Financial Crisis of 2008

Econ 102 2014

Worst recession in 80 years

• How did it happen?• How was the situation before the crisis?

‘Great Moderation’Stable growth and low inflation

Worst recession in 80 years

• How did it happen?• How was the situation before the crisis?

‘Great Moderation’Stable growth and low inflation

Too much saving in Asia, very low global interest rates

Low interest rates

Borrowing,

Households, businesses, Banks!

PurchaseHousehold bought houses,

(mortgage)Banks bought ‘securities’ (bond like

assets)

Households

• Borrowed from banks for long term, which is called ‘Mortgage’.

• Banks wants some guarantee, ‘collateral’

• HH used their houses as collateral,

House prices were rising

• All over in the US. • Hence banks do not hesitated.

• They started lending to parties with ‘poor credit histories’, ‘sub prime borrowers’

Why did not just hurt the banks which gave the initial loans?

• Financial innovations:

• Repackage the mortgages, How?• Pool different mortgages, mix them and call it

a new asset.Eg. (10% high income mortgage+30% middle income mortgage+60% low income mortgage) ‘mortgage backed securities’

Continued to repackage...

• Mix them even more and call them...

Eg. (10% Boston mortgage+30% DC mortgage+60% Texas mortgage)

‘Collateralized Debt Obligations’ : CDO

Continued to repackage...

• Mix them even more and call them...

Eg. (10% Boston mortgage+30% DC mortgage+60% Texas mortgage)

‘Collateralized Debt Obligations’ : CDOAsk credit rating agencies to value these Moody’s or Standard & Poors triple A (AAA)

Who purchased these?

• All Investors.... in US, in Europe, in Asia and in the whole world.

To make return higher than the market interest rates

Next ....

• House prices in the US started declining.the households can not pay back their debt, value of the collateral declined,‘mortgage backed securities’ became worthless

Banks lost their assets..., they started selling assets,

‘fire-sales prices’

Next ....

• House prices in the US started declining.the households can not pay back their debt, value of the collateral declined,‘mortgage backed securities’ became worthless

Banks lost their assets..., they started selling assets,

Mortgage backed securities, CDO became worthless

Complete loss of assets

• Banks can not find new lenders to pay back their debt.

• Banks worth decline, because of ‘mark-to-market

accounting’.

First Casualty

• Northern Rock – British Mortgage lender (late 2007)

Another financial innovation and another casualty...

• ‘Credit Default Swaps’- insurance to compensate the buyer of a loan if the 3rd party does not pay.

• AIG- Insurance company got into trouble. FED come to rescue with a $ 85 billion

help.

Another real casualty

• Lehman Brother went bankrupt. FED did not rescue them.

Why?

BIG PANIC-

Another real casualty

• Lehman Brother went bankrupt. FED did not rescue them.

Why?

BIG PANIC- No one is lending, no one is

borrowing...

PANIC and financial markets almost stopped working.

• Consumption dropped, • Investment dropped, • Exports drastically dropped,

• What happened to Aggregate Demand?

GREAT RECESSION

What can the policy makers do?

• Fiscal Policy,

• Monetary Policy,

What can the policy makers do?

• Fiscal Policy,

• Monetary Policy, This was challenging because the interest rates were very low,

• With expansionary monetary policy they hot zero....

Liquidity trap

Creative monetary policy

• How to increase spending and investment?• Inject money into the system through banks...• How ?

Creative monetary policy

• How to increase spending and investment?• Inject money into the system through banks...• How ?

• But their worthless ‘toxic assets’, reserves increase

loans increase, ‘Quantitative Easing’

US Money growth rate

Nonconventional monetary policy

• FED was buying $85 billion worth of assets each month.

• ‘Tapered off’... dropped to $65 billion worth of assets each month.

Bernanke mentioned in June 2013, then changed his decision in September 2013.

$4.1 trillion of QE bond buys,

Quantitative Easing

• Now it is $ 55 billion purchases each month.

• Will stop some time in late 2014 or early 2015, and promised that they will not raise the interest rates until 2015.

How do they decide?

• Unemployment rate:

GDP growth rate in the US