An Overview of Recent Financial Problems: Focus on U.S. Credit is necessary for economies to expand: Investors provide it for entrepreneurs Entrepreneurs create new enterprises, productivity, and, thereby, new wealth When investors (people and institutions with cash and other resources) fear economic conditions, they hold cash. Confidence in markets is important, but hard to define and cannot be forced

Housing Prices Rose 65% from

The Bubble Has Burst

What Caused This Mess? Bad Laws Built Up Over Time 1930s—Law changed to put risk of default on the government through Fannie Mae and Freddie Mac. Banks sold mortgages they made to those “public corporations” which insulated banks from some risk. 1977—Community Reinvestment Act—banks forced to begin to expand loans to higher-risk areas. 1990s—Government pressures banks to increase risky mortgages. Government agency says: “Lack of credit history should not be seen as a negative factor.”

Some Lenders Greatly Expand Loans Countrywide and other new lenders began to make loans to people who could not qualify under traditional rules. Fannie & Freddie back $1 trillion subprime loans. Many people buy homes who could not before (ownership rises from 65% up to 70% of families); and existing owners trade up to more expensive homes; high demand pushes prices up; builders happy to build more homes; lenders happy to make loans and collect a payment.

Bubble Builds Quickly rising demand. Increasing supply. Prices rising faster than real value. Inflated “assets” appear on books (mark to market accounting) and in derivatives exploiting the value. Home buyers making money as prices increased % a year in some “hot markets” such as Las Vegas, Phoenix, Miami, and Los Angeles. People buying & selling fast & buying multiple houses. All on credit—little cash needed.

Reality – and Fear – Sets In By 2006, the problem becoming clear and prices begin to fall. Weakest markets fall hardest and fastest— Average fall— 20% Estimates— 10-15% more decline coming. 10 million+ bad mortgages

Easy Money Government forces lenders to make risky loans, but government “guarantees” loans. Mortgage brokers encourage people to buy houses or trade up to more expensive house. No down payment needed! Worst feature—adjustable rate mortgages— ARMs—first year or two, very low rate, then rises to market. People thought they would cash out. But bubble bursts—demand falls. House worth less than mortgage & owner can’t afford higher payment—default.

Where Are the Mortgages? Few banks keep mortgages—most are bundled together and sold as “Special Investment Vehicles” (SIVs) to creditors all over the world. Mortgages backed by Fannie Mae—so why worry? Government of China holds $375 billion worth of Fannie Mae backed loans. Insurance companies, especially AIG, insure the purchase of the SIVs. No loss possible! What is in an SIV? A jumble of good and bad mortgages. Hedge funds take positions on mortgages—derivatives. Those on the wrong side took huge losses. No one really knows who has what in detail.

Fear Sets In Creditors begin to fear the value of the mortgages as defaults are rising—people stop making payments. Demand for housing drops—prices plunge. Builders abandon projects as they go bankrupt. Entire economy cooling (no demand for supplies). Surprise! Fannie & Freddie have no legal obligation to cover losses—but they (U.S. taxpayers) will. AIG goes bankrupt—no private insurance to cover losses. Creditors sell mortgages; hedge funds hit hardest. Price of SIVs collapse—everyone afraid to buy.

Financial System Comes Apart 1.U.S. housing sector collapses (about 30%?). 2.Cost of bad mortgages causes general fear by lenders —credit markets slow way down. [Loss from bad mortgages probably $300 billion when all finished.] 3.Recession in economy means losses in other sectors; many bankruptcies will occur. 4.Weak financial firms collapsed; more likely. 5.Commercial real estate will weaken as business does. 6.Many large banks in danger of failing taken over by other bank with government help.

Trouble Keeps Going… 7. People, banks and other financial institutions in trouble—dumping assets to get cash as required by government liquidity rules. 8. Dumping assets helped trigger stock crash. Average bear market sees 28% decline; this one much larger. 9. Credit drying up as liquidity of banks dropped and lenders fear making loans. 10. One problem can lead to another—strings of failures and market declines. $2 trillion loss to date in U.S. Problem quickly became global—capital is global.

Bad Accounting Regulation Made It Worse Government requires banks and other publicly-traded institutions to use mark to market accounting of assets. When assets inflated in value—holders appear to have more wealth than is true. When market for mortgages collapsed due to unclear value, markdown of assets made many technically insolvent, causing a panic. Most SIVs (packages of mortgages) are not worthless; many estimated to have 60-80% value, but will take time to clear hundreds of billions.

The European Problem Worse than the U.S. mess in some respects. Western European banks hold most of the paper (loans) to Russia, Eastern Europe, Latin America, and South Asia—over $3 trillion. Exposure of Austria’s banks equals 85% of GDP. Exposure of Swiss banks equals 50% of GDP. Exposure of UK, Swedish and Spanish banks: 25% GDP. Exposure of U.S. banks is “only” 4% of GDP. Loans being called—but can borrowers pay? Russia in trouble due to drop in oil price. Eastern Europe has few assets; currencies crashed.

Solution? No one completely sure. Most important is liquidity in banking sector—keep credit flowing to strong businesses or they must contract and make recession far worse. If borrowers are afraid to borrow due to weak conditions, even at low interest rates they may not borrow. And lenders are afraid to lend—holding on to cash. Suggestions: stop foreclosures on houses until conditions stabilize—no market for houses anyway. Get cash into banks for lending purposes, not to buy their weak assets—that is just a bailout, not a solution to liquidity problem. BUT—Who wants to buy a trillion $ U.S. new debt?