The Great Recession
Dr. Joshua J. Lewer
Some Recent Financial Crises
Theme: Bad Loans
U.S. Savings and Loans - 1985 to 1989
Japan’s Banking Crisis – 1989 to present
Mexican Banking Crisis of 1995
Asian Flu of 1997-98 – The “Contagion”
Russian Implosion of 1998
Functions of the Financial System
Essential for overall economic performance, see King and Levine (1993)
Funnel savings to borrowers
Short term needs – Baltimore steel framer story
Exchange assets across generations
The Roots of the Current Problem
The current crisis
A crisis in financial institutions
Collapse of a speculative bubble in the housing market
Triggered a credit crunch -> Recession since Dec ‘07
The Savings Tsunami
Savings glut in Asia -> global interest rates low since 1991
Low interest rates stimulate the demand for housing
Historic low federal funds rate
Federal policies that promoted homeownership
Greed, speculation, and the lack of personal responsibility
“SubPrime” -- a loan under conditions which make the risk higher than “prime”
The borrower could be more risky than one who would get the usual 20% down, 30-year fixed rate
The borrower could get a 0% down mortgage
Grandma Tesch story
Subprime Issuance and Ratings 2005-07 U.S.$ Billions
Source: Greenlaw et al. (2008), Inside Mortgage Finance
Note: 2000-2007 subprime issuance total is $2.71 trillion, before this - minimal
From Wall Street to Main Street: How has the Financial Crisis Impacted the Real Economy?
1. Credit markets have seized up - interest rate premiums persist, but some recovery here
2. The decapitalization and failure of financial institutions - credit crunch
3. Household bankruptcies and foreclosures
4. U.S. consumer confidence at an all-time low
5. Job losses and insecurity - a recession of fear
Foreclosure Rates in U.S.
Source: RealtyTrac U.S. Foreclosure Market Report
The Economic Stimulus Act of 2008
The $152B law was intended to boost the U.S. economy in 2008 and avert a recession.
Signed into law on February 13, 2008.
The law provides:
Tax incentives to stimulate business investment
Housing relief by gov’t sponsored enterprises.
$300 per person ($600 for married filing jointly)
Plus, $300 per dependent child under the age of 17
Business tax incentives:
One-time depreciation tax deduction equal to 50% of the cost of specific new investments during 2008.
Emergency Economic Stabilization Act of 2008
Troubled Assets Relief Program
“Provide stability or prevent disruption to the financial markets or banking system,”
“Protecting the taxpayer.”
The $700B act allows the federal government to:
Buy and sell MBS
Buy and sell illiquid whole loans
TARP I (Oct – Dec 2008): The first $350B was applied to a capital purchase program – buy preferred stocks in banks
TARP II (current) – Geitner buying MBS with “Bad Banks?”
The program lasts for 2 years
Funded by government bonds
National debt cap increases to $11.35t
Asset managers and contracted firms are to conduct transactions on behalf of the Treasury Secretary – fiduciary responsibility to U.S.
To obtain enough votes for passage, additional riders were added
There are two oversight committees over the Troubled Assets Relief Program of the Act.
Congressional oversight panel
Five members appointed by House and Senate leadership from both parties.
Financial Stability Board
Reports to Congressional Panel
Made up of -- Fed Chair, SEC Chair, Fed Home Fin Dir, HUD Sec, Treasury Sec
Has it Fixed the Problems in the Financial Markets?
With concurrent Federal Reserve actions,…
Lowering the Federal Funds rate to 0 to 0.25%
Using MBS as collateral for Term Auction Facility (TAF) loans - $900B by end of year.
Buying commercial paper - $275B since August ‘08
Buying MBS - $500B starting in Nov. ’08
Buying the spectrum of Treasuries to keep long-term interest rates low and increase liquidity - $600B
…capitalization and liquidity in the financial sector has been significantly enhanced, but…
…credit access still remains a problem in some areas.
The American Recovery and Reinvestment Act of 2009
% of GDP 5.5%
“The” Stimulus Package
(T) Tax Relief for Ind’s $246B 31.2 31.2
(S) Transport and Infra. $98B 12.4 43.6
(T) Aid to States & Local Gov’t $95B 12.1 55.7
(T) Aid to Those Effected by Rec. $62B 7.8 63.5
(S) Aid to States & Local Gov’t $58B 7.4 70.9
(S) Education $48B 6.1 77.0
(S) Energy $41B 5.2 82.2
(S) Aid to Those Effected by Rec. $37B 4.7 86.9
(S) Health Care $20B 2.5 89.4
(T) Renew Energy Tax Credits $20B 2.5 91.9
Category (S=Spending, T=Taxation)
Tax Relief for Individuals
For 2009 and 2010, a refundable tax credit of up to $400 ($800 joint return) for working individuals ($33 per month or claim on tax return). Phase out $75,000 ($150,000 joint return). Cost = $116B
Extension of the alternative minimum tax for 2009 - extends AMT relief for nonrefundable personal credits and increasing the AMT exemption amount to $70,950 for joint filers and $46,700 for individuals. Cost = $69B
Other components: increase eligibility of child tax credit, one-time payment of $250 to retired and disabled individuals, tax credit up to $2,500 for college, $8,000 for first-time home buyer, etc.
3 Part Plan
Geitner proposes to create one or more “bad banks” to buy and hold toxic assets.
He proposes a lending program that would spend $1 trillion to cover the decline in the issuance of securities backed by consumer loans.
He proposes more capital infusions to banks to spur lending. In exchange, banks would have to cut the salaries and lower dividends.
Obama’s Plan Aides Homeowners
The $275B plan helps 9 million struggling homeowners by:
Modify existing mortgages
$200B to refinance: only available through Fannie Mae and Freddie Mac
$75B to encourage lenders to modify loan terms
Lenders and the gov’t would jointly lower monthly payments to 31% of income
Lenders receive $1,000 per modification
Borrowers receive $1,000 principal reduction for up to 5 years
Short Run Prognosis
4th quarter 2008 economic numbers were bad
Real GDP growth at -6.2% (worst quarter was 1st quarter 1980 = -7.8%)
1st half 2009 economic estimates also look negative
Real GDP growth estimates Q1 = -4.6% and
Q2 = -1.5%
Unemployment expected to peak at 9% 1st quarter ’10
Global growth slows to 0.5% ’09 and 3% ’10 (IMF, 2009)
What Happens to Manufacturing?
Since World War II
Each 1% change in GDP has Caused 1.7% Change in Manufacturing
Each 1% change in GDP has Caused 2.2% to 2.5% Change in Durables Manufacturing
What Happens to Manufacturing?
The 12.3% annualized GDP drop of Q4 ’08 and the First Half of ’09
12.3% * 1.7 = 20.91% annualized drop yields a 5.2% total drop in Manufacturing
12.3% * 2.3 = 28.3% annualized drop yields a 7.1% total drop in Durables Manufacturing
Visibility of Recession’s End
The 3rd Quarter of 2009 has the potential to be the initial quarter of the next economic recovery.
The second half of 2009 should see the US economy on a slow recovery track.
Q3 = 0.7%
Q4 = 1.9%
Projected 2009 US GDP decline at 0.9%.
Why a Slow Recovery?
“Growth Dynamics: The Myth of Economic Recovery” Cerra and Saxena (2008, AER) find:“Using panel data for a large set of high-income, emerging market, developing, and transition countries, we find robust evidence that the large output loss from financial crises and some types of political crises is highly persistent. The results on financial crises are also highly robust to the assumption on exogeneity. Moreover, we find strong evidence of growth overoptimism before financial crises. We also find a distinction between the output impact of civil wars versus other crises, in that there is a partial output rebound for civil wars but no significant rebound for financial crises or the other political crises.”
What Will Drive the Recovery?
Thawing of the credit markets
Some improvement in the financial sector
Yield curve (in recovery zone) and Ted spread (not yet)
Massive stimulus packages by Obama and rest of world
China recovery underway
Lower oil and commodity prices
Stimulates aggregate supply
Dr. Lewer’s Policy Prescriptions
Delay Obama’s tax increases on high-income Americans
Support open trade...not the time for a trade war
Combine fiscal and monetary policies efforts
Like pharmaceuticals, the potency is enhanced
Provide short-term support to American families behind on their mortgages - $275B plan
Support small business start-ups and cut red tape for entrepreneurs
Risk Indicators Improving
1. TED spread – the difference between the yield on the 3-month Treasury Bill and the 3-month Libor
Indicator of health of global credit markets
Excellent measure of fear banks have when lending
Spread was 465 basis points in October, Jan’ 09 at 100 now
Normalized credit conditions spread would be near 50
2. Yield curve – the ten-year treasury less federal funds rate
Currently at (3.02% = 3.02%-0%)
Leading recovery spread is above 2.50%
Transport and Infrastructure
Highway infrastructure investment. Cost = $27B
High speed rail capital assistance. Cost = $8B
Defense environmental cleanup. Cost = $5B
Aid to States and Local Gov’t
Medicaid increase for states. Cost = $87B
State Fiscal Stabilization Fund to avoid cutbacks and layoffs (82% must be used for education while 18% may be used for public safety and other government services. The latter part may be used for repairs and modernization of K-12 schools and college and university buildings.) Cost = $54B
One-time grants to encourage states to increase unemployment coverage. Cost = $3B
Aid to People Affected by the Downturn
Extension of emergency unemployment compensation. Cost $26B
Premium subsidies for COBRA continuation for unemployed workers. Cost = $25B
Temporary increase in benefits under the Supplemental Nutrition Assistance Program (food stamps) Cost = $20B
Rural Housing Service insurance fund program account - direct loans and unsubsidized guaranteed loans Cost = $12B
Increases weekly unemployment benefits by an additional $25 through 2009. Cost = $8B
Pell grants for higher education (Pell Grant’s award at $5,350 in 2009 and $5,550 in 2010 ). Cost $16B
Special education funding under the Individuals with Disabilities Education Act. Cost = $12B
Education for the disadvantaged - elementary and secondary education Cost. = $10B
Innovative technology loan guarantee program. Cost $26B
Weatherization Assistance Program (increases maximum income level and maximum assistance). The Weatherization Assistance Program enables low-income families to permanently reduce their energy bills by making their homes more energy efficient. Cost = $6B
Federal building conversion to “high-performance green buildings.” Cost = $5B
National Institutes of Health fund to support scientific research . Cost $7.4B
Construction, renovation, equipment and information technology for health centers. Cost = $1.5B
Department of Health and Human Services Prevention and Wellness Fund. Cost = $1B
National Institutes of Health grants and contracts to renovate non-federal research facilities. Cost = $1B
Increases weekly unemployment benefits by an additional $25 through 2009. Cost = $8B
Renewable Energy Tax Credits
Long-term Extension and Modification of Renewable Energy Production Tax Credit. The bill would extend the placed-in-service date for wind facilities for three years (through Dec. 31, 2012). The bill would also extend the placed-in-service date for three years (through Dec. 31, 2013) for certain other qualifying facilities: closed-loop biomass, open-loop biomass, geothermal, small irrigation, hydropower, landfill gas, waste-to-energy and marine renewable facilities. Cost = $13B
Tax Credits for Energy-Efficient Improvements to Existing Homes ($1,500). Cost $2B
Plug-in Electric Car Credit ($2,500). Cost $2B