Key Events Leading up to the Crisis• Housing price increase during 2000-2005, followed bya levelling off and price decline• Increase in the default and foreclosure rates beginningin the second half of 2006• Collapse of major investment banks in 2008• 2008 collapse of stock prices
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Major Cause• Multiple causes, but US housing bubble was bigpiece• Focus on securitization of “nonprime” (subprime andAlt-A) mortgages• Gorton (2009):“The [2007-2009] credit crisis was sparked by ashock to fundamentals, housing prices failed torise.”
Housing price declineThe decline in house prices reduced the value ofmortgage backed securities. Be-cause ofleverage, this threatened the solvency of anumber of ﬁnancial institutions, includingmajor investment banks. Risk premiums rosesharply on many kinds of lending, and thestock market lost about half its value.
The US housing bubble020406080100120140160180200220189018921894189618981900190219041906190819101912191419161918192019221924192619281930193219341936193819401942194419461948195019521954195619581960196219641966196819701972197419761978198019821984198619881990199219941996199820002002200420062008U.S. Real Housing Price Index 1890-2008U.S. RealHousingPriceIndex 1890-2008Source: Case-Shiller index
2007-2009 financial crisis These shocks have combined to put the U.S.economy and many economies through-out theworld into a ﬁnancial crisis and a deep recession,likely the largest since the Great Depression.Balance sheets are an accounting device forsummarizing the assets, liabilities , and net worth(or equity) of an institution. This can be a bank, ahousehold, or a government, for example
2007-2009 financial crisisLeverage magniﬁes both returns and losses, sothat small percentage changes in the value ofassets or liabilities can be enough to entirelywipe out equity, causing an institution tobecome insolvent, or bankrupt.Credit unionsCommercial banksSavings institutionsBrokers/hedge FundsFannie MaeFreddie Mac0 20 40 60 8067.921.518.104.22.168.1
Systemic RiskDuring the height of the ﬁnancial crisis, thesolvency of numerous ﬁnancial institutionswas called into question. Because ﬁnancialﬁrms are interlinked through a complex webof loans, insurance contracts, and securities,problems in a few ﬁnancial institutions cancreate problems in many others, which iscalled systemic risk.
Restructuring of the Economy : A Remedy• To promote recovery in a crisis-affectedeconomy, it is essential to link together arestructuring of the financial and thecorporate sectors, a so-called rapidsequencing restructuring of the economy.
Cont.....• International coordination at setting new rules willbe necessary Otherwise race to the bottom leadingto new deregulation International coordination ofrule setting is most challenging
rev200902The Economic Crisis of 2008: Causeand AftermathSlide 13 of 31Lessons From the Great DepressionAvoid these policies:– Monetary contraction– Trade restrictions– Tax increases– Constant changes in policy; this merely creates uncertainty and delays privatesector recovery.
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