Understanding The Economic Crisis

in Plain English
Bruce Judson
Senior Faculty Fellow,
Yale School of Management

At Poughkeepsie Day School

December 9, 2008

Copyright 2008 Bruce Judson

Todays Talk
Provide a foundation for
understanding what is happening
and assessing future events
A test of success: Understanding
how each days news stories fit into
our overall framework
Give you the tools to ask the right
questions
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Todays Approach
Discussion assumes no prior knowledge of economics
or finance
Many concepts are simplifiedto meet time
constraints
Only the U.S. is discussedalthough this is a global
crisis
Special emphasis on explaining jargon so you can
more easily follow future events in the newspaper
No moral judgments
No blame
Emphasis on describing what has happened, not
on saying this was good or bad
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The Best Way to Understand the Crisis:

A Domino Effect
Housing Bubble
Housing Crisis
Credit Crisis
Stock Market Decline
Lower Consumer Spending
Decreased Company Profits
Layoffs & Job Cuts
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The Crisis Begins with Home Prices

Early 2000s: Historic Home Price Increases

What is a Home Price Index?

The same house bought
in 1987 for $100,000
(Index =100)

Is worth $171,000 in
2005 (excluding
inflation) (Index = 171).

A Traditional 30 Year Fixed-Rate Home Mortgage:

Buyer Pays 20% and Borrows 80% From the Bank
To Buy a $200,000
Home
Down-Payment of
$40,000 (20%)
Borrow $160,000
from the bank
(80%)

At 4% interest

monthly payment of
$764.
At 8% interest
monthly payment of
$1,174.

The Value of a Traditional Mortgage

Buyer shows she is responsible by first saving $40,000.

With a set monthly fee, buyer always knows how much
she will pay each month for 30 years
Banks also verified the income of borrowers to make
sure they could handle the monthly payments.
If the buyer cant pay her mortgage the bank gets the
house (foreclosure) to pay-off the remaining mortgage
(from the $160,000)
The buyers down-payment ($40,000) protects the
bank in case the houses value goes down.
Foreclosure example: The house declines in value to
$180,000 and the buyer owes $160,000 --- The bank
sells the house, gets its $160,000, and the buyer
gets back $20,000.

The Housing Bubble Begins: As Home Prices

Start Their Huge Rise, Everyone Assumes
Home Prices Will Never Go Down

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Banks Create Easy Low-Interest Mortgages :

These High Risk Loans Are Called Sub-Prime Mortgages

No money down
Borrow 100% of the Purchase Price
(No protection for the bank if prices drop and
buyer is foreclosed)
No Income Verification Loans
To qualify for loans buyers need a certain
income.
Now, banks dont check if buyers really have
the income.
Interest Only loans
Low payments for the first few years of the
mortgage
Then, monthly payments jump!
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Home Prices Rise: People Feel Rich!

The house I bought for
$200,000 is now worth
$300,000.
I am $100,000 wealthier!
Maybe I should borrow
more and buy an even
bigger housebefore
prices go up even
further?
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As Home Prices Rise, Banks Also Encourage

Existing Home Owners to Borrow More
Your Home is worth
$100,000 more.
Refinance or get a Home
Equity Loan to access your
higher wealth!
Home prices never fall so
you dont need to worry
about borrowing too much.
People borrowed more
money than they could
prudently afford.
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What is a bond?
Bonds are a way for governments and
businesses to borrow money.
Hypothetical Example: A $100 U.S.
savings bond
You give the government $100
today.
In return, you get 7% of $100 ($7)
each year for 20 years.
At the end of 20 years you get
back your $100.
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Bonds and the Risk of Default

Bonds have risks
If a company (or anyone else) issues a
bond, there is always the chance they
may not be able to pay back the money
they borrowed (default).
Higher risk companies issue junk
bonds which pay higher interest rates.
The higher interest rates compensate
buyers for the added risk of default.
The U.S. Government is seen as the safest
borrower
So, U.S. Government bonds pay lower
interest ratessince they have less risk.
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Wall Street Bundles Subprime Loans

into Bonds

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Mortgage-Backed Subprime Bonds Become

A Hugely Profitable Business for Banks and
Wall Street Companies
Banks get a fee for creating the mortgage and
selling it to Wall Street companies.
Wall Street companies get fees for turning
the mortgages into bonds and selling them.
These mortgage-backed securities are sold
to investors (such as pension funds).
Many Wall Street companies also hold large
amounts of these bonds as investments.
These bonds are also called CDOs
Collateralized Debt Obligations.
The bonds are seen as low risk because
many mortgage buyers wont default at once.
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No One Worries About Risk

Traditionally, neighborhood banks kept the
borrowers mortgage
They lost money if the borrower
defaulted and the foreclosure value was
less than the money owed.
Now, the banks and Wall Street firms are
earning fees for selling mortgage bonds
which are sold to investors as low-risk
Remember, these bonds are based on
100% down and no income verification
mortgages.
Plus, refinanced and home equity loans
based on rising home values.
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Then, Home Prices Start to Fall

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As Home Prices Fall, People Owe More For

Their Mortgage Than Their Home Values
Extreme example:
A Family Borrows $300,000 to buy a
home with a no down payment
mortgage.
Now, the home is only worth
$200,000.
If the family defaults, the bank loses
$100,000 (remember the bank takes
back the house and sells it)
So long as the family keeps paying
the mortgage the decline in the
value of the home has no effect
(except that the family feels poorer).
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As Home Prices Fall, Subprime

Borrowers Default at High Rates

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Falling Home Prices and Rising Default Rates

Create A Crisis For Wall Street Companies
Subprime bonds (now called toxic
mortgages) are worth much less than
anyone thought
Since borrowers are defaulting the
monthly payments disappear.
With default and foreclosure, the
bond owners get paid the value of
the homes with the defaulted
mortgages.
But, the homes have declined in
value and are worth much less than
the amount borrowed.
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As Defaults Continue, Millions of Families

Are Losing Their Homes

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For Wall Street, The Credit Crisis Has

Two Components:
First, many firms invested
in mortgage-backed
securities that have now
plummeted in value
These companies cant
meet their obligations.
Leading to bankruptcies
and mergers (required
by the government).
Second, it is a crisis of trust.
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The Credit Crisis and Trust:

What Happened in Early Fall 2008
Every day companies borrow money for shortterm needs (such as payroll) .
Credit is the life blood of the financial system.
But, no one knows which financial firms are
effectively bankruptbecause they have
invested in toxic mortgage bonds.
So no one trusts anyone elseand lending
slows.
The financial system is in danger of grinding to
a halt.
The 700 billion government bailout plan is
passed by Congress to keep credit flowing.
The Federal Reserve (an independent
government agency) takes massive actions to
keep credit flowing.
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What Are Stocks?

A share of stock is the partial ownership of a company.
Example: You start a business and want to raise money to build a new factory
So you divide your ownership into 100 shares of stock.
You keep 30 shares and sell 70 shares to the public through the stock
market.
Now, these 70 shares own 70% of the company
After all salaries, including yours, the 70 shares are entitled to 70% of
the companys profits.
A Stock price goes up if buyers think the company will be more
profitable in the future They believe over time its shares will be
worth more.
A Stock prices goes down if people think the companys profits will go
down in the future, and sell their shares in the company.
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Credit Crisis Leads to the Stock Market Crisis

As the credit crisis unfolds, people realize it is going to be more

expensive for businesses to borrow money
These higher borrowing costs will reduce profits in the future
Plus, It is going to be harder to get loans.
And financial companies are worth less than anyone thought
(because they are holding toxic mortgages).
People are also going to spend less since they feel less wealthy as
home prices go down
This will also hurt company profits.
Peoples confidence in a prosperous future plunges.
All of this leads people to sell stocks (because they believe profits
will go down in the future) and the value of most stocks decline
dramatically
At the end of last week, stock prices were down an average
of 35% in 2008.
Savings in stocks (for pensions, college, etc) of $100,000 at
the start of 2008 are now worth $65,000.
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The Wealth Effect and Consumer Spending

Consumer spending (people) is
70% of our economic activity
As stock values fall and home
prices decline, people feel less
wealthy
When people feel poorer they
spend less money.
By spending less money they
lead to lower business profits
This is called the wealth
effect.
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Lower Consumer Spending is Reducing Profits,

So Companies Are Cutting Jobs
Housing Bubble
Housing Crisis
Credit Crisis
Stock Market Decline
Lower Consumer Spending
Decreased Company Profits
Layoffs & Job Cuts
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The Recent News on Jobs

On Friday, the Labor Department

estimated that about 530,000 jobs were
cut in November.
Bringing the total job losses this year
to almost 2 million.
In addition, we need to create more
than 100,000 new jobs a month to
keep up with population growth
(young people starting to work)
Unemployment is now at 6.7% (percent of
workers without jobs who want them) and
likely to increase.
Unemployment plus underemployment
(people working part-time or fewer hours,
but want full time) is now about 12.5%
and likely to increase.
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The U.S. Car Companies

As people started spending less, they stopped buying

new cars.
New car sales decreased dramatically and quickly.
GM, Ford and Chrysler already had business problems,
but lower consumer spending made them much worse,
very quickly.
This shows how this crisis increases the problems of
companies that already have business problems.
Unfortunately, many companies (but not necessarily the
car companies) will go bankrupt (close up) before this is
over because lower spending hurts their businesses so
badly.
Many store chains (retailers) have now declared
bankruptcy and will close.

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A Bad Cycle
People
have less
confidence

Lower
housing &
stock prices

People
Spend Less

Job Cuts

Lower
Profits

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President-Elect Obama
On Saturday, President-elect
Obama said things will get
worse before they get better
But, we can and will fix this
bad cycle
He plans large-scale government
spending on infrastructure
construction projects (roads,
bridges) to create jobs and
stimulate spending
With government spending, he
hopes to break this bad cycle
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How Government Spending Can Break The Bad Cycle

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Debates on Government Policy

When you see a new problem, you

experiment with solutions.
All of this happening at once is effectively
a new problem.
The government is experimenting with
solutions
To find the best ways of fixing these
problems.
Plans could change if government officials
decide other solutions will work better
and some experiments will not work.
Experimentation is good.
Franklin Roosevelt was experimenting
when he created New Deal programs, such
as social security, to end the Great
Depression in the 1930s.
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What All of This Means for Everyone

Everyone is affected in some way.

Unfortunately, even people who are prudent,
pursue responsible lives, work hard, and have
saved money are being hurt
Some people will have job problems.
Some people will have retirement problems
(lower stock values reduced the money that
pays for pensions and retirement plans).
Many people have savings in stocks for
future plans (such as college & retirement)
which are now worth much less.
Its much harder for people who need
money to borrow particularly since their
home values have decreased.
Millions more families are projected to lose
their homes in the next two years (unless
the government intervenes).
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A Few Ending Thoughts

This is a very difficult moment
So cut your parents some slack
This crisis demonstrates we are all connected
If your neighbor loses his home, the value
of your home goes down.
If America loses its car industry, the job
cuts and loss of our manufacturing base
will hurt us all.
A crisis is a chance to rebuild in a better way.
Now is the time to focus on solutions not
blame.
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