Understanding The Economic Crisis In Plain English

Understanding The Economic Crisis in Plain English Bruce Judson Senior Faculty Fellow, Yale School of Management

At Poughkeepsie Day School

December 9, 2008

Copyright 2008 Bruce Judson

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Today’s Talk • Provide a foundation for understanding what is happening – and assessing future events • A test of success: Understanding how each day’s news stories fit into our overall framework • Give you the tools to ask the right questions 2

Today’s Approach • Discussion assumes no prior knowledge of economics or finance • Many concepts are simplified—to meet time constraints • Only the U.S. is discussed—although this is a global crisis • Special emphasis on explaining jargon – so you can more easily follow future events in the newspaper • No moral judgments – No blame – Emphasis on describing what has happened, not on saying this was “good” or “bad” 3

The Best Way to Understand the Crisis: A Domino Effect Housing Bubble Housing Crisis Credit Crisis Stock Market Decline Lower Consumer Spending Decreased Company Profits Layoffs & Job Cuts 4

The Crisis Begins with Home Prices…

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Early 2000’s: Historic Home Price Increases

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What is a Home Price Index? • The same house bought in 1987 for $100,000 (Index =100)…

• … Is worth $171,000 in 2005 (excluding inflation) (Index = 171).

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A Traditional 30 Year Fixed-Rate Home Mortgage: Buyer Pays 20% and Borrows 80% From the Bank • To Buy a $200,000 Home – Down-Payment of $40,000 (20%) – Borrow $160,000 from the bank (80%)

• At 4% interest

monthly payment of $764. • At 8% interest monthly payment of $1,174.

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The Value of a Traditional Mortgage • •

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Buyer shows she is responsible by first saving $40,000. With a set monthly fee, buyer always knows how much she will pay each month for 30 years – Banks also verified the income of borrowers to make sure they could handle the monthly payments. If the buyer can’t pay her mortgage the bank gets the house (foreclosure) to pay-off the remaining mortgage (from the $160,000) – The buyer’s down-payment ($40,000) protects the bank in case the house’s value goes down. – Foreclosure example: The house declines in value to $180,000 and the buyer owes $160,000 --- The bank sells the house, gets it’s $160,000, and the buyer gets back $20,000.

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The Housing Bubble Begins: As Home Prices Start Their Huge Rise, Everyone Assumes Home Prices Will Never Go Down

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Banks Create “Easy” “Low-Interest” Mortgages : These High Risk Loans Are Called “Sub-Prime Mortgages” •

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“No money down” – Borrow 100% of the Purchase Price – (No protection for the bank if prices drop and buyer is foreclosed) No Income Verification Loans – To qualify for loans buyers need a certain income. – Now, banks don’t check if buyers really have the income. Interest –Only loans – Low payments for the first few years of the mortgage – Then, monthly payments jump! 11

Home Prices Rise: People Feel Rich! • The house I bought for $200,000 is now worth $300,000. • I am $100,000 wealthier! • Maybe I should borrow more and buy an even bigger house—before prices go up even further? 12

As Home Prices Rise, Banks Also Encourage Existing Home Owners to Borrow More • Your Home is worth $100,000 more. • “Refinance” or get a “Home Equity Loan” to access your higher wealth! • Home prices never fall so you don’t need to worry about borrowing too much. • People borrowed more money than they could prudently afford. 13

What is a bond? • Bonds are a way for governments and businesses to borrow money. • Hypothetical Example: A $100 U.S. savings bond – You give the government $100 today. – In return, you get 7% of $100 ($7) each year for 20 years. – At the end of 20 years you get back your $100. 14

Bonds and the Risk of Default • Bonds have risks – If a company (or anyone else) issues a bond, there is always the chance they may not be able to pay back the money they borrowed (default). – Higher risk companies issue “junk bonds” which pay higher interest rates. – The higher interest rates compensate buyers for the added risk of default. • The U.S. Government is seen as the safest borrower – So, U.S. Government bonds pay lower interest rates—since they have less risk. 15

Wall Street Bundles Subprime Loans into Bonds

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Mortgage-Backed Subprime Bonds Become A Hugely Profitable Business for Banks and Wall Street Companies • Banks get a fee for creating the mortgage and selling it to Wall Street companies. • Wall Street companies get fees for turning the mortgages into bonds and selling them. • These “mortgage-backed securities” are sold to investors (such as pension funds). • Many Wall Street companies also hold large amounts of these bonds as investments. • These bonds are also called “CDO’s”— Collateralized Debt Obligations. • The bonds are seen as low risk – because many mortgage buyers won’t default at once. 17

No One Worries About Risk… • Traditionally, neighborhood banks kept the borrower’s mortgage – They lost money if the borrower defaulted and the foreclosure value was less than the money owed. • Now, the banks and Wall Street firms are earning fees for selling mortgage bonds – which are sold to investors as low-risk – Remember, these bonds are based on 100% down and no income verification mortgages. – Plus, refinanced and home equity loans based on rising home values. 18

Then, Home Prices Start to Fall…

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As Home Prices Fall, People Owe More For Their Mortgage Than Their Home Values • Extreme example: – A Family Borrows $300,000 to buy a home with a no down payment mortgage. – Now, the home is only worth $200,000. – If the family defaults, the bank loses $100,000 (remember the bank takes back the house and sells it) – So long as the family keeps paying the mortgage the decline in the value of the home has no effect (except that the family feels poorer). 20

As Home Prices Fall, Subprime Borrowers Default at High Rates…

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Falling Home Prices and Rising Default Rates Create A Crisis For Wall Street Companies • Subprime bonds (now called toxic mortgages) are worth much less than anyone thought – Since borrowers are defaulting the monthly payments disappear. – With default and foreclosure, the bond owners get paid the value of the homes with the defaulted mortgages. – But, the homes have declined in value and are worth much less than the amount borrowed. 22

As Defaults Continue, Millions of Families Are Losing Their Homes

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For Wall Street, The Credit Crisis Has Two Components: • First, many firms invested in mortgage-backed securities that have now plummeted in value – These companies can’t meet their obligations. – Leading to bankruptcies and mergers (required by the government). • Second, it is a crisis of trust. 24

The Credit Crisis and Trust: What Happened in Early Fall 2008 • Every day companies borrow money for shortterm needs (such as payroll) . • Credit is the life blood of the financial system. • But, no one knows which financial firms are effectively bankrupt—because they have invested in toxic mortgage bonds. • So no one trusts anyone else—and lending slows. • The financial system is in danger of grinding to a halt. • The 700 billion government bailout plan is passed by Congress to keep credit flowing. • The Federal Reserve (an independent government agency) takes massive actions to keep credit flowing. 25

What Are Stocks? • A share of stock is the partial ownership of a company. • Example: You start a business and want to raise money to build a new factory – So you divide your ownership into 100 shares of stock. – You keep 30 shares and sell 70 shares to the public through the stock market. – Now, these 70 shares own 70% of the company • After all salaries, including yours, the 70 shares are entitled to 70% of the company’s profits. • A Stock price goes up if buyers think the company will be more profitable in the future— They believe over time its shares will be worth more. • A Stock prices goes down if people think the company’s profits will go down in the future, and sell their shares in the company. 26

Credit Crisis Leads to the Stock Market Crisis •

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As the credit crisis unfolds, people realize it is going to be more expensive for businesses to borrow money – These higher borrowing costs will reduce profits in the future – Plus, It is going to be harder to get loans. – And financial companies are worth less than anyone thought (because they are holding toxic mortgages). People are also going to spend less since they feel less wealthy as home prices go down – This will also hurt company profits. People’s confidence in a prosperous future plunges. All of this leads people to sell stocks (because they believe profits will go down in the future) and the value of most stocks decline dramatically – At the end of last week, stock prices were down an average of 35% in 2008. – Savings in stocks (for pensions, college, etc) of $100,000 at the start of 2008 are now worth $65,000. 27

The Wealth Effect and Consumer Spending • Consumer spending (people) is 70% of our economic activity • As stock values fall and home prices decline, people “feel” less wealthy – When people feel poorer they spend less money. – By spending less money they lead to lower business profits – This is called “the wealth effect.” 28

Lower Consumer Spending is Reducing Profits, So Companies Are Cutting Jobs Housing Bubble Housing Crisis Credit Crisis Stock Market Decline Lower Consumer Spending Decreased Company Profits Layoffs & Job Cuts 29

The Recent News on Jobs •

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On Friday, the Labor Department estimated that about 530,000 jobs were cut in November. – Bringing the total job losses this year to almost 2 million. – In addition, we need to create more than 100,000 new jobs a month to keep up with population growth (young people starting to work) Unemployment is now at 6.7% (percent of workers without jobs who want them) and likely to increase. Unemployment plus underemployment (people working part-time or fewer hours, but want full time) is now about 12.5% and likely to increase. 30

The U.S. Car Companies • • •

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As people started spending less, they stopped buying new cars. New car sales decreased dramatically and quickly. GM, Ford and Chrysler already had business problems, but lower consumer spending made them much worse, very quickly. This shows how this crisis increases the problems of companies that already have business problems. Unfortunately, many companies (but not necessarily the car companies) will go bankrupt (close up) before this is over – because lower spending hurts their businesses so badly. – Many store chains (retailers) have now declared bankruptcy and will close.

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A Bad Cycle People have less confidence

Lower housing & stock prices

People Spend Less

Job Cuts

Lower Profits

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President-Elect Obama • On Saturday, President-elect Obama said things will get worse before they get better • But, we can and will fix this bad cycle • He plans large-scale government spending on infrastructure construction projects (roads, bridges) to create jobs and stimulate spending • With government spending, he hopes to break this bad cycle 33

How Government Spending Can Break The Bad Cycle

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Debates on Government Policy • • •

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When you see a new problem, you experiment with solutions. All of this happening at once is effectively a new problem. The government is experimenting with solutions – To find the best ways of fixing these problems. Plans could change if government officials decide other solutions will work better – and some experiments will not work. Experimentation is good. Franklin Roosevelt was experimenting when he created New Deal programs, such as social security, to end the Great Depression in the 1930’s. 35

What All of This Means for Everyone • •

Everyone is affected in some way. Unfortunately, even people who are prudent, pursue responsible lives, work hard, and have saved money are being hurt – Some people will have job problems. – Some people will have retirement problems (lower stock values reduced the money that pays for pensions and retirement plans). – Many people have savings in stocks for future plans (such as college & retirement) which are now worth much less. – It’s much harder for people who need money to borrow – particularly since their home values have decreased. – Millions more families are projected to lose their homes in the next two years (unless the government intervenes). 36

A Few Ending Thoughts • This is a very difficult moment – So cut your parents some slack • This crisis demonstrates we are all connected – If your neighbor loses his home, the value of your home goes down. – If America loses its car industry, the job cuts and loss of our manufacturing base will hurt us all. • A crisis is a chance to rebuild in a better way. • Now is the time to focus on solutions not blame. 37