🔍
The Great Recession - YouTube
Channel: Marginal Revolution University
[0]
♪ [music] ♪
[14]
[Tyler] A lot of ink
already has been spilt
[16]
discussing the Great Recession of 2008.
[18]
And a full examination of that
would require
[20]
a lot more than just one video.
[23]
So today, I'm going
to limit our discussion
[25]
to just one central theme
of the crisis,
[28]
namely financial intermediation.
[31]
Let's say you're buying a home
that costs $100,000.
[35]
A typical down payment
might have been, say, 20%,
[39]
and that would mean your mortgage
was for 80% of the home value,
[42]
or $80,000.
[45]
Now in the lead up to the crisis,
many homes were being purchased
[49]
with much less than 20% down --
10% down or 5% down.
[54]
Or in a lot of cases,
[55]
nothing was put down at all --
zero down.
[60]
When you put money down on a house,
[61]
that creates a kind
of protective cushion.
[64]
Now, the difference
between the value of the house
[67]
and the unpaid amount
of the mortgage --
[69]
that's called "owner's equity."
[72]
So now, when you first buy a house,
[74]
your down payment
is your owner's equity.
[78]
Over time, as you pay down
your mortgage
[80]
and if your home value goes up,
[82]
well, in those cases,
your owner's equity rises
[86]
and that makes
the protective cushion bigger.
[89]
The ratio of debt to equity,
which represents
[92]
how much of a protective cushion
is in a home or in a company --
[96]
that's called the "leverage ratio."
[98]
So, a 5% down payment
on a $100,000 house
[102]
would mean you'd have
$5,000 in owner's equity,
[106]
which when compared
to the mortgage of $95,000,
[110]
would give you
a leverage ratio of 19.
[113]
So what's the effect
of high leverage?
[115]
It means there's very little room
for the price on your home to drop
[119]
before the value of your house
[121]
is less than the unpaid
mortgage amount.
[124]
That is, if you needed
to sell the home
[126]
to pay off your mortgage,
[127]
the proceeds from the house sale
would not be enough
[130]
to pay off the bank.
[131]
Being under water is clearly not good
[133]
for the individual home owner.
[136]
But very importantly,
it's also not good for the bank.
[139]
In the case of foreclosure,
[141]
say the homeowner cannot
keep on paying the mortgage.
[144]
Well the bank is getting a home
but the home isn't worth enough.
[148]
The bank loses money because
the value of the home is less
[152]
than what the bank was expecting
to receive from the home owner
[155]
in the form of mortgage payments.
[157]
So again, back to the broader picture.
[160]
It wasn't just home owners
who were using more leverage.
[163]
Banks were using more leverage.
[165]
They were buying assets
using more debt
[167]
and less of their own cash.
[169]
So what we're doing here
is stacking problems:
[171]
the problem
of the home owner's leverage,
[173]
the problem of the bank leverage.
[175]
And the more problems
like these you stack,
[178]
the more financial fragility
you're bringing into the economy.
[182]
Now in 2004, the investment bank
Lehman Brothers --
[186]
it had a leverage ratio
of about 20.
[189]
But it continued
to borrow more money.
[191]
And by 2007, that leverage ratio
went as high as 44.
[198]
Now in that setting,
[199]
if Lehman Brothers sees its assets
fall in value very quickly,
[204]
Lehman Brothers too
will in essence be under water.
[207]
That is the assets of the company
will be worth less
[210]
than the debt the company owes.
[213]
In other words, in that case,
the company would be insolvent.
[217]
This sounds like
such a terrible state of affairs.
[220]
So you have to wonder
[221]
"Why would the experienced managers
[224]
of a large firm like Lehman Brothers
have been so risky?"
[228]
There are a few reasons,
[229]
but the first
and most important reason
[231]
was just sheer excess confidence.
[235]
Those managers
bought mortgage securities
[237]
and they made
other risky investments.
[239]
But the managers,
like indeed most other people,
[242]
they just didn't think
[244]
that American home prices
could fall so much.
[247]
And they also didn't understand
[249]
that a fall in home prices
could potentially create
[252]
so much turmoil
in American capital markets.
[256]
Another key factor
behind the failure was incentives.
[260]
The managers at Lehman --
they got big bonuses
[262]
based on the profits
of the company.
[265]
And in some cases, this can lead
managers to take on too much risk.
[269]
How does that work?
Well think about it.
[271]
Bigger profits typically meant
bigger bonuses.
[274]
So if you go from
a leverage ratio of 20 to 44,
[278]
as Lehman Brothers did,
that means you can buy
[281]
more than double
the amount of assets
[283]
with the same amount
of initial capital,
[285]
because you're using more debt.
[287]
That means
more than double the profit
[289]
if asset prices rise
as indeed they had been doing.
[293]
But what if the assets
fall in value?
[296]
What if the initial risk
does turn out badly?
[299]
And you have to ask
when the asset prices did fall
[302]
and Lehman Brothers went bankrupt,
[304]
did the managers also
personally go bankrupt?
[308]
No, they did not.
They still, for the most part,
[311]
had a lot of money
in their bank accounts.
[313]
So in this setting, Lehman managers
had a lot to gain
[317]
if things would go well,
[318]
but they faced
only limited downside
[321]
in the scenario
where things would go sour.
[324]
Let's add
another factor to this mix
[326]
that ended up pushing the economy
[328]
even a bit closer
toward the edge of the cliff,
[331]
and that additional factor
was securitization.
[335]
So how does securitization work?
[337]
Briefly, individual mortgages
are bundled together
[340]
and sold to outside parties
as liquid financial assets.
[345]
So rather than lending
a company money directly,
[348]
as you would do with a bond,
you buy a mortgage security,
[351]
and indirectly
you provide money to people
[353]
who use it to buy homes.
[355]
So it turned out there were
all these securities out there
[359]
which were very hard to value,
[360]
many of them were riskier
than advertised,
[363]
and many of them
were just bad outright,
[366]
filled with too many
high-risk loans.
[369]
How is it that this happened?
Well there were a few factors.
[372]
Sometimes the problem
was outright fraud
[375]
in terms of how the security
was sold and how it was explained.
[379]
Or sometimes it was a failure
of the rating agencies,
[383]
which were supposed to assess risk
more or less accurately,
[386]
but they performed poorly.
[388]
But probably the biggest
single problem was again
[391]
a kind of complacency.
[393]
Most people incorrectly assumed
[395]
American housing was really
quite a safe investment,
[399]
and that prices
would either continue to rise,
[402]
or at the very least
hold fairly stable.
[404]
One final factor set the stage
and brought all of this together,
[408]
and that's what is called
the shadow banking system.
[412]
So what does that mean?
[413]
Well here I need
to give some terminology.
[416]
What you and I commonly
would just call a bank
[419]
is actually more technically
a commercial bank.
[422]
And that means a bank
that takes deposits
[425]
from individuals and businesses
[427]
and it's insured by the government
through the FDIC.
[430]
Because of
the government guarantee,
[432]
depositors don't feel
the need to run to the bank
[435]
at the first sign of trouble
and pull out their money.
[439]
Now investment banks --
they're different.
[441]
Investment banks,
like Lehman Brothers,
[443]
were a different kind of bank
[445]
without a comparable
governmental guarantee
[448]
for deposits or liabilities.
[450]
The money they used --
it came from investors,
[453]
not from depositors.
[455]
So the investors
were always asking,
[456]
"If I lend to an investment bank,
are my funds safe?
[460]
Will I get my money back?"
[462]
And these investors
were more watchful
[464]
and sometimes even prone to panic
[466]
if something seemed to be wrong
with the investment bank.
[470]
Now the shadow banking system
as a whole is made up
[472]
of investment banks
[474]
along with other complex
financial intermediaries,
[477]
such as hedge funds,
issuers of asset-backed securities
[481]
like the mortgage bonds
discussed earlier,
[483]
money market funds,
[485]
and even some parts
of traditional commercial banks,
[488]
which are not covered
by the deposit insurance guarantee.
[491]
So, in that setting,
by the year 2008,
[496]
the shadow banking system actually
was lending considerably more
[500]
than were traditional
commercial banks.
[503]
So we've got
highly leveraged houses and banks,
[506]
banks and other investors
holding risky mortgage securities,
[510]
and a massive shadow banking system
[512]
highly dependent
on short-term loans,
[515]
which in turn were dependent
on investor confidence.
[519]
This was the proverbial case
of being very close to the cliff
[523]
and needing only
an extra nudge to fall off.
[526]
And that nudge came in 2007
[529]
when housing prices
started to fall,
[531]
causing many home owners
to be under water.
[535]
This meant that the assets
owned by banks,
[537]
such as mortgage-backed securities,
were dropping in value.
[541]
Remember, banks were
highly leveraged too.
[544]
So this fall in asset values pushed
many banks closer to insolvency.
[550]
Worse yet,
the complexity of investments
[552]
in mortgage-backed securities
obscured how much exposure
[556]
particular banks faced.
[558]
The market started to think
of virtually all banks
[561]
as really quite risky,
[563]
and this exacerbated
the financial crisis.
[566]
The investors who provided
the short-term loans
[569]
to fund the shadow banking system --
well, they fled to safety.
[573]
They pulled their capital
away from these short-term loans
[576]
to investment banks
such as Lehman Brothers,
[579]
and this run
on the shadow banking system
[581]
was similar to the runs
on traditional commercial banks
[584]
by depositors, as seen
in America's Great Depression.
[588]
And that was a time when even
bank deposits were not insured
[591]
by the government.
[593]
Without these short-term loans,
[595]
investment banks
and other financial institutions --
[598]
they were starved of the money
they needed to function.
[601]
They couldn't keep on
making loans of their own
[604]
and so they started
selling their own assets
[607]
to get operating funds
just to stay up and running.
[611]
But that leads
to yet another problem.
[613]
When a lot of financial institutions
are all selling assets
[617]
at the same time, you end up
with what's called a fire sale.
[621]
As they all sell,
[622]
that selling pushes asset prices
lower -- even lower.
[627]
And those lower asset values --
[629]
that pushes even more
financial institutions
[632]
closer toward bankruptcy.
[634]
So, financial intermediaries
came crashing down
[639]
and this led to a credit crunch
that damaged the entire economy.
[643]
In this setting, many businesses
that depended on credit --
[646]
they failed
or they stopped growing.
[649]
Maybe they laid off workers
to conserve cash
[651]
and unemployment spiked.
[654]
So, looking back we have to ask,
"What could have been done?
[659]
What should have been done?"
[660]
It's now considered
a general problem
[662]
that short-term loans
for the shadow banking system
[665]
can flee rapidly in times of crisis
[668]
and cause widespread
financial and economic turmoil.
[672]
So what to do?
[674]
In response to this,
some suggest a similar solution
[677]
to what we did for runs
on traditional commercial banks,
[680]
namely a government guarantee
[682]
of some, or all,
of those liabilities.
[685]
However,
that's a pretty radical step.
[688]
It would put an even larger
potential burden on taxpayers,
[691]
maybe trillions.
[693]
And it also doesn't fix
the incentive problems
[696]
I mentioned earlier,
namely that when there’s leverage,
[699]
and especially guaranteed liabilities,
[702]
the managers have an incentive
to take too much risk.
[705]
It would make that problem worse.
[707]
Since the financial crisis,
other regulations have been enacted
[711]
to cover the shadow banking system,
and also traditional banks.
[715]
Those regulations require
more equity and less leverage.
[719]
And that makes sense
in terms of my earlier discussion
[722]
of needing a larger
financial protective cushion.
[726]
Still, it remains to be seen
[728]
just how effective
these regulations will prove.
[731]
So far there's been
no market turmoil
[733]
comparable to the crisis of 2008.
[736]
So we just don't know
exactly how well
[738]
the new institutions will work.
[740]
There's a lot more to cover
on the Great Recession.
[743]
And if you're interested
in learning more,
[745]
please just let us know.
[746]
Thanks.
[749]
[Narrator] If you want
to test yourself,
[751]
click "Practice Questions."
[753]
Or, if you're ready to move on,
[754]
you can click
"Go To The Next Video."
[757]
♪ [music] ♪
[760]
You can also visit MRUniversity.com
[762]
to see our entire library
of videos and resources.
Most Recent Videos:
You can go back to the homepage right here: Homepage