1 section 2b financial crisis of 2008. 2 overview key events of the economic crisis the four causes...
TRANSCRIPT
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Section 2B
Financial Crisis of 2008
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Overview
• Key events of the economic crisis
• The four causes of the economic crisis
• 3 lessons we should learn from economic crisis
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Key Events of the Economic Crisis
This economic downturn was characterized by:
• The boom and bust of the housing market
• Rising default and foreclosure rates
• Sharp downturn in the stock market
• Soaring energy prices
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Boom and bust of the housing market
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Mortgage Default Rates
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Foreclosure Rates
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Sharp downturn in the Stock Market
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What caused the economic crisis of 2008?
1. Regulations that lowered mortgage lending standards
2. Prolonged low interest rate policy of the Fed during 2002-2004
3. Increased debt to capital ratio of lending institutions
4. High and growing debt to income ratio of American households
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1. Regulations Lowered Lending Standards
A. Government Sponsored Enterprises (GSE’s): Fannie Mae and Freddie Mac
B. Department of Housing and Urban Development (HUD) required them to extend loans to low and moderate income households
C. Community Reinvestment Act (CRA) also pushed banks to extend loans to high risk borrowers
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1. Regulations Lowered Lending Standards
Subprime loans: loans made to borrowers with a blemished credit history
Alt-A loans: loans extended to borrowers with a poorly documented credit history
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1. Regulations Lowered Lending Standards
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2. Low interest rate policy of the Fed
• The Fed kept interest rates low in 2002-2004 to stimulate the economy.
– This increased the attractiveness of Adjustable Rate Mortgages (ARM loans)
• The Fed pushed interest rates back up in 2005-2006 to combat inflation.
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2. Low interest rate policy of the Fed
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2. Low interest rate policy of the Fed
When interest rates on ARM loans increased, so did the foreclosure rates (for both subprime and prime loans)
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2. Low interest rate policy of the Fed
When interest rates on ARM loans increased, so did the foreclosure rates (for both subprime and prime loans)
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3. Increased Debt to Capital Ratio
A. In 2004, SEC regulations allowed banks to leverage their capital and extend more loans
B. So banks bundled mortgages together into “AAA” securities.
C. This led to the collapse of investment banks and other financial institutions
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3. Increased Debt to Capital Ratio
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4. High and growing debt to income ratio of American households
A. The debt to income ratio of households has risen sharply since the early 1980s.
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4. High and growing debt to income ratio of American households
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4. High and growing debt to income ratio of American households
B. Because mortgage and home equity loans are tax deductible, but other forms of debt are not, household debt is concentrated in housing assets
C. As a result, housing is hit especially hard when economic conditions weaken
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Lessons from the Financial Crisis
1. Be careful with regulations: They can create perverse incentives.
2. Monetary policy should focus on price stability, rather than trying to stimulate or slow the economy.
3. American households should probably carry less debt relative to their income
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Review
1. Know the key events surrounding the 2008 economic crisis.
2. Know the four causes of the economic crisis.
3. Understand the lessons we should take from the mistakes made leading up to the economic crisis (and don’t repeat them).