Chapter 10. The Great Recession: A First Look. (1) Spike in oil prices. (2) Collapse of house prices. (2) Collapse in house prices

Transcription

1 Discussion sections this week will meet tonight (Tuesday Jan 17) to review Problem Set 1 in Pepper Canyon Hall 106 5:00-5:50 for 11:00 class 6:00-6:50 for 1:30 class Course web page: Chapter 10 The Great Recession: A First Look 1 (1) Spike in oil prices Main shocks of the Great Recession (Dec 007 June 009): (1) Spike in oil prices () Collapse of house prices (3) Financial turmoil (most important) Caused by: booming demand for oil and stagnating world production Effects: rapid fall in consumer spending on autos and other goods What caused each shock, and what were its effects? 3 () Collapse in house prices Caused by: loose monetary policy (low interest rates) global savings glut (low interest rates) Mortgage securitization (encouraged lending to risky borrowers) () Collapse of house prices (a) What caused house prices to collapse ? (b) What were effects of house price collapse? Loss of household wealth, inability to get new loans, debt overhang less consumer spending and less new home construction As banks lost money on mortgages, they could not borrow or lend themselves financial turmoil 5 6 1

2 (3) Financial turmoil Main shocks of the Great Recession: (1) Spike in oil prices () Collapse of house prices (3) Financial turmoil April 007: Bankruptcy of New Century Financial (a major subprime mortgage lender) Jan 008: Countrywide Financial (a major mortgage lender) purchased by Bank of America for small fraction of its previous value March 008: Failure of Bear Stearns (a major investment bank) Sept 008: Failure of Lehman Brothers (a major investment bank) 7 8 (3) Financial turmoil Rate at which banks borrowed from each other (e.g., LIBOR) spiked relative to 3-month Tbill (a) What caused the financial turmoil of ? Answer: nobody was sure which banks were safe to lend to 9 10 (3) Financial turmoil Result: banks could not or would not lend to consumers and businesses Banks and businesses wanted to strengthen their balance sheets (no new projects) 11 (a) What caused the financial turmoil of ? (b) What were the effects of the financial turmoil? Sharp curtailment of lending meant further declines in house prices and spending by consumers and businesses Lower income meant more loans went unpaid 1

3 Summary of shocks The economy was hit by 3 big shocks: (1) Spike in oil prices () Collapse of house prices (3) Financial turmoil (most important) Next question: What did we see happen during the Great Recession and how does it compare with other recessions? Each had the effect of sharply lowering spending by consumers and businesses : unemployment up.5% avg of other recessions: up.5% : employment down 6.3% avg of other recessions: down.5% 11 Unemployment rate.0 Employment growth The inflation rate became negative (deflation) in Inflation rate Source:

4 007-09: real GDP fell.7% avg of other recessions: down 1.7% : real consumption fell 3.% avg of other recessions: up 0.% GDP growth and recessions 6 Real consumption growth : real investment fell 3.0% avg of other recessions: down 1.% 5 Real investment growth Note: new home construction counted in investment, not consumption Summary The Great Recession was like other postwar recessions, only worse What was different? Earlier postwar recessions did not have house price crash and financial turmoil (shocks and 3) 3

5 China and India did not face financial turmoil Europe faced financial turmoil in (banks exposure to U.S. mortgages) Second phase of financial turmoil in 011 in Europe but not in U.S. (sovereign debt concerns high cost of govt to borrow, doubts about banks exposure) Unemployment rate in the euro area 5 6 Great Recession of was only postwar U.S. recession accompanied by a financial crisis But many other countries experienced financial crises during last 50 years Spain (1977), Norway (1987), Finland and Sweden (1991), Japan (199) And before World War II ( ), U.S. had several financial crises 7 Great Depression ( ) Great Recession ( ) lasted years Great Depression ( ) lasted years and was much more severe 8 Source:

6 Summary Recessions and depressions are associated with sharp drops in spending Financial crises cause the drops to be more severe and effects to be longer lasting Final goal of Chapter 10: Understand how financial markets are supposed to function and what went wrong in the Great Recession 31 3 Asset: something of value that you own Liability: something you owe to somebody else Money you borrow from the bank is a liability from your point of view but an asset form the bank s point of view If you own a Treasury bond, that is an asset from your point of view but a liability from the government s point of view 33 3 Categories of bank s assets Loans bank has made to customers Investments Treasury securities Mortgage-backed securities Reserves Cash in the bank s vaults Deposits in the bank s account with the Federal Reserve System (Fed sometimes called the bank s bank ) 35 Categories of bank s liabilities Deposits customers have in their account with the bank Long-term debt (1 year or longer) Short-term debt Repo (repurchase agreements: use investments as collateral for 1- to 30-day loan) Investments Fed funds borrowed (money borrowed overnight from other banks) 36 6

7 Balance sheet: summary of all of an institution s assets and liabilities as of a particular point in time (typically last day of the quarter or last day of the year) To make the balance sheet balance, we add the category of equity (also called net worth ) on the liabilities side Example: if you own a $500,000 house (as asset from your point of view) but owe a $500,000 mortgage (a liability) your net worth is zero If you own a $500,000 house but only owe a $00,000 mortgage, your net worth is 39 0 $100,000 A bank makes a profit by earning a higher interest rate on its assets (loans to customers or investments) than it pays on its liabilities (deposits of customers or the bank s debt) To start the bank, you could Put in $00 of your own money (equity) Borrow another $800 in debt Get customers to deposit $1000 Lend out $1000 Buy another $900 in investments Keep $100 on hand in case customers want money back 1 7

8 3 Leverage: ratio of total liabilities to net worth Example: Total liabilities = $1800 Net worth = $00 Leverage = 1800/00 = 9 Higher leverage means higher profit (more of the money bank lends is somebody else s) What if customers want more than $100 today? Could try to borrow overnight from another bank (called the fed funds market ) Could try to sell some of my investments or loans to raise more cash Liquidity management: making sure I always have enough cash to give back to customers Reserve requirements: Fed requires banks to hold vault cash or deposits with the Fed equal to a certain fraction of the total value of deposits that customers have with the bank 5 6 What if I don t have cash and other banks won t lend to me? Could sell assets, but if I have to do this quickly I will take a loss Capital requirements: net worth must be a certain fraction of total assets 7 8 8

9 Bank run What happens if: Customers all lose confidence in the bank Bank has to sell its loans and investments at a loss Loss is greater than the bank s net worth Then Bank will not have enough money to pay back customers Bank run could be the result American Union Bank, New York City, Shadow banking system Banking Act of 1933 created Federal Deposit Insurance Corporation to Set capital requirements for banks Guarantee deposits by U.S. Treasury As of Dec. 31, 01 had guaranteed $7.5 T in deposits No U.S. bank runs during the Great Recession 51 Banks created off-balance-sheet entities (called conduits or special purpose vehicles ) that Purchased mortgage-backed securities and collateralized debt obligations Financed largely with short-term repos and asset-backed commercial paper Highly leveraged, no capital requirements When real estate market crashed, could not roll over short-term debt Run on the shadow banking system 5 MBS as percent of GDP Yield on asset-backed commercial paper minus nonfinancial CP Source: 53 Source: 5 9

10 Results: the regular banking system also had difficulties borrowing and cut back lending Source: Gorton (009), Slapped by the invisible hand Source: 01/december/008-financial-crisis-bank-lending-contraction 10