Housing Bubble and Credit Crunch by yaofenji


Lecture 1 – Origins of the current crisis
 Wages disconnected from productivity; debt
   increased; inequality reached pre-Great Depression
 “Mixed economy” economics replaced by free
   market ideology (Keynes vs. Hayek); government is
   the problem; deregulation spreads
 Financialization of the economy; securitization of
   mortgages; “originate to distribute banking”
Lecture 2 – Money and the FED
 Money supply consists of coin, currency and
  checking account deposits
 FED controls the money supply by:
       Changing the reserve requirement
       Through the “discount” window
       Buying or selling treasury bonds in open markets
   FED is dominated by banking interests
Housing Bubble and
Credit Crunch
The Economy Hits the Fan
“Financial Instability
Hyman Minsky
Future is Unknowable
 Economic expansion depends on willingness
  of people and banks “to speculate on future
  cash flows and financial market conditions”
 Banks primary allocator of capital
       Like all businesses banks compete to supply
        capital by expanding existing forms of credit
        innovate new financial “products”
What Causes Financial Instability?
   Shifts occur in investors’ psychology moving
    out of a recession into an economic expansion
     At first very cautious (hold large cash reserves)
     As recovery continues, expectations rise (more
      risky loans made)
     Finally “Ponzi Finance”
         Where future payments depend on new or additional
         sources of revenue
What’s to stop this boom-bust cycle?
   “Thwarting institutions”
     Regulations designed to limit speculation
     Government bailouts to prevent a major economic
   But overtime the effectiveness of bailouts will
       Double-edged: prevent depressions, but limit the
        costs to spectulators
Score card last twenty years
 Stock market crash in 1987
 S&L crisis in 1989-90
 “Emerging markets” crisis of 1997-98
       Brought down Long-Term Capital Management
 Dot-com market bubble in 2001
 Each could have produced a 1930s-style
  collapse in absence of govt bailout operations
Upshot: Stability is Destabilizing
 Any given period of calm is a “transitory state
  because speculation upon and experimentation
  with liability structures and novel financial
  assets will lead the economy to an investment
  boom.” [Minsky]
 Banks are “merchants of debt”
Informal timeline
1.   The Spark (2003)
2.   Lure of Real Estate (Boom, 2003-2006)
3.   Sub-prime Chain (Euphoria/Peak, 2006-07)
4.   The Unraveling (Bust, 2007-08)
1. THE SPARK (2003)
   What was the spark that caused the
    underlying forces of the developing “Perfect
    Storm” to combine into a “bubble”?
       The FED lowered the Federal Funds Rate from
        6.5% in May, 2000 to 1.00% in June, 2003
                                                                 May, 2000 = 6.5%

                                                                                       June, 2003 = 1.0%

Source: Federal Reserve Board. Link: http://www.moneycafe.com/library/fedfundsratehistory.htm
Cheap Credit
   Borrowing binge, esp. financial sector and
   Banks increased leverage and risk
       Borrow cheap to lend more
       Greater use of shifting liabilities to “off balance sheets”
         The shadow banking system

   Merrill Lynch’s liabilities:
       End of 2002 = $422B
       End of 2006 = $800B
Lax regulatory oversight provided the
dry brush for the spark
   Greenspan played in key role during the
    1990s in the dismantling of the Glass-Steagall
    Act of 1933
       Had kept depositary institutions (e.g. Citibank)
        from taking part in investment banking activities
        (selling stocks, bonds, mortgage securities)
           Traditional banking vs. casino-like gambling
   Replaced by Gramm-Leach-Bliley Act of
(Boom 2003-2006)
   Total value of real estate owned by American
    families ballooned between 1997 and 2006
       1997 = $8.8T
       2002 = $14.5T (a 65% increase)
       2006 = $21.9T (a 150% increase in 9 years)
Speculative element in real estate
   Higher prices can generate higher demand
       It’s different than airplane travel, steaks,
        entertainment, etc.
   Also different from past bubbles (dot.com)
       Family home building block of community, social
        life, the economy
       Downturns can cause ripple effects almost
Additional housing demand:
“Ownership Society”
   Clinton’s National Homeownership Strategy
       Increase minority homeownership
   Bush 2’s agenda
       American Dream Act (2002): $10,000 for low-income
        households struggling to make a down payment on a new
   Both President’s pressed Fannie Mae/Freddie Mac to
    increase funding of home loans to middle-class and
    low-income lenders
   2004: Homeownership rate at all time high of 69%
   “Tulipmania” – crowd psychology, copycat
   People assuming that recent trends are typical
    and extrapolating from them
   People who don’t share the consensus view of
    the market start to feel left out
       Eventually it appears the really crazy people are
        those NOT in the market.
(Euphoria/peak, 2006-07)
   From “hard money lending” until the early
    1990s …..
       B&C lending: Where loan applications were
        carefully scrutinized
       Remember Beneficial Finance?
   …. to “Ponzi mortgages”
       Credit to people with poor credit histories
       Where applications were screened by computers
        based on self-reported information
The Subprime Machine
Sample deal: CMLTI 2006-NC2
   4,499 mortgages made by New Century
       $940M for these mortgages came from borrowing from 8
        banks [secured by the mortgages themselves]
         The banks borrowed short term thru repurchase
           (“repo”) agreements
   Two months later, New Century sold the RMBS to
    Citigroup for $979M (including interest)
       After paying the repo lenders, New Century pocketed
        $24M in fees (2.5%)
The CDO Machine
   Recall …. Combining many RMBS into a sort
    of mutual fund to create a “collateralized debt
   Key players
       Securities firms [Merrill Lynch, Goldman Sachs,
       Rating agencies [S&P, Moody’s]
       Investors in tranches [public, banks, other CDOs]
       Financial guarantors [AIG]
CMLTI 2006-NC2, the story continued
   After Citigroup purchased this mortgage-
    backed security …..
   It sold them to a separate legal entity that
    Citigroup owned (off balance sheet)
       The “SIV” purchased it with cash raised by
        selling securities these loans would back
       That “SIV” issued tranches to be sold to investors
Trillions of dollars in securities rested
   The ability of millions of homeowners to
    make payments on their subprime mortgages
   Stability of the market value of their homes
       Even expecting rising home prices
Lending Standards Fall
   Minsky’s financial instability hypothesis at
   Types of mortgages near peak of cycle
       Alt-A, subprime, interest only, low-doc, no-doc,
        ninja (no income, no job, no assets), 2-28s, 3-27s,
        liar loans, pick-a-pay adjustable rate mortgage
   Mortgages packaged into securities and sold
    off: IBGYBG
       “I’ll be gone, you’ll be gone”
Where were the “thwarting agencies”?
   As long as housing prices continued to rise,
    the “Ponzi” process would continue
   The only checks
       Government oversight and regulation
           Which we know adhered to the Efficient Market
       Rating agencies
Role of the Credit Rating Agencies
   “Essential cogs” in the meltdown [FCIC]
   Problem: “issuer pays” model of credit ratings
       Moody’s, S&P, Fitch received generous fees
         For “CMLTI” sample Moody’s was paid $208,000 &
          S&P was paid $135,000
   Example:
       2006 Moody’s issued 30 AAA ratings on mortgage-
        related securities every working day
       83% of those were later downgraded
       Note: in 2010 only 6 US corporations carried this rating
   Related problem: laxer home appraisal standards
Final link in the chain: Credit Default
Swaps [CDS]
   These should be called “credit insurance contracts”
   Basically it’s buying insurance against default
       A bank (say Citigroup) holding CDOs pays a premium to
        an insurer (like AIG).
       If a default occurs, then AIG covers the losses
   1998 – 2004: they increased exponentially
       This insurance market was entirely unregulated
   “Financial weapons of mass destruction” [W. Buffet]
Total Credit Default Swaps
Outstanding [$B]
   2001      918.87
   2002    2,191.57
   2003    3,779.40
   2004    8,422.26
   2005   17,096.14
   2006   34,422.80
   2007   62,173.20
   2008   38,563.82
   2009   30,428.11
 Composition of US Dollar CDS

Years to

                           Total $15.5T
                           2008 2Q
FED Chair Greenspan
   “Recent regulatory reform coupled with innovative
    technologies has spawned rapidly growing markets
    for, among many other products, asset-backed
    securities, collateral loan obligations, and credit
    derivative default swaps.”
   “These increasingly complex financial instruments
    have contributed ...to the development of a far more
    flexible, efficient, and hence resilient financial
    system than existed just a quarter-century ago.”
It’s even worse ….
   So far my focus has been on subprime lending
       Bernanke: “Prospective subprime losses were
        clearly not large enough on their own to account
        for the magnitude of the crisis.”
   Shadow Banking System
       Comprised of investment banks, hedge funds,
        money market mutual funds, insurance
       These were never regulated by the FED
            US Banking System             Ultimate Creditors

             Traditional Banking System

            “Cash” Shadow Banking System

            “Synthetic” Shadow Banking System
As the securitization boom continued
into 2006 and early 2007
   Some of the biggest holders of subprime
    RMBS and CDOs ended up being the very
    banks and investment banks that created them
   Citigroup
       Set up off-balance-sheet “vehicles”
       Issued short term debt to investors
       Used cash to buy long term assets for their parent
        company (including CDOs)
Running out of investors
   As supply of subprime paper increased, the
    interest-rate premiums [“spread”] decreased
       Yet Wall Street firms continued issuing subprime
        securitizations for their hefty underwriting fees
        and bonuses
   Buyers balked, especially at investing in the
    senior tranches
       Thus Wall street firms ended up holding them
       “They ate their own cooking, and got poisoned.”
What could go
What could go
(Bust, 2007-08)
“When the music stops, in terms of liquidity,
  things will be complicated. But as long as the
  music is playing, you’ve got to get up and
  dance. We’re still dancing.”
     Citigroup CEO Charles Prince

London Bridge is Falling Down
Millennium Bridge
   The footbridge opened on June 10, 2000
       Closed on June 12
       “Synchronous lateral excitation”
           Reopened February 2002
   Relationship to financial markets?
       Pedestrians on the bridge are like banks adjusting
        their stance
       Movements of the bridge are like price changes
The “first step”
   BNP Paribas – August 9, 2007
   Great credit crunch of 2007-2009 had begun
       Rush to government bonds (yields down sharply)
       Interbank lending largely dried up
         Information lacking about other banks’
           holdings [that long sub-prime mortgage chain]
         Hayek’s telecommunications system no longer
           emitted reliable price signals, if any at all
Initially, FED policymakers
underestimated the unfolding calamity
   Thought it was a temporary liquidity crisis
       Discount window opened
   The illusion of stability
   Thought the sub-prime market was small
       Besides, losses would be concentrated outside of
        the banking system
Final months of 2007, first part of
   Clearly the shadow banking system had helped
    concentrate the risks associated with subprime
    lending at the heart of the financial world
   “Synchronous lateral excitation”
       Market prices played a key role coordinating self-
        defeating behavior: “mark to market”
       The loss spiral: leveraging down (total assets/equity
        capital, spreadsheet example)
       All banks trying to shrink their balance sheets
        simultaneously  asset prices continue to fall
Add to this the slumping housing
   As we’ve seen delinquencies rose
   By February 2008, roughly one in four
    subprime borrowers was at least one month
    behind on mortgage payments
   The slump in residential investment did
    serious damage to the construction industry
   The recession had begun: Officially,
    December 2007
Fall 2007: mortgage-related losses
   Biggest losers
       Citigroup $23.8B; Merrill Lynch $24.7B
   More losers
       Bank of America $9.7B; Morgan Stanley $10.3B;
        JP Morgan $5.3B; Bear Sterns $2.6B
   AIG, other insurance companies, hedge funds,
    other financial institutions $100B
FED enlarges its role
   It arranged a takeover of Bear Sterns by JPMorgan
    Chase (March 2008)
       It agreed to shoulder the risk of losses of Bear’s toxic
       Bear was small, but “too interconnected to fail”
   It opened discount window to other Wall Street
    firms needing cash
       Collateral included “toxic” mortgage securities
   The FED thus acknowledged that some of the losses
    would be socialized
Fannie and Freddie put under
   September 7, 2008: The Treasury took an
    80% ownership in each of the companies
       Appointed new managements
       Agreed to provide up to $100B each in fresh
   They remained nominally independent, but
    the Treasury Department effectively
    controlled them
“Free Market Day”
   September 15, 2008 Lehman Brothers was allowed
    to fail
   Leverage ratio: 30/1
     4% drop in value of firm’s assets can wipe out its
        entire capital base
   At the time the largest bankruptcy filing at $600B in
   Beginning of the worst market disruption in postwar
    American history ...and the FED blinked
Within 24 hours: AIG was bailed out
   It had $400B in credit protection provided to
    banks (CDS)
   The FED promised to lend AIG up to $85B
       As collateral demanded AIG’s entire assets,
        including its profitable life and property
        insurance divisions
       Obtained warrants entitling the FED to an 80%
        equity state in AIG
Contrast with Scandinavia
   Finland
       The government combined 40+ savings banks
        into one state-owned bank
       It nationalized the country’s three largest banks
        (wiping out their shareholders)
   Sweden
       The government seized control of the two largest
        banks and shunted their toxic assets into a state-
        owned company
(Hidden) Socialism in our time
   FED was running out of resources (and legitimacy)
   Bernanke and Treasury Sec’y Paulson asked
    President Bush and Congress for authority to spend
    $700B (5% of GDP) to strengthen the financial
       The now much-despised Troubled Asset Relief Program
       Recapitalizing the banks directly through the purchase of
        preference shares and toxic assets
Elements of the financial stabilization
   A pledge not to let systemically important
    institutions collapse
   A commitment to use taxpayers’ money to
    socialize some losses
   An endorsement of unorthodox central bank
    policies aimed at kick-starting the credit
   It also discredited “laissez faire” economics
Worth the price?
   IMF’s price tag for western governments to shore up
    their financial systems: $10 T
       Half from direct commitments; half in insurance schemes
        and guarantees.
   It did not stop the global recession
       It did prevent a wholesale collapse of the financial system
   In the US, homeowners had little or no relief
   “Tea Partiers” and “Occupiers” clearly don’t think it
    was worth the price.
So how do we deal with
the “Great Recession”?
Next: do we have a debt crisis or a jobs crisis?

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