The Great Recession of 2008: Financial Intermediation

Introduction

• Focus on financial intermediation as a central theme of the crisis.

Home Buying and Mortgages

• Home Purchasing Options
  • Typical down payment: 20% of home value.
  • Pre-crisis: Down payments were often less than 20%, sometimes zero.
• Owner's Equity
  • Difference between house value and unpaid mortgage.
  • Starts with a down payment; increases as mortgage is paid and home value rises.

Leverage Ratio

• Definition: Ratio of debt to equity.
• Example: 5% down payment on $100,000 house → $5,000 equity → leverage ratio of 19.
• High Leverage Consequences
  • Small room for house price drop before loan is underwater.
  • Risk for both homeowners and banks in cases of foreclosure.

Banks and Leverage

• Banks were highly leveraged, using more debt and less own cash.
• Example: Lehman Brothers
  • Leverage increased from 20 in 2004 to 44 in 2007.
  • Risk of insolvency if assets devalue.

Causes of Risky Practices

• Excess Confidence
  • Misbelief that American home prices wouldn't fall significantly.
• Incentives
  • Managers received bonuses based on company profits, encouraging risky behavior.

Securitization

• Process: Bundling mortgages and selling as liquid financial assets.
• Risks
  • Difficulty in valuing securities.
  • High-risk loans and fraud.
  • Rating agencies' failures.
• Complacency
  • Assumption that housing was a safe investment.

Shadow Banking System

• Definition: Includes investment banks, hedge funds, issuers of asset-backed securities, money market funds.
• Differences from Commercial Banks
  • No government deposit insurance.
  • Dependent on investor confidence.
• Role in Crisis
  • Significant lending amount compared to traditional banks.

Crisis Development

• Trigger: Housing prices falling in 2007.
• Effects
  • Underwater homeowners.
  • Devalued bank assets.
  • Investor panic and withdrawal of capital.
  • Credit crunch.
• Fire Sale
  • Institutions selling assets simultaneously, further lowering prices.

Economic Impact

• Credit Crunch
  • Businesses reliant on credit failed or reduced operations.
  • Unemployment spike.

Solutions and Regulations

• Proposals
  • Government guarantee for shadow banking liabilities (controversial).
• Post-Crisis Regulations
  • Require more equity and less leverage.
  • Effectiveness of new regulations uncertain.

Conclusion

• Discussion on the potential for future turmoil and effectiveness of new regulations.
• Encouragement to explore further resources for more on the Great Recession.