1. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page GWARTNEY – STROUP – SOBEL – MACPHERSON To Accompany: “Economics: Private and Public Choice, 15th ed.” James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson Slides authored and animated by: James Gwartney & Charles Skipton Full Length Text — Micro Only Text — Part: 6 Part: 5 Special Topic: 5 Macro Only Text —Part: 5Special Topic: 5 The Crisis of 2008: Causes & Lessons For the Future

2. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson The Crisis of 2008

3. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson The Crisis of 2008 The headlines of 2008 were about falling housing prices, rising default and foreclosure rates, failure of large investment banks, and huge bailouts arranged by both the Fed and the Treasury The crisis reduced the wealth of most Americans and generated widespread concern about the future of the economy This crisis and the response to it may be the most important macroeconomic event of our lives

4. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Key Events Leading up to the Crisis

5. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Boom and bust in housing prices Rising default and foreclosure rates Sharp downturn in the stock market Soaring prices of crude oil and other energy sources Key Events Leading Up to the Crisis

6. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson but began to rise toward the end of the decade. Between Jan. 2002 and mid-year 2006, housing prices increased by a whopping 87% Housing prices were relatively stable during the 1990s … Change in Housing Prices, 1987-2008 Housing Prices (annual percent change) - 10 0 10 20 15 5 - 5 - 15 - 20 1987198919911993199519971999200120032005200720082006200420022000199819961994199219901988

7. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson In late ‘06, the boom turned to a bust and housing prices declined throughout 2007-’08. By year-end 2008, housing prices were approximately 30% below their 2006 peak Change in Housing Prices, 1987-2008 Housing Prices (annual percent change) - 10 0 10 20 15 5 - 5 - 15 - 20 1987198919911993199519971999200120032005200720082006200420022000199819961994199219901988

8. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Mortgage Default Rate, 1979-2008 Prior to 2006, the default rate fluctuated within a narrow range (around 2%). It increased only slightly during the recessions of 1982, 1990, and 2001. The rate began increasing sharply during the 2 nd half of 2006 It reached 5.2% during the 3 rd quarter of 2008. Mortgage Default Rate 19791985198820001994 0 1% 2% 5% 6% 20031982199119972006 2008 3% 4%

9. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Housing Foreclosure Rate, 1979-2008 The foreclosure rate followed a similar path as the default rate Prior to mid-2006, the foreclosure rate fluctuated between 0.15% and 0.50% But in 2007-2008, it increased sharply and moved to the highest level in decades Housing Foreclosure Rate 19791985198820001994 0 0.2 0.4 1.0 1.2 20031982199119972006 2008 0.6 0.8 Percent (%)

10. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Changes In Stock Prices, 1996-2009 The S&P 500 fell by more than 55% between October 2007 & March 2009 This collapse eroded the wealth and endangered the retirement savings of many Americans S&P 500 Index 19961998200020042002 0 1200 1600 2005199720012008 2009 400 800 2003

11. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson What Caused the Crisis of 2008?

12. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Four major causes of the Crisis of 2008: Regulations that lowered mortgage lending standards A prolonged low interest rate policy of the Fed during 2002-2004 Increased debt-to-capital ratio of investment banks and other lending institutions High and growing debt-to-income ratio of American households Four Major Causes of the Crisis of 2008

13. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson The role of Fannie Mae and Freddie Mac: These two government sponsored enterprises (GSEs) were set up as “for profit” firms by the federal government Because of their GSE status and the perceived government backing of their bonds, they could borrow funds at 50 to 75 basis points cheaper than other lenders The GSE structure meant they were asked to serve two masters: (1) their stockholders and (2) Congress and federal regulators Factor 1: Change In Mortgage Lending Standards

14. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson The GSEs were highly political: their top management provided key congressional leaders with large contributions and often hired away congressional staffers into high paying jobs lobbying former bosses Fannie and Freddie did not originate mortgages, instead they operated in the secondary market where they purchased the mortgages originated by banks and other lenders They dominated the secondary mortgage market As a result, their lending practices exerted a huge impact on the standards accepted by mortgage originators The Role of Fannie Mae & Freddie Mac

15. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Mortgages of the GSEs, 1990-2008 The share of all mortgages held by Fannie and Freddie rose from 25% in 1990 to 45% in 2001 Since 2001, their share has fluctuated between 40% and 45% Share of Total Mortgages Outstanding Held by Fannie Mae and Freddie Mac 19901994199620021998 20 25 30 45 2004199220002006 2008 35 40 Percent (%)

16. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Regulations imposed by the Department of Housing and Urban Development (HUD) in the mid-1990s, forced Fannie and Freddie to extend more loans to low and moderate income households The HUD mandates required Fannie and Freddie to extend 40% of their new loans to borrowers with incomes below the median in 1996. This mandated share was increased to 50% in 2000 and 56% in 2008 Regulations and Lending Standards

17. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson In 1999, HUD guidelines required Fannie and Freddie to accept smaller down payments and extend larger loans relative to income In order to meet HUD mandates, the GSEs accepted more subprime loans. Mortgage originators were willing to make subprime and other high risk loans because they could be passed on to the GSEs. This resulted in the deterioration of lending standards Regulations and Lending Standards

18. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Beginning in 1995, modified regulations imposed by the Community Reinvestment Act (CRA) also lowered mortgage lending standards The CRA pushed banks to extend more loans to high risk borrowers. Mortgage loans to subprime borrowers soared as a result of these regulations. This is important because the foreclosure rate on subprime loans is 7 to 10 times higher than for prime loans The intent was to promote affordable housing, but the regulations eroded lending standards, fueled the housing price boom & bust, and the defaults and foreclosures that followed. Regulations and Lending Standards

19. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Subprime and Alt-A Mortgages Alt-A loans were extended with incomplete documentation and verification Both subprime and Alt-A loans are risky. These loans rose from 10% of the total in 2001-2003 to 33% in 2005-2006 Share of Total Mortgages Outstanding Held by Fannie Mae and Freddie Mac 1994199820022000 10 15 20 30 200419962006 25 35 Percent (%) 0 5 Subprime + Alt-A Subprime

20. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson 15 th edition Gwartney-Stroup Sobel-Macpherson Low-Down Payment Loans by Fannie Mae and Freddie Mac Loans to borrowers with 5% or less down payment extended by Fannie Mae and Freddie Mac jumped from less than 100,000 in 1998 to more than 600,000 by 2007. These low-down payment loans increased from 4% in 1998 to 12% in 2003, and more than 23% in 2007. Predictably, many of these low-down payment loans extended to borrowers would end up in default & foreclosure. 1998199920002001200220032004200520062007 1998199920002001200220032004200520062007 Share of Fannie Mae & Freddie Mac loans with less than 5% down Number of loans extended by Fannie Mae & Freddie Mac 5% 10% 15% 20% 25% 100k 200k 300k 400k 500k 600k

21. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Questions for Thought: 1. Why did regulators and the politicians who directed them want to make it easier for low- and middle-income households to borrow more money and obtain a mortgage with little or no down payment? 2. What is the predictable impact of the increase and subprime and Alt-A loans on the default and foreclosure rates? Explain. 3. What impact will an increase in the share of low-down payment loans extended to borrowers have on the future default and foreclosure rates?

22. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson During 2002-04 the Fed supplied additional reserves to the banking system & kept short-term interest rates low. This policy supplied additional bank credit, increased the attractiveness of adjustable rate mortgages (ARMs), and fueled the housing price boom But, as inflation increased during 2005-2006, the Fed increased interest rates and this helped turn the housing boom to a bust Factor 2: Low-Interest Rate Policy of the Fed During 2002-2004

23. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Fed Policy and Short-term Interest Rates, 1995-2009 Fed policy kept short- term interest rates at 2% or less throughout 2002-2004 As inflation rose in 2005-2006, the Fed pushed interest rates upward. Interest rates on adjustable rate mortgages rose and the default rate began to increase rapidly. Federal Funds Rate and 1-Year T-Bill Rate 1995199920032001 2 3 4 6 200519972007 5 7 Percent (%) 0 1 2009 1-Year T-bill Federal Funds

24. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson ARM Loans Outstanding, 1990-2008 Measured as a share of total mortgages outstanding, ARMs increased from 10% in 2000 to 21% in 2005. ARM Loans as a Share of Total Outstanding Mortgages 19901994199620021998 0 5 1010 20 2004199220002006 2008 15 Percent (%)

25. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Foreclosures on Subprime Loans, 1998-2008 The foreclosure rate for subprime loans is shown here Note, how the foreclosure rate rose for ARM loans during 2006, but this was not true for fixed rate mortgages Foreclosure Rate on Fixed & Adjustable Subprime Mortgages 1998200020032002 2 3 4 6 200519992007 5 7 Percent (%) 0 1 Fixed Adjustable 200120042006

26. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Foreclosures on Prime Loans, 1998-2008 For prime loans, the foreclosure rate for ARMs also rose in 2006 while it was relatively constant for fixed rate loans. Thus, the pattern was the same for both subprime and prime Note, the foreclosure rate was 7 to 10 times higher for subprime than prime loans. Foreclosure Rate on Fixed & Adjustable Prime Mortgages 1998200020032002 0.4 0.6 1.0 200519992007 0.8 Percent (%) 0 0.2 Fixed Adjustable 200120042006

27. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Both the regulations that eroded mortgage lending standards and the Fed’s interest rate manipulations contributed to the housing price boom and bust They also resulted in malinvestment – investments that should never have been made. It will take time to correct for these malinvestments Housing Price Boom and Bust

28. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson A regulation adopted by the SEC in April 2004, permitted investment banks to leverage their capital by a larger amount and thereby extend more loans Banks were required to maintain 8% capital against commercial loans, but only 4% against residential housing loans, and only 1.6% against low-risk (AAA rated) securities Factor 3: Increased Debt-to-Capital Ratio of Investment Banks

29. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Thus, if mortgage-backed securities had a AAA rating they could be leveraged up to 60 to 1 against bank capital Major investment banks and many commercial banks bundled mortgages together and received AAA ratings for the securities backing the mortgages These highly leveraged securities generated large profits for investment and commercial banks and the GSEs (Fannie and Freddie) during the housing boom Factor 3: Increased Debt-to-Capital Ratio of Investment Banks

30. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Based on prior history of default rates, lending institutions thought the mortgage-backed securities were quite safe. But they failed to recognize that the erosion of the lending standards would lead to higher default and foreclosure rates. As housing prices leveled off in the latter half of 2006, default rates increased and the value of the highly leveraged mortgage-backed securities plummeted. This led to the collapse of investment banks like Bear Stearns and Lehman Brothers, and serious problems for other financial institutions. Factor 3: Increased Debt-to-Capital Ratio of Investment Banks

31. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson The debt-to-income ratio of households has risen sharply since the early 1980s Because mortgage and home equity loans are tax deductible, but other forms of debt are not, household debt is concentrated against housing assets As a result, housing is hit hard when economic conditions weaken. Factor 4: High Debt to Income Ratio of Households

32. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Household Debt as a Share of Income, 1953-2008 Between 1953-1980, household debt as a share of disposable (after-tax) income ranged from 40% to 65%. Since the early 1980s, the debt-to-income ratio of households has risen at an alarming rate. It reached 135% in 2007, more than twice the level of the mid-1980s. Ratio of Household Debt to Disposable Personal Income 1953 1963 1973 1993 1983 20 40 80 120 140 2008 1958 1968 1978 1988 1998 2003 60 100

33. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Housing, Mortgage Defaults, and the Crisis of 2008

34. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Housing, Mortgage Defaults, and the Crisis of 2008 Regulations that eroded lending standards, the Fed’s interest rate policy, imprudent leverage lending by banks with the help of security rating firms, and the growth of household debt combined to create the 2008 financial crisis. Mortgage-backed securities were marketed throughout the world, and as default rates rose, the value of the securities plummeted and the crisis spread around the world. Default and foreclosure rates rose well before the recession started in December 2007, indicating that it was the housing crisis that caused the recession, not the other way around.

35. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Continuing Impact of the 2008 Crisis

36. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Continuing Impact of the 2008 Crisis With the Treasury takeover of Fannie Mae and Freddie Mac, the mortgage lending market has, essentially, been nationalized. 90% of the new mortgages for housing are currently financed by the Federal Government. The 2008 crisis reflects what happens when policies confront people with perverse incentives. Institutional reforms that restore sound lending practices, strengthen the property rights of shareholders, and provide corporate managers with a stronger incentive to pursue long-term success would help prevent future crises. Regulation, however, is a two-edged sword – it can generate adverse as well as positive results.

37. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Questions for Thought: 1.Many politicians have responded to the financial crisis by calling for more regulations and closer oversight of banks. Do you think more regulation will prevent the occurrence of another financial crisis? Why or why not? 2.Was the 2008 crisis a failure of markets or government? Why? 3.The Federal Reserve and Treasury provided bailouts to Fannie and Freddie, Wall Street investment banks, and large commercial banks. Many of these firms were insolvent. Why didn’t they go into bankruptcy and have their assets liquidated?

38. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 15 th edition Gwartney-Stroup Sobel-Macpherson Questions for Thought: 4. Did political action save us from the disastrous consequences of the 2008 crisis? Did the politicians inadvertently cause the crisis and then attempt to shift the blame elsewhere?

39. Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page End of Special Topic 5