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Presentation Notes
Overview
2007-2009
Unemployment reached 10%
GDP declined by almost 4.3%
The US has only reached its potential output (climbed out of the recession’s trough) in the past few years
Causes
Housing market bubble
Subprime loans (failure in credit rating)
Mortgage Backed Securities
Credit Default Swaps
House prices climbed because of an expectation of future price growth, not because of the underlying value of the house.
Banks provided loans with very little down payment from buyers, increasing risk of default if the home values declined. Many loans called subprime were made to people who were unlikely to be able to repay the loan, which would have been fine because the house price was predicted to increase.
Subprime loans were packaged with good loans into mortgage backed securities and then sold to other financial institutions.
Financial institutions took out insurance on the mortgage backed securities so that if many people defaulted on their loan, the holder of the mortgage backed security would not lose money. This type of insurance is a credit default swap.
This interconnected, fragile web created a house of cards. In 2007, the housing market collapsed, with prices declining. Then, because the down payment was so low, the outstanding loans on houses were greater than their actual value, causing people to default on their loans. Issuers of credit default swaps could not possible pay out insurance to all of the holders of insured mortgage backed securities, so the Federal Reserve had to bailout banks that held useless assets or issued the credit default swaps. Some banks like Lehman Brothers failed entirely. Banks were now more focused on survival than profit, so they stopped making loans, causing investment spending to shrink and aggregate demand to decline. The stock market crashed as a result of the failing banks. Now, millions of people were homeless and the economy was in a state of recession.
Fiscal Policy
American Recovery and Reinvestment Act of 2009
$787 billion (later $831B) of fiscal stimulus
2/3 in spending increases
1/3 in tax cuts
Monetary Policy
Decreased federal funds rate to 0% (zero lower bound)
Forward Guidance: “exceptionally low interest for an extended period”
Quantitative Easing/Large Scale Asset Purchases
MBS from Fannie Mae and Freddie Mac
Longer-term treasury bonds
Two stages of QE: 2009, 2010-11
Operation Twist
The Federal Reserve took quick and large-scale action. First, they cut the federal funds rate to 0%, the zero lower bound. The zero lower bound exists because a negative interest rate means that banks lose money from lending, which means that banks will just stop lending.
The Federal Funds Rate is the shortest-term interest rate in the market, but consumers borrow at much longer term rates, making the 10 yr interest rate more important to investment spending than the 1 day interest rate. The Federal Reserve now noticed that long-term interest rates were still high (draw yield curve), so the Fed sought to reduce expectations of future rate increases by publicizing future plans of keeping interest rates low. This is called forward guidance.
Long-term interest rates were still too high, so the Fed “printed money” to buy up mortgage backed securities from Freddie Mac and Fannie Mae. Then, the Fed conducted two large scale asset purchases called quantitative easing which bought long-term treasury bonds, reducing longer-term interest rates.
Then, the Fed wanted to flatten the yield curve further and increased its holdings of longer term bonds through reducing its holdings of short term bonds in a process called Operation Twist.
The Fed throughout this process also increased loans to banks through the discount window and the Term Auction Facility, bailing out these banks.
The Fed successfully increased liquidity in the banking system, saved banks from default, and reduced interest rates across the board to increase investment spending.
Dodd-Frank
Volcker Rule-–separates investment and commercial functions of the bank
Central clearinghouses for many derivatives including CDS
More regulation of too big to fail banks
Established SEC credit rating agency
Dodd-Frank was a major financial regulation bill that passed in 2010. It separated investment and commercial functions of the banks, regulated derivatives and large banks more closely, and established a new credit rating agency. The point of the bill was to prevent a recurrence of the events that led up to the Great Recessions. The Republicans repealed portions of this law in May 2018.