The Economic Crisis of 2008 Cause and Aftermath

The Economic Crisis of 2008: Cause and Aftermath U.S. housing policies are the root cause of the current financial crisis. Other players-- “greedy” investment bankers; foolish investors; imprudent bankers; incompetent rating agencies; irresponsible housing speculators; short sighted homeowners; and predatory mortgage brokers, lenders, and borrowers--all played a part, but they were only following the economic incentives that government policy laid out for them. - Peter J. Wallison rev200902 The Economic Crisis of 2008: Cause and Aftermath

Exhibit 1: House Price Change January 2002 and mid-year 2006, housing prices increased by a whopping 87 percent. Housing prices were relatively stable during the 1990s, but they began to rise toward the end of the decade. The boom had turned to a bust, and the housing price declines continued throughout 2007 and 2008. By the third quarter of 2008, housing prices were approximately 25 percent below their 2006 peak. Annual Existing House Price Change Source: www.standardpoors.com, S and P Case-Schiller Housing Price Index. rev200902 The Economic Crisis of 2008: Cause and Aftermath

Subprime Mortgages NINJA loans No Doc loans Piggyback loans Interest Only (IO) loans Stated-Income (liar loans) 40 year mortgage Option ARM

The Economic Crisis of 2008: Cause and Aftermath The Default Rate The default rate fluctuated, within a narrow range, around 2 percent prior to 2006. It increased only slightly during the recessions of 1982, 1990, and 2001. The rate began increasing sharply during the second half of 2006 It reached 5.2 percent during the third quarter of 2008. Default Rate Source: mbaa.org, National Delinquency Survey. rev200902 The Economic Crisis of 2008: Cause and Aftermath

Subprime Mortgage Originations as a Share of Total Subprime Mortgages Subprime mortgages as a share of total mortgages originated during the year, increased from 5% in 1994 to 13% in 2000 and on to 20% in 2004-2006. Subprime Mortgage Originations as a Share of Total Source: Data from 1994-2003 is from the Federal Reserve Board while 2001-2007 is from the Joint Center for Housing Studies at Harvard University rev200902 The Economic Crisis of 2008: Cause and Aftermath

So What? Well, the brokers who underwrote all of these loans then sold them to Wall Street banks who amassed giant bundles worth billions of dollars (mortgage brokers can make up to $15k on a $300k home loan) They then sold off shares of these “collateralized assets” to eager investors (pension funds, mutual funds, etc.) But these bundles were full of toxic assets (risky loans), so why such high demand? Introducing the Credit Default Swap, a brand new financial instrument for a brand new century. You too can have a AAA rating, no matter how worthless the assets!

Leverage Ratios (June 2008)‏ Remember the simple T-account that we used in class? The leverage ratios of loans and other investments to capital assets for various financial institutions are shown here. When Bear Stearns was acquired by JP Morgan Chase its leverage ratio was 33 to 1. Note, this was not particularly unusual for the GSEs and large investment banks. Leverage Ratios (June 2008)‏ Source: The Rise and Fall of the U.S. Mortgage and Credit Markets: A Comprehensive Analysis of the Meltdown, Milken Institute rev200902 The Economic Crisis of 2008: Cause and Aftermath

Credit Default Swaps: Insurance posing as a derivative First introduced by JP Morgan in 1995. Value of this market in 2007 estimated to be $45 - $60 TRILLION. Sold by Bear Sterns, Lehman Brothers, AIG, Citigroup, and many other banks and financial service companies. Buyer pays a premium to seller so that in case of a “negative credit event,” the seller takes on the credit risk. If no credit default, seller pockets the premium and everyone is happy.

Example of CDS I loan you $1,000,000 for a house Holden LeBag Bank offers me a contract; for $25,000/year, they will pay off the $1,000,000 if you default on your loan This is a CDS; I have “hedged” against potential losses Whatever you do- DON’T CALL IT INSURANCE!

It gets worse! Holden LeBag can sell as many of these CDS contract as it wants, to any interested party In 2007, there were estimated to be $45-$60 trillion in CDS contracts (2x total value of U.S. stock market)

So What’s the Big Deal? Holden LeBag is an insurance company He need not have any reserves to insure that he can actually pay off if the borrower really does default There is no regulation over the forms of these agreements. There is no regulation and no agreement on what constitutes a “credit event.” So what? These are grownup willing buyers and sellers who know what they are doing.

Credit Default Swaps: The Ticking Time Bomb Problem… the bonds and other underlying debts referenced by these swaps started to deteriorate. The market started experiencing “negative credit events,” something sellers assumed would never happen. Even bigger problem… the sellers of these instruments didn’t set aside adequate capital to cover possible payments on these contracts. “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.” — Joseph J. Cassano, a former A.I.G. executive, August 2007 (as quoted in NYT, 9/28/2008) Perhaps – if AIG, Lehman, Bear Sterns top executives hadn’t gotten such generous paychecks and bonuses, some money would have been available to make good on these claims…(opening can, worms everywhere)

Collateralized Debt Obligation (CDO) U.S. financial markets booming, domestic and international demand for assets skyrockets Wall Street turned to the CDO, created in 1987, and sold investors a share of these enormous bundles of asset-backed securities

Shady Shrew, CDO Manager Generic CDO Structure Senior Fixed or Floating Rate Notes Shady Shrew, CDO Manager Diversified Pool of Underlying Assets (Collateral) CDO Special Purpose Vehicle (SPV) Mezzanine Fixed or Floating Rate Notes Subordinated Notes Equity

Nine Failures in Third Quarter Include Washington