Financial Crisis James Barth Powerpoints March 2009 Complete presentation at Follow this link to Barth’s “Leverage and Risk in Financial Institutions” presentation in Amsterdam, February

2 Did the Fed lower interest rates too much and for too long? Federal funds rate vs. rates on FRMs and ARMs Sources: Federal Reserve, Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.

3 Home mortgages: Who borrows, how much has been borrowed, and who funds them? Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $700 billion Government- controlled 46% Private sector- controlled 54% Total value of housing stock = $19.3 trillion Sources: Federal Reserve, Milken Institute.

4 Subprime mortgages accounted for half or more of foreclosures since 2006 Sources: Mortgage Bankers Association, Milken Institute.

5 The mortgage model switches from originate-to-hold to originate-to-distribute Sources: Federal Reserve, Milken Institute. Residential mortgage loans 1980: Total = $958 billion Residential mortgage loans Q3 2008: Total = $11.3 trillion 11% 89%

6 Mortgage-backed securities issued by issuer Sources: Inside Mortgage Finance, Milken Institute. Note: 2008 data are annualized.

7 Home mortgages: Who borrows, how much has been borrowed, and who funds them? Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $700 billion Government- controlled 46% Private sector- controlled 54% Total value of housing stock = $19.3 trillion Sources: Federal Reserve, Milken Institute.

…small events at times have large consequences. A liquidity crisis in a fractional reserve banking system is precisely the kind of event that can trigger – and often has triggered – a chain reaction. And economic collapse often has the character of a cumulative process. Let it go beyond a certain point, and it will tend for a time to gain strength from its own development as its effects spread and return to intensify the process of collapse. Because no great strength would be required to hold back the rock that starts a landslide, it does not follow that the landslide will not be of major proportions. Friedman and Schwartz A Monetary History of the United States

9 Subprime mortgage meltdown timeline December 2006–October 2008 Sources: BusinessWeek, S&P, Global Insight, Milken Institute.

10 Financial market capitalization takes big hit Note: Bear Stearns stock price is to May Countrywide stock price is to June Merrill Lynch stock price is to December Wachovia stock price is to December Sources: Bloomberg, Milken Institute.

11 Counterparty risk increases Note: Counterparty Risk index averages the market spreads of the credit default swaps (CDS) of fifteen major credit derivatives dealers, including ABN Amro, Bank of America, BNP Paribas, Barclays Bank, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs Group, HSBC, Lehman Brothers, JPMorgan Chase, Merrill Lynch, Morgan Stanley, UBS, and Wachovia. Sources: Datastream, Milken Institute.

12 Federal Reserve assets increased but asset quality deteriorated Sources: Federal Reserve, Milken Institute.

13 Balance sheet information on FDIC-insured institutions Sources: FDIC, Milken Institute.

14 U.S. regulatory capital requirements and prompt corrective action categories Tier 1 leverage Tier 1 risk- based Total risk- based Well capitalized>= 5% and>= 6% and>= 10% Adequately capitalized >= 4% and >= 8% Undercapitalized< 4% or < 8% Significantly undercapitalized < 3% or < 6% Critically undercapitalized Tangible equity capital ratio that is <= 2% Source: FDIC.

15 Leverage ratio for commercial banks Sources: Historical Statistics of the United States, FDIC, Milken Institute. Note: The leverage ratio is the reciprocal of the capital-asset ratio.

16 XI. When will we hit bottom?

Conservatorship of Fannie Mae and Freddie Mac…

Bailing out AIG…

Capital Purchase Program under the TARP…

Automotive Industry Financing Program…

Targeted Investment Program and Asset Guaranty Program…

And Still……

23 The U.S. regulatory regime: In need of reform? Sources: Financial Services Roundtable (2007), Milken Institute.