An explanation by Joseph Stenard The Credit Crunch An explanation by Joseph Stenard

The Credit Crunch – a house of cards implodes Economist of the Day Mortgage Market foundation Fannie Mae Involvement Institutional Investors and Bond Holders Derivatives as a hedge against default Derivatives as a concentration of risk Mortgage Brokers and Predatory Lending Moral Hazard

Anna Katherine Barnett-Hart

A.K. Hart Student of Economics Valedictorian, Harvard University 2010 Musical Prodigy – Studied Violin at Juilliard for a year deferring her Harvard admission Senior Thesis on CDO’s Collateralized Debt Obligations & CDS’s Credit Default Swaps written from an insider’s perspective thanks to her internship on Wall Street Next door neighbor to Prof. Stenard’s sister "I'm coming into the middle of the financial crisis saying, 'I want to write about the financial crisis.'" "I saw no point in changing my topic to something I wasn't as interested in — so I used contacts from my internship to gather original data my advisers said I couldn't get.”

Traditional Home Mortgage Market Stable, Market driven No safety nets No PMI Downpayments, Real estate market risk, Inflation risk, default risk all accepted by the bank. Traditional Home Mortgage Market

Enter Fannie Mae Provides liquidity Increases availability of home mortgages Involves Government inefficiencies Dictates conformity Acts algorithmically Insulates banks from risks Creates Moral Hazard

Moral Hazard When the terms of a contract encourage actions which are counter to the principles assumed at the time of contract If “Plan B” is attractive then “Plan A” can be more risky Fire Insurance, Bail Money, Air Bags Insurance Risk can be shifted to another person who is willing to bear it--the speculator. Another way of dealing with risk is by pooling it using insurance. The idea is simple. If one out of 1000 homes will burn each year, and if each person contributes to a general fund 1/1000 of the value of his home, the fund will have enough (ignoring administrative expenses and the question of whether expensive homes are more or less likely to burn than cheap homes) to reimburse those whose homes burn down. The size of the insurance industry indicates that people are eager to pay to avoid risk. They pay and get nothing if fortune smiles on them, whereas if misfortune strikes, they break even because the insurance should just pay back the value lost in the misfortune. Because insurance changes the costs of misfortune, and because people's choices depend on costs and benefits, insurance should change people's behavior. They should make less effort to avoid misfortune, and this change in behavior is called moral hazard. For example, if an accident costs a person $1000 but insurance pays $900, the insured person has less incentive to avoid the accident. If the accident costs the person $1000 but pays $2000, the person not only has no incentive to avoid the accident but may have an incentive to seek it out. Sometimes moral hazard is dramatic. Fire insurance encourages arson, automobile insurance encourages accidents, and disability insurance encourages dismemberment. In a story in its December 23, 1974 issue, The Wall Street Journal reported this bizarre instance of moral hazard: "[T]here is the macabre case of "Nub City," a small Florida town that insurance investigators decline to identify by its real name because of continuing disputes over claims. Over 50 people in the town have suffered 'accidents' involving the loss of various organs and appendages, and claims of up to $300,000 have been paid out by insurers. Their investigators are positive the maimings are self-inflicted; many witnesses to the 'accidents' are prior claimants or relatives of the victims, and one investigator notes that 'somehow they always shoot off parts they seem to need least.'"The problem of moral hazard also affects government programs that insure people against misfortune. A variety of programs help people who suffer the misfortune of poverty. Aid to dependent children helps people who suffer the misfortune of having children to raise that they cannot financially support. Unemployment compensation pays people who suffer the misfortune of losing their jobs. Food stamps and public housing help the poor. Yet all these programs also suffer from problems of moral hazard. They increase children born out of wedlock, unemployment, and poverty. Moral hazard is the result of maximizing behavior. A person weighs the costs and benefits of an action, and when benefits exceed costs, he takes the action. This does not mean that if a person has a building insured for $50,000 but only has a market value of $30,000, the owner will necessarily commit arson. There may be costs of violating one's moral code and of getting caught and convicted for arson. But some people put into this situation will find a way to torch the building because they do not find the cost of violating a moral code very high and they consider the chances of being caught small, and other people will be less careful about avoiding fires. Moral hazard does not require that people intentionally cause the misfortune. If they simply take fewer measures to prevent misfortune, the same outcome occurs. The problem of moral hazard creates problems both for private insurance and the government. Private insurance tries to keep the insured value of any misfortune less than the value to the insured person. It tries to keep buildings and autos insured for less than their true worth. In addition, it is usually against the law to create the misfortune that you are insured against. Finally, if the problem of moral hazard is too great, there will be no insurance coverage for the misfortune. The government can and sometimes does take a similar approach. It can give so little aid to those in distress that it provides little encouragement for people to put themselves in the situation, but it then provides little help for those in distress. As it expands a program to provide more aid to those in distress, it also encourages people to put themselves in distress. If people are paid to be poor, some will become poor. If people are paid to have children out of wedlock, some will. If people are paid to be unemployed, more will be unemployed. Thus government programs that act to insure citizens against some misfortunes have a basic tradeoff that cannot be escaped. Greater efforts to help those in need also increase actions that are considered socially undesirable. Unintended consequences abound in the area of moral hazard. The insurance industry can also face problems of signaling and screening. People who buy insurance often have a better idea of the risks they face than do the sellers of insurance. People who know that they face large risks are more likely to buy insurance than people who face small risks. Insurance companies try to minimize the problem that only the people with big risks will buy their product, which is the problem of adverse selection, by trying to measure risk and to adjust prices they charge for this risk. Thus, life insurance companies require medical examinations and will refuse policies to people who have terminal illnesses, and automobile insurance companies charge much more to people with a conviction for drunk driving

Secondary Mortgage Market ★ A statement by Jeffrey A. Miron, a lecturer in economics at Harvard, in opposition to the bailout. He thinks the bailout is a terrible idea and this is why. The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk. Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared. This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle. Once housing prices declined and economic conditions worsened, defaults and delinquencies soared, leaving the industry holding large amounts of severely depreciated mortgage assets. The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government. The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company. Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable. In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This “moral hazard” generates enormous distortions in an economy’s allocation of its financial resources. Secondary Mortgage Market

Savings and Loan Crisis 1980’s S&L’s were restricted to low interest home loans Rising interest rates put a strain on the S & L’s Deregulation permitted risky investing S&L managers used Bank money to buy junk bonds 747 Savings and Loans went bankrupt Cost of crisis $160 Billion Taxpayer portion was $124 Billion 7 savings and loan associations (S&Ls) in the United States. The ultimate cost of the crisis is estimated to have totaled around $160.1 billion, about $124.6 billion of which was directly paid for by the U.S. taxpayer.[1] The accompanying slowdown in the finance industry and the real estate market may have been a contributing cause of the 1990-1991 economic recession

Homeowners Down payment of 20% Shopped around for the best interest rates Paid off the mortgage to own the home Very Reliable No Money Down Mortgage Brokers sought them out Leveraged properties to maximize consumption Unreliable

Banks and Lending Institutions Competed with other banks and lenders Were responsible to the depositors Cautious – would avoid lending to risky clients Foreclosure meant loss for the bank Acted as an Agent of Fannie Mae FDIC and Secondary Mortgage Market created Moral Hazard Overextended Origination fees and Servicing of loans were additional revenue

Fannie Mae and Freddie Mac Created in 1938 and 1970 respectively At the center of the Credit Crunch Buy Mortgages from Banks and other lenders Bundle the mortgages into Bonds (Mortgage Backed Securities) Algorithmically follow policy Drones motivated by keeping job

Institutional Investors Pension Funds, Capital Accounts, Trust Funds and Endowments Administrators are very risk-adverse Motivated by protecting assets Bought Fannie Mae Bonds, the Collateralized Debt Obligations which were as good as the underlying mortgages Purchased Derivatives for “insurance”

Mortgage Brokers Paid by lenders for closing deals on mortgages, refinances, home equity loans. Commission paid was percentage of the loan amount Different loans paid different rates Predatory Loans – Adjustable rate mortgages Aggressive selling with preference to higher paying loans The ultimate Agency Problem

Derivatives Market The issuer of the derivative is effectively making a “side-bet”, which will pay in the event of the bond defaulting. The cost of the derivative can be likened to an insurance premium. The cost should fluctuate with risk. The issuer, competing with other issuers, collects premiums and pays out according to the contract

Derivatives Market Institutional Investors purchased Derivatives Commercial banks like Lehman Brothers issued the derivatives Very lucrative in good times Incredible overexposure wasn’t discovered until too late Followed the crowd instead of analyzing the data

The collapse The Derivatives were under priced Derivatives on top of derivatives Homeowners miss payments Fannie Mae bonds default Institutional investors call the derivatives Insufficient funds on the part of issuers – they declare bankruptcy The financial markets dry up.

CREDIT CRUNCH Part 2 The Implications

Michael Lewis

Michael Lewis The author of Liar's Poker, The Blind Side and a new book about the collapse, The Big Short, Lewis contacted A.K. Hart about the paper and wound up dropping her name in the book. Called her paper "more interesting than any single piece of Wall Street research on the subject."

Winners and Losers WINNERS Mortgage Brokers Banks LOSERS Fannie Mae The taxpayers Banks Homeowners Derivatives Market Institutional Investors

Congress and Treasury arrange a Bailout Government (the American People) buys the most toxic mortgages Government stock ownership of companies “too big to fail” Billions paid out to AIG Nearly $1 Trillion http://www.youtube.com/watch?v=zfTld4mo1FM

How Much is a Trillion? It is a Million Millions Spend one dollar per second for 32,000 years Can pay the rent for every renter in the US for 3 years Enough to cover every mortgage in America for 14 months Enough to buy 40,000,000 new cars More than the entire defense spending since 9/11 (currently 80M cars on road)

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