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

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1 Chapter 11 The Federal Reserve System, the Housing Bubble and the Subsequent Recession The Federal Reserve System (Fed) is the U.S. central bank. The governing body of the Fed is the Board of Governors, headed by the Chairman of the Board of Governors (Ben Bernanke). Functions of the Fed: 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. 6. Provide check-clearing services. 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. Note: Refer to Examples 1A and 1B in the textbook. When the monetary base changes, 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 For example: The Fed increases the monetary base by $150 million. The money supply increases by $375 million. The actual money multiplier is 2.5 ($375 million $150 million = 2.5). Tools for controlling the money supply: 1. Open market operations the Fed buying and selling U.S. govt. 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. Most important monetary policy tool. Note: Refer to Example 3 in the textbook or make up your own example. 2. Changing the reserve requirement. Lowering the reserve ratio would increase the money supply. Note: Refer to Example 4 in the textbook or make up your own example. Instructor s Manual 11-1

2 3. Changing the discount rate (the interest rate the Fed charges banks that borrow reserves from it). A bank in need of reserves can borrow from other banks (federal funds market) or from the Fed. Borrowing from the Fed will increase the money supply. Lowering the discount rate will increase the money supply. The economy entered into a recession in December of Note: Refer to the statistical data about Real GDP, the unemployment rate, the DJIA, and the budget deficit. The primary cause of the recession was the credit crisis arising from the bursting of the housing bubble. Note: Refer to the statistical data about home prices and to Example 5 on page Mortgage interest rates generally fell from 1982 through Note: Refer to Example 6 on page Mortgage interest rates in the U.S. 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 The low short-term interest rates contributed to the housing bubble by: (1) Encouraging the use of adjustable rate mortgages. ARMs made mortgage payments affordable for more buyers and thus contributed to rising home prices. For example: 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. (2) Encouraging leveraging (investing with borrowed money). Leveraging could increase investors returns. For example: 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 $3.7 million on equity of $10 million). Leveraging increased the financing available for mortgage lending and thus contributed to rising home prices. Instructor s Manual 11-2

3 The impact of the bursting of the housing bubble was increased by the degree of leverage in the economy. For example: 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 mortgagebacked 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 mortgagebacked securities. Many other highly-leveraged firms are going through the same deleveraging process, driving the price of mortgage-backed securities still lower. In the mid 1990s, new governmental policies were enacted that contributed to a relaxing of standards for mortgage loans. Note: Refer to the changes in the Community Reinvestment Act and the changes in the standards for Fannie Mae and Freddie Mac. With the internet came greater competition in the mortgage loan market. The greater competition contributed to relaxed mortgage standards. As the housing market heated up, lenders relaxed their mortgage standards even further. Loan originators who practiced originate to sell felt little concern for the longterm credit-worthiness of borrowers. Mortgage loans were originated and then quickly sold to investment banks, who issued mortgage-backed securities. The relaxing of mortgage standards is exemplified by the increase in subprime mortgages. Subprime mortgages increased from 5% of new home loans in 1994 to 20% in Irrational exuberance (a heightened state of speculative fervor) 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. Note: Refer to Example 11 on page Home prices kept rising for a long time, rewarding those who contributed to the housing bubble. For example: 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 It is not necessarily good to avoid irrational exuberance. Instructor s Manual 11-3

4 For example: 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. When the housing bubble burst, mortgage default rates began to rise. For example: Home prices fell by less than 2% from the 2 nd quarter of 2006 to the 4 th quarter of Foreclosure start rates increased by 43% over these two quarters, and increased by 75% in 2007 compared to Falling home prices meant that ARMs could not be refinanced. For example: 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). Falling home prices reinforced the continuing fall in home prices: (1) The increase in foreclosures added to the inventory of homes available for sale. (2) The increase in foreclosures made it difficult for investment banks to issue new mortgage-backed securities. Most of the losses caused by the bursting of the housing bubble fell not on homeowners but on the financial system, especially investment banks, mortgage lenders, foreign investors, and insurance companies. The bursting of any housing bubble would hurt the economy: (1) The decline in home building would reduce GDP. (2) The decrease in home prices would reduce consumption due to the wealth effect. The bursting of this housing bubble sent a shock through the entire financial system, increasing the perceived credit risk. For example: The TED spread is the difference between the interest rate on three-month U.S. treasury bills and the interest rate on three-month interbank loans as measured by the London Interbank Offered Rate (LIBOR). 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 4.5% on October 10, The TED spread finally fell back below.5% in June of The increased perceived credit risk decreased investment spending. For example: Real investment spending decreased by 33% from the third quarter of 2007 to the second quarter of By contrast, real consumption spending decreased by only 2% over this time period. Instructor s Manual 11-4

5 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 stimulus plans, in February of 2008, in October of 2008, in February of 2009, and in December of 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. Questions for Chapter 11 Fill-in-the-blanks: 1. The Federal Reserve System is the U.S. central bank. 2. The most important function of the Fed is controlling the money supply. 3. The federal funds rate is the interest rate one bank charges another bank to borrow reserves. 4. The discount rate is the interest rate the Fed charges banks that borrow reserves from it. 5. _Leveraging is investing with borrowed money. 6. _Subprime mortgages are home loans given to persons who are considered a poor credit risk. 7. _Irrational _exuberance is a heightened state of speculative fervor. Multiple Choice: d. 1. The functions of the Fed include: a. holding banks reserves b. supplying the economy with currency c. controlling the money supply a. Holding banks reserves is one of the functions of the Fed. b. Supplying the economy with currency is one of the functions of the Fed. c. Controlling the money supply is one of the functions of the Fed. d. All of the answers are correct. Instructor s Manual 11-5

6 c. 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 a. The usual practice for a bank in need of reserves would be to borrow from other banks in the federal funds market. b. As a last resort, a bank in need of reserves may borrow from the Fed. c. Both answers a. and b. are correct. d. Both answers a. and b. are correct. d. 3. Monetary base consists of: a. currency in circulation b. bank reserves c. checkable deposits d. Both a. and b. above a. See answer d. b. See answer d. c. See answer d. d. Monetary base consists of currency in circulation plus bank reserves. c. 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 c d. 5.5 a. See answer c. b. See answer c. c. Actual money multiplier = Change in Money Supply Change in Monetary Base = $550 million $200 million = 2.75 d. See answer c. c. 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 U.S. government securities in the open market a. See answer c. b. See answer c. c. When the Fed buys and sells U.S. government securities in the open market this is open market operations. d. 6. If the Fed buys U.S. 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 Instructor s Manual 11-6

7 a. If the Fed buys U.S. government securities in the open market, bank reserves will increase. b. If the Fed buys U.S. government securities in the open market, monetary base (which includes bank reserves) will increase. c. If the Fed buys U.S. government securities in the open market, the increase in monetary base will set off the money creation process, resulting in a multiplied increase in the money supply. d. All of the answers are correct. d. 7. If the Fed lowers the reserve ratio: a. banks will be short on reserves b. the money supply will decrease a. If the Fed lowers the reserve ratio, banks will have excess reserves. b. If the Fed lowers the reserve ratio, the money supply will increase. c. Neither of the answers is correct. d. Neither of the answers is correct. d. 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 a. When a bank borrows from the Fed, the interest rate the Fed charges the bank is called the discount rate. b. When a bank borrows from the Fed, the reserves in the financial system increase. c. When a bank borrows from the Fed, the increase in reserves causes the money supply to increase by a multiplied amount. d. All of the answers are correct. b. 9. The Fed can decrease the money supply by: a. lowering the required-reserve ratio b. selling U.S. government securities in the open market c. lowering the discount rate a. Lowering the required-reserve ratio would increase the money supply. b. Selling U.S. government securities in the open market would decrease the money supply. c. Lowering the discount rate would increase the money supply. d. Only answer b. is correct. c. 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 Instructor s Manual 11-7

8 a. See answer c. b. See answer c. c. The Fed s most important tool for controlling the money supply is open market operations. d. See answer c. _b._ 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 a. Real GDP was flat for the year b. The unemployment rate did more than double, from 4.7% to 9.7%. c. Only answer b. is correct. d. Answer b. is correct. _d._ 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 a. This is incorrect. b. The home price index increased by over 132% from the 1 st quarter of 1997 to the 2 nd quarter of 2006, and then decreased by over 32% from the 2 nd quarter of 2006 to the 1 st quarter of c. Home prices increased by about 57% over this entire period. d. Both b. and c. are correct. _b._ 13. During the housing bubble, mortgage interest rates were low: a. because of the high savings rate in the U.S. b. because of an influx of savings entering the U.S. from other countries a. The savings rate in the U.S. was low. b. The influx of savings entering the U.S. from other countries helped to keep mortgage rates low. c. Only answer b. is correct. d. Answer b. is correct. _a._ 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 Instructor s Manual 11-8

9 a. The low short-term interest rates encouraged the use of ARMs. b. The low short-term interest rates encouraged leveraging not deleveraging. c. Only answer a. is correct. d. Answer a. is correct. _c._ 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 a. This is correct. b. This is correct. are correct. d. Both of the above are correct. _c._ 16. Beginning in 1996, Fannie Mae and Freddie Mac: a. were required to hold an increasing percentage of mortgage loans to lower-income households in their portfolios b. began to relax the standards that mortgages had to meet to be classified as conforming a. HUD required this for Fannie Mae and Freddie Mac. b. To meet the requirement, Fannie and Freddie relaxed the standards for conforming mortgages. are correct. d. Both of the above are correct. _a._ 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 a. This is correct. b. The greater competition led to a decrease in the average fee on a mortgage loan. c. The greater competition led to a relaxing of standards. d. Only answer a. is correct. _a._ 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 Instructor s Manual 11-9

10 a. This is correct. b. Subprime mortgages have had a foreclosure rate 10 times as high c. Subprime mortgages charge a higher interest rate to offset the greater risk of default. d. Only answer a. is correct. _b._ 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 a. See answer b. b. This is the correct answer. c. See answer b. d. See answer b. _b._ 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 a. See answer b. b. The home price index was higher in 2007 than in c. See answer b. _d._ 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 a. This is correct. b. See answer c. c. This is correct. d. Both a. and c. are correct. Instructor s Manual 11-10

11 _b._ 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 mortgagebacked securities a. This is correct. b. See answer a. c. Foreclosure rates increased much more for ARMs than for fixed rate mortgages. d. Only answer a. is correct. _b._ 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 a. The decrease in home prices would lead to a decrease in consumption due to the wealth effect. b. This is correct. c. Only answer b. is correct. d. Answer b. is correct. _d._ 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 a. The TED spread increased to over 4.5%. b. Real investment spending decreased by 33%. c. Neither of the above is correct. is correct. _a._ 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 Instructor s Manual 11-11

12 a. This is correct. b. This hasn t happened. c. This hasn t happened. d. Only answer a. is correct. _d._ 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 a. See answer d. b. See answer d. c. See answer d. d. This is the correct answer. Problems: 1. Explain how the Fed buying U.S. government securities in the open market will increase the money supply. When the Fed buys U.S. 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. List the four causes of the housing bubble. (1) Low mortgage interest rates (2) Low short-term interest rates (3) Relaxed standards for mortgage loans (4) Irrational exuberance 3. List three factors that contributed to the relaxed standards for mortgage loans. (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. Explain how the increase in foreclosures after the bursting of the housing bubble led to further increases in foreclosures. 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. Instructor s Manual 11-12

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