a summary of the current economy ..
These are more or less chronological notes – a scorecard – on what has been happening with financial markets and the unfolding recession. Many of the postings below may seem difficult to understand without a strong background in macroeconomics; so, hopefully at least what you read provides a big incentive to learn! (The notes below may be updated or corrected as more information is found and details reveal themselves.)
October 2007: Stock market reaching peak over 14,000 Dow Jones Industrial Average – indicating optimism about economy. At same time, fourth quarter real GDP growth proving to be anemic, oil prices rising, and many housing markets across nation showing decline in prices. General Problem in Housing Market: Real estate rapid expansion led banks to aggressively offer subprime mortgages to high risk borrowers with little down and wishful thinking that property inflation would continue to cover lending risk. Borrowers willingly signed up for deals. Eventually most everyone realized that real estate inflation was due mostly to speculation without fundamental causes. When the real estate bubble popped and home prices fell, many borrowers defaulted because their homes could not sell for enough to cover the mortgage loans. Financial institutions were left with these bad loans on their books and also other loans that were not being paid every month by households caught in a stagnate economy. This tightened lending practices in general and a credit crunch (even on less risky borrowing) precipitated. Country Wide: The home lender near bankruptcy was purchased by Bank of America in January.
Fiscal Policy – Tax Rebate: In January, Congress passed the President’s proposed stimulus plan that called for $600 to $1,200 tax rebates starting to May in hopes of buttressing consumer spending at the cost of a wider government deficit. Indymac Bank:
In July, Office of Thrift closed mortgage heavy bank and the FDIC moved in to sell bank assets and assure depositors they were covered to the legal limits. Bear Stearns (investment bank): Rescued via loans by the Fed because this was a surprise early trouble spot in March.
Monetary Policy: Fed injects massive amounts of liquidity earlier in the year as well as during the summer and the horrendous week of September 14th. Fed realized that banks are reluctant to loan short-term excess reserves to each other because they see each other as risky. Therefore, the Fed made massive increases (via open market operations) to maintain the fed funds rate at current level. The fed funds rate would otherwise rise substantially. This allowed banks to meet reserve requirements without borrowing from each other. For some, there will remain excess reserves which are certainly available for loan-making to bank customers where credit conditions have been tight. (Note: Many banks also fear borrowing from discount window because it would signal stock market that they may have problems.) (Note: Generally the money supply has not been increasing like it should with such massive injections because the loan-making money multiplier process has bogged down.) Most of the following occurred during the week following September 14…
Stock Market and Treasuries: As bank credit froze up early in the week, investors were selling stocks and using the cash to purchase treasury bills to the point that the yield on t-bills was near zero. As some of the policy actions below took place, the yield bounced back to near one percent while the stock market rebounded.
Fannie Mae and Freddie Mac: These GSEs (government sponsored enterprises) which had implicit government guarantees purchased lots of bad banks mortgage loans. They have traditionally seen their function as trying to promote more homeownership, and the housing bubble was a good means for this while earning a profit. They purchased bunches of subprime mortgages, which encouraged banks to issue even more and resell them to Fannie and Freddie. The Treasury nationalized both, kicked out management and will oversee their operations. The Fed said it would buy some of debt.
Lehman Brothers: Filed for bankruptcy because it held too many real estate assets. The government and Fed allowed this to happen which will also send a signal to others government bailout is not necessarily an option and therefore hopefully allow firms to recognize moral hazard in decision making. Lehman will sell some of its assets to Barclays (British bank). Merrill Lynch: Sells itself to Bank of America.
AIG: Federal Reserve made a bridge loan to AIG (world’s largest insurance company) under the provision to optionally take an 80% equity stake in the company until financing can be privately resolved. Fed replaced AIGs chairman. The loan was to be $85 billion but on 10/9 the amount was increased to $123 billion. Money Market Mutual Funds: Reserve Primary Fund (nation’s oldest fund) claimed it was unable to assure it had assets to back client’s dollars. This caused panic as some investors withdrew their (uninsured deposits) from money market funds. As a result, the Fed announced it will make loans to money market funds via its discount window.
SEC: Bans short-selling (betting price will fall, selling now and buying on the cheap later) of financial institution shares in hopes that this will prevent speculative action on banking stocks.
Ban got lifted on 10/9. Currency Swaps: Fed attempts to calm international markets via currency swaps where it works with other central banks to exchange their foreign currencies for Fed dollars. This provides a means for large global financial institutions to borrow dollars from other central banks. Things that have transpired since the bad week of September 14th… Goldman Sachs and Morgan Stanley: On 9/21 Fed allowed the last two major investment banks to change to bank holding companies, which will allow them to establish commercial banks and take deposits.
WaMu: 9/25 – Largest bank failure in US history, the FDIC seized the bank and engineered a deal whereby JP Morgan Chase purchased WaMu’s deposits and some of its branches. WaMu had been losing deposits during the past week as customers feared the prospects of bank failure.
Wachovia Bank: Citigroup tried to purchase on 9/29 but Wells Fargo came in a few days later with better offer and won Wachovia and FTC approval (on 10/10). Citigroup will sue for breach of contract. Government Rescue Bill: Treasury to purchase (maybe $700 billion) in risky mortgages from financial institutions. It could also use some of the money to purchase preferred stock in banks .
The financial institutions would sell mortgages to the Treasury at a fraction of their original value. The government would receive stock warrants (right to purchase stock at a low price) in exchange for purchasing the mortgages. The government would take full losses on some but be able to sell them back to financial institutions later for perhaps greater than the purchased price. The government would be required to attempt to renegotiate lower monthly mortgage payments with homeowners in risk of default. Alternatively, some financial institutions could elect to keep their securities and instead purchase insurance to guard against default from the government. (CEO pay would be subject to regulation for banks participating in bailout, a move from both political parties to demonstrate anger at CEOs.)
FDIC: As part of the rescue package, the FDIC was granted permission to raise insurance on deposits from $100 to $250 thousand to better inhibit bank runs. Lawmakers are also considering proposing unlimited insurance on deposits.
Fed to Pay Interest on Reserves: The Fed announced it will pay interest on required and excess reserves (held at the Fed) in order to prevent the fed funds rate from falling to zero and losing control of monetary policy. In other words, an interest rate paid by the Fed creates an opportunity cost in banks lending to each other and therefore they will not lend to each other for less than they would receive from the Fed. Strangely, this will reduce incentives for banks to lend to each other their excess reserves. However, this move may be intended to provide incentives for banks to seek better yields than the fed funds market while competitively offering long-term loans like mortgages (so called, operation twist eventually helps reduce long-run interest rates when more funds are brought to that market by banks).
Commercial Paper: Tightening credit conditions due to fear of lending have left many firms without the opportunity to refinance through the use of (short-term) commercial paper. On 10/7 the Federal Reserve stated that it will be buying commercial paper. It will commence purchasing October 27th. Money market funds typically purchase commercial paper when risks are normal. Thus the Fed will lend directly short-term to corporations.
Monetary Policy: On 10/8 Fed cuts the fed funds rate from 2 to 1.5% along with a coordinated effort from other central banks of the world. Treasury: On 10/10 announced the Troubled Asset Relief Program (TARP) will focus $250 billion of the funds from the rescue package to purchase preferred stock, and assume non-voting equity stakes in banks. The top 9 banks in the nation will go first, and other banks will follow. The idea is to buy preferred stock then sell it back to the banks after economic conditions improve. Other governments worldwide announced similar proposals prior to the start of business on 10/13. This policy was successfully implemented by the Swedish government in the early 1990s under similar conditions.
Stock Market: Dow Jones losses over 20% in 10 days perhaps hitting bottom below 8,000 at the beginning of the day, 10/10, as investor confidence in not only financial sector but all companies seems to be at low point. GM lost about 1/3rd due to projected decrease in sales and tight credit markets for buying cars and trucks. Ford was hit hard, too. Middle-aged people with 401k based retirement accounts are feeling anxiety as their accounts have gone down by about a third since the beginning of the year. On October 13, the market rebounded with the DJ going up a record 930 points.
The stock market fell dramatically again on 10/15 as investors worried about reported dismal results for retails sales. Monetary Policy: On 10/29 the Fed continued its expansionary monetary policy by supplying enough money to cut the fed funds rate from 1.5 to 1%. The rate has not been this low since 6/29/04 when the next day the Fed began a more restrictive monetary policy with a rate hike to 1.25%. The fed funds rate peaked at 5.25% between 6/29/06 – 9/17/07, but the next day the Fed reversed course and began reducing the rate via expansionary monetary policy with a rate of 4.75%.
Real GDP: The 10/30 Commerce Department’s initial estimate of 2008 III quarter was that real GDP fell .3%. The prior quarter experienced 2.8% growth. Two consecutive quarters of decline would otherwise confirm a recession; it is expected that the IV quarter will do just that. The third quarter subtitle was that consumption spending dropped 3.1% following moderate gains the past three quarters. The decline seems to relate to a loss of wealth (via home equity and stocks holdings) and drop in consumer confidence related to deflated expectations about the economy. Automobile Industry: Automobile executives from Detroit testify before Congress requesting loans to help their businesses which have suffered from the economic downturn and producing vehicles consumers have rejected in favor of competitor products. Counter testimony points out that labor union negotiated contracts have led to long-run non-competitive cost structures which may not be affectively addressed through a temporary government bailout. Congress has previously authorized $ 25 billion in loans to automakers for the production of fuel efficient vehicles.
Unemployment Benefits: Congress on 11/20 approved extending unemployment benefits from 26 to 39weeks. Fiscal Policy Proposal: President-elect Obama proposes (on 11/22) an increase in government purchase toward infrastructure improvements that would create jobs in construction and hopefully have a multiplier effect.
The President-elect was said to be ready to nominate Lawrence Summers (former Clinton Treasury Secretary) as his top economic advisor, and Timothy Geithner (President of the Fed in NY) as Treasury Secretary. CitiGroup: The nation’s second largest bank has seen its stock price fall from a high of over $50 to about $3.50. The Treasury department and the Federal Reserve on 11/23 announced special plans to support the bank. The Treasury has offered a large amount of bailout money, and along with the FDIC will guarantee a huge amount of loans that appear to be high risk.
The Fed will also make loans to CitiGroup. Fed: Announced on 11/23 it will purchase $100 billion in securities from Fannie Mae, Freddie Mac and the Federal Home Loan Bank and $500 billion in additional mortgaged backed securities. The Fed will also make about $200 billion in loans to institutions that hold securities backing consumer and small business lending. Business Cycle: Revised estimates on 11/24 from the Department of Commerce are that it fell by .5% during third quarter 2008. It also fell in the fourth quarter of 2007. The good news was that consumer confidence was up a little from last month as reported by the Conference Board.
On 12/2 the National Bureau for Economic Research (NBER), a non-profit research organization, stated that they believe the economy has been in recession since December 2007 based on a broad range of data including industrial production and employment. NBER’s assessment is widely accepted by many analysts and the media even when the conventional definition of two consecutive quarters decline in real GDP has not yet proved to exist. Monetary Policy:
On 12/16 the Fed implemented monetary policy to reduce the federal funds rate in the range of 0% to .25%. Obviously the fed funds rate cannot be any lower, thus indicating that the Fed is relying heavily on new monetary policy targets such as mortgage interest rates via the Fed directly purchasing mortgage backed securities. Automobile Industry: After Congress did not pass a bill, President Bush on 12/19 announced the administration will use about $17 billion in Treasury bailout money to make loans to the automakers with the condition that they have a plan in three months to restructure.
Fiscal Policy: On 1/5/09, President elect Obama proposed to Congress a plan that calls for tax cuts and massive federal spending to total about about $800 billion over two years. Tax cuts would feature reduced withholding from paychecks over several months for lower and middle income earners to effectively rebate $500 per individual and $1,000 per couple. About $500 billion of the plan would include spending on extended unemployment compensation and health care benefits for the unemployed, infrastructure improvements on roads and bridges and alternative energy programs.
Bank of America: The nations largest bank requested at was granted $20 billion more in bailout funds from the Treasury in part to deal with Merrill Lynch which it acquired earlier. In addition, the Fed and the FDIC agreed to provide guarantees in case of losses on real estate loans.
Treasury Department: On 2/10/09 announced that the TARP money would be more directly focused on ridding banks of toxic investments in housing. Fed: On 2/10/09 the Fed announced it would be dedicating $1 trillion to purchase bonds that would finance consumer loans. Fiscal Policy: On 2/11/09, both houses of Congress reconciled the details of the stimulus package. It will cost $800 billion over several years and about 1/3 rd will include tax cuts aimed at middle and low income households. Those households that do not pay income taxes will be provided tax cuts for Social security and Medicare. There will be an increase in transfer payments for extended unemployment insurance, food stamps and health care. State governments would receive money for transportation projects and several miscellaneous categories. The majority federal government purchases will be related to roads, energy programs and schools. Some of the spending may occur soon, but other projects will not see spending until later years.
2010 Federal Budget: On 2/26, President Obama proposed to Congress a $3.6 trillion spending plan for fiscal year 2010. He forecasts that the deficit would be $1.2 trillion, less than the $1.7 trillion expected in 2009. He contends that some of the gap would be closed by reducing Medicare payments to insurance companies and also raising the top marginal tax rate on income from 35% to 39.6%.
Miserable Friday – 2/27/09: US Stocks fell to a 12 year low, where the Dow finished at 7062, half the amount it was in October 2007. This pinches wealth among many across the nation, not the least 401k retirement accounts. The federal government will convert its preferred stock to common stock and hold a 36% share of Citigroup, thus nationalizing part of the company. The Commerce Department revised its estimate of fourth quarter real GDP, where it reports now a 6.4% drop, the worst fall since 1982. Cram down Legislation update on 3/5/09: The House approve a bill that would would allow bankruptcy judges to determine solutions that could force banks to rewrite delinquent mortgages instead of foreclosing.
Unemployment rate: February’s unemployment rate was reported to be 8.1%. The amount of discouraged workers and those who could only find full time positions has increased significantly. Fed: On 3/18/09 announced it will beginning purchasing $300 billion of long-term government bonds in addition the short-term bonds it usually purchases through open market operations. Interest rates on long term lending for consumer purchases, mortgages and business investment spending are anticipated to decrease as a result. In addition, the Fed will continue to purchase more (about $700 billion) mortgage backed securities initiated by Fannie Mae and Freddie Mac.
