Professor John Kessler delivered this speech to the Fort Wayne Business Weekly Breakfast in Fort Wayne, Indiana on February 16, 2009.
(Data on GDP growth - 4th quarter 2008 -3.8% and 3rd quarter -.5% and unemployment – 7.2% end of 2008 and currently 7.6% - PPT slide)
Housing prices rose rapidly increasing 87% between 2002 and 2006 and then fell rapidly, going down 25% from 2006 to 2008. With this decrease in housing prices foreclosures and defaults increased. This caused investment banks to get into trouble because of highly leveraged residential loans and mortgage backed securities and soon they started to collapse. With this the problem expanded to the rest of economy.
We see the results of this today – GDP has had two consecutive quarters of negative growth and unemployment is up to 7.6% and rising. In 2008 stock values fell 37% - nearly twice the magnitude of any year since 1950.
(January 2002 to Mid 2006 housing prices up 87% , mid 2006 to third quarter 2008 housing prices down 25%),(default rate averaged around 2% a year prior to 2006, increased to 5.2% during 3rd quarter 2008), (between 25:1 and 60:1 leverage ratios), (stocks fell 37% in 2008 – nearly twice the magnitude of any year since 1950)
Causes of the Crisis
The question is, why did this happen? There are many reasons why this might have happened but I want to focus on what I believe are four of the main causes.
The first is the increase in household debt. For decades prior to the mid 1980’s the debt-to-income ratio of households was generally between 45 and 60%. By 2007 the debt-to-income ratio had increased to 135% and more disposable income was being used to pay for interest payments on that debt. Because interest on mortgages is tax deductible there was an increased demand for housing and an incentive to wrap more debt into housing loans. Later when adjustable rate mortgage payments started to rise many households were unable to deal with the unexpected expenses because of their large debt.
The Role of the Federal Reserve
Federal Reserve Monetary Policy 2002-2006 – emphasis of monetary policy changed from inflation to employment and real GDP under Alan Greenspan
Fed Funds rate held at 2% or less for more than 3 years in response to 2001 recession
This increased demand for, and price of, housing
Made adjustable rate loans with low down payments highly attractive (ARMs jumped from 17% of loans made in 1998-2001 to 33% during 2004-2005)
In response to inflationary pressures the Fed starting pushing the Fed Funds rate up in 2005-2006 (from low of 1% in 2003 to 5.25% in 2006).
As ARMs adjusted to higher interest rates borrowers were unable to make the higher monthly payments and default rates began to increase.
The Role of Financial Institutions
Fannie and Freddie – 1995 – HUD regulations required Fannie and Freddie to increase their holdings of loans to low and moderate income borrowers (by 2008 56% of all loans financed by Fannie/Freddie had to be for low to moderate-income households)
1999 – HUD regulations required them to accept more loans with little or no down payment
The share of all mortgages held by Fannie and Freddie rose from 25% in 1990 to 45% in 2001 and has fluctuated around 45% since
During recent years Fannie and Freddie have purchased about 90% of the mortgages sold in the secondary market, exerting a large impact on the standards accepted by mortgage originators
Mortgage lenders and banks had less incentive to scrutinize the credit worthiness of borrowers because Fannie/Freddie would take the risk.
This led to upward pressure on housing prices
Highly Leveraged Banks – large investment banks began bundling mortgages together and borrowing money to finance them. This seemed like a good idea because of the previously low default rates. But because borrowers were able to obtain larger loans with lower down payments than previously there was more risk than expected. SEC rule changes allowed them to increase their leverage from a typical 12:1 to more like 33:1. With this kind of leverage a 3% decrease in asset value would wipe out a company. This was okay as long as housing prices were increasing, when housing prices started to decrease the entire financial system was at risk.
The mortgage backed securities were designed to help spread the risk of mortgages around and led to an increase in investment in housing.
When default rates began increasing in 2006 and 2007 these banks were in trouble.
This leads to the demise of Bear Stearns, Lehman Brothers, and AIG. Banks had to start holding more cash or disappear as the defaults increased. This made credit dry up. This is where the “credit freeze” began and how we got where we are today.
Is this another Great Depression?
Many people have been comparing this current crisis with the Great Depression. One CEO going to Washington to ask for a bailout said that his company needed it because of the “unprecedented economic crisis”. Let’s get some perspective here and see if this is truly unprecedented.
Unemployment in January 2009 – 7.6%
At least 3 fairly recent recessions have had higher peak unemployment rates than today:
We have learned some lessons from the Depression that do apply here:
What can we learn from the current crisis?
Now I would like to take a moment to talk about what this means for our future. How do we make sure this kind of thing doesn’t happen again? I believe there are two things we need to do. We need to make sure that we get good policies from Washington and that we make good decisions with our individual finances.
First, to get good policies from Washington, we the people must understand economics. Economics education is more important today than at any time in recent history.
Economics teaches us that:
Incentives Matter – people respond to incentives in predictable ways – just like the mortgage lenders responded to the incentives given them by Fannie/Freddie
There is no such thing as a free lunch – every choice has a cost. The bailouts and stimulus packages are not free. Every time you bailout someone you increase the potential for moral hazard in the future as people take more risky actions because they think they won’t have to bear all the cost.
Long term consequences, or secondary effects, are often ignored – we can’t do just one thing. Every action we take has multiple effects. The Feds attempts to increase employment and economic growth led to unintended consequences. We should keep this in mind as we go forth with the stimulus package. What potential problems are we creating for the future?
Simple economic reasoning could have prevented a lot of the problems we are facing today.
Second, we need to take care with our own personal finances. We need to go back to basics.
Spend less than you earn – start a regular savings program for rainy days and the future
Diversify – don’t put all your eggs in one basket
Invest for the long term
Beware of investment schemes promising high returns with little or no risk
Don’t finance anything for longer than its useful life
Teach your children how to earn money and spend it wisely
This Crisis is an Opportunity
It is important that we learn from our past mistakes so that we don’t repeat them. I believe that economics education is the key to making this happen. Economics at its essence is the study of making wise choices. I invite you to join me in helping to make our world a better place. If you are interested in supporting our work at the IPFW Center for Economic Education please contact me.