PA 315 Government Business Relations

Lecture 4

The Late-2000s Financial Crisis

Learning Objectives
Understand the background of the late-2000s financial crisis Understand how government policies interact with market Understand the implications of corporate social responsibility in exacerbating financial swings Apply models of government business relations to interpret current events

Factors in the Economic Crisis

Decrease in Personal Wealth (i.e. housing prices, stock prices)

Decrease in spending; Increase in uncertainty (i.e. investment)

Decrease in demand of goods and services; Reduced inputs for production

Rise in unemployment; other social and economic problems

National averages in housing

Housing trends National

Historic growth since 1940 Money moved from dot.com to housing after 2000 By 2003 the housing sector started to skyrocket in most places Bubble started to burst in 2007, dropped precipitously in 08 and 09, and has continued small decline to date (about 20% nationally)

California Trends
The national trends disguise the effects on the hot markets: West Coast, AZ, NV, TX, and Florida which were on boom-bust cycle In early 2007 the median house in CA was over $500,000. Today southern CA median is $270,000. (7% drop in 2011)

Background: Supply-side support by governmentstep 1

Mortgage interest deductions a part of national policy

Started in 1913 Became very substantial in the 1950s Became one of the major investment strategies of the American family

Background: Supply-side support by governmentstep 2

The creation of mortgage-backed securities market

1930~1940s Creation of Federal Home Loan Banks and Federal National Mortgage Association (Fannie Mae) 1960~1970s Privatization of Fannie Mae and the creation of Federal Home Loan Mortgage Corporation (Freddie Mac) 2000s: allowed risk to be disguised in bundled and securitized arrangements with Fannie and Freddie taking on larger and larger risks; when markets dont
function primarily on risk, problems will eventually occur

Background: Other Causes

Push for sub-prime (riskier) lending: for different reasons

Spurred by HUDs affordable housing goal for Fannie Mae and Freddie Mac (under both D and R) gov Rose from below 10% to nearly 20% Profits from subprime loan bundles were wonderful (so lots of private investors held around the world)
The Fed lowered rate from 6.5% to 1.0% (2000 to 2003); only went to 5.25% to cool market; again dropped precipitously after crash in 2008 A flood of funds from foreign countries flowed in to U.S.

Encouraged borrowing (U.S. policy)

Causes, cont.

Weak and fraudulent underwriting practices boomed in 2000s and became common practice

Down payments Income and assets proof Suspicious Activity Reports pertaining to Mortgage fraud increased by 1,411 percent between 1997 and 2005

Predatory lending:

Bait and switch lending practices Encouragement of unrealistic loans

Frenzy in housing market (euphoria) and stock market

Investors swarmed to housing Home-owners moved up as much as possible

Deregulation: Banks were deregulated through:

The Depository Institutions Deregulation and Monetary Control Act of 1980 (allowing similar banks to merge and set any interest rate). The GarnSt. Germain Depository Institutions Act of 1982 (allowing Adjustable-rate mortgages). The GrammLeachBliley Act of 1999 (allowing commercial and investment banks to merge).

Government Response

The Bailout and other support

$700 billion to purchase the toxic assets (borrowing $1.7 trillion: $250 b deficit + $700 b bailout + $800 b stimulus package of 2009) Housing and Economic Recovery Act of 2008 (300 b)
Wall Street Reform and Consumer Protection Act of 2009 (Dodd-Frank legislation)

Some re-regulation

Impacts to US Economy

Housing: drop in values; foreclosures; tax revenue

reduction at state and local level

Unemployment

From 4.2% to 10.1% Oct. 2009; 8.5 in early 2012

Real GDP Decrease Stock market drop: Nearly 50% from peak to bottom;
currently about 15% from peak

Distribution of wealth worsened: The top 1% who

owned 34.6% of the nation's wealth in 2007 increased their proportional share to 37.1% by 2009

Global effects: hardest hit, Europe; least, Asia

How the Decision of Bailout Was Made?

Watch the video:

Inside the Meltdown

Discussion
Do you think the $700 billion bailout is a wise decision and based on what timeline? (e.g., short term risk of depression and long-term moral hazard) Who should be responsible and who should assume the burden? What are the ethical implications? Should government regulate more than Dodd-Frank or less? Use the four Government-Business models to explain your answer (market capitalism, dominance,

countervailing forces, corporate social responsibility)