1. The Financial Crisis and the Great Recession 14

2. Start with the 2001 recession and weak recovery Fed responds by cutting interest rates (FFR = 1%) Since interest rates move together, mortgage rates fell Mortgage - A type of loan used to buy a house, which usually serves as collateral for the loan Low mortgage rates increased demand for housing and led to a bubble Increase in the price of an asset or assets that goes far beyond what can be justified by improving fundamentals 2 2007–2009, The Great Recession Roots of the Crisis

5. Roots of the Crisis Low interest rates on Treasuries caused investors to “reach for yield” Investors bought riskier assets that paid greater interest Higher demand for junk bonds, mortgage backed securities, etc. pushed up prices and reduced yields Interest rate spreads compressed Difference between the interest rate on a risky asset and the interest rate on a risk-free Treasury security 5

6. Roots of the Crisis Low interest rates spreads, fewer defaults and delinquencies Lenders believed the riskier assets were not so risky Lax regulation Both encouraged careless lending Subprime mortgages – borrower fails to meet traditional credit standards NINJA loans – no income, no job, no assets 6

7. Roots of the Crisis More leverage Leverage – using borrowed money to buy an asset to boosts returns Vulnerabilities in our financial system Crisis - far worse than it otherwise would have been 7

8. Leverage, Profits, and Risk Leverage Use of borrowed funds to purchase assets Leverage is not per se bad, excessive leverage is Importance of leverage for banks 8

9. Table 1 Balance Sheet of Bank-a-Mythica, December 31, 2014 9 Leverage = Value of assets / Net worth(equity) Leverage = $5,500 / $500 = 11 Assuming a 20% reserve requirement

10. Leverage, Profits, and Risk Importance of leverage for banks Source of profits for banks Bank-a-Mythica Interest on deposits = 2%, $100,000 (2% of $5 mill) Interest on loans = 4%, $180,000 (4% of $4.5 mill) $80,000 profit or a 16% investor return $80,000 / $500,000 =.16 or 16% Suppose the bank forced to operate without borrowed funds – they can’t borrow! 10

11. Table 2 Unleveraged Balance Sheet 11 How much return do investor’s earn? Interest on loans = 4%, $20,000 (4% of $500,000) Return = 4%

12. Leverage, Profits, and Risk Leverage essential to bank’s profits, but leverage also exacerbates risk Suppose loans decline in value by 10% 12

13. Table 3 Unleveraged Balance Sheet after 10 Percent Loan Losses 13 Stockholders lose 10%

14. Table 4 Leveraged Balance Sheet after 10 Percent Loan Losses 14 Stockholders lose 90%

15. Leverage, Profits, and Risk So leverage is good and bad Magnifies returns on upside and downside Prior to financial crisis leverage rates increased Traditional leverage: 10-to-1 Crazy leverage 30-to-1 to 40-to-1 Once housing bubble burst Bad mortgage loans, loans value declines. Value of bank liabilities exceeds the value of Negative net worth – insolvency. 15

16. Leverage, Profits, and Risk Four main ingredients in the witches brew before the bubble burst The housing bubble itself Lenient lending standards, which fed the bubble Compressed risk spreads, which led to riskier investments High leverage, which increased the risk of insolvency 16

17. House Price Bubble and Subprime Crisis Housing prices in the U.S. 2000-2006(7), increased by 60-90% 2007-2009, dropped by 12-25% In some areas, 50% drop 17

18. House Price Bubble and Subprime Crisis Effects of decline in housing prices 1.Decrease in residential investment Both buying and building less attractive when prices fall Inventories built up pushing prices down further From winter 2005-2006 to spring 2009, 56% drop in construction Drop in I reduced GDP growth in late 2005 Effects of decline in housing prices 2.Consumer wealth declined Led to lower consumer spending, C, in 2008 and 2009 18

19. House Price Bubble and Subprime Crisis Effects of decline in housing prices 3.Increase in number of defaults and foreclosures During boom lending standards fell in three ways Old fashioned rules ignored: > 25-33% Loans granted with low or 0 down payments More and more subprime mortgages As housing prices fell, subprime mortgages started to default House of cards started to crumble 19

20. From Housing Bubble To Financial Crisis How do we misread the signals from the subprime mortgage problem? Underestimated the volume of subprime mortgages Poor understanding of financial instruments and potential risk 20

21. From Housing Bubble To Financial Crisis Some aspects of finance Securitization Loans are transformed into marketable securities Packaged together into a bond-like instrument that can be sold to investors Mortgage-backed security, MBS A type of bond whose interest payments and principal repayments derive from monthly mortgage payments of many households 21

22. From Housing Bubble To Financial Crisis MBS’s reduce risks in two ways Geographical diversification: prices won’t fall everywhere Risks spread out over thousands of investors So what happened? Housing bubble burst nationally MBS’s riskier than thought so market values fell Not as widely held as thought Failure of Bear Stearns, Lehman Brothers etc. related to excessive concentrations of mortgage-related risks 22

23. From Housing Bubble To Financial Crisis MBS’s and related assets more complex than we realized As some mortgages went into default, all MBS’s affected Nobody knew what they were really worth Values plummeted, panic summer 2007 STOP HERE, p286!!! 23