The Fulbright Program

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The Fulbright Program From Wall Street to Main Street: The Financial Crisis in the US Douglas J. Young Professor of Economics, Montana State University, USA Visiting Professor, IIT Bombay Senator J.

1 The Fulbright Program From Wall Street to Main Street: The Financial Crisis in the US Douglas J. Young Professor of Economics, Montana State University, USA Visiting Professor, IIT Bombay Senator J. William Fulbright, USA Purpose: Promote mutual understanding through educational exchange Since 1948: 225, Fulbright Scholars; 14 countries Next year: >1 Indians to USA; >1 Americans to India Nicole Young Age 14 Woodstock School, Mussoorie Picture on Facebook Financial Crisis Causes Not one, but many Consequences In Financial Markets (Wall Street) In Homes and Businesses (Main Street) In India

2 Index: January, 2 =1 Case-Shiller 1 City House Price Index 25 Nominal Real Latest data: February, 29 Case-Shiller & BLS What s Normal for House Prices? Average Annual Percentage Increase after Inflation: :.4% per Year 196-2:.2% per Year This Decade Jan, 2 Jan, 26: 11.2% per Year Aug, 23 Aug, 24: 17.3% per Year Shiller reported at Rising House Prices => Buyers were able to Refinance after a few years And buy a new car, too! Refinancing 24: Buy $2, house with 2% down payment Mortgage = $16, (8% of value) 26: House worth $26, New Mortgage = $28, (8%) Pay Old Mortgage = $16, Cash: $28,-16, = $48,

3 Personal Savings Rate BEA Percent of Disposable Incom e Rising House Prices => Fewer Loan Defaults and Foreclosures => Lower Lending Standards Lower Lending Standards Lower Down Payment (1% - 5% - %) Lower Income Requirements No Income or Asset Verification NINJA Loan = No Income, No Job or Assets Teaser Interest Rates Predatory/Fraudulent Lending Positive Feedback Loop Higher Home Prices => More Demand for Loans and Lower Lending Standards => More Demand for Homes => Higher Home Prices

4 Why (Else) Lower Lending Standards? Financial Innovation Mortgages sold, assembled, sliced into tranches and resold MBAs/PhDs: We can manage the risk! BUT: Bad Statistical Models Higher Global Wealth Global Glut of Saving More demand for real estate-backed securities Why (Else) Lower Lending Standards? Public Policy Home ownership a national priority Encourage lending in depressed areas and to low-income people Deduct mortgage interest Low interest rates Competition among Lenders P e rc e n t O w n e r O c c u p ie d Home Ownership But. Defaults up sharply if: Interest rates increase, and/or Home prices fall (or stop rising) Why? Most (all?) equity from price increases Many borrowers can t afford payments if interest rates rise Bureau of the Census, CPS, Series H-111

Definancing 26: House worth $26, Mortgage = $28, (8%) 29: House Price down 3% => House Value = $182, Upside Down Incentive: Walk away from house; maybe, put holes in the wall.

5 Definancing 26: House worth $26, Mortgage = $28, (8%) 29: House Price down 3% => House Value = $182, Upside Down Incentive: Walk away from house; maybe, put holes in the wall. Negative Feedback Loop Mortgage Defaults up => Lower Home Prices => More Defaults => Lower Home Prices Where Was the Oversight? Shareholders / Boards of Directors Appropriately monitor managers? Appropriate compensation? Rating Agencies Correctly rate risk of mortgage securities? Regulators Appreciate nature of systemic risk? Wall Street Main Street Consequences

6 What Do Financial Institutions Do? Channel funds from lender-savers to borrower-spenders Crucial for economic performance Finance new/expanded business Finance consumption (cars, washing machines, AC, ) Finance homes! The Balance Sheet Assets (uses of funds) Liabilities (sources of funds) Short-Term (cash) $5 Deposits $15 Short-Term Debt $1 Long-Term $175 Long-Term Debt $75 (loans, securities) Other Assets (buildings) $2 Capital (Net Worth) $1 Total $2 Total $2 25 What if Asset Values Decline? Bank Failure -193s Assets (uses of funds) Liabilities (sources of funds) Short-Term (cash) $5 Deposits $15 Short-Term Debt $1 Long-Term $15 Long-Term Debt $75 (loans, securities) Other Assets (buildings) $2 Capital (Net Worth) -$15 Total $175 Total $175 26

7 Bank Failure 2s LEHMAN BROTHERS What s the Big Deal? Potential for Severe Economic Contraction Great Depression? Credit freeze impacts Main Street: Short-run business activity Investment spending Consumption spending Consumer Wealth Losses Real Estate: -3% $6 trillion + Stocks (Shares): -4% $4 trillion $1 trillion Loss of Consumer Wealth (= $1,, crore = $1 lakh crore) Consumer Net Worth (= Assets Liabilities) $5 trillion Wealth => Consumption Consumer Demand will fall by $5 billion 3.% Decline in Incomes Consumer Demand will Decline further as Incomes Fall => Recession: Higher Unemployment

8 7.3 Million Homeowners Default Million Lose Homes Foreclosures Billions of $ Residential Investment 1 BEA Rising Unemployment What about India? Internal Financial Crisis? Excess Lending for Houses / Flats and other Property Development? No, apparently not. Real estate boom, but Boom based on rapid income growth Indian Banks less heavily leveraged => No Financial Crisis like US US BLS

9 India s Exposure to the World Economy 1. Current Account 2. Capital Account (Financial Flows) India s Exposure to World Economy 1. Current Account a. Exports Imports b. Income on Foreign Investments c. Private Transfers (Worker Remittances) India s Balance of Trade Depends on Incomes in Rest of World Prices of Imports and Exports Exchange Rates Annual Percent Change Increases in House Prices: Europe UK FRA ESP 1995Q4 1997Q4 1999Q4 21Q4 23Q4 25Q4 27Q4-5 IMF 4 Quarter Moving Average

Percent Change 5 4 3 2 1-1 -2 GDP (Income) Growth 2.7 USA Euro Area 2. 1.1.9. 27 28 29 21-.4 India s Oil Imports -3-2.8 IMF -4-5 -4.2 RBI, 29 Percent of GDP -.5-1 -1.

10 Percent Change GDP (Income) Growth 2.7 USA Euro Area India s Oil Imports IMF RBI, 29 Percent of GDP IMF: Current Account Balance India s Exposure to World Economy 2. Capital Account (Financial Flows) Foreign Direct Investment Portfolio Investment (FIIs) Foreign Exchange Reserves IMF

11 Reserve Bank of India April, 29 The adverse conditions for access to external capital, and the depressing effects of the global crisis on domestic business confidence, contributed to the moderation in investment demand IMF Percent Change GDP Growth in India and the World 9.3 India World Summary US Financial Crisis Resulted from a Combination of Factors, including Public Policy, Financial Innovation, and just plain Bubble Mania. Reforms: Greater transparency, greater regulation / capital requirements. Lenders will be more careful, anyway. Questions? This presentation is available at: Click on Papers

From Wall Street to Main Street: The Financial Crisis in the US

From Wall Street to Main Street: The Financial Crisis in the US Douglas J. Young Professor of Economics, Montana State University Indian Institute of Technology - Bombay Sabbatical Other Activities Extension-type