“Everything You Wanted to Know About the Current Financial/Economic Crisis, but were Afraid to Ask” Or: Where are we, how did we get here and where are we headed? Professor Michael Palmer Leeds School of Business Presentation to Eastside Residential Brokers Bellevue, Washington December 5, 2008

Quick Bio Michael Palmer, Professor of Finance, Leeds School of Business, University of Colorado. Education: Ph.D. University of Washington, 1967 (Finance and Macro-economics) Visiting Professor Status: Kansai Gaidai University, Osaka, Japan; Jiao Tong University, Shanghai, China; Semester at Sea Academic Director: London Seminar in International Finance

Ben Bernanke’s View and My View Ben Bernanke (April 10, 2008): "We now know the lessons from [the Depression]. We are certainly going to make sure that the financial system remains in good functioning order.“ My view: We are in an unprecedented economic slowdown, caused by a combination of (1) a historically financial market freeze, (2) a massive negative wealth effect resulting from a dual real estate and stock market collapse and (3) a collapse of consumer confidence. In this unique environment, the past is probably not a particularly good road map for the present nor the future. True for policy makers and forecasters.

Goal of this Presentation Three primary issues to be covered today: (1) The Past: How did we get here; aka How Did we Get into this Mess in the First Place? (2) The Present: Where Are we Today? (3) The Future: Where Might we be Going? With focus on the national and global economies.

Theme of Presentation The country is caught in an unprecedented crisis involving a: (1) lack of confidence in its financial markets and financial institutions. Affecting interbank and external lending and essentially freezing these critical markets. (2) a collapse of stock prices and real estate prices. Resulting in massive negative wealth effects. (3) a collapse of confidence of consumers in the economy and in their situation. Affecting household spending

What we Must do We cannot let the financial system fail. The financial system is the grease that keeps the economy going. We need to shore up financial market liquidity and provide direct lending where markets are not functioning. We need to address mounting home foreclosures. Currently in foreclosure (2.97% of all mortgages) and 30 days overdue 6.99% – both figures at the highest level since data was collected 29 years ago. We need to restore consumer confidence. No magic bullet here, but it is likely a combination of political and fiscal stimulus.

Issue #1: How Did We Get Here How did this happen? The 2002-2006 period was characterized by over-stimulative monetary and fiscal policies which contributed to a surge in (1) financial and real asset prices along with (2) skyrocketing consumer debt. And created unsustainable “Super Bubbles” The first bubble to burst was the housing bubble.

Housing Leads the Way August 2007, the sub-prime mortgage market surfaces as a potential issue. A combination of economic and financial factors results in rising home foreclosures. Foreclosures in 3Q06: 223,223 Foreclosures in 3Q07: 446,726 (+100%) Foreclosures in 3Q08: 765,558 (+71%) and the highest since records began in January 2005.

And Housing Continues to Suffer Housing prices, starts and sales slide. New house prices 3Q08: -16.6% from 3Q07 (Median price of $218,000 in Oct is lowest since September 2004) Existing house prices: Oct 08: Median price $183,000, down 11.1% from a year ago. Housing starts: Oct 08: 791,000 annual rate (lowest since records began in 1959). Sales of new homes: Oct 08: -5.3% annual rate to 433,000 annual units (lowest since January 2001 and 40% lower than a year ago) Sales of existing homes: Oct 08: -3.1% annual rate to 4.98 million units

Enter Securitization Financial institutions were also involved in the “securitization” (i.e., pooling and distribution) of loans (sub-prime mortgage loans, commercial real estate loans, consumer loans, student loans). This took place at the same time that rating services were unable (or unwilling) to successfully evaluate the risk associated with these loan packages. Regulations, unfortunately, did not keep pace with changing financial structure.

Financial Market Freeze While there were “sub-prime market” danger signs as far back as August 2007, U.S. financial markets really began to “freeze up” in early to mid-September 2008 around the time of: the Fannie Mae/Freddie Mac bailout (Sept 8), Lehman Brothers failure (Sept 12), Merrill Lynch take-over by BofA (Sept 15), AIG $85 billion rescue plan (Sept 16th) Washington Mutual take-over by JPMorgan (Sept 25th) Federal Reserve rescue of commercial paper markets (Oct 7).

Manifestations of Financial Market Freeze Freeze was manifested in: Spreads of investment grade corporate bonds (e.g., Aaa and Baa) over Treasury bonds rising to record levels. Commercial paper market and investment grade bond markets shutting down. Money market fund outflows (some “broke the buck”). Increasing interbank lending spreads to default free returns (in the Fed funds and LIBOR markets) Reflecting a lack of confidence in financial institutions and over-all risk aversion

Corporate Spreads Baa – Aaa and Baa- Gov’t Basis Point Spreads Both a measure of risk aversion and confidence. Baa-Aaa average spread (1977 to Present): 107basis points. Dec 2, 2008: +349 Baa-10 yr Gov’t average spread (1977 to Present: 208 basis points. Dec 2, 2008: +612

TED Spread: Interbank Market’s Lack of Confidence in One Another 2007 - Present TED Spread (another measure of confidence and risk aversion): TED = 3-month $LIBOR rate – 3-month T-Bill rate January 1990 to July 2007 the TED spread averaged 41 basis points. In October 2008 the spread reaches 464 basis points (the highest since data collection began in 1971. Reflected a frozen interbank market.

Response of U.S. to Freeze U.S. responded with $700 billion bailout package (Troubled Asset Relief Program, Oct 3rd ) and Federal Reserve interest rate reductions and Federal Reserve emergency loans/liquidity injections. TARP program has thus far injected $350 billion ($250 billion to buy equity states in banks and $100 billion to AIG). On November 24, the Government announces it (Treasury and Fed) is prepared to lend more than $7.4 trillion to rescue financial markets. This is roughly equal to 50% of nominal U.S. GDP

Result of U.S. Credit Freeze on Financial Players and Markets Bailouts or sales of financial institutions (Fannie Mae, Freddie Mac, AIG, Merrill Lynch, Citigroup) Disappearance of stand-alone U.S. investment banking firms. Bankruptcies of long standing financial institutions (Lehman Brothers and Bear Sterns) And, within a short period of time, the U.S. credit freeze spreads to overseas financial markets.

Freeze Spreads to Real Economy The ripple effects of the credit freeze quickly spread to the consumer sector where we saw a rapid decline in consumer spending. The combined freezing of credit and the decline in consumer spending become the main drivers in pushing down the real economy. At the same time, and in response to the crisis, an erosion of confidence in the financial system and in the economy itself takes hold. Further affecting consumer and business spending.

But how Did We Get to this Point? Enter Alan Greenspan Fed Funds Rate Federal Reserve responds to the 2000 “dot-com” stock market crash and “terrorist- attack” induced recession of 2001. NASDAQ loses 72% of its value; S&P 500 loses 46%; DJ loses 29% Greenspan pushes Fed funds rate to 1.0% (levels not seen since the 1950s)

Greenspan Pushes Real Interest Rates Below Zero Concept of Real Rate Real Fed Funds Rate The real rate of interest is the market rate adjusted for the rate of inflation (or market interest rate – inflation) A high real rate is regarded as a very restrictive policy stance, while A low or negative rate is seen as very easy policy stance. Why? Lenders will pay back loans with cheaper money.

And Real Interest Rates Fall on Long term Debt as Well Corporate Bond Rates Mortgage Rates

Creation of Super Bubbles Seeds of the Bubbles Economic Growth Excessively expansionary monetary policy, results in: Falling real rate of interest Which in turn over-stimulates borrowing and economic activity. And creates the seeds for the super bubbles!

Creation of The Super Bubbles Stock Market: 2003 – 2007: Dow Up 76.5% Housing Market: 1998-2006 Real House Prices Up 8% per year

And Super “Debt” Bubbles Total U.S. Debt as a % of GDP Over 325% Debt Market: Household Debt Rising to 130% of GDP (While Savings Falls)

U.S. and the Rest of the World U.S. Debt with the Rest of the World: Current Account Deficit $200 Billion a Year by 2007 And our Dollar Starts to Fall

End of the Super Bubbles: Negative Wealth Effects Stock Market: Oct 2007 to Present: – 44% (-$100 - $3 in consumer spending) Housing Prices: Peak 2Q06; - 18% (-$100 = -$13 in consumer spending)

Consumer Confidence Goes South Consumer Confidence Index (CCI) CCI: October 07: 95.6 CCI: October 28: -23.04 CCI: November 25: +44.0 This is probably the most widely reported consumer confidence measure. The index is released by the Conference Board on the last Tuesday of each month (ever since 1967). CCI is a mail survey of about 5,000 households.

And Consumers Cut Back on Spending Why is this Sector Important? Consumption Excluding Real Estate (monthly data) Household spending represents 68% of GDP Household spending peaked in 2Q08 (May 2008). Consumer spending fell by 3.7% in the 3Q08 (which was the first quarterly negative change since 1991)

But As Noted Slowdown Started Earlier in Residential Real Estate Why is this Sector Important? Real Residential Investment, Billions of $ While residential housing represents about 3.5% of real GDP, it is one of the most volatile components in GDP (fluctuations of +/- 20% in one year). This sector has a large economic spillover effect (indirect effects) which is estimated at from +/- .5 to 1.1 percentage points to GDP growth. GDP account peaked in 4Q05

Spillover to Business Sector Producer’s Durables Peaked in early 2008 Producers’ durable equipment (machinery, trucks, communications equipment, etc) represents about 11% of real GDP. It is regarded as a “derived” investment. Based on final demand. Peaked in 2Q08

Quick Review of Current Situation U.S. in a housing lead slowdown Financial crisis spilling over to real economy through: Growing loss of confidence resulting in: Frozen financial markets Falling asset prices (Good-bye Super Bubbles) Negative wealth effects from equities and real estate continue. Consumers cutting back and, Negative GDP growth (NBER 12 month to date recession) Now nicknamed the “Great Recession.” Weakened financial institutions requiring ongoing government assistance. Weak household balance sheets (too much debt). Global contagion effect (economic slowdowns in Europe and Asia) which complicate U.S. recovery 0.2%

Impact of Credit Freeze and Spending Reductions: Issue #2 Where are We Today? In a Recession!!! Real GDP Traditional definition: Two consecutive quarters decline in real GDP. In the 3rd quarter of 2008, GDP fell -0.5%, after rising 2.8% in the 2rd quarter. NBER data: Put the beginning of this recession as December 2007. Which would put us 12 months into current recession.

What Has been the Federal Reserve’s “Monetary Policy” Response to the Financial Crisis? Lowered Interest Rates: From 5.25 to 1.0% Injected Liquidity: Monetary Base: Oct +33%

Observations on Interest Rate Changes While lower interest rates might make us “feel better” -- they have done little up to now to stimulate buying or lending or to restore confidence. Questions regarding interest rate policy: (1) Are we getting dangerously close to a “Keynesian liquidity trap” where low interest rate discourage lending? And if so, (2) Has the Fed really adopted a “quantitative easing policy” whereby injecting financial markets with liquidity become the overriding policy? And if so, (3) Is the Fed setting the stage for the next bubble?

What’s the Problem with Lowering Interest Rates Even More? Keynesian Liquidity Trap Elastic Demand for Liquidity We may be facing a form of the Keynesian liquidity trap? “Liquidity-preference may become virtually absolute in the sense that almost everyone (i.e., banks) prefers cash (reserves) to holding a debt (a loans) which yields so low a rate of interest....” John M. Keynes, General Theory (1936) Monetary policy will not work at this point because lenders are not willing to make loans.

And if we are at this point, has the Fed Adopted Quantitative Easing?

Effective Fed Funds Rate Versus Target Rate Since Oct 29th

And What’s been Happening to the Real Interest Rate During this Time? Real Fed Funds rate Fed Reserve Interest Rate Policy With its initial easing of the fed funds rate in September 2007, the fed has lowered rates 9 times from 5.25% to 1.0%. In December 2007 the real rate reached 0%. Since that time it has been negative.

Observations on Liquidity Injections Fed and Treasury Department have responded with injections (actual and announced) of large amounts of liquidity into the financial system. 3 Issues to think about: (1) The government is becoming a major shareholder in banks and other financial institutions. Globally, governments have estimated holdings of $500 billion in their banks, or about 25% of current market values. Is there a risk of creeping intervention in the day-to-day management of these banks (e.g., Japan in the 1990s). How will governments sell back such large positions?

Observations on Liquidity Injections (2) How does the government prevent banks and other financial institutions from simply choosing to shore up their capital base as opposed to making loans to sound business firms and households. This is bank-lending liquidity trap. U.S. position thus far has been to “encourage lending” -- but there is not much accountability. France has actually mandated lending quotas to their banks. Should the U.S. do this?

Observations on Liquidity Injections (3) There is the danger that the Fed and Treasury Department will go too far, setting the stage for a big rise in inflation or more asset bubbles in the future. At this point, however, the downside risk with this massive liquidity injection is overshadowed by the risk that the economy could spiral into a deflationary nosedive. But at some point, this liquidity will have to be neutralized (“sterilized” or withdrawn).

Let’s See What the Market Done With Some of this Liquidity? A Flight to “Safety” Impact on Yield Curve: July 2007 – End of October Investing in “Safe-Haven” financial assets because of an increase in risk aversion Moving into U.S. Treasury bills and U.S. Treasury notes. A global movement. Biggest impact on shorter segment of U.S. yield curve; pushing down the short end of the curve.

And the Yield Curve Now All Maturities are Down Early Nov to Dec 4, 2008 Reflecting: On going flight to safety Continued easing by Fed in fed funds market. Expectations for Fed involvement in longer term segment of Treasury market. http://stockcharts.com/charts/yieldcurve.html

Issue #3: Where are we Headed? Bloomberg Forecast NABE Forecast November 17th National Association of Business Economists survey found the following GDP forecasts: 3Q08 actual: -0.5% 4Q08 forecast: -2.6% 1Q09 forecast: -1.3% Forecast for 3 quarters decline in GDP November 12th survey of 59 economists found the following GDP forecasts: 3Q08: actual: -0.5% 4Q08 forecast: -3.0% 1Q09 forecast: -1.5% Forecast for 3 quarters decline in GDP

How Long Might this Recession Last How Long Might this Recession Last? Recall we are about 12 months into it 1902 – 2001 Recessions: Average length 13 months 1973 – 2001 Recessions: Average length 10.8 months

Consumer is an Important Key to the Future of this Economy Consumer spending will be affected by: Confidence (thus far a negative effect of the financial and economic crisis on consumer confidence) Income levels (thus far negative effects from income and unemployment trends) Wealth effects (thus far negative effects of declining stock market and housing prices) Look for signal from upcoming holiday season: Will the recent reduction in gas prices provide a boost to retail sales? Black Friday sales up a “decent” 3% from a year ago (smallest since .9% decline in 2005; 6.0% in 2006; 8.3% in 2007). Cyber Monday (Dec 1) sales were up 15%, the second biggest increase on record.

Follow Consumer Spending and Income Consumer Sentiment Index Monthly Consumer Data Monthly data released by the Commerce Department the last Wednesday of the month: Consumer spending: September: -0.3% October: -1.0%, the most since the 2001 recession. Personal income September: +0.1% October: +0.3% Difference represents an increase in household savings (savings rate now at 2.4% of disposable income; a 5 year high)

Unemployment Rates Unemployment Unemployment Rate now at a 14 year high (Nov 6.7%; Oct 6.5%; Sept 6.1%) Affects consumer confidence and consumer spending decisions. Unemployment rates normally lag behind a business cycle recovery thus tending to rise even after a recovery is underway. Average lag since 1949 (7 recessions) has been 10.4 months, but the variation is very large (1 to 19 months). Nov 2001 recession ended and unemployment peaked in June 2003 (19 months later).

Follow the Stock Market 2001 Halfway Rule Forecasters have noted that historically investors start discounting a recovering about half way through an average recession. Historically, stock prices move up (on average) about 5 to 6 months before a recession ends. Has the market bottomed out? Last week (Nov 24 – 29) stocks posted their biggest weekly gain since 1974

Stock Market Signals 1970s 1980s – Early 1990s

Follow Important Interest Rates TED +464 in October; Has TED Peaked? Interbank Rates Measure the confidence in the interbank markets and possible “thawing” TED Spread (3-month LIBOR – 3-Month T-bill) Dec 3: down to 218Bpts Link to daily data at: http://www.bloomberg.com/apps/quote?ticker=.TEDSP%3AIND

Follow Important Interest Rates Mortgage Rates: October 2 to Present (30 year fixed); Weekly Averages External Market Rates Mortgage rates After the Fed’s Nov 26 announcement to purchase $600 billion of mortgage related debt, the 30 year fixed fell to 5.47% from 5.94% the week before This might help bring housing demand in line with supply? For the last week mortgage applications soared 112%. (includes both new purchase and refinancing)

Follow Political Announcements Out-going Administration In-coming Administration No new fiscal stimulus package should be expected. Perhaps ongoing capital infusions into banks and other key financial institutions. Expanded debt buyouts and direct market involvement as needed. Federal Reserve involvement in commercial paper markets and more recently in mortgage markets. FDIC initiated “foreclosure prevention plan” (involving loan re-negotiations) perhaps expanding to Treasury Look to “team” Role of Paul Volcker Early fiscal stimulus. What will it include? Need for quick start state by state infrastructure projects. Business and personal tax cuts. Help for the home sector. Expanded policies to deal with foreclosure.

Follow Fed Policies and Statements Statements Worth Noting Policies Fed funds rate. Not likely to move to 0% but still a little downward flexibility. Also look to spread of effective rate to target rate. If the effective rate moves closer to the target this might signal the Fed is more confident in financial situation. Any other policy initiatives? Look for Fed open market operations in longer term Government securities markets. This could ease longer term interest rates. “We are clearly behind the curve on mortgage foreclosures.” Shelia Blair (December 2, 2008) Despite good-faith efforts by both the private and public sectors, the foreclosure rate remains high. More needs to be done.” Ben Bernanke (Dec 4, 2008)

Now Add this to the Mix: Recession is Becoming a Global Phenomenon Europe Asia and the Americas Iceland is bankrupt Germany and the rest of the Euro-zone (with the exception of France) have experienced 2 consecutive quarters decline in real GDP. The United Kingdom has its own housing mess (house prices have fallen for 13 straight months). Forecasting worse recession in 30 years with a turnaround not expected until 2010. Japan is in a recession having experienced 2 consecutive quarters decline in real GDP. First recession since 2001. China is slowing World Bank 2009 estimates 7.5% down from 9.2% Also experiencing a deflating housing bubble Russia is in trouble. Canada is forecasting a recession through 2Q09

Foreign Central Banks Have Also Lowered their Interest Rates Previous Rates Current Rates/Change Canada: 2.50% England: 3.0% Japan: 0.5% ECB: 3.25% Switzerland: 2.0% Australia: 5.25% New Zealand 6.5% Korea: 4.25% China: 6.66% Canada: 2.25%; Oct 21/08 England: 2.0%; Dec 04/08 Japan: 0.3%; Oct 31/08 ECB: 2.50%; Dec 04/08 Switzerland: 1.0%; Nov 20/08 Australia: 4.25%; Dec 02/08 New Zealand: 5.0%; Dec 04/08 Korea: 4.0%; Nov 07/08 China: 5.58%; Nov 26/08

Are there Foreign Countries that We Should Monitor? Perhaps Asia Europe Japan In recession (consumer spending has fallen for 8 straight months), but the least G7 affected by credit freeze. China and India GDP slowing (still positive) but recent fiscal and monetary stimulus may improve growth. Possible kick-starters for global economy (through import demand) Nothing here to help global economy. U.K. expected to suffer its worse recession in 30 years. Germany in recession and government running a fiscal surplus. Both U.K. and Eurozone have introduced their own stimulus packages. These will take time to turn these economies around.

And What About the U.S. Dollar? Turn around in July $ In Favor Again Over the last 6 months the dollar has taken on a global safe haven status The Japanese yen has also strengthened due to unwinding of carry trades. $ likely to remain strong if global uncertainty continues and as long as Europe appears relatively weak. Will ease U.S. inflationary pressures, but make it more difficult for foreigners to purchase U.S. real assets.

Possible Macro-Economic Scenarios Scenario 1: V shape Scenario 2: U, W or L shape Quick recovery Within 2 quarters Three of the last 5 recession have ended within 2 quarters. Early on optimism for quick turnaround resulted from: Assumed positive lagged response of Fed interest rate cuts and Spring 08 tax rebates. Now we are thinking about other possibilities: U: More gradual recovery (e.g., 18+ months), or W: Recovery followed closely by another recession (aka “double dip” e.g., in 1981, or L: Prolonged recession (e.g., 43 months in 1929 or Japan in the 1990s).

My View: U-Shaped 18/21-Month Recovery Most Likely Scenario Caveat: The factors underlying a U-shaped scenario are notoriously difficult to predict. Specifically, exactly when and to what degree factors impacting household and business behavior will kick in and when they will translate into GDP. However, a U-Shaped recovery scenario is likely based on: Severity of the financial/real asset bubble collapse and the financial market freeze and their affect on the real economy. Announced and anticipated layoffs (140,000 in the financial sector plus lagged unemployment effect) Falling retail sales. Large household debt burdens Little, if any, help from the foreign sector. I see this recession ending in the 2Q09/3Q09 (Summer 09).

And What About Seattle? Seattle Housing Data: Seattle Economic Base: House prices down 17% a year ago and sales down 17.5% a year ago (35.8% down from last month) Seattle Economic Base: Increasing unemployment October 2008: State unemployment rate: 6.3% (4.8% a year ago); Seattle area: 5.4% (4.0% a year ago). (see second slide) Negative: Impacts of recent layoffs (WaMu cutting 3,400 Seattle jobs) Positive: Global links Exporting Bellevue-Seattle-Tacoma Metropolitan Area is the fourth largest export market in the nation (2007 data) with Japan, China, and Canada the leading export destinations.

Seattle House Prices: More to Come? Seattle Price Data Nominal Median Housing Prices since Peak U.S.: peak, 2Q06 Peak: $252,514 Currently: $206,500 Down: 18% Seattle: peak: Aug 07 Peak: $501,000 Currently: $415,000 (Nov) Down: -17% Source: Professor Robert Shiller’s data base and Seattle Post

Seattle’s Unemployment Picture Data Comparisons In October 2008, about 203,820 people were out of work and seeking employment in Washington. the biggest job declines occurred in retailing (down 1,700 jobs), education services (down 1,700), manufacturing (down 1,300) and construction (down 1,100). Economists don't count striking workers as unemployed, so the 24,000 striking Boeing Machinists didn't contribute to the unemployment rate.

Final Quotes “An economic [forecaster] is an expert who will know tomorrow why the things he/she predicted yesterday didn't happen today.” Laurence J. Peter “If past history was all there was to the game, the richest people would be librarians.” Warren Buffett

Questions and Answers and Comments and Discussion Follow-up Questions/Comments Michael.Palmer@colorado.edu