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The Current Economic and Financial Crises

The Current Economic and Financial Crises

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The Current Economic and Financial Crises

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  1. The Current Economic andFinancial Crises

  2. How did we get here? • Background • Housing Market • Mortgage Market • Main Street • Wall Street

  3. 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

  4. Housing Market • Easy credit increased demand for homes. • Housing prices increased • Supply increases overtake demand increases. • Prices fell • Speculators demand decreased • Prices fell further

  5. 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.

  6. 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.

  7. 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

  8. 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

  9. 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.

  10. 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.

  11. 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

  12. 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.

  13. 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.

  14. 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

  15. Housing Market Test (2) • Builders overbuild • Credit tightens • Borrowers default • Speculators and others lose confidence

  16. C, I, G, X, or M? • Lower housing values, negative wealth effect. • Purchase of durable goods fell. • Expenditure multiplier as a result of (1) and (2) • Construction declines. • Consumer confidence falls.

  17. C, I, G, X, or M • Credit crunch • Increased federal spending • Decreased federal taxes • Decreased state and local spending • Increased state and local taxes