10. Great Recession Ithe worst recession since the Great Depression of the 1930s.The causes of the financial crisis that began in the summer of 2007 and where the economy currently stands.
How the current financial crisis compares to previous recessions and to previous financial crises in the United States and around the world.
10.2 Recent Shocks to the MacroeconomyWhat shocks to the macroeconomy have caused the global financial crisis?Housing pricesGlobal saving glutSubprime lending and rise in interest ratesPrevious financial turmoilOil prices
Housing PricesHousing prices tripled between 1996 and 2006.Housing bubbleBetween mid-2006 and the first quarter of 2012, the national index for housing prices plummeted by 42 percent.The bubble burst
The Global Saving GlutThe current financial turmoil was caused partly by prior financial crises.Ben Bernanke March 2005: global saving glutGlut = excessThe United States had an excess of savings with desire to invest.Higher investment demand contributed to rising asset prices in the housing market.
Subprime Lending and the Rise in Interest RatesThe savings glut led to low interest rates, and many borrowers took out mortgages to buy homes between 2000 and 2006.Many of these borrowers were subprimepoor credit recordshigh debt-to-income ratios.Between 2004 and 2006, the Fed raised its interest rate from 1.25 to 5.25 percent.
The Taylor rule demonstrated that rates had been too low in previous years.However, many subprime borrowers were now facing mortgages that were increasing from their initial teaser rates.By August 2007 nearly 16 percent of subprime mortgages with adjustable rates (as opposed to fixed rates) were in default. This led to a downward spiral of the housing market.
Federal funds rateIt is the interest rate paid from one bank to another for overnight loans.However, the Fed can actually control the level of the fed funds rate.It will be discussed in ch 12.
The Financial Turmoil of 2007-2009Before the crisis, subprime mortgages were sold to investors through a financial innovation known as securitization.SecuritizationThe process of pooling a group of financial instruments, such as mortgages, and then slicing them up in a different way and selling off the pieces.Meant to diversify risk.
As mortgages were developed and traded, it became difficult to know how much risk an individual bank was exposed to.
August 2007: flight to safety.Lenders put funds in T-bills: T-bills (U.S. Treasury bills) are safer.
Liquidity crisisThe volume of transactions in some financial markets falls sharply.Makes it difficult to value certain financial assets.raises questions about the overall value of the firms holding those assets.Financial markets plunged and the S&P index dropped 50 percent from its peak in November 2007. Other stock indices include DJI and Nasdaq.
Oil PricesTo make matters worse, oil prices were extremely volatile in this period. 2002: $20 per barrel.Summer of 2008: $140 per barrel.December 2008: $40 per barrel.2009Present: $80 to $100 per barrel.
The oil price increase was caused by:Demands from China, India, and the Middle East.Short-term supply disruptions.The economic slowdown helped to alleviate oil demand pressures.It is possible that price speculation also played a role.
10.3 Macroeconomic OutcomesThe recession, starting in December 2007, was first visible in unemployment. By 2009:Output was 7 percent below potential.Unemployment peaked at 10 percent.February 2010:8.5 million jobs lost
A Comparison to Previous Recessions Compared to an average of all recessions since 1950, this recession is significantly worse.A striking difference about this recession is the decrease in consumption that occurred: why is the decrease in consumption is striking?
InflationVolatile oil prices caused sharp swings in inflation for all items in 2008.In the recession, core inflation (all items excluding food and fuel) declined slightly.
10.4 Some Fundamentals of Financial EconomicsIt is helpful to understand some basic financial principles in order to understand the crisis as a whole.
Balance SheetsBalance sheetAccounting tool with assets on the left side and liabilities and net worth on the right side.The two sides sum to the same value when net worth is included.AssetsItems of value that an institution owns: loans, investments, cash and reserves.
LiabilityAn amount that is owed to someone else: deposits, short-term and long-term debts.Equity = capitalThe difference between total assets and total liabilities on a balance sheet.Represents the value of an institution to its shareholders or owners.Also known as net worth or capital.
Banks are also subject to a number of financial regulations that apply to their balance sheets.The reserve requirementA mandate that financial institutions keep a certain percent of their deposits in a special account with the central bank.The capital requirementThe legal obligation that a financial institution have a certain ratio of its assets supported by capital on its balance sheet.
LeverageLeverageThe ratio of total liabilities to net worth.This ratio magnifies any changes in the value of assets and liabilities in terms of the return to shareholders.This principle also applies to homeowners.
If a bank is highly leveraged, it may makeLarge gains off of small increases in market prices: incentives to increase leverage.Large losses off a small decrease in prices: risk of high leverage ratio.Insolvency Situation in which the liabilities of a bank or other company exceed its assets.Before the financial crisis, many investment banks were highly leveraged.
Bank Runs and Liquidity CrisesThe Great Depression of the 1930s was caused by nearly all depositors converging on banks at once and demanding the return of their deposits.Bank runA situation in which depositors or creditors worry about a financial institutions solvency and its ability to repay its deposits or short-term debt.Everyone runs to withdraw all funds, and the bank cant meet all these requests.
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