The financial Crisis: A broad view Eric Tymoigne Lewis and Clark College Econ 220, Fall 2009

House developers, sellers Households Appraisers Loan Officers Mortgage Brokers Commercial Banks, REITs, Finance Companies, Thrifts Investment Banks Retirees Financial Investment Companies Credit Rating Agencies Monolines, (re)Insurance companies GSE, Gov. Bonus $Commission $ Money $ Strong incentive to work implicitly together to get highest price possible on the house and to qualify as many people as possible MORTGAGES: Principal and interest $ Money $ Conventional Mortgages: Principal and interest$ -FEE$ Conforming Mortgages: Principal and interest $ - FEE$ GSE MBS: Principal and interest $ Money $ PL MBS: Principal and interest $ Premium CDS Strong Incentive to work together to sell securities with low risk and good return Pension – FEE $ Return - FEE $ Want a house and a good return on financial investments Want to promote homeownership, free market ideology: deregulation CDS Premium FEE Some of the main players Money $

House developers, sellers Households Appraisers Loan Officers Mortgage Brokers Commercial Banks, REITs, Finance Companies, Thrifts Investment Banks Retirees Financial Investment Companies Credit Rating Agencies Monolines, (re)Insurance companies GSE, Gov. Bonus $Commission $ Money $ MORTGAGES: Principal and interest $ Money $ Conventional Mortgages: Principal and interest$ -FEE$ Conforming Mortgages: Principal and interest $ - FEE$ GSE MBS: Principal and interest $ Money $ PL MBS: Principal and interest $ Premium CDS Pension – FEE $ Return - FEE $ CDS Premium FEE The cash-flow cascade Money $

What is missing in the previous analysis Resecuritization business: MBS –> CDO -> CDO-squared -> CDO-cubed + synthetic securitization (LSS, etc.) Some other players: property insurance (for house), Special Purpose Entities (SPE) (Shadow banking: issue MBS, etc), central bank and Federal Home Loan Bank System (provide major refinancing sources to mortgage lenders), government loan programs Many other illiquid financial claims beside mortgages (ABS: asset-backed securities): credit cards, auto loans, students loans, rock-start royalties (Bowie bonds), movie royalties (Bond bonds), etc. It is not as clear cut in terms of cash flows: insurance companies also bought CDS (and so paid premium to each other), mortgage bankers issued and sold MBS and CDS, SPEs bought MBS of other SPEs (same with investment banks and commercial banks), financial investment companies usually are net sellers of CDS (major net buyers are banks), etc.

CDS MARKET

Collateral for MBS and CDO

Resecuritization, Re-resecuritization, etc.

Quality of Mortgages went Down

Quality of Mortgagors went down

Excess and Fraud Mortgage Lenders: put prime borrowers into subprime deals, do not verify creditworthiness of mortgagors, assume that home price will always go up (so no problem if mortgagors does not pay), fraudulent behaviors (inflated fees, change terms of mortgage at the last minute without informing mortgagors, etc.) Mortgage broker/loan officers: same as mortgage lenders + lie on mortgage application (boost income of borrowers) + push people into exotic mortgages (ARM-IO, payment option, etc.) Investment banker: Toxic financial innovations, assume that home price will always go up, poor disclosure of information, fraud CRA: pressured to rate quickly toxic innovations (no look at underlying loan files), use rating techniques used on corporate bonds and assume they are good for toxic securities GSE: accounting fraud Deregulation: – Unregulated CDS (2000) – Pension fund allowed to buy toxic financial innovation (as long as they are AAA)

House developers, sellers Households Appraisers Loan Officers Mortgage Brokers Commercial Banks, REITs, Finance Companies, Thrifts Investment Banks Retirees Financial Investment Companies Credit Rating Agencies Monolines, (re)Insurance companies GSE, Gov. Bonus $Commission $ MORTGAGES: Principal and interest $ Money $ Conventional Mortgages: Principal and interest$ -FEE$ Conforming Mortgages: Principal and interest $ - FEE$ GSE MBS: Principal and interest $ Money $ PL MBS: Principal and interest $ Premium CDS Pension – FEE $ Return - FEE $ CDS Premium FEE Money $ FORECLOSURES HUGE INSURANCE PAYMENTS DUE ON CDS Asset liquidation: other markets affected Unable or unwilling to pay: Unemployment, too high mortgage cost, underwater The Crisis Refinancing crisis!! Money $ Central bank, Treasury, FDIC, FHLBS: lender of last ressort, buyer of last resort, TARP, etc.

No Just a Subprime Crisis

Some fun… 9g