10/14/20091Freedom and Virtue:Challenges and Prospects in a Time of Economic CrisisOctober 10, 2009Gabriel Martinez, PhDChairman, Economics DepartmentAve Maria Universitybloomberg.com10/14/2009224-Oct-08506070809010-Aug-0721-Aug-0801020304050Sep-06Nov-06Jan-07Mar-07May-07Jul-07Sep-07Nov-07Jan-08Mar-08May-08Jul-08Sep-08Nov-08Jan-09Mar-09May-09Jul-09Sep-09finance.yahoo.com8910Baa CorporationsPacific Life Insurance45672003200420052006200720082009Aaa CorporationsExxonMobil, Microsoftresearch.stlouisfed.org/fred2/An Explanatory Diagram9Risk and ReturnAssets (houses for rent) = 100$100 per houseYield (rental/price)= 6%Revenue (rental income) = 610Risk and ReturnAssets = 100 Yield = 6% Revenue = 6Cil 11Liabilities = 90Capital = 10Risk and ReturnAssets = 100 Yield = 6% Revenue = 6Cil Bi 12Liabilities = 90Capital = 10Borrowing Cost = 5.5%Cost = 4.9510/14/20093Risk and ReturnAssets = 100 Yield = 6% Revenue = 6Cil Bi 13Liabilities = 90Capital = 10Borrowing Cost = 5.5%Cost = 4.95Profit Rate= 10.5%Profit= 1.05Risk and ReturnAssets = 100 Yield = 6% Revenue = 6Bi 14Liabilities = 96Capital = 4Borrowing Cost = 5.5%Cost = 5.28Profit Rate= 18%Profit= 0.72•More Leverage: Less Capital / AssetsRisk and ReturnAssets = 100 Yield = 6% Revenue = 6Bi 15Borrowing Cost = 4.5%Cost = 4.32Profit Rate= 42%Profit= 1.68•More Leverage: Less Capital / Assets•Lower Interest Rates: Lower CostsLiabilities = 96Capital = 4Risk and ReturnAssets = 100 Yield = 6% Revenue = 6Bi 16Borrowing Cost = 2.5%Cost = 2.4Profit Rate= 90%Profit= 3.6•More Leverage: Less Capital / Assets•Drastically Lower Interest RatesLiabilities = 96Capital = 4Risk and ReturnAssets = 100$213 per houseYield = 2.82%Revenue(per $100) = 2.82Bi Rent/Price17Borrowing Cost = 2.5%Cost = 2.4Profit Rate= 10.5%Profit= 0.42•More Leverage: Less Capital / Assets•Drastically Lower Interest Rates•Demand goes up, prices go up• Normal market: people buy for use or long-term income. As prices rise, yields go down.Liabilities = 96Capital = 4Risk and ReturnAssets = 100Yield = 2.82%Appreciation = 12.18%Revenue = 15Bi 18Borrowing Cost = 2.5%Cost = 2.4Profit Rate= 315%Profit= 12.6•More Leverage: Less Capital / Assets•Drastically Lower Interest Rates•Demand goes up, prices go up• Speculative market: people buy to re-sell. As prices rise, asset becomes more attractive: appreciation rate gets built into revenue, which rises.Liabilities = 96Capital = 410/14/20094Risk and ReturnAssets = 100 Revenue = 15Bi Yield= 2.82%Appreciation = 12.18%19CapiBorrowing Cost = 2.5%Cost = 2.45Profit Rate= 627%Profit= 12.55•More Leverage: Less Capital / Assets•Drastically Lower Interest Rates•Speculative Demand•Borrowed money flows in, leverage rises moreLiabilities = 98Capital = 220Risk and ReturnAssets = 100 Revenue = 25Bi Yield = 0.82%Appreciation = 24.18%CapiBorrowing Cost = 2.5%Cost = 2.45Profit Rate= 1127%Profit= 22.55•More Leverage: Less Capital / Assets•Drastically lower interest rates•Speculative demand•Borrowed money flows in, leverage rises more•Greater speculative demand drives prices fasterLiabilities = 98Capital = 2A $100,000 home,at different rates of appreciation$800,000$1,000,000$1,200,000$1,400,00021$0$200,000$400,000$600,000$800,0001234567891011121314153 percent6 percent20 percentCapi22Risk and ReturnAssets = 100 Revenue = 25Bi Yield = 0.82%Appreciation = 24.18%Liabilities = 98Capital = 2Borrowing Cost = 2.5%Cost = 2.45Profit Rate= 1127%Profit= 22.55•More Leverage: Less Capital / Assets•Drastically Lower Interest Rates•Speculative Demand•Borrowed money flows in, leverage rises more•Greater Speculative Demand drives prices faster23Risk and ReturnAssets = 100Revenue = 2.4Yield = 1%+ Appreciation = 1.4%Borrowing Cost = 4.5%Cost = 4.41Profit= 22.55Liabilities = 98Capital = 2Capital = -0.01Profit= -2.01•Borrowing costs rise•Price appreciation slows down•Losses ensue•As capital is depleted, bankruptcies followhttp://research.stlouisfed.org/maps/failed_banks.php10/14/20095http://research.stlouisfed.org/maps/tarp_distribution.phpForeclosures per 1000 unitschange from last year26http://data.newyorkfed.org/creditconditions/#US_expMay2011_spRed - Conditions have worsenedGreen - Conditions have improvedYellow - No change (within 0.05%)Student Loan Delinquencieschange from last year27http://data.newyorkfed.org/creditconditions/#US_expMay2011_spRed - Conditions have worsenedGreen - Conditions have improvedYellow - No change (within 0.05%)The Causes Opportunity Government encouragement of homeownership Especially for low-income groups Deregulation Means More world savings: lower long-term rates Recession-aversion: lower short-term rates Financial development and sophistication Motive Greed Need Gambling itchOpportunity: Opening Finance Regulatory encouragement of certain kinds of risk-taking Fannie Mae & Freddie Mac “Protected” with strategies29gFannie Mae & Freddie MacFannie Mae Eases Credit To Aid Mortgage Lending By Steven A. Holmes, September 30, 1999[...] Fannie Mae Corporation is easing the credit requirements on loans that it 30will purchase from banks and other lenders […] to encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. [...]Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.http://www.nytimes.com/10/14/20096Fannie Mae & Freddie MacFannie Mae Eases Credit To Aid Mortgage Lending By Steven A. Holmes, September 30, 1999[...] In moving, even tentatively, into this new area of lending, Fannie Mae is 31taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.''http://www.nytimes.com/Opportunity: Opening Finance Regulatory