Macro Lecture 14: Late 2000 s Revisited

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1 Macro Lecture 14: Late 0 s Revisited Review gage-backed Securities (MBS) Figure 14.1 summarizes mortgage backed securities (MBS) A financial organization such as Fannie Mae or Bear Stearns or o buys a bunch of whole Bank A mortgages from primary "Whole" gages lenders (banks). o o cobbles the mortgages together into a single mortgage back security (MBS). then sell shares of the mortgage back security (MBS) to others. Each share of the security represents a fraction of all the mortgages that have been cobbled together into the security. The monthly mortgage payments provide the revenue to pay those who purchased shares of the mortgage backed security (MBS). Hunter Fannie Mae Changes Its Policy Fannie Mae Eases Credit To Aid gage Lending By STEVEN A. HOLMES Christin Figure 14.1: gage backed securities (MBS) New York Times: September 30, 1999 WASHINGTON, Sept. 29 the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders. The action, will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring.. Effect of the Policy Change Banks provide mortgages to households that would not have received them previously, the less credit worthy households. Question: What type of mortgage would you expect most the less credit worthy households choose, fixed rate mortgages or graduated payment mortgages? To address this question compare the payment pattern for a 20-year $,000 fixed rate and graduated payment mortgage: $,000 gage at a 10 Percent Interest Rate Fixed Rate Graduated Payment Payment for the first 3 years: $23,492 $20,000 Payment for the next 17 years: $23,492 $24,933 Answer: The annual payments for a graduated payment mortgage are nearly $3,500 less for the first 7 years. Since the less credit worthy households have fewer financial resources, they would no doubt find a graduated payment mortgage more attractive. Haley Jayde Bank B "Whole" gages Mateo Bear Stearns, Fannie Mae, etc. Cobbles a large number of these mortages into a single mortgage-backed security (MBS) Splits the MBS into a large number of shares Private parties including banks and other financial institutions Kate Each share of the MBS represents a fraction of each mortgage that have been cobbled together into the MBS The owners of the shares earn income as the mortgages included in the MBS are repaid.

2 2 Banks then sold some of these whole mortgages to Bear Sterns, Fannie Mae, etc. In turn, Fannie Mae: o Kept some of the mortgages. o Cobbles the whole mortgages together into mortgage backed securities (MBSs) and sells the MBSs to private financial institutions (Citibank, Bank of America, etc.). Prior to 7: Bank sells Elaine s and Brady s mortgages to Fannie Mae and buys mortgage backed securities with the proceeds. Assets Liabilities Reserves 50 Deposits 500 Vault Cash 30 Dep at Fed 20 Securities Stock&Bonds 60 MBS 40 Loans Hunter 20 Elaine 20 Borrowing 10 Brady 20 Total Assets 590 Total Liabilities 510 Net Worth = Total Assets Total Liabilities = = 80 The loans component of the bank s balance sheet decreases by 40 from 480 to 440 and the securities component increases by 40 from 60 to 100. Question: How did this affect the price of homes? Answer: Since more families were now eligible for home mortgages, this increased the demand for homes resulting in increase in the price. As illustrated in figure 14.2 the price of homes rose dramatically between 0 and 7. Question: Consider a less credit worthy household, the Jones, who purchased a home in 4 for $230,000 with a graduated mortgage that we described above. In 7, the Jones payment rises from $20,000 per year to $24,933 per year. The Jones can t afford to pay this much. So, they decide to sell their home. Will this be a problem? Answer: No. In 7 they can sell their home for only $320,000. But they only owe $230,000 on their mortgage. The sale of Figure 14.2: Real price of single family homes: their home generates more than enough revenue to pay off their mortgage. In fact, they have a tidy $90,000 left over to enjoy Real Price of Single Family Homes

3 3 After 7 After 7: The price fell from $310,000 in to $260,000, $50,000 as shown in figure Some home buyers discovered a few years after purchasing their homes that they could not afford the higher payments required by their graduated payment mortgages. Was this a problem for the home buyer? Question: Consider a second less credit worthy household, the Smiths, who purchased a home in 7 for $300,000 with a graduated mortgage that we described above. In 2010, the Smiths payment rises from $20,000 per year to $24,933 per year. The Smith can t afford to pay this much. So, they decide to sell their home. Will this be a problem? Answer: Yes. In 2010 they can sell their home for only $260,000. But they owe $300,000 on their mortgage. The sale of their home will not generate Figure 14.3: Real price of single family homes: enough revenue to pay off their mortgage and they can t afford the new higher payments. This is a serious problem because will default on their mortgage Real Price of Single Family Homes ($1,000): After 7: Yes. Since home prices fell somewhat in all regions of the country and very dramatically in some parts (Nevada, California, Arizona, Florida, etc.), many buyers could not sell their homes for enough to pay off the mortgage. These households defaulted on their mortgages and stopped making payments. Eventually, they were eventually evicted from their homes. Question: How did this affect consumer confidence? Answer: Figure 14.4 shows that consumer University of Michigan Index of Consumer confidence plummeted. Sentiment Figure 14.4: Consumer Sentiment: Jan 6-Jan 9 Question: How did the fall in home prices affect the MBSs? Answer: When households stopped making their mortgage payments many MBSs could not make the payments that they promised and their values plummeted.

4 4 Let us now see how this affected banks that owned mortgage backed securities. Many mortgage backed securities became virtually worthless. Suppose that 30 of the 40 bank s MBSs became worthless: Fall 8 Assets Liabilities Reserves 50 Deposits 500 Vault Cash 30 Dep at Fed 20 Securities Stock&Bonds 60 MBS Loans 440 Borrowing 10 Elaine 20 Total Assets Total Liabilities 510 Net Worth = Total Assets Total Liabilities = = The securities component of the bank s balance sheet falls by 30 from 100 to 70. Since assets have fallen by 30, the net worth falls by 30 also, from 80 to 50. This would diminish the value of the bank s stock. Question: What would occur if the net worth of the bank fell below 0? Answer: The value of the bank s assets would be less than the value of its liabilities. That is, the bank would no longer be able to meet all its financial obligations including its obligations to its depositors. Needless to say, this would be very disruptive to the economy Citigroup Closing Stock Prices In fact one bank, Bear Sterns, was forced into bankruptcy and other banks saw the value of their stock plummet as their net worth fell. As shown in figure 14.5, Citigroup s stock fell dramatically. In fact one bank, Bear Sterns, was forced into bankruptcy and other banks saw the value of their stock plummet as their net worth fell. As shown in figure 10.11, Citigroup s stock fell dramatically. gage Insurance Many financial institutions that purchased mortgage backed securities (MBSs) also purchased mortgage insurance on these securities. In the event that the holders of the mortgages included in an MBS defaulted the company insurance company would pay the owner of the MBS instead. Unfortunately when the MBSs defaulted, however, many mortgage insurance companies did not have the financial resources to make good on their promises and indeed they declared bankruptcy. American International Group (AIG) was one of these mortgage insurance companies that experience this difficulty. As figure 14.6 illustrates its stock price fell dramatically Jan 06 Jul 06 Jan 07 Jul 07 Jan 08 Jul 08 Figure 14.5: Citigroup stock price: Jan 6-Jan 9 AIG Closing Stock Price: Jan 8 Jan 9 1, Jan 08 May 08 Sep 08 Jan 09 Figure 14.6: Business confidence:

5 5 Clearly, business confidence faltered as illustrate in figure OECD Manufacturing Confidence Indicators for U.S Figure 14.7: Business confidence: Business and Consumer Confidence Claim: Changes in consumer confidence shift the aggregate demand (AD) curve. Increases in confidence shift the aggregate demand (AD) curve right Decreases in confidence shift the aggregate demand (AD) curve left. Figure 14.8 shows how a decline in consumer and/or business confidence affects the aggregate demand (AD) curve: FP Question: What would the real AD Question: How many final goods and interest rate (r) equal, if the inflation rate services would be purchased if the inflation rate () were percent, given that the () were percent, given that all other Fed does not change its inflation policy? factors relevant to demand remained the same? FP At a given inflation rate () Consumer and/or business confidence decline Households and/or firms purchase less r (%) Fewer goods and services purchased Figure 14.8: Decline in Consumer Confidence AD AD G&S Aggregate demand (AD) curve shifts left

6 6 Late 0 s Table 14.1 reports data from the late 0 s. Once again, we apply the adaptive expectations principle to complete the expected inflation rate column. Unemp Real Actual Infl Expected Infl Govt Productivity Year Rate (%) GDP Rate (%) Rate (%) Purch Growth (%) , , , , , , Table 14.1: Late 0 s macro data: 7-9 Figure 11.9 illustrates the data: 3.0 AS AS AS AD AD 9 AD 8 14,400 14,500 14,600 14,700 14,800 14,900 15,000 Figure 14.9: Late 0 s: 7-9 G&S Aggregate Supply (AS) Curve The expected inflation rate fell from 3.1 to 2.7 to 2.0 percent. Since the aggregate supply (AS) curve intersects the long run aggregate supply (LRAS) curve at the expected inflation rate, the aggregate supply (AS) curve shifts down as seen in figure Table 11.5 provides a summary: Expected inflation rate falls Expected inflation rate falls AS down Shifts down Table 14.2: aggregate supply (AS) curve 7-9

7 7 Aggregate Demand (AD) Curve While government purchases increased modestly, the loss in consumer and business confidence more than offset the increase in government purchases. The aggregate demand (AD) curve shifted left as illustrated in figure Table 14.3 provides a summary: Fiscal Policy Business and Consumer Confidence Fiscal Policy Business and Consumer Confidence Expansionary Falls Expansionary Falls AD shifts right AD shifts left AD shifts right AD shifts left é ã é ã In net, the AD curve shifts left In net, the AD curve shifts left Fall in business and consumer confidence dominates expansionary fiscal policy Fall in business and consumer confidence dominates expansionary fiscal policy Table 14.3: Aggregate demand (AD) curve 7-9 Government s Response The Federal government responded with three initiatives: Troubled Asset Relief Program (TARP) American Recovery and Reinvestment Act of 9 (Stimulus Bill) Quantitative Easing (QE1, QE2, and QE3) All three of these programs were designed to shift the aggregate demand (AD) curve back to the right thereby mitigating the contractionary effects of business and consumer confidence. By doing so, GDP would increase and unemployment fall as shown in figure We begin with the Troubled Asset Relief Program (TARP). AS AD AD G&S Figure 14.10: Policy maker s goal