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Amanda Roraback's World in a Nutshell |
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COUNTRIES
CONCEPTS TEACHER'S CORNER
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Enisen Publishing
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ECONOMIC CRISIS |
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SUBPRIME
LENDING The banks were comfortable extending these loans for a variety of reasons:
HOUSING BUBBLE
demand > supply = higher
prices Home prices rose so rapidly that it became a profitable pursuit to "flip" houses -- that is, to buy homes solely in order to sell them soon after at a profit.
Eventually prices got so high that
people stopped buying. The housing "bubble" had
burst causing house prices to drop.
demand < supply = lower
prices
The situation worsened when borrowers began defaulting on loans at a rapid pace leaving lenders with a supply of foreclosed homes whose value had dropped below the amount of the original loan. The system was breaking down.
PASSING THE
BUCK
MORTGAGE-BACKED
SECURITIES
Investment firms make their money by
acting as middle-men between corporations and the
people who want to invest in the corporations. Often
they roll up stocks and bonds from a number of
companies into packages or "portfolios"
that are then sold to investors. Unfortunately, some
investment companies also included "mortgage-backed
securities" among the packages. Hence, when the
housing market collapsed, so did the value of the
portfolios causing a dangerous sense of uncertainty
on Wall Street (the investment community).
THE DOMINO
EFFECT Investors fearful that their portfolios had been compromised by poisoned "mortgage-backed securities" began selling their stocks causing stock prices to fall.
supply > demand = lower prices Investment companies began to fail. Corporations saw the prices of their stocks drop and the financial market as a whole was in turmoil prompting the government to step in. In an attempt to restore confidence, the government developed a $700 billion bail-out packet to help prevent companies from going bankrupt and insure loans. The Federal Reserve also lowered the Federal Funds Rate (bank-to-bank interest rates) to encourage lending and stimulate growth (see below).
Countries whose currencies were
pegged (valued) to the dollar also felt the pinch as
the U.S. economy faltered, as did countries like
China and Japan that invested heavily in U.S.
Treasury bonds (whose value derived from high
interest rates). TERMS: Supply-and-Demand -- the economic concept that theorizes that when there is a greater supply of a product than a demand for the product, the price of the product goes down. Conversely, if the supply is lower than demand, the product appears more valuable and hence commands a higher price. GDP (Gross Domestic Product) -- Everything produced by all the people in all the companies in a country. Consumer Price Index (CPI) -- The CPI measures the price of all goods and services purchased by urban households to check for inflation or deflation. Inflation -- The state of the economy when prices and wages go up. Usually wages do not increase at the same rate as prices causing a decrease in the standard of living. Inflation is triggered when the supply of goods is lower than the demand. The opposite effect is called "deflation." Recession -- A country is in recession when growth, measured by the GDP, is slow, businesses stop expanding, unemployment rises and housing prices decline. Federal Reserve (Fed) -- Created by Congress in 1913, this organization acts as the country's central bank. It's job is to control inflation without triggering a recession. It does this by raising or lowering interest rates. Ben Bernanke -- Bernanke is the current head (or "chairman") of the Federal Reserve The Chairman of the Fed, as he is called, was appointed by President G.W. Bush in 2006 for a 4-year term. He can be reappointed but can serve no longer than 14 years. Bernanke is one of the most important decision-makers of American economic policy. Interest rate -- The percentage charged for borrowing money. When a loan is repaid, the borrower is obliged to pay an additional percentage of the loan in interest. For example, if a person borrows $100 from a bank that charges 8% interest, the total amount the borrower is obliged to repay will be $108. When interest rates are too high, fewer people and businesses can afford to borrow money thereby slowing the economy. Federal Funds Rate-- When banks borrow money from other banks, they must pay the lending bank an interest fee. The rate of the interest is set by the Federal Reserve. The fee is then passed on to customers (individuals or businesses) borrowing money from the banks. If the fee is too high, people will borrow less money resulting in a slow-down of the economy or recession. When the interest rates are low, people borrow more money enabling them to start or expand their businesses. From June 2006 to August 2007, the Federal Funds Rate was 5.25%. It fell to 1% by the end of October 2008 (see chart below).
Default -- Failure to meet a financial obligation, i.e. not paying back a loan ("defaulting" on a loan). Credit default swap (CDS) -- An agreement in which a lender buys "insurance" from a bank or other entity to cover a loan given to a corporation or other party. For example, Mr. Lender offers to lend money to the Widget Company to be repaid at 8% interest. Mr. Lender then buys insurance from Main St. Bank on the loan. If the Widget Company is successful, it will pay back Mr. Lender -- who will only be out the small amount it paid to Main St. Bank for insurance. But if Widget Company fails and can't repay ("defaults") the loan, Main St. Bank (the insurer) must pay Mr. Lender (the insured) the remaining amount of the loan made to Widget Company plus the 8% interest that Widget Company originally agreed to pay. CDS speculation -- Mr. Lender can buy $10 million worth of insurance (or "protection") from Main St. Bank to cover the loss if Widget Company fails. To buy $10 million worth of protection, Mr. Lender must pay 5% a year to Main St. Bank ($500,000 per year) for a fixed period (say, two years). If Widget Company doesn't default and pays off the loan as contracted, Mr. Lender will be out $1,000,000 ($500,00 x two years). But if Widget Company defaults (i.e. files for bankruptcy and can't repay the loan), then Main St. Bank will have to pay Mr. Lender $10 million and Mr. Lender is only out the money he paid Main St. Bank (if the default happens after one year, he's out $500,000, if after two years, $1 million). domino effect -- A chain reaction sparked by one small change but effecting a whole string of events. credit crunch -- In an unstable market, banks and other lending institutions (i.e. credit card companies, car loan companies etc.) will give fewer loans. Without loans, businesses can't be created or grow, people won't shop, and the economy will come to a standstill. THE HOUSING CRISIS (explained in more detail) TERMS: FICO Score (Fair Isaac Credit Organization) -- A person's FICO Score is determined by a person's history of debt payment. If a person pays off all debts (i.e. credit card payments) on time, they will have a higher FICO score. A bad FICO score can result if one has defaulted on debts, declared bankruptcy at some point, or if a person has too much debt in relation to their income. If there is no credit history (for example, in the case of a young borrower), lenders will have no way to gauge whether a borrower can reliably repay debts and may therefore be hesitant to extend large lines of credit. Subprime borrowers -- Borrowers who are at a higher risk of defaulting on loans, for example: borrowers who have defaulted on previous loans, borrowers who declared bankruptcy in the past or borrowers who don't have an established record of borrowing and repaying debts (i.e. have never had a credit card or borrowed money to buy a car) are all considered credit risks or "subprime borrowers." A borrower's risk level is gauged by his/her FICO score. Subprime lending -- In order to absorb the risk of default when lending to a subprime borrowers, lending institutions will usually require subprime borrowers to pay higher interest payments on the money they borrow. In the worst case, crooked lenders may engage in predatory lending by applying unreasonably high interest rates to loans or demanding that the loans be backed by some kind of collateral such as a car or a house. If the borrower defaults on the loan, the predatory lender may repossess or foreclose on the collateral property (that is, take possession of the house or car that was put up by the borrower to guarantee that the loan would be repaid) and then sell it at a profit. mortgage -- A mortgage is a loan given to finance the purchase of real estate (house, building etc.). The lending institution owns the property for the duration of the loan (usually paid over a few years) and can repossess or "foreclose" on the property if a borrower defaults on the loan. Security or collateral -- property that a borrower puts up as a guarantee that a loan will be repaid. If the borrower defaults on a loan, the lender is entitled to take possession of the collateral (car etc.) In the case of a mortgage loan, the borrower puts up his/her house as collateral. Foreclosure -- If a borrower can't meet their commitments (that is, can no longer pay their mortgage, or "defaults" on their loan), the lending institution has the right to repossess the property that was put up as collateral (i.e. a house). The house then goes into a legal process called a "foreclosure," that is, ownership reverts to the bank.
U.S. HOUSING BUBBLE
The bubble began to burst in 2006 and 2007 when houses became too expensive for ordinary buyers (who rented instead) and subprime borrowers defaulted on loans in great numbers. As houses became vacant (or rather, were transferred to the mortgage lenders), the prices dropped (supply-and-demand) leaving lenders with homes whose value was below the price that they had lent the original borrowers. Without liquid capital (money), mortgage-lending institutions like Countrywide Financial Corporation which financed 20% of all mortgages in the United States, suffered. Some, like American Home Mortgage Investment Corporation, the 10th largest retail mortgage lender, filed for bankruptcy. Fannie Mae (Federal National Mortgage Association or FNMA) - Fannie Mae was formed by the U.S. Government in 1938 to promote home ownership after the Great Depression. Fannie Mae did so by buying mortgages from lenders (i.e. banks). With the extra money (or capital), the lenders could issue more loans. In 1968, the government also created the Government National Mortgage Association (called Ginnie Mac) and Federal Home Mortgage Corporation (Freddie Mac) that had a similar role. All three organizations then repackaged and sold the mortgages to new lenders.
6
6 In the beginning, the mortgage-backed securities (MBS) (as the loans were called) were good investments offering a consistent flow of interest payments to the final holder of the loan from the borrower. As long as home prices continued to rise, borrowers who had trouble paying their mortgage loans could refinance (that is, borrow money on the higher value of the home to pay off the loan on the lower value) or sell the house for a profit. But the risk grew rapidly as banks, in order to make more money, increasingly issued mortgages to subprime borrowers. The banks would keep the "closing costs" and then sell the loans (along with the risk) to other companies. By the time the subprime borrowers defaulted on their loans, the loans had been sold and sometimes resold to other companies -- including some from Europe, Japan, Latin America and Asia. The collapse in the housing market badly affected mortgage lending institutions like IndyMac Bank, which declared bankruptcy in August 2008, and even Fannie Mae and Freddie Mac which were taken over by the government in September. It also hit financial institutions that engaged in the trade of mortgage-backed securities like Bear Stearns, one of the world's largest investment firms with offices in more than a dozen cities worldwide. Shareholders in Bear Stearns saw the value of their stocks drop from $154 (at its highest rate) to $3 a share when the failing company was acquired by JP Morgan Chase. (Stockholders in IndyMac were not so lucky, they lost all of their investments when the company declared bankruptcy). Investment bank -- An investment bank (like Bear Stearns) sells stocks and bonds to the public. The bank helps companies raise capital to expand and grow by selling shares or "stocks" in their company. As the company grows, so does the value of the stock. Stockholders can then sell their shares (stocks) to other investors for a profit. Cities and towns raise money to build roads, hospitals, schools and other projects by selling municipal bonds to the public through investment banks. The crisis also affected other large financial institutions that had MBDs in their portfolios (a collection of investments owned by one person or corporation), among them: Lehman Brothers, AIG, Merrill Lynch,, Morgan Stanley, Goldman Sachs and Washington Mutual, the largest savings and loan association in the United States. It then hit insurers who participated in credit default swaps (see above) such as American International Group (AIG). THE CRISIS When there is uncertainty on Wall Street, lenders are less likely to lend money causing a "credit crunch." Without loans, companies cannot grow, people cannot buy houses or cars, credit-card companies don't issue new cards and the economy can come to a standstill. In order to stop that from happening, the government (via the Federal Bank) tried to inject confidence in the economy by bailing out failing companies and cutting interest rates. $700 billion bailout plan -- In October, 2008, the U.S. Congress passed the Emergency Economic Stabilization Act authorizing the US Secretary of the Treasury to spend up to $700 billion to buy distressed assets (especially mortgage-backed securities or MBSs) and help select U.S. and foreign banks that were in trouble. The government hoped the move would restore confidence in the country's economy preventing the collapse of more financial corporations. Critics objected to the use of taxpayer money to bail out wealthy Wall Street firms without guaranteeing that the firms will not simply return to their old practices of making risky investments. THE CONSEQUENCES Lower interest rates -- As interest rates fall, foreign investors sell their dollar holdings to find other investments with higher returns. With more dollars on the market, the value of the dollar drops (supply-and-demand) meaning Americans must pay higher prices for imports. (If the exchange rate from euros to dollars is 1 dollar = 1 euro, a widget that costs 10 euros will cost 10 dollars. If the exchange rate is one euro = 1.5 dollars, the 10 euro widget will cost 15 dollars). WORLDWIDE CRISIS
International investors When interest rates drop (currently the yield on the two-year Treasury note dropped below 1% for the first time), foreign investors earn smaller returns which may inspire them to pull out their investments in dollar-based holdings in order to put them into higher yielding investments.
Currencies pegged to US Dollar
Price of oil
demand < supply = lower prices Because of lower profits, many large-scale oil-related projects including work on refineries in Saudi Arabia, offshore fields in Brazil and projects to exploit tar sands in Canada. It's estimated as much as 4 million barrels of future oil production capacity could be jeopardized. This could have a long-term affect when prices rise again. The world could see prices become especially steep.
Automobile industry
RUSSIA
CHINA Despite the efforts, China is suffering from a rise in work-related protests as labor-intensive businesses shutdown due to a drop in sales.
JAPAN
SAUDI ARABIA
ITALY AND SPAIN
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