October 13, 2008 The Subprime Crisis, Panic and Crash: The Day Trust Died

2 Where Are We Today?  Institutions –Commercial Bank and Savings Associations: 13 failures from January-September 2008 (includes Washington Mutual) – Compared to 3 in 2007, 0 in 2006 and 2005 –Investment and Security Firms 2 “official” collapses (Bear Sterns and Lehman Brothers), 1 “shotgun merger” (Merrill Lynch), 2 changes to bank holding companies (Goldman Sachs and Morgan Stanley) –Money Market Mutual Funds 1 fund “broke the buck” (Reserve Primary Fund), second time in history  Markets –Total Excess Reserves at the Federal Reserve (in millions) $ 136,035 (Oct. 8), $ 60,051 (September), $ 1,986 (August), $ 1,984 (July) Fed Funds Target: 1.50% (10/10) –LIBOR Overnight 2.46% (10/10), 3 months 4.82% (10/10) –Treasury One month 0.04% (10/10), 3 months 0.11% (10/10) –S&P % year to date (December 31, 2007 to October 13, 2008) -19.8% month to date (September 12, 2008 to October 13, 2008)

3 No Man is an Island “…never send to know for whom the bell tolls; it tolls for thee.” John Donne ( )

4 How Did We Get Here?  US Financial System is very complex –Simple concepts are those that fail  Some things are eternal –ALL transactions between 2 parties involve lack of knowledge and a lot of trust One party knows something the other party does not  Asymmetry of Information –ALL investors (savers) want positive returns on investments  Once upon a time...

5 Once Upon a Time…  Banks made loans with the money from depositors –First: bankers gathered information about the borrower The 5 Cs of credit –Character : the willingness to payback –Capacity : the ability to payback such as sources of income –Capital : the ability to payback from other resources other than income –Conditions : the economic conditions that affect repayment –Collateral : the last source of repayment if all else fails, such as the house being mortgaged –Second: bankers set the price of loan such that good borrowers could pay back Majority of mortgages were at fixed interest rates –Third: bankers watched the borrowers behavior If borrowers could not pay, bankers tried renegotiation and then, foreclosure  Bad news: Bankers did not lend more than the deposits on banks –Capital constraints  some borrowers didn’t get loans  Good news: Depositors trusted bankers to watch and take care loans –Banks were the DELEGATED MONITOR

6 21 st Century Banking  Banks made loans –Subprime borrowers and Alt-A borrowers represent high adverse selection risk House prices were “always increasing”  bankers decided collateral was sufficient for loan Price the loan expecting refinance –Set initial price so borrowers can pay, such as “teaser” low interest rate –Lock in borrower by imposing prepayment fees so borrower does not refinance elsewhere during “teaser” period –When rates change, refinance the loan –If borrower can’t pay, then sell the higher priced house –If house prices increase, banks cannot lose Sell the loan to somebody else –Securitize: create securities that are sold in the markets and whose payments are backed by the payments of the loans, i.e. mortgages  KEY  Good news: Selling loans raises capital and allows banks to make more loans  Bad news: Who has the incentive to monitor the borrower?

7 The 21 st Century Alphabet Soup Basics  Asset Backed Securities (ABS) and Mortgage Backed Securities (MBS) –Sale of loans by bank to a trust that raises cash through the creation and sale of securities –The securities issued are divided into tranches with different characteristics –Payments from loans purchased by the trust are distributed to tranches following a cascading pattern Top tranches get paid first, bottom tranches get paid last if there is anything left Can improve chances of some tranches getting payments by making some enhancements, purchasing insurance etc… Tranches get rated for credit risk by rating agencies –Institution doing securitization sold tranches to investors all over the world and may have kept some of the tranches And yet again, maybe not…  Collateralized Debt Obligations (CDO) –Purchase of ABS and MBS by a trust that raises cash through the creation of securities –The securities are issued in tranches –Payments from ABS, MBS are distributed to tranches following a cascading pattern….

8 The 21 st Century Alphabet Soup  Structured Investment Vehicle (SIV) –Not a standard securitization, but a managed operating company that has very high leverage –Generally owned by a commercial bank or an investment bank, but off balance sheet The SIV purchases fixed income assets, which can be mortgage related securities Borrows in the financial markets by issuing debt securities –Asset Backed Commercial Paper is the short term debt issued by SIVs »Money Market Mutual Funds purchased them  Securitization and asset backed securities are not a new idea –Subprime securitization is “sort of new” and it is more complicated Loans are supposed to be constantly refinanced –“Rules” of payments among tranches are extremely complex »VERY hard to value

9 The 21 st Century Alphabet Soup Basics  Who were the security investors? –Everyone and everywhere Commercial Banks, Investment Banks, Insurance Companies, Mutual Funds, Hedge Funds, Government Sponsored Agencies (Fannie Mae, Freddie Mac), etc.. Investors wanted good returns –Interest rates were low 2001 to 2006 in response to 9/11 and subsequent recession »All investors searched for higher yield  Good news: Easy to raise money for lending purposes  Bad news: Difficult to value debt without detailed knowledge of assets. Investors must trust issuer and rating agencies

10 The 21 st Century Alphabet Soup Basics  Credit Default Swap (CDS) –Not a security and not insurance, but a contract between 2 parties related to the default of a particular bond –One party pays fees, while the counter party offers payment in case the bond defaults The party purchasing the CDS replaces the risk of default of the original issuers of the bond by the risk of default of the counter party selling the CDS  Who sells CDSs? –Everyone and everywhere Hedge Funds, Investment Banks, Subsidiaries of Insurance Companies (i.e. AIG) etc..  Good news: Investors don’t worry about security defaults and may purchase more  Bad news: Investors are exposed to default of the seller of CDS. Who is monitoring the debt issuer/borrower?

What Went Wrong?  House prices declined –Started September 2007, first time since Great Depression of the 1920s Caused by increase in interest rates? –Inability for subprime borrowers to refinance due to falling house prices and higher rates Decrease in value of subprime securitized debt, but by how much?  The Big Wake Up –Investors unable to accurately price subprime debt –Investors unable to know exposure of counterparties to subprime debt –Subprime exposure is contagious Any party can be hurt if counterparty is exposed to risk and fails –Trust no one No collateral is good, only US Treasury Everyone needing cash that is not US Treasury is “shut out” –Hurts general businesses, individuals and state and local governments »Decreases value of everything, increases risk of generalized bankruptcies 11

Transactions require trust Trust Is Dead 12

Solutions?  Need to restore trust –Government interference is inevitable in the short run Only current source of trust, albeit “fragile” –Establish system such that prices can reflect fundamentals and not “fire sale” Need to stabilize house prices –Establish a clear mortgage renegotiation system »Renegotiation is not forgiveness Need to establish “auction” for complex securitized debt –Provides information about underlying assets –Private solutions in the long run Clear standards for borrowers and lenders Increase transparency about assets backing securitized loans Creation of a “clearing house” for credit derivatives to allow substitution of counterparty risk for clearing house risk –Futures markets appear to be a good model 13