The Current Economic and

Financial Crises

How did we get here?

• Background

• Housing Market

• Mortgage Market

• Main Street

• Wall Street

Background

• World money markets awash with savings ($72 trillion)

• Rates on T bills too low, looked to mortgage loans

• Lenders loaned NINJA loans, et. al. • Lenders “bundled” these loans and sold them

as MBSs• Sub Prime loans – interest only, low interest

and balloon payment

Housing Market

• Easy credit increased demand for homes.

• Housing prices increased• Supply increases overtake demand

increases.• Prices fell• Speculators demand decreased• Prices fell further

Housing Market (2)

• Easy payments ended, interest rates rose, many found themselves “upside down.”

• Excess capacity caused housing prices to decline further.

• Upside down homeowners walk away from their homes, housing prices decline further.

Mortgage Market

• “Creative” mortgages worked well as long as housing prices rose. Borrowers expected increases to continue; many did well buying low and selling high.

• Sales of MBSs takes risk away from bundlers. Incentives to sellers

• Some buy MBSs and bundle them into Collateralized Debt Obligations (CDOs). Thought to be as good as cash.

• As long as housing prices continued to rise, all was well.

Mortgage Market (2)

• As upside down borrowers walked away from their loans, the value of bundled packages fell.

• The value of highly leveraged bank’s assets dropped dramatically, causing failures and inability and unwillingness to make new loans.

• Credit freeze

Main Street

• C + I + G + (X-M)• Fall in home equity reduces borrowing, C

falls. • Slow housing demand reduces construction,

and durable goods production and sales – C and I fall

• Construction and other businesses lay off workers, employment falls, income falls –C falls.

• Wealth effect

Main Street (2)

• Credit freeze decreased demand for automobiles. Workers in autos and related industries laid off.

• Businesses, large and small, unable to borrow to finance inventories, workers laid off.

• Decreased employment causes decreased income, causes decreased spending, causes decreased employment.

Main Street (3)

• Consumer confidence falls further.• State and local governments have less

revenue, G falls.• The multiplier worsens the situation.• Loss of jobs, loss of income – induced

consumption falls.• Low consumer confidence, lack of credit, high

debt – autonomous consumption falls.

Wall Street

• Largely dependent on expectations

• No reason to be confident

• Temptation to dump stocks and move into other assets (bonds, commodities)

• Fear of the President’s bill

Is this another depression?

• What caused the depression?– Perverse monetary policy– Perverse fiscal policy– Smoot Hawley Tariff

• 25% unemployment, 50% of industrial capacity stood idle.

MB/MOC AnalysisUpside Down Mortgage

• You owe more than the value of the home. If you sell the home, you won’t have enough to pay off the mortgage.

• Three alternatives– Sell the home for less than you owe– Keep making payments that you may not be able

to afford. Maybe no food or shoes for the kids. – Walk away; default on the loan. You end up with

no home and bad credit.

Housing Market Test(S or D, I or D)

• Easy credit• Government policies to encourage

lenders to lend to low income borrowers.

• Inability of construction to keep up with demand.

• Speculation that housing prices would continue to increase

Housing Market Test (2)

• Builders overbuild

• Credit tightens

• Borrowers default

• Speculators and others lose confidence

C, I, G, X, or M?

1. Lower housing values, negative wealth effect.

2. Purchase of durable goods fell.

3. Expenditure multiplier as a result of (1) and (2)

4. Construction declines.

5. Consumer confidence falls.

C, I, G, X, or M

6. Credit crunch

7. Increased federal spending

8. Decreased federal taxes

9. Decreased state and local spending

10. Increased state and local taxes