Jean Walker
West Texas Center for Economic Education
College of Business
West Texas A&M University
Canyon, Texas
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. . . presents an organizing framework for putting into context the media attention that has been paid to the
2008 financial crisis . . .
This publication, in it’s entirety, is included on the Virtual Economics
CD, version 4.
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 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
(Dot-Com bubble burst, Enron, Worldcom, et.)
(oil price shock due to Gulf War)
(tight money to control inflation)
▪ Recession of 1973-75 (stagflation; OPEC oil embargo spiked oil prices)
▪ Great Depression 1929-38 (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
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 Specific focus on the recent financial crisis
 Lesson 5 – focuses on monetary policy
▪ Students role play as Federal Reserve Board governors
 Lesson 6 – examines the housing bubble
▪ Heavy use of supply/demand graphs
▪ Securitization simulation for students
 Lesson 7 – helps students learn terminology about modern financial markets
▪ Quiz bowl game on terminology
 Lesson 8 – interaction between modern financial markets and monetary and fiscal policies
▪ Students take part in mock trial
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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
1890.
Prices peaked in 2006.
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 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
2nd & 3rd 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.
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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
 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.
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April
 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
 May 9 – AIG posts $7.8 billion quarterly loss.
June
 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
 July 12 – Regulators seize IndyMac bank.
 July 14 – Treasury and Fed place Fannie Mae and Freddie Mac under govt. control.
 July 31 – Pres. Bush signs a housing-rescue bill.
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 August
 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.
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 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 McDonald’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.
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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)
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One of the very few beneficiaries of the Recession
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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.
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Announcer
Joe, who needs money for his kid’s college tuition
Bruce, the mortgage banker/mortgage broker
Mortimer, the old-time banker
Uncle Sam
Wall Street banker
Investment salesman
Village treasurer of Narvik, Norway
Bruce’s boss
The World – (all together)
(Nine characters plus “the world”)
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Have students complete
Activity 1 as you progress through the slides of visual 1.
If you have not taught about the recent financial crisis, you will find information in other lessons to assist with explanations.
FYI:
The slides for Activity 1 are available in powerpoint on www.councilforeconed.org/financialcrises
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THE PANIC OF 1907
THE FINANCIAL CRISIS OF
2007

DEVASTATION SAN FRANCISCO EARTHQUAKE
 Shortly after 5 a.m. on April
18, a 7.8-magnitude quake, unleashed offshore, shook the city for just less than a minute.

UNCONTROLLABLE BLAZE 80% OF THE CITY DESTROYED
 Though the damage from the quake was severe, the subsequent fires from broken gas lines caused the vast majority of the destruction.

3,000 PEOPLE DIED
THE FIRES RAGED FOR FOUR
DAYS

TOUGH BALANCING ACT INFLEXIBLE CURRENCY
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Between 1870 and 1914, many countries adhered to a gold standard.
This strictly tied national money supplies to gold stocks.
Currency was redeemed for gold at a fixed exchange rate.

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At the end of 1905, nearly 50% of the fire insurance in San Francisco was underwritten by British firms.
The earthquake gave rise to a massive outflow of funds—of gold—from
London.
The magnitude of the resulting capital outflows in late summer and early autumn 1906 forced the Bank of England to undertake defensive measures to maintain its desired level of reserves.
The central bank responded by raising its discount rate 2.5% in 1906.
Actions by the Bank of England attracted gold imports and sharply reduced the flow of gold to the United States.
Interest rates rose and by May 1907, the United States had fallen into one of the shortest, but most severe, recessions in American history.

At the beginning of the century, the nation was brimming with a great amount of optimism.
Here is a list of familiar companies founded between 1900 and
1905.
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Eastman Kodak
Firestone Tire
Ford Motors
Harley-Davidson
Hershey
U.S. Steel
J.C. Penney
Pepsi-Cola
Texaco
Sylvania Electric

 In October 1907 two brothers,
Otto and F. Augustus Heinze, attempted to manipulate the stock of a copper company.
 They planned to corner the market in the copper company's shares by buying aggressively in hopes they could later force short sellers to buy them at high prices.
 The plan did not have sufficient backing and failed.

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News a number of prominent New York bankers were involved in the failed scheme began a crisis of confidence among depositors.
As additional institutions were implicated, queues formed outside numerous banks as people desperately sought their savings.

KNICKERBOCKER TRUST COMPANY

Illustration from Harper's Weekly December 20, 1913 by Walter J.
Enright
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They were able to hold a wide array of assets and were not required to hold reserves against deposits.
They earned a higher rate of return on investments and paid out higher rates, but, to do this, they had to be highly leveraged.
They took more risks than traditional banks.

The runs on deposits that sparked the Panic of 1907 were at two of the largest
New York City trust companies:
Knickerbocker
Trust and Trust
Company of
America.
A NEW YORK CITY BANK RUN IN NOVEMBER 1907

The crash and panic of 1907 had a dramatic effect on the health of the
American and worldwide economies. In the United States:
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Commodity prices fell 21 %.
Industrial production fell more than in any other crisis in American history to that point.
The dollar volume of bankruptcies declared in November was up 47 % from the previous year.
The value of all listed stocks in the U.S. fell 37 %.
In October and November 1907, 25 banks and 17 trust companies failed.
Thousands of depositors lost their life savings.
Gross earnings by railroads fell by 6 % in December and production fell
11%.
Wholesale prices fell 5 %.
Imports shrank 26 %.
In a few short months, unemployment rose from 2.8 % to 8%.
Immigration reached a peak of 1.2 million in 1907 but fell to around 750,000 by 1909.

J.P. MORGAN
NEITHER ELECTED NOR
APPOINTED, HE FELT IT WAS HIS
TIME TO ACT
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In the absence of a strong federal regulatory structure or any safety nets, the response to this crisis had to be delivered by a private citizen, J.P. Morgan, the world’s most powerful banker.
He used all of his influence to convince fellow titans of industry to pool their resources and salvage the nation.
The Panic subsided after six weeks.

SPECULATION IN OFF-STREET
MARKETS
Bucket shops were blamed for fueling the speculation in 1907.
They enabled people to speculate on the value of a stock without having to purchase the stock itself.
The actual order to purchase went in the “bucket.” Beginning in
1909, New York banned bucket shops and other states followed.
A BUCKET SHOP IN 1907

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.

DURING AND AFTER THE MILD
RECESSION OF 2001, THE FED LOWERS
INTEREST RATES
FORMER FED CHAIRMAN ALAN
GREENSPAN

FORMER PRESIDENT GEORGE
BUSH
STRONGLY PROMOTED
HOMEOWNERSHIP
 “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.

HIGHLY COMPLEX FORMS OF
FINANCING
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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

TRUSTED AGENCIES FAILED TO
WARN INVESTORS
 Mortgage-backed securities were constructed of mortgages of differing quality levels.
 The obligations of solid and sub-
prime 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

WHAT WERE WE THINKING?
THE PERFECT STORM
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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.

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Bank failures: 183 (2%) 12/07-
2/10 (No deposits lost)
Unemployment rate: 10.1%
(10/09)
Economic decline: -4.1% (4Q
2007-2Q 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

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.

1907
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Highly complex and linked financial system
Strong growth in the economy starting in 1900
Many people and institutions highly leveraged
Innovative form of finance: trust companies
Stock market setting all-time highs
A limited role for government
Markets swing from great optimism to great pessimism
2007
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Global interdependent financial system
Vibrant economic recovery after recession in 2001
Lenders willing to take more risk in making loans
Unregulated financial institutions: hedge funds
Companies reporting record earnings
Absence of many safety buffers
Dow 14,164 to 6,500 in 16 months

1907
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J.P. Morgan, a private citizen, orchestrated the bailout
The Panic lasted for six weeks, though the economy didn’t return to pre-
Panic levels until 1909
Many banks were closed and many depositors lost their savings
The nation was on the gold standard and the supply of money was fixed
The San Francisco earthquake was a catalyst for the Panic
The climate toward business was hostile prior to crisis
2007
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The Federal Reserve and Treasury
Department organize the reaction
The event has been unfurling for more than five years
Many banks closed and folded into healthier banks, but depositors did not lose any of their savings
The nation uses Federal Reserve notes, creating a flexible money supply
Hurricane Katrina was generally benign as a catalyst
The climate toward business was friendly prior to crisis

 Community Reinvestment Act – signed in 1977 by Jimmy Carter
 Induced lenders to enter underserved or “red-lined” areas.
 1993 -1995, President Clinton asked regulators to reform the CRA to
"deal with the problems of the inner city and distressed rural communities”--availability of credit should not depend on where a person lives.
 The Interstate Banking and Branching Efficiency Act of 1994, which repealed restrictions on interstate banking, used CRA ratings as a consideration when determining whether to allow interstate branches
 George Bush, as early as 2002, pushed home ownership—”an ownership nation.”
 In 2007 Ben Bernanke suggested further increasing the presence of
Fannie Mae and Freddie Mac in the affordable housing market to help banks fulfill their CRA obligations by providing them with more opportunities to securitize CRA-related loans.
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 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.
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U.S. Homeownership rate:
2000 67.4%
2004 69.0%
2010 66.9%
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 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.
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 Before teaching this lesson, make sure students understand the concept of business cycles:
 Expansion
 Recession
 Peaks
 Troughs
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Growth of real GDP measures health of economy
 Generally, we say two quarters of declining GDP is a recession, but economists at the National Bureau of Economic Research actually make the determination
 GDP = C + I + G + Net Exports
▪ Consumer spending is 60-70% of U.S. GDP
▪ Investment spending, government spending, and net exports make up the rest
Contributing factors to growth:
 Level and rate of change of technology
 Investment in tools, machines, computers, infrastructure, and building
 Skill and experience levels of the economy’s labor
The main activity in this lesson asks students to work in groups to analyze 6 of the 14 recessions between 1929 and 2007. Before working, they should understand
business cycles and how GDP and Unemployment affect or are affected by recessions.
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 The Great Depression (1929-
1938)
 Duration: 1929-1933 (43 months)
& 1937-1938 (13 months)
 Began with falling demand for durables and investment goods
 Stock market crashed in Oct. 1929
 By March 1933, 25% of the workforce was out of work.
 More than 9,000 bank failures between 1929 and 1933
 Fed did not act as the lender of last resort, even raising interest rates in late 1931
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Remember Gerald Ford and the WIN buttons – Whip Inflation Now!
 The Recession of 1973-1975
 Duration – Nov. 1973 to March
1975 (16 months)
 Peak unemployment - 9.0%
(May, 1975)
 Inflation rate - 11%
 Economic stagflation
 Causes
▪ 1973 Oil Crisis – OPEC’s oil embargo caused “oil price shock”, which slowed production of goods and services
▪ Vietnam War
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President Reagan was in office and is often credit with “breaking the back of inflation.”
 The Recession of 1981-1982
 Duration – July 1981 to Nov.
1982 (16 months)
 Peak unemployment - 10.8%
(Nov., 1982)
 Inflation rate – 8.9%
 Business bankruptcies up 50%
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Farmers especially hard hit
▪ Ag exports declined
▪ Crop prices fell
▪ Interest rates rose
Causes
▪ Iranian Revolution increased oil prices and new Iranian regime exported oil inconsistently
▪ FED adopted tight money policy
(high interest rates) to break the back of inflation
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 The Recession of 1990-1991
 Duration – July 1990 to March
1991 (8 months)
 Peak unemployment - 7.8%
(June, 1992)
 Although brief, the recession caused George H.W. Bush to be defeated by Bill Clinton
 Causes
▪ 1990 oil price shock because of the Gulf War
▪ Ongoing concerns of savings and loan crisis
▪ After a long expansion, inflation began to increase so the FED increased interest rates
▪ Debt accumulated in the 1980’s was a concern
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Since most dot.com stocks were traded on the NASDAQ, the stock graph tells the story of the bubble collapse that was a cause of the recession.
 The Recession of 2001
 Duration – March 2001 to
November 2001 (8 months)
 Peak unemployment -
6.3% (June, 2003)
 NASDAQ returns
▪ 2000 (40%)
▪ 2001 (21%)
 Causes
▪ Collapse of speculative dot.com bubble
▪ Uncertainty after attacks of
9-11-2001
▪ Accounting scandals and fraud at Enron, Worldcom, etc.
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 The Financial Crisis of 2007-
09
 Duration – December 2007 to
June 2009 (18 months)
 Peak unemployment - 10.1%
(October, 2009)
 GDP Decline peak to trough:
(4.1%)
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Bank failures (2007 – 2009): 168
Causes
▪ Subprime mortgage crisis led to housing market collapse
▪ Collapse of MBS brought down
Bear Stearns, Fannie Mae, Freddie
Mac, Lehman Brothers, and AIG
▪ Investment banks used too much leverage
▪ All remaining investment banks turned into commercial banks
▪ Government bailout of financial services and auto industries
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▪ 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
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 Hyman Minsky’s phases of a bubble:
 Displacement
▪ Crisis begins with an outside shock to the system—war, new invention, political event, etc.
 Boom
▪ Rapid rise in prices of a financial or physical asset as investors and speculators earn profits
 Euphoria
▪ 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
▪ A few insiders begin to take profits and get out, and price increases begin to level out.
 Panic
▪ 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.
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 Strong demand for Japanese exports
 Large amounts of foreign currency flowed to Japan as a result
Low interest rates
Speculative surge in Japanese stock market
Speculative surge in Japanese real estate
Boom in stocks and real estate were supported by debt
Japanese govt. feared an asset bubble and decided to
“pop the bubble” by increasing interest rates
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It had been easy for the Japanese to borrow money to invest in stocks or real estate because rates had been low
Collapse in prices led to a credit crisis —banks suffered massive losses as defaults on loans rose
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 Government said banks were “too big to fail”
 This led to “zombie banks ”
 Housing prices peaked in 1991
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By 1995, the Japanese had spent nearly $2.1 trillion on public projects to stimulate the economy.
In 1994-95 the economy began to rebound, but it was a false recovery.
 The stimulus plans had created huge budget deficits.
 Some argued the govt. stopped spending too soon; others argued reducing taxes would have been better.
 The govt. increased taxes to reduce the deficits, and by
1997, growth was again at zero.
 Between 1994 and 2009, prices declined (deflation) in all but one year.
 Growth recovered in 2003-04.
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Through opinion pieces in the Financial Times and
Washington Post, Larry Summers, former economic adviser to Barack Obama and Treasury secretary under Bill Clinton’s presidency, expressed concern that the United States is heading for a “lost decade” similar to Japan’s lost decade in the 1990s.
This country has already experienced five years of economic growth under 1% annually, and that’s half way to a decade.
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Jean Walker
Director, West Texas Center for Economic
Education
College of Business
West Texas A&M University
Canyon, Texas 79016
806-651-2515 jwalker@wtamu.edu
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