Financial Crisis 2008

Financial Crisis of 2008 and Government Bailout ****************************************** - Preliminaries and Some Basic Notions - Stock Market Valuation - Real Estate Trends and Housing Bubble - Various Players in Subprime Real Estate Crisis - Financial Crisis of 2008 - The Bailout Package - Why It Did not Pass Initially - Will it be Effective? - Short Term and Long Term Outlook

Wh Where IIs th the U U. S S. E Economy H Heading di F For? ?

Main Objectives: Offer some basic understanding of the financial crisis, crisis its causes causes, consequences consequences, and culprits; Offer an economic outlook

Preliminaries and Some Basic Notions -- Psychological y g Basis of Wealth and Value The Painting experiment -- Financial Economy vs. Real Economy PsychologyÆFinancial EconomyÆReal Economy (Sentiments)

-- Savings S i Problem bl Pre-historic Era (Storage Issue) R l off Finance Role Fi & Contracts C t t Fear of Losing It All

Stock Market Valuation -- The Firm Foundation Paradigm (Rational) Profit Potentials (Earnings) are Important -- Castle in the Air Paradigm (Irrational) Role of Psychology and Herd-like Behavior Buy at any price only to sell at a higher price -- Recent Developments: Challenging the Rationality; Irrational Exuberance (Recent bubbles as evidence)

Real Estate Trends & Facts and Housing Bubble 1- Risingg prices: p Duringg much of the 1990s and 2000s the housing experienced a remarkable boom: construction ppeaked and prices p soared in most major j markets across the U.S. (adjusting for inflation, housing price index more than doubled from 1998 to 2006 while construction also had an unprecedented pace) 2- Low Interest Rates (and ( d mortgage rates): ) They h were at historical lows during much of this period also (30 year fi d as hi fixed high h as 19% in i 1981, 1981 but b t as low l as low l 5% to t high 6% in 2002-2006);

3 ARMs and Only Interest Mortgage Loans 3ARMS: -- Gained popularity in 2000s; 5 year ARM was around low 5% % to low 6%; %; Teaser rates -- Had 20% delinquency rate compared to 8% for fixed rates in 2006-07 OIML: --Encouraged buying more expensive homes that one could afford with regular loans -- Consumers therefore assumed more debt -- Borrower would ld never own his hi home h -- Borrower has incentive to keep the loan when real estate t t market k t booms, b but b t walk lk away when h it fails. f il (not good for banks either)

44- Popularity of Mortgage Backed Securities: Fannie Mae ((Federal National Mortgage g g Association)) Founded as a government agency in 1938 to provide liquidity q y to the mortgage g g market by y buying y g loans from mortgage originators and repackages the loans, as mortgage backed security and sells them on the secondary mortgage market, with some guarantee that the interest and principal will be paid. (90+% of their loans in 2004 were ARM)

-- Freddie Mac ((Federal Home Loan Mortgage g g Corporation) was created as a private corporation by Congress in 1970 to provide competition in the secondary mortgage market and to end monopoly of Fannie Mae (that was partly privatized). In 1989 HUD was given i oversight i h off Freddie ddi Mac and its role in subprime lending was expanded.

-- Popularity of mortgage-backed securities involved many financial institution all over the world with domestic U.S. real estate market, also leading to creation of complex p mortgage-based g g securities,, such as subprime bonds and collateralized debt obligations, g increased financial institutions that had mortgage risk exposure 5- Introduction of Marking-to-Market Rule: SEC overseas that banks, hedge funds, mutual funds, and h ld off financial holders fi i l instruments i change h the h value l off their assets to its market value (if no active market, th markk to then t model!) d l!) G Good d on th the upside, id bbad d on th the downside.

All of the above helped the real estate boom till 2006

Then, interest rates started to rise, as oil prices rose p ((Fed’s role)) and inflation fears became widespread Home prices started to tumble, and foreclosures became rampant Income from f real estate instruments i started to decline i and asset values depreciated, leading to fall of some of th iinvolved the l d fi financial i l institutions i tit ti and d the th domino d i effect thereafter.

Many institutions that benefited from the bubble are now crying foul for the reversal of their fortune. fortune (e.g., complains about marking-to-market rule that looked sweet when asset values were rising, g, but not now)) Did anyone y p predict the calamity? y Few including Roubini from NYU who predicted many of these events in September of 2006, but was laughed at. He saw in the U.S. patterns similar to patterns observed just before crises in Mexico 1994, Thailand, Indonesian, andd Korea 1997, Russia i andd Brazil il 1998, andd Argentina A i 2000, namely huge Current Account deficit, too much li idit financial liquidity, fi i l deregulation, d l ti excessive i borrowing, b i and reckless lending

Various Players in Real estate Subprime Crisis “Subprime: Refers to low quality mortgage loans made to people with high potential default rate rate. Misnomer!! Misnomer!!”

Player y 1: Elected Officials -- Bank Discrimination and District Redlining -- Community Reinvestment Act (CRA) of the 1977 Passed despite opposition from banking industry Banks to meet the credit need of the community Little Teeth (promised deposit facility & merger ease if complied; Enforced by FDIC, OCC, OTS, FED)

Encouragedd mortgage E t lending l di through th h Fannie F i Mae M and Freddie Mac

-- New regulations aimed at increasing mortgage credit for inner city and distressed rural communities went into effect in 1995,, requiring q g banks to have good CRA rating (to be able to have access to credit or gget merger g approval). pp ) This lead to an increase in the CRA loans by 39% during the 93-98 period (compared to 17% for other loans) -- While CRA has clearly contributed to bad mortgage l loans, many bad b d loans l were also l made d by b mortgage companies that were not under CRA rules l (often ( ft att muchh higher hi h interest i t t rates) t )

Player 2: Fed -- Fed kept the interest rate low during much of 1990s and p particularlyy 2001-2005 ((low oil prices, p , and low inflation prompted the policy), fueling the market -- Duringg the 2001-2005, FFR was in the 1% to 3% range, and mostly in the 1% range -- Fed encouraged more risky ARM lending (Greenspan) Player 3: Mortgage Salespersons -- Worked k d on commission i i based b d on the h number b off arms successfully twisted

Player 4: Primary Lenders -- No incentives for judicious lending Banks no longer needed to hold on to the mortgage, as use of mortgage-backed g g securities made risk taking more appealing -- Use of ARMs with low teaser rates ((below market rates for a while, followed by much higher rates tied to index, LIBOR + some %). Teaser rates are popular when long-term interest rates are at historical lows (like much of this period), as they h l lenders help l d benefit b fi from f ARMs A as rates rise. i -- Net Effect: Many loans were made to NINJA’s (people with ith No N Income, I N Jobs No J b or Assets). A t ) See S thi this http://www.youtube.com/watch?v=laot_Eomr3s

Player y 5: Other Financial Institutions -- Freddie Mac and Fannie Mae issued many Mortgage Backed Securities -- Other financial institutions that traded in these as well as derivatives based on real estate assets. Many off these h were global l b l institutions i i i

Player 6: Credit rating Agencies and Analysts -- Lack of market for many of these securities, securities so models were used to price them -- Inflated ratings, g , mostly y in A range g ((similar to T-Bills)) -- Conflict of Interest: Investment bankers’ analysts were ratingg investment bankers’ clients ((scandal)) -- For example, 3 months prior to its demise, AIG was rated strong buy (8 analysts), buy(3), hold (10))!!! Player 7: Home Buyers (Taking Excessive Risk) -- Home buyers b were enjoying j i the h ride id -- New ones were joining the ride, even if unqualified -- Home H ownership hi up ffrom 60% in i 1990s 1990 to t 70%

Player y 8: Tax Payers y (Voting (V g Public)) -- Remained silent and disinterested For example, p in 2003, serious concerns were voiced over Freddie and Fannie, with proposals to put oversight of both under Treasury Department. Congress objected; The Public was too preoccupied with more i important things hi (Jessica ( i Simpson Si andd Nick Lachey’s newly married life!!)

Financial Crisis of 2008 -- Citi Bank problems and infusion of cash by UAE Founded as the City Bank of New York in 1812 1400 offices, half in the U.S. and others in 100 countries Was at the center if the LDC default crisis of the 1980s Lost $15+B in 2007 due mostly to subprime exposure R i d $7.5B Received $7 5B cashh (for (f equity) i ) from f Abu Ab Dhabi Dh bi

-- Collapse of Bear Sterns, Sterns March 2008 Founded as equity trading house in 1923 In November 2006, 2006 the company had $66B capital capital, $350B assets, 15,000 employees Faced serious subprime induced crisis and was sold to JP Morgan Chase for $10 a share ($1B total) while shares had year high of $133+

-- IndyMac Bank, mortgage lender and largest S&L in Los Angels, fails due to run, July 2008 In 2008: Capital inadequacy, followed by deposit run; stock price i dropped d d to pennies i from f $50 high hi h in i 2006 Placed into conservatorship in mid July 2008 for liquidity problems. A bridge bank was established to assume control of IndyMac Bank's assets & liabilities (largest bank failure in U.S. since S&L Crisis)

-- Failure of Fannie Mae & Freddie Mac,, July-Sept. y p 2008 In September 2008, the two were put in conservatorship of newly established Federal Housing Finance Agency The Treasury committed as much as $200 billion ($100 for each) in preferred stock and extend credit through 2009 to keep the two solvent and operating

-- Lehman Brothers filed for Chapter 11 bankruptcy protection in September of 2008 Among ten firms charged by SEC for undue influence of investment-banking over research analysts to generate t favorable, f bl market-moving k t i researchh in i exchange for underwriting. Fine of $1.4 B, including $80M aga $80 against st Lehman, e a , aandd reforms e o s (separation (sepa at o of o investment banking from research) Held on to large positions in subprime & other lower-rated mortgage assets when h securitizing i i i the h underlying d l i mortgages; Highly leveraged Reported billions of dollars of losses for 2008 Declared bankruptcy Sept.15, 2008 (largest investment banking bankruptcy since Drexel in 1990)

-- AIG P Problems bl and d governmentt iintervention t ti In early 2008, it was 18th largest company in the world and its 2007 income=$9B, income=$9B equity=$78B, equity=$78B assets=$1T Suffered a liquidity crisis in Sept. 2008 due to $441 billion exposure p to credit default swaps p (CDS) ( ) (instruments used to insure against default on assets like subprime mortgages) Stock price dropped from $68 to $1.2 $1 2 Its bailout involves loans of $85B and $38B from NY Fed ((interest rate of LIBOR+8.5%)) and in exchange g for 80% equity steak in AIG for government

-- Washington g Mutual is closed down, September p 2008 Sustained huge losses, received $7B capital infusion from independent investors in early 2008 In September 2008, WaMu faced a run of $16B, stock plummeted to $2 from $30 a year earlier OTS seized WaMu and placed it into receivership with the FDIC who sold most of its assets, liabilities and debts to JPMorgan Chase for $1.9 billion. Largest bank failure in U.S. history but No loss to FDIC

-- Fear of bank deposit run, especially smaller banks (Similar to the Great Depression)

-- Loss of bank capital and hesitation to extend credit Fear of loan defaults affects interbank lending (overnight LIBOR 5%+); short-term business loans & credit lines,, mortgage g g & consumer loans (Where are the monies? Parked in safe T-Bills)

-- Prospects of (i) reduced consumer spending (70% of GDP), (ii) business b i bankruptcy b k andd job j b loss l Creates fear of economic recession, which puts downward pressure on the stock markets Financial system problems Spillover to real economy

The $700 billion Bailout Package (Emergency Economic Stabilization Act of 2008)

-- Treasury purchases troubled assets from financial institutions through Trouble Assets Relief Program -- Treasury insures troubled assets (bad loans), collect premiums to be used for payouts -- SEC will have authority to suspend Mark-to-Market -- FDIC will increase insurance coverage from $100K to $250K till end of 2009 -- Treasuryy shall take steps p to mitigate g foreclosure (subsidy to change ARMS to low fixed rates) -- Limits on executive compensation (wage & severance pay) ($700B excludes earlier rescues, i.e., AIG, Freddie & Fannie)

Why It Did not Pass Initially -- Public was against it; Why did the officials officials’ warnings fall on deaf ears? Lack of trust in ppoliticians in ggeneral Truth-stretching (!) by officials, just months earlier President Bush: “U.S. Economyy is strong”!! g Fed Chairman: “No subprime spillover effect”!! Treasury Secretary Paulson: “Financial System more sound than it has ever been”!! -- All members b off the h house h were up for f reelection l i Most of those in competitive races (71% off the th Democrats D t andd 85% off the th republicans) bli ) voted NO (fear?)

Bailout Implementation & Other Global Steps Taken -- Treasury plan for quick purchase of $250B shares of troubled financial institutions ((rather than bad loans)) -- FDIC guarantees new debt issued by banks -- Fed lends to companies by buying commercial papers

-- Fed and other central banks lowered interest rate by .5% in early October (U.S. FFR dropped to 1.5%) to increase liquidity q y -- British Government will pput $100B- into its banks and Bank of England will provide $350 in short term loans to banks -- French Government has announced a $50B bailout f d fund -- bank b k off Japan J announces unlimited li it d short h t term t dollar d ll offering to financial institutions who demand $

Will it be Effective? -- No one knows; but what are the options? Fearing Psychological Factor (Sentiments); Deposit Run on Banks; Liquidity problem and effect on businesses (spill over from the financial side to real economy)

-- Note that GDP grew at a rate of around 1% & 3.1% for 2008 Q1 & Q2; So no definitional recession yet!! -- It is important that the rescue does not provide i incentive i for f unsafe f future f practices i -- Oversight O i ht on financial fi i l innovation i ti needs d (tens (t off trillions of derivatives)

-- This is not new: S&L crisis of 80s &90s was similar More than 700 S& S&Ls failed FSLIC reserves were wiped out RTC was established to assist the bailout Initial Cost of nearly $200 B Overall cost of $500 B

--Also Al LDC C Default f l Crisis C i i off 1980s

Short Term and Long Term Outlook Recap: -- Liquidity, low interest rate, strong economy Æ real estate boom ((bubble)of ) late 1990s and 2000s -- Lack of oversight, too much risk taking (by ALL)Æ highly g y leveraged g and near implosive p situation -- High oil prices, fear of inflationÆ high interest rate -- High rates, burst of real estate bubbleÆ disaster for risk taking players (Government to the Rescue!!) Who Shall S Pay For This? i? -- The battle if over dividing the $2+T real estate loss plus l losses l from f its it impact i t among various i players, l Many of whom never profited from the boom!!

Serious Debt Problem: -- Consumer debt: negative saving rate; credit card debt, home equity loans, reverse annuity mortgage -- Highly leveraged financial industry with risky assets -- Government debt: Deficit of $500 a year and $10T half of it accumulated during the past 8 years National Debt Clock: http://zfacts.com/p/461.html

IIs D Depression i IImminent: i t No!! During the Great Depression -- Combined C bi d GDP off 7 largest l t economies i dropped d d by b 20% during 1929-1932 -- There were no deposit insurance, insurance so people withdrew money from banks and many banks failed -- Fed increased interest rate ((!!)) and reduced liquidity q y -- U.S. imposed heavy tariffs and other countries reciprocated lowering world trade by 70%

The situation is much different as a lot is learned from experiences i off the th Great G t Depression D i