CHARTING THE FINANCIAL CRISIS U.S. Strategy and Outcomes at BROOKINGS Introduction The global nancial crisis of 2007-2009 and subsequent Great Recession 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 intensied, 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 eorts of the Federal Reserve, Treasury Department, and other agencies were ultimately forceful, exible, and eective. Federal regulators greatly expanded their crisis management toolkit 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 eorts 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. 1 Antecedents of the Crisis 2 ANTECEDENTS In the years leading up to the crisis, the underlying performance of the U.S. economy had eroded in important ways. 3 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. Average growth in real potential GDP (August 2018 estimate) 5% Contribution to potential GDP from: Productivity growth Labor force growth 4 3 2 1 0 1975 1980 1985 1990 1995 2000 2005 2008 Sources: Congressional Budget Ofce, “An Update to the Economic Outlook: 2018 to 2028”; internal calculations 4 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 5 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 Middle 60 percent Bottom 20 percent – 50 of households of households 1970 1975 1980 1985 1990 1995 2000 2005 2008 Source: Congressional Budget Ofce, “The Distribution of Household Income, 2014” 6 ANTECEDENTS Household debt as a share of income had risen to alarming heights. Aggregate household debt as a share of disposable personal income (after taxes) 140% 120 100 80 60 40 Mortgage debt 20 Consumer debt 0 1970 1975 1980 1985 1990 1995 2000 2005 2008 Sources: Federal Reserve Board Financial Accounts of the United States; Federal Reserve Board, “Household Debt-to-Income Ratios in the Enhanced Financial Accounts” 7 ANTECEDENTS Meanwhile, the fnancial system was becoming increasingly fragile. 8 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 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 9 ANTECEDENTS The “Great Moderation” — two decades of more stable economic outcomes with shorter, shallower recessions and lower infation — had added to complacency. Quarterly real GDP growth +20% +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 10 ANTECEDENTS Long-term interest rates had been falling for decades, refecting decreasing infation, an aging workforce, and a substantial rise in global savings. Benchmark interest rates, monthly 20% 15 30-year fxed 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 via Federal Reserve Economic Data 11 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 12 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 MMF Insurers 50 0 1970 1975 1980 1985 1990 1995 2000 2005 2008 Source: Federal Reserve Financial Accounts of the United States Notes: GSE: government-sponsored enterprise (including Fannie Mae and Freddie Mac); ABS: asset-backed securities; MMF: money market funds 13 ANTECEDENTS The amount of fnancial assets fnanced with short-term liabilities had also risen sharply, increasing the vulnerability of the fnancial system to runs. Net repo funding to banks and broker-dealers $2.00 trillion 1.75 The use of repo funding tripled 1.50 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 14 ANTECEDENTS The regulatory capital regime for the U.S. fnancial system was inadequate. Tier 1 common equity as a percent of risk-weighted assets Tangible common equity to tangible assets ratio 14% 4.0% Wells Fargo 3.5 Goldman Sachs Morgan 12 Stanley Citi Tier 1 common equity 3.0 JPMorgan 10 Chase Merrill Lynch All U.S. fnancial institutions 2.5 Bank of America 8 2.0 Lehman Bear Estimated Stearns 6 Largest U.S. bank capital and funding holding companies 1.5 ratios, Q4 2007 Commercial bank 4 1.0 Investment bank 2 The pre-crisis capital ratios Some institutions more did not refect the growing risks. 0.5 dependent on short-term funding were more leveraged. 0 0 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 0% 10% 20% 30% 40% 50% 60% Reliance on short-term funding* Sources: Capital ratios: Federal Reserve Bank of New York‘s Research and Statistics Group; tangible common equity to tangible assets: company reports *Determined by share of fnancial assets pledged 15 The Arc of the Crisis 16 ARC OF THE CRISIS The fnancial crisis unfolded in several phases. Bank credit default swap spreads and Libor-OIS 500 basis points Increasing Stress Early Breaking the Panic Escalation and Resolution 400 300 200 Bank CDS spreads 100 Libor-OIS spread 0 2007 2008 2009 Source: Bloomberg. Note: Credit default swap spreads are equal-weighted averages of JPMorgan Chase, Citigroup, Wells Fargo, Bank of America, Morgan Stanley, and Goldman Sachs. 17 ARC OF THE CRISIS Home prices peaked nationally in the summer of 2006, then fell rapidly — eight major cities had declined more than 20 percent by March 2008. +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 18 ARC OF THE CRISIS Stress in the fnancial 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 the troubled mortgage lender, Jan. 11, 2008 250 Banks and GSEs start reporting billions in losses in November 2007, and warn of dividend cuts and a need Stock markets plunge 200 for more capital; stocks fall Jan. 21–24, 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 ABCP markets spread 0 2007 2008 2009 Source: Bloomberg Note: GSE: government-sponsored enterprise 19 ARC OF THE CRISIS Investors were fearful that Fannie Mae and Freddie Mac might soon be swamped by losses . 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 writedowns.