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Review Of The Market Crisis As Of 10 13 08

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A slide show that I presented to my students in the middle of the market meltdown of October 2008.

A slide show that I presented to my students in the middle of the market meltdown of October 2008.

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Review Of The Market Crisis As Of 10 13 08 Presentation Transcript

  • 1. An overview of the market crisis As of October 13, 2008
  • 2. What has happened? • The capital markets are going through a significant structural correction… • Investment bankers have been dealt a punishing blow for their excessive leverage and inadequate risk management • Insurers have had to reckon with their likely inability to cover potential claims • Credit markets have over-adjusted their risk tolerances, causing a liquidity crisis • Stock markets have reacted to the possible consequences of a credit market shut-down • Governments have taken, and will continue to take, extreme and costly action steps to stabilize markets and head off the domino effect
  • 3. Who has been affected? • Investment Banks • Bear Stearns is bankrupt and has been absorbed by JP Morgan Chase • Lehman Brothers is bankrupt and their assets are being liquidated • Merrill Lynch has agreed to be acquired by Bank of America • Goldman Sachs is now a bank holding company, subject to the same regulations as commercial banking firms • Commercial Banks • Many commercial banks with comparable risk profiles have suffered as well: Indy Mac Bank, WAMU, Wachovia, National City… more to come
  • 4. Who has been affected? • Insurers • AIG, the largest insurer in the world and second largest in the USA has been bailed out by the Federal Reserve who lent the insurer $85 billion • Fannie Mae and Freddie Mac, two quasi-government, publically traded mortgage insurers were placed into conservatorship and have become governmental agencies, under the control of the Federal Housing Finance Agency. Each agency will have access to $100 billion of credit to support them through a rescue period
  • 5. Who has been affected? • Credit Markets • Borrowers of all types have felt the effects of tighter credit. • Commercial paper markets have declined by $230 billion since the beginning of the year, off 13%. • Short term commercial paper rates (A2-P2) have risen from under 5% to 6.2% since the beginning of the year. • Mortgage applications fell 23% in August as consumers and creditors took a conservative turn. • In a flight to quality, investors have placed such heavy demand on risk-free Treasury securities that yields on these securities have fallen from 3.25% at the start of the year to .26% as of mid-October.
  • 6. Who has been affected? • Stock Markets • In the USA, stock market indices have fallen significantly on worries about global liquidity. Losses in US markets are valued at over $7.2 trillion by The Wall Street Journal • Dow Jones Industrial Average – down 36.8% YTD • NASDAQ Index – down 39.2% YTD • S&P 500 Index – down 39.5% YTD • International indexes have followed US trends as worries are evenly shared around the world • London FTSE – down 37.7% YTD • German DAX – down 43.7% YTD • Japanese NIKKEI – down 45.9% YTD • Chinese HANG SENG – down 46.8% YTD • Gold, the universal parking lot for worrisome investors, has risen by 34.6% since the beginning of 2007 Data as of 10/10/08 @ 11:00 AM
  • 7. Who has been affected? • Governments • The US Government finds itself as the largest creditor in history as the “Emergency Economic Stabilization Act of 2008” provides funding to stabilize the system. • Critics mistakenly call the program a “bailout” when it actually serves as a market stabilization vehicle that creates a government-assisted flow of capital in an otherwise “too scared to trade” securities market • Provisions of the Act restrict compensation programs for executives of troubled companies and create warrants on the stock of many benefiting companies, thereby providing for public sector gains as firms benefit from the plan • Federal Reserve cuts the Fed funds rate by 50 basis points (1/2 %) to increase the level and cut the cost of liquidity in the system
  • 8. Who has been affected? • Governments (global theater) • Numerous sovereign states have followed the Federal Reserve lead and cut short term interest rates • Financial institution rescue packages have taken the form of direct government investment and government assisted bailouts from the private sector • British government invests over $80 billion (50 billion pounds) to partially nationalize major banks • The governments of Belgium and Luxembourg partnered with French bank BNP Paribas to acquire Fortis NV • Iceland’s banking system is nearly collapsed and the government has assumed control of Kaupthing and Landsbanki, two of the largest institutions. The English has guaranteed some deposits in Icelandic banks and the Swedish government has provided an emergency credit line. In both cases these sovereign actions were taken to protect citizens deposits. • Germany agreed to a 15 billion Euro bailout of Hypo Real Estate Holding AG after initially providing a 30 billion Euro rescue package
  • 9. Who has been affected? • Governments (global theater) • Sovereign investment funds have been approached (mostly unsuccessfully) by financial institutions in an effort to raise equity capital to strengthen balance sheets • The Russian stock market has suspended trading on several occasions to reduce the impact of high volume sell-offs • The G7 economic powers agree to a set of common guidelines for supporting a rescue to troubled financial institutions.
  • 10. What is the root cause? Who should we blame? • The Government • Insufficient regulation? • Asset classes, capital requirements, product sets, disclosure requirements, credit enhancement • Public and economic policy? • Housing finance, mortgage guarantees, low interest rates, weak dollar • Indecision and Political maneuvering? • Initial defeat of Emergency Plan added to uncertainty • Regulatory mishaps? • Sarbanes Oxley + Fair Value Accounting (FASB 157)
  • 11. What is the root cause? Who should we blame? • The Bankers? • Proliferation of cheap credit • Short-cuts in credit decision process • Exotic product development • Excessive leverage and associated risk • Inadequate capital to absorb losses
  • 12. What is the root cause? Who should we blame? • The People • Revision to “The American Dream” • Before: • Own you own home and pay off the mortgage. • After: • Leverage up to the highest home you can afford. • Take out the equity that you build and use it as a down payment on a second property. • Capitalize on property and investment asset appreciation to propagate the cycle. • Treat yourself to a few extra luxuries with any remaining equity that you can refinance. • Never consider paying off the debt!
  • 13. Case Study EVOLUTION OF A MORTGAGE TRANSACTION
  • 14. Evolution of a mortgage transaction Home buyers secure Depositors maintain mortgage financing a stable supply of at a fixed rate for a funds to finance long term lending activities Commercial Bank or other mortgage lender Homeowners make monthly payments and slowly retire mortgage debt
  • 15. Evolution of a mortgage transaction Home buyers secure Depositors maintain mortgage financing a stable supply of at a fixed rate for a funds to finance long term lending activities Commercial Bank or other mortgage lender Homeowners make monthly Payments and slowly retire Fannie Mae and Freddie Mac mortgage debt support homeownership through mortgage guarantees
  • 16. Evolution of a mortgage transaction Home buyers secure Depositors maintain mortgage financing a stable supply of at a fixed rate for a funds to finance long term lending activities Commercial Bank or other mortgage lender Homeowners make monthly Payments and slowly retire Fannie Mae and Freddie Mac mortgage debt support homeownership Investment bankers through mortgage guarantees offer “asset securitization” to create more liquidity in the mortgage market
  • 17. Evolution of a mortgage transaction Home buyers secure Depositors maintain mortgage financing a stable supply of at a fixed rate for a funds to finance long term lending activities Commercial Bank or other mortgage lender As a consequence, retail mortgage lenders Homeowners make monthly Payments and slowly retire Fannie Mae and more capacity, have Freddie Mac mortgage debt create more products, support homeownership Investment bankers through mortgage guaranteesand compete on price offer “asset make more loans securitization” to create more liquidity in the mortgage market
  • 18. Evolution of a mortgage transaction Home buyers secure Depositors maintain a stable supply of Federal Reserve mortgage financing at a fixed rate for a funds to finance introduces easy money long term lending activities policy as an economic stimulus,Commercial Bank causing short term rates or other mortgage lender to fall to historical lows Homeowners make monthly Payments and slowly retire Fannie Mae and Freddie Mac mortgage debt support homeownership Investment bankers through mortgage guarantees offer “asset securitization” to create more liquidity in the mortgage market
  • 19. Evolution of a mortgage transaction Consumers respond to buyers secure Home Depositors maintain widespread credit mortgage financing a stable supply of availability, low interest term for a at a fixed rate funds to finance long lending activities rates and easy approval Commercial Bankmore by borrowing or other mortgage lender Homeowners make monthly Payments and slowly retire Fannie Mae and Freddie Mac mortgage debt support homeownership Investment bankers through mortgage guarantees offer “asset securitization” to create more liquidity in the mortgage market
  • 20. Evolution of a mortgage transaction Home buyers secure Depositors maintain mortgage financing a stable supply of at a fixed rate for a funds to finance long term lending activities Commercial Bank or other mortgage lender Bankers respond with more competitive products, led by the affordable “variable rate Homeowners make monthly loan” Payments and slowly retire Fannie Mae and Freddie Mac mortgage debt support homeownership Investment bankers through mortgage guarantees offer “asset securitization” to create more liquidity in the mortgage market
  • 21. Evolution of a mortgage transaction Depositors maintain Consumers take Home buyers secure advantage of low interest at a fixed rate for a mortgage financing a stable supply of funds to finance lending activities and affordable payments rates long term by upgrading to larger homes Commercial Bank or other mortgage lender Homeowners make monthly Payments and slowly retire Fannie Mae and Freddie Mac mortgage debt support homeownership through mortgage guarantees Investment bankers offer “asset securitization” to create more liquidity in the mortgage market
  • 22. Evolution of a mortgage transaction Home buyers secure Depositors maintain mortgage financing a stable supply of at a fixed rate for a funds to finance lending activities …and second homes long term Commercial Bank or other mortgage lender Homeowners make monthly Payments and slowly retire Fannie Mae and Freddie Mac mortgage debt support homeownership Investment bankers through mortgage guarantees offer “asset securitization” to create more liquidity in the mortgage market
  • 23. Evolution of a mortgage transaction Home buyers secure Depositors maintain mortgage financing a stable supply of at a fixed rate for a funds to finance long term lending activities Commercial Bank or other mortgage lender Homeowners make monthly Banks respond again to the Payments and slowly retire Fannie Mae in demand, this time surge and Freddie Mac mortgage debt support homeownership relaxing credit standards Investment bankers through mortgage guarantees and relying on credit scores offer “asset instead of traditional securitization” to create mortgage lending procedures. more liquidity in the Subprime lending was born. mortgage market
  • 24. Evolution of a mortgage transaction Not too surprisingly, home prices escalated as a result of increased demand.
  • 25. Evolution of a mortgage transaction Potential homeowners race to buy in fear of never being able to afford a home!!!! Others who never owned a home before now find it possible to finance a home.
  • 26. Evolution of a mortgage transaction Low variable rate mortgages make this possible by keeping payments low. “And besides, property values are rising! If rates rise, I can sell my house at a profit.”
  • 27. Evolution of a mortgage transaction “Maybe I should buy another house as an investment. They keep going up in After a few value and I can use years the house is the equity in my worth even more. home to finance Your banker the down payment!” suggests that you “take some equity out of the home.”
  • 28. Evolution of a mortgage transaction
  • 29. Evolution of a mortgage transaction Meanwhile, back at the Investment Banks… “Securitized” mortgage portfolios are packaged and sold to investor groups to generate ongoing liquidity. At first, all is well, then creativity sets in!
  • 30. Evolution of a mortgage transaction Meanwhile, back at the Investment Bank… “Securitized” mortgage portfolios are packaged and sold to investor groups to generate ongoing liquidity. Mortgage portfolios are At first, all is well, broken into “tranches,” then creativity sets “credit enhancement” is in! purchased and high risk portfolios suddenly become Investment Grade
  • 31. Evolution of a mortgage transaction What’s not to love? A mortgage loan portfolio, guaranteed by a quasi-government agency like Fannie Mae, backed up with credit enhancement from AIG (the largest insurer in the world), and collateralized by homes that are rising in value!
  • 32. Evolution of a mortgage transaction “I’ll take three trillion dollars worth!”
  • 33. Evolution of a mortgage transaction 1. Short term interest rates begin to rise
  • 34. Evolution of a mortgage transaction 1. Short term interest rates begin to rise. 2. Housing demand (especially speculative demand) begins to deplete.
  • 35. Evolution of a mortgage transaction 1. Short term interest rates begin to rise. 2. Housing demand (especially speculative demand) begins to deplete. 3. Housing prices begin to fall.
  • 36. Evolution of a mortgage transaction 1. Short term interest rates begin to rise. 2. Housing demand (especially speculative demand) begins to deplete. 3. Housing prices begin to fall. 4. Monthly mortgage payments begin to reset (upwards)
  • 37. Evolution of a mortgage transaction 1. Short term interest rates begin to rise. 2. Housing demand (especially speculative demand) begins to deplete. 3. Housing prices begin to fall. 4. Monthly mortgage payments begin to reset (upwards) 5. The theory of “I can sell the appreciated house if I can’t afford the payments” is put to the ultimate test as…
  • 38. Evolution of a mortgage transaction 1. Short term interest rates begin to rise. 2. Housing demand (especially speculative demand) begins to deplete. 3. Housing prices begin to fall. 4. Monthly mortgage payments begin to reset (upwards) 5. The theory of “I can sell the appreciated house if I can’t afford the payments” is put to the ultimate test as… 6. A wave of houses are put on the market, all at once
  • 39. Evolution of a mortgage transaction 1. Short term interest rates begin to rise. 2. Housing demand (especially speculative demand) begins to deplete. 3. Housing prices begin to fall. 4. Monthly mortgage payments begin to reset (upwards) 5. The theory of “I can sell the appreciated house if I can’t afford the payment” is put to the ultimate test as… 6. A wave of houses are put on the market, all at once 7. Home prices fall further
  • 40. Evolution of a mortgage transaction Homeowners and real estate speculators realize that their debts are greater than the value of the houses they own. The easiest solution is to declare bankruptcy.
  • 41. Evolution of a mortgage transaction Interest rates rise and home values fall. Home owners fall Consumer spending behind on payments Asset backed securities falls and economy and some declare begin to lose value as enters a recession, bankruptcy the mortgage payments placing further risk of fall behind or go into mortgage defaults and default housing price declines The market for these securities evaporate as Stock markets decline most investment banks over fears of liquidity share the same crunch and high problem degrees of uncertainty Investment banks Credit markets tighten must “mark securities as investors of all sizes to market.” With no reset their risk Investment banks active markets, tolerance and move to begin to fail as losses securities have to be avoid losses absorb all of their valued at or near zero limited equity capital base
  • 42. Evolution of a mortgage transaction Unwinding the situation will not be easy
  • 43. Evolution of a mortgage transaction Titles to assets, roles of guarantors, financial status of players, the global nature of the problem and other transaction complexities make unwinding the situation difficult
  • 44. Evolution of a mortgage transaction Nobody know what the paper is worth, and there are no buyers!
  • 45. Evolution of a mortgage transaction Nobody know what the paper is worth, and there are no buyers! The Federal Government is working to create a market for the securities through the $700 Billion “Emergency Economic Stability Act Of 2008”
  • 46. Evolution of a mortgage transaction Private sector, inter-institutional credit has evaporated since everyone has reset their institutional risk tolerance level to an abundantly cautious level
  • 47. Evolution of a mortgage transaction Private sector, inter-institutional credit has evaporated since everyone has reset their institutional risk tolerance level to an abundantly cautious level This affects banks, corporations, small businesses and consumers alike
  • 48. Evolution of a mortgage transaction Which explains why even the stock market has reacted so badly. How far away can a recession be?
  • 49. Evolution of a mortgage transaction The First Step: “The Emergency Economic Stabilization Act of 2008” •Creates a market for illiquid securities •Creates an insurance pool for troubled assets •Creates a vehicle for managing these assets •Creates a provision for capital infusion into US Banks •Limits financial executives compensation programs •Provides for addressing accounting issues •Provides assistance for homeowners •Increases deposit insurance maximums Which explains why even the stock market has reacted so badly. How far away can a recession be?
  • 50. Evolution of a mortgage transaction EESA will take some time to have an effect!
  • 51. Will There be a Sequel? • Credit Card Debt • Auction Rate Securities • Credit Default Swaps • Hedge Funds • Further Credit Deterioration Caused by a Recession • Corporate Bankruptcy Caused by Liquidity Crunch • Small Business Loan Failures • More Commercial Bank Failures • Sovereign Bankruptcies
  • 52. Where do we go from here? • Recession? Very Likely • Jobs? Tight market • Housing? Long term recovery • Banking? Long term recovery with an industry transformation • Stock Markets? Slow recovery, with an initial spurt if/as liquidity is re-established. Rate of recovery will vary by sector • Commodities? Suppressed prices but reductions in output may put a floor on downward spiral
  • 53. Where do we go from here? Bright spots Dark spots • Rental housing • Consumer spending • Infrastructure • Consumer credit • Energy • Housing finance • Healthcare demand • Financial services • Education • Auto industry • Global demand • Healthcare Costs • Risk tolerance • Public Policy Issues • Welfare • Public Policy Issues • Medicare • Returns from “bailout” • Tax Policy • Tighter controls on financial • Mortgage guarantees engineering • The end of Political entitlement?
  • 54. Discussion • Who is to blame for this situation? • Are we victims of public ignorance? • Have there been any ethical or legal violations? • Could the crisis have been prevented? • Can controls be put in place to prevent a re- occurrence? • Will these controls have unintended consequences? • How will society pay for this?