By the end of 2008, the unemployment rate in Elkhart, Indiana, had jumped from 4.9 to 16.2 percent. Almost twenty thousand jobs were lost. The effects of unemployment were felt in schools and charities throughout the region. Soup kitchens in Elkhart saw twice as many people showing up for free meals, and the Salvation Army saw a jump in demand for food and toys during the Christmas season. If it weren’t for the Great Recession, the income of the United States in 2012 would have been higher by $2 trillion, around $17,000 per household.
It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts.
Between 2000 and 2007, the household debt-to-income ratio skyrocketed from 1.4 to 2.1.
Both recessions started off with a mysteriously large drop in household spending. Purchases of durable goods like autos, furniture, and appliances plummeted early in the Great Recession—before the worst of the financial crisis in September 2008.
Growth in household debt is one of the best predictors of the decline in household spending during the recession. Banking crises and large run-ups in household debt are closely related
The expansion in debt is five times as large before a banking-crisis recession
Economic disasters are almost always preceded by a large increase in household debt
The financial system actually works against us, not for us.
For many Americans, home equity is their only source of wealth. The mortgage lender has the senior claim on the home and is therefore protected if house prices decline. The home owner has the junior claim and experiences huge losses if house prices decline.
House prices may fall so far that even the senior claims take losses, but they are much less severe than the devastation wrought on the borrowers.
During the Great Recession, house prices fell $5.5 trillion
Home owners in the bottom 20 percent of the net-worth distribution—the poorest home owners—were highly levered.
The poorest home owners relied almost exclusively on home equity in their net worth. About $4 out of every $5 of net worth was in home equity
The combination of high leverage, high exposure to housing, and little financial wealth would prove disastrous
Because low net-worth home owners had a leverage ratio of 80 percent, a 30 percent decline in house prices completely wiped out their entire net worth
The rich made out well because they held financial assets that performed much better during the recession than housing.
A financial system that relies excessively on debt amplifies wealth inequality
A negative externality occurs whenever there are negative effects on other people from a private transaction between two parties
The National Bureau of Economic Research dates the beginning of the recession in the fourth quarter of 2007, three quarters before the failure of Lehman Brothers.
Residential investment was a serious drag on GDP growth even before the banking crisis. In the third quarter of 2008, the collapse in GDP was driven by the collapse in consumption. Non-residential investment contributed negatively to GDP growth, but its effect was less than half the effect of consumption. The decline in business investment was a reaction to the massive decline in household spending
The MPC out of housing wealth tells us how many dollars less an individual spends in response to a wealth shock.
The higher the leverage in the home, the more aggressively the household cuts back on spending when home values decline.
Rich households with little debt tend to have a very low MPC out of wealth. As a result, we shouldn’t be surprised that the bursting of the tech bubble had almost no impact on spending.
A collapse in asset prices when an economy has elevated debt levels leads to economic disaster with massive job losses.
The supply-side view emphasizes the productive capacity, or supply, of resources.
Severe recessions are triggered even when no obvious destruction of productive capacity occurs.
The borrower has the junior claim on the home and therefore experiences the first losses associated with any decline in house prices.
The rich are protected against house-price declines not only because they are rich but also because they have a senior claim on housing.
The first way that the economy tries to prevent economic catastrophe when indebted households cut back is through a sharp reduction in interest rates
Very serious adjustments in the economy are required when levered households cut spending. Wages need to fall, and workers need to switch into new industries.
There was a very strong relation between job losses at auto dealers in a county and the size of the local net-worth shock. In counties with the largest shock to net worth, 14 percent of jobs at dealerships were lost.
4 million jobs were lost between March 2007 and March 2009 because of levered losses, which represents 65 percent of all jobs
Delayed foreclosures and government assistance reduced the incentive of workers to find jobs during the Great Recession.
A worker laid off in a recession loses income equal to three times his or her annual pre-layoff earnings over the rest of their lifetime
Marginal Borrower: Borrower that is shopping for a low interest rate.
Throughout American cities, credit was pumped into low credit-score zip codes that were experiencing declining income growth.
At the peak of the housing boom in 2006, house prices in low credit-score zip codes had risen by 80 percent since 2002. In comparison, house prices in high credit-score zip codes had risen by only 40 percent.
House prices in high credit-score zip codes in inelastic cities increased by 50 percent between 2002 and 2006. However, house prices in low credit-score zip codes increased by twice as much, rising 100 percent over the same period.
From 2002 to 2007, home owners in inelastic counties increased their debt by 55 percent compared to only 25 percent for home owners in elastic counties
From 1993 to 1996, the volume of real estate loans tripled
in 1970 the U.S. Department of Housing and Urban Development promoted securitization through government-sponsored enterprises (GSEs)
The two most important mistakes made were related: investors underestimated the probability of mortgage default and the correlation of those defaults
This ability of structured finance to repackage risks and to create “safe” assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. securitization directly encouraged irresponsible lending
One in ten mortgage loans in private-label securitization pools were misclassified as owner-occupied despite being investor-owned.
A triple-A MBS originated in 2007 worth $100 in face value was trading at only $50 as of 2012
The main driver of asset-price bubbles was almost always an expansion in credit supply
What should be the price of an asset such as a stock or a house? Standard asset pricing theory suggests that it should equal the sum of expected payoffs from the asset
Bubbles do exist and that they can make prices deviate substantially from their long-run fundamental value
By enhancing optimists’ buying power in the future, debt increases the probability that a greater fool will indeed be waiting tomorrow.
Debt facilitates an increase in the price of assets by enabling optimists to increase their influence on the market price
Debt leads to bubbles in part because it gives lenders a sense of security that they will be unaffected if the bubble bursts.
Certain unlikely events can materialize that are completely unexpected, because investors neglect the risks that they could happen.
The Spanish economy foundered, with unemployment topping 25 percent by 2012.
Harsh Spanish mortgage laws remain on the books, and Spain has endured a horribly severe recession, comparable to the Great Depression in the United States.
In July 2012 the Spanish banking system was given a $125 billion bailout package by Eurozone countries. And it was actually backed by Spanish taxpayers.
Because depositors are generally insured and can demand their money back instantaneously, the non-deposit debt of a bank is considered junior to deposits and is usually called subordinated debt.
Quantitative Easing: Involves the Fed buying long-term assets that include agency debt, mortgage-backed securities, and long-term treasuries from banks. It has been enormous by any standard. By the middle of 2013, these Fed purchases had increased the size of its balance sheet from around $800 billion in 2007 to a whopping $3.3 trillion.
If banks get in the business of producing bad loans, why should the government step in to protect incompetent bank managers and their creditors and shareholders?
Financing and interest rates as a main concern never rose above 5 percent throughout the financial crisis—in fact, the fraction actually went down from 2007 to 2009.
More debt is not the way to escape a recession caused by excessive debt. This is like trying to cure a hangover with another binge-drinking episode.
Campaign contributions by financial firms led congressional representatives to be more likely to vote for the bank-bailout legislation.This was more than just a correlation. For example, we showed that representatives who were retiring were less sensitive to bank campaign contributions than those looking to get reelected.
The Home Affordable Modification Program was supposed to help 3 to 4 million at-risk home owners avoid foreclosure by easing mortgage terms. Five years later, it had led to only 860,000 permanent modifications
Up to 40 percent of private-label MBS contained some restriction limiting the servicer’s ability to modify mortgages in the securitization pool. The Trust Indenture Act of 1939 stipulated that “modifying the economic terms of RMBS required the consent of 100 percent of their holders.” If even one MBS holder decided it would be better to foreclose than to renegotiate, the servicer’s hands would be tied.
Given that creditors tend to have high income and low leverage whereas borrowers tend to have low income and high leverage, a more equal sharing of losses would have transferred wealth from people with very low marginal propensities to consume to people with very high marginal propensities to consume. This would have boosted overall demand. A creditor barely cuts spending when a dollar is taken away, but a borrower spends aggressively out of a dollar gained.
Debt forgiveness actually made creditors better off. Individuals who received more debt forgiveness saw a decline in five-year mortality risk and significant increases in both earnings and employment.
Moral hazard refers to a situation in which a sophisticated individual games a flawed system by taking advantage of a naive counterparty. This does not explain what happened during the housing boom. Home owners were not sophisticated individuals who took advantage of naive lenders because they understood house prices were artificially inflated. They weren’t counting on a government bailout, and indeed they never received one. In reality, home owners mistakenly believed that house prices would rise forever.
Preventing deflation is one thing; generating significant inflation is much harder.
In the five months from August 2008 to January 2009, bank reserves increased by ten times—from $90 billion to $900 billion—which reflects the extremely aggressive stance of the Fed. Aggressive monetary policy continued through 2013, with bank reserves over $2 trillion today
When central bankers expand bank reserves in a levered-losses recession, there is no increase in lending or borrowing, and a severe and long economic slump ensues.
If the Fed can just get you to believe that inflation will eventually emerge, the inflation expectations view holds that this can boost the economy. The problem with this argument, however, is that it assumes that household spending is very sensitive to changes in real interest rates.
Most economists agree that in normal times government spending has little effect on the economy, because it crowds out private spending and because households understand that they eventually have to pay higher taxes to finance the spending.
Fiscal policy is an attempt to replicate debt restructuring, but it is particularly problematic in the United States, where government revenue is raised from taxing income, not wealth
When a crisis materializes, the fraction of the population calling themselves centrists falls sharply. In its place is a large increase in the share of extremists, on both the left and the right.
Outstanding student debt doubled from 2005 to 2010, and by 2012 total student debt in the U.S. economy surpassed $1 trillion.
Student debt is especially pernicious in this regard because it cannot be discharged in bankruptcy. And the government can garnish your wages or take part of your tax refund or Social Security payments to ensure that they get paid on federal loans
In both Australia and the United Kingdom, students pay only a fixed percentage of their income to pay down student loans
When borrowers are forced to bear the entire brunt of the crash in asset prices, the levered-losses cycle kicks in and a very severe recession ensues. If financial contracts more equally imposed losses on both borrowers and lenders, then the economy would avoid the levered-losses trap in the first place.
SRMs (Shared Rate Mortgages) provide an important mechanism needed to solve the levered-losses problem. The downside protection to borrowers will help stave off dramatic declines in demand, and the shared capital gains on the upside will compensate lenders.