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Hard (To Understand) Times and Effects

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  • 1. Hard ( To Understand ) Times and Effects Stanley D. Smith Professor of Finance, UCF November 21, 2008
  • 2. Greenspan Testimony 10.23.08
    • “ What went wrong with global economic policies that had worked so effectively for nearly four decades?”
    • He expressed “shocked disbelief” that financial companies failed to execute sufficient “surveillance” on their trading counterparties to prevent surging losses.
    • “ I see no choice but to require that all securitizers retain a meaningful part of the securities they issue.”
  • 3. Mortgages and Home Values: The Heart of the Problem
    • Orlando MSA Real Estate Prices : 2003 = 8%, 2004 = 17%, 2005 = 33%, 2006 = 12%, 2007 = -3%, 2008H1 = -7%
    • What caused these price changes?
    • Interest rates declined then increased.
    • Lending standards were severely reduced and the low quality loans were sold to others in mortgage-backed securities.
  • 4. Mortgage Standards
    • Interest rate risk : most banks will not keep long-term fixed-rate mortgages because their short-term cost of funds may increase above the fixed long-term rate.
    • To offset this type of interest rate risk, the banks will make adjustable-rate mortgages (ARMs) that will adjust their rate as the banks cost of funds adjusts.
  • 5. Credit Risk
    • The two major ratios for assessing credit risk are the borrower’s ability to make the payments (PITI and sometimes HOA fees), e.g., payment/income , and the borrower’s equity in the home (down payment) which reduces the loan/value and indicates that the borrower has a greater ability to absorb any decreases in value of the home and has a strong interest in maintaining the home and the loan.
  • 6. Factors in Reducing Loan Quality (1)
    • ARMs became more common as short-term rates decreased, but if the payments increase due to higher interest rates, then the payment/income (P/I) increases and risk increases
    • Many ARMs had teaser rates, artificially lower rates than the full interest rate, which is the index + margin. This meant that the P/I will increase even if interest rates do not.
  • 7. Factors in Reducing Loan Quality (2)
    • Most home loans amortize or decline over time, i.e., the loan payments include interest plus some principal.
    • Some loans were interest only or optional (skip) payments which leads to an increasing loan amount (negative amortization).
    • Some home equity loans and cash-out refinancings increased the total or combined loan/value on the home.
  • 8. Factors in Reducing Loan Quality (3)
    • No documentation (aka low-docs & stated-docs) loans did not require verification of the borrower’s income or ability to pay
    • Non-owner occupied/investor loans were used to speculate on home price increases
    • Risk: Condominiums > new single-family homes > existing single-family loans
  • 9. Why such bad credit standards?
    • The use of private mortgage-backed securities (MBS) allowed an originate-to-distribute (or sell) business model where these risky loans were knowingly made, but as long as investors would buy them they would be made. ( See Greenspan )
    • Private MBS were 49% of new home mortgages from 2004 to 2006, while in 2004 they represented about 13% of outstanding home mortgages.
    • High quality ratings by rating agencies (Moody’s, S&P, Fitch) gave the appearance that these MBS were less risky than they were.
  • 10. Credit Default Swaps (CDS)
    • CDS were written on the MBS and alternative versions such as Credit Default Obligations (CDO) where default risk is segmented or tiered so that some of the securities carry higher risk than others
    • AIG wrote many of the CDS and is a counter party to many MBS and CDO
  • 11. Markets Realized Mistakes
    • Once these loans started becoming delinquent or in default in a short period, investors realized how risky they were.
    • As the perception of uncertainty or risk increased, investors could not sell the MBS because there were no buyers or would sell at a substantial loss, i.e., liquidity risk .
    • What is the price of an illiquid asset?
    • “ Mark-to-market” or “ fair value ” accounting
  • 12. Effect on Commercial (CB) & Investment Banks (IB)
    • If a bank has to lower the value of its assets, then these losses will be written off against net income and if they are large enough, against common equity.
    • CBs must meet certain capital standards such as a certain level of equity for its size and risk.
    • The standards for IBs and FNMA and FHLMC were lower than for CBs.
    • Sr. preferred stock (TARP) increases capital
  • 13. “ Fair Value” Problem
    • Many of the MBS have two problems: (1) credit risk, and (2) liquidity risk. The lack of liquidity makes it very difficult to assess the fair value. The idea is that these securities will have a higher value when the markets return to normalcy, i.e., more liquidity, and these securities can be sold.
  • 14. High Leverage and Liquidity Problems
    • Banks are very highly leveraged (CBs about 12/1, IBs may be 30/1).
    • A bank has to meet deposit withdrawals and loan commitments or demand. If customers are worried about their deposits above the FDIC limit ($250K), then they will withdraw them.
    • FED has acted as “ lender of last resort ” to provide liquidity.
  • 15. Treasury and FED Actions
    • FED – Term Auction Facility (TAF) = $347B (<$900B)
    • FED Primary Credit Discount Window = $109B
    • FED & Treasury – AIG Loan and Purchase of $40B Preferred Stock; Total = up to $152.5B
    • FED – Term Securities Lending Facility (TSFL),
    • Primary Dealers Credit Facility (PDCF) = $72B,
    • Commercial Paper Funding Facility (CPPF) = $243B,
    • Money Market Investor Funding Facility (MMIIF) = $85B
    • Fannie Mae & Freddie Mac Conservatorship (approx. $5.3 trillion)
    • Maiden Lane LLC (Bear/JPM) = $27B
  • 16. Troubled Asset Relief Program (TARP)
    • Total = $700B
    • Bank Recapitalization ($250B)
    • AIG Sr. Preferred Stock ($40B)
    • ?Need for ABS in consumer credit markets
    • Private ABS represented 47% of revolving (credit card) consumer credit in Sep. 2008
    • Private ABS represented 13% of non-revolving consumer credit in Sep. 2008
    • ?Detroit 3 Auto Companies - ?25B
  • 17. What do ABS do for lender?
    • Act as an alternative source of funding to the lender and are related to liquidity
    • Allows lender to sell off risk of loan but make origination fees and possibly servicing fees and cross-sell other products
    • Provide market information on how different loan characteristics are priced
    • If active market then lender can easily sell the loan, e.g., GSEs
    • If no market, then difficult to price credit risk
  • 18. Deleveraging of Economy Prospects
    • The lending and financial markets are returning to a previous time with more reasonable credit standards
    • Prospects: Any product or service that relied on “easy credit” will have to downsize and will have to reduce excess capacity, e.g., cars,
    • Loan/value by auto finance companies
    • July = 95%, August = 88%, September = 85%
    • Discretionary services (Starbucks, haircuts, dry cleaning, restaurants, medical services, accounting) will be affected as economy declines
  • 19. Deleveraging Prospects (2)
    • As different industries downsize, employment will decrease
    • As the use of asset-backed securities (ABS) decreases, the use of CBs as lenders will increase its relative size in the financial markets
    • Flights to quality and FED actions will lead to more commercial, consumer and mortgage loans being tied to LIBOR, rather than the prime rate, Fed Funds rates, or Treasury security rate
  • 20. Decoupling of FF Target with Other Bank Reference Rates?
    • All BHCs with >= $10B in Total Assets
    • FF Purchased rate decreased 2.01% from H12007 to H12008
    • CDs >= $100k only decreased 0.92%
    • CDs < $100k only decreased 0.53%
    • All interest-bearing funds decreased 1.03%
  • 21. International Actions
    • Coordinated rate decreases
    • Provide lending facilities
    • 11 of Top 50 U.S. BHCs are completely foreign-owned (6/30/08)
    • Increased deposit insurance
    • EU less coordinated than U.S.
  • 22. Lost or Changed Names
    • Wachovia (Wells Fargo)
    • WAMU (JP Morgan Chase)
    • National City (PNC)
    • Sovereign (Santander)
    • Merrill Lynch (Bank of America)
    • Bear Stearns (JP Morgan Chase)
    • Lehman Brothers (failed, Barclays bought North America investment banking and management)
    • Conversions to BHCs (Goldman Sachs, Morgan Stanley, American Express)