Great Depression2008 Financial CrisisGreat Depression2008 Financial CrisisFinancial CrisisElias YannopoulosNovember 12, 2012Elias Yannopoulos Financial CrisisGreat Depression2008 Financial CrisisFinancial Panics and the Real EconomyWhy did we worry about saving the financial companies?The financial sector is not huge, we don’t care nearly as muchif airline or automobile companies go underThe reason is that all sectors rely on the financial sectorIf I am a firm, I need to pay my workers, If I don’t have thecash I have to get a short term loan. Without the financialsector I can’t operateThe fear in 2008 was that the crisis in the financial sectorwould spread to the real economy as credit froze upBefore we go into the government’s actions in 2008 and 2009let’s go back to the Great Depression, because it is the lasttime we had a financial crisis on this magnitudeElias Yannopoulos Financial CrisisGreat Depression2008 Financial CrisisThe Great DepressionIn the 1920s, times were good stock prices where climbingand people where making tons of moneyIn September and October of 1929 stock prices fell by almost50%Now you may be thinking, sure we all know that the stockmarket crashed caused the Great DepressionBut what is the impact on the real economy? Everyone whoowned stocks lost wealth, but that didn’t affect our ability toproduce or that people still needed to eatThe belief at the time was, hey that sucks for those guys butthe economy will bounce back on its ownThe real problems came when the financial sector started tofailElias Yannopoulos Financial CrisisGreat Depression2008 Financial CrisisFinancial Crash of the 1930sGoing back to the 1929 crash, a lot of that investing in thestock market was done with borrowed money, it was leverages,done on the margin (all mean the same thing)Ex: stocks Ex: housePeople who lost all that money in the crash couldn’t pay backtheir loansDepositors at the banks where unsure if the banks could covertheir deposits, because these loans weren’t getting paid backThere is no FDIC then, so if a bank has to close because itcan’t give people their deposits those deposits are lostSo if people got even a hint of a bank failure then they wouldrun on the bankBanks are then forced to hold all their money in reserve (noloans)If the banks aren’t loaning then firms can’t invest and thenunemployment rises and firms have to cut backElias Yannopoulos Financial CrisisGreat Depression2008 Financial CrisisThe BubbleIt wasn’t until 1933 that the government step in and tookmeasures to avoid the complete collapse of the financial sectorIn 2008, the Fed and Congress quickly stepped in to preventfurther financial meltdown and a deeper recessionThe only issue being whether these bailouts would ultimatelyundermine the long run health of the economyThe first stage of a crisis is a bubble - unsustainable rapidlyrising prices of some type of financial assetThis price increases during a bubble are not sustainablebecause they aren’t based on a productivity increase, justspeculationIn 1929, it was stocks, in 2008 it was housesElias Yannopoulos Financial CrisisGreat Depression2008 Financial CrisisThe Housing BubbleIn the early, 2000s times were good (sounds familiar), looselending standards allowed more and more families to buyhousesPeople’s house price was climbing and they felt richer, but in2007 housing prices were plummeting and it was apparentthat the price increase was a bubbleHow do we get a bubble in the housing market? (true for anymarket)You mix herding - the human tendency to follow the groupand leverage - borrowing to buy financial assets, and whatyou get is a bubbleWe can use supply and demand to show how herding can leadto a bubble, through peoples expectations Ex: graphElias Yannopoulos Financial CrisisGreat Depression2008 Financial CrisisLeverageLeverage can make betting on financial assets very lucrativeLet’s use a relevant example of buying a house, for the onlypurpose of selling it later for more moneySuppose you buy a house you get a mortgage from the bankfor a house that costs $200,000They ask you for a down payment of $20,000Now while you wait for the price of the house to increase, youcan live in it (only works with houses not stocks)You have to make the mortgage payments (interest paid onmortgages is tax deductible)Suppose after a few months the price rises by 20You sell the house pay off the $180,000 you owe for the loan,get back your $20,000 minus what payments you made on themortgage and there is $40,000 leftSo on a $20,000 investment you made $40,000 thats 200%profit!! and the price only went up by 20%Elias Yannopoulos Financial
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