other banks ❑ Interest rates spiked on commercial paper, leading to a liquidity crisis
