The Financial Crisis of 2008 Special Lecture

Easy Credit – The main culprit American economy is based on credit From heating up homes in winter to buying homes, people use credit In the booming financial market, it became very easy to take loan Rise in Property prices Low interest rates Loose lending policy - expecting rising property prices

The Mortgage brokers Mortgage brokers approved credit for all type of customers (including sub-prime loans) This way they increased their commission income brokers absolved themselves of responsibility by packaging these bad mortgages with other mortgages and reselling them as “investments.”

Home buyers contact a mortgage broker MB Approves loans including risky ones to get more commission Loans are given by a mortgage bank (Countrywide, Indy Mac, Fannie & Freddie , Citibank) Investment Bankers (Bear Stearns, Lehman, Merrill Lynch) classify loans according to risk level called CDO The AAA CDOs are paid first incase of mortgage defaults, but the rate of return is lower Lenders Issue Mortgage backed securities (MBS) and sell to investment banker The rated CDOs were sold and junk kept in SPV

V(A) + V(E) > V(D) House Income MBSs CDOs Mortgage Lenders Banks Subprime Mortgage Lenders (Countrywide, Indy Mac, Fannie & Freddie) Banks (Citibank, BOA) Insurers (AIG) Rating MBSs Investment Banks (Bear Stearns, Lehman, Merrill Lynch) CDOs Root of crisis is housing price and economic condition : Low FED rate make it cheap to borrow money to invest in real estate and reduce mortgage rate Assuming always-up about house’s price lead to open-up lending policy created subprime lending Economic recession and housing bubble started 2006 lead to growth of unemployment rate and massive loses of mortgage-related derivative assets SPV Investors (Banks, Funds, Insurance) 5

The loan bubble Swelled Thousands of people took out loans larger than they could afford With the hope to sell the house for profit or refinance with lower rate But slump in the property prices disturbed everything…..

Homeowners Equity vs. Mortgage Source: The Federal Reserve

Slump in the property prices and Unemployment In 2006, property prices started falling down and investors could no longer ssell their homes for a quick profit adjustable rates mortgages adjusted skyward Also in 2006, unemployment rate increased mortgages no longer became affordable for many homeowners thousands of mortgages defaulted

Home Price Indices Source: Standard & Poor’s

Money started bleeding The defaults caused massive losses in mortgage backed securities The property prices fell further that caused slower growth in construction of new homes and thousands of jobs were lost Due to fall in prices of mortgage backed securities many investors chose to walk away without paying the loan, increasing further the losses of banks

Write-Offs by Financial Institutions 11 11

Credit well dried up As the losses went up, banks tightened control on credit Many banks could not survive the bolt and sank under the heavy losses, others merged and some got help from govt Govt did not support all of the falling firms

Pakistan and US financial crisis Pakistan escaped from the direct effect of US financial crisis But indirectly, there are several areas of concern: tightened terms for access to international debt markets Slowing world growth rate can effect our exports But at the same time, recession will translate into lower demand which will cause fall in oil prices

Pakistan economic problems Pakistan’s economic problems are not tied to the current global financial crisis The main economic problems of Pakistan are: Trade deficit Budget deficit Currency devaluation Inflation