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									      THE CREDIT CRISIS
CAUSES, CONSEQUENCES & CURES
                  University of Nevada, Reno
 Institute for the Study of Gambling & Commercial Gaming
 14th International Conference on Gambling & Risk Taking
              Stateline, Nevada May 25-29, 2009




                                             Mark Sievers
                                               Sievers & Sievers
                                                 P.O. Box 546
                                           Cripple Creek CO 80813
                                                (719) 659-7580
                                          MarkSievers@Skybeam.com
     MAY YOU LIVE IN INTERESTING TIMES
    MAY ALL OF YOUR DREAMS COME TRUE
   4 consecutive Qs of GDP declines          Stock market (S&P 500) down
    ◦   2.7% in 3d Q 08                        about 40% from 2008
    ◦   5.4% in 4th Q 08                      June „09 average housing prices
    ◦   6.4% in 1st Q‟09                       down about 30% from Jan. „07
    ◦   1% in 2nd Q „09                       July „09 foreclosures 32% higher
   7.4 million jobs lost since Jan. 08        than July ‟08
    ◦ Unemployment rate = 9.7% (4.9% in          ◦ 800,000 homes in foreclosure –
      Jan 2008)                                    expected to peak at 1.15 million in
                                                   2010
    ◦ Unemployment projected to be 10.5%
      in Dec. 2009                               ◦ Cure rates for defaulting mortgages:
                                                 ◦ Prime loans - 6.6% from 45% (2006)
 Spending for business equipment
  dropped 30%                                    ◦ Alt-A loans - 4.3% from 30%
                                                 ◦ Subprime – 5.3% from 19.4%
 Industrial output dropped 20% in
  1st Q 2009 (equal to 1998 levels)             1.4 million
 Industrial capacity used dropped to            bankruptcies
  69% (lowest ever)                              expected in 2009
 Banks in trouble                               – 75% higher
    ◦ 89 bank failures in2009                       than 2007
    ◦ 416 banks failed FDIC grading system
LOCAL BUSINESS CONDITIONS
   20-30% BELOW 2001
  ARE YOU COMING OR GOING?
BUILDING PERMITS & FORECLOSURES
INTERCONNECTED CAUSES
   Era of Easy/Cheap Money 2000-2005
    ◦ Greatly expanded the supply of loans
         Created a Real Estate Bubble
   Rise of the Shadow Banking System
    ◦ Highly leveraged, risk-seeking business model
    ◦ Equal in size to traditional banking system
   Securitization of loans
    ◦   Expanded cheap/easy money
    ◦   Agency problems – “loan to sale” business models
    ◦   Gambling with Credit Default Swaps widespread
    ◦   Inability to re-negotiate defaulting loans and loans on
        property where value falls below loan principle
          WHAT (WHO) CAUSED THIS MESS?
            BOOM & BUST MONETARY POLICY
                          2000-2004 – Fed reduces interest rates
                           to combat 9/11 and dot-com recessions
                           ◦ Wave of cheap money  Housing price
                             bubble caused by:
                              Dramatically reduced mortgage rates & sub-
“May you come to the           prime mortgages increase house prices
 attention of higher          Securitized loan instruments makes even more
    authorities.”              money available for cheap mortgages
                          2005 – 2006 Fed increases interest
                           rates and bursts the housing bubble
                           ◦ Falling House prices  upside-down loans
                           ◦ Collapse in the securitized loan market
                          Fed missed the rise of securitization &
                           highly-leveraged shadow banks
                                           FEDERAL RESERVE MONETARY POLICY 
                                                  HOUSING PRICE BUBBLE
                                          240%                                                7%


                                          220%                                                6%
US Housing Prices -- Case-Shiller Index




                                          200%                                                5%




                                                                                                   Federal Funds Rate
                                          180%   1% Reduction in Market Mortgage Rates        4%

                                                 Causes a 10-16% Increase in Housing Prices
                                          160%   Robert Schiller – Irrational Exuberance      3%


                                          140%                                                2%


                                          120%                                                1%


                                          100%                                                0%
GREENSPAN‟S BUBBLES
FINE-TUNING THE ECONOMY WITH MONETARY POLICY

                             1999 Stock Market Bubble
                             “Irrational Exuberance”



                               2006 Housing Price Bubble




                       Source: Paul Krugman, The Return
                       of Depression Economics (2009)
US & Japanese Real Estate Bubbles




                Japanese decline   65%
MAJOR CONTRIBUTOR – SECURITIZATION
   Bundling & selling loans in bond-like instruments
    ◦ 25% mortgages; 21% credit card loans; 13% auto loans; 15% other (student
      loans, business loans)
   Massive Boom & Bust Cycle
    ◦ 1997  $300 billion  2006  $2 trillion  2007  $121 billion
   Agency Problems
    ◦ Borrowers are unknown to the bundled loan purchasers – loan
      renegotiations are virtually impossible when borrower gets into trouble
    ◦ “Loan to sale” business models -- compensation based on # of loans not
      loan quality (rise of unregulated mortgage brokers & mortgage lenders)
   Serious Structural Problems
    ◦ Low quality (sub-prime) loans in securitized tranches carried high returns,
      create incentives to make low-quality, risky loans
    ◦ Valuation grossly complex making after-market sales to 3d parties nearly
      impossible
    ◦ Insurance/Gambling via Credit Default Swaps
      SECURITIZATION IN A NUTSHELL
      AKA TOXIC ASSETS, LEGACY ASSETS

  Borrowers               Loans/Assets
                                                     Special Purpose Vehicle
  •Households          •Mortgages
  •Businesses             •Sub-Prime Loans                  Arranger
                          •Alt-A Loans
                          •FHA/VA Loans
                                                  Securitized Instrument
                       •Credit Cards
                                               •Collateralized Debt Obligations
    Lenders            •Auto Loans
                                               •Collateralized Loan Obligations
•Banks                 •Student Loans
                                               •Asset Backed Securities
•Credit Cards          •Commercial Loans
                                               •Mortgage Backed Securities
•Auto Lenders
•Hedge Funds
•Mortgage Lenders   Buyers (Highly Leveraged)
                    •Investment Banks                    Rating Agency
                    •Pension Funds
                    •Hedge Funds
                    •Private (Foreign) Investors              Insurers
   Speculators                                         •Insurance Companies
•Investment Banks                                      •Investment Banks
•Hedge Funds                                           •Hedge Funds
                       Credit Default Swaps            •Individuals
•Investors
                 SECURITIZED LOAN INSTRUMENTS
                                    THE WATERFALL                  Securitized loan
                                                                   portfolio divided into
                          Senior Tranche
                        •High quality loans                        tranches of bond-
   Loans/Assets
•Mortgages              •Priority on cash flow                     like instruments with
   •Sub-Prime Loans     •Lower coupon                              different prices,
   •Alt-A Loans                                                    interest rates and
   •FHA/VA Loans                                                   claims on cash flow
•Credit Cards
                                          MediumTranche
•Auto Loans
                                       •Medium quality loans
•Student Loans
                                       •2d Priority on cash flow
•Commercial Loans
                                       •Higher coupon


Prices determined by changes in :
• Risk rating by rating agency                                  Junior Tranche
                                                           •Lowest quality loans
• Interest rates (P when interest rates )
                                                           •Last priority on cash flow
• Loan to value ratio (Market price of assets)             •Highest coupon
• Repayment patterns (Foreclosures)
               LEVERAGING & SHADOW BANKS
                   (MAGNIFIES RETURNS & LOSSES)
Conservative Lenders
                                                     10% Return to
  10% Loan Terms
                                                     Conservative
                                                       Lenders
       $95 M
                           Lender’s Money         $9.5 M
                             $95 Million
                                                        $100 Million Security
                                                           10.5% Return
                         Hedge Fund Money
Hedge Fund                                       $1 M
                             $5 Million                    20% Return to
 Investors     $5 M                                         Hedge Fund
                                                             Investors
       Problems:
       • Moral Hazard – Hedge Fund gambles with Conservative Investors‟
          Money
       • No Regulatory Oversight of Leveraging
           • Oct. 2004 -- SEC suspended net capital rule for largest investment
              banks eliminating regulatory restrictions on leveraging
SHADOW BANK RUN
                                                                   Federal Reserve
                                                                  Increases Interest
                             Price/Value of
                              securitized                         Rates  Causes
                            bonds/assets falls.                  Bond Prices to Fall



                                                       Investors: “I „m
                                                      outta here. I want
Value of firm falls.
                                                       to withdraw my
                                                           money.”




                                                                        Credit Default
                                                                             Swaps:
                                                                      Bets that firm will fail.
             Sell securities.                We don‟t have the
            Reduce prices to                 cash to cover the
             raise the cash.                    withdrawals
CONSEQUENCES – FORECLOSURES
                      HOW LONG THIS WILL LAST?
                   CBO ESTIMATES – 2014 BEFORE GDP
                     GROWTH RETURNS TO NORMAL




        Congressional Budget Office: A Preliminary Analysis of the President‟s Budget and an Update of
        CBO‟s Budget and Economic Outlook (March 2009).


Assumptions:
• No exogenous shocks (e.g., no oil price , major bankruptcies,)
• Government solutions actually work -- do not create other issues
LOCAL BUSINESSES‟ FORECASTS
    NOW, THE BAD NEWS
   Expects further declines in real estate prices
    ◦ Japan‟s experience – 65% overall decline; 83% decline in commercial real estate
    ◦ Commercial real estate bubble expected to be as large as securitized mortgage losses
   Alt-A and Jumbo mortgages (bigger than sub-prime) have begun to reset
    ◦ Why renew a mortgage on a property worth less than the mortgage?
   Potential bank-run from pre-existing lines of credit
    ◦ Approximately $4.5 trillion outstanding
   Large, high-profile insolvencies disrupting markets(GM, Citigroup)
   State, local government shortfalls
    ◦ State/Local governments cannot engage in deficit spending, so MUST increase taxes or
      substantially decrease spending – both options retard economic growth
   Political pressure to erect trade barriers to protect domestic industries
    ◦ Replay of Smoot-Hawley disaster of the Great Depression
   Return of Stagflation
    ◦ Replay of the Great Inflation driven by dramatic increases in government spending
    ◦ Unemployment > 15% (projection for Dec. 2009 = 10.5%)
             Economic Policy Cures…
                     Digging out of the Hole
    Stimulate the                         Fix the Credit
      Economy                                Markets

 Keynesian Policies             Government Buys Toxic Assets
  ◦ Spend LOTS of money on       Quasi-Nationalization
    stimulus projects             ◦ Government invests in financial firms
 Monetary Policies              Government Guarantees
  ◦ Federal funds rate = 0%       ◦ Government issues auto warrantees,
  ◦ Discount window = 0%            guarantees bank deposits
  ◦ Interest on reserve          New Banking & Investment
    requirements                  Regulations
 Trade Barriers                 Bans/Restrictions on Short Sales
  ◦ Not yet happened              ◦ Prevents runs on leveraged firms
                                 Bankruptcy to Clean Up Illiquid
                                  Assets & Force Re-negotiation of
                                  Loan Terms
                                  ◦ Bankruptcy courts empowered to
                                    alter terms of mortgages
                                  ◦ Pre-packaged bankruptcy of Chrysler
  PUTTING THE NUMBERS IN CONTEXT
     (TAKE A VERY DEEP BREATH BEFORE PROCEEDING …)
Total Spending in Entire US Economy (GDP)                       $14.3 trillion
Total US Stock Market Capitalization                            $15.4 trillion
Total Value of US Housing Stock                                 $18.3 trillion
     Total Outstanding Mortgage Balances                           $10.4 trillion
     Total Consumer Equity                                         $2.6 trillion
Total Corporate Real Estate                                     $8.4 trillion
     Total Corporate Inventories & Equipment                       $5.8 trillion
Total Federal, State & Local Government Spending                $5.2 trillion
     Total Government spending on Health Care                      $910 billion
     Total Defense spending                                        $729 billion
     Total Federal, State & Local Education spending               $838 billion
Total US, State & Local Government Receipts (Taxes)             $4.2 trillion
Total Federal Government Debt                                   $10 trillion
     Total 50-State Government Debt                                $2.5 trillion

Total US “Near-cash” Money Supply (M2)                          $8.2 trillion
US Spending on Military Conflicts (2008 dollars; CBO figures)
     Iraq/Afghanistan (6 years)                                 $804 billion
     World War II (5-6 years)                                   $3.9 trillion
     Vietnam (10-15 years)                                      $518 billion
     Korea (4 years)                                            $456 billion
BAILOUT & STIMULUS PROGRAMS
Program                              Commitment
Government as an Investor            $ 4.8 trillion
Government as a Lender               $ 2.3 trillion
Government as an Insurer/Guarantor   $ 5.14 trillion
Stimulus Spending                    $1.2 trillion
  As of May 8, 2009
   (changes daily)
  GOVERNMENT AS AN INVESTOR
  COMMITMENT = $4. 8 TRILLION
Program                                                                       Commitment
Commercial paper                                                              $1.6 trillion
The Fed is the buyer of last resort in the commercial paper market.
Public-private investment fund                                                $900 billion
Fund seeks private investors and uses a combination of private and
public money to guarantee and buy nonperforming assets.
Troubled Asset Relief Program (TARP)                                          $700 billion
Treasury buys stock in banks, General Motors, Chrysler and AIG.
Federal Home Loan Bank Securities                                             $1.5 trillion
Government buys mortgage-backed securities from Fannie Mae, Freddie
Mac and Ginnie Mae.
A.I.G.                                                                        $53 billion
Fed provided seed money to create investment vehicles to buy, hold and
possibly dispose of bad AIG securities.
Bear Stearns                                                                  $29 billion
Fed bought distressed assets/securities from Bear Stearns to facilitate its
sale to JPMorgan Chase
Reserve US Government Fund                                                    $4 billion
Government buys assets to bailout troubled money market fund
HOW THE TARP WAS SPENT?
ONLY ABOUT $467 MILLION REPAID
Who Received TARP Funds?                              How Much?
Banks                                                 $310.4 billion (44%)
Other Financial Companies                             (9%)
    AIG                                               $69.8 billion
    American Express                                  $ 3.4 billion
    Discover Card                                     $ 1.2 billion
    Capital One                                       $ 3.6 billion
    GMAC                                              $ 5 billion (+ $7.5 billion)
    Chrysler Financial                                $ 1.5 billion
    CIT Group                                         $ 2.3 billion
    Other                                             $238 million
Automakers                                            $24.8 billion (4%)
TALF Funding to provide loans using toxic assets as   $100 billion (14%)
collateral
Homeowner Mortgage Re-negotiation Program             $50 billion (7%)
Public-Private Investment Fund to buy toxic assets    $100 billion (14%)
Uncommitted                                           $52.6 billion (8%)
        GOVERNMENT AS A LENDER
        COMMITMENT = $2.3 TRILLION
Program                                                            Commitment
Term Asset-Backed Securities Loan Facility (TALF)
Provides loans and accepts securities backed by consumer and         $900 billion
small business loans as collateral.
Term Auction Facility
The Federal Reserve makes low-interest, short term loans to          $900 billion
financial institutions, allowing them to pledge asset-backed
securities as collateral.
Discount Window Loans
Extended time (90 days v. overnight), amount and eligibility        $236 billion +
(investment banks v. commercial banks) for Federal Reserve
discount window loans.
Debt Swaps (Term Securities Lending Facility)
The Federal Reserve loans/swaps US Treasury notes in exchange        $200 billion
for less liquid debt, mortgage-backed securities and investment-
grade corporate debt.
AIG Loans
A line of credit offered by the Federal Reserve.                     $60 billion
  GOVERNMENT AS INSURER/GUARANTOR
  COMMITMENT = $5.14 TRILLION
Program                                                            Commitment
Bank Debt (Temporary Liquidity Guarantee Program)
FDIC insures senior subordinated debt issued by banks and poorly    $700 billion
performing assets owned by Fannie Mae and Freddie Mac.
Temporary Liquidity Guarantee Program
FDIC insures non-interest bearing bank accounts.                    $684 billion
Citigroup Guarantees
Government guarantees that exclude the direct                       $249 billion
investments made through the TARP program
Fannie Mae/Freddie Mac Guarantees                                   $400 billion
Treasury pledged up to $200 billion each to cover their losses.
Bank of America Guarantees                                           $98 billion
Government guarantees that exclude direct investment through
the TARP program
Money market fund guarantees                                         $3 trillion
Morgan Stanley Guarantees                                            $9 billion
Treasury guarantees for a capital infusion by a Japanese bank
RAW GOVERNMENT SPENDING (PORK)
COMMITMENT = $1.2 TRILLION
Program                                                     Commitment
Stimulus Bill (HR-1)                                        $787 billion
All the pork you can eat.
Omnibus Budget Act 2009 (HR 1105)                           $410 billion
The remaining nine appropriations bills that the Congress
failed to pass during the 2008 term

Gross Domestic Product =
  Consumer Spending
+ Government Spending - Taxes
+ Business Investment
+ Exports – Imports

Keynesian Economic Prescription  Government
 deficit spending will stimulate economic growth
THE STIMULUS “BUBBLES”
HR-1 – AMERICAN RECOVERY & REINVESTMENT ACT
DOES GOVERNMENT SPENDING STIMULATE ECONOMIC GROWTH?

                            $6.0                                                                    10%
                                     Government                                      Government
                                       Deficits                                        Deficits
                            $5.0
                                                                                                    8%
                            $4.0
   NET GOVERMENT SPENDING




                                                                                                          GDP GROWTH RATE
                            $3.0                                                                    6%

                            $2.0
                                                                                                    4%
                            $1.0

                            $0.0                                                                    2%

                            -$1.0                                               Boom years when
                                                                                government ran a    0%
                            -$2.0                                               surplus and when
                                                       Government Surplus       spending dropped
                            -$3.0                                                                   -2%




                                                   RECENT US EXPERIENCE 1990-2008
                                    NET GOVERNMENT SPENDING (SPENDING MINUS TAXES) VS. GDP GROWTH

   DATA SOURCE: US BUREAU OF ECONOMIC ANALYSIS
   TIMESERIES: 1990(1Q) – 2008(4Q) IN CONSTANT 2000 DOLLARS (TRILLIONS OF $)

                             “We’re all Keynesians, now.” Richard Nixon
                DOES GOVERNMENT SPENDING STIMULATE ECONOMIC GROWTH?
                “We’re all Keynesians, now.” Richard Nixon
                                                                         Increase in
                                                                        GDP Growth

                                                                          5%
                                                                                                         If deficit spending was correlated with
                                                                                                           economic growth, points should be
                                                                          4%
                                                                                                             clustered around a line like this.

                                                                          3%


                                                                          2%


                                                                          1%

  Decrease in net                                                                                                                   Increase in net
                                                                          0%
government spending                                                                                                              government spending
                          -100%     -80%      -60%      -40%     -20%          0%      20%   40%   60%    80%        100%
                                                                         -1%
                                   Correlation between GDP
                                  Growth and Net Government
                                       Spending = 0.05                   -2%
                                  1 means perfect correlation
                                    0 means no correlation
                                                                         -3%

                                                                        Decrease in
                                                                        GDP Growth

                      HISTORICAL CORRELATION BETWEEN GDP GROWTH AND NET GOVERNMENT SPENDING (SPENDING MINUS TAXES)

                      DATA SOURCE: US BUREAU OF ECONOMIC ANALYSIS
                      TIMESERIES: 1970(1Q) – 2008(4Q) IN CONSTANT 2000 DOLLARS
                      Vertical Axis: % Change in GDP
                      Horizontal Axis: % Change in Net Government Spending w/6 month lag
               Looking into the Crystal Ball
   Can we spend our way out                Zombies
    of the crisis?                           ◦ Firms kept alive for political
    ◦ Didn‟t work in Japan                     reasons but that consume
    ◦ No correlation (0.05) between            resources and slow the
      spending & economic growth               recovery
                                                GM, AIG, Citigroup, Chrysler
    ◦ Sharp stimulus cutbacks will hit
      state/local governments hard          New Regulations
   How will we pay for the                  ◦ Expansion of bankruptcy
                                               and government to
    spending & debt?                           intervene in private
    ◦ Increase taxes                           agreements
    ◦ Devalue the currency                   ◦ End of high-flying
      (inflation)                              investment banks & loan
    ◦ Collapse of                              securitization
      foreign-government lending to
      US
      Top 10 Business Strategies
1.    Be Realistic/Pessimistic                 6. Shed Real Estate Investments
      This won’t turn around quickly.            Commercial real estate fell 83%
2.    Exogenous Shocks to Equities                  in Japan
      Finance for expansion by IPO or new 7. Keep your customers happy
        share issues is unrealistic.              It is easier to keep old customers
3.    Right Size, Right Now                         than to attract new customers
      Don’t staff at levels in hopes that     8. Market Smart
        things will turn around soon.             Cut everything before marketing
      Outsource as much as possible              Focus on how your product meets
4.    Investigate Your Lender                       the new economic reality (e.g.,
                                                    saves customers’ money)
      Assess likelihood of lender’s failure.
                                               9. Keep remaining employees happy
      Draw down lines of credit (especially
        for critical projects)                    Employee problems can spook
                                                    customers.
5.    Understand Landlord/Tenant Issues
                                              10. Review your vendors
      What happens if your landlord
        owner becomes insolvent                   Back-ups for critical vendors
      Tenants have strong economic               Contract review for insolvency,
        incentives to terminate leases               force majeure and dispute
                                                     resolution

								
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