Economic Environment Part 1

The Great Recession

You should read this material prior to class
We (may) be passing through the end of a major macroeconomic event the Great Recession of
2008 - 201 _? Technically, the recession ended years ago but the size and impact of this event
are only now being fully understood. It was a significant event and its legacy will affect the
business environment for years to come.
So we need to go back, which we rarely do in this course, to look at the Great Recession, in order
to better understand the five year future from an economic perspective.

Chronology of the 'Great Recession'

Commenced in September 2007 with problems emerging in USA subprime mortgage market.
Prime mortgages are mortgages made to borrowers that have reasonably good credit histories
and credit scores. Sub-prime mortgages are loans made to borrowers that do not have good
credit histories, scores or income levels that can safely support carrying a mortgage.
In 2000s, USA economy became heavily skewed toward residential real estate development

Investment capital flowed into residential real estate, not into manufacturing
New job growth in USA increasingly was tied to residential real estate
development

Just about all Americans came to believe that house prices would forever
rise.
That conviction made a borrowers income and cash equity seem unimportant
to lenders, who shovelled out money, confident that rising house prices would
cure all problems.
As house prices fall, a huge amount of financial folly is being exposed. You
only learn who has been swimming naked when the tide goes out and
what we are witnessing at some of our largest financial institutions is an ugly
sight
Warren Buffet, February 28 2008

Warning Signs of Real Estate Bubble in USA - 2006-2008

-Lowering of minimum down payment required
-Double digit increases in home values
-Amortization period for mortgages lengthened
-Pre-sales selling out
-Increasing use of home equity loans
(similar practices in Canadian residential real estate market, but perhaps not to same extent.
Note the percentage of Canadian residential mortgages guaranteed by the CMHC steadily
increased during the post 9/11 economic boom. Effectively this makes the federal tax payer the
guarantor of a growing number of residential mortgages. The impact of this on Canadian
banking practices and the number of defaults is unknown. The USA had and has no similar
guarantee program.)
These warning signs resulted in what was initially called the American sub prime mortgage
crisis a massive number of defaulting residential mortgages in the USA market, most of which
were subprime in nature i.e. they had been made to borrowers whose credit profile was
subprime ..they could not pay off the mortgage.
USA subprime mortgage market problems emerged in late 2007. A slowdown in new home
construction and fall in residential real estate values began and intensified in 2008.

Late Summer 2008 - late 2009 Credit Market Freeze Stage

The crisis extends past residential mortgages and beyond the USA
The USA downturn accelerated in the late summer of 2008 with the failure of high profile
American investment companies such as Bear Stearns and Lehman Brothers.
The global credit market freezes even overnight type lending stops or slows down
dramatically for periods of time during September 2008
Hard for companies to get credit, particularly companies tied to residential real estate lending
Gradually, awareness grows that the scope of exposure to USA residential real estate market
problems is global, not just tied to American financial institutions
Why?

Mortgages, like all other financial instruments, can be bought and sold after they are issued.
USA subprime residential mortgages were purchased from the banks that issued the mortgages
by investment banks like Bear Stearns.
For example, say Bank X issues a mortgage to Charlie Brown in 2005. Charlie has a low credit
score and shaky income, with very little collateral. Bank X knows that it can sell Charlies
mortgage to an investment bank like Bear Stearns as part of a pool of thousands of loans like
Charlies.
Once the loan is sold, Bank X is not responsible for the possible default of Charlies loan.
Bank X thus loses the usual lender incentive to exercise caution and due diligence in making
loans.
Many of the lenders making mortgages are not Bank Xs at all i.e. not normal banks with
regulatory limitations and safeguards they are near banks that are not subject to the same
regulatory oversight that conventional banks are e.g. Countrywide
The investment banks buying mortgages from lenders like Countrywide then placed these
mortgages in pools and sold investors shares in the various pools. This pooling is part of a
common financial practice known as securitization (fyi see
http://en.wikipedia.org/wiki/Securitization ). Ironically, the theory behind securitization is that it
allows risk to be reduced by spreading it amongst a vast number of lenders and loans through the
pooling concept.
Shares in pools of USA residential mortgages were sold worldwide
Thus, the impact of a defaulting mortgage in Cleveland was felt in Mumbai, Moscow,
Morovia
Another factor amplifying the risk of these mortgages comes to light in 2008.
The realization emerges that the impact of the default of subprime mortgages was magnified by
the use of derivatives whose value is based on the health of the subprime mortgages in the
securitized mortgage pool i.e. not only were investors bearing the risk of the mortgage, they
were also in effect placing a side bet on whether the mortgage would be paid or not. These side
bets often took the form of 'credit default swaps'.
If you are interested - see the video "Wall Street's Shadow Market' at
http://www.cbsnews.com/stories/2008/10/05/60minutes/main4502454.shtml?
source=search_story for further explanation of the credit default swap and derivative concepts
Lets continue.back to late summer 2008

The global market for credit default swaps alone was and still is in the trillions of dollars
The worst case financial impact of a default on a $200,000 mortgage could thus be much higher
than loss of some or all of the $200,000:

The loss could be multiplied several times because of losses connected to

derivatives you bought that are based on the mortgage not defaulting i.e. you lose
some or all of the $200,000 and you lose the bets you placed that the mortgage
would not default.

AND
the geographic reach of the defaults impact could be global because the risk of
the mortgage was globalized by the widespread use of securitization.
Residential real estate markets begin to decline outside of the USA, particularly in the EU.
September 2008
Extent to which major companies around the world are exposed to USA real estate becomes
known
Failure of major investment banking house Lehman Brothers on September 15 ignites a global
financial crisis
Major companies like Merrill Lynch and AIG cannot meet their obligations and are bailed out or
fail
Global stock markets begin to swing up and down
Commodity prices decline, dramatically in some cases
e.g. Oil moves from high of $143 per barrel in early 2008 to below $61 per barrel
USA and other Western countries announce bank bailout packages
October 2008
Swings in global stock markets continue
Evidence emerges that USA consumer spending is significantly declining
Globalized impact becomes more visible
Countries cannot meet their obligations (Iceland, Ireland.)
Emergency measures taken by several central banks around the world
Some positive impact, but not dramatic

Economies that primarily export commodities show major swings in currency and stock market
values
Canadian dollar plunges below 80 cents $US
Russian stock market drops dramatically
Russian ruble devalued extensively
IMF intervenes in smaller countries who face currency devaluation issues
Iceland, Ukraine
November 2008
USA retailers begin to report rapidly declining sales
Consumer demand in developing nations seen as fragile and unlikely to pull global economy out
of slowdown
E.g Russian economy contracts dramatically because of lower oil prices
E.g China projects much lower future GDP growth

December 2008 mid 2009

Unemployment Stage Begins

Unemployment stage of global slowdown begins to manifest itself

USA, Canada, other countries begin to show rapidly growing unemployment
Most major retailer sales decline on year to year basis
Oil price moves between $35 and $70 a barrel
Japan begins to show serious symptoms of economic decline
USA, China, some EU countries begin massive government-financed bailouts/stimulus spending
to get economies moving
Prime rate declines toward zero in most developed economies
Stock markets trend upward

July 2009 - 2010 Dead Cat Bounce

Growing feeling that that government bailouts/stimulus have positively affected economic
indicators in most countries

Stock market values rise

Housing starts, prices and sales volume show signs of picking up
Corporate bottom lines improve, largely due to cost cutting measures
Commodity prices rise.

But sovereign debt problems in EU begin a new period of volatility that gradually wipes away
the perception that the global economy has turned the corner.
Uncertainty about the financial health of many governments, and by implication the health of
financial institutions that are creditors to these institutions, reduces optimism about recovery and
makes the good news 2010 period look like a dead cat bounce.

2012 - ?

Recovery?

Many key indicators remain uncertain in many countries

Retail sales growth still sluggish, particularly USA

Unemployment still relatively high in some countries, e.g. parts of Europe
Consumer spending in Japan still sluggish despite massive government stimulus
EU economies a mixed bag some have recovered from 2008 (e.g. Germany),
others have not (e.g. Greece)
What's really going on in China?

Stock markets hit record highs. Housing markets appear on the way to recovery in the USA and
some parts of Europe.
Sovereign debt - ability of governments to meet their obligations - becomes a pressing concern in
some countries. Governments in other countries show some improvement in their financial state.
( we will discuss this week in lecture, so not much on it here).
Whats next? To be discussed this week

Background information on the Great Recession, strictly FYI

-

the best source is found at http://www.pbs.org/wgbh/pages/frontline/go/financial-crisis/?

utm_campaign=homepage&utm_medium=fixed&utm_source=fixed

the best way to go at this material is to watch two videos on this sitestart with this one
http://www.pbs.org/wgbh/pages/frontline/meltdown/ and then watch this one
http://www.pbs.org/wgbh/pages/frontline/warning/

PBS programming often has an orientation, but this site is relatively balanced in its
explanation of the causes of the Great Recession

Another interesting source is Too Big To Fail, an HBO film released in June 2011. A
reasonably objective account of the start of the Great Recession and it has the virtue of being
entertaining.