Jean Walker West Texas Center for Economic Education College of Business West Texas A&M University Canyon, Texas Teaching Financial Crises
Teaching Financial Crises: . . . 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.
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 (Dot-Com bubble burst, Enron, Worldcom, et.) • Recession of 1990-1991 (oil price shock due to Gulf War) • Recession of 1981-82 (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
Teaching Financial Crises lessons: • 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
Financial Crisis: What happened? Why? In 5 years, how far have we come?
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 1890. Prices peaked in 2006.
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 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.
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 • 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.
2008, The Year It All Fell Apart • 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.
September 2008: The Month Wall Street Died • 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.
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 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.
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)
How did major players survive 2008? One of the very few beneficiaries of the Recession
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.
Lesson 1, Activity 3, page 11 • Introduce the 2007 Financial Crisis with Activity 3 – Characters in the Financial Crisis • 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”)
Lesson 1, Activity 1, page 15 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
THE FINANCIAL CRISIS OF 2007 PANDEMONIUM IN THE MARKETS THE PANIC OF 1907
SAN FRANCISCO EARTHQUAKE EVENTS IN 1906 DEVASTATION Shortly after 5 a.m. on April 18, a 7.8-magnitude quake, unleashed offshore, shook the city for just less than a minute.
80% OF THE CITY DESTROYED SAN FRANCISCO EARTHQUAKE 1906 UNCONTROLLABLE BLAZE Though the damage from the quake was severe, the subsequent fires from broken gas lines caused the vast majority of the destruction.
THE FIRES RAGED FOR FOUR DAYS REMEMBERING THE SAN FRANCISCO EARTHQUAKE OF 1906 3,000 PEOPLE DIED
INFLEXIBLE CURRENCY THE GOLD STANDARD TOUGH BALANCING ACT 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.
THE WORLD’S FINANCIAL SYSTEM HAD BECOME COMPLEX & INTERRELATED 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.
GREAT ECONOMIC PROMISE 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. • Eastman Kodak • Firestone Tire • Ford Motors • Harley-Davidson • Hershey • U.S. Steel • J.C. Penney • Pepsi-Cola • Texaco • Sylvania Electric
EVENTS IN 1907 • 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.
PANIC IN THE STREETS • 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.
FURTHER COMPLICATING MATTERS Trust companies were a financial innovation of the 1890s. They had many functions similar to state and national banks but were much less regulated. KNICKERBOCKER TRUST COMPANY
GREATER RISKS WERE TAKEN • 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. Illustration from Harper's Weekly December 20, 1913 by Walter J. Enright
A NEW YORK CITY BANK RUN IN NOVEMBER 1907 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.
THE IMPACT The crash and panic of 1907 had a dramatic effect on the health of the American and worldwide economies. In the United States: 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.
NEITHER ELECTED NOR APPOINTED, HE FELT IT WAS HIS TIME TO ACT WHAT WAS DONE? J.P. MORGAN 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.
A BUCKET SHOP IN 1907 LESSONS FROM THE PANIC OF 1907 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.
……….AND LOST!! THE FINANCIAL CRISIS OF 2007 THE WORLD MADE HUGE INVESTMENTS IN THE U.S. HOUSING MARKET 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.
FORMER FED CHAIRMAN ALAN GREENSPAN THE ORIGINS OF THE CRISIS DURING AND AFTER THE MILD RECESSION OF 2001, THE FED LOWERS INTEREST RATES
STRONGLY PROMOTED HOMEOWNERSHIP THE ORIGINS OF THE CRISIS 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.
THIS WAS TOO TEMPTING FOR THE FINANCIAL INSTUTIONS 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.
RISK-RATING AGENCIES 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 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.
THE PERFECT STORM EFFECTS OF THE CRISIS 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%) 12/07-2/10 (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
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.
2007 SIMILARITIES 1907 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 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