Video Transcript: Lesson 24

Can we continue in unit eight? This is lesson three. We want to discuss when  things go badly wrong for banks, okay? Everything that we have talked about in  this section helps us to explain why central bankers must be skilled and  knowledgeable individuals with a good grasp of both economics and the  workings of financial markets. Still, we have essentially been describing the job  of a technocrat, right? Central bankers really earn their salaries in abnormal  rather than normal times. 

So let's look back at 2007 and stretch into 2008. The United States and other  countries began to experience the financial crisis that was similar to those that  were experiencing the Great Depression. The crisis seemed to begin innocently  enough with a decrease in the housing market, right? This left some people  unable or unwilling to cover their mortgage payments. 

But because of the way financial markets work, it became more difficult for  lenders to work out which of their assets were non-performing, which means  that which one of those assets were unlikely to be repaid. So as a result, the  financial markets froze up. So banks didn't know what to do. 

Some of these banks were loaning on balloon mortgages or these subprime  mortgages where once they were adjustable based on interest rates, right? So  we just discussed how the Federal Reserve raises interest rates. And as they  raise interest rates, banks have to raise rates relative to the amount that the  Federal Reserve is raising rates, right? So from 2000, well, really we were in a  boom cycle from early 90s to 2007, 2008, a great economic expansion. In early  2000s, 2002, 2003, 2004, the economy grew really, really fast. 

There was a lot of tax cuts, a lot of deregulation. And so in the housing market,  banks were seeing that asset prices were creeping up very, very, very rapidly,  right? So there was an opportunity for banks to make loans on housing,  package up these loans and sell them into the secondary market. So when they  did that, they were able to get those loans off their books and pass them on to  somebody else. 

And so they've started making more and more and more and more loans. This  equated to the subprime mortgage environment, okay? So during this period,  asset prices were going up very, very fast exponentially. And a lot of people  were buying and selling flipping houses, making profits as asset prices  continued to go up. 

The banks wanted to make more and more loans, so they started bringing on  more and more risky people and making loans that were based on interest rates

that were adjustable. They were moving. They weren't fixed. 

So the reason why a lot of people had to lose their homes or they had to not, felt like they didn't want to pay for their homes is because, you know, they started  out with a $700 mortgage payment in the first two years and the next thing you  know they're paying $1,000, $1,200, $1,500 a month for the same house  because they had an adjustable interest rate. So this is why a lot of people  started not paying their mortgages and getting foreclosed on. So this really  seized up the banks because they were so heavily weighted in how much loans  they were making towards housing. 

They weren't able to determine which of these assets were not performing or  performing and a lot of these were, a lot of these assets were packaged  together and sold off to another bank so it made it even harder. This is why the  banking system got froze up. So part of the Fed's response was an aggressive  use of the tools that we described in this section. 

For example, the Fed reduced the federal funds rate down to 0.25%. At that  point the Fed had just about reached the limit of what was possible with  monetary stimulus. So basically the federal funds rate is what banks in the  market base their interest rates on. So the federal funds rate got taken down to  a quarter of a percent, not even 1% but a quarter of a percent, basically zero  interest rates. 

They couldn't take them to zero and you can't take interest rates negative, well  you could take interest rates negative but if you make interest rates negative  when depositors deposit money into a bank, then that money as soon as they  deposit it automatically loses value because interest rates are negative. So you  are going to be penalized for depositing funds into a bank if negative, if interest  rates are negative. All right. 

So the Fed took the interest rates down to 0.25%, a quarter of a percent, as low  as they possibly could take it, right, without really going negative. So they had  no more ammunition. They lowered interest rates as low as possible, right. So they were limited what they could do moving forward as far as stimulus for  the economy at this time. All right. The problem with nominal rates, you know,  they can't go below zero because cash has a nominal interest rate of zero. 

If you keep a dollar bill from this year to next year, it is worth a dollar next year.  Therefore, it would always just be better to keep cash rather to invest in an  asset with negative nominal return. The Fed had hit what is known as zero lower bound.

They couldn't go any further, 0.25 is as low as they could get. Cash has a  nominal interest rate of zero, as we just explained. A dollar is worth a dollar  today and next year. 

Even though it was at zero, at the zero lower bound, the Federal Reserve still  had other options, right. In normal circumstances, it operates in the economy by  buying and selling short-term government debt, one of the other assets in the  economy, but these were highly abnormal circumstances and it is possible for  the Fed to buy and sell other assets as well. This is what the Fed did. 

During the crisis, the Fed started purchasing many other assets such as  commercial paper, commercial paper stocks, bonds inside the financial market.  

So they started buying common stocks and, you know, firm debt. In other words, instead of just lending to banks, the Fed started lending directly to firms in the  economy. 

Central banks in some other countries, such as the United Kingdom, pursued  similar policies. Explaining what happened in 2008 involves understanding the  actions of the Fed, but it requires many other tools as well.