overview how did the financial crisis affect us? what are some likely hypotheses regarding the...

OverviewHow did the financial crisis affect us?What are some likely hypotheses regarding

the causes of the financial collapse?What do today's banks do?

Hint: Do they still follow the 3-6-3 rule? Ideas for teaching about the financial crisisQuestions

How did the financial crisis affect us?

Average Real Disposable Income Was Rising

Savings Rates Were Falling

Household Debt to Disposable Personal Income Ratio Increases

1953 1955 1958 1960 1963 1965 1968 1970 1973 1975 1978 1980 1983 1985 1988 1990 1993 1995 1998 2000 2003 2005 2008

20%

40%

60%

80%

100%

120%

140%

Subprime, Alt-A, and Home Equity Loans Increase

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 20070%

10%

20%

30%

40%

50%

Subprime (FRB) Subprime (JCHS) Subprime + Alt-A Subprime + Alt-A + Home Equity

Fall in Housing Prices

DJIA, S&P and Nasdaq Trends: Stock Wealth Evaporates

Default Rates Rise

1979 1980 1981 1982 1984 1985 1986 1987 1989 1990 1991 1992 1994 1995 1996 1997 1999 2000 2001 2002 2004 2005 2006 2007

0%

1%

2%

3%

4%

5%

6%

Foreclosure Rates Increase

1979 1980 1981 1982 1984 1985 1986 1987 1989 1990 1991 1992 1994 1995 1996 1997 1999 2000 2001 2002 2004 2005 2006 2007

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

Recession

Unemployment

What are some likely hypotheses regarding the causes of the financial collapse?

What Happened?What Happened?

In1989 Berlin wall falls.In1989 Berlin wall falls. China and India deregulate.China and India deregulate. Expanded production capacity puts damper Expanded production capacity puts damper

on inflation. Central banks now can increase on inflation. Central banks now can increase money supply without much concern about money supply without much concern about inflation.inflation.


In 2001, the Fed consistently lowered interest In 2001, the Fed consistently lowered interest rate from 6.5% to 1.75 % and to 1.0 % by rate from 6.5% to 1.75 % and to 1.0 % by June 2003. June 2003.

Central banks around the world followed suit Central banks around the world followed suit creating an unprecedented increase in the creating an unprecedented increase in the supply of credit. supply of credit.


The low rates made borrowed money cheap The low rates made borrowed money cheap and households and businesses responded and households and businesses responded as expected: they bought and bought. as expected: they bought and bought.

In the housing market, the Case-Shiller home In the housing market, the Case-Shiller home price index increased 80% from January price index increased 80% from January 2001 to December 2005.2001 to December 2005.

What Happened?What Happened? Federal government aggressively promotes Federal government aggressively promotes

home ownershiphome ownership Homeownership rate increased from normal Homeownership rate increased from normal

64 percent (which was the rate for 35 years) 64 percent (which was the rate for 35 years) to 69 percent in 2004to 69 percent in 2004

Subprime loans totaled $330 billion in 2001Subprime loans totaled $330 billion in 2001 By 2004 they reached $1.1 trillion (37% of By 2004 they reached $1.1 trillion (37% of

residential mortgages)residential mortgages) By 2006 they were 48% of all mortgages.By 2006 they were 48% of all mortgages.


In mid-2004, the Fed reversed its interest policy In mid-2004, the Fed reversed its interest policy -- the rate climbed to 2.25 % by December -- the rate climbed to 2.25 % by December 2004 and reached 5.25% in 2006.2004 and reached 5.25% in 2006.

The demand for houses and other durable The demand for houses and other durable goods decreased and prices declined 33% from goods decreased and prices declined 33% from a peak in July 2006.a peak in July 2006.

Interest Rates and Lagged Housing PricesInterest Rates and Lagged Housing Prices

Housing prices

Interest rates

Housing Bubble – Jan 92 to July 09Housing Bubble – Jan 92 to July 09source: S&P Case-Schiller National Home Price Index 1987-2008 - inflation adjustedsource: S&P Case-Schiller National Home Price Index 1987-2008 - inflation adjusted

LeverageLeverage

The magnitude of the current financial crisis The magnitude of the current financial crisis has grown because of the amount of has grown because of the amount of leverageleverage used. used.

Leverage and IncentivesLeverage and Incentives

Investment banks were leveraged by a ratio of Investment banks were leveraged by a ratio of 30 to 1, government sponsored mortgage giants 30 to 1, government sponsored mortgage giants Freddie and Fannie were closer to 50 to 1. Freddie and Fannie were closer to 50 to 1.

When asset prices are rising, this system works When asset prices are rising, this system works like a dream.like a dream.

What do today’s banks do?

PeriodNon interest income as a % of net operating income (Banks with total assets under $1 billion)

Non interest income as a % of net operating income(Banks with total assets over $1 billion)

1991 20.07% 35.16%

1992 19.39% 34.82%

1993 20.58% 36.59%

1994 20.57% 35.78%

1995 20.91% 36.65%

1996 22.22% 37.85%

1997 23.73% 38.43%

1998 25.59% 41.47%

1999 26.26% 44.01%

2000 25.59% 44.30%

2001 26.23% 42.89%

2002 26.19% 42.30%

2003 28.30% 44.04%

10%

20%

30%

40%

50%

60%

70%

80%

90%

200920072005200320011999199719951993199119891987198519831981

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Net Interest Income

Noninterest Income

Actual Data Predicted

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< $100M $100M-$1B

>$1B All Comm. Banks

Teaching about the financial crisis

Open Market Operations Discount Policy Reserve Requirements Interest on Required Reserve Balances and Excess Balances Term Auction Facility Primary Dealer Credit Facility Term Securities Lending Facility ABCP MMMF Liquidity Facility Commercial Paper Funding Facility Money Market Investor Funding Facility Term Asset-Backed Securities Loan Facility

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