VIEWS: 5 PAGES: 65 POSTED ON: 11/27/2011
Recap Lecture 1 – Origins of the current crisis Wages disconnected from productivity; debt increased; inequality reached pre-Great Depression levels “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” Recap 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 Hypothesis” 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 depression But overtime the effectiveness of bailouts will diminish 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 households 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 1999 2. THE LURE OF REAL ESTATE (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 everywhere 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 home 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% Overconfidence “Tulipmania” – crowd psychology, copycat behavior 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. 3. THE SUB-PRIME CHAIN (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%) LIBOR+ (5.32%) The CDO Machine Recall …. Combining many RMBS into a sort of mutual fund to create a “collateralized debt obligation” Key players Securities firms [Merrill Lynch, Goldman Sachs, Citigroup] 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 on: 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 work 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 Hypothesis 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 maturity 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 companies These were never regulated by the FED US Banking System Ultimate Creditors Traditional Banking System Ultimate Borrowers “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 wrong? What could go wrong? 4.THE UNRAVELING (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 Subprime adjustable Prime fixed 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 2008 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 market 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 mortgages 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 conservatorship 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 capital 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 assets 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 sector The now much-despised Troubled Asset Relief Program [TARP] Recapitalizing the banks directly through the purchase of preference shares and toxic assets Elements of the financial stabilization program 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 markets 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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