Chapter 10: The Great Recession and Financial Crisis

Chapter 10: The Great Recession
Ryan W. Herzog
Spring 2021
Ryan W. Herzog (GU) Great Recession Spring 2021 1 / 40

1 Introduction
2 Recent Shocks to the Macroeconomy
3 Macroeconomic Outcomes
4 Some Fundamentals of Financial Economics

Introduction
Learning Objectives
The causes of the financial crisis that began in the summer of 2007
and where the economy currently stands.
How the current financial crisis compares to previous recessions and
to previous financial crises in the United States and around the world.
The financial crisis that started in the summer of 2007 and intensified
in September 2008 marked the end of an era for U.S. investment
banking.
Several important concepts in finance, including balance sheet and
leverage.
The National Bureau of Economic Research determined that a
recession began in December 2007 and was the worst recession since
the Great Depression of the 1930s.

Recent Shocks to the Macroeconomy
Recent Shocks
What shocks to the macroeconomy have caused the global financial
crisis?
Housing prices
Global saving glut
Subprime lending and rise in interest rates
Previous financial turmoil
Oil prices

Housing Prices
Housing prices tripled between 1996 and 2006.
“Housing bubble”
Between mid-2006 and February 2009, housing prices plummeted by
31.6 percent.
The bubble “burst”

Housing Bubble

Global Saving Glut
The current financial turmoil was caused partly by prior financial
crises.
Ben Bernanke March 2005: “global saving glut”
Glut = “excess”
The United States had an excess of savings with desire to invest.
Higher investment demand contributed to rising asset prices in the
housing market.

Subprime Lending and the Rise in Interest Rates
The savings glut led to low interest rates, and many borrowers took
out mortgages to buy homes between 2000 and 2006.
Many of these borrowers were ‘subprime’
poor credit records
high debt-to-income ratios.
Between 2004 and 2006, the Fed raised its interest rate from 1.25 to
5.25 percent.

The Taylor Rule
The Taylor rule demonstrated that rates had been too low in previous
years.
However, many subprime borrowers were now facing mortgages that
were increasing from their initial teaser rates.
By August 2007 nearly 16 percent of subprime mortgages with
adjustable rates were in default. This led to a downward spiral of the
housing market.

Federal Funds Rates

The Financial Turmoil of 2010
Before the crisis, subprime mortgages were sold to investors through a
financial innovation known as securitization.
Securitization
The process of pooling a group of financial instruments, such as
mortgages, and then slicing them up in a different way and selling off
the pieces.
Meant to diversify risk.
As mortgages were developed and traded, it became difficult to know
how much risk an individual bank was exposed to.
August 2007: “flight to safety” and lenders put funds in T-bills

Liquidity and Risk Shocks

Liquidity Crisis
Liquidity crisis
The volume of transactions in some financial markets falls sharply.
Makes it difficult to value certain financial assets.
Raises questions about the overall value of the firms holding those
assets.
Financial markets plunged and the S&P index dropped 50 percent
from its peak in November 2007.

S&P 500 Index

Oil Prices
To make matters worse, oil prices were extremely volatile in this
period.
2002: $20 per barrel.
Summer of 2008: $140 per barrel.
December 2008: $40 per barrel.

The Price of Oil

Oil Prices
The oil price increase was caused by:
Demands from China, India, and the Middle East.
Short-term supply disruptions.
The economic slowdown helped to alleviate oil demand pressures.
It is possible that price speculation also played a role.

Practice Questions 1/2
The Great Recession began in and ended in .
a December 2007; June 2009
b December 2008; June 2010
c May 2008; March 2010
d June 2007; December 2009
e June 2007; June 2009

During the Great Recession, the unemployment rate peaked at
a 12.1 percent.
b 9.5 percent.
c 10.0 percent.
d 25.8 percent.
e 6.7 percent.

Macroeconomic Outcomes
The recession, starting in December 2007, was first visible in
unemployment.
By 2009:
Output was 3.6 percent below potential.
Unemployment was up to 8.9 percent.
February 2010:8.5 million jobs lost

Historical Perspectives
Compared to an average of all recessions since 1950, this recession is
significantly worse.
A striking difference about this recession is the decrease in
consumption that occurred.

Employment

Short-Run Output, Ỹ

U.S. Unemployment Rate

Changes in Key Macroeconomic Variables
Average of Previous
Country Recessions since 1950 The Great Recession
GDP -1.7% -3.7%
Nonfarm Employment -2.1 -6.1
Unemployment Rate 2.5 5.1
Components of GDP
Consumption 0.4% -1.9%
Investment -14.7 -31.4
Government 1.2 4.0
Exports -1.5 -12.6
Imports -4.4 20.0

Employment Losses

Inflation
Volatile oil prices caused sharp swings in inflation for all items in 2008.
In the recession, core inflation (all items less food and fuel) declined
slightly.

Inflation

Comparing to Other Financial Crises
According to a study (Reinhart and Rogoff) summarizing worldwide
financial crises, the typical crisis sees an unemployment rate increase of 7
percent for five years, a doubling of government debt, and a 10- percent
decline in real GDP.

Average Outcomes
Economic Stat Average Outcome
Housing Prices -35%
Equity Price -56%
Unemployment +7 points
Duration of Rising Unemployment 4.8 years
Real GDP -9.3%
Duration of Falling GDP 1.9 years
Increase in real debt (gov’t) +86%

Changes in Real GDP Around the World
Country 2009 2010
Japan -5.3 1.7
U.K. -4.8 1.3
Euro Area -2.9 1.0
United States -2.5 2.7
Asian NICs -1.2 4.8
China 8.7 10.0
India 5.6 7.7
World -0.8 3.9

EU Unemployment

In the middle of 2009 ; by February 2010 .
a over 8 million jobs were lost; short-run output bottomed out at over -6
percent
b short-run output bottomed out at over -6 percent; over 8 million jobs
were lost
c inflation was 5 percent; the unemployment rate was 12 percent
d the federal funds rate was 5 percent; it had fallen to 1 percent
e unemployment fell to 8 percent; home sales were rising steadily

Some Fundamentals of Financial Economics
Balance Sheets
Balance sheet:
Accounting tool with assets on the left side and liabilities and net
worth on the right side.
The two sides sum to the same value when net worth is included.
Assets: Items of value that an institution owns.
Liability: An amount that is owed to someone else.
Equity
The difference between total assets and total liabilities on a balance
sheet.
Represents the value of an institution to its shareholders or owners.
Also known as net worth or capital.

Banks are also subject to a number of financial regulations that apply
to their balance sheets.
The reserve requirement: A mandate that financial institutions keep a
certain percent of their deposits in a special account with the central
bank.
The capital requirement: The legal obligation that a financial
institution have a certain ratio of its assets supported by capital on its
balance sheet.

Balance Sheet
Assets Liabilities
Loans 1,000 Deposits 1,000
Investments 900 Short-term Debt 400
Cash and Reserves 100 Long-term Debt 400
Total Assets 2,000 Total Liabilities 1,800
Equity (net worth) 200

Leverage
The ratio of total liabilities to net worth.
This ratio magnifies any changes in the value of assets and liabilities
in terms of the return to shareholders.
This principle also applies to homeowners.

If a bank is highly leveraged, it may make
Large gains off of small increases in market prices.
Large losses off a small decrease in prices.
Insolvency: Situation in which the liabilities of a bank or other
company exceed its assets.
Before the financial crisis, many investment banks were highly
leveraged.

Bank Runs
The Great Depression of the 1930’s was caused by nearly all
depositors converging on banks at once and demanding the return of
their deposits.
Bank run
A situation in which depositors or creditors worry about a financial
institution’s solvency and its ability to repay its deposits or short-term
debt.
Everyone “runs” to withdraw all funds, and the bank can’t meet all
these requests.
In the recent crisis, a similar problem occurred on the liability side.
Financial institutions usually have large amounts of short-term debt,
which are often financed by commercial paper.
After the collapse of Lehman Brothers, banks became worried about
lending to other banks.
Interest rates spiked on commercial paper, leading to a liquidity crisis.

Net worth is equal to a bank’s:
a investments minus deposits.
b cash plus reserves.
c deposits plus loans.
d loans minus capital.
e total assets minus its total liabilities.

Chapter 10: The Great Recession and Financial Crisis

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