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PA 315

Government Business Relations

Lecture 4

The Late-2000s Financial Crisis

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Learning Objectives

Understand the background of the late-2000sfinancial crisis

Understand how government policies interact

with market Understand the implications of corporate social

responsibility in exacerbating financial swings

Apply models of government business relationsto interpret current events

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Factors in the Economic Crisis

Decrease inPersonal

Wealth (i.e.housing prices,stock prices)

Decrease inspending;

Increase inuncertainty (i.e.

investment)

Decrease indemand ofgoods andservices;

Reduced inputsfor production

Rise inunemployment;other social and

economicproblems

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National averages in housing

w

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Housing trends National

Historic growth since 1940

Money moved from dot.com to housing after2000

By 2003 the housing sector started to skyrocketin most places

Bubble started to burst in 2007, dropped

precipitously in 08 and 09, and has continuedsmall decline to date (about 20% nationally)

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California Trends

The national trends disguise the effects on thehot markets: West Coast, AZ, NV, TX, andFlorida which were on boom-bust cycle

In early 2007 the median house in CA was over$500,000. Today southern CA median is$270,000. (7% drop in 2011)

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Background: Supply-side support

by governmentstep 1

Mortgage interest deductions a part of nationalpolicy

Started in 1913

Became very substantial in the 1950s Became one of the major investment strategies of the

American family

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Background: Supply-side support by

governmentstep 2

The creation of mortgage-backed securitiesmarket

1930~1940s Creation of Federal Home Loan Banks

and Federal National Mortgage Association (FannieMae)

1960~1970s Privatization of Fannie Mae and thecreation of Federal Home Loan Mortgage Corporation

(Freddie Mac) 2000s: allowed risk to be disguised in bundled and

securitized arrangements with Fannie and Freddietaking on larger and larger risks; when markets dontfunction primarily on risk, problems will eventually occur

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Background: Other Causes

Push for sub-prime (riskier) lending: for different reasons

Spurred by HUDs affordable housing goal for FannieMae and Freddie Mac (under both D and R) gov

Rose from below 10% to nearly 20% Profits from subprime loan bundles were wonderful

(so lots of private investors held around the world)

Encouraged borrowing (U.S. policy)

The Fed lowered rate from 6.5% to 1.0% (2000 to2003); only went to 5.25% to cool market; againdropped precipitously after crash in 2008

A flood of funds from foreign countries flowed in to

U.S.

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Causes, cont.

Weak and fraudulent underwriting practicesboomed in 2000s and became common practice

Down payments

Income and assets proof Suspicious Activity Reports pertaining to Mortgage

fraud increased by 1,411 percent between 1997 and2005

http://en.wikipedia.org/wiki/Mortgage_fraudhttp://en.wikipedia.org/wiki/Mortgage_fraudhttp://en.wikipedia.org/wiki/Mortgage_fraudhttp://en.wikipedia.org/wiki/Mortgage_fraud

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Predatory lending:

Bait and switch lending practices

Encouragement of unrealistic loans

Frenzy in housing market (euphoria) and stockmarket

Investors swarmed to housing

Home-owners moved up as much as possible

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Deregulation: Banks were deregulated through:

The Depository Institutions Deregulation andMonetary Control Act of 1980 (allowing similar banks

to merge and set any interest rate). The GarnSt. Germain Depository Institutions Act of

1982 (allowingAdjustable-rate mortgages).

The GrammLeachBliley Act of 1999 (allowing

commercial and investment banks to merge).

http://en.wikipedia.org/wiki/Depository_Institutions_Deregulation_and_Monetary_Control_Acthttp://en.wikipedia.org/wiki/Depository_Institutions_Deregulation_and_Monetary_Control_Acthttp://en.wikipedia.org/wiki/Garn%E2%80%93St._Germain_Depository_Institutions_Acthttp://en.wikipedia.org/wiki/Garn%E2%80%93St._Germain_Depository_Institutions_Acthttp://en.wikipedia.org/wiki/Garn%E2%80%93St._Germain_Depository_Institutions_Acthttp://en.wikipedia.org/wiki/Adjustable-rate_mortgageshttp://en.wikipedia.org/wiki/Gramm%E2%80%93Leach%E2%80%93Bliley_Acthttp://en.wikipedia.org/wiki/Gramm%E2%80%93Leach%E2%80%93Bliley_Acthttp://en.wikipedia.org/wiki/Gramm%E2%80%93Leach%E2%80%93Bliley_Acthttp://en.wikipedia.org/wiki/Gramm%E2%80%93Leach%E2%80%93Bliley_Acthttp://en.wikipedia.org/wiki/Gramm%E2%80%93Leach%E2%80%93Bliley_Acthttp://en.wikipedia.org/wiki/Gramm%E2%80%93Leach%E2%80%93Bliley_Acthttp://en.wikipedia.org/wiki/Gramm%E2%80%93Leach%E2%80%93Bliley_Acthttp://en.wikipedia.org/wiki/Gramm%E2%80%93Leach%E2%80%93Bliley_Acthttp://en.wikipedia.org/wiki/Gramm%E2%80%93Leach%E2%80%93Bliley_Acthttp://en.wikipedia.org/wiki/Gramm%E2%80%93Leach%E2%80%93Bliley_Acthttp://en.wikipedia.org/wiki/Adjustable-rate_mortgageshttp://en.wikipedia.org/wiki/Adjustable-rate_mortgageshttp://en.wikipedia.org/wiki/Adjustable-rate_mortgageshttp://en.wikipedia.org/wiki/Garn%E2%80%93St._Germain_Depository_Institutions_Acthttp://en.wikipedia.org/wiki/Garn%E2%80%93St._Germain_Depository_Institutions_Acthttp://en.wikipedia.org/wiki/Garn%E2%80%93St._Germain_Depository_Institutions_Acthttp://en.wikipedia.org/wiki/Depository_Institutions_Deregulation_and_Monetary_Control_Acthttp://en.wikipedia.org/wiki/Depository_Institutions_Deregulation_and_Monetary_Control_Act

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Government Response

The Bailout and other support

$700 billion to purchase the toxic assets (borrowing$1.7 trillion: $250 b deficit + $700 b bailout + $800 b

stimulus package of 2009) Housing and Economic Recovery Act of 2008 (300 b)

Some re-regulation

Wall Street Reform and Consumer Protection Act of

2009 (Dodd-Frank legislation)

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Impacts to US Economy

Housing: drop in values; foreclosures; tax revenuereduction at state and local level

Unemployment

From 4.2% to 10.1% Oct. 2009; 8.5 in early 2012 Real GDP Decrease

Stock market drop: Nearly 50% from peak to bottom;currently about 15% from peak

Distribution of wealth worsened: The top 1% whoowned 34.6% of the nation's wealth in 2007 increasedtheir proportional share to 37.1% by 2009

Global effects: hardest hit, Europe; least, Asia

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How the Decision of Bailout Was Made?

Watch the video:

Inside the Meltdown

http://www.pbs.org/wgbh/pages/frontline/meltdown/view/http://www.pbs.org/wgbh/pages/frontline/meltdown/view/

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Discussion

Do you think the $700 billion bailout is a wisedecision and based on what timeline? (e.g.,short term risk of depression and long-term

moral hazard) Who should be responsible and who should

assume the burden? What are the ethicalimplications? Should government regulate more

than Dodd-Frank or less?

Use the four Government-Business models toexplain your answer(market capitalism, dominance,countervailing forces, corporate social responsibility)