Under U rstan nding g the e Financial C Crisis s and d Its Impact on o C empo Conte orary ry Bu usines ss

Dr. Douglas D s Hearth h Sam m M. Wal lton Col llege of f Busines ss Univ versity of o Arkan nsas

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Understanding the Financial Crisis and Its Impact on Contemporary Business

Learning Goals
Define a speculative bubble and discuss the causes of the recent housing bubble. Describe the economic impact of the housing bubble. Explain the securitization of the mortgage market and credit default swaps. Outline how the breaking of the housing bubble led to the credit crisis. Discuss the spread of the credit crisis from Wall Street to Main Street. Describe the governments response to the credit crisis.

INTRODUCTION
By September of 2008 it was apparent that the credit crisis, which had first reared its head a little over a year earlier, had potentially morphed into the largest economic catastrophe since the Great Depression of the 1930s. On September 7th, fearing a total collapse in mortgage lending, the government took control of giant mortgage lenders Fannie Mae and Freddie Mac. Less than a week later, Treasury and Federal Reserve officials met to decide whether or not to rescue Lehman Brothers, one of the largest and oldest Wall Street investment firms. In March, the government had helped to engineer the fire sale of another Wall Street titan, Bear Sterns, to JP Morgan Chase. This time, however, federal officials decided not to intervene and Lehman filed for bankruptcy on September 15th. That same day, Merrill Lynch sold itself to Bank of America to avoid a similar fate. Later in the week, AIG, the nations largest insurance company with close to $1 trillion in assets, had to be rescued by a massive government investment. These events sent shockwaves through an already ailing financial system. Even healthy banks almost completely stopped making new loans, even to customers with excellent credit. Interest rates on loans and securities soared with one important exception. Nervous banks and other investors poured money into U.S. Treasury securities, considered to be among the worlds safest investments. Consequently, the yield on short-term Treasury bills fell to close to zero.

Understanding the Financial Crisis and Its Impact on Contemporary Business | 1

Stock markets worldwide plunged. The well-known Dow Jones average dropped by around 8 percent between September 12th and September 17th. Fearing a total breakdown in the global financial system, then Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke told stunned Congressional leaders on September 18th that a major federal bailout of the financial system was needed. Congress eventually passed a $700 billion rescue package that would allow the government to take several major steps aimed at restoring confidence in the financial system. Governments in other countries took similar steps. Even with these unprecedented actions, the financial system continued to deteriorate during fall of 2008. Other prominent financial institutions, such as Washington Mutual and Wachovia had to be rescued. Credit remained tight and the stock market continued to slide. During October alone, the Dow lost another 14 percent. And events in the financial system affected the larger economy as well. Unemployment rose and consumer confidence sank. Retail sales in October, for instance, recorded the largest one-month drop ever recorded. As Eleanor Roosevelt said many years ago, about another crisis, these are no ordinary times. This guide has been prepared to help you better understand the challenges posed by this unprecedented financial crisis. Well examine the causes and some of the effects of the credit crisis on the overall environment of contemporary business. Well examine the housing bubble and other events that helped to trigger it. In doing so, well explain such things as sub-prime mortgages, asset backed securities, government sponsored enterprises, and credit default swaps.

THE HOUSING BUBBLE

While it may take years to fully understand all the causes of the credit crisis, there is already widespread agreement among experts that a speculative bubble in housing was in large part responsible. A bubble is a situation where the price of assets such as stocks or real estate rise significantly, over a short period of time, often with little justification other than the belief, or hope, that prices will rise further. Bubbles have been common throughout history. One of the earliest recorded bubbles, for example, occurred in 17th Century Holland and involved, of all things, tulip bulbs. Much more recently, the stock market experienced a bubble in the late 1990s involving the shares of technology companies, especially those tied to the Internet, which was then just beginning to emerge as a social and economic force. The stock price history of one particular Internet-related company, Yahoo, helps illustrate the scope of the tech bubble. Between the end of 1996 and the end of 1999, the price of Yahoos stock rose by a staggering 14,000 percent, topping out at over $100 per share. While that may have been great news for anyone who was smart, or lucky enough to have bought Yahoo back in the mid 1990s, the euphoria didnt last. All bubbles eventually break and, when they do, prices can fall almost as quickly as they rose. Over the next three years (between the end of 1999 and the end of 2002), Yahoos stock lost over 92 percent of its value. Today, Yahoo sells for less than $15 per share. Soon after the tech stock bubble broke in late 1999 and early 2000, the housing bubble probably began and continued for the next few years. Figure 1 illustrates the size of the housing bubble. The widely followed Case-Shiller housing price indexbased on home prices

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in 20 large metropolitan areasmore than doubled between the beginning of 2000 and the middle of 2006. Home prices in several individual metro areas exhibited even greater increases during the same period. For instance, prices rose by over 120 percent in Phoenix; by over 130 percent in Las Vegas; by around 170 percent in Los Angeles; and by almost 181 percent in Miami. 1 By contrast, median household income in the United States rose by less than 15 percent over the same time period.2 By 2006, the typical single family home in the U.S. was worth a record $221,900.3 Overall, the value of private residential construction rose by over 70 percent between 2000 and 2006.4 Several factors explain the recent housing bubble. One is related to the simple fact that Americans have long viewed home ownership as an excellent investment. In fact, U.S. homeownership rates, currently around 70 percent, are higher than they are in most other countries. According to data from the Federal Reserve, Americans have more money invested in their homes than they do in any other asset, such as stocks, bonds, or mutual funds. Moreover, government policy encourages home ownership by allowing individual homeowners to deduct their mortgage interest and property tax payments. These factors combine to help drive the demand for homes, generally putting upward pressure on prices. Another important factor in explaining the housing bubble was cheap money, important because virtually all home buyers must finance their purchases. Starting in early 2000, mortgage interest rates have generally declined. This decline accelerated after the September 11th terrorist attacks when the Federal Reserve began to aggressively push interest rates lower. For instance, between the beginning of 2000 and the middle of 2005, average mortgage rates fell from 8.33 percent to 5.58 cheaper. The significance of cheaper mortgage money is illustrated by a simple example. Assume a household has an annual income of $60,000 (or $5,000 per month). Using a standard lending rule that the monthly mortgage payment shouldnt exceed 30 percent of the households monthly income, this household could afford a maximum mortgage loan of around $198,000 (at 8.33 percent interest). By contrast, if mortgage rates are only 5.58 percent, this same household could afford a mortgage of over $260,000. Simply put, cheaper money makes monthly payments more affordable. So, cheap money also increased demand for homes and pushed prices up further and faster. Overall, the amount of outstanding mortgage debt owed by individuals almost doubled between 2000 and 2005 to around $8.9 trillion.5

S&P/Case-Shiller Home Price Indices, Standard & Poors, http://www2.standardandpoors.com, accessed November 18, 2008.
2 3

U.S. Census Bureau, Historical Income Tables, http://www.census.gov, accessed November 18, 2008.

National Association of Realtors, Monthly Housing Affordability Index, http://www.realtor.org, accessed November 18, 2008.
4 5

Construction Spending, U.S. Census Bureau, http://www.census.gov, accessed November 18, 2008.

Flow of Funds, Board of Governors of the Federal Reserve System, http://www.federalreserve.gov, accessed November 18. 2008.

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Figure1 The Housing Bubble: 2000-2006

200% Percent Change in Case-Shiller Housing Price Index (January 2000-May 2006) 180% 160% 140% 120% 100% 80% 60% 40% 20% 0% 20 city composite Phoenix Las Vegas Los Angeles Miami

Source: S&P/CaseShiller Home Price Indices, Standard & Poors, http://www2.standardandpoors.com, accessed November 18, 2008.

The explosion of so-called subprime and alt-a mortgage lending, along with generally lower lending standards, also helped fuel the housing bubble. A subprime loan is one made to a household with poor credit while an alt-a loan is one made without the lender carefully verifying a lenders income, assets, and existing debts. Subprime mortgage lending alone grew from around $130 billion in 2000 to $625 billion in 2005.6 Traditionally, it was much harder for a borrower to get a mortgage loan than other types of consumer credit, such as credit cards and auto loans. Most lenders imposed fairly strict standards when it came to the borrowers income, assets, and existing debts and were reluctant to make a loan if the payment exceeded around 30 percent of the borrowers monthly income. Moreover, lenders typically required a minimum down payment of at least 10 percent. Thus a $200,000 house would require that the buyer come up with at least $20,000 in cash.

Michael Lewis, The End of Wall Streets Boom, Portfolio.com, November 11, 2008, http://www.portfolio.com, accessed November 19, 2008.

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For a variety of reasons, many lenders greatly relaxed their lending standards in recent years. Loans with payments that were 40 percent or even 50 percent of the borrowers monthly income became commonplace. Loan applications from individuals who probably never would have qualified for a mortgage loan 10 or 15 years earlier were routinely approved. Theres a story of a farm worker in California who found a bank willing to lend him every dollar needed to buy a $720,000 house in spite of the fact that his annual income was less than $20,000.7 Since the end of World War II, most mortgages have been 30-year fixed rate loans.8 This means that the borrowers monthly payment remained the same. Some of the payment was interest and some repayment of principal so the amount owedthe loan balancefell over time. During the bubble, some lenders began offering loans requiring zero down, artificially low rates (teaser rates) for the first couple of years, interest only loans, and loans where the loan balance actually rose instead of falling. A few of these new, nontraditional loans required that the borrower refinance the loan balance every few years. Even more unsettling, more than a few nontraditional loans depended on continual increases in home prices in order to remain viable. There were actually lenders who specialized in these new types of loans. Financial writer Michael Lewis cites this example, Long Beach Financial, wholly owned by Washington Mutual [then the nations largest mortgage lender] was a great example. [It] was moving money out the door as fast as it could, few question asked, in loans built to self-destruct. It specialized in asking homeowners with bad credit and no proof of income to put no money down and defer interest payments for as long as possible.9 Finally, speculators played a role in the housing bubble as well. Not surprisingly, as housing demand and prices increased, so too did home sales and new housing construction. Over 1.5 million more homes were sold in 2005 than were sold five years earlier. In 2000, around 1.5 million new homes were started; by 2005, housing starts exceeded 2 million. 10 But this increased demand was due to more than rising personal incomes, population growth or household formationsthe primary long-term drivers of housing demand. Much of the increased demand came from speculators. By some estimates, close to 30 percent of all purchases in 2005 were made for investment purposes, not for primary residences. 11 Speculators were pouring into many of the nations hottest markets, hoping to make a quick profit by flipping homes (selling them within a few weeks or months). Stories of dozens of

Michael Lewis, The End of Wall Streets Boom, Portfolio.com, November 11, 2008, http://www.portfolio.com, accessed November 19, 2008. Fixed rate loans with shorter terms, such as 15 years, were also available as well as loans that had adjustable rates (so-called adjustable rate mortgages or ARMs). The vast majority of mortgages, however, were 30-year, fixed rate loans.
9 8

Michael Lewis, The End of Wall Streets Boom.

10

2008 Statistical Abstract of the United States, U.S. Census Bureau, http://www.census.gov, accessed November 19, 2008. Les Christie, Homes: Big drop in speculation, CNN/Money, April 20, 2007, http://money.cnn.com, accessed November 19, 2008.

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speculators literately waiting in line to buy homes and condos in Phoenix, South Florida or Las Vegas, even before construction started, became common.

THE HOUSING BUBBLE AND THE ECONOMY

The housing bubble had several important impacts on the overall economy. For one, employment in the construction industry soared. According to data from the Bureau of Labor Statistics, employment in the construction industry rose by almost 40 percent between 2000 and 2006. By contrast, overall employment in the U.S. rose by slightly more than 8 percent during the same period.12 Employment in the real estate and related industries also rose much faster than average. The housing bubble also affected consumer spending. Consumer spending accounts for around two-thirds of GDP and obviously changes in consumer spending can have a significant impact on the overall economy. Part of the impact of rising home prices is psychological. As their homes appreciate in value, homeowners often feel wealthier and spend more. However, rising home prices affected consumer spending in a much more direct way as well. For instance, lets say a couple (call them Juan and Anita) purchased a home in the Los Angeles area for $350,000 in 2000, taking out a $280,000 mortgage. Based the Case-Shiller price index for the Los Angeles area, their home could easily have been worth in excess of $700,000 by the middle 2006. Therefore, the equity in their home (the difference between the value and balance of the mortgage loan) rose by more than $350,000. If Juan and Anita wanted to tap some of this equity, to buy a new car or send a child to college, one way would be a home equity loan. Another option would be to refinance their existing mortgage, taking out a new loan for more than $280,000.13 Millions of homeowners did just this. In fact, many economists believe that tapping home equity contributed substantially to the growth in consumer spending between 2000 and 2006 given that median household income rose only slightly during this period.

MORTGAGES AS SECURITIES
Coupled with a housing bubble were several important changes to the mortgage market which also contributed to the credit crisis. In any mortgage loan transaction, there are three parties, in addition to the borrower. They are the originator, the servicer, and the mortgage holder. The originator is the firm that accepts the loan application. The servicer collects the monthly payment from the borrower and forwards the payment to the mortgage holder. The holder is, in essence, the investor. At one time, the same financial institution usually played all three roles. For a number of reasons, this began to change in the 1930s when the federal government created a government sponsored enterprise called the Federal National Mortgage Association (known today as Fannie

12 13

Labor Force Statistics, Bureau of Labor Statistics, http://www.bls.gov, accessed November 20, 2008.

The balance of Juan and Anitas mortgage would also have fallen by around $20,000 between 2000 and the middle of 2006, thus adding additional equity on top of any price appreciation.

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Mae). Fannie Mae sold bonds and used the proceeds to purchase mortgage loans from the financial institutions which originated the loans. In brief, the idea was to increase the supply of mortgage credit and reduce regional variations in mortgage lending. In the decades following the end of the World War II, home ownership rates rose sharply and Fannie Mae was joined by another government sponsored enterprise called the Federal Home Loan Mortgage Corporation (or Freddie Mac). During the 1970s, Fannie and Freddie became private, stockholder-owned corporations, even though they retained important links to the federal government. By the early 1990s, Fannie and Freddie were far and away the largest holders of home mortgage loans. Another important innovation in the mortgage market also occurred during the 1970s mortgage pass-through securities. Mortgage pass-through securities are bond-like securities backed by a self-liquidating pool of mortgages. A sponsor puts together the pool by purchasing the loans from originators. It then sells off parts of the pool to investors. As homeowners make their monthly payments, these cash flows are passed through to the investors who own the securities. Fannie and Freddie were among the first sponsors of mortgage pass through securities but they were soon joined by other financial institutions, such as Merrill Lynch and Lehman Brothers. By 2000, outstanding mortgage-backed securities exceeded $3.5 trillion; by August 2008, there were over $7.5 trillion in these securities. It is estimated that over half of all mortgage loans are now parts of pools.14 The creation of mortgage pass-through securities along with the other activities of Fannie and Freddie (selling bonds and buying mortgages) led to what experts call the securitization of home loans, transforming mortgages from loans into securities. And the system worked well for a number of years. Up until recently, mortgage-backed securities were considered to be very safe because the pools consisted of high-quality mortgages, many of which were insured. Likewise, loans held by Fannie and Freddie were generally high quality. Its also important to note that the securitization of mortgages probably did increase the supply and lower the cost of mortgage loans, helping to increase homeownership rates. At the same time, these new mortgage-backed securities offered attractive, low risk returns to investors, such as banks, investment companies, and even individuals. One consequence of securitization, however, was an increasing disconnect between mortgage originators and mortgage investors. Thousands of so-called mortgage bankers emerged whose purpose was simply to originate and sell the loans to investors and mortgage pool sponsors. As a result, the link between the borrower and the ultimate holder of the mortgage often became rather vague. The fact is that mortgage bankers and pool sponsors had strong financial incentives to originate and sell as many loans and mortgage backed securities as possible, as quickly as possible. [Think Long Beach Financial.] They collected fees of each transaction; the more transactions, the more they collected. For instance, at many mortgage bankers, employees were compensated almost solely on the basis of how many loans they originated.

Based on data published the Board of Governors of the Federal Reserve System (http://www.federalreserse.gov) and the Securities Industry and Financial Markets Association (http://www.sifma.org).

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As subprime, alt-a, nontraditional, and generally lax lending increased, more and more of these loans started to find their way into mortgage pools where they were sliced and diced and sold to investors. Because these pools consisted of high risk loans, a new type of pass-through security began to be offered, one where the pool was further divided based on who had the most senior claim to the cash flow produced by the pool. These slices, known as tranches, had, therefore, varying degrees of risk. The senior tranche had the least amount of risk, with subsequent tranches becoming progressively riskier. The rating agenciesMoodys and Standard & Poorsassigned different ratings to the different tranches based on their assessment of risk. Ratings are important because some investors, such as pension funds and insurance companies, are restricted in the sense that they can invest only in the highest rated securities. In theory, it was possible for an investor to purchase a low-risk securitythe most senior trancheeven though the pool consisted of high risk loans. These senior tranches usually had AAA ratings (which signifies the lowest amount of risk). Unfortunately, the idea that low risk securities can be created from pools of high risk loans often turned out to be an illusion. In fact, some critics contend that the models being used by Moodys and Standard & Poors to assign ratings to these securities were based on the assumption that housing prices would never fall.15 Its also worth noting that the rating agencies receive fees from the security issuers in return for the ratings. Moodys alone collected more than twice as much revenue from ratings in 2007 as it did in 2003. This relationship between issuer and rater, some argue, creates a built-in conflict of interest and can lead to mistakes. An anonymous managing director at Moodys is quoted as saying in an internal report written in 2007 that, These errors make us look either incompetent at credit analysis or like we sold our soul to the devil for revenue, or a little bit of both.16

HOW NOT TO MANAGE RISK

As this point, we need to stop and point out that not only did individuals borrow record amounts to buy homes during the first half of the decade but governments, corporations, and financial institutions also borrowed huge sums of money. Outstanding debt of U.S. households, corporations and governments rose by over $11 trillion between 2000 and 2006, an increase of over 60 percent.17 Since every borrower has to have a lender, financial institutions and other investors throughout the world added trillions of dollars of debt securities and loans to their balance sheets. Many investors were both borrowers and lendersthey borrowed money to raise the funds necessary to purchase debt securities issued by others. The interest cost on the funds borrowed, in theory, was less than the interest earned on investments like mortgage backed securities. This arrangement has always been used by banks.

15 16

Michael Lewis, The End of Wall Streets Boom.

Gretchen Morgenson, Debt Watchdogs: Tamed or Caught Napping? The New York Times, December 7, 2008, http://www.nytimes.com, accessed December 8, 2008 Flow of Funds, Board of Governors of the Federal Reserve System, http://www.federalreserve.gov, accessed November 21, 2008.

17

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Because of the unprecedented increase in debt, many borrowers and lenders decided to engage in activities designed to manage some of the risks associated with debt. E. Stanley ONeal, then CEO of Merrill Lynch, famously claimed in 2005, Weve got the right people in place as well as good risk management and controls.18 One popular risk management tool, heavily used by Merrill Lynch and others, was the credit default swap. It is estimated today that the total amount of outstanding credit default swaps worldwide could exceed $60 trillion.19 Essentially credit default swaps are insurance contracts, in which one party guarantees the debt of another. Heres how it works: one party, the insurer, sells a credit default swap on a specific debt security, to another party, the insured. If the issuer of the debt security defaultsmeaning it fails to pay interest or principal when duethe insurer pays the insured a predetermined sum of money. This arrangement is much like any normal insurance policy. For instance, say a homeowner (the insured) has an insurance policy with State Farm (the insurer) to insure her home. State Farm receives an annual premium in exchange for insurance protection. Should something like a fire occur, State Farm pays the homeowner an amount specified by the policy to cover her loss. Even though credit default swaps are similar to insurance policies, there are important differences, the implications of which have become very apparent over the past year and a half. For one thing, traditional insurance companies, and policies, are subject to government regulation. There was no oversight or regulation of credit default swaps. Another problem was the fact that many of the firms selling credit default swapsthe insurershad insufficient funds set aside to pay claims. Prudent insurance companies always keep sufficient funds in the form of reserves in case losses are greater than expected. Moreover, the nature of the risk credit default swaps were being used to insure against was misunderstood. If your neighbor has an auto accident, that doesnt affect the odds of you having an accident. On the other hand, the factors that might cause one security to default usually affected all other similar securities. This potential for mass loss was widely ignored. Finally, the link between the insured and insurer was, at times, tenuous. All sorts of investment firms and banks were buying and selling these instruments, even if they had no position in the underlying securities. Credit default swaps were thus being treated almost as side bets. All in all, credit default swaps and other risk management tools were being misused.

SUMMARIZING THE SITUATION

So, heres a summary of the situation in late 2006. A bubble had inflated the price of homes; the wealth affect had juiced consumer spending; households, businesses, and financial institutions had borrowed trillions of dollars; lending standards had been greatly relaxed; and risk management tools were being abused. This financial house of cards was bound to come

18

Gretchen Morgenson, How the Thundering Herd Faltered and Fell, The New York Times, November 9, 2008, http://www.nytimes.com, accessed November 24, 2008. Gretchen Morgenson, Arcane Market Is Next to Face Big Credit Test, The New York Times, February 17, 2008, http://www.nytimes.com, accessed November 24, 2008.

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tumbling down; the only questions were how fast would it collapse, and what would the consequences be. Unfortunately, we now know the answer to both questions.

THE HOUSING BUBBLE BREAKS

As noted earlier, all bubbles eventually break. It is difficult, however, to pin down the reasons. Often, there is a recognition among some that prices have risen too far, too fast and a few decide to cash out by selling. As the number of sellers increases in size, prices often reach a plateau. Then, its usually only a matter of time before there are more sellers than buyers and the bubble breaks. In the case of housing, an oversupply of newly built homes probably hastened the bubbles end. Ivy Zelman was at the time a housing credit analyst at Credit Suisse. In early 2005 she became convinced that the home values had entered an unsustainable bubble. To her, there is a simple measure of the proper level of housing prices, the ratio of median home prices to personal income. Over the long run, the ratio has averaged about 3 to 1. At the end of 2004, this ratio was more like 4 to 1. According to Zelman, all these people were saying it was nearly as high in some other countries. But the problem wasnt just that it was 4 to 1, in Los Angeles it was 10 to 1, and it Miami 8.5 to 1. And then you coupled that with the buyers. They werent real buyers, they were speculators. Zelman added later, It wasnt that hard in hindsight to see it. It was very hard to know when it would stop.20 For the most part, Realtors, mortgage bankers, lenders, Wall Street and others chose to ignore Zelmans warnings; they were making too much money building and selling homes, making mortgage loans, and buying and selling mortgagebacked securities. In retrospect, the housing bubble broke sometime in 2006. The Case-Shiller housing price index peaked in July 2006. Prices in some individual markets peaked a couple of months earlier and, some, a few months later. Prices in virtually all markets then began to fall, slowly at first and then faster and faster. As Figure 2 illustrates, between the peak in housing prices in 2006 and September 2008, the overall Case-Shiller index fell by over 21 percent. Local markets which had experienced the fastest price increases, such as Miami, Las Vegas, Los Angeles, and Phoenix showed the greatest declines. The price index fell by over 30 percent in all four of these markets between the peak in 2006 and September 2008. In Phoenix, the index dropped by over 38 percent. Data from the National Association of Realtorswhich reflect actual sale prices in major metropolitan areasalso illustrates the extent to which the housing bubble has collapsed (see, Figure 3). In 2006, the median sale price of a single family home in the U.S. was almost $222,000, a record; by October of 2008 the median sale price had fallen to around $183,000, a decline of almost 17.5 percent. The decline in prices just between October 2007 and October 2008 was over 9 percent, the largest one-year price decline ever recorded by the NAR. In

20

Michael Lewis, The End of Wall Streets Boom.

10 | Understanding the Financial Crisis and Its Impact on Contemporary Business

certain regions, price declines were even larger. In the western U.S., for example, prices declined by over 24 percent between the end of 2006 and October 2008.21 As housing prices fell, so too did home sales, new housing starts, and construction employment. For instance, since peaking in September 2006, the construction industry has shed more than 700,000 jobs.22 On an annual basis, home sales fell from over 7 million in 2005 to around 5 million in the third quarter of 2008.23

Figure2 The Housing Bubble Breaks

20 city composite Percent Change in Case Shiller Price Index (2006 peak to September 2008) Phoenix Las Vegas Los Angeles Miami

-21.8%

-32.6% -38.5% -37.6% -36.4%

Source: S&P/CaseShiller Home Price Indices, Standard & Poors, http://www2.standardandpoors.com, accessed November 18, 2008.

21

Metropolitan Median Prices, National Association of Realtors, http://www.realtor.org, accessed November 25, 2008.

22

The Employment Situation in October 2008, Bureau of Labor Statistics, http://www.bls.gov, accessed November 15, 2008. Data from the National Association of Realtors, http://www.realtor.org, accessed December 3, 2008.

23

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Figure3 Median Sale Prices of Homes: 2000-2008

400,000 350,000 300,000 Median Sales Price 250,000 200,000 150,000 100,000 50,000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008
Note: 2008 data are through the third quarter. Source: Based on data published by the National Association of Realtors, http://www.realtor.org.

National Northeast Midwest South West

TUMBLING HOME PRICES, BAD MORTGAGES, AND TOXIC SECURITIES

As home prices fell, mortgage delinquencies and foreclosures rose sharply. The delinquency ratethe percentage of loans delinquent for 30 days or morehad averaged around 4.5 percent since 2000; by the end of August 2008, it was close to 6.5 percent, the highest ever recorded. The subprime delinquency rate was 19 percent. The foreclosure rate has also soared recently, almost tripling between 2005 and August 2008 and now stands at close to 3 percent nationwide.24 A recent report by RealtyTrac shows that one out of every 171 U.S. households received a foreclosure notice during the second quarter of 2008, a 121 percent increase over the second

Delinquencies and Foreclosures Increase in Latest MBA National Delinquency Survey, National Mortgage Bankers Association, September 5, 2008, http://www.mortgagebankers.org, accessed November 13, 2008.

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quarter of 2007. In some metro areas foreclosure activity is much higher. The California metro areas of Stockton and Riverside-San Bernardino have the nations highest foreclosure rates according to RealtyTrac. In Stockton, one out of every 25 households received a foreclosure notice during the second quarter of 2008. In Riverside-San Bernardino, that rate was one in 32 households.25 So, whats the relationship between falling housing prices and rising delinquencies and foreclosures? One is fairly direct while the other is more indirect. As we discussed earlier, a large number of mortgage loans made during the housing bubble were based on the assumption that housing prices would continue to rise. Most of these loans had artificially low payments for the first couple of years and some more or less forced the borrower to refinance within a short amount of time. If the value of the borrowers homecollateral for the loanfell, refinancing on affordable terms became next to impossible. Delinquency and eventual foreclosure often followed. Coupled with loanslike the $700,000 loan to the farm worker mentioned earlierthat were almost guaranteed to go bad, theres little doubt that questionable lending practices contributed to the historic level of mortgage delinquencies and foreclosures. Falling housing prices also affect delinquency and foreclosure rates indirectly. Lets say Mark has a mortgage with a loan balance of $200,000 on a home he paid $225,000 for a few years earlier. For some reason, Mark has to sell his home but its value has fallen to $180,000. Mark is now underwater meaning the value of his home is less than the loan balance and he has negative equity. If Mark were to sell his home for its current market price, he would have to come up with $20,000 in cash to fully repay the lender. Households in Marks situation often just walk away and allow the lender to foreclose, known in the real estate business as mailing the keys to the bank. As of September 30th, there were an estimated 7.6 million properties in the country underwater, with another 2.1 million right on the brink. Thats around 25 percent of all homes. In Lee Country, Florida (Ft. Myers), the percentage of homes underwater exceeds 70 percent.26 Rising foreclosures and falling prices have created a dangerous feedback loop. Lenders put foreclosed homes on the market, often at greatly discounted prices, this puts additional downward pressure on home prices, which in turn increases foreclosure activity, putting even more pressure on prices, and so on. In the three months ending September 30, 2008, an estimated 40 percent of properties sold during the quarter had been repossessed by lenders.27 Its tough to sell a home when youre competing with banks trying to unload foreclosed properties at almost any price. Not surprisingly, as more and more mortgages went bad, so too did the quality of many mortgage-backed securities. As the quality of any security declines, so does its market value.

25

Foreclosure Activity Up 14 percent in Second Quarter, RealtyTrac, http://www.realtytrac.com, accessed December 1, 2008.

26

David Strettfeld, A Town Drowns in Debt as Home Values Plunge, The New York Times, http://www.nytimes.com, accessed December 1, 2008. Les Christie, Home Prices Decline a Record 9 percent, CNN/Money, http://cnnmoney.com, accessed December 1, 2008.

27

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However, because of all the slicing and dicing of loans as they were packaged into securities, it was difficult to pin down which loans were backing which securities. This created even more uncertainty about the real value of billions of dollars worth of mortgage-backed securities. Suddenly, no one wanted to buy what were now considered to be toxic securities, at any price. What had started as a mortgage crisis soon became a full-fledged credit crisis. Many banks and other financial institutions were now in serious trouble.

THE GIANTS OF WALL STREET START TO FALL

Now you may wonder how a crisis in the mortgage market could bring down a giant financial institution with billions of dollars in assets. There are only two sources of funds for any business, including a financial institution. Funds can either be borrowed or provided by owners (or stockholders). These funds, called debt and equity, are then invested in assets. The amount of debt a firm uses, relative to equity, is called leverage. Financial institutions are unique in the sense that they have very little equity relative to assets. The typical bank, for instance, has less than 10 cents in equity for every dollar in assets.28 This makes financial institutions potentially vulnerable to failure if the value of their assets falls. For instance, assume a bank has $10 billion in equity and $100 billion in assets. Of that $100 billion, $30 billion is invested in mortgages and mortgage-backed securities. If the value of those assets falls by halfnot unreasonable given what happened all of the banks equity is now gone and the bank is technically insolvent. Moreover, financial institutions must be continually able to borrow money in order to fund day to day operations. Since the bank in our example is insolvent, it will probably find it very difficult to borrow money. At this point, the bank is faced with several unpleasant options: sell its good assets to quickly raise cash, find a merger partner, or appeal for a government bailout. Though many financial institutions started taking write downsreducing the value of specific assetsas early as the spring of 2007, the first major financial institution in real trouble was probably Bear Sterns. Two hedge funds owned by Bear Sterns failed in 2007. At first, it appeared as though the financial impact on Bear Sterns itself was managed. However, it soon became apparent that the firms problems extended well beyond the two failed hedge funds. The firm owned billions of dollars of toxic securities and its lenders had pretty much cut off funding. Faced with almost certain bankruptcy, the Federal Reserve and Treasury arranged for a quick sale of Bear Sterns to JP Morgan Chase in March 2008. Next up were mortgage giants Fannie Mae and Freddie Mac. Fannie and Freddie had, at first, avoided making substantial investments in subprime mortgages and mortgage-backed securities but, under pressure from a variety of parties, had relented. At the same time, both companies had become substantially more levered over the previous decade. As delinquencies and foreclosures increased, concerns about the financial health of both rose. Consequently, Fannie and Freddie found it harder and harder to borrow money. Given the importance of Fannie and Freddie in the mortgage marketthe two own directly or indirectly more than half of all

28

This fact is one of the reasons why many financial institutions are regulated.

14 | Understanding the Financial Crisis and Its Impact on Contemporary Business

outstanding loansand afraid that mortgage lending would effectively cease if one or both failed, the government took control of Fannie and Freddie on September 7, 2008. Both are now essentially what they once were, government-owned corporations. Whether or not Fannie and Freddie ever become privately owned again is unclear. On September 12th, government and finance officials met to decide what to do with another giant financial institution, Lehman Brothers. Lehman, like Bear Sterns, owned billions of toxic securities and was facing a liquidity crisis. No agreement could be reached, and, unlike Bear Sterns, the Treasury refused to help Lehman Brothers and the firm filed for bankruptcy and is in the process of being liquidated. Merrill Lynch, faced with an almost identical fate, sold itself to Bank of America for a fraction of what it had been worth even a year earlier. Then, four days later, on September 16th, the Treasury and Federal Reserve stepped in and provided emergency assistance to insurance giant AIG, which faced a liquidity crisis of its own. The cause of AIGs problems wasnt related to mortgage investments directly, but rather credit default swaps. Through its sale of credit default swaps, AIG had effectively insured hundreds and hundreds of billions of dollars of debt securities, many of which were now toxic. AIG had already lost billions and lacked the reserves necessary to cover additional losses. Only a multibillion dollar infusion of funds from the federal government kept AIG from filing for bankruptcy. Since the AIG bailout, other major financial institutions have failed or been acquired at bargain-basement prices. These include Washington Mutual (the nations largest mortgage lender), Wachovia Corporation (then the nations fourth largest bank), and National City (an Ohio-based financial institution with over $150 billion in assets). More recently, the government even came to rescue of Citicorp, the parent of the nations largest bank. Even relatively healthy firms such as Goldman Sachs and Morgan Stanley have been forced to raise billions of dollars of additional capital. And it isnt just U.S. financial institutions. Banks throughout the world held toxic securities as well, and many have been sold to other banks, failed outright, or received government assistance. The credit crisis almost bankrupted the entire country of Iceland. One measure of the frozen state of the credit markets is whats happened to the interest rate on U.S. Treasury bills since the beginning of 2008. T-bills are short-term debt securities sold by the U.S. Treasury. They are considered to be among the safest investments in the world. When banks and other lenders get nervous, they sharply cut back on lending to businesses and consumers and buy T-bills. At the beginning of 2008, the interest rate on T-bills was around 3 percent; by the end of November that rate had dropped to close to zero. (See, Figure 4.) By contrast, the rates charged business and consumer borrowers have either remained the same or even risen slightly since the beginning of the year.

Understanding the Financial Crisis and Its Impact on Contemporary Business | 15

Figure 4 Interest Rate on Short-Term Treasury Bills

3.50

3.00

Interest Rate (percent)

2.50

2.00

1.50

1.00

0.50

0.00 2-Jan 2-Feb 2-Mar 2-Apr 2-May 2-Jun 2-Jul 2-Aug 2-Sep 2-Oct 2-Nov

Source: Federal Reserve Bank of St. Louis, FRED Database, http://research.stlouisfed.org/fred2/.

FROM WALL STREET TO MAIN STREET

Obviously there are direct economic consequences on Main Street as a result of the housing bubble breaking. As home prices sagged, thousands of jobs in construction, mortgage lending, and other related industries disappeared. Falling home construction meant lower sales of building materials, appliances, and home furnishings. These industries employ hundreds of thousands of people. Tax revenue to state and local governments also dropped. But the impact of the credit crisis on Main Street goes far beyond housing and related industries. As noted earlier, when housing prices were rising, homeowners felt wealthier and increased their consumption accordingly. Many consumers used rising home values as a bank to support increased consumption through refinancing and home equity loans. When home prices began falling, the opposite occurred and hundreds of billions of dollars of home equity vanished. Many economists believe that falling home prices were in large part responsible for historic declines in consumer spending during the fall of 2008. Given that consumer spending accounts for two-thirds of U.S. GDP, any decline in consumer spending will have an adverse economic impact. And any decline in consumer spending creates a dangerous feedback loop: as consumer spending declines, businesses cut back on production,

16 | Understanding the Financial Crisis and Its Impact on Contemporary Business

laying off more workers, and with increased production cutbacks and layoffs, consumer spending drops even further. The fact is the entire U.S. economy runs on credit. For example, a local retail store probably has to borrow money each fall from a bank to purchase inventory for the holiday selling period. Consumers rely on credit to make many major purchases, like new vehicles. Many college students must borrow money to pay for their tuition. State and local governments borrow money to build new schools and highways. In the face of the credit crisis, most banks have severely tightened their lending standards. Even business and consumers are finding it increasingly difficult to borrow money. Major credit card issuers, for example, have slashed credit limits to consumer and business customers by around $2 trillion. 29 Some colleges reported delays in the disbursement of student loans. State and local governments are collecting less in taxes, and slashing spending. The lack of easy access to credit has a cascading impact throughout the economy. Businesses, for instance, who cant borrow as much to buy inventory, reduce their orders with suppliers, leading suppliers to cut back on production, laying off workers. Consider the impact on just the auto industry. If it becomes more difficult, or expensive, for consumers to finance car purchases, sales will fall. Couple a credit crisis with a deteriorating economy, and its no surprise that car sales have fallen by record amountsover 30 percent in some cases. Two of the Big Three auto companies (GM and Chrysler) recently received federal assistance warning that, without it, they faced bankruptcy. Even Ford, which is in slightly better financial shape, still faces an uncertain future. The auto industry in the U.S. directly or indirectly employs millions. But the financial problems of the auto industry have even broader ramifications. For instance, the Big Three are among the nations largest advertisers, especially on sporting events. A major cutback in their marketing budgets could affect everything from media companies to professional and even college sports. Buick recently dropped a multimillion endorsement agreement with pro golfer Tiger Woods and may cancel its sponsorship of several PGA tour events. In response to declining ad revenue, newspapers, magazines, radio stations, and TV networks are all announcing cutbacks and layoffs. Figures 5 and 6 put the current state of the U.S. economy into some perspective. Figure 5 shows the monthly change in retail sales along with consumer confidence from the beginning of 2004 to October 2008. Notice that as consumer confidence has sagged, so too have retail sales. In both September and October 2008, consumer confidence and retail sales each registered almost record monthly declines. In October, for instance, retail sales fell by almost 2 percent on a seasonally adjusted basis. Consumer confidence fell by over 18 percent in the same month. This is hardly surprising; when consumers are confident about their economic future, they tend to spend more. The reverse is also true. The civilian unemployment rate since January 2004 is shown in Figure 6. The affect of the credit crisis on the jobs market is apparent. From a low of less than 4.5 percent in late 2006,

29

Next Stage Of Credit Freeze May Hit Home Prices, Credit Cards, CNN/Money, December 2, 2008, http://money.cnn.com, accessed December 3, 2008.

Understanding the Financial Crisis and Its Impact on Contemporary Business | 17

the unemployment rate has soared to almost 7 percent. During the first 11 months of 2008, employers have slashed over 1 million jobs. The November 2008 jobs report was, according to the Bureau of Labor Statistics, the worst since 1974. Moreover, these data really dont tell the whole story about the sorry state of todays employment market. The duration of unemployment is the highest its been since 1981, as are the number of so-called discouraged workers (people whove given up looking for a job) and the number of part-time workers seeking full-time employment.30 Other economic indicators also reflect the nations current economic turmoil. Since the beginning of 2008, the stock market has lost around 40 percent of its value. In fact, 2008 will probably go down as the worse year for stocks in the U.S. since 1932. So, millions of investors, from individuals saving for retirement to employee pension funds to college foundations, have seen trillions of dollars of value disappear. Even what appear to be bright spotssuch as the record decline in oil prices or the huge sales being offered during the holiday shopping periodhave a dark side. Lower prices mean lower profits for many businesses. Lower profits mean these businesses are less likely to expand or add employees.
Figure 5 Monthly Consumer Confidence and Monthly Change in Retail Sales: 2004 to Present
120.0 Percent Change in Retail Sales Consumer Confidence 3.0

100.0

2.0

80.0

1.0

60.0

0.0

40.0

-1.0

20.0

-2.0

0.0

-3.0

30

November 2008 Employment Report, Bureau of Labor Statistics, http://www.bls.gov, accessed December 8, 2008.

18 | Understanding the Financial Crisis and Its Impact on Contemporary Business

Percent Change in Retail Sales

Consumer Confidence (index)

Source: Federal Reserve Bank of St. Louis, FRED Database, http://research.stlouisfed.org/fred2/

Figure 6 Civilian Unemployment Rate

7.0

6.5 Unemployment Rate (percent)

6.0

5.5

5.0

4.5

4.0 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jul-04 Jul-05 Jul-06 Jul-07 Oct-04 Oct-05 Oct-06 Oct-07 Jul-08 Oct-08 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08

Source: Bureau of Labor Statistics, http://www.bls.gov.

According to preliminary data, the U.S. economy contracted at an annual rate of more than 3 percent during the third quarter of 2008one of the sharpest declines ever recorded. Many economists believe that the recession facing the country could be one of the longest and deepest since the early 1980s. Moreover, given the interconnected nature of the global economy today, most other countries from China to Japan to European nations face deep recessions as well.

THE GOVERNMENTS RESPONSE

Initially, the Federal Reserve, the Treasury, and other key agencies responded to early stages of the credit crisis by employing fairly standard actions. The Fed, for example, used its traditional monetary policy tools (these are discussed in Chapter 17) to push interest rates lower. Lower interest rates, in theory, encourage increased borrowing and help to bolster economic growth. The Fed also instituted a new program of directly lending money to banks at very low rates in order to boost lending. Starting with the Bear Sterns bailout in March 2008, the governments actions became more aggressive. Congress and the president also agreed on a modest economic stimulusin the form of tax rebatesin the spring. These actions obviously proved to be inadequate as the credit crisis continued to deepen and economic conditions further deteriorated. The Treasury and Fed then took other actions including raising the FDIC insurance limit on most bank deposits from $100,000 to $250,000 and insuring money market

Understanding the Financial Crisis and Its Impact on Contemporary Business | 19

mutual funds (a popular savings instrument). The Treasury also took control of Fannie Mae and Freddie Mac. In the face of dire warnings about the overall financial system, Congress passed a massive financial rescue package in September. The Treasury was given wide latitude over how the funds would be used, but the initial thought was to use the money to purchase toxic securities from financial institutions. This would do two things: it would get these bad securities off the bank balance sheets and inject additional funds into the banking system. Both, it was hoped, would unfreeze credit. The Treasury, however, quickly determined that buying toxic assets wasnt practical and it then began to directly inject funds into the banking system by buying equity stakes. At the end of 2008, the Treasury has spent approximately half of the $700 billion amount approved by Congress. Other recent actions include Fannie and Freddie freezing home foreclosures as well as other initiatives designed to stabilize home prices. The incoming Obama administration intends to make changes to the financial rescue package perhaps focusing more attention on home foreclosuresas well as push for another, much larger economic stimulus. This new stimulus will likely include tax cuts for most households and businesses, increased unemployment assistance, large spending on public infrastructure such as roads and bridges, and aid to state and local governments. The total amount of all of these actions could be as high as $1 trillion, spread out over two years. The new administration has also pledged to improve government oversight of the financial system and coordinate its actions with other countries.

SOME CONCLUDING OBSERVATIONS

Critics contend that the government helped to facilitate the housing bubble, and related activities, through lax oversight. Indeed, there has been a trend since the early 1980s of deregulating business activities. Many of the laws and regulations affecting financial institutions, some of which were established during the Great Depression, were, as a result, relaxed or repealed outright. For example, a law passed in 2000 specifically prohibited the government from regulating credit default swaps. Moreover, some argue that the governments response to the early stages of the credit crisis was totally inadequate. Better oversight and a more aggressive response might have adverted, or at least substantially reduced, the severity of the crisis. Others disagree. That debate is probably best left up to history. There is, however, little question that it will take many months, perhaps even several years for economic conditions to improve. The economy is likely to continue to contract and unemployment is probably headed higher, maybe reaching 10 percent or more. But its important to remember that the United States and the American people have faced economic challenges in the past and have always met those challenges. We all will again.

20 | Understanding the Financial Crisis and Its Impact on Contemporary Business

QUESTIONS FOR CRITICAL THINKING 1 Explain what caused the housing bubble. What were the roles of speculators and lenders? 2 Discuss the wealth effect caused by rising home prices. How could the wealth effect lead
to higher consumer spending? Mae and Freddie Mac play?

3 Describe how mortgage loans have been transformed into securities. What role did Fannie 4 Why did the housing bubble break? What were some of the immediate consequences? 5 How did a housing and mortgage loan crisis become a wider credit crisis? How did the
government respond?

6 Collect some more recent data on stock prices (as measured by the Dow-Jones average)
retail sales, consumer confidence, and unemployment. Do your data suggest that the economic conditions are starting to improve? Why or why not?Artwork

Understanding the Financial Crisis and Its Impact on Contemporary Business | 21