Charting the Financial Crisis

CHARTING THE FINANCIAL CRISIS U.S. Strategy and Outcomes January 2020 at BROOKINGS Introduction The global !nancial crisis and great recession of 2007–2009 constituted the worst shocks to the United States economy in generations. Books have been and will be written about the housing bubble and bust, the !nancial panic that followed, the economic devastation that resulted, and the steps that various arms of the U.S. and foreign governments took to prevent the Great Depression 2.0. But the story can also be told graphically, as these charts aim to do. What comes quickly into focus is that as the crisis intensi!ed, so did the government’s response. Although the seeds of the harrowing events of 2007–2009 were sown over decades, and the U.S. government was initially slow to act, the combined e"orts of the Federal Reserve, Treasury Department, and other agencies were ultimately forceful, #exible, and e"ective. Federal regulators greatly expanded their crisis management tool kit as the damage unfolded, moving from traditional and domestic measures to actions that were innovative and sometimes even international in reach. As panic spread, so too did their e"orts broaden to quell it. In the end, the government was able to stabilize the system, re-start key !nancial markets, and limit the extent of the harm to the economy. No collection of charts, even as extensive as this, can convey all the complexities and details of the crisis and the government’s interventions. But these !gures capture the essential features of one of the worst episodes in American economic history and the ultimately successful, even if politically unpopular, government response. Copyright © 2020 Hutchins Center at the Brookings Institution and Yale Program on Financial Stability www.som.yale.edu/!nancialcrisischarts 1 Antecedents of the Crisis In the years leading up to the crisis, the underlying performance of the U.S. economy had eroded in important ways. 2 ANTECEDENTS Because the growth of productivity and the labor force had slowed in the decade before the crisis, the potential economic growth rate was falling. Growth in real potential GDP 5% Contribution to real potential GDP from: Productivity growth Labor force growth 4 3 2 1 0 1970 1975 1980 1985 1990 1995 2000 2005 2008 Sources: Congressional Budget O!ce, “An Update to the Economic Outlook: 2018 to 2028”; authors’ calculations 3 ANTECEDENTS Overall prime-age participation in the labor force had been falling, as the participation of women slowed and men’s continued a decades-long decline. Civilian labor force participation rates for people ages 25–54, indexed to January 1990=100 106 Women, ages 25–54 104 102 100 All people, ages 25–54 98 Men, ages 25–54 96 94 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 Source: Bureau of Labor Statistics via Haver Analytics 4 ANTECEDENTS Income growth for the top 1 percent had risen sharply, driving income inequality to levels not seen since the 1920s. Cumulative growth in average income since 1979, before transfers and taxes, by income group +300% Top 1 percent +250 of households +200 +150 +100 81st to 99th percentiles of households + 50 0 Bottom 20 percent Middle 60 percent – 50 of households of households 1970 1975 1980 1985 1990 1995 2000 2005 2008 Source: Congressional Budget O!ce, “The Distribution of Household Income, 2014” 5 ANTECEDENTS Meanwhile, the !nancial system was becoming increasingly fragile. 6 ANTECEDENTS A “quiet period” of relatively low bank losses had extended for nearly 70 years and created a false sense of strength. Two-year historical loan-loss rates for commercial banks 10% 8 6 4 2 0 1920 1930 1940 1950 1960 1970 1980 1990 2000 2008 Sources: Federal Deposit Insurance Corp.; Federal Reserve Board; International Monetary Fund 7 ANTECEDENTS The “Great Moderation”—two decades of more stable economic outcomes with shorter, shallower recessions and lower in!ation—had added to complacency. Quarterly real GDP growth, percent change from preceding period +20% The “Great Moderation” +15 +10 + 5 0 – 5 –10 –15 1970 1975 1980 1985 1990 1995 2000 2005 2008 Source: Bureau of Economic Analysis via Federal Reserve Economic Data (FRED) 8 ANTECEDENTS Long-term interest rates had been falling for decades, re!ecting decreasing in!ation, an aging workforce, and a rise in global savings. Benchmark interest rates, monthly 20% 15 30-year !xed mortgage rate 10 5 10-year Treasury 2-year Treasury 0 1970 1975 1980 1985 1990 1995 2000 2005 2008 Sources: Federal Reserve Board and Freddie Mac Primary Mortgage Market Survey® via Federal Reserve Economic Data (FRED) 9 ANTECEDENTS Home prices across the country had been rising rapidly for nearly a decade. Real home price index, percentage change from 1890 +100% + 80 Home prices had increased modestly through several boom-and-bust cycles since the 1970s, but started a much more dramatic rise in the late 1990s. + 60 + 40 + 20 0 1970 1975 1980 1985 1990 1995 2000 2005 2008 Source: U.S. Home Price and Related Data, Robert J. Shiller, Irrational Exuberance 10 ANTECEDENTS Household debt as a share of income had risen to alarming heights. Aggregate household debt as a share of disposable personal income 140% 120 100 80 60 40 Mortgage debt 20 Consumer debt 0 1970 1975 1980 1985 1990 1995 2000 2005 2008 Source: Federal Reserve Board Financial Accounts of the United States, based on Ahn et al. (2018) 11 ANTECEDENTS Credit and risk had migrated outside the regulated banking system. Credit market debt outstanding, by holder, as a share of nominal GDP 250% Q1 1980 Q1 2008 31% Nonbank Financials 64% Broker-Dealers 200 69% Banks 36% 150 GSEs ABS 100 MMFs Insurers 50 0 1970 1975 1980 1985 1990 1995 2000 2005 2008 Notes: GSE: government-sponsored enterprise (including Fannie Mae and Freddie Mac); ABS: asset-backed securities issuers; MMFs: money market funds Source: Federal Reserve Board Financial Accounts of the United States 12 ANTECEDENTS The amount of !nancial assets !nanced with short-term liabilities had also risen sharply, increasing the vulnerability of the !nancial system to runs. Net repo funding to banks and broker-dealers $2.00 trillion 1.75 The use of repo funding— 1.50 a form of secured, short-term lending—tripled in the decade prior to 2008. 1.25 1.00 0.75 0.50 0.25 0 1970 1975 1980 1985 1990 1995 2000 2005 2008 Source: Federal Reserve Board Financial Accounts of the United States 13 The Arc of the Crisis 14 ARC OF THE CRISIS The !nancial crisis unfolded in several phases. Bank credit default swap spreads and Libor-OIS spread 500 basis points Increasing Stress Early Panic and Resolution Escalation 400 Two widely accepted indicators of !nancial sector stress are credit default swap (CDS) spreads, which measure the cost of insuring a !rm’s debt, and the 300 Libor-OIS spread, which is a common measure of banks’ counterparty credit risk. 200 Bank CDS spreads 100 Libor-OIS spread 0 2007 2008 2009 Notes: Credit default swap spreads are equal-weighted averages of JPMorgan Chase, Citigroup, Wells Fargo, Bank of America, Morgan Stanley, and Goldman Sachs. Libor-OIS spread used throughout is the spread between the 3-month London Interbank O"ered Rate and the 3-month USD overnight indexed swap rate. 15 Sources: Libor-OIS: Bloomberg Finance L.P.; bank CDS spreads: Bloomberg Finance L.P., IHS Markit ARC OF THE CRISIS Home prices peaked nationally in the summer of 2006, then fell rapidly— eight major cities had declines of more than 20 percent by March 2008. Change in S&P CoreLogic Case-Shiller Home Price Indexes for 20 cities and U.S., from U.S. peak in July 2006, not seasonally adjusted +10% U.S. peak: U.S. change by March 2008: –9.0% July 2006 0 –10 –20 Change, July 2006–March 2008 Detroit –22.5% San Francisco –22.6 –30 Miami –23.1 Tampa –23.4 Los Angeles –24.4 San Diego –25.6 –40 Phoenix –26.6 Las Vegas –27.7 –50 2006 2007 2008 Sources: S&P CoreLogic Case-Shiller Home Price Indexes for 20 individual cities and National Home Price Index via Federal Reserve Economic Data (FRED) 16 ARC OF THE CRISIS Stress in the !nancial system built up gradually over late 2007 and early 2008, as mortgage troubles and recession fears increased. Libor-OIS spread 400 basis points 350 Bank of America announces intent to buy Countrywide Financial, 300 a troubled mortgage lender, Jan. 11, 2008 250 Banks and GSEs start reporting billions in losses in Nov. 2007, and warn of dividend cuts and a need for Stock markets plunge 200 more capital; stocks fall Jan. 21, 2008, amid recession fears Bank of England provides JPMorgan Chase 150 emergency credit to Northern rescues Bear Stearns Rock, a troubled mortgage with emergency support lender, Sept. 14, 2007 from Federal Reserve, 100 March 14, 2008 BNP Paribas freezes three funds on 50 Aug. 9, 2007, amid Libor-OIS fragile ABS markets spread 0 2007 2008 2009 Note: GSE: government-sponsored enterprise Source: Bloomberg Finance L.P. 17 ARC OF THE CRISIS Investors were fearful that the mortgage giants Fannie Mae and Freddie Mac might collapse and cause severe damage to the housing market. Stock price of Fannie Mae and Freddie Mac $80 a share New York attorney general subpoenas 70 Freddie Mac Fannie Mae and Freddie Mac, Nov. 7, 2007, in mortgage fraud investigation Morgan Stanley takes $3.7 billion loss on subprime mortgage exposure; other big banks 60 also warn of huge write-downs 50 Fannie Mae reports $1.4 billion loss on Nov.

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