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Jean Walker West Texas Center for Economic Education College of Business West Texas A&M University Canyon, Texas 1.

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1 Jean Walker West Texas Center for Economic Education College of Business West Texas A&M University Canyon, Texas 1

2 ... 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. 2

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4  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 (oil price shock due to Gulf War) ▪ Recession of (tight money to control inflation) ▪ Recession of (stagflation; OPEC oil embargo spiked oil prices) ▪ Great Depression (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 ▪ The Roaring 20’s Stock Bubble – 1920’s ▪ Japan’s Bubble Economy – ▪ The Dot-Com Bubble – 1990’s  Lesson 4 – comparison to Lost Decade in Japan 4

5  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 5

6 What happened? Why? In 5 years, how far have we come? 6

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10 10 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 Prices peaked in 2006.

11  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. 11

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14  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. 14

15  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. 15

16  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 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. 16

17  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 %.  Dec. 17 – Goldman Sachs posts $2.12 billion loss, first since going public in  Dec. 20 – White House agrees to lend GM and Chrysler $17.4 billion. 17

18 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) 18

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21 One of the very few beneficiaries of the Recession 21

22 22 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.

23  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”) 23

24 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 24


26 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.

27 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.


29 TOUGH BALANCING ACT INFLEXIBLE CURRENCY  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.

30  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  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.

31 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  Eastman Kodak  Firestone Tire  Ford Motors  Harley-Davidson  Hershey  U.S. Steel  J.C. Penney  Pepsi-Cola  Texaco  Sylvania Electric

32  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.

33  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.

34 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

35  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

36 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.

37 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.

38 J.P. MORGAN NEITHER ELECTED NOR APPOINTED, HE FELT IT WAS HIS TIME TO ACT  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.

39 SPECULATION IN OFF-STREET MARKETS A BUCKET SHOP IN 1907 Bucket shops were blamed for fueling the speculation in 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.

40 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.


42 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.

43 HIGHLY COMPLEX FORMS OF FINANCING THIS WAS TOO TEMPTING FOR THE FINANCIAL INSTUTIONS  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.

44 TRUSTED AGENCIES FAILED TO WARN INVESTORS RISK-RATING AGENCIES  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.

45 WHAT WERE WE THINKING? THE PERFECT STORM  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.

46 “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.

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

48 THE FINANCIAL CRISIS OF 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%

49 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.

50  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

51  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  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

52  Community Reinvestment Act – signed in 1977 by Jimmy Carter  Induced lenders to enter underserved or “red-lined” areas.  , 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. 52

53  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. 53

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55 U.S. Homeownership rate: % % % 55

56  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. 56

57  Before teaching this lesson, make sure students understand the concept of business cycles:  Expansion  Recession  Peaks  Troughs 57

58  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 Before working, they should understand business cycles and how GDP and Unemployment affect or are affected by recessions. 58

59  The Great Depression ( )  Duration: (43 months) & (13 months)  Began with falling demand for durables and investment goods  Stock market crashed in Oct  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

60  The Recession of  Duration – Nov 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 Remember Gerald Ford and the WIN buttons – Whip Inflation Now! 60

61  The Recession of  Duration – July 1981 to Nov (16 months)  Peak unemployment % (Nov., 1982)  Inflation rate – 8.9%  Business bankruptcies up 50%  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 President Reagan was in office and is often credit with “breaking the back of inflation.” 61

62  The Recession of  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 62

63  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 bubble ▪ Uncertainty after attacks of ▪ Accounting scandals and fraud at Enron, Worldcom, etc. Since most stocks were traded on the NASDAQ, the stock graph tells the story of the bubble collapse that was a cause of the recession. 63

64  The Financial Crisis of  Duration – December 2007 to June 2009 (18 months)  Peak unemployment % (October, 2009)  GDP Decline peak to trough: (4.1%)  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 64

65 ▪ Tulipmania in the Dutch Republic – 1630’s ▪ The South Sea Bubble – Great Britain ▪ The Roaring 20’s Stock Bubble – 1920’s ▪ Japan’s Bubble Economy – ▪ The Dot-Com Bubble – 1990’s  65

66  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. 66

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68 “The four most expensive words in the English language are, this time it’s different.” attributed to Sir John Templeton 68


70  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  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 70

71  Govt. injected massive amount of money into banks—was controversial  Government said banks were “too big to fail”  This led to “zombie banks ”  The problems in real estate and stock spilled over into the rest of the economy  Housing prices peaked in 1991  The whole economy fell into recession  A series of graphs in Activity 2 compares the 2007 recession in the U.S. to Japan’s lost decade 71

72  By 1995, the Japanese had spent nearly $2.1 trillion on public projects to stimulate the economy.  In 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

73  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. 73

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75 Jean Walker Director, West Texas Center for Economic Education College of Business West Texas A&M University Canyon, Texas

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