Troubled Times - How We Got Here Ned Hill 2010 Jan.pptPresentation Transcript
Troubled Times: How We Got Here and What May Lie Ahead Ned C. Hill National Advisory Council Professor of Finance Fellow of the Wheatley Institution Academic Director, H. Taylor Peery Institute of Financial Services Marriott School of Management Brigham Young University January 2010
Seeds of the economic crisis
Results—failures, mergers, credit squeeze
Remedies—government bailout efforts
Foundations of Our Strong U.S. Economy—mid 1970’s to 2007
Strong entrepreneurial innovation generating business ideas (most jobs generated by start-ups, not big business)
Productivity increases (mostly due to computerization, including the Internet)
Low tax, interest and unemployment rates
Growth in U.S. economy from 2002-2007 exceeded entire Chinese economy!
Six Factors Contributing to the Crisis Accounting Rules Huge Global Demand for Fixed-rate Debt The Federal Reserve and other Regulators The Housing Market Creation of New Securities for Which Few Understood the Risks
1. The Global Fixed-Rate Investment Market Who Invests? Insurance companies, individuals, pension funds, mutual funds, governments, investment funds, banks, municipalities, etc., etc. 2000 $36 Trillion 2008 $70 Trillion
Sources of New Demand for Fixed Income Securities
Developing economies—where do they put their cash?
U.S. “Baby Boomers” putting more and more into fixed income securities
2. The Federal Reserve and Deregulation
2004 (in the wake of tech bubble bursting) the Fed (Alan Greenspan) thought economy was much weaker than it was—pumped money into the economy.
How? They buy treasury securities in the open market
That increases the money supply
This led to artificially low interest rates .
Fixed-rate investors hungering for a place to put their money—but U.S. short-term securities paid hardly anything.
Dollar sank in value relative to Yen, Euro, etc.
Many commodities are priced in USD
So commodity prices rose rapidly
Especially oil, steel, cement, etc.
Chinese and other countries also had a building boom, putting pressure on commodities
2. …Deregulation (cont.)
1999 Gramm-Leach-Bliley (Financial Services Modernization Act)—effectively repealing Glass-Steagall Act of 1933 that kept banks and investment banks separated
2000 The Commodity Futures Modernization Act opened the doors to deregulate credit default swaps
2002 Sarbanes-Oxley had the unintended consequence of making the issuance of corporate bonds more difficult
Lack of regulation regarding mortgage securities, other securitized bonds, swaps, hedge funds
Where was the SEC when Lehman went to 44:1 leverage?
Both administrations (Clinton and Bush) leaned on the Fed to extend home ownership to all Americans
3. The Housing Market
Housing prices began rising rapidly.
Tax laws exempted home ownership from capital gains in most cases.
To satisfy huge demand from debt markets: new forms of mortgages created:
Adjustable rate—many with low “teaser rates”
Easy qualifications (e.g., NINA loan = “no income, no assets” and NINJA = “no income, no job, no assets”)
Problem : issuers rarely hold mortgages now—they sell them up the chain where they are packaged for the final investors.
3. The Housing Market—cont.
Fannie Mae and Freddie Mac were encouraged to become “more inclusive” in generating mortgages—led to huge growth in “sub-prime”, “alt-A” mortgages.
Home buyers, appraisers, mortgage processors, etc., all played a part.
The nation had about 2,000,000 more homes than needed to support the demand
“ But that’s OK—Housing prices have never fallen by more than 5% in any year since the Great Depression!”
Mortgages from Start to Finish Individual Mortgages Tranche 1 Tranche 2 Tranche 3 Tranche 4 Grouped Mortgages AAA AA A BBB $70 Trillion Fixed-Income Market CDS CMOs CDOs
It’s Even More Complex
A CDO is a “company” that owns a pool of mortgages and…
Has its own CUSIP number
May issue additional debt so investors can have their returns on the mortgages leveraged up (or down?)
Might invest in other CDOs (CDO 2 , CDO 3 )
Usually offers investors different “tranches” with different characteristics, e.g., “interest only”, different mixes of prime, alt-A, subprime, etc.
May mix in other securitized debt, e.g., credit card, auto financing; and even corporate bonds
4. Creation of New, Essentially Unregulated Securities
New mortgage investment instruments (CDO’s, CMO’s)
Credit default swaps (CDS’s)—some firms sell “insurance” that a bond will not default—if it does, they’ll trade it for a good bond or cash. AND you can buy a CDS even if you don’t own the bond... so some bonds have 10x (or more) volume of CDS’s issued against them.
AIG had over $1 trillion in CDS positions
Problem: we don’t have data for a really bad times in the economy, so pricing models don’t work for extreme situations like we’re in now!
5. Rating Agencies
Standard & Poors, Moody’s and Fitch (perhaps using faulty data and models)
Gave their stamp of approval to these new investment securities (“AAA”, “AA”, “A”, “BBB”, etc.)
Charged $600,000 to rate a $500M CDO offering
In fact, they even packaged the mortgages for the investment banks!
Investment banks (esp. Bear, Lehman and Merrill Lynch) aggressively pushed these “safe” investments to satisfy the huge fixed-rate demand (and made good profits thereby).
But few really understood the risks.
E.g., a AAA-rated CDO in July 2006 yielded only 10-15 basis points higher than a Treasury bond of the same maturity!
Ethical Issues Involved The Obvious Ones Mortgage Originators Mortgage Packagers Investment & Commercial Banks Rating Agencies Chief Investment Officers, Treasurers Regulators Government Officials and Elected Representatives Greed Dishonesty Short-term vs long-term “ Not my problem” Investment Funds Home Buyers
Deeper Ethical Issues Raised
“ Paying for Peril”
Bonuses now for future expected results
Upside reward but little downside risk
“ Normalization of Bad Behavior”
Many new mortgage market in serious trouble—but investors (and salespeople) expect to “dance while the music’s playing.”
Lack of courage to act on better judgment
“ Tech Shock”—CDOs, CMOs, CDSs all new
Since we didn’t understand the risks they posed, we based assumptions on past (and, therefore, inappropriate) data, incentives and processes
Gradually we found better ways of thinking about them
Based on Dr. Thomas Donaldson, Wharton, comments from Wheatley Inst. Ethics Conference
6. Additional Factor: Accounting Rules “Stabbing the Wounded”
Intent is to accurately report value of a firm’s assets, liabilities and equity.
“ Mark-to-market” means that firms must record paper assets at today’s market value— whether higher or lower than yesterday.
But what if there is no market for a security or an artificially low market value?
Must use best estimates provided by bids, similar securities or mathematical models.
Difference between original price and market value must be written off.
Bank’s Balance Sheet Equity Capital Assets Liabilities “ Good” = 8-12% Loans to customers, investments, cash Deposits, borrowings, other obligations Past profits/losses, stock purchases, adjustments
Equity Capital Assets Liabilities “ Toxic” Assets NOTE: These are “book write downs” and not actual losses. The bank may still hold the assets and it may still be receiving interest and principle payments. What Happens When We Have “Toxic” Assets on Our Books?
Assets Liabilities What Happens When We Have “Toxic” Assets on Our Books?
Assets Liabilities Toxic Assets Not good - 3% What Happens When We Have “Toxic” Assets on Our Books? Equity capital has turned negative!
Then the Inevitable The Housing Bubble Burst
Early 2007, housing prices began to slip in key markets like Phoenix, Las Vegas, California, Florida, etc.
The actual risk of sub-prime and alt-A loans began to emerge.
Liquidity of mortgage-related securities became an issue—no one wanted to buy them, hence, very difficult to value.
This caused a precipitous drop in the prices of CMO’s and CDO’s—used to be “AAA” but now almost worthless.
Accounting rules— write them down!
We Can’t Let “Negative Equity” Stand—What to Do?
Option 1: Close or sell the institution
Bear Stearns (founded 1923), on the failure of two of its hedge funds that heavily invested in CMOs and CDOs, sold 3/2008 to JPMorganChase for $2/sh (revised later to $10/sh)—previous year was $133/sh
Countrywide Financial was bought by Bank of America (7/2008)
IndyMac (Independent National Mortgage Corp.) seized (7/2008) and assets sold off
Lehman Brothers (founded in 1850) broken up, parts sold to Barclays (9/2008) and Nomura Holdings (10/2008)
Washington Mutual seized by FDIC, assets sold to JPMorganChase
We Can’t Let “Negative Equity” Stand—What to Do?
Option 2: Find a stronger institution and merge
Merrill Lynch merged with Bank of America (9/2008)
Scandal about huge pay package of top management
Wachovia merged with Wells Fargo (10/2008)
Option 3: Infuse more capital
Morgan Stanley —sold 21% of firm for $9B to Mitsubishi (10/2008)
No institution wanted to loan money—even overnight—to another institution. They were afraid the borrower might be “next on the chopping block.”
The economy runs on credit—even healthy companies borrow frequently to meet short-term swings in cash flows.
Consumers feel poorer—401(k), equity in home, job uncertainty
We ran the risk of seeing the entire economy shut down.
We are inter-connected to the rest of the global economy
Many international banks, insurance companies, funds bought these CMOs, CDOs, CDSs
Iceland’s major banks failed—British savers lose $8B
Some European banks failing
Government Bailout Efforts—A
Federal Reserve infused massive amounts of cash into the system— how much??
Allowed investment banks to borrow directly—even converted them into bank holding companies
Eased terms for loans for all institutions
Congress passed “Troubled Asset Relief Program” (TARP) 10/2008—government authorized Treasury to use $250B immediately, $100B subject to president’s approval and $350B if further authorized by Congress. Plan was to buy “toxic assets”—changed to purchase of preferred stock.
In addition, the FDIC is assisting in bank closures.
Assets Now good! 10% What Happens When We Infuse New Money into a Troubled Bank? Cash Equity Capital Liabilities
Government Bailout Efforts—B
“ Obama Stimulus Package”—2/2009
Aid to homeowners in danger of foreclosure
FDIC insurance on deposits increased to $250K and unlimited for corporate deposits
Bailing out of specific industries (auto industry and possibly others)
American Recovery and Reinvestment Act (ARRA) of 2009 $787 B
39% for Federal Agencies/Programs ($308.3 B)
61% for Individuals and States (including tax cuts and credits) $478.9 B
Includes payroll-tax cut
Credits for first-time home purchases
Help for car buyers
Tax provisions total $288 B
Funds go directly to states to help them narrow their deficits and bridge budget gaps
Categories of ARRA
Relief to states $90.0 B
Health, labor and education programs $71.3 B
Housing and transportation programs $61.2 B
Unemployment and low-wage assistance $58.1 B
Grants to states, mostly for education $53.6 B
Energy and water development $50.8 B
Agriculture, rural aid and FDA $26.4 B
Health insurance assistance $24.7 B
Medical record modernization $17.6 B
Commerce, justice and science programs $15.8 B
Interior Department and environmental aid $10.5 B
Government buildings and financial services $6.7 B
Defense Department $4.5 B
Military and Veterans Affairs $4.2 B
Homeland Security Department $2.7 B
State Department $0.6 B
Only 1/3 of the Obama package actually spent—the rest is forthcoming over several years
What happens in 2010 when the 2009 money is not repeated?
Moral hazard issue?
What Are Possible Outcomes?
Worst case —prolonged depression similar to the 1930’s (25% unemployment, no growth for 3-5 years, great personal hardship)
Best case —short recession (unemployment 6-8%, no/slow growth for 6-18 months)
Most likely case —serious recession (unemployment 7-12%, no/slow growth for 1-2 years)
View of the Crisis from the DJIA Peak in October, 2007 14,100 Low in March, 2009 6,600 -53% +57%
Other Outgrowths of the Crisis
More regulation of securities industry
Packaging of mortgages/other structured products
Credit default swaps
Retention of some risk by lower levels in the chain
Reinstate separation wall between banks and investment banks?
Government could make a good return on much of the bailout investments: buying toxic assets, buying stock in troubled institutions, etc.
May see higher taxes to pay for bailout. (But we need to be cautious—high taxes generally not good for recoveries).
Inflation may be a problem in the recovery.
Fannie Mae and Freddie Mac are requiring banks and other mortgage originators to buy back mortgages that were flawed (insufficient income, misstatements on applications, etc.).
Government is looking into how AIG used the $180B to pay back banks. May “claw back” some of those funds.
Suggestions for Individuals
Don’t panic—selling stock now may be the worst thing to do.
Remember the stock market is a “leading indicator”—it will pick up far before the rest of the economy.
In fact, now may be a good time to buy—most stocks are at “bargain basement” prices.
If you’re employed, become a very valuable employee, sharpen your skills, dust off your resume.
Now may be a good time to go back to school.
Make sure your food supply and your emergency cash supply is in good order.
Teach your children and grandchildren sound financial principles.
Most Important Suggestion
Heed the words of the prophets.
“ We wish the presidencies of the stakes and the bishops of the wards to urge, earnestly and always upon the people, the paramount necessity of living righteously ; of avoiding extravagance ; of cultivating habits of thrift, economy, and industry ; of living strictly within their incomes ; and of laying aside something, however small the amount may be, for the times of greater stress that may come to us . By no other course will our people place themselves in that position of helpful usefulness to the world which the Lord intends we shall take.”
First Presidency, July 1933 Who Said This (and When)?
President Gordon B. Hinckley Priesthood Meeting, October 3rd, 1998
Story of Pharaoh’s dream of the seven fat cattle and the seven lean cattle
“… I want to make it very clear that I am not prophesying, that I am not predicting years of famine in the future. But I am suggesting that the time has come to get our houses in order . There is a portent of stormy weather ahead to which we had better give heed.”
“ So many of our people are living on the very edge of their incomes. In fact, some are living on borrowings.”
President Gordon B. Hinckley (cont.)
“ I urge you, brethren, to look to the condition of your finances.”
“ I urge you to be modest in your expenditures; discipline yourselves in your purchases to avoid debt to the extent possible.”
“ Pay off debt as quickly as you can, and free yourselves from bondage.”
“ That’s all I have to say about it, but I wish to say it with all the emphasis of which I am capable.”
President Gordon B. Hinckley General Conference, October 7 th , 2001
“ The economy is particularly vulnerable. We have been counseled again and again concerning self-reliance, concerning debt, concerning thrift. So many of our people are heavily in debt for things that are not entirely necessary.”
“ I urge you as members of this Church to get free of debt where possible and to have a little laid aside against a rainy day.”
Elder Joseph B. Wirthlin April 2004
“ Remember this: debt is a form of bondage. It is a financial termite. When we make purchases on credit, they give us only an illusion of prosperity. We think we own things, but the reality is, our things own us.”
“ Some debt—such as for a modest home, expenses for education, perhaps for a needed first car—may be necessary. But never should we enter into financial bondage through consumer debt without carefully weighing the costs.”
Elder L. Tom Perry November 2008
“ We have been encouraged at almost every general conference of the Church I can remember not to live beyond our means. Our income should determine the kind of housing we can afford, not the neighbor’s big home across the street.
“ President Heber J. Grant once said: ‘From my earliest recollections, from the days of Brigham Young until now, I have listened to men standing in the pulpit … urging the people not to run into debt; and I believe that the great majority of all our troubles today is caused through the failure to carry out that counsel.’” (in Conference Report , Oct. 1921, 3).
President Boyd K. Packer November 2008
“ It is my purpose to show that in troubled times the Lord has always prepared a safe way ahead. We live in those ‘perilous times’ which the Apostle Paul prophesied would come in the last days. If we are to be safe individually, as families, and secure as a church, it will be through ‘obedience to the laws and ordinances of the Gospel.’ ”
Read More about the Crisis
Andrew Sorkin— Too Big to Fail
Richard Bookstaber —A Demon of Our Own Design
Lawrence McDonald— A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers
Charles Morris —The Trillion Dollar Meltdown
William Cohan —House of Cards: A Tale of Hubris and Wretched Excess on Wall Street
Bill Bamber and Andrew Spencer— Bear Trap: The Fall of Bear Stearns and the Panic of 2008
David Wessel— In Fed We Trust: Ben Bernanke’s War on the Great Panic