How did this happen?

“If it sounds too good to be true, it probably is.” –oldadage

Through the last half of the 1990s, America enjoyed a period of unprecedented growth and prosperity. Unemployment was low, productivity was high, inflation was low, and the real standard of living for the average American rose significantly. The American GDP, a key measure of economic performance, increased $2,382 billion, growing from $7,325 billion to $9,708 billion, a jump of nearly 33% in just five years. But the scene changed for the worse when the dot-com bubble burst in 2000, followed by the 9/11 terrorist attacks in 2001. As the stock market dropped and unemployment rose, economic experts feared that the country was hovering on the brink of a full-blown recession.

In an effort to avert recession by increasing the money supply and encouraging investment, the Federal Reserve decreased interest rates from 6.5% in mid-2000 to 1.25% by the end of 2002. As a result, the economy was awash with money, but opportunities to invest yielded paltry returns. This is when subprime mortgage loans came into play. Most experts define subprime mortgages as loans to borrowers with low credit scores, high debt-to-income ratios, or other signs of a reduced ability to repay the money they borrow.

These subprime mortgage loans were attractive to borrowers and lenders alike. Hundreds of thousands of people could afford homes for the first time ever. Banks were all too willing to give them mortgage loans, sometimes with little or no documentation (such as proof of income), and sometimes with little or no money down. As demand skyrocketed, home prices continued to rise year after year. Borrowers took on adjustable rate loans, assuming that when their loans adjusted up—usually sharply up—they could simply refinance their now more valuable homes for a new low starter rate, and maybe even pull out some equity to buy expensive new toys.

Subprime loans were attractive to lenders because they provided a higher return than many other investments, and—given the growth in housing prices—they seemed relatively low risk. Banks and investment houses invented a range of stunningly complex financial instruments to slice up and resell the mortgages as specialized securities. Hedge funds swapped the new securities, falsely confident that they were virtually risk-free. With a lack of regulation—or any sort of government oversight—financial institutions did not maintain reserves in case those mortgage-backed funds lost value.

And they did indeed lose value. In 2006 housing prices peaked, and in the months that followed, prices began falling precipitously. Increasing numbers of subprime borrowers found themselves “upside down”—and once they owed their lenders more than the value of their homes, they were unable to refinance to lower their payments. Foreclosure rates climbed at an increasing pace. RealtyTrac, a

Global Economic Crisis

What happened?

“A billion here and a billion there, and pretty soon you’re talking real money.” –U.S.SenatorEverettDirksen

In September 2008 the U.S. economy plunged into the worst fiscal crisis since the Great Depression. Huge, venerable financial institutions faced collapse, spurring unprecedented bailouts by the Federal Reserve. On September 29, October 9, and October 15, the stock market plummeted—each day, the Dow Jones Industrial average dropped about 7%, posting three of its all-time largest losses. Economic turmoil in the United States spread quickly around the world, causing sequential economic shocks from Europe to Far East Asia.

Source: Based on data from Historical Changes of the Target Federal Funds and Discount Rates, 1971 to present, Federal Reserve Bank of New York website, http://www.newyorkfed .org/markets/statistics/dlyrates/fedrate.html, accessed November 6, 2008.

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Source: Based on data from S&P/Case-Shiller Home Price Indices, August 2008 data, Standard & Poor’s website, http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indi-ces_csmahp/0,0,0,0,0,0,0,0,0,1,1,0,0,0,0,0.html, accessed November 6, 2008.

Home Price Index (Base Period: January 2000)

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Oct

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Dec

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Global Economic Crisis

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leading online marketplace for foreclosure properties, reported that foreclosure rates through August 2008 were 50% higher than the same period in 2007, and they anticipate that rates will continue to climb throughout 2008 and beyond.

As mortgage values dropped, financial institutions began to feel the pressure—especially firms such as Bear Stearns that specialized in trading mortgage-backed securities, and firms such as Washington Mutual that focused on selling subprime mortgages. When financial institutions actually began to face collapse, a wave of fear washed over the entire banking industry. Banks became unwilling to lend money to each other or to clients, which meant that funds were not available for businesses to finance either day-to-day operations or longer-term growth. Company after company—from General Motors to Yahoo!, American Express, and countless small employers—began to announce layoffs. The October 2008 unemployment rate hit 6.5%, a 14-year high, and the GDP for the third quarter of 2008 dropped by 0.3%, with greater losses expected in the months to come. Experts anticipate that the negative impact will continue to ripple throughout the economy, despite a $700 billion federal government bailout package.

What have we learned?

“We are all faced with a series of great opportunities brilliantly disguised as impossible situations.”

–CharlesR.Swindoll

The key drivers of the 2008 credit crisis suggest the need for some fundamental changes by all sectors of our nation’s economy—changes that can lay the foundation for long-term prosperity. In particular, we’ve learned that we need:

• Greater Federal Fiscal Responsibility: Deficit spending can be a powerful, positive force during wars and economic crises. But the federal debt now exceeds $10 trillion. Reduced deficit spending could help free up financial capital for the private sector, decrease American dependence on foreign nations, and lessen the burden on future generations.

• More Conservative Money Supply Management: The Federal Reserve must have the flexibility to increase the money supply and cut interest rates when the economy faces a severe downturn. But long-term reliance on cheap money can encourage risky speculation that leaves the economy vulnerable to financial crises.

• Wise Regulation of Financial Markets: From credit cards to financial markets, deregulation has been disastrous. A new, more effective regulatory approach would allow the economy to thrive long-term without reckless risk-taking.

• More Emphasis on Personal Responsibility: Over the last two decades, many American families incurred a mountain of debt, and were unprepared for financial setbacks. The recent crisis may spur households to reset their priorities and emphasize savings rather than consumption.

• Investment in the Future: Targeted government spending could help upgrade our nation’s crumbling infrastructure, educate our labor force, clean up and preserve our environment, and devel-op renewable energy sources. Focusing on these priorities would lay solid groundwork for a more competitive national economy.

Despite recent turmoil, the American economy has historically proven to be flexible and resilient; phenomenal opportunities may arise from even the most adverse economic climate, giving us all reason for measured optimism.

Global Economic Crisis

Global Economic Crisis

Subprime Collapse to Global Financial Meltdown: Timeline by Chris Dolmetsch, Bloombergwebsite, October 13, 2008, http://www.bloomberg.com/apps/news?pid=20601208&sid=aleqkSjAAw10, accessed November 6, 2008.

There Is a Silver Lining by Fareed Zakaria, Newsweek website, October 20, 2008, http://www.newsweek.com/id/163449/output/print, accessed November 6, 2008.

GDP Declines 0.3 Percent in Third Quarter, “Advance” Estimate of GDP, Bureau of Economic Analysiswebsite, October 30, 2008, http://www.bea .gov/newsreleases/national/gdp/gdphighlights.pdf, accessed November 6, 2008.

SourcesCredit Crisis—The Essentials, The New York Times website, http://topics.nytimes.com/top/reference/timestopics/subjects/c/credit_crisis/index.html, accessed November 6, 2008.

Table 10.1—Gross Domestic Product and Deflators Used in the Historical Tables: 1940-2009, White House Office of Management and Budget website, http://www.whitehouse.gov/omb/budget/fy2005/hist .html, accessed November 6, 2008.

What Is Subprime Lending? Monetary Trends, Federal Reserve Bank of St. Louis website, June 2007, http://research.stlouisfed.org/publica-tions/mt/20070601/cover.pdf, accessed November 6, 2008.

Subprime woes could spill over into other sectors by John Waggoner, USAToday website, March 15, 2007, http://www.usatoday.com/money/perfi/columnist/waggon/2007-03-15-subprime-woes_N.htm, accessed November 6, 2007.

RealtyTrac’s James J. Saccacio to Discuss Foreclosure Crisis Fallout at AFSA State Government Affairs Forum by RealtyTrac staff, RealityTrac website, October 1, 2008, http://www.realtytrac.com/ContentManagement/pressrelease .aspx?ChannelID=9&ItemID=5284&accnt=64847, accessed November 6, 2008.

Greatest DJIA % Losses of All Time, Md Leasing Corp. website, October 28, 2008, http://www.mdleasing.com/djia-losses.htm, accessed November 6, 2008.

Unemployment Rate

Source: Based on data from Labor Force Statistics from the Current Population Survey, Bureau of Labor Statistics website, http://data.bls.gov/PDQ/servlet/SurveyOutputServlet?data_tool=latest_numbers&series_id=LNS14000000, accessed November 6, 2008.

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