Chapter 11 The Federal Reserve System and the Housing Bubble and Subsequent Recession

Transcription

1 Chapter 11 The Federal Reserve System and the Housing Bubble and Subsequent Recession The basic economic problem is scarcity Human wants are unlimited Resources are limited The basic goal in dealing with the problem of scarcity is to produce as much consumer satisfaction as possible with the limited resources available Achieving each of the three macroeconomic goals (price level stability, full employment, and economic growth) will contribute toward reaching this basic goal Proper control of a nation s money supply is essential to achieving the macroeconomic goals A nation s money supply is controlled by its central bank Most nations have a central bank Some examples are; the Reserve Bank of Australia, the Bank of Canada, the Bank of England, the Reserve Bank of India, the Bank of Japan, the Banco de Mexico and the Central Bank of the Russian Federation The central bank of the European Union is called the European Central Bank The Federal Reserve System (commonly called the Fed) is the US central bank The Federal Reserve System was created by the Federal Reserve Act in 1913 There are twelve Federal Reserve District Banks in the Federal Reserve System The governing body of the Fed is the Federal Reserve Board of Governors The seven members of the Board are appointed by the President with the consent of the Senate The Board is headed by the Chairman of the Federal Reserve Board of Governors (Ben Bernanke, since February 1, 2006) The Chairman of the Federal Reserve Board is the key person in establishing monetary policy in the US Functions of the Federal Reserve System The Federal Reserve System performs a number of important functions in the US economy Among the functions of the Fed are: 1 Control the money supply This is the most important function of the Fed, and will be discussed in more detail later in this chapter 2 Supervise and regulate banking institutions Regulations, such as the required-reserve ratio, are established by the Board of Governors Supervision, such as audits of bank lending policies, is carried out by the Federal Reserve District Banks 3 Serve as the lender of last resort A bank in need of reserves can borrow reserves from other banks or from the Fed A bank in need of reserves will usually borrow reserves from other banks through the federal funds market But what if there is a shortage of reserves throughout the financial system? In a fractional reserve banking system, it is possible for widespread financial panic to occur The creation of the Federal Reserve System was largely motivated by the Panic of 1907 In a financial panic, many banks would need reserves, and would be unable to borrow reserves from other banks The Fed acts as the lender of last resort 4 Hold banks reserves Banks are required to hold reserves (vault cash plus the bank s deposit with the Fed) to back up their checkable deposits Most banks maintain a deposit with the Fed as part of their reserves 5 Supply the economy with currency The Fed does not produce currency Paper money (Federal Reserve Notes) is printed by the Bureau of Engraving and Printing Coins are minted by the US Mint The currency is put into circulation through depository institutions by the twelve Federal Reserve District Banks 6 Provide check-clearing services When Arlene writes a check on her account at Bank X to pay her auto insurance, the money in her account has to move to the auto insurance company s account in Bank Y The Fed is a large provider of check-clearing services in the US economy The Fed handles about 18 billion checks per year 11-1 The Federal Reserve System

2 Monetary Base and the Money Supply The primary function of the Fed is controlling the money supply But the Fed does not directly control the money supply The Fed influences the money supply by changing the monetary base Monetary base currency in circulation plus bank reserves (vault cash plus bank deposits with the Fed) When the Fed makes a purchase or a sale, the monetary base changes (What the Fed primarily buys and sells is US government securities) When the Fed makes a purchase, the monetary base increases When the Fed makes a sale, the monetary base decreases Example 1A: The Fed buys $250,000 of US government securities in the open market The seller is Bank Y The Fed pays Bank Y for the securities by increasing Bank Y s deposit account balance with the Fed by $250,000 Bank Y now has $250,000 in new reserves Thus, there is a $250,000 increase in monetary base Example 1B: The Fed sells $100,000 of its holdings in US government securities The buyer is Bank Z Bank Z pays for the securities by using some of its excess reserves Bank Z now has $100,000 less in reserves Thus, there is a $100,000 decrease in monetary base The Actual Money Multiplier When the monetary base changes, money creation or money destruction is triggered, and the money supply changes by a multiplied amount The actual money multiplier measures the change in the money supply for a given dollar change in monetary base Actual money multiplier = Change in Money Supply Change in Monetary Base Example 2: The Fed increases the monetary base by $150 million The money supply increases by $375 million The actual money multiplier is 25 ($375 million $150 million = 25) Tools for Controlling the Money Supply The Fed has three major monetary policy tools available for controlling the money supply The most important monetary policy tool is open market operations Open market operations refers to the Fed buying and selling US government securities in the open market The Federal Open Market Committee (FOMC) determines the policy for open market operations The voting members of the FOMC are the seven Federal Reserve Board Governors, the president of the Federal Reserve Bank of New York, and four of the other eleven Federal Reserve District Bank presidents, who serve on a rotating basis The Chairman of the Board of Governors also serves as the Chairman of the FOMC Open market operations, along with the other two monetary policy tools, are discussed below: 1 Open market operations As discussed earlier in the chapter, when the Fed makes a purchase or a sale, the monetary base changes When the monetary base changes, the money supply changes by a multiplied amount What the Fed primarily buys and sells is US government securities US government securities are an attractive asset for the Fed to hold for the same reasons (discussed in Chapter 10) that US government securities are an attractive asset for banks to hold If the Fed buys securities in the open market, bank reserves increase When bank reserves increase, banks have excess reserves, which they can loan out triggering the money creation process The money creation process leads to a multiplied expansion of the money supply The Federal Reserve System 11-2

3 Example 3: The Fed buys $300,000 of US government securities in the open market The seller is Bank X The Fed pays Bank X for the securities by increasing Bank X s deposit account balance with the Fed by $300,000 Below is the updated balance sheet for Bank X from page 10-5 After Bank X sells the $300,000 of US government securities to the Fed, Bank X s holdings of US government securities decrease by $300,000 and its reserves increase by $300,000 Bank X now has $300,000 in excess reserves, which it may loan out, triggering the money creation process Bank X Balance Sheet Liabilities: Checkable Deposits $50,000,000 Assets: Reserves; Vault Cash $500,000 Deposit with the Fed $4,800,000 (+$300,000) Loans Outstanding; Mortgage Loans $20,000,000 Business Loans 13,000,000 Personal Loans 11,000,000 US Government Securities 700,000 (-$300,000) Total Loans Outstanding $44,700,000 Total Assets $50,000,000 If the Fed wanted to reduce the money supply, it would sell US government securities in the open market If the Fed sells securities in the open market, bank reserves decrease When bank reserves decrease, this leads to a multiplied contraction of the money supply Open market operations is the Fed s most important tool for controlling the money supply 2 Changing the reserve requirement The Fed sets the required-reserve ratio Lowering the reserve ratio would give banks excess reserves The excess reserves would allow the banks to make new loans, which would trigger the money creation process Thus, lowering the reserve ratio will cause the money supply to increase If the Fed raises the reserve ratio, the money supply will decrease Example 4: Refer to Example 3 Initially the reserve ratio is 10% Bank X has deposits of $50,000,000, and is required to hold $5,000,000 in reserves If the Fed lowers the reserve ratio to 9%, Bank X would be required to hold only $4,500,000 in reserves Bank X would now have $500,000 of new excess reserves, which it could loan out, triggering the money creation process 3 Changing the discount rate A bank in need of reserves can borrow reserves from other banks or from the Fed A bank can borrow reserves from other banks in the federal funds market The interest rate charged in the federal funds market is the federal funds rate Federal funds rate the interest rate one bank charges another bank to borrow reserves A bank also can borrow reserves from their Federal Reserve District Bank When a bank borrows reserves from the Fed, the interest rate charged is the discount rate Discount rate the interest rate the Fed charges banks that borrow reserves from it If a bank borrows reserves from other banks, the money supply is not changed The borrowing bank has more reserves, but the lending bank has fewer reserves There is no change in overall bank reserves Thus, the money supply is not changed 11-3 The Federal Reserve System

4 If a bank borrows reserves from the Fed, the Fed is injecting new reserves into the financial system and the money supply increases To encourage borrowing from the Fed, the Fed would lower the discount rate Thus, lowering the discount rate will increase the money supply To discourage borrowing from the Fed, the Fed would raise the discount rate Thus, raising the discount rate will decrease the money supply The Housing Bubble and the Subsequent Recession The economy entered into a recession in December of 2007 Real GDP was flat in 2008 Real GDP decreased by 26% in 2009 Real GDP increased by 29% in 2010 The unemployment rate increased from 47% in November of 2007 to 101% in October of 2009 Though the recession officially ended in June of 2009, the unemployment rate was still at 90% in October of 2011 The Dow Jones Industrial Average (DJIA) reached a peak of 14,27996 on October 11, 2007, and then fell to 6,44008 on March 9, 2009, a drop of almost 55% from the peak The federal budget deficit increased from $161 billion in 2007 to $459 billion in 2008 and then to $1,413 billion in 2009 The deficit was $1,294 billion in 2010 and was $1,299 billion in 2011 Most economists agree that the primary cause of the recession was the bursting of the housing bubble and the subsequent credit crisis Home prices nationwide were relatively flat throughout most of the 1990s According to the S&P/Case-Shiller Index, home prices increased by about 83% from the 1 st quarter of 1990 to the 1 st quarter of 1997 Then home prices began a rapid increase, peaking in the 2 nd quarter of 2006, at over 132% higher than they had been in the 1 st quarter of 1997 By the 1 st quarter of 2009, home prices had decreased by over 32% from their 2006 peak However, home prices were still 57% higher than they had been in the 1 st quarter of 1997 (See Example 5 below) Why did the housing bubble arise and why did its bursting cause a credit crisis leading to a severe recession? The four primary causes of the housing bubble and the credit crisis arising from the bursting of the housing bubble are discussed in this chapter Example 5: The graph below illustrates the Case-Shiller Index of home prices for the years from 1991 to 2009 Case- Shiller Index z Years (1 st Quarter) The Federal Reserve System 11-4

5 Low Mortgage Interest Rates Mortgage interest rates in the US peaked at 18% in 1982, as the Federal Reserve drove interest rates skyward in a successful attempt to squeeze inflation out of the economy Mortgage interest rates generally fell over the next twenty years, with the rate on a 30-year fixed mortgage falling below 6% late in 2002 The rate stayed below 6% most of the time through 2005 Example 6: Average 30-year fixed mortgage interest rates from 1982 to % - 13% - 12% - Mortgage Rates 11% - 10% - 9% - 8% - 7% - 6% - 5% - z N I I I I I I I I Years Mortgage interest rates were falling despite the low savings rate in the US because of an influx of savings entering the US from other countries Most of this savings came from countries with high savings rates such as Japan and the United Kingdom and from countries with rapidly growing economies such as China, Brazil, and the major oil-exporting countries The net inflow of foreign saving to the US increased from about 15% of GDP in 1995 to about 6% in 2006 Investors in these countries sought investments providing low risk and good returns Initially, they focused on US government securities Seeking better returns, they branched out into mortgagebacked securities issued by Fannie Mae and Freddie Mac, two enormous government-sponsored enterprises (GSEs) Foreign investors assumed that these securities were low-risk because, if trouble arose, the federal government would step in to bail out Fannie and Freddie Eventually the foreign investors grew bolder, investing in mortgage-backed securities issued by Wall Street firms These mortgage-backed securities appeared to be low-risk, since they had received favorable ratings issued by highly respected credit rating agencies, such as Moody s and Standard & Poor s The low mortgage interest rates contributed to the housing bubble by keeping monthly mortgage payments affordable for more buyers even as home prices rose 11-5 The Federal Reserve System

6 Low Short-term Interest Rates The US economy entered into a recession in March of 2001 Over the course of 2001, the Federal Reserve lowered the federal funds rate eleven times, from 650% to 175% When the economic recovery proved sluggish and no sign of significant inflation appeared, the Fed continued its low interest rate policy, lowering the federal funds rate to 125% in November of 2002 and to 100% in June of 2003 The Fed began gradually increasing the rate in June of 2004, but the rate remained at 200% or lower for more than three years The low short-term interest rates contributed to the housing bubble in two primary ways The low short-term interest rates encouraged the use of adjustable rate mortgages (ARMs) As home prices rose faster than household incomes, many prospective home buyers were unable to afford house payments under fixed rate mortgages But ARMs could provide the buyer with a lower monthly payment initially, since short-term interest rates were lower than long-term interest rates Example 7: The monthly principal and interest payment on a $200, year fixed rate mortgage with an interest rate of 6% would be about $1200 The monthly principal and interest payment on a $200, year ARM with an initial interest rate of 4% would initially be only about $950 As the housing market heated up, mortgage lenders became more creative with ARMs, developing option ARMs With an option ARM, the borrower could choose to make standard payments of both principal and interest (thus reducing the balance outstanding on the loan each month), or could choose to make payments of interest only (thus not changing the balance outstanding on the loan each month), or could choose to make payments of only a portion of the interest due (thus increasing the balance outstanding on the loan each month) ARMs made monthly mortgage payments temporarily affordable for more buyers and thus contributed to rising home prices When the interest rate on the mortgage adjusted upward (typically after two years), the higher mortgage payments would prove unmanageable for many home buyers The second way that low short-term interest rates contributed to the housing bubble was by encouraging leveraging (investing with borrowed money) With short-term interest rates extremely low, investors could increase their returns by borrowing at low short-term interest rates and investing in higher yielding long-term investments, such as mortgage-backed securities Example 8A: XYZ Company invests $10 million in mortgage-backed securities paying 7% interest XYZ s return on equity is 7% If XYZ borrows $100 million on short-term loans at 4% interest in order to invest an additional $100 million in mortgage-backed securities paying 7% interest, XYZ is now leveraged at 10 to 1 ($10 in debt for every $1 in equity) XYZ s return on equity will now be 37% (profit of $37 million on equity of $10 million) Leveraging increased the financing available for mortgage lending, thus contributing to rising home prices When the housing bubble eventually burst and home prices fell, the impact of the bursting of the housing bubble was increased by the degree of leverage in the economy Example 8B: The bursting of the housing bubble led to increased mortgage foreclosures and caused the value of mortgage-backed securities to fall If the value of the mortgage-backed securities held by XYZ Company from Example 8A falls by more than $10 million, XYZ Company becomes insolvent and will be unable to obtain new short-term financing XYZ is forced to deleverage by selling some of its holdings of mortgage-backed securities Many other highlyleveraged firms are going through the same deleveraging process, driving the price of mortgagebacked securities still lower The Federal Reserve System 11-6

7 Relaxed Standards for Mortgage Loans Standards for mortgage loans were fairly consistent in the decades prior to the housing bubble Most mortgages were 30-year fixed rate loans requiring a down payment of at least 20%, or mortgage insurance if the 20% down payment requirement were not met The borrower also had to have sufficient income to ensure that the monthly mortgage payments would be manageable Governmental policies have long encouraged home ownership The tax law has for decades permitted the deduction of mortgage interest and real estate taxes In 1997, the tax law was changed to permit homeowners to exclude from taxation a gain of up to $500,000 from the sale of a home In the mid 1990s, new governmental policies were enacted that contributed to a relaxing of standards for mortgage loans In 1995, the Community Reinvestment Act was modified to compel banks to increase their mortgage lending to lower-income households To meet the new requirements of the Community Reinvestment Act, many banks relaxed their mortgage lending standards Beginning in 1996, the Department of Housing and Urban Development (HUD) began to increase the percentage of mortgage loans to lower-income households that Fannie Mae and Freddie Mac were required to hold in their portfolios Fannie Mae and Freddie Mac are government-sponsored enterprises that increase the funding available in the mortgage market by purchasing mortgages from loan originators Fannie and Freddie buy only mortgages that conform to certain standards for down payment requirements and income requirements Historically, mortgages taken out by lower-income households often did not conform to these strict standards After HUD increased the percentage of mortgage loans to lower-income households that Fannie and Freddie were required to hold in their portfolios, Fannie and Freddie relaxed the standards that mortgages had to meet to be classified as conforming and thus eligible for purchase by Fannie and Freddie Down payment requirements and income requirements were reduced With the internet came greater competition in the mortgage loan market Home buyers were no longer limited to borrowing locally, but could search nationally for the mortgage provider who would offer the most favorable terms This is exemplified by the reduction in the average fee paid on a mortgage Example 9: According to the Federal Housing Finance Board, the average fee on a mortgage loan fell from around 1% of the amount of the loan in 1998 to less than 5% from 2002 to 2007 The greater competition in the mortgage industry contributed to relaxed mortgage standards Mortgage lenders who were willing to lower their standards gained market share More conservative mortgage lenders either had to lower their standards or lose market share As irrational exuberance caused the housing market to overheat, lenders relaxed their mortgage standards even further This was particularly true for loan originators who planned to quickly sell their mortgages and thus felt little concern for the long-term credit-worthiness of the borrowers This practice (called originate to sell as opposed to the traditional practice of originate to hold ) became more common with the increasing purchases of mortgages by investment banks The investment banks were increasing their purchases of mortgages to enable them to issue more and more of the highly profitable mortgage-backed securities The relaxing of mortgage standards is exemplified by the increase in subprime mortgages Subprime mortgages are home loans given to persons who are considered a poor credit risk Historically, subprime mortgages have had a foreclosure rate about ten times higher than prime mortgages Subprime mortgages charge a higher interest rate than conventional mortgages to offset the greater risk of default Subprime mortgages increased from 5% of new home loans in 1994 to 20% in The Federal Reserve System

8 Irrational Exuberance As with all bubbles, irrational exuberance played a key role in the housing bubble Robert Shiller, who wrote a book titled Irrational Exuberance, defines the term as; a heightened state of speculative fervor The term became famous when, in a speech given on December 5, 1996, Alan Greenspan hinted that stock prices might be unduly escalated due to irrational exuberance The Dow Jones Industrial Average fell 2% at the opening of trading the next day All the participants who contributed to the housing bubble (government regulators, mortgage lenders, investment bankers, credit rating agencies, foreign investors, insurance companies, and home buyers) acted on the assumption that home prices would continue to rise Example 10: Frank Nothaft, chief economist of Freddie Mac, was quoted in the June 22, 2005 issue of BusinessWeek magazine as saying, I don t foresee any national decline in home price values Freddie Mac s analysis of single-family houses over the last half century hasn t shown a single year when the national average housing price has gone down Since home prices had not fallen nationwide in any single year since the Great Depression, it seemed reasonable to most people to assume that they would not fall Example 11: Government regulators did not try to slow rising home prices, which they did not see as a bubble Mortgage lenders continued to make more and more subprime and adjustable rate mortgages These mortgages would continue to have low default rates, if home prices kept rising Investment bankers continued to issue highly leveraged mortgage-backed securities These securities would perform well, if home prices kept rising Credit rating agencies continued to give AAA ratings to securities backed by subprime, adjustable rate mortgages These ratings would prove to be accurate, if home prices kept rising Foreign investors continued to invest heavily in highly-rated mortgage-backed securities These securities would prove to deserve their high ratings, if home prices kept rising Insurance companies continued to sell credit default swaps (a type of insurance contract) to investors in mortgage-backed securities The insurance companies would face little liability on these contracts, if home prices kept rising And home buyers continued to purchase homes even though the monthly payments would eventually prove unmanageable They expected to be able to flip the home for a profit or refinance the loan when the adjustable rate increased And this would work, if home prices kept rising And home prices kept rising for a long time Warnings of a housing bubble were issued as early as 2002 By the 1 st quarter of 2003, home prices had risen by about 59% from the 1 st quarter of 1997 Should a wise homeowner have bailed out of the housing market at this point to avoid being caught up in the housing bubble? Example 12: If the average homeowner had sold their home in the 1 st quarter of 2003, for fear of the housing bubble bursting, they would have sold it for 28% less than they could have received in the 2 nd quarter of 2007, one year after home prices peaked The S&P/Case-Shiller Index was at in the 1 st quarter of 2003 and was at in the 2 nd quarter of 2007 The irrational exuberance that occurs during price bubbles is hard to recognize, hard to avoid, and not necessarily good for an individual to avoid Housing was a good investment up until just before the peak of the housing bubble, the same way that stocks were a good investment up until just before the dot-com bubble burst in 2000 Example 13: At the time Alan Greenspan made his irrational exuberance comment, the Dow Jones Industrial Average had risen by an incredible 364% over the previous nine years, and stood at However, this would not have been a good time for an investor to bail out of the stock market The DJIA would increase by another 75% over the next three years The Federal Reserve System 11-8

9 The Bursting of the Housing Bubble and the Credit Crisis Home prices reached their peak in the 2 nd quarter of 2006 They did not fall drastically at first Nonetheless, mortgage default rates began to rise as soon as home prices began to fall Example 14: Home prices fell by less than 2% from the 2 nd quarter of 2006 to the 4 th quarter of 2006 Foreclosure start rates increased by 43% over these two quarters, and increased by 75% in 2007 compared to 2006 Speculators who bought homes (often with no money down) simply walked away from the property when the home price fell Many never made even the first monthly payment Homeowners with adjustable rate mortgages found that they could not refinance, because the decrease in home prices meant that they had negative equity in their homes When their mortgage interest rates adjusted upward, their monthly payment was no longer manageable Example 15: Foreclosure rates for adjustable rate mortgages increased much more than foreclosure rates for fixed rate mortgages From the 2 nd quarter of 2006 to the end of 2007, foreclosure rates for fixed rate mortgages increased by about 55% (prime) and about 80% (subprime) During this same time period, foreclosure rates for ARMs increased by about 400% (prime) and about 200% (subprime) (Information is from Anatomy of a Train Wreck by Stan J Liebowitz of the Independent Institute) Just as rising home prices reinforced the continuing rise in home prices, falling home prices reinforced the continuing fall in home prices The increase in foreclosures added to the inventory of homes available for sale This further decreased home prices, putting more homeowners into a negative equity position and leading to more foreclosures The increase in foreclosures also decreased the value of mortgage-backed securities This made it difficult for investment banks to issue new mortgage-backed securities, eliminating a major source of financing for new mortgage loans, and contributing to the continuing decline in home prices The bursting of the housing bubble led to enormous losses Some of those losses were incurred by homeowners, particularly those who bought their homes or who took out home equity lines of credit against the value of their homes too close to the peak Most of the losses were not incurred by homeowners, but by the financial system Large losses were incurred by: 1 Mortgage lenders Since the housing bubble burst, a number of the largest mortgage lenders have either been acquired (eg Countrywide Financial by Bank of America), have filed for bankruptcy (eg New Century Financial), or have been liquidated 2 Investment banks Since the housing bubble burst, the five largest US investment banks have either filed for bankruptcy (Lehman Brothers), been acquired by other firms (Bear Sterns and Merrill Lynch), or have become commercial banks subject to greater regulation (Goldman Sachs and Morgan Stanley) 3 Foreign investors (mainly banks and governments) who had invested in mortgage-backed securities 4 Insurance companies (eg AIG) who had sold credit default swaps Credit default swaps are a type of contract that insures against the default of debt instruments, such as mortgage-backed securities The bursting of any housing bubble would be expected to have a negative effect on the economy for two reasons: First, home construction is an important economic activity and the decline in home construction would reduce GDP Second, the decrease in home prices would also reduce household consumption due to the wealth effect (See Example 1A on page 6-2) 11-9 The Federal Reserve System

10 But the bursting of this housing bubble caused more severe and widespread harm than would be predicted from just these two reasons As mentioned previously, most of the losses were suffered by the financial system, not by the homeowners The bursting of the housing bubble sent a shock through the entire financial system, increasing the perceived credit risk throughout the economy, as indicated by the TED spread The TED spread is the difference between the interest rate on three-month US treasury bills and the interest rate on three-month interbank loans as measured by the London Interbank Offered Rate (LIBOR) Example 16: The TED spread is considered a good indicator of the perceived credit risk in the economy Historically, the TED spread has ranged between 2% and 5% In August of 2007, the TED spread jumped above 1% and generally stayed between 1% and 2% until mid-september of 2008, when it began spiking upward, reaching a record level of over 45% on October 10, 2008 The TED spread finally fell back below 5% in June of 2009 The increased perceived credit risk throughout the economy meant that not only would home buyers find it more difficult to obtain financing, but so would commercial real estate investors, corporations seeking financing for investment, municipalities seeking to issue new bonds, etc Example 17: Real investment spending decreased by 33% from the third quarter of 2007 to the second quarter of 2009 By contrast, real consumption spending decreased by only 2% over this time period Government Intervention The bursting of the housing bubble did not immediately create widespread credit problems The TED spread did not significantly increase until August of 2007 When the credit crisis arising from the bursting of the housing bubble became apparent, the federal government began to intervene in the economy in unprecedented ways In September of 2007, the Federal Reserve began to take steps to attempt to ease the credit crisis On September 18, 2007, the Fed lowered the target for the federal funds rate from 525% to 475% Over the succeeding 15 months, the Fed would lower the rate nine more times, eventually to a range of 000%-025% on December 16, 2008 In December of 2007, the Fed began to lend billions of dollars directly to financial institutions (through such programs as the Term Auction Facility) to enhance the Fed s ability to provide liquidity to the financial system In February of 2008, the federal government enacted the Economic Stimulus Act of 2008 This was a $168 billion stimulus plan, consisting primarily of tax rebates to individual taxpayers The act also increased the dollar size of mortgages eligible for purchase by Fannie Mae and Freddie Mac In March of 2008, the Fed provided a $29 billion loan to facilitate the purchase of Bear Stearns, an investment bank on the brink of bankruptcy, by JPMorgan Chase From August of 2008 to December of 2008, the Fed increased the money supply (M1) by more than 14% On September 7, 2008, the Federal Housing Finance Agency placed Fannie Mae and Freddie Mac into conservatorship With the conservatorship, the federal government committed to provide up to $100 billion in additional capital to each of the GSEs On September 16, 2008, the Fed provided an $85 billion loan to AIG, the largest insurance company in the world, to prevent its bankruptcy The Fed received an 80% equity stake in the company The loans and lines of credit provided to AIG would eventually grow to over $180 billion In October of 2008, the Fed introduced facilities to purchase highly rated commercial paper and to provide backup liquidity for money market mutual funds These actions were intended to improve liquidity outside the financial sector The Federal Reserve System 11-10

11 On October 3, 2008, the $700 billion Emergency Economic Stabilization Act of 2008 was enacted The initial plan was to buy up illiquid mortgage assets from banks Instead, the bailout money was used to make direct investments in financial institutions On November 25, 2008, the Fed announced a program to provide up to $200 billion to support the issuance of asset-backed securities backed by newly and recently originated consumer and small business loans That same day the Fed announced another program to purchase up to $100 billion in the direct obligations of Fannie Mae and Freddie Mac and to purchase up to $500 billion in mortgage-backed securities backed by Fannie Mae, Freddie Mac, and Ginnie Mae On February 17, 2009, the federal government enacted a $787 billion economic stimulus plan, consisting mainly of new federal spending On December 17, 2010, the federal government enacted an $858 billion economic stimulus plan, consisting of tax cut extensions, new tax cuts, and new federal spending The Essential Cause of the Housing Bubble The severe recession that began in December of 2007 was caused by the bursting of the housing bubble and the resulting credit crisis Each of the four primary causes played an important role in creating the housing bubble and the credit crisis The combination of all four causes created a type of perfect storm causing the housing bubble to be extreme and the resulting credit crisis to be severe Three of the causes, though they contributed to the housing bubble, were not essential to the development of the bubble Low mortgage interest rates, low short-term interest rates, and relaxed mortgage lending standards all contributed to the housing bubble But the absence of any of these three causes would not necessarily have prevented the housing bubble For example, if mortgage interest rates had not been at historically low levels, a housing bubble could still have developed A housing bubble occurred in the late 1980s at much higher mortgage interest rates Likewise, without low short-term interest rates or relaxed mortgage lending standards, there still could have been a housing bubble, though it would have been less extreme The one essential cause of the housing bubble was irrational exuberance The housing bubble would not have occurred without the widespread belief that home prices would continue to rise And irrational exuberance contributed to the other three causes Mortgage interest rates would not have been so low if foreign investors and credit rating agencies had not believed that US home prices would keep rising Low short-term interest rates would not have led to such extensive use of ARMs and such a high degree of leveraging without irrational exuberance And relaxed standards for mortgage loans would not have led to such a large increase in subprime mortgages without irrational exuberance Study Guide for Chapter 11 Chapter Summary for Chapter 11 The Federal Reserve System (Fed) is the US central bank The governing body of the Fed is the Board of Governors, headed by the Chairman of the Board of Governors (Ben Bernanke) The Fed performs a number of important functions, including; (1) control the money supply, (2) supervise and regulate banking institutions, (3) serve as the lender of last resort, (4) hold banks reserves, (5) supply the economy with currency, and (6) provide check-clearing services The Fed influences the money supply by changing the monetary base, which is currency in circulation plus bank reserves When the Fed makes a purchase or a sale, the monetary base changes When the monetary base changes, the money supply changes by a multiplied amount The Federal Reserve System

12 The actual money multiplier is equal to the change in the money supply divided by the change in monetary base The Fed s primary tool for controlling the money supply is open market operations; the Fed buying and selling US government securities in the open market If the Fed buys securities in the open market, bank reserves increase, which leads to money creation To reduce the money supply, the Fed would sell securities The Fed can also control the money supply by changing the reserve requirement or changing the discount rate Lowering the reserve ratio would increase the money supply Lowering the discount rate would increase the money supply The economy entered into a recession in December of 2007 The primary cause of the recession was the credit crisis arising from the bursting of the housing bubble The four primary causes of the housing bubble were; (1) low mortgage interest rates, (2) low short-term interest rates, (3) relaxed standards for mortgage loans, and (4) irrational exuberance Mortgage interest rates in the US were kept low by an influx of savings from other countries Much of this saving was invested in mortgage-backed securities issued by Wall Street firms The low mortgage interest rates contributed to the housing bubble by keeping monthly mortgage payments affordable for more buyers even as home prices rose Fed policies caused short-term interest rates to be extremely low from 2002 to 2004 The low short-term interest rates contributed to the housing bubble by; (1) encouraging the use of adjustable rate mortgages, and (2) encouraging leveraging The use of adjustable rate mortgages made monthly mortgage payments temporarily affordable for more buyers and thus contributed to rising home prices Leveraging increased the financing available for mortgage lending, thus contributing to rising home prices In the mid 1990s, new governmental policies were enacted that contributed to a relaxing of standards for mortgage loans Greater competition in the mortgage industry contributed to relaxed mortgage standards As irrational exuberance caused the housing market to overheat, lenders relaxed their mortgage standards even further Irrational exuberance played a key role in the housing bubble All the participants who contributed to the housing bubble acted on the assumption that home prices would continue to rise Home prices kept rising for a long time, rewarding those who contributed to the bubble When the housing bubble burst, mortgage default rates began to rise Falling home prices meant that ARMs could not be refinanced, which reinforced the continuing fall in home prices Most of the losses caused by the bursting of the housing bubble fell not on homeowners but on the financial system, especially mortgage lenders, investment banks, foreign investors, and insurance companies The bursting of the housing bubble sent a shock through the entire financial system, increasing the perceived credit risk The increased perceived credit risk decreased investment spending When the credit crisis arose, the federal government began to intervene in the economy in unprecedented ways The Fed lowered the federal funds rate and greatly increased the money supply The Fed loaned billions of dollars to financial institutions The Fed provided loans to facilitate the purchase of Bear Stearns and to prevent the bankruptcy of AIG The federal government placed Fannie Mae and Freddie Mac into conservatorship and injected new capital into the GSEs The federal government enacted four economic stimulus plans, in February of 2008, in October of 2008, in February of 2009, and in December of 2010 The one essential cause of the housing bubble was irrational exuberance The housing bubble would not have occurred without the widespread belief that home prices would continue to rise The Federal Reserve System 11-12

13 Questions for Chapter 11 Fill-in-the-blanks: 1 The Federal Reserve System is the US bank 2 The most important function of the Fed is controlling the 3 The rate is the interest rate one bank charges another bank to borrow reserves 4 The rate is the interest rate the Fed charges banks that borrow reserves from it 5 is investing with borrowed money 6 mortgages are home loans given to persons who are considered a poor credit risk 7 is a heightened state of speculative fervor Multiple Choice: 1 The functions of the Fed include: a holding banks reserves b supplying the economy with currency c controlling the money supply d All of the above 2 A bank in need of reserves: a will usually borrow reserves from other banks b as a last resort, may borrow from the Fed c Both of the above d Neither of the above 3 Monetary base consists of: a currency in circulation b bank reserves c checkable deposits d Both a and b above 4 If the monetary base increases by $200 million and the money supply increases by $550 million, the actual money multiplier is: a 36 b 250 c 275 d 55 5 Open market operations refers to the Fed: a acting as lender of last resort for banks b changing the required-reserve ratio c buying and selling US government securities in the open market The Federal Reserve System

14 6 If the Fed buys US government securities in the open market: a bank reserves will increase b monetary base will increase c the money supply will increase by a multiplied amount d All of the above 7 If the Fed lowers the reserve ratio: a banks will be short on reserves b the money supply will decrease c Both of the above d Neither of the above 8 When a bank borrows from the Fed: a the interest rate paid is the discount rate b the Fed is injecting new reserves into the financial system c the money supply increases d All of the above 9 The Fed can decrease the money supply by: a lowering the required-reserve ratio b selling US government securities in the open market c lowering the discount rate d All of the above 10 The Fed s most important tool for controlling the money supply is: a printing more currency b changing the discount rate c open market operations d changing the required-reserve ratio 11 During the recession caused by the bursting of the housing bubble: a Real GDP decreased by over 5% for the year 2008 b the unemployment rate more than doubled from November of 2007 to October of 2009 c Both of the above d Neither of the above 12 From the 1 st quarter of 1997 to the 1 st quarter of 2009: a home prices increased by a steady 5% per year b home prices increased by over 132% and then decreased by over 32% c home prices increased by about 57% d Both b and c above 13 During the housing bubble, mortgage interest rates were low: a because of the high savings rate in the US b because of an influx of savings entering the US from other countries c Both of the above d Neither of the above 14 The low short-term interest rates from 2002 to 2004: a encouraged the use of adjustable rate mortgages b forced mortgage lenders to deleverage, thus triggering the bursting of the housing bubble c Both of the above d Neither of the above The Federal Reserve System 11-14

15 15 Leveraging: a increased the financing available for mortgage lending and thus contributed to rising home prices b increased the impact of the bursting of the housing bubble because the deleveraging contributed to falling home prices c Both of the above d Neither of the above 16 Beginning in 1996, Fannie Mae and Freddie Mac: a were required to hold an increasing percentage of mortgage loans to lowerincome households in their portfolios b began to relax the standards that mortgages had to meet to be classified as conforming c Both of the above d Neither of the above 17 The greater competition in the mortgage market caused by the internet: a meant that home buyers were no longer limited to borrowing locally b led to an increase in the average fee on a mortgage loan c forced all mortgage lenders to adopt stricter standards for their loans d All of the above 18 Subprime mortgages: a are home loans given to persons who are considered a poor credit risk b historically, have had a foreclosure rate almost twice as high as prime mortgages c charge a lower interest rate than conventional mortgages in order to encourage home ownership by lower-income borrowers d All of the above 19 The term irrational exuberance was first used by Alan Greenspan as he: a hinted in 1991 that a little irrational exuberance might help the economy recover from the recession of 1991 b hinted in 1996 that stock prices might be unduly escalated due to irrational exuberance c hinted in 1999 that irrational exuberance would carry the economy to continued rapid growth d described in 1997 how he felt about marrying the much-younger Andrea Mitchell 20 If a homeowner could have foreseen the bursting of the housing bubble and had sold their home in 2003: a they would have been better off than if they had sold their home in 2007, one year after the bubble burst b they would have been worse off than if they had sold their home in 2007, one year after the bubble burst c they would have been about as well off as they would have been if they sold their home in 2007, one year after the bubble burst 21 After Alan Greenspan made his irrational exuberance comment, the Dow Jones Industrial Average: a fell 2% at the opening of trading the next day b went into a long-term decline c increased by another 75% over the next three years d Both a and c above The Federal Reserve System

16 22 When the housing bubble burst and home prices began to fall: a the increase in foreclosures brought new buyers into the market, helping to slow the fall in home prices b the increase in foreclosures decreased the value of mortgage-backed securities, making it difficult for investment banks to issue new mortgage-backed securities c Both of the above d Neither of the above 23 The bursting of any housing bubble would be expected to have an impact on the economy because: a the decrease in home prices would free up more discretionary income leading to an increase in consumption b the decline in home construction would reduce GDP c Both of the above d Neither of the above 24 The increased perceived credit risk caused by the bursting of the housing bubble: a caused the TED spread to increase to a record level of over 10% in October of 2008 b caused real investment spending to decrease by over 80% from the third quarter of 2007 to the second quarter of 2009 c Both of the above d Neither of the above 25 In response to the recession caused by the bursting of the housing bubble, the federal government: a has enacted four economic stimulus plans b has imposed strict import restrictions to protect domestic jobs c has created jobs programs employing millions of workers and has deported millions of illegal immigrants d All of the above 26 The essential cause of the housing bubble was: a greed and corruption among investment bankers b weak oversight by government regulators c irresponsible borrowing by speculative homebuyers d irrational exuberance Problems: 1 Explain how the Fed buying US government securities in the open market will increase the money supply The Federal Reserve System 11-16

17 2 List the four causes of the housing bubble 3 List three factors that contributed to the relaxed standards for mortgage loans 4 Explain how the increase in foreclosures after the bursting of the housing bubble led to further increases in foreclosures Answers for Chapter 11 Fill-in-the-blanks: 1 central 5 Leveraging 2 money supply 6 Subprime 3 federal funds 7 Irrational exuberance 4 discount Multiple Choice: 1 d 10 c 19 b 2 c 11 b 20 b 3 d 12 d 21 d 4 c 13 b 22 b 5 c 14 a 23 b 6 d 15 c 24 d 7 d 16 c 25 a 8 d 17 a 26 d 9 b 18 a The Federal Reserve System

18 Problems: 1 When the Fed buys US government securities in the open market, bank reserves increase When banks have excess reserves, they make new loans This triggers the money creation process, leading to a multiplied expansion of the money supply 2 The four causes of the housing bubble were: (1) Low mortgage interest rates (2) Low short-term interest rates (3) Relaxed standards for mortgage loans (4) Irrational exuberance 3 Three factors that contributed to the relaxed standards for mortgage loans were: (1) Governmental policies aimed at fostering an increase in home-ownership rates, particularly among lower-income households (2) Greater competition in the mortgage loan market (3) The irrational exuberance of all parties involved in the mortgage lending process 4 The fall in home prices with the bursting of the housing bubble caused an increase in foreclosures The increase in foreclosures added to the inventory of homes available for sale This further decreased home prices, putting more homeowners in a negative equity position and leading to more foreclosures The Federal Reserve System 11-18