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Economic Indicators: Group 6

ECO 314A
Ashlyn Anthony Brian Jake Margaret Pesikov

10/12/2011

Table of Contents Part I:...Page 2 Leading and Lagging Indicators Part II: .Page 5 Using the Stock Market as Economic Indicators Part III: .Page 10 The Financial Market and Sub-Prime Crisis Part IV: .Page 14 TARP and the Financial Recovery Plan Part V: ..Page 19 Commercial Paper Funding Facility (CPFF), Term Securities Lending Facility (TSLF), and AMLF Works Cited..Page 22

Part I: Leading and Lagging Indicators

The economic indexes contain the key elements of an economy. They are designed to signal peaks and troughs in the business cycle. The leading and lagging economic indexes are essentially averages of several leading, or lagging indicators. They are constructed to summarize and reveal common turning point patterns in economic data. The index is presented in a clearer and more convincing manner than any individual component because it smooths out some of the volatility of individual components. Leading indicators are indicators that usually change before the economy as a whole changes. They are therefore useful as short-term predictors of the economy. Stock market returns are a leading indicator. The stock market usually begins to decline before the economy as a whole declines and usually begins to improve before the general economy begins to recover from a slump. The Leading Economic Index (LEI) for the U.S. increased 0.3 percent in August to 116.2 (2004 = 100), following a 0.6 percent increase in July and a 0.3 percent increase in June. The August increase in the U.S. LEI was driven by components measuring financial and monetary conditions. The leading indicators point to rising risks and volatility, and increasing concerns about the health of the expansion. There is growing risk that sustained weak confidence could put downward pressure on demand and business activity, causing the economy to potentially dip into recession.

Leading Economic Index

Factor

1 Average weekly hours, manufacturing 0.2725 2 Average weekly initial claims for unemployment insurance 0.0322 3 Manufacturers new orders, consumer goods and materials 0.0809 4 Index of supplier deliveries vendor performance 0.0715 5 Manufacturers new orders, nondefense capital goods 0.0192 6 Building permits, new private housing units 0.0263 7 Stock prices, 500 common stocks 0.0373 8 Money supply, M2 0.3248 9 Interest rate spread, 10-year Treasury bonds less federal funds 0.1058 10 Index of consumer expectations 0.0295

The Lagging Economic Index (LAG) increased 0.3 percent in August to 110.3 (2004 = 100), following a 0.3 percent increase in July, and a 0.3 percent increase in June. Lagging indicators are indicators that usually change after the economy as a whole does. Typically the lag is a few quarters of a year. The unemployment rate is a lagging indicator. Employment tends to increase two or three quarters after an upturn in the general economy.

Lagging Economic Index 1 Average duration of unemployment 0.0356 2 Inventories to sales ratio, manufacturing and trade 0.1192 3 Labor cost per unit of output, manufacturing 0.0631 4 Average prime rate 0.2731 5 Commercial and industrial loans 0.1071 4

6 Consumer installment credit to personal income ratio 0.2117 7 Consumer price index for services 0.1902

Part II: Using the Stock Market as Economic Indicators 5

In order to predict the future economic status of the country, the stock market is commonly used as an indicator. Changes in the stock market often reflect changes in the economy. Although this is not always the case, whenever the stock market has declined substantially, a fear of a recession sets in. Based on the current status of the stock market, some economists fear the second part of a double-dip recession is in the future for the United States. Stocks are used as economic indicators for many reasons. One reason can be found in Tobins q theory which explains how the stock market can reflect the economy as a whole. The theory represents the ratio of the market value of installed capital to its replacement cost. Therefore, when there is a fall in a stocks price, there is a fall in Tobins q. According to Gregory Mankiws Macroeconomics, this means that investment is lower at any given interest rate and the result leads to lower output and employment because of the decreased demand for goods (Mankiw, 535). Another reason is that stock is part of household wealth. Therefore, when stock prices decrease, people become poorer, causing less consumption, a decrease in demand, and lower output. Dips in stock prices might also act as economic indicators because they may reflect lags in technology which would prevent economic growth. This would cause the supply and output to move more slowly than expected (Mankiw, 535). When analyzing the stock market as an indicator, one may look at the leading physical stock market, the New York Stock Exchange (NYSE). The exchanges that take place at the NYSE are auction exchanges, where the buyers bid on the sellers auctions. In order to trade here, one has to have a seat, which is usually reserved for a representative from leading companies. The index includes 1863 companies (1519 of them being domestic) and is made up 6

of common stocks, ADRs, ADSs, tracking stocks, and REITs are allowed to be included in the NYSE Composite index (nyse.com). Another stock market to analyze is the National Association of Securities Dealers Automatic Quotations (NASDAQ), which is the leading over-the-counter dealer market in the Unites States. It is an automatic information network, which allows dealers and buyers to negotiate prices for securities. Although the stocks listed on the NASDAQ must maintain a $1 million stock price, NASDAQ is the largest market with about 3,700 listed companies (Derderian). The Standard & Poor 500 Stock Index (S&P 500) is also used as an economic indicator. It is made up of 500 different stocks for the purpose of being a representation of the overall market. The stocks traded in this market are from the leading companies in the leading industries, which represents a significant portion of the United States market (nyse.com). Based on evidence of all three exchanges historical prices, the stock markets act as economic indicators. When looking at the stock market from 2008 to 2009, the S&P 500, NYSE, and NASDAQ all show dips. At the same time, the economy was going through a recession, which shows that the stock market is a good indicator of the economic status of the country. The evidence is shown here:

Figure 1: S&P 500 from 2007 until 2011

Figure 2: NYSE from 2008 until late 2009

Figure 3: NASDAQ from 2008 until 2009

By analyzing the above figures, the dips take place in late 2008 and early 2009, which was when the recession took place. Since the stock prices go along with Tobins q Theory, it shows that a dip in stock prices is reflected in the economic status of the country. Currently, economic analysts are examining the stock market to predict the economic status of the country. According to a recent article published on marketwatch.com, the S&P 500 price recently fell 32.19 points, which was its lowest close since September 2010. The article also states that some analysts are predicting the S&P 500 to continue decreasing into the 2010 lows (Hong). Although the article mainly used the S&P 500 to predict the economic status, all three indexes are currently following the same pattern, which is shown in these figures:
Figure 4: S&P 500 Past 6 Months

Figure 5: NYSE Past 6 Months

Figure 6: NASDAQ Past 6 Months

Based on the three figures, all three indexes have similar dips that not only reflect each other, but also reflect the economys status as analysts fear the past recession was part of a double-dip recession. Since the market is commonly used to predict what is in store for the United States, it is considered an economic indicator.

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Part III: The Financial Market and Sub-Prime Crisis

December 2007 marked the beginning of what most individuals now refer to as the Great Recession. As a result of the recession, economic activity declined causing an increase in unemployment, housing foreclosures and a steep downturn in various financial markets. Although many professionals disagree about various aspects of the recession, most assert that the primary cause of the recession was a crisis in the housing industry, mainly the bursting of the housing bubble. In addition, an increase in subprime mortgages in the marketplace also contributed to the housing markets downfall. One major effect that resulted from the recession was the impact on the financial market. The financial market provides a means for individuals to buy, sell and trade securities such as stocks, bonds and commodities among other financial instruments. Essentially, such markets bring together buyers and sellers in an effort to promote an efficient economy. During the Great Recession, measures of financial markets, for instance the stock market, sharply declined and remained volatile, as shown below. Overall, the stock market was just one of several markets, institutions and individuals that were negatively impacted by the recession 11

In addition, the housing crisis, which is detailed below, was negatively impacted by the subprime mortgages during the recession. Such mortgages impacted the financial markets and in turn resulted in a global recession. According to the PEW research poll just over half of all working Americans faced some form of work related hardship such as being laid off or taking a pay cut. Furthermore, according to the Bureau of Labor Statistics, unemployment rates increased from 5.8 in 2008 to 9.3 in 2009 and additionally increased .3 percent in 2010. As a result, consumer confidence remained at all-time lows further exacerbated the preexisting issues. Prior to the start of the recession housing prices steadily increased in the early to mid2000s but subsequently declined in 2007. The graph below indicates the rise and decline in housing prices with respect to time.

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Housing Prices from 1970-2010

Prior to the decline in the housing market, homeowners, lenders and financial institutions all benefited from the continual increase in housing prices. Lenders repackaged mortgages to investments banks, both of whom made substantial profit. Due to the successful gains of such transactions institutions, lenders and banks all requested to purchase more mortgages or mortgage backed securities. The high demand of mortgages combined with the low supply of quality homeowners, resulted in lenders deriving subprime mortgages to sell to homeowners who did not have high enough credit to but prime loans. Such subprime loan required little documentation, proof of income, or down payment. In addition, the rates were higher in order to compensate for the increased risk. Due to the high payments and the homeowners inability to make their monthly mortgage payments, banks and other lenders began to own houses instead of receiving the anticipated monthly payments. As more and more homeowners faced foreclosure, the value houses began to decrease due to having an increased supply and less demand. 13

Currently, approximately 1.5 million homes are foreclosed and years after the beginning of the recession, the percentage of new foreclosures is still increasing. For example from July to August of 2011 the National Foreclosure Rate increased 7.21 percent. Homeowners with prime loans that are still able to pay their mortgages also suffer as they are still paying their loan equivalent to the original value of their home when they first purchase it. However, the value of their house has declined and the amount they are paying far exceeds that worth of the house. Many lending institutions and borrowers based mortgage assumptions on the continued increase in housing prices and as a result allocated what they believed as the appropriate risk and return to such loans. As a result of the sub-prime mortgages that many individuals held, the decline in housing prices resulted in homeowners being unable to pay their mortgage interest rates. As a result, no institutions or potential homeowners were purchasing loans or mortgages creating a credit freeze.

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Part IV: TARP and the Financial Recovery Plan

The Troubled Asset Relief Program (TARP) was suggested on September 19th of 2008 by the Secretary of the Treasury, Henry Paulson. This program was also referred to as the Emergency Stabilization Act of 2008. TARP was approved by the House of Representatives on October 3rd of the same year, under George Bushs presidency. TARP was created in an attempt to respond effectively to the subprime mortgage crisis. Subprime mortgages are loans that are given to people with bad credit, minimal assets, and little or no experience with debt. Because so many banks were giving loans to people that had difficulty repaying the bank, a lot of mortgages were defaulted on. This would not have happened if banks screened loan applicants properly before lending to them. As shown in the following graph, the annual volume of subprime mortgages increased at an alarming rate between the years of 2003 and 2005. Subprime mortgages were also a significant percent of the mortgage market and therefore the defaults had an enormous impact on the economy. By the year 2005, nearly one in every five mortgages was subprime.

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Due to the foreclosures, banks that did a lot of subprime lending acquired a significant amount of bad assets. TARP took bad mortgages off of the books of financial institutions in America and made them a government responsibility. By removing these bad assets from the financial system, TARP made it so that these assets were no longer on banks balance sheets and banks could avoid further losses. The government also believed that once these assets began being traded again, their prices would increase in value and this would benefit both the banks and the Treasury. TARP had several goals that it was formulated to achieve. It was created to assist financial institutions, encourage banks to increase lending, help banks avoid further losses from these bad assets, and address the credit crisis. TARP would address the credit crisis though injecting capital into banks that needed it, purchasing bad assets from financial institutions, supporting business lending, and helping homeowners. The treasury hoped that all of these methods would strengthen the American Economy.

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TARP gave the US Treasury $700 Billion in purchasing power. $250 Billion of this amount was accessible immediately. $100 Billion, however, would be accessible with the Presidents authorization and the remaining $350 Billion had to have the approval of Congress. This money was spent on buying mortgage backed securities and creating liquidity. By September 30, 2010 the TARP had disbursed over $388 billion of the $475 billion that was finally allocated to the program. The recipients that received the largest parts of this sum were AIG, General Motors, Citigroup, and Bank of America.

Through these capital injections and purchases of toxic assets, TARP encouraged banks to increase their lending back to the levels they lent at prior to the economic crisis. Increased 17

lending leads to loosened financial markets and eventually increased investor confidence in the economy. When purchasing bad assets, however, TARP encountered the issue of how to price these assets. It was very difficult to place a value on these assets, especially because the pricing must strike a balance between efficiently using public funds provided by the taxpayer and providing adequate assistance to the financial institutions that need it (Nothwehr 2). This program was ended on September 30, 2010 when Congress decided not to extend it. TARP was not as successful as the Treasury hoped it would be and whether it was successful at all is debated by economists. TARP was successful in preventing a complete collapse of the financial system. Also, credit still remains tight but it is better that it was during the credit crunch. In addition to this, TARP was successful in bailing out the banking system and giving banks the opportunity to raise capital and increase profits. Unfortunately, TARP did not achieve its other goals. Home foreclosures continued and many people ended up losing their homes. Also, levels of unemployment were extremely high and to this day are very high. Unemployment is currently 9.1%. Supporters of TARP argue that without the program, unemployment would be significantly higher. One reason that TARP was not as successful as the government intended it to be was because it was difficult to keep track of the use of the funds. It gave money to banks to increase the amount of loans and give the banks an opportunity to earn profit. TARP, however, failed to set regulations regarding the use of this money and instead banks used the funds to protect themselves against debt. Also, several banks used this money to acquire other businesses and also invest for the future. In addition to that, several banks used the money to pay bonuses to their executives.

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Another criticism of TARP is that it privatized profits and socialized losses (Fernando 1). In other words, the program was fueled by taxpayers, yet they reaped little benefit. However, Government has recovered about $192 billion from the repurchase of bank securities by financial institutions and earned $30 billion in interest. Most of the institutions that received the largest sums of money, have already repaid the government. Due to this, the cost to taxpayers is significantly lower than what was originally expected. As of November of 2010, the cost to taxpayers was expected to be about $25 billion. In conclusion, billions of dollars were injected into the economy as a result of TARP and there were little effects on banks lending habits and instead there was a big issue of moral hazard in regard of how the funds were used. This money was neither used efficiently nor effectively. In defense of TARP, the economy benefited from preventing the collapse of the financial system but this could have been prevented in a much more effective manner that would lead to more benefits to society.

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Part V: Commercial Paper Funding Facility (CPFF), Term Securities Lending Facility (TSLF), and AMLF

In response to many of the financial issues that the United States faced during the subprime mortgage crisis, the Federal Reserve used many tools. Details of these tools are listed below: Name: Description: The Commercial Paper Funding Facility (CPFF) Created in October 2008 to provide a liquidity backstop to U.S. issuers of commercial paper. The CPFF was designed to improve liquidity in short-term funding markets and thereby contribute to greater availability of credit for 20

businesses and households. Under the CPFF, the Federal Reserve Bank of New York financed the purchase of highly rated unsecured and asset-backed commercial paper from eligible issuers through eligible primary dealers. The facility expired on February 1, 2010. Result: (The Federal Reserve)

The Term Securities Lending Facility (TSLF) A weekly loan facility that promoted liquidity in Treasury and other collateral markets and thus fostered the functioning of financial markets more generally. The program offered Treasury securities held by the System Open Market Account (SOMA) for loan over a one-month term against other program-eligible general collateral. Securities loans were awarded to primary dealers based on a competitive single-price auction. The TSLF was announced on March 11, 2008, Description: and the first auction was conducted on March 27, 2008. Result: The TSLF was closed on February 1, 2010. (The Federal Reserve)

Name:

Asset-Back Commercial Paper A short-term investment vehicle with a maturity that is typically between 90 and 180 days. The security itself is typically issued by a bank or other financial institution. The notes are backed by physical assets such as trade receivables, and Description: are generally used for short-term financing needs. (The Federal Reserve)

Name:

The Money Market Investor Funding Facility (MMIFF) A Facility designed to provide liquidity to U.S. money market investors. Under the MMIFF, the Federal Reserve Bank of New York could provide senior secured funding to a series of special purpose vehicles to facilitate an industrysupported private-sector initiative to finance the purchase of eligible assets from Description: eligible investors. Result: The MMIFF expired on October, 20, 2009. (The Federal Reserve)

Name:

Name: Description:

The Primary Dealer Credit Facility (PDCF) An overnight loan facility that provided funding to primary dealers in exchange for a specified range of eligible collateral and was intended to foster the 21

functioning of financial markets more generally. The PDCF began operations on March 17, 2008. Result: The PDCF was closed on February 1, 2010. (The Federal Reserve)

Term Auction Facility (TAF) Through TAF, the Federal Reserve auctioned term funds to depository Description: institutions. Bids were submitted by phone through local Reserve Banks. Result: The final TAF auction was conducted on March 8, 2010. (The Federal Reserve)

Name:

Term Asset-Backed Securities Loan Facility (TALF) TALF was created to help market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities (ABS) collateralized by auto loans, student loans, credit card loans, equipment loans, floorplan loans, insurance premium finance loans, loans guaranteed by the Small Business Administration, residential mortgage servicing Description: advances or commercial mortgage loans. Result: The facility was closed on March 31, 2010. (The Federal Reserve)

Name:

After many of these tools had expired, federal agencies issues The Secure and Fair Enforcement for Mortgage Licensing Act: The Secure and Fair Enforcement for Mortgage Licensing Act (S.A.F.E Act) The S.A.F.E. Act mandates that all employees of banks / credit unions who are Description: mortgage loan originators (MLOs) are federally registered. (National Credit Union Administration) Name:

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Works Cited Baker, Dean. "The Failures of TARP | Testimony." CEPR. 19 Nov. 2009. Web. 11 Oct. 2011. <http://www.cepr.net/index.php/publications/testimony/the-failures-of-tarp>. The Bureau of Labor Statistics. The Average Unemployment Civilian Labor Force. Web. 09 October 2011. http://www.bls.gov/cps/prev_yrs.htm. The Conference Board. Leading and Lagging Indicators. Web. 11 October 2009. < http://www.conference-board.org/>. Derderian, Mara. "Finance 201." Bryant University, Smithfield, RI. Sept. 2011. Lecture. 23

Epstein, Lita. "TARP Saved the Banking System, but Failed at Everything Else DailyFinance." Business News, Stock Quotes, Investment Advice - DailyFinance. 20 Nov. 2009. Web. 5 Oct. 2011. <http://www.dailyfinance.com/2009/11/20/tarp-saved-bankingsystem-but-failed-at-everything-else-expert/>. The Federal Reserve. Board of Governors of the Federal Reserve System. Web. 11 Oct. 2011. <http://www.federalreserve.gov/>. The Federal Reserve. The Panic of 2008. Web. 09 October 2011. <http://www.federalreserve.gov/newsevents/speech/warsh20090406a.htm.>

The Federal Reserve Bank of Dallas. The Rise and Fall of Subprime Mortgages. 09 October 2011. <http://www.dallasfed.org/research/eclett/2007/el0711.html.> Fernando, Vincent. "TARP Saved The Entire Financial System For Just The Cost Of A Few Months At War - Business Insider." Featured Articles From The Business Insider. 04 Oct. 2010. Web. 5 Oct. 2011. <http://articles.businessinsider.com/2010-1004/wall_street/29984711_1_tarp-military-aid-government-contractors>. Hong, Nicole. "S&P 500 Closes at Year Low, Nears Bear Market - Market Extra MarketWatch." MarketWatch - Stock Market Quotes, Business News, Financial News. Web. 11 Oct. 2011. <http://www.marketwatch.com/story/sp-500-closes-at-year-lownears-bear-market-2011-10-03?link=MW_latest_news>. "Listings Indices." NYSE, New York Stock Exchange. Web. 11 Oct. 2011. <http://www.nyse.com/about/listed/nya.shtml>. Mankiw, N. Gregory. "Investment." Macroeconomics. 7th ed. New York: Worth, 2007. Print.

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Montgomery, Lori. "TARP Expected to Cost U.S. Only $25 Billion, CBO Says." The Washington Post: National, World & D.C. Area News and Headlines - The Washington Post. The Washington Post, 30 Nov. 2010. Web. 5 Oct. 2011. <http://www.washingtonpost.com/wpdyn/content/article/2010/11/29/AR2010112905453.html> Morgenson, Gretchen. "TARP Is Done, but Count on Sequels - NYTimes.com." The New York Times - Breaking News, World News & Multimedia. 02 Oct. 2010. Web. 5 Oct. 2011. <http://www.nytimes.com/2010/10/03/business/economy/03gret.html>. "NASDAQ Composite: INDEXNASDAQ:.IXIC Quotes & News - Google Finance." Google. Web. 11 Oct. 2011. <http://www.google.com/finance?q=INDEXNASDAQ:.IXIC>. National Credit Union Administration (NCUA). "S.A.F.E. Act." National Credit Union Administration (NCUA). Web. 11 Oct. 2011. <http://www.ncua.gov/Resources/SAFEAct.aspx>. Nothwehr, Erin. "Emergency Economic Stabilization Act of 2008 | University of Iowa Center for International Finance and Development." The University of Iowa College of Law. Web. 5 Oct. 2011. <http://blogs.law.uiowa.edu/ebook/global-financial-crisis/emergencyeconomic-stabilization-act-of-2008>. "Troubled Asset Relief Program (TARP)." Track the Stimulus. Web. 5 Oct. 2011. <http://trackthestimulus.com/TARP.aspx>. "Troubled Asset Relief Program (TARP)." Troubled Asset Relief Program (TARP) - the Bailout Bill. Web. 5 Oct. 2011. <http://troubled-asset-relief-program.net/>.

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