Overview   How did the financial crisis affect us?   What are some likely hypotheses regarding the causes of the financial collapse?   What do today's banks do? Hint: Do they still follow the rule?   Ideas for teaching about the financial crisis   Questions

How did the financial crisis affect us?

Average Real Disposable Income Was Rising

Savings Rates Were Falling

Household Debt to Disposable Personal Income Ratio Increases

Subprime, Alt-A, and Home Equity Loans Increase

Fall in Housing Prices

DJIA, S&P and Nasdaq Trends: Stock Wealth Evaporates

Default Rates Rise

Foreclosure Rates Increase

Recession

Unemployment

What are some likely hypotheses regarding the causes of the financial collapse?

What Happened?  In1989 Berlin wall falls.  China and India deregulate.  Expanded production capacity puts damper on inflation. Central banks now can increase money supply without much concern about inflation.

What Happened?  In 2001, the Fed consistently lowered interest rate from 6.5% to 1.75 % and to 1.0 % by June  In 2001, the Fed consistently lowered interest rate from 6.5% to 1.75 % and to 1.0 % by June  Central banks around the world followed suit creating an unprecedented increase in the supply of credit.

What Happened?  The low rates made borrowed money cheap and households and businesses responded as expected: they bought and bought.  In the housing market, the Case-Shiller home price index increased 80% from January 2001 to December 2005.

What Happened?  Federal government aggressively promotes home ownership  Homeownership rate increased from normal 64 percent (which was the rate for 35 years) to 69 percent in 2004  Subprime loans totaled $330 billion in 2001  By 2004 they reached $1.1 trillion (37% of residential mortgages)  By 2006 they were 48% of all mortgages.

What Happened?  In mid-2004, the Fed reversed its interest policy -- the rate climbed to 2.25 % by December 2004 and reached 5.25% in  The demand for houses and other durable goods decreased and prices declined 33% from a peak in July 2006.

Interest Rates and Lagged Housing Prices Housing prices Interest rates

Housing Bubble – Jan 92 to July 09 source: S&P Case-Schiller National Home Price Index inflation adjusted

Leverage The magnitude of the current financial crisis has grown because of the amount of leverage used.

Leverage and Incentives  Investment banks were leveraged by a ratio of 30 to 1, government sponsored mortgage giants Freddie and Fannie were closer to 50 to 1.  When asset prices are rising, this system works like a dream.

What do today’s banks do?

Period Non interest income as a % of net operating income (Banks with total assets under $1 billion) Non interest income as a % of net operating income (Banks with total assets over $1 billion) %35.16% %34.82% %36.59% %35.78% %36.65% %37.85% %38.43% %41.47% %44.01% %44.30% %42.89% %42.30% %44.04%

Teaching about the financial crisis

  Open Market Operations   Discount Policy   Reserve Requirements   Interest on Required Reserve Balances and Excess Balances   Term Auction Facility   Primary Dealer Credit Facility   Term Securities Lending Facility   ABCP MMMF Liquidity Facility   Commercial Paper Funding Facility   Money Market Investor Funding Facility   Term Asset-Backed Securities Loan Facility

Questions