1. The Current Credit Crisis By Dr. Paul Lockard Professor Black Hawk College

2. Causes of the Banking Crisis and the Great Recession

3. Brief Summary: Factors Causing Crises Bank deregulation Adjustable Rate Mortgages Transformation of lending industry Creation of incredible financial devices Exploding housing prices Stagnating income Rising gasoline price

4. Background Brief Overview of Home Buying

5. Brief Overview of Housing Market When people buy a house, they borrow the money. The loan is in the form of a mortgage. A mortgage has two parts: –principal and interest.

6. Brief Overview of Housing Market The principal is the amount of money borrowed. It is supposed to be nearly the value of the property.

7. Brief Overview of Housing Market The interest is the price of borrowing the money from the lender. There are two basic types of loans: –Fixed rate –Adjustable rates

8. Brief Overview of Housing Market Lenders used to sort borrowers into different categories. –Prime –Alt A –Sub prime

9. Brief Overview of Housing Market Prime borrowers – higher incomes, stable jobs, good credit, Sub-prime – low incomes, unstable job history, poor credit Sub-prime – traditionally people who wouldn’t receive loans

10. Brief Overview of Housing Market Lenders (banks and credit unions) make a profit by lending money. When they lend to home buyers, they make a profit in two ways: –The interest on the loan –The fees charged for the paperwork.

11. Background Old Style Home Mortgages

12. Background: Old Style Mortgages Traditionally, from the 1930’s to the 1980’s, banks lent money for mortgages in a simple fashion. Home mortgage loans were for a fixed time and a fixed rate: 15 to 30 years.

13. Background: Old Style Mortgages A fixed rate mortgage meant that the interest rate was fixed, and therefore, so were the monthly payments. Predictable mortgage payments meant predictable payments for the homeowners.

14. Background: Old Style Mortgages Predictable mortgage payments also meant predictable revenue for the lender.

15. Background: Old Style Mortgages Banks and Savings & Loans were careful about who they lent to, since they kept the mortgages themselves. Local banks – local lending – more care in lending, and more interest in helping homeowners.

16. Background: Old Style Mortgages Bank revenues were stable but low. And it was all a bit boring for bankers.

17. Financial Deregulation

18. 1980’s: Saving and Loan Crisis As a result of 1970’s inflation, banks were losing money on most older mortgages. How?

19. Real vs. Nominal Interest Rates Nominal Interest Rate = Face Value of the Interest Rate Real Interest Rate = Nominal Interest Rate – Rate of Inflation

20. Real vs. Nominal Interest Rates Bankers care about the Real, not the Nominal, interest rates. Real Interest Rates can be either positive or negative.

21. Real vs. Nominal Interest Rates Negative Real Interest Rate = Bank losses Positive Real Interest Rates = Bank profits

22. 1970’s: Real Interest Rates Due to the high inflation of the 1970’s and early 1980’s, virtually every older loan had negative real interest rates. In particular, the Savings & Loan industry was suffering massive losses.

23. Solution to the Saving and Loan Crisis In 1980 and then in 1982, the Savings & Loan industry and the other banking industries, were partly deregulated. Republicans overwhelmingly in favor, and had large majority of Democrats with them.

24. Results of Financial Deregulation

25. Result of Bank Deregulation With no legal limit on home mortgage interest rates, mortgage interest rates jumped, up to 15% in some cases. Also, banks could now offer different types of mortgages.

26. Results of Deregulation: Adjustable Rate Mortgages The main type of home mortgage since deregulation is some type of Adjustable Rate Mortgage (ARM) Usually begins with low interest rates, and then the bank is free to raise or lower the interest rate as it sees fit.

27. Results of Deregulation Changing interest rates meant changing monthly mortgage payments: hard for consumers to budget! Later, to help homeowners, laws put in place to slow down how fast rates could rise.

28. Other Bills During the 1980’s and 1990’s, a series of bills were passed that dismantled more of the Federal government regulations on the financial industries.

29. 1999 Gramm-McCain Bill Later, the last remains of Federal regulation were eliminated with the passage of the Gramm-McCain Bill. This was passed with the support of President Clinton, the Republicans, and plenty of Democrats.

30. Results: Banks freed to create all sorts of types of mortgages, and to create all sorts of financial “instruments”. Banks freed to set up branches everywhere. Banks freed to enter into all types of financial services.

31. Results: Financial industries grew spectacularly. In 1978, all commercial banks held $1.2 trillion in assets, = to 53% of US economy. In 2007, all commercial banks held $11.8 trillion in assets, = to 84% of US economy.

32. Results: Largest banks grew even faster. JPMorganChase is the result of mergers of Chemical Bank with Hanover Bank, First Chicago, National Bank of Detroit, Chase Manhattan, Bank One, J.P. Morgan, all since 1990 I

33. Results: Source: 13 Bankers, Simon Johnson and James Kwak, (New York: Pantheon Books, 2010), pgs. 59,85. Based on Federal Reserve Flow of Funds

34. Transformation of Financial Industries

35. New Lending Industries There was also a tremendous change in home mortgage business, beginning in the late 1980’s, and through the 1990’s.

36. Old Style to New Style The mortgage process was completely taken apart and rebuilt into many different stages, with more companies at each stage. Everyone was making a profit up front, and passing the borrower to someone else.

37. New Style Banks no longer generated home mortgages, and no longer kept them. They made their money upfront in application fees, and then sold the mortgage down the river to someone else.

38. New Style As long as your business made a profit, you didn’t care at all about the borrower, or whether they could really afford a loan. Employees and managers paid by commission, by volume of work.

39. New Style Starting slowly in the 1990’s, and very rapidly expanding in the 2000’s, mortgage companies extended loans to people who should never have had them. “Liar loans, NINJA loans, toxic waste.”

40. Securitization The new technique was (and is) to combine a large number of similar loans (similar in dollar amount, interest rate etc.) into a packet. Then you sell the packet to someone else. And they sell it to someone else…

41. Securitization So your home mortgage could be anywhere in the world.

42. Securitization The creators of liar loans and toxic waste buried them deep in bundles of other mortgages. Think of them as rotten apples deliberately hidden deep in a bag, where no one can see them.

43. Failure of Credit Rating Agencies

44. Credit Rating Agencies Normally, there are a number of credit rating agencies, that are supposed to rate banks, bank loans etc., very carefully. They exist to help investors determine if they should make any particular investment.

45. Failure of Credit Rating Agencies In the 1990’s they quit doing their job: everything a bank or a mortgage company did became prime (= top quality).

46. Financial Deregulation: Results The financial world became a wide open frontier, and all of the normal business checks and balances were thrown out the window, by businesses.

47. End of Section

48. Housing Market Meanwhile, back at the ranch…

49. Housing Market House prices normally increase at about the rate of inflation. But from 1995 to 2007, house prices nation- wide increased 70% more than inflation, On average, that is – some places were even worse.

50. Housing Problems Once prices started to drop, they dropped almost as fast as they went up. Now many people find they have reverse mortgages: a mortgage worth more than the house.

51. i

52. Housing Market With the surge in housing prices from the 1990’s on, people became more desperate for a loan to be able to buy a house. E.g. $950,000 for a two bedroom ranch in parts of California.

53. Housing Market Lenders came up with ever more creative loans. They usually were ARMs of some sort, and the interest rates were set to automatically increase after a couple of years, or even 6 months.

54. Housing Market They also started to go after people that they knew should not borrow money for a house: the sub-prime market. Why? Mortgage companies paid by commission.

55. Housing Market Housing prices reached insane levels in many parts of the country: plenty of credit- worthy people with too expensive houses, and/or outrageous ARM’s. And plenty of people who should never have been lent to.

56. Financial Derivatives

57. As a result of deregulation, banks created a whole alphabet soup of financial instruments that virtually no one can understand.

58. Financial Derivatives Remember securitization? That was the simplest of the new devices. Most of these involved borrowing money to invest in something else.

59. Financial Derivatives In normal times, when banks borrow from each other, it isn’t a problem. Also, as long as prices are going up, most of these “instruments” work fine. But nobody bothered to look at what would happen if prices fell, or “something” happened.

60. Housing Market, Family Incomes and the Real World

61. Housing Crisis: A predictable storm Stagnant wages Rising gasoline prices ARM’s kick in

62. Housing Crises: Stagnant Wages Individual wages have stagnated for many years. Household income never recovered from the 2000-2001 recession

63. Current Situation

65. Housing Crises: Rising Gasoline Prices For most of the 1990’s and early 2000’s, gasoline prices remained low and stable. They started to rise in 2003, and really jumped from 2006 onwards.

67. Housing Problems Once prices started to drop, they dropped almost as fast as they went up. Now many people find they have reverse mortgages: a mortgage worth more than the house.

68. Housing Problems: Jumping ARMs Beginning in 2006, many new ARMs started to increase their interest rates. Suddenly, large numbers of monthly mortgage payments jumped. A lot…

69. Housing Problems: Jumping ARMs Very quickly, starting with the subprime loans, large numbers of people found couldn’t afford the monthly payments. And at first, everyone said “No problem : its only the subprime borrowers”

70. Housing Problems 2006-2007 Between rising interest rates, rising mortgage payments, and rising gasoline prices: Large number of people defaulted on sub- prime loans.

71. Housing Problems 2007-2008 What started among sub-prime borrowers spread quite quickly up the income brackets, around all housing markets, and to all types of borrowers. It became a tidal wave of defaults.

72. Housing Problems 2007-2008 Once the number of defaults started to rise, the price increases halted and then prices started to drop. Once housing prices started to fall, they went into free-fall.

73. Banking Crises Not good news…

74. Global Financial Crises Banks and investors around the world have always trusted the US financial system: If Lehman Brothers is selling the product, its American – its safe and it must be good.

75. Global Financial Crises So banks and investors around the world purchased large quantities of home mortgages and other financial instruments from US banks. They especially liked the securitized bundles of mortgages.

76. Global Financial Crises So when the sub-prime crises hit, all of a sudden banks and investors around the world found that their investment bundles contained “toxic waste”.

77. Global Financial Crises Toxic waste is the term used by bankers, and mortgage companies for the sub-prime and other poor quality loans. These guys knew they were bad news, but hey, not my problem, you know?

78. Global Financial Crises All of a sudden, banks and investors around the world found that their US investments were losing unbelievable sums of money. Around the world, large numbers of banks and major investment companies were bankrupt, or nearly so.

79. Global Financial Crises Global, and local, banking systems are built on trust: if BlackHawk Bank buys something from Kewanee Bank, there is a trust that it isn’t a rattlesnake. (Of course they do their homework). Now a lot of that trust has evaporated.

80. Global Financial Crises Without that trust, throughout the world, banks quit lending to each other. (2007-2008) Bank after bank declared losses, and then found no one would help them.

81. Global Financial Crises We had a vicious cycle in place: falling housing prices led to more falling prices- Which leads to more financial instruments turning into losses- Which led to more bank losses- Which led to less bank lending.

82. Global Financial Crises Which led to financial companies that need help were cut off from other financial lenders- Which lead to more failures- Which lead to more pullbacks and lack of trust

83. Main Street Woes Meanwhile, a recession was triggered by high gasoline prices Which led to a fall in consumption Which led to layoffs Which led to more defaults on loans

84. Main Street Woes Starting in 2007, a US recession. By the beginning of 2008, a global recession. Investment and trade dropped as quickly as it had in 1929-1931. We were looking at another Great Depression.

85. Great Recession Not good news…

86. For an excellent chart on this topic, see VoxEU.org “What do the new data tell us?” Barry Eichengreen and Kevin O’Rourke, March 8, 2010

87. Great Recession During 2007-2008: World trade collapsed more quickly than 1929-1931 World industrial production collapsed more quickly than 1929-1931 The global banking system nearly collapsed

88. Great Recession It now appears that a global banking system meltdown was averted. (End of 2011) It also appears that a second Great Depression was averted. Instead, we have a Great Recession.

89. Federal Reserve to the Rescue The job of Federal Reserve? –preserve and maintain the banking system. How did they respond to the meltdown? “Cash for Trash” program – Feds bought toxic assets from banks, at the price the banks named, for cash.

90. Federal Reserve to the Rescue This had to be done, since the usual tools weren’t working. Problem: loans with no strings attached. No punishment for incompetent managers or owners. No restrictions on bonuses, or dividends.

91. Federal Reserve to the Rescue Most importantly No changes in the law to prevent banks from repeating the same behavior!!!

92. Summary Not good news…

93. Brief Summary, Again NOT THE FAULT OF THE GOVERNMENT FORCING BANKS TO LEND TO MINORITIES!!!!!!.

94. Brief Summary, Again UNDER THE INFLUENCE OF BUSINESS LOBBYING, THE DEREGULATION OF THE FINANCIAL INDUSTRIES LEAD TO A HOUSING BUBBLE.

95. Brief Summary, Again THE BURSTING OF THE HOUSING BUBBLE LEAD TO THE CURRENT DEPRESSION. THE FEDERAL RESERVE HELPED CREATE THE BUBBLE, WHILE UNDER THE INFLUENCE.

96. Community Reinvestment Act

97. Many conservatives, and the banks, blame the government for forcing them to lend to unqualified minorities. This is blamed on Community Reinvestment Act of 1977.

98. Logic Question Logic question: Please explain how a law passed in 1977 could cause the problems of 2007?

99. Logic Question Logic question: The financial industries lobbied for deregulation (= no government supervision ) and won. So how is it the fault of government?

100. Logic Question Logic question: The financial industries restructured themselves in the 1990’s. How is it the fault of the government?

101. Logic Question Logic question: The financial industries had high profit margins through the creation of financial instruments that no one can understand. How is it the fault of the government?

102. Summary Conservative blame “the government” for the recession. True: the government was taken over by large corporations, and therefore helped create the recession.