Title:
1Everything You Wanted to Know About the Current
Financial/Economic Crisis, but were Afraid to
AskOr Where are we, how did we get here and
where are we headed?
- Professor Michael Palmer
- Leeds School of Business
- Presentation to Eastside Residential Brokers
- Bellevue, Washington
- December 5, 2008
2Quick Bio
- Michael Palmer, Professor of Finance, Leeds
School of Business, University of Colorado. - Education Ph.D. University of Washington, 1967
(Finance and Macro-economics) - Visiting Professor Status Kansai Gaidai
University, Osaka, Japan Jiao Tong University,
Shanghai, China Semester at Sea - Academic Director London Seminar in
International Finance
3Ben Bernankes View and My View
- Ben Bernanke (April 10, 2008)
- "We now know the lessons from the Depression.
We are certainly going to make sure that the
financial system remains in good functioning
order. - My view
- We are in an unprecedented economic slowdown,
caused by a combination of (1) a historically
financial market freeze, (2) a massive negative
wealth effect resulting from a dual real estate
and stock market collapse and (3) a collapse of
consumer confidence. - In this unique environment, the past is probably
not a particularly good road map for the present
nor the future. - True for policy makers and forecasters.
4Goal of this Presentation
- Three primary issues to be covered today
- (1) The Past How did we get here aka How Did we
Get into this Mess in the First Place? - (2) The Present Where Are we Today?
- (3) The Future Where Might we be Going?
- With focus on the national and global economies.
5Theme of Presentation
- The country is caught in an unprecedented crisis
involving a - (1) lack of confidence in its financial markets
and financial institutions. - Affecting interbank and external lending and
essentially freezing these critical markets. - (2) a collapse of stock prices and real estate
prices. - Resulting in massive negative wealth effects.
- (3) a collapse of confidence of consumers in the
economy and in their situation. - Affecting household spending
6What we Must do
- We cannot let the financial system fail.
- The financial system is the grease that keeps the
economy going. - We need to shore up financial market liquidity
and provide direct lending where markets are not
functioning. - We need to address mounting home foreclosures.
- Currently in foreclosure (2.97 of all mortgages)
and 30 days overdue 6.99 both figures at the
highest level since data was collected 29 years
ago. - We need to restore consumer confidence.
- No magic bullet here, but it is likely a
combination of political and fiscal stimulus.
7Issue 1 How Did We Get Here
- How did this happen?
- The 2002-2006 period was characterized by
over-stimulative monetary and fiscal policies
which contributed to a surge in (1) financial and
real asset prices along with (2) skyrocketing
consumer debt. - And created unsustainable Super Bubbles
- The first bubble to burst was the housing bubble.
8Housing Leads the Way
- August 2007, the sub-prime mortgage market
surfaces as a potential issue. - A combination of economic and financial factors
results in rising home foreclosures. - Foreclosures in 3Q06 223,223
- Foreclosures in 3Q07 446,726 (100)
- Foreclosures in 3Q08 765,558 (71) and the
highest since records began in January 2005.
9And Housing Continues to Suffer
- Housing prices, starts and sales slide.
- New house prices 3Q08 -16.6 from 3Q07 (Median
price of 218,000 in Oct is lowest since
September 2004) - Existing house prices Oct 08 Median price
183,000, down 11.1 from a year ago. - Housing starts Oct 08 791,000 annual rate
(lowest since records began in 1959). - Sales of new homes Oct 08 -5.3 annual rate to
433,000 annual units (lowest since January 2001
and 40 lower than a year ago) - Sales of existing homes Oct 08 -3.1 annual
rate to 4.98 million units
10Enter Securitization
- Financial institutions were also involved in the
securitization (i.e., pooling and distribution)
of loans (sub-prime mortgage loans, commercial
real estate loans, consumer loans, student
loans). - This took place at the same time that rating
services were unable (or unwilling) to
successfully evaluate the risk associated with
these loan packages. - Regulations, unfortunately, did not keep pace
with changing financial structure.
11Financial Market Freeze
- While there were sub-prime market danger signs
as far back as August 2007, U.S. financial
markets really began to freeze up in early to
mid-September 2008 around the time of - the Fannie Mae/Freddie Mac bailout (Sept 8),
- Lehman Brothers failure (Sept 12),
- Merrill Lynch take-over by BofA (Sept 15),
- AIG 85 billion rescue plan (Sept 16th)
- Washington Mutual take-over by JPMorgan (Sept
25th) - Federal Reserve rescue of commercial paper
markets (Oct 7).
12Manifestations of Financial Market Freeze
- Freeze was manifested in
- Spreads of investment grade corporate bonds
(e.g., Aaa and Baa) over Treasury bonds rising
to record levels. - Commercial paper market and investment grade bond
markets shutting down. - Money market fund outflows (some broke the
buck). - Increasing interbank lending spreads to default
free returns (in the Fed funds and LIBOR markets) - Reflecting a lack of confidence in financial
institutions and over-all risk aversion
13Corporate Spreads
- Both a measure of risk aversion and confidence.
- Baa-Aaa average spread (1977 to Present)
107basis points. - Dec 2, 2008 349
- Baa-10 yr Govt average spread (1977 to Present
208 basis points. - Dec 2, 2008 612
14TED Spread Interbank Markets Lack of Confidence
in One Another
- TED Spread (another measure of confidence and
risk aversion) - TED 3-month LIBOR rate
- 3-month T-Bill rate
- January 1990 to July 2007 the TED spread averaged
41 basis points. - In October 2008 the spread reaches 464 basis
points (the highest since data collection began
in 1971. - Reflected a frozen interbank market.
15Response of U.S. to Freeze
- U.S. responded with 700 billion bailout package
(Troubled Asset Relief Program, Oct 3rd ) and
Federal Reserve interest rate reductions and
Federal Reserve emergency loans/liquidity
injections. - TARP program has thus far injected 350 billion
(250 billion to buy equity states in banks and
100 billion to AIG). - On November 24, the Government announces it
(Treasury and Fed) is prepared to lend more than
7.4 trillion to rescue financial markets. - This is roughly equal to 50 of nominal U.S. GDP
16Result of U.S. Credit Freeze on Financial Players
and Markets
- Bailouts or sales of financial institutions
(Fannie Mae, Freddie Mac, AIG, Merrill Lynch,
Citigroup) - Disappearance of stand-alone U.S. investment
banking firms. - Bankruptcies of long standing financial
institutions (Lehman Brothers and Bear Sterns) - And, within a short period of time, the U.S.
credit freeze spreads to overseas financial
markets.
17Freeze Spreads to Real Economy
- The ripple effects of the credit freeze quickly
spread to the consumer sector where we saw a
rapid decline in consumer spending. - The combined freezing of credit and the decline
in consumer spending become the main drivers in
pushing down the real economy. - At the same time, and in response to the crisis,
an erosion of confidence in the financial system
and in the economy itself takes hold. - Further affecting consumer and business spending.
18But how Did We Get to this Point?
- Federal Reserve responds to the 2000 dot-com
stock market crash and terrorist- attack
induced recession of 2001. - NASDAQ loses 72 of its value SP 500 loses 46
DJ loses 29 - Greenspan pushes Fed funds rate to 1.0 (levels
not seen since the 1950s)
19Greenspan Pushes Real Interest Rates Below Zero
- The real rate of interest is the market rate
adjusted for the rate of inflation (or market
interest rate inflation) - A high real rate is regarded as a very
restrictive policy stance, while - A low or negative rate is seen as very easy
policy stance. - Why? Lenders will pay back loans with cheaper
money.
20And Real Interest Rates Fall on Long term Debt as
Well
21Creation of Super Bubbles
- Excessively expansionary monetary policy, results
in - Falling real rate of interest
- Which in turn over-stimulates borrowing and
economic activity. - And creates the seeds for the super bubbles!
22Creation of The Super Bubbles
- Stock Market 2003 2007 Dow Up 76.5
- Housing Market 1998-2006 Real House Prices Up 8
per year
23And Super Debt Bubbles
- Total U.S. Debt as a of GDP Over 325
- Debt Market Household Debt Rising to 130 of GDP
(While Savings Falls)
24U.S. and the Rest of the World
- U.S. Debt with the Rest of the World Current
Account Deficit 200 Billion a Year by 2007
- And our Dollar Starts to Fall
25End of the Super Bubbles Negative Wealth Effects
- Stock Market Oct 2007 to Present 44 (-100
- 3 in consumer spending)
- Housing Prices Peak 2Q06 - 18 (-100 -13 in
consumer spending)
26Consumer Confidence Goes South
- Consumer Confidence Index (CCI)
- CCI October 07 95.6
- CCI October 28 -23.04
- CCI November 25 44.0
- This is probably the most widely reported
consumer confidence measure. - The index is released by the Conference Board on
the last Tuesday of each month (ever since 1967). - CCI is a mail survey of about 5,000 households.
27And Consumers Cut Back on Spending
- Why is this Sector Important?
- Consumption Excluding Real Estate (monthly data)
- Household spending represents 68 of GDP
- Household spending peaked in 2Q08 (May 2008).
- Consumer spending fell by 3.7 in the 3Q08 (which
was the first quarterly negative change since
1991)
28But As Noted Slowdown Started Earlier in
Residential Real Estate
- Why is this Sector Important?
- Real Residential Investment, Billions of
- While residential housing represents about 3.5
of real GDP, it is one of the most volatile
components in GDP (fluctuations of /- 20 in one
year). - This sector has a large economic spillover effect
(indirect effects) which is estimated at from /-
.5 to 1.1 percentage points to GDP growth. - GDP account peaked in 4Q05
29Spillover to Business Sector
- Producers durable equipment (machinery, trucks,
communications equipment, etc) represents about
11 of real GDP. - It is regarded as a derived investment.
- Based on final demand.
- Peaked in 2Q08
30Quick Review of Current Situation
- U.S. in a housing lead slowdown
- Financial crisis spilling over to real economy
through - Growing loss of confidence resulting in
- Frozen financial markets
- Falling asset prices (Good-bye Super Bubbles)
- Negative wealth effects from equities and real
estate continue. - Consumers cutting back and,
- Negative GDP growth (NBER 12 month to date
recession) - Now nicknamed the Great Recession.
- Weakened financial institutions requiring ongoing
government assistance. - Weak household balance sheets (too much debt).
- Global contagion effect (economic slowdowns in
Europe and Asia) which complicate U.S. recovery
31Impact of Credit Freeze and Spending Reductions
Issue 2 Where are We Today?
- Traditional definition
- Two consecutive quarters decline in real GDP.
- In the 3rd quarter of 2008, GDP fell -0.5, after
rising 2.8 in the 2rd quarter. - NBER data
- Put the beginning of this recession as December
2007. - Which would put us 12 months into current
recession.
32What Has been the Federal Reserves Monetary
Policy Response to the Financial Crisis?
- Lowered Interest Rates From 5.25 to 1.0
- Injected Liquidity Monetary Base Oct 33
33Observations on Interest Rate Changes
- While lower interest rates might make us feel
better -- they have done little up to now to
stimulate buying or lending or to restore
confidence. - Questions regarding interest rate policy
- (1) Are we getting dangerously close to a
Keynesian liquidity trap where low interest
rate discourage lending? And if so, - (2) Has the Fed really adopted a quantitative
easing policy whereby injecting financial
markets with liquidity become the overriding
policy? And if so, - (3) Is the Fed setting the stage for the next
bubble?
34Whats the Problem with Lowering Interest Rates
Even More?
- Elastic Demand for Liquidity
- We may be facing a form of the Keynesian
liquidity trap? - Liquidity-preference may become virtually
absolute in the sense that almost everyone (i.e.,
banks) prefers cash (reserves) to holding a debt
(a loans) which yields so low a rate of
interest.... - John M. Keynes, General Theory (1936)
- Monetary policy will not work at this point
because lenders are not willing to make loans.
35And if we are at this point, has the Fed Adopted
Quantitative Easing?
36Effective Fed Funds Rate Versus Target Rate Since
Oct 29th
37And Whats been Happening to the Real Interest
Rate During this Time?
- Fed Reserve Interest Rate Policy
- With its initial easing of the fed funds rate in
September 2007, the fed has lowered rates 9 times
from 5.25 to 1.0. - In December 2007 the real rate reached 0.
- Since that time it has been negative.
38Observations on Liquidity Injections
- Fed and Treasury Department have responded with
injections (actual and announced) of large
amounts of liquidity into the financial system. - 3 Issues to think about
- (1) The government is becoming a major
shareholder in banks and other financial
institutions. - Globally, governments have estimated holdings of
500 billion in their banks, or about 25 of
current market values. - Is there a risk of creeping intervention in the
day-to-day management of these banks (e.g.,
Japan in the 1990s). - How will governments sell back such large
positions?
39Observations on Liquidity Injections
- (2) How does the government prevent banks and
other financial institutions from simply choosing
to shore up their capital base as opposed to
making loans to sound business firms and
households. - This is bank-lending liquidity trap.
- U.S. position thus far has been to encourage
lending -- but there is not much accountability. - France has actually mandated lending quotas to
their banks. - Should the U.S. do this?
40Observations on Liquidity Injections
- (3) There is the danger that the Fed and Treasury
Department will go too far, setting the stage for
a big rise in inflation or more asset bubbles in
the future. - At this point, however, the downside risk with
this massive liquidity injection is overshadowed
by the risk that the economy could spiral into a
deflationary nosedive. - But at some point, this liquidity will have to be
neutralized (sterilized or withdrawn).
41Lets See What the Market Done With Some of this
Liquidity?
- Impact on Yield Curve July 2007 End of October
- Investing in Safe-Haven financial assets
because of an increase in risk aversion - Moving into U.S. Treasury bills and U.S. Treasury
notes. - A global movement.
- Biggest impact on shorter segment of U.S. yield
curve pushing down the short end of the curve.
42And the Yield Curve Now
- Reflecting
- On going flight to safety
- Continued easing by Fed in fed funds market.
- Expectations for Fed involvement in longer term
segment of Treasury market. - http//stockcharts.com/charts/yieldcurve.html
43Issue 3 Where are we Headed?
- November 17th National Association of Business
Economists survey found the following GDP
forecasts - 3Q08 actual -0.5
- 4Q08 forecast -2.6
- 1Q09 forecast -1.3
- Forecast for 3 quarters decline in GDP
- November 12th survey of 59 economists found the
following GDP forecasts - 3Q08 actual -0.5
- 4Q08 forecast -3.0
- 1Q09 forecast -1.5
- Forecast for 3 quarters decline in GDP
44How Long Might this Recession Last? Recall we are
about 12 months into it
- 1902 2001 Recessions Average length 13 months
- 1973 2001 Recessions Average length 10.8
months
45Consumer is an Important Key to the Future of
this Economy
- Consumer spending will be affected by
- Confidence (thus far a negative effect of the
financial and economic crisis on consumer
confidence) - Income levels (thus far negative effects from
income and unemployment trends) - Wealth effects (thus far negative effects of
declining stock market and housing prices) - Look for signal from upcoming holiday season
- Will the recent reduction in gas prices provide a
boost to retail sales? - Black Friday sales up a decent 3 from a year
ago (smallest since .9 decline in 2005 6.0 in
2006 8.3 in 2007). - Cyber Monday (Dec 1) sales were up 15, the
second biggest increase on record.
46Follow Consumer Spending and Income
- Monthly data released by the Commerce Department
the last Wednesday of the month - Consumer spending
- September -0.3
- October -1.0, the most since the 2001
recession. - Personal income
- September 0.1
- October 0.3
- Difference represents an increase in household
savings (savings rate now at 2.4 of disposable
income a 5 year high) -
47Unemployment Rates
- Unemployment Rate now at a 14 year high (Nov
6.7 Oct 6.5 Sept 6.1)
- Affects consumer confidence and consumer spending
decisions. - Unemployment rates normally lag behind a business
cycle recovery thus tending to rise even after a
recovery is underway. - Average lag since 1949 (7 recessions) has been
10.4 months, but the variation is very large (1
to 19 months). - Nov 2001 recession ended and unemployment peaked
in June 2003 (19 months later).
48Follow the Stock Market
- Forecasters have noted that historically
investors start discounting a recovering about
half way through an average recession. - Historically, stock prices move up (on average)
about 5 to 6 months before a recession ends. - Has the market bottomed out?
- Last week (Nov 24 29) stocks posted their
biggest weekly gain since 1974
49Stock Market Signals
50Follow Important Interest Rates
- TED 464 in October Has TED Peaked?
- Measure the confidence in the interbank markets
and possible thawing - TED Spread (3-month LIBOR 3-Month T-bill)
- Dec 3 down to 218Bpts
- Link to daily data at
- http//www.bloomberg.com/apps/quote?ticker.TEDSP
3AIND
51Follow Important Interest Rates
- Mortgage Rates October 2 to Present (30 year
fixed) Weekly Averages
- Mortgage rates
- After the Feds Nov 26 announcement to purchase
600 billion of mortgage related debt, the 30
year fixed fell to 5.47 from 5.94 the week
before - This might help bring housing demand in line with
supply? - For the last week mortgage applications soared
112. (includes both new purchase and
refinancing)
52Follow Political Announcements
- No new fiscal stimulus package should be
expected. - Perhaps ongoing capital infusions into banks and
other key financial institutions. - Expanded debt buyouts and direct market
involvement as needed. - Federal Reserve involvement in commercial paper
markets and more recently in mortgage markets. - FDIC initiated foreclosure prevention plan
(involving loan re-negotiations) perhaps
expanding to Treasury
- Look to team
- Role of Paul Volcker
- Early fiscal stimulus.
- What will it include?
- Need for quick start state by state
infrastructure projects. - Business and personal tax cuts.
- Help for the home sector.
- Expanded policies to deal with foreclosure.
53Follow Fed Policies and Statements
- Fed funds rate.
- Not likely to move to 0 but still a little
downward flexibility. - Also look to spread of effective rate to target
rate. - If the effective rate moves closer to the target
this might signal the Fed is more confident in
financial situation. - Any other policy initiatives?
- Look for Fed open market operations in longer
term Government securities markets. This could
ease longer term interest rates.
- We are clearly behind the curve on mortgage
foreclosures. - Shelia Blair (December 2, 2008)
- Despite good-faith efforts by both the private
and public sectors, the foreclosure rate remains
high. More needs to be done. - Ben Bernanke (Dec 4, 2008)
54Now Add this to the Mix Recession is Becoming a
Global Phenomenon
- Iceland is bankrupt
- Germany and the rest of the Euro-zone (with the
exception of France) have experienced 2
consecutive quarters decline in real GDP. - The United Kingdom has its own housing mess
(house prices have fallen for 13 straight
months). - Forecasting worse recession in 30 years with a
turnaround not expected until 2010.
- Japan is in a recession having experienced 2
consecutive quarters decline in real GDP. - First recession since 2001.
- China is slowing
- World Bank 2009 estimates 7.5 down from 9.2
- Also experiencing a deflating housing bubble
- Russia is in trouble.
- Canada is forecasting a recession through 2Q09
55Foreign Central Banks Have Also Lowered their
Interest Rates
- Canada 2.50
- England 3.0
- Japan 0.5
- ECB 3.25
- Switzerland 2.0
- Australia 5.25
- New Zealand 6.5
- Korea 4.25
- China 6.66
- Canada 2.25 Oct 21/08
- England 2.0 Dec 04/08
- Japan 0.3 Oct 31/08
- ECB 2.50 Dec 04/08
- Switzerland 1.0 Nov 20/08
- Australia 4.25 Dec 02/08
- New Zealand 5.0 Dec 04/08
- Korea 4.0 Nov 07/08
- China 5.58 Nov 26/08
56Are there Foreign Countries that We Should
Monitor?
- Japan
- In recession (consumer spending has fallen for 8
straight months), but the least G7 affected by
credit freeze. - China and India
- GDP slowing (still positive) but recent fiscal
and monetary stimulus may improve growth. - Possible kick-starters for global economy
(through import demand)
- Nothing here to help global economy.
- U.K. expected to suffer its worse recession in 30
years. - Germany in recession and government running a
fiscal surplus. - Both U.K. and Eurozone have introduced their own
stimulus packages. - These will take time to turn these economies
around.
57And What About the U.S. Dollar?
- Over the last 6 months the dollar has taken on a
global safe haven status - The Japanese yen has also strengthened due to
unwinding of carry trades. - likely to remain strong if global uncertainty
continues and as long as Europe appears
relatively weak. - Will ease U.S. inflationary pressures, but make
it more difficult for foreigners to purchase U.S.
real assets.
58Possible Macro-Economic Scenarios
- Scenario 2 U, W or L shape
- Quick recovery
- Within 2 quarters
- Three of the last 5 recession have ended within 2
quarters. - Early on optimism for quick turnaround resulted
from - Assumed positive lagged response of Fed interest
rate cuts and Spring 08 tax rebates. -
- Now we are thinking about other possibilities
- U More gradual recovery (e.g., 18 months), or
- W Recovery followed closely by another recession
(aka double dip e.g., in 1981, or - L Prolonged recession (e.g., 43 months in 1929
or Japan in the 1990s).
59My View U-Shaped 18/21-Month Recovery Most
Likely Scenario
- Caveat The factors underlying a U-shaped
scenario are notoriously difficult to predict. - Specifically, exactly when and to what degree
factors impacting household and business behavior
will kick in and when they will translate into
GDP. - However, a U-Shaped recovery scenario is likely
based on - Severity of the financial/real asset bubble
collapse and the financial market freeze and
their affect on the real economy. - Announced and anticipated layoffs (140,000 in the
financial sector plus lagged unemployment effect) - Falling retail sales.
- Large household debt burdens
- Little, if any, help from the foreign sector.
- I see this recession ending in the 2Q09/3Q09
(Summer 09).
60And What About Seattle?
- Seattle Housing Data
- House prices down 17 a year ago and sales down
17.5 a year ago (35.8 down from last month) - Seattle Economic Base
- Increasing unemployment
- October 2008 State unemployment rate 6.3
(4.8 a year ago) Seattle area 5.4 (4.0 a
year ago). (see second slide) - Negative Impacts of recent layoffs (WaMu
cutting 3,400 Seattle jobs) - Positive Global links
- Exporting
- Bellevue-Seattle-Tacoma Metropolitan Area is the
fourth largest export market in the nation (2007
data) with Japan, China, and Canada the leading
export destinations.
61Seattle House Prices More to Come?
- Nominal Median Housing Prices since Peak
- U.S. peak, 2Q06
- Peak 252,514
- Currently 206,500
- Down 18
- Seattle peak Aug 07
- Peak 501,000
- Currently 415,000 (Nov)
- Down -17
- Source Professor Robert Shillers data base and
Seattle Post
62Seattles Unemployment Picture
- In October 2008, about 203,820 people were out of
work and seeking employment in Washington. - the biggest job declines occurred in retailing
(down 1,700 jobs), education services (down
1,700), manufacturing (down 1,300) and
construction (down 1,100). Economists don't count
striking workers as unemployed, so the 24,000
striking Boeing Machinists didn't contribute to
the unemployment rate.
63Final Quotes
- An economic forecaster is an expert who will
know tomorrow why the things he/she predicted
yesterday didn't happen today. - Laurence J. Peter
- If past history was all there was to the game,
the richest people would be librarians. - Warren Buffett
64Questions and Answers and Comments and
DiscussionFollow-up Questions/CommentsMichael.P
almer_at_colorado.edu