♪ [music] ♪ [Tyler] A lot of ink
already has been spilt discussing the Great Recession of 2008. And a full examination of that
would require a lot more than just one video. So today, I’m going
to limit our discussion to just one central theme
of the crisis, namely financial intermediation. Let’s say you’re buying a home
that costs $100,000. A typical down payment
might have been, say, 20%, and that would mean your mortgage
was for 80% of the home value, or $80,000. Now in the lead up to the crisis,
many homes were being purchased with much less than 20% down —
10% down or 5% down. Or in a lot of cases, nothing was put down at all —
zero down. When you put money down on a house, that creates a kind
of protective cushion. Now, the difference
between the value of the house and the unpaid amount
of the mortgage — that’s called “owner’s equity.” So now, when you first buy a house, your down payment
is your owner’s equity. Over time, as you pay down
your mortgage and if your home value goes up, well, in those cases,
your owner’s equity rises and that makes
the protective cushion bigger. The ratio of debt to equity,
which represents how much of a protective cushion
is in a home or in a company — that’s called the “leverage ratio.” So, a 5% down payment
on a $100,000 house would mean you’d have
$5,000 in owner’s equity, which when compared
to the mortgage of $95,000, would give you
a leverage ratio of 19. So what’s the effect
of high leverage? It means there’s very little room
for the price on your home to drop before the value of your house is less than the unpaid
mortgage amount. That is, if you needed
to sell the home to pay off your mortgage, the proceeds from the house sale
would not be enough to pay off the bank. Being under water is clearly not good for the individual home owner. But very importantly,
it’s also not good for the bank. In the case of foreclosure, say the homeowner cannot
keep on paying the mortgage. Well the bank is getting a home
but the home isn’t worth enough. The bank loses money because
the value of the home is less than what the bank was expecting
to receive from the home owner in the form of mortgage payments. So again, back to the broader picture. It wasn’t just home owners
who were using more leverage. Banks were using more leverage. They were buying assets
using more debt and less of their own cash. So what we’re doing here
is stacking problems: the problem
of the home owner’s leverage, the problem of the bank leverage. And the more problems
like these you stack, the more financial fragility
you’re bringing into the economy. Now in 2004, the investment bank
Lehman Brothers — it had a leverage ratio
of about 20. But it continued
to borrow more money. And by 2007, that leverage ratio
went as high as 44. Now in that setting, if Lehman Brothers sees its assets
fall in value very quickly, Lehman Brothers too
will in essence be under water. That is the assets of the company
will be worth less than the debt the company owes. In other words, in that case,
the company would be insolvent. This sounds like
such a terrible state of affairs. So you have to wonder “Why would the experienced managers of a large firm like Lehman Brothers
have been so risky?” There are a few reasons, but the first
and most important reason was just sheer excess confidence. Those managers
bought mortgage securities and they made
other risky investments. But the managers,
like indeed most other people, they just didn’t think that American home prices
could fall so much. And they also didn’t understand that a fall in home prices
could potentially create so much turmoil
in American capital markets. Another key factor
behind the failure was incentives. The managers at Lehman —
they got big bonuses based on the profits
of the company. And in some cases, this can lead
managers to take on too much risk. How does that work?
Well think about it. Bigger profits typically meant
bigger bonuses. So if you go from
a leverage ratio of 20 to 44, as Lehman Brothers did,
that means you can buy more than double
the amount of assets with the same amount
of initial capital, because you’re using more debt. That means
more than double the profit if asset prices rise
as indeed they had been doing. But what if the assets
fall in value? What if the initial risk
does turn out badly? And you have to ask
when the asset prices did fall and Lehman Brothers went bankrupt, did the managers also
personally go bankrupt? No, they did not.
They still, for the most part, had a lot of money
in their bank accounts. So in this setting, Lehman managers
had a lot to gain if things would go well, but they faced
only limited downside in the scenario
where things would go sour. Let’s add
another factor to this mix that ended up pushing the economy even a bit closer
toward the edge of the cliff, and that additional factor
was securitization. So how does securitization work? Briefly, individual mortgages
are bundled together and sold to outside parties
as liquid financial assets. So rather than lending
a company money directly, as you would do with a bond,
you buy a mortgage security, and indirectly
you provide money to people who use it to buy homes. So it turned out there were
all these securities out there which were very hard to value, many of them were riskier
than advertised, and many of them
were just bad outright, filled with too many
high-risk loans. How is it that this happened?
Well there were a few factors. Sometimes the problem
was outright fraud in terms of how the security
was sold and how it was explained. Or sometimes it was a failure
of the rating agencies, which were supposed to assess risk
more or less accurately, but they performed poorly. But probably the biggest
single problem was again a kind of complacency. Most people incorrectly assumed American housing was really
quite a safe investment, and that prices
would either continue to rise, or at the very least
hold fairly stable. One final factor set the stage
and brought all of this together, and that’s what is called
the shadow banking system. So what does that mean? Well here I need
to give some terminology. What you and I commonly
would just call a bank is actually more technically
a commercial bank. And that means a bank
that takes deposits from individuals and businesses and it’s insured by the government
through the FDIC. Because of
the government guarantee, depositors don’t feel
the need to run to the bank at the first sign of trouble
and pull out their money. Now investment banks —
they’re different. Investment banks,
like Lehman Brothers, were a different kind of bank without a comparable
governmental guarantee for deposits or liabilities. The money they used —
it came from investors, not from depositors. So the investors
were always asking, “If I lend to an investment bank,
are my funds safe? Will I get my money back?” And these investors
were more watchful and sometimes even prone to panic if something seemed to be wrong
with the investment bank. Now the shadow banking system
as a whole is made up of investment banks along with other complex
financial intermediaries, such as hedge funds,
issuers of asset-backed securities like the mortgage bonds
discussed earlier, money market funds, and even some parts
of traditional commercial banks, which are not covered
by the deposit insurance guarantee. So, in that setting,
by the year 2008, the shadow banking system actually
was lending considerably more than were traditional
commercial banks. So we’ve got
highly leveraged houses and banks, banks and other investors
holding risky mortgage securities, and a massive shadow banking system highly dependent
on short-term loans, which in turn were dependent
on investor confidence. This was the proverbial case
of being very close to the cliff and needing only
an extra nudge to fall off. And that nudge came in 2007 when housing prices
started to fall, causing many home owners
to be under water. This meant that the assets
owned by banks, such as mortgage-backed securities,
were dropping in value. Remember, banks were
highly leveraged too. So this fall in asset values pushed
many banks closer to insolvency. Worse yet,
the complexity of investments in mortgage-backed securities
obscured how much exposure particular banks faced. The market started to think
of virtually all banks as really quite risky, and this exacerbated
the financial crisis. The investors who provided
the short-term loans to fund the shadow banking system —
well, they fled to safety. They pulled their capital
away from these short-term loans to investment banks
such as Lehman Brothers, and this run
on the shadow banking system was similar to the runs
on traditional commercial banks by depositors, as seen
in America’s Great Depression. And that was a time when even
bank deposits were not insured by the government. Without these short-term loans, investment banks
and other financial institutions — they were starved of the money
they needed to function. They couldn’t keep on
making loans of their own and so they started
selling their own assets to get operating funds
just to stay up and running. But that leads
to yet another problem. When a lot of financial institutions
are all selling assets at the same time, you end up
with what’s called a fire sale. As they all sell, that selling pushes asset prices
lower — even lower. And those lower asset values — that pushes even more
financial institutions closer toward bankruptcy. So, financial intermediaries
came crashing down and this led to a credit crunch
that damaged the entire economy. In this setting, many businesses
that depended on credit — they failed
or they stopped growing. Maybe they laid off workers
to conserve cash and unemployment spiked. So, looking back we have to ask,
“What could have been done? What should have been done?” It’s now considered
a general problem that short-term loans
for the shadow banking system can flee rapidly in times of crisis and cause widespread
financial and economic turmoil. So what to do? In response to this,
some suggest a similar solution to what we did for runs
on traditional commercial banks, namely a government guarantee of some, or all,
of those liabilities. However,
that’s a pretty radical step. It would put an even larger
potential burden on taxpayers, maybe trillions. And it also doesn’t fix
the incentive problems I mentioned earlier,
namely that when there’s leverage, and especially guaranteed liabilities, the managers have an incentive
to take too much risk. It would make that problem worse. Since the financial crisis,
other regulations have been enacted to cover the shadow banking system,
and also traditional banks. Those regulations require
more equity and less leverage. And that makes sense
in terms of my earlier discussion of needing a larger
financial protective cushion. Still, it remains to be seen just how effective
these regulations will prove. So far there’s been
no market turmoil comparable to the crisis of 2008. So we just don’t know
exactly how well the new institutions will work. There’s a lot more to cover
on the Great Recession. And if you’re interested
in learning more, please just let us know. Thanks. [Narrator] If you want
to test yourself, click “Practice Questions.” Or, if you’re ready to move on, you can click
“Go To The Next Video.” ♪ [music] ♪ You can also visit MRUniversity.com to see our entire library
of videos and resources.

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58 thoughts on “The Great Recession”

  1. Great subject! It would be interesting for me to know more about the impact of the stimulus packages and various toxic assets buying programs. Did they work? And what about the new regulations already in place: who's assessing if they're working or not?

  2. Has the Fed had a role in the 2008 financial crisis and/or beginning of the recession? If it has, what role would that be? At least in the consensus or neo monetarist view (maybe other views also if not too much/long)

  3. It seems like 90% of what I read about the financial crisis are conservatives blaming it entirely on the government or liberals blaming it entirely on the market, so it was quite a pleasant surprise to see how much this video seems to focus on just explaining what happened without an ideological axe to grind.

    Great use of animations, too.

  4. Wall street certainly shared a lot of the blame, but the fuel for the crisis was mostly provided by the government in the form of cheap money from the Federal Reserve (aka Washington's Monopoly Money Machine), and the implicit too big to fail guarantee which created all sorts of moral hazards.

  5. I think that any content that try to explain the 2008 financial crisis that doesnt mention the artificial low interests rates is kinda incomplete… I feel kinda weird disagreeing with economics PHD's >.<… still. awesome video!

  6. Can tell you where most of the blame rest is the former fed chairman of the Federal reserve Mr. Alan Greenspan which he was born of over eating in the real estate market which he could easily stopped but he failed to see what was going to happen

  7. Can you tell me what the total value derivatives that in country and do you see a Bubble in this market and what happens when you have a rapid deflation

  8. if you dont own you home 100% you will loae it soon. if you do own it 100% it will be worth less then half of what it is now soon. The end!

  9. this video was made for total retards. simply not exactly what happened. 1st. 08 was not a great depression. it was simply a time when many mortgages went belly up from unscrupulous loans. loans were given to most anyone who applied. 3 percent down was most often put down as required by fed loans. Freddie Mac Fannie Mae were the largest holders. Lehman brothers were just one one bank investment firm who bought Cdo's. cdo is a packaged investment portfolio based on mortgages.
    when banks bought the cdo they soon discovered that they were too high risk. repackaged them and resold at higher rates. and that kept going. when a lot of mortgages went bad, too many cdo lost value. banks were left holding the cdo bag including Lehman, that were worth much less if anything.
    went belly up not paying off the huge debt because all the owners didn't even have 3 percent the value in their wealth to pay off the debt.

  10. Ugh. Near 7:00 or 8:00, he seems to imply that the problem was…lack of a government guarantee, such as FDIC. No, the problem doesn't come from watchful investors, it's when people ignore the risks because of the "guarantees".

  11. the one thing I dont like about this video is how he just kinda glosses over certain things as arbitrary, or given. he never talks about how or why housing prices ever fluctuated in the first place, or anything like that. as if a lot of these factors are just the ghost of george washinton moving scales up and down on the economy

  12. what made the housing price fall the economy was able to handle all the stress untill the price of the houses fell in america so how did that property market get affected

  13. when you put it like that, it looks as if its a benefit for banking/financial executives to be as irresponsible as possible….in fact its a benefit to them if the economy crashes…they still get their bonus/salary and they can buy up real assets on the cheap.

  14. how the fuck were these Lehman Brothers bosses not held accountable?..like if I were a shareholder in Lehman,,id be fucking pissed!

  15. Interesting video, but I think a number of points need to be considered first.

    1. There was already a government guarantee on the risky assets of the financial crisis, just not in the form we understand the FDIC to be. Fannie Mae and Freddie Mac purchased up mortgage balance sheets to open up more credit to the market. That guarantee, along with artificially low interest rates provided an incentive to banks to turn a blind eye to lending standards.

    2. The credit crunch did not "hurt" the economy. It may have been a symptom of the recession, but the recession would have helped purge the market of problematic assets and reset lending standards to something more reasonable. What hurt the economy were the prevailing causes of the recession, namely artificially low interest rates and incentives for no money down borrowing.

    3. To solve the problem it may require us examining the credit market and its role in the economy. Just as the investors were certain that US housing was a sure thing, I think too many people are sure that credit expansion is the sure fire way to sustainable overall growth in the economy. If anything, this crisis is perfect illustration of the flaws in such an idea.

  16. There's also A.R.M. loan effects on the poor, high gas prices in the mid-2000's, oversupply of houses, and Credit default swaps. Shrinking demographics in the Midwest also contributed. Still a good video though.

  17. So far this is the best video explaining the crisis with a clear, short and organized description of what really happened. Even-tough it doesn't question the fundamentals of the economic system in place that produced and will continue to produce such dramatic consequences , it does much better than 100's of interview and debates you watch on TV that adds more confusion than clarity. I hope Marginal revolution Uni will continue producing videos that deconstruct the complexity of economic subjects with a clear explanation and intuitive animations with an elaborate criticism of the fundamentals of the economical system in use.

  18. Pittsburgh was one of ONLY 3 places that prospered in the 2008 recession
    The other 2 were like a town in Kentucky and Dallas

  19. Business people's use Economic regression period to buy stocks and shares if they try to buy them in Economic depression time means will it be more cheaper?

  20. An good explanation of what happened. But why were standard lowered to buy a home ? No down payment to purchase a home ?? Where did that come from ?

  21. Well this is August 2018 and those regulations that you are talking about at the end of the video no longer exists.

  22. I want to know why your viewers are so less in short run instead your explaination are awesome. Please explain it with economics!

  23. Requiem for Greed (https://youtu.be/J_jYXod5ehc), an award-winning animated film narrated by Adam Smith and Karl Marx is describing what politicians do for votes, bankers for money, and media for ratings. Also, what happened before, during, and after the Great Recession.

  24. I am not sure why the Federal reserves did not just take over the bad mortgages, and take lower payments from the home owners. If out of work, even give them a 1-2 year payment break period, instead of buying up the Mortgage securities and making people homeless. There would not be a mortgage crises, and house prices always go back up. The drop in house prices happen, but they are always temporary, especially as a population tends to continue to grow the demand for homes will always be there. I know some people would say that would be unfair to bail out home owners, but it is far better than bailing out the banks and all the zombie companies in the S&P today, and that debt that keeps on growing today. Buying bad mortgages with the full intention of recouping the money back, would probably see today's debt go down especially as more and more people are in work today. The whole financial crises seems to have been on big con job to get tax payers money from bad debt. Most of these mortgage securities are still on the Feds balance sheet today after decade!

  25. Tyler is very good at explaining the common narrative. But there's another aspect you can learn via my playlist on this topic: https://www.youtube.com/watch?v=XlYxb6c87aw&list=PLgC87pss25svhLCh9Sh9IR_4-ymVuxjer

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