Chapter Eighteen

Too Big to Fail

The Great Recession

After a period of unprecedented economic stability, many believed that economists had finally cracked the code of the macroeconomy. Taxes had been lowered, industries (especially the financial industry) had been deregulated, and the U.S. was opened to international trade. An era of investment, innovation, and growth had been ushered in by the supply-siders. At the same time, monetary shocks had been smoothed out by competent monetary policy with moderate inflation and stable growth in the money supply. But in the canyon of skyscrapers surrounding Wall Street, a crisis was brewing.

Mortgage-Backed Securities

During the Great Depression, the National Housing Act established a government-sponsored enterprise called the Federal National Mortgage Association, whose abbreviation - FNMA - has given it the common name of Fannie Mae. The purpose of the company was to buy mortgages from lenders and pool them together. In the 1970s, another organization called Freddie Mac was created to expand this secondary market for mortgages. By the 1980s, these Mortgage-Backed Securities (MBS) has become one of Wall Street's favorite investments.

Open Video Transcript

A mortgage is a loan you can take out to purchase a home. They are one of the most common ways in which people borrow money and they offer the opportunity for everyday people to own a home. Mortgages as we know them are a lot more modern than you might think. Home ownership throughout history was as rare as land ownership, and usually property was consolidated into the hands of the very few and wealthy. Prior to the 1930s, you would usually have to put down a 50% down payment and pay back the entire mortgage within 5 years, but since the Great Depression, financial innovation has reduced the risk of mortgage lending and made it something that is affordable to most people. There is a handy formula for calculating what your monthly mortgage payment will be based on the principal amount borrowed, the interest rate, and the term of the loan. In this equation, P is the principal, r is the monthly interest rate paid, and n is the number of months the loan will be paid back over. Let’s do an example. Let’s say you buy a house for $300,000, and you put 10% or $30,000 of your own money down. That means you need to borrow the remaining $270,000. That will be the principal amount borrowed. If you get a 30-year fixed rate mortgage, the most common type, at a 6% interest rate, then r will be 0.005 and n will be 360 months. Let me walk you through that. Mortgages are usually paid monthly, and so to find the monthly amount, we need to put everything in monthly terms. With 12 months in the year, you take the 6%, which in decimal form is 0.06, and divide it by 12 to get 0.005. And then 30 years times 12 months per year is 360 months. When you plug those in and use a calculator to solve, you a monthly payment of $1,618.79. So, you would make that payment each month for 30 years. Note that you are paying back quite a bit more than $270,000. 360 times $1,618.79 is over $582,000, which means you are paying back the $270,000 borrowed and over $312,000 in interest over those 30 years. --The interest is what makes it worthwhile for someone to lend you the money to buy the house up front and be paid back slowly over the course of 30 years. Banks and other mortgage brokers make loans to many different people, and each month the borrowers make their mortgage payment, giving the lender a nice stream of income in the form of that extra bit of interest. --Starting in the 1980s, financial institutions started to bundle these mortgage payments together into something called mortgage-backed securities which they could sell to investors. People with extra money looking to earn a good rate of return could buy these securities. For example, a bank might have lent out say $2 million total to the people who bought these six houses. The bank could then bundle those six mortgages together and sell that mortgage-backed security for something above that amount, say $2.5 million. The bank gets paid back with a little interest early, and now the holder of the mortgage-backed security is the one who receives the monthly mortgage payments, and over the life of the security they will earn their money back and then some. --Bundling mortgages together like this is a great way to reduce the risk of mortgage lending. If you had $300,000 that you wanted to invest, it would be really risky to lend it all to someone so they can buy a house. If something goes wrong, and they lose their job or their source of income, they might not be able to repay you and you’ll lose everything. There are a lot of other investments you could make with a lower risk of delinquency, and so anyone who wants to buy a house would need to pay a really high interest rate to attract any lenders at all. But if instead you could spread out your $300,000 investment across a bunch of homes, the risk would be way lower. The bigger the pool of mortgages is, the more certain you can be about how many people will default and not pay you back. You might know that 2 or 3% will default, and so you will lose 2-3% of your money, but you also know it won’t be more than that, and you’ll need enough interest to cover those loses to make it worthwhile. Pooling risks together reduces the overall risk, and that reduces the interest rate. --These mortgage-backed securities grew into an extremely common investment. Mortgages would be pooled together, and then the payments would be broken into tranches. Because many hundreds of millions of dollars’ worth of mortgages would be pooled together into one security, many different investors would put their money into the security. Investors could decide which tranch they wanted to invest into. Every month the mortgage payments would be pooled together, and the investors who bought into the top tranch would be paid first, then down the levels it would go all the way to the bottom tranch. Investors who bought into the top tranch got a low rate of return on their investment, but the investment was very safe because they would be paid first. Investors who bought into the bottom tranch got a higher return on their investment, but it was riskier. If too many people in the mortgage pool defaulted, then there wouldn’t be enough money to pay investors in the bottom tranch. And if things were really bad, and lots of people defaulted, even those in the tranches above it would lose their investments. But those who didn’t want to take that risk could take the lower rate of return and essentially have a sure thing, because certainly not all of the people in the pool would default. It may sound weird to you, but this was a brilliant and economically beneficial financial innovation. The role of the financial sector is to transform savings into investment. Things like mortgage-backed securities do that job more efficiently. By pooling risk together, and then attracting investment with different levels of risk and reward that allow the investors to choose what they are most comfortable with, mortgage rates could be driven down to historically low levels. Essentially the risk that comes with making any loan could be efficiently distributed amongst those most willing to take that risk. --The result was spectacular for American home buyers. In the early 1980s, interest rates were over 15%. Our $270,000 mortgage at 6% interest had a monthly payment of about $1,619. That same mortgage at 15% interest would have a monthly payment of $3,414. The house cost the same amount of money, but the higher interest rate more than doubles the monthly payment!But since 1980, with the advent of mortgage-backed securities and other financial innovations, interest rates have steadily fallen. In the years prior to the financial crisis of 2008, average mortgage rates were around 6%, but they have continued to fall since and were around 3% in 2020. At that rate, the $270,000 mortgage comes with a monthly payment of $1,138, almost $500 less per month than it was at a 6% rate. These lower mortgage rates were saving typical American’s a lot of money and making the dream of home ownership available to a massively larger number of Americans.

Practice Questions

1. Erika is buying a $450,000 home. She has a $25,000 down payment and the bank has offered her a 30-year fixed rate mortgage at 7%. What will be Erika's monthly mortgage payment?

Reveal the Answer

The formula for the monthly mortgage payment is:

Payment = P*r*(1+r)n / ((1+r)n - 1)

The principle amount borrowed (P) is the cost of the house minus the down payment. For Erika, that would be:

P = $450,000 - $25,000 = $425,000

The monthly interest rate (r) is the annual rate divided by 12:

r = 0.07 / 12 = 0.0058333333

The term of the loan (n) is the number of months until the loan is paid off:

n = 30 year * 12 = 360 months

With these values, we can use the formula to find the monthly payment:

Payment = $425,000*0.00583*(1.00583)360/(1.00583360 - 1) = $2,827.54

*Note: When doing this calculation, don't round the interest rate as is shown here for convenience*

Erika's monthly payment will be $2,827.54

2. After two years of home ownerships, Erika still owes $416,053.53 on her mortgage, but has the opportunity to refinance with a 3% interest rate. If she does so, she will need to include an additional $10,000 in fees onto the amount she borrows. What will be her new monthly payment after refinancing?

Reveal the Answer

When you refinance, you essentially take out a new loan to pay back your old one. But they always get you with those fees! The fees are usually folded into the new amount borrowed, which means Erika will need to borrow $426,053.53 to pay off the old mortgage plus the fees. For that principle amount borrowed at 3% interest for 360 months, her payments would be:

Payment = $426,053.53*0.0025*(1.0025)360/(1.0025360 - 1) = $1,796.26

Over the first two years, Erika paid $2,827.54 for 12 months, which is $33,930.48. If she had continued to make that payment for 28 more years, she would have paid another $950,053.44. But by refinancing, she will instead pay $1,796.26 each month for the next 30 years, which totals to $646,653.60. Over the next 30 years, Erika will save over $300,000 just be refinancing to a lower interest rate!!!

Shadow Banking

Commercial banks provide banking services to regular people. Investment banks provide banking services to investors and large corporations. If you want to keep your money safe and available for everyday purchases, then you keep it in a commercial bank. If you want to save your money for a long period of time and let it grow, you usually need to turn to an investment bank or a similar type of financial institution. Commercial banks operate with a lot of regulation from the government and the Federal Reserve, but the deregulation campaign of the 1980s freed many of the investment banks and similar institutions of those regulations. With no one watching over their shoulders, it started to be referred to as the shadow banking system.

Open Video Transcript

I like this photo of the American Union Bank in 1931 amidst a run. We saw it before in the chapter on the Great Depression. What I find so interesting is the sign for the bank, which is advertising 4% interest paid on what they called a thrift account, at the time that was just another term for savings. For most of my adult life, a savings account with a regular commercial bank has typically only paid a tiny fraction of percent interest, usually as low as 0.01%. How on earth was it that ordinary people were getting 4% interest on their savings. At that rate you could double your money in just over 17 years. But after the Great Depression, Glass-Steagall had separated commercial and investment banking, and over the many decades since the world of finance has changed quite a bit. If you want to earn something like 4% on your savings today, you need to take your money to an investment bank like Goldman Sachs.Starting in the 1980s, the freshwater economists had convinced policymakers to deregulate many industries, but among them was the financial industry which started to see a rollback of the regulations placed on it after the Great Depression. By 1999, they had even repealed the parts of Glass-Steagall that separated commercial and investment banking. --They weren’t wrong. Deregulation led to a great deal of innovation in financial products, such as the mortgage-backed securities that helped manage risk efficiently and lower mortgage rates for everyday people. But that sort of risk pooling did not stop there. As we learned, the bottom tranches of these mortgage-backed securities conveyed the most risk. But that risk could also be pooled together, further reducing uncertainty. --The lower-rated tranches of the mortgage-backed securities were pooled together into a new security called a collateralized debt obligation, or CDO for short. They basically work the same way as mortgage-backed securities. The money paid to the lower-rated tranches gets pooled together, and then distributed to each tranch of the CDO in sequence. If one mortgage-backed security didn’t pay out it was ok, because the CDO contained many dozens of them. So, the people invested in the highest rated tranch of the CDO saw very little risk of not getting paid. The CDOs took a risky investment and turned it into a safe one. This is why mortgage rates kept falling. Everyone wants a nice safe investment with low risk and a steady return. CDOs were rapidly expanding the supply of those safe investments, and investors had an insatiable appetite for them. Trillions of dollars poured into these mortgage-backed securities and CDOs. --But there are other ways to mitigate your risk. Say you’re an investor, and you are looking for a place to park your money and let it grow for a while. A collateralized debt obligation is a great investment for just that purpose. You invest your money, and each month you get a little payment from all the people who pay their mortgage. You can reinvest it, live off it, do whatever you want with it, all the while your initial investment is safe in the value of the CDO. You can sell the CDO and get it all back if you wanted. But maybe you are worried that a wave of mortgage defaults means you will lose your initial investment. You want to protect yourself from the potential downside of your investment, so you go to an insurance company and take out an insurance policy on it. That insurance policy is called credit default swaps. Essentially, you agree to make small monthly payments, or premiums, to the insurance company. In exchange, if your investment ever does go under and you lose it all, then the credit default swap will pay out and you will get your money back. It’s just like any other insurance policy. They actually became so common, people started buying these swaps even if they didn’t own a CDO. They were just gambling on the possibility that the CDOs could go bust. --All of this should be fine. It all sounds crazy, but this world of high finance is truly awesome. These innovations are complicated, and you need advanced math degrees to even begin to calculate the risk, but they are absolutely worth it in the end because they help drive our economy to greater prosperity through investment. Unfortunately, not everyone involved was a math wizard, and some financial institutions were making really big mistakes. The problem was a disregard for correlated risk. You can buy insurance in case your house burns down. Insurance gives people peace-of-mind and lets them offload some of the risk they face in their life onto an insurance company. Insurance companies are able to provide this insurance because they can sell lots of policies and pool the risk together. Fires that burn down houses are basically random events. Every individual homeowner might face, say, a 1% risk of their house burning down each year, which is a big risk for an individual to take with something so valuable. But if an insurance company insures millions of homes, the law of large numbers guarantees that only about 1% of them will burn down, and the insurance company can charge appropriate premiums to make sure they bring in enough money to pay out on 1% of their policies each year. But that assumes that if my house burns down, it doesn’t change the probability that your house will burn down. That isn’t always true. People who live in places prone to wildfires have a difficult time getting insurance, because risk pooling doesn’t work in this circumstance. There may only be a 1% chance of a wildfire, but if that 1% chance does happen, everyone’s house burns down, not just 1% of homes. The insurance company would have to pay out everyone’s policy all at the same time, and there is no way to make that profitable. The people creating collateralized debt obligations and credit default swaps were assuming that the risk of default on mortgages was independent. They didn’t account for the possibility that something might happen that would make significantly more people default on their mortgage. And that would prove to be their fatal error. --In fairness, quite a few people saw the disaster coming, and many of them bet big on potential collapse, making billions of dollars as financial markets collapsed in 2008. But no one wanted to listen to them. Investment banking was in a golden age. Between 2002 and 2007, total revenue for investment banking doubled from $100 billion to over $200 billion. But these investment banks were essentially operating in the shadows. Investment banks are not part of the Federal Reserve system. Even though they essentially take in deposits and make investments with them, just like a regular bank, there are no reserve requirements, no deposit insurance, no safeguards against runs. All the protections put into place after the Great Depression just didn’t apply to these investment banks. And a perfect storm was about to threaten the whole thing.

The Largest Bankruptcy Ever

If you've seen the 1987 film Wall Street, or the 2013 film The Wolf of Wall Street, than you have a pretty good idea of Wall Street's reputation. In 1913 people decried the creation of the Federal Reserve because it would be a system that helps bail out rich bankers when things went bust. That attitude didn't go away. No one wants to give multimillionaires more millions because their reckless behavior has endangered their company. But some worried that these companies were so vital to the proper functioning of credit markets that we could not afford to let them go under. They were too big to fail.

Open Video Transcript

Over the course of the early-2000s, housing prices were rapidly climbing. Access to mortgage lending along with other programs were driving millions of Americans to buy a home. And the demand for mortgage-backed securities on Wall Street was ensuring that the credit was not going to end. Where in the past most mortgage lenders would keep the loan for its entire duration, now almost every mortgage any mortgage lender originated was bundled up with others within three months and sold off to investors. Mortgage lenders faced essentially zero risk, because they were selling the mortgages off to these bundlers, and the bundlers were willing to accept mortgages issued to sub-prime borrowers – or borrowers who had low credit scores. Once again, we need to have some humility in our assumptions about people. Lenders were willing to give mortgages to people with a history of not being able to repay their loans. That sounds stupidly risky, but remember, the key innovation of the financial industry over the previous decades was tools for pooling risk so that it became predictable. These innovations were opening up possibilities that were not previously available. It was now possible to give people who made mistakes when they were young a second chance, offering them the same opportunity at home ownership as those who had more support. --But the rising home prices did lead to some very risky behavior on the part of borrowers and lenders. One example of the sort of sub-prime lending that was problematic were mortgages with balloon payments. These borrowers would be given a mortgage with no money down. When you don’t have any money to put down on a house, it’s almost impossible to get a good interest rate. These subprime mortgages would offer them a nice low interest rate for the first two years, but after two years went by, they had to pay the rest of the mortgage off all at once. People would borrow hundreds of thousands of dollars for a home, make 24 payments of a couple thousand, and then all the sudden owe hundreds of thousands for the rest of the mortgage. They did this with open eyes though. Their plan was to refinance the home two years later. When you refinance your home, you are essentially taking out a new mortgage under better terms and paying off your old mortgage with the money. When housing prices are going up, refinancing can be a great deal. You can buy a house for $240,000 say, but two years later the house is worth $300,000. Because the house appreciated in value by $60,000, and in a mortgage the house is put down as collateral, it’s like being able to make a $60,000 down payment on the home. Having started with no money down, the borrower is essentially putting 20% down due to the appreciated home price, and that gives them access to a normal 30-year fixed rate mortgage at a low interest rate. It’s really a great arrangement for the borrower, but only if the value of the house goes up enough over those two years. --In the early 2000s, seeing the value your home rise considerably in two years was the norm. It was a hot market. I remember being in my youth at the time, and at night these long infomercials would come on television with people trying to peddle a get-rich-quick scheme that involved buying houses and then selling them months later at a huge profit. But then, after decades of housing prices always going up, the bubble burst, and they suddenly started to come down. The people who bought houses with adjustable-rate mortgages or mortgages with those balloon payments were suddenly left with a bill they had no hope in the world of paying. Refinancing their home was no longer an option because the value of the house had fallen below what they owed, and no one was willing to lend more money than the house was worth. Mortgage delinquency went from under 4% to over 11% over the course of 2007 and 2008, and the fuse was lit for a bomb that would shake the entire financial industry. --Investors and credit rating agencies had thought that the historical pattern of mortgage delinquencies would hold forever, but instead those past relationships were broken. The sudden rise in delinquencies due to the drop in housing prices meant that the bottom tranches of the mortgage-backed securities all went under and stopped paying out. The money feeding into the collateralized debt obligations dried up, and entire securities went bust. A forest fire of delinquency was causing everything to go bad all at once. The key here are these investments: the top tranches of the CDOs, that were supposed to be totally safe, and the investors who put their money there did so because they didn’t want to take on any risk. When they started to go bad, those risk-averse investors saw their portfolios drop substantially, and not wanting to lose any more money, they called their brokers at the investment banks, and they pulled all their money out. --Bear Stearns was the first major Wall Street firm to be hit by a run. They were the 7th largest investment bank in the world, but their customers were panicking and closing their accounts. With money pouring out, Bear was at risk of bankruptcy. The Federal Reserve, which was headed by Ben Bernanke, stepped in with a $30 billion loan, despite that fact that Bear Sterns was not a normal bank. Bernanke came from academia and had spent his career studying the Great Depression. Perhaps more than anyone else on the planet, he knew the importance of keeping the financial markets calm and not letting a run spread from one investment bank to the next. He put the leaders at Bear Sterns together with JP Morgan, and provided the guarantees needed to get Morgan to buy Bear Sterns and keep it from collapsing. Things calmed, but over the summer of 2008, the sub-prime mortgage crisis kept growing. --By September, another financial giant was seeing its reserves depleted by panicking customers and falling asset prices. Lehman Brothers had gone big on CDOs, and they were losing incredible amounts of money on them. It was clear that they would go under if no one stepped in to stop it. But fear of a public backlash against bailing out another big bank meant the Fed and the Treasury weren’t willing to help out with government money. Instead, Treasury Secretary Hank Paulson and the President of the Federal Reserve Bank of New York Tim Geithner brought the heads of every major financial firm together to try and put together a plan to save Lehman that would come from the private sector. Essentially, they needed one of the large banks to buy Lehman Brothers and guarantee its deposits but doing so meant taking on these toxic assets whose value could not even be determined. Paulson and Geithner eventually convinced the British bank Barclays to agree to a purchase of Lehman, but British regulators nixed the deal. On Monday, September 15th, 2008, after 158 years in business, Lehman Brothers filed for bankruptcy with nearly $700 billion in assets. It remains the largest bankruptcy ever. Lehman Brothers had over 100,000 creditors it would no longer be paying back, and nobody really knew the full impact it would have on the market. --At first markets held steady, and some praised the decision to let Lehman fail as good governance. Lehman had made huge mistakes, and it went bankrupt because of those bad choices, not because of something out of their control. But soon after, analysts started to realize just how bad the situation was. The insurance giant AIG had sold massive amounts of those Credit Default Swaps, and the massive increase in defaults was threatening their entire business. AIG provided insurance to millions of people and businesses. If they collapsed, it would set off a chain reaction of bankruptcy that didn’t just threaten the financial industry, it threatened the entire economy. The 2011 film Too Big to Fail dramatizes the attempt to save Lehman Brothers, and William Hurt plays Treasury Secretary Hank Paulson. In this scene, he can’t sleep, and he explains to his wife how dire the situation really is. --“There’s not a bank in the world that has enough money in its vault to pay its depositors. It’s all built on trust and… and Wendy… we… we are so very close. Morgan Stanley, Goldman, are an inch away. If the other banks stop trusting them, if they pull back on interbank lending its over in a matter of hours. And from there it goes, too fast to stop, a run, and not just one bank, I mean on the whole system. And average people wondering, ‘Is my money safe?’ And they start pulling their cash. And after that: lines outside the bank, smashed ATMs; couple of weeks, there’s no milk in the store.”

Too Big to Fail

As a lover of cinema, I think the the 2011 film Too Big to Fail is just ok. But as an economist interested in the financial crisis of 2008, I think it is essential viewing (you can watch it on HBO). Here is a great scene from this film, which walks through the chain reaction that was about to take down the economy.

The Plan to Save the Economy

Yuval Noah Harari wrote the following about money in his book Sapiens: A Brief History of Humankind:

"Money is accordingly a system of mutual trust, and not just any system of mutual trust: money is the most universal and most efficient system of mutual trust ever devised... For thousands of years, philosophers, thinkers and prophets have besmirched money and called it the root of all evil. Be that as it may, money is also the apogee of human tolerance. Money is more open-minded than language, state laws, cultural codes, religious beliefs and social habits. Money is the only trust system created by humans that can bridge almost any cultural gap, and that does not discriminate on the basis of religion, gender, race, age or sexual orientation. Thanks to money, even people who don’t know each other and don’t trust each other can nevertheless cooperate effectively. "

Without a functioning credit system, that trust breaks down. The United States was on the brink of repeating the Great Depression, but with further to fall it promised to be much worse.

Open Video Transcript

Just days after Lehman Brothers had failed, the financial system was on the brink of total collapse. Hank Paulson, the Treasury Secretary, working with Federal Reserve Chairman Ben Bernanke, put together a last-ditch effort to save the American economy. They met with leaders in Congress and asked for $700 billion and no strings attached. The plan was to use the money to buy the toxic mortgage-related assets from the investment banks to take them off their books and calm the nerves of their depositors, freeing up cash, and getting the credit system moving again. But it wasn’t clear at the time that this would even work. To make sure he had the ability to change course, Secretary Paulson asked for total discretion over how the funds would be used. Congress found this difficult to accept. The investment banks had taken on too much risk and made bad investments, and now taxpayers were being asked to bail them out while the typical American wasn’t getting any help at all. They asked for the weekend to think about it, and they would reconvene on Monday. Ben Bernanke is reported to have replied, “If we don’t do this, we won’t have an economy on Monday.” --On Monday the Dow Jones dropped significantly after the opening bell on the news that Lehman was just the first domino to fall, and massive institutions like AIG were at risk. Speaker Nancy Pelosi brought the bill to a vote, and there was a brief rally as many saw this as a sign that she believed the bill would pass. But as the votes were counted, it became clear that President Bush and Secretary Paulson had been unsuccessful in convincing fellow Republicans of the urgent need for the plan. As the fate of the bill became clear, the stock market plummeted, and eventually closed down 777 points for the day, one of the largest single day drops in the history of the index. The immediate and unrelenting turmoil in financial markets convinced those who had their doubts, and a week later Congress passed the bill as credit markets froze and major corporations who had no hand in the mortgage crisis were finding it difficult to finance their day-to-day operations. Everyone was running out of cash, and no one was lending. While Congress had given Paulson the money, he needed to take big actions. The problems had accelerated to the point where the plan to buy toxic assets just wasn’t going to work fast enough to prevent the collapse.--Instead, Paulson assembled the heads of nine of the largest banks in the country and told them that the United States government was going to be buying stock in their companies, injecting them with cash that they could use to make loans and get credit flowing again. Having learned from the mistakes of the Reconstruction Finance Corporation during the Great Depression, which had published the names of the banks it made emergency loans to thus signaling to the market their weakness and ensuring their demise, Paulson insisted that all of the banks take the money. That way, the healthy banks who weren’t in trouble could shield the ones that were. If everyone took the money, people wouldn’t know which ones were really in a weak position. They initially infused them with $125 billion in cash, but in the end around $416 billion would be spent, with bailouts for AIG, automakers, and the eventual purchase of the toxic mortgage-related securities. Because the money was used to buy preferred stock, which was later bought back, TARP returned the taxpayer money it used in the end. --Although financial Armageddon had been averted, the hopes that the capital injections would resuscitate the credit markets were overly optimistic. Lending remained frigid, and the impact rippled through the economy and sunk the U.S. into the worst recession since the Great Depression. It was one of the longest lasting in modern times. Real GDP fell by 4% and unemployment peaked at over 10%, remaining over 9% until the fall of 2011. In a survey of the top economists around the country, there was unanimous agreement that the recession would have been worse without the TARP program. Though the economist Austan Goolsbee summed up how most felt, saying, “The fact it was necessary doesn't mean we should be happy about it.” Irrational exuberance had led investment bankers to turn a blind eye to the risks they were taking, but rather than bearing the burden of their mistakes, the bankers were saved while regular people lost their jobs and their businesses. --Unlike the Great Depression, the Federal Reserve did not sit on their hands. They took quick and decisive action, driving interest rates down with open market purchases and stimulating the economy. But for the first time since their inception, the Fed has hit a wall in the zero lower bound. By the end of 2008 they had set a target for the Federal Funds Rate of zero, and there was nowhere lower to go. Negative interest rates, while a theoretical possibility, are hard to implement in real life. A negative interest rate implies that the lender is actually paying you to borrow money. It would be as if I lent you $100, which you would pay me back in a week, but every day of that week I gave you a dollar for borrowing my money. No lender is actually going to do that. They’ll just keep the cash themselves. At this zero lower bound, open market operations had reached the limit of their usefulness. The Fed had to start buying different assets which would push down other longer term interest rates in a process called Quantitative Easing. --In the preceding years, even Keynesian economists had abandoned the idea of using fiscal policy in a recession. It wasn’t that they thought it wouldn’t work, it was just that there was nothing fiscal policy could do that monetary policy couldn’t. But with monetary policy at its limit, New Keynesians started to call for government spending to aid the economy in its recovery. With the election of President Barack Obama just months after the financial crisis had played out, those economists got their wish. The American Recovery and Reinvestment Act spent $500 billion in an effort to put people back to work, and also gave almost $300 billion in tax cuts. But aggregate demand had fallen by over $2 trillion, and many worried that this would not be enough. In the end, economists remain divided on the issue. --The American economy recovered very slowly from this recession, and in many ways still hasn’t fully recovered. It appears to have had a long-run impact on the make-up of the labor supply, and it hastened declines in many sectors of the economy which were slowly losing out to foreign competition. Economic policy had, since the Great Depression, made recessions less frequent and less severe. But short memories and hubris had driven the consensus among economists to a belief that instability was not inherent in the system. The financial crisis in 2008 had proven them wrong.

Quick Quiz

Now is the time to test yourself on these concepts! This quick quiz is a great way to see what has clicked and what needs more attention. It is also a good time to reach out to your instructor with questions.

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Dr. Goegan Explains...

Example Question
Davie bought his home several years ago with a 30-year fixed rate mortgage at an interest rate of 6.99%. He bought the house initially for $207,000 with a down payment of $36,000.

Since he bought the house it has appreciated considerably, and is now worth $772,000. Davie is considering refinancing the house while taking out some of his home equity as cash. He is interested in a 15-year fixed rate mortgage and the bank has offered him one at 3.86% interest. He will need $113,000 to pay off his initial mortgage, plus he wants to take out an additional $65,000 for himself.

What will be the change in Davie's monthly mortgage payment if he chooses to refinance?

Your answer can be positive or negative, and should be the New Mortgage Payment - Old Mortgage Payment. Round your answer to two decimal places.

Video Solution

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