Breeden: Credit and the Macroeconomy, February 2010

Duke University Fuqua School of Business Reference materials for: The Role of Credit in the Macroeconomy and Root Causes of the Financial Panic of 2008/2009 Douglas T. Breeden* February 27, 2010 Reference materials for presentation at the symposium at Duke on “The Future of Capitalism: The Future of Lending, Credit and Leverage.” I thank Laurie Goodman of Amherst Securities for the use of some of her slides. *William W. Priest Professor of Finance and Former Dean, Duke University, Fuqua School of Business, One Towerview Drive, Durham, North Carolina 27708.

My Assignment
Describe the “critical role of credit in the macroeconomy.”
2. Describe the root causes of the “Financial Panic of 2008/2009”.
… and do this all in 15 minutes!
Goal: to give students common background on credit before our distinguished panel.

I. The Critical Role of Credit in the Macroeconomy (See the Appendix for basics on the role of credit.)

Let’s remember back to a time long ago and far away … : Autumn of 2008: After Countrywide, Bear Stearns, Fannie Mae, Freddie Mac, Lehman, AIG, Washington Mutual, Merrill Lynch and Wachovia The headlines remind us of the nerve-shattering look into the abyss

Does This Deserve To Be Called “The Financial Panic of 2008/2009”?
Q1 : Was this extreme enough to be called a “Financial Panic”, much like those in the 1800s and 1907 and 1937-1938?
Q2 : Is this bigger than all recessions in the past century, except the Great Depression?
Q3 : For financial stocks and bonds, is this even as large or larger than the Great Depression?

Leverage Matters. And if you are levered and “Correlations go to 1.0 in extreme markets …” Leverage Ratios (Assets/Equity) for Bear Stearns, Goldman, Morgan Stanley and Lehman 1996-2007 15.0 20.0 25.0 30.0 35.0 40.0 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 BSC GS MS LEH

Stock Price Falls of Big 5 Investment Banks in 2008/2009 Price 12/31/2006 2008 Low Price 2009 Low Price Feb 2010 Bear Stearns $162.78 $ 4.81 Sold to JPM Sold to JPM Goldman Sachs $199.35 $ 78.20 $47.41 $156.70 Lehman Brothers $ 78.12 $ 0.05 Bankrupt Bankrupt Merrill Lynch $ 93.10 $ 13.10 Sold to BAC Sold to BAC Morgan Stanley $ 67.20 $ 9.58 $ 6.71 $ 27.15

Stock Price Falls of Commercial Banks 12/31/06 2008 Low 2009 Low Feb 2010 Bank of America $53.39 $18.52 $ 2.53 $15.94 Citigroup $55.70 $11.52 $ 0.97 $ 3.35 JP Morgan $48.30 $31.02 $14.96 $39.88 National City $36.56 $ 1.36 Sold to PNC Sold to PNC Wachovia $56.95 $ 1.84 Sold to WFC Sold to WFC Wells Fargo $35.56 $20.51 $ 7.80 $27.29

Stock Price Falls of Insurers and Thrifts Price 12/31/2006 2008 Low Price 2009 Low Price Feb 2010 Fannie Mae $59.39 $0.43 $0.30 $ 0.96 Freddie Mac $67.90 $0.26 $0.25 $ 1.18 Washington Mutual $45.49 $0.03 Bankrupt Bankrupt AIG $71.66 $1.35 $0.33 $ 1.21 Ambac $89.07 $1.16 $0.35 $ 0.69 MBIA $73.06 $3.90 $2.17 $ 4.93

Bank Stock Panic of 2008/2009 versus the Great Depression End of Month, June 2007- Jan 2010 vs. Aug1929- Aug1933

Credit Yield Spread: Baa Corp-10 Yr Treasury Basis Points, EOQ, 1926-2009Q1 (Semiannual 1926-1959)

Critical Roles of Credit for Individuals
If credit is not available, many young families cannot borrow to purchase homes or autos. This reduces business profits and jobs.
Credit cards are routinely used to manage purchases, as well as for borrowing by individuals who do not have other credit. When credit cards are terminated or fees and rates increased substantially, or credit lines substantially diminished, there is pain. These can also trigger insolvencies.

Critical Roles of Credit for Businesses
If banks will not lend money or roll over loans to small businesses, they may have to curtail growth or actively shrink or close.
If institutions will not lend to one another and roll over their short-term financing, financial institutions quickly become insolvent. This happened to Bear Stearns, Lehman and was a big concern to Merrill Lynch, Morgan Stanley and Goldman Sachs, the “Big 5 Investment Banks.”

Critical Roles of Credit for Governments
Governments (such as Greece now) that lose the confidence of bond investors are forced to make very painful cutbacks in government services and public sector benefits.
Their currencies often suffer greatly, making imported goods much more expensive. Anticipating the disruptions, stock and bond prices can fall dramatically. Employment and wages often fall sharply.

Global GDP Growth Showed Sharp Slowdown Source: IMF WEO for 2007, Economist for 2008, 2009
North America 2007 2008e 2009e Change ’07-’09
United States 2.0% 1.2 -2.0 -4.0%
Canada 2.7 0.5 -0.7 -3.4%
Mexico 3.2 1.8 -1.4 -4.6%
Europe
U.K. 3.0 0.7 -2.6 -5.6%
Germany 2.5 1.1 -2.5 -5.0%
France 2.2 0.7 -1.7 -3.9%
Italy 1.5 -0.6 -2.3 -3.8%
Spain 3.7 1.1 -2.3 -6.0%
Russia 8.1 6.0 1.0 -7.1%

Global GDP Growth Showed Sharp Slowdown Source: IMF WEO for 2007, Economist for 2008, 2009
Latin America 2007 2008e 2009e Change ’07-’09
Brazil 5.4% 5.3 1.6 -3.8%
Argentina 8.7 5.5 -1.8 -10.5%
Chile 5.1 3.5 1.0 -4.1%
Asia/Australia
Australia 4.2 2.2 0.3 -3.9%
Japan 2.1 -0.2 -3.2 -5.3%
South Korea 5.0 4.1 -2.8 -7.8%
Hong Kong 6.4 3.0 -3.0 -9.4%
Singapore 7.7 1.2 -7.2 -14.9%
Taiwan 5.7 1.8 -3.5 -9.2%
China 11.9 9.0 6.0 -5.9%
India 9.8 5.3 5.0 -4.8%

Insurance Premiums for Selected Emgerging Markets

U.S. Total Employment Growth Plummeted Last Twelve Months Percent, EOQ 1960-2009. 23

U.S. Unemployment Rate Surged to 10% EOQ, 1960-Q4 2009

Ok, now that we remember why some of us are still in therapy … II. What were the root causes of the “Financial Panic of 2008/2009"?

Global Economy Was In the Zone in 2007
Real consumption and GDP had not had a serious recession for 25 years, since 1982, 25 years ago. Recessions in 1991-2 and 2001 were not deep.
Global economies were the strongest in decades, with the largest number of people coming out of poverty in a decade in modern history, led by China and India.
Real corporate profits were at record levels, with very high returns on equity, exceeding 15%.

4. Loan delinquencies were at very low levels for corporations, and were also low or moderate on consumer and mortgage loans.
5. Real estate prices had grown solidly nationwide and sharply in several hot markets on both coasts and sunshine states.
6. Household net worth was very strong, highest ever, reflecting stock profits and real estate gains.
7. Early 2007 unemployment rate was near 40-year lows in the 4-4.5% range. Jobs were plentiful for workers with modern technological skills and in many service jobs.
Global Economy In the Zone (cont.)

A. But Very High Debt Levels At Individual, and State Government and Agency Levels
Debt was at a very high level for both individuals and for many governments.
Aging populations and rapidly rising health care costs make budget balance unlikely.
Bank loans were high in early 2007, leaving them with little liquidity. When tough times came, loans sharply cut back.

Debt Service As A Percent of Income

Aging Populations Are Debt Burdens

B. Housing Market Weaknesses Began To Show in 2007
Interest rates were very low (bond “bubble”?), encouraging heavy borrowing. Housing starts had been high for several years.
Homeownership percentage was an all-time high.

B. Housing Market Weaknesses Began To Show in 2007 (cont.)
3. After a decade of growth of 11% per year (vs. 2.5% inflation) in Top 10 markets (led by California, Florida, Arizona), housing prices were very high.
4. Professor Shiller of Yale ( Irrational Exuberance book) saw them as a bubble, out of proportion to rental rates and to construction costs.
5. Inventories began to build sharply.

C. Credit Quality Deterioration in New Mortgages Issued from 2004-2007 Gaming in Securities Structuring?

Percentage Mortgage Backed Securities Agency Insured vs. Nonagency Source: Laurie Goodman, Amherst Securities

FICO Scores Were Stable for Nonagency Mortgage Securities 2001-2007 Source: Laurie Goodman, Amherst Securities

Percent Loan/Value >90% Increased on Nonagency Mortgage Securities Source: Laurie Goodman, Amherst Securities

Percent Full Documentation Decreased on Nonagency Mortgage Securities Source: Laurie Goodman, Amherst Securities

Percent Paying Interest Only Increased on Nonagency Mortgages (No Principal) Source: Laurie Goodman, Amherst Securities

C. “Six Sigma” Drop In Real Estate Prices and Loan Delinquencies Soar
Real estate prices have dropped by amounts that were truly unmeasured previously. Recent moves reflect many (6-10?) standard deviation events.
We tend to gauge what is a “bad scenario” by looking at historical data to see how bad situations can be. We need to think “out of the box” to worlds and equilibria that have not been seen, but are possible.
Doug, the recent Turner report in the UK suggests that one problem was that the history Used in the empirical analysis, often just 5-6 years, was insufficient. JWPayne

U.S. Real Estate Price Appreciation Experience
Since 1975 OFHEO/Freddie Mac price index started, there has never been a 5-year or a 10-year period when housing prices declined.
Lowest 5-year growth from 1990-1995 at 2%.
Lowest 10-year growth rate was 3% from 1989 to 1999.
Highest 5-year growth was 11% in 1975 to 1980.
Highest 10-year growth was 7.5% from 1975 to 1985.
Average price growth over 30 years was 5%.

Housing Prices Continued to Decline Nov 08-Nov 09: Source: Freddie Mac, National Association of Realtors, S&P/Case-Shiller, Amherst Securities

U.S. Banks’ Net Chargeoffs: Single Family Real Estate Annualized Percentage, Quarterly 1991-2008 Q3

Banks Tighten Loan Standards for Residential Loans

Banks Tighten Loan Standards: Commercial RE Loans

Prices of AAA-original rating, floating rate mortgages backed by Subprime and Prime/Alt-A Securities End of month, December 2006 to January 2009

As Of November 2008: Collateral Requirements Raised Dramatically Source: UBS

Vicious Circle—De-leveraging in a Stressed Market

Margin calls: Speculation is not always stabilizing, although as Keynes said, “Profitable speculation is stabilizing.”
“ Markets can remain irrational longer than you can remain solvent.”
John Maynard Keynes
With marking to market and the requirement to meet margin calls, at some point even a great speculator has to start selling more as prices fall and they lose wealth, rather than “doubling up” and buying more at better prices and returns. Capital is not infinite. LTCM and I learned this.
Yes, if speculation is profitable, one has bought low and sold higher. But speculation can turn unprofitable and lead to the dynamics above, where speculators are forced to do the opposite of what their economic analysis would lead them to do.

Mix Assets of Households and Nonprofit Organizations as of Dec 31, 2007 (% Net Worth)

Cure Rates Are Low: Equity (LTV) Matters Behavior Of Borrowers Who Were 30 Days Delinquent 6 Months Ago Source: Loan Performance, Amherst Securities

Cure Rate Time History Source: Loan Performance, Amherst Securities

Percent of The Original AAA Universe Currently Below Investment Grade (Junk Rated). Stunning Percentages. Source: BlackRock Solutions® as of Feb 8, 2010

We didn’t realize it, but we were holding “Economic Catastrophe Bonds” as shown by Josh Coval, Jakub Jurek, Erik Stafford of Harvard American Economic Review , forthcoming
AAA rated securities do not pay off only if there is a major catastrophe. So long Treasurys, short AAA rated bonds is a bet on a catastrophe.
Are these bonds priced appropriately relative to the prices for insuring against catastrophes that we see in other markets, like out of the money S&P 500 put options?
Quote from article’s Abstract:
“ We show that many structured finance instruments can be characterized as economic catastrophe bonds, but offer far less compensation than alternatives with comparable payoff profiles. We argue that this difference arises from the willingness of rating agencies to certify structured products with a low default likelihood as “safe” and from a large supply of investors who view them as such.”

Headwinds for the Economy: Vacant Properties, Weak Hiring

Housing Overhang – A Growing Problem Source: Loan Performance, Mortgage Bankers Association, Amherst Securities

Months Supply of High-End Inventory On The Rise Source: National Association of Realtors

Bank Balance Sheets: Deposits Up, Loans Down. Government Leaders Push Loans, Examiners Curtail Them Source: Federal Reserve

Motor Vehicles, Parts: Consumer Expenditures Plummet (Quarterly 2006 to 2008, Economic Indicators, Bureau of Economic Analysis, DOC)

Housing Starts Plummet Annualized Thousands Quarterly 1959-Q4 2008

Corporate Profits Plummet: Financial and Retail Sectors Quarterly 2006 to 2008, Economic Indicators, Bureau of Economic Analysis, DOC

GSE Credit Has Tightened, FHA Has Not Source: Freddie Mac, Fannie Mae, Ginnie Mae, Amherst Securities

But: Prices Down, Rates Low -> Affordability is at a 20 Year High Source: Freddie Mac, National Association of Realtors, S&P/Case-Shiller, Amherst Securities

Appendix: Primer on Credit Markets and Banking in the Macroeconomy

Sources and Uses of Credit by Individuals
1 . Individual borrowers use credit to buy: (1) houses, (2) autos, and (3) for transactional convenience (credit cards).
Individual investors buy bonds for fixed income for retirement. Bonds normally have predictable income and stable values.

Business Sources and Uses of Credit
1. Many small businesses are critically dependent upon bank loans to fund their startups and to expand and employ.
Large businesses use credit (bank loans or corporate bonds) to build plants, to develop costly products and to buy other businesses, as well as for working capital needs.

Financial Institutions: Uses of Credit
Financial institutions borrow money to fund loans and to make investments.
Loans normally have larger profit margins, but are not liquid (quickly saleable).
Securities investments are usually more liquid, but have lower profit margins. They may be traded frequently.

Financial Institutions: Sources of Credit
Borrowings may be via small retail deposits from individuals or via large wholesale borrowings from institutions (other banks, pensions, mutual funds, hedge funds).
Wholesale borrowings are usually cheaper, having low interest rates and little overhead expense.
Retail deposits are more stable (sticky) funding, but are costly to service (branches).

Financial Institutions: Normal Use of Substantial Leverage
Large commercial banks normally have (GAAP) capital that is only 8% of assets, which means that debt is 92% of assets, leverage 12.5 to 1.
2. Investment banks have normally had capital of only 3% to 5% assets, which means debt is 95% to 97% and leverage is 20 or 30 to 1.

Financial Intermediation: Mismatches in Maturities and Liquidity Risk
A key part of banking is “intermediation” between the needs of borrowers and lenders.
Banks’ borrowers usually like longer-term loans and fixed rates, like 30-year mortgages.
Loans are illiquid, as the money is spent by borrowers and not easily, quickly repaid.

Financial Intermediation: Mismatches in Maturities and Liquidity Risk
Banks’ depositors, both small retail depositors and large institutional (wholesale) lenders usually like to tie up their funds only for short periods, so funding must be rolled over repeatedly.
If lenders lose confidence and will not roll over their deposits, a financial institution may quickly become insolvent, unable to pay back debts on time. It is then in default and may file bankruptcy.

Government Sources and Uses of Credit
1. Governments use credit to fund deficits caused by financial needs for infrastructure, defense, health care, and recessionary safety nets.
Governments with surpluses buy bonds to hold money for future contingencies for their constituents’ needs and to smooth out the ups and downs of income from commodities such as oil or crops.

Breeden: Credit and the Macroeconomy, February 2010

by Duke's Fuqua School of Business on Mar 01, 2010

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