Jean Walker West Texas Center for Economic Education College of Business West Texas A&M University Canyon, Texas. Teaching Financial Crises. Teaching Financial Crises:.
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West Texas Center for Economic Education
College of Business
West Texas A&M University
Teaching Financial Crises
. . . presents an organizing framework for putting into context the media attention that has been paid to the 2008 financial crisis . . .
This publication, in it’s entirety, is included on the Virtual Economics CD, version 4.
In 5 years, how far have we come?
The Case-Schiller Price Index represents the real price of housing throughout the country, so it is inflation-adjusted.
The index equals 100 for the price of housing in 1890.
Prices peaked in 2006.
Sample of Bankruptcy filings in 2008:
One of the very few beneficiaries of the Recession
Unintended consequence of low rates since 2009: when interest rates are low, corresponding investment yields are low and investors move to riskier assets trying to find yield.
(Nine characters plus “the world”)
Have students complete Activity 1 as you progress through the slides of visual 1.
If you have not taught about the recent financial crisis, you will find information in other lessons to assist with explanations.
The slides for Activity 1 are available in powerpoint on www.councilforeconed.org/financialcrises
THE FINANCIAL CRISIS OF 2007
THE PANIC OF 1907
SAN FRANCISCO EARTHQUAKE
Shortly after 5 a.m. on April 18, a 7.8-magnitude quake, unleashed offshore, shook the city for just less than a minute.
80% OF THE CITY DESTROYED
Though the damage from the quake was severe, the subsequent fires from broken gas lines caused the vast majority of the destruction.
THE FIRES RAGED FOR FOUR DAYS
3,000 PEOPLE DIED
TOUGH BALANCING ACT
Between 1870 and 1914, many countries adhered to a gold standard.
This strictly tied national money supplies to gold stocks.
Currency was redeemed for gold at a fixed exchange rate.
At the end of 1905, nearly 50% of the fire insurance in San Francisco was underwritten by British firms.
The earthquake gave rise to a massive outflow of funds—of gold—from London.
The magnitude of the resulting capital outflows in late summer and early autumn 1906 forced the Bank of England to undertake defensive measures to maintain its desired level of reserves.
The central bank responded by raising its discount rate 2.5% in 1906.
Actions by the Bank of England attracted gold imports and sharply reduced the flow of gold to the United States.
Interest rates rose and by May 1907, the United States had fallen into one of the shortest, but most severe, recessions in American history.
At the beginning of the century, the nation was brimming with a great amount of optimism.
Here is a list of familiar companies founded between 1900 and 1905.
Trust companies were a financial innovation of the 1890s. They had many functions similar to state and national banks but were much less regulated.
KNICKERBOCKER TRUST COMPANY
Illustration from Harper's Weekly December 20, 1913 by Walter J. Enright
The runs on deposits that sparked the Panic of 1907 were at two of the largest New York City trust companies: Knickerbocker Trust and Trust Company of America.
The crash and panic of 1907 had a dramatic effect on the health of the American and worldwide economies. In the United States:
Commodity prices fell 21 %.
Industrial production fell more than in any other crisis in American history to that point.
The dollar volume of bankruptcies declared in November was up 47 % from the previous year.
The value of all listed stocks in the U.S. fell 37 %.
In October and November 1907, 25 banks and 17 trust companies failed. Thousands of depositors lost their life savings.
Gross earnings by railroads fell by 6 % in December and production fell 11%.
Wholesale prices fell 5 %.
Imports shrank 26 %.
In a few short months, unemployment rose from 2.8 % to 8%.
Immigration reached a peak of 1.2 million in 1907 but fell to around 750,000 by 1909.
NEITHER ELECTED NOR APPOINTED, HE FELT IT WAS HIS TIME TO ACT
In the absence of a strong federal regulatory structure or any safety nets, the response to this crisis had to be delivered by a private citizen, J.P. Morgan, the world’s most powerful banker.
He used all of his influence to convince fellow titans of industry to pool their resources and salvage the nation.
The Panic subsided after six weeks.
A BUCKET SHOP IN 1907
SPECULATION IN OFF-STREET MARKETS
Bucket shops were blamed for fueling the speculation in 1907. They enabled people to speculate on the value of a stock without having to purchase the stock itself.
The actual order to purchase went in the “bucket.” Beginning in 1909, New York banned bucket shops and other states followed.
THE WORLD MADE HUGE INVESTMENTS IN THE U.S. HOUSING MARKET
By ignoring risk, remaining irrationally optimistic, and forgoing transparency through an array of fantastically complicated investment vehicles, the world’s financial markets were extremely dependent on housing prices.
The underlying assumptions were (1) that housing prices never fall and (2) homeowners almost always pay their mortgages.
FORMER FED CHAIRMAN ALAN GREENSPAN
DURING AND AFTER THE MILD RECESSION OF 2001, THE FED LOWERS INTEREST RATES
STRONGLY PROMOTED HOMEOWNERSHIP
FORMER PRESIDENT GEORGE BUSH
“We can put light where there’s darkness, and hope where there’s despondency in this country. And part of it is working together as a nation to encourage folks to own their own home” –President Bush, October 15, 2002.
THIS WAS TOO TEMPTING FOR THE FINANCIAL INSTUTIONS
HIGHLY COMPLEX FORMS OF FINANCING
The momentum behind the expansion of homeownership led the government to reduce regulations and capital requirements for making loans.
This led to a dizzying number of innovative ways to get less-qualified borrowers a mortgage and seemed to reduce risk for the lender.
Mortgages could be bundled and sold around the world as securities.
TRUSTED AGENCIES FAILED TO WARN INVESTORS
Mortgage-backed securities were constructed of mortgages of differing quality levels.
The obligations of solid and sub-prime borrowers were mixed in a manner that made it very difficult for experts to calculate risk.
The assumption that U.S. housing prices would continue to rise and incentives to provide good ratings led agencies to rate these securities as AAA, lowering investors’ concerns.
THE PERFECT STORM
WHAT WERE WE THINKING?
Homeownership peaks in early 2005 at 70% of households.
The Fed raises interest rates.
Home prices fall.
Higher adjustable interest rates increase payments for borrowers.
Borrowers default in waves.
Dozens of subprime lenders file for bankruptcy.
Mortgage-backed securities lose value as investors question their contents.
Financial institutions struggle to find buyers for the MBSs.
Financial institutions could purchase credit default swaps.
A CDS is a private insurance contract that paid off if the investment failed.
One did not actually have to own the investment to collect on the insurance.
These promises were unregulated, and the sellers did not have to set aside money to pay for losses.
6.7 million jobs lost in 2008 and 2009
Capital investment levels lowest in 50 years
Domestic demand declines 11 consecutive quarters
Industrial production down worldwide: Japan 31%, South Korea 26% , Russia 16% , Brazil 15% , Italy 14%, Germany 12%
The federal government unleashed a series of remedies in an attempt to limit the contagion.
Massive sums of bank reserves were created to ease fears.
In the process, the taxpayers took over or funded several familiar financial and nonfinancial companies.
This time the government bails out the economy and business leaders and bankers are criticized.
Highly complex and linked financial system
Strong growth in the economy starting in 1900
Many people and institutions highly leveraged
Innovative form of finance: trust companies
Stock market setting all-time highs
A limited role for government
Markets swing from great optimism to great pessimism
Global interdependent financial system
Vibrant economic recovery after recession in 2001
Lenders willing to take more risk in making loans
Unregulated financial institutions: hedge funds
Companies reporting record earnings
Absence of many safety buffers
Dow 14,164 to 6,500 in 16 months
J.P. Morgan, a private citizen, orchestrated the bailout
The Panic lasted for six weeks, though the economy didn’t return to pre-Panic levels until 1909
Many banks were closed and many depositors lost their savings
The nation was on the gold standard and the supply of money was fixed
The San Francisco earthquake was a catalyst for the Panic
The climate toward business was hostile prior to crisis
The Federal Reserve and Treasury Department organize the reaction
The event has been unfurling for more than five years
Many banks closed and folded into healthier banks, but depositors did not lose any of their savings
The nation uses Federal Reserve notes, creating a flexible money supply
Hurricane Katrina was generally benign as a catalyst
The climate toward business was friendly prior to crisis
U.S. Homeownership rate:
The main activity in this lesson asks students to work in groups to analyze 6 of the 14 recessions between 1929 and 2007. Before working, they should understand business cycles and how GDP and Unemployment affect or are affected by recessions.
Remember Gerald Ford and the WIN buttons – Whip Inflation Now!
President Reagan was in office and is often credit with “breaking the back of inflation.”
Since most dot.com stocks were traded on the NASDAQ, the stock graph tells the story of the bubble collapse that was a cause of the recession.
“The four most expensive words in the English language are, this time it’s different.”
attributed to Sir John Templeton
Director, West Texas Center for Economic Education
College of Business
West Texas A&M University
Canyon, Texas 79016