Press Review Us Economic Crisis July 3rd 2008


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This paper is a summary of press clippings gleaned from Internet during the period April to July 2008. This exercise was performed to provide a quick summary of the US credit crisis at that particular point in time / 2nd quarter 2008. The paper was presented to a non native English speaking European audience consisting primarily of insolvency judges July 3rd 2008 in Paris. Event 2nd annual insolvency judges summer camp organised by Cabinet Isabelle DIDIER, Paris FRANCE.

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Press Review Us Economic Crisis July 3rd 2008

  1. 1. PRESS REVIEW The US Sub-prime crisis! Background, Causes, Effects, Solutions, Accountability and the French Point of View. BACKGROUND At origin of the current economic crisis in the United States of America is the firmly-held belief by most Americans that credit is secure, there is safety in borrowing and the US economy is forever robust! Should the unforeseen happen, a hard-working, healthy and otherwise typical American will overcome the difficulty! Another catalyst of the crisis is the deregulation of the US banking industry, which began in the early 1980s, favouring conditions for lenders. At that time, Washington began drifting away from its role as financial services regulator, especially in the protection of consumers. During Ronald Reagan’s tenure as President, the federal government considerably reduced its funding available for low-income housing. Homeownership was later pushed by the Republican George Bush Junior government. Former Federal Reserve Chairman Alan Greenspan congratulated the financial communities for offering new and easier credit facilities – he was mainly referring to the SubPrime loan. Around 1998, exuberant brokers and financial lending institutions began pushing subprime loans (otherwise known as B loans or second-chance loans) to borrowers who did not qualify for market rate conventional loans. Subprime loans are considered risky for both borrower and lender, hence the higher interest rates, which in turn increases the likelihood of default. In 2006, subprime loans helped boost US homeownership to a record 69% of households. There are various types of subprime loans: “Interest only mortgages”, which allow borrowers to pay interest for a period of time, “pick a payment” which gives the borrower the option on how to repay the loan and “initial fixed-rate mortgages” which convert to variable rate loans like ARM’s. Subprime loans are typically 2% higher than standard loans – brokers handle approximately 70% of the initial contact with the homebuyer. Brokers then match the prospective buyer with lenders who further lure borrowers with exotic mortgages like “no doc” mortgages, which do not require any evidence of income or savings. Big banks and wholesale lenders then buy the debt, repackage them and sell them to Wall Street firms. Wall Street banks and investment houses further repackage the loans into mortgage backed securities (MBS) and collateralised debt obligations (CDO). These structured products include many types of mortgages (prime and subprime, etc…) which makes their sale very easy based on the aggregate risk (volume and mix of mortgages). These investment instruments yield high rates of return and are sold to pension funds, hedge funds and institutions. Page 1 of 6 / July 3rd 2008
  2. 2. CAUSES Causes of the economic crash…. Some consider that there are three principal causes of the crisis: Buyers overborrowed on homes they couldn’t afford, Lenders approved risky borrowers and then divested that risk by selling the mortgages on the financial markets. And predatory lending, where people were seduced into believing that if they held tight for about three years they could make a windfall and with the profit buy another home outright. Meltdown signs were felt as early as 2006 – because of an escalating number of subprime house foreclosures. Lenders and brokers had lent out hundreds of billions of dollars to home buyers in the early 2000’s due to a legal leniency among finance houses and brokers who escape from the very strict controls imposed on banks and thrifts houses (savings institutions) for the same subprime loans. Predatory loans and fraudulent conduct were all too frequent. Lenders knew that they themselves held very little short-term risk as they quickly sold their loans to major institutions who then sold them to the stock markets in the form of investment instruments. Further under US law, investors who buy securities backed by mortgages or even the actual mortgages themselves are not exposed to lawsuits or fraud. This protection partly explains how the US mortgaged backed securities market expanded at such a rapid pace. In 2006 more than half of collateralised securities were backed by subprime loans. Subprime rate borrowers were described as unsuspecting or at-risk to default. For the record, $805 billion was loaned out in 2005 - $600 billion in 2006. Further 21% of mortgage applications between years 2004-2006 were subprime as compared to 9% between years 1996-2004. Predatory lending practices enjoyed free reign in many states - up to 2007. The exact moment the crisis / meltdown began is pinpointed somewhere between July 19th and August 22nd 2007 when the (Chicago Board Exchange) CBOE Volatility Index rose from $15 to $23 per contract. The stock market was predicted to fall over the next year, however the market carried on trading it upwards as no one knew the timing of the correction. Beginning 1998, more than 7 million borrowers bought homes with sub-prime loans. By December 2007, one million of those homeowners had defaulted on their loans. Financial analysts predict that at least a quarter of these people – over 2 million families – will default and lose their homes over the next few years. In February 2008, losses from bad mortgages and mortgage-backed securities had climbed past the $200 billion mark Page 2 of 6 / July 3rd 2008
  3. 3. EFFECTS The aftermath of the bubble bursting… Subprime loans had been repackaged into interesting investment vehicles which were purchased around the world. When the crisis hit, investments were severely devalued, which led to uncertainty, panic and a halt in lending by banks and institutions. This is turn raised the interest rates dramatically which had an immediate effect on businesses not being able to access credit at reasonable rates which in turn led to distressed companies going into receivership. Further in the USA with increased energy costs, severe job losses, and a relatively sluggish economy, many Americans could not keep up their house loan payments. In the USA, and due to the bankruptcy of more than 100 subprime mortgage lenders, including the former no. 2 lender New Century Financial Corporation, a collapse occurred in the $6.5 trillion mortgage backed securities market. The broader impacts of this are: A dangerously weakened U.S. housing market and economy! As at June 2008, Americans had lost billions of dollars in home equity. Standard and Poor’s index shows that home prices in 10 major metropolitan areas are down 16.35% from a year ago, April. There are now 8,000 foreclosures of home mortgages per day. Beyond the American borders, and needless to say due to the globalisation of economies, the effects were also powerfully and dramatically felt by the European and Asian markets: China’s second largest bank, Bank of China Ltd, had invested in almost 10 billion dollars of US securities – repackaged subprime loans. Canada has not yet felt any “significant” ripple effects due to the US credit crisis nor do they expect to in the near future. The Canadian Toronto-Dominion Bank however, says that there is a downside…surely Canadian exports will go down, there will definitely be an economic impact on Canadians…but up to now house values remain stable in Canada although the market is slowing down. Their dollar is now equivalent to the US when only 10 years ago, the Canadian dollar was only worth 60 cents American! SOLUTIONS Proposals – Barack OBAMA speaks out… At his March 27th 2008 New York address while campaigning for the democratic leadership, Senator Obama intelligently and eloquently put forth his ideas on Renewing the American Economy, which appear to be shared by many fellow countrymen and WOMEN….(Hillary is going to bring him the female vote!) He spoke of several solutions: 1. Evolution of industries warrants regulatory reform Establishing a new regulatory framework which takes into account the swift changes due to globalisation and technologies, i.e., Better oversight (controls) on the part of government to protect business and consumers from massive over-investment, market Page 3 of 6 / July 3rd 2008
  4. 4. manipulation, accounting fraud, etc… Modernise legislation to target products (sub prime loans) and not institutions (banks). Streamline institutions that control so as not to overlap….better management… 2. Introducing measures to restrict lobbying / special interest groups Stopping the lobbyists // what is wrong for Main Street is wrong for Wall Street! Government has a role to play in advancing our COMMON prosperity: by providing stable macroeconomic and financial conditions for sustained growth; by demanding transparency; and by ensuring fair competition in the marketplace. 3. Short term measures to get the economy going again! Providing a stimulus by investing cash from the bottom up (special fund to assist homeowners, extension of unemployment insurance for those out of work, income tax cuts for working families, and more suspicious (no taxes for retirees making less than $50,000 per year (baby boom is aging……nobody’s perfect!)…ensure liquidity of institutions and lenders, etc…. The same month, March 2008, former running mate, democratic Senator Hillary Clinton, had proposed that Congress inject $30 Billion to help states and communities lessen the number of foreclosures. She had recommended a high-level working group to come up with ideas to restructure at-risk mortgages to avert further foreclosures. Yesterday, the Senate was to have ratified a by-partisan bill helping homeowners and lenders by allowing qualified owners to refinance into more affordable, 30-year fixed-rate loans with a federal guarantee. Skeptics say the plan is a handout for irresponsible borrowers and lenders, who would be able to get rid of their worst-performing mortgages, putting taxpayers on the hook for billions of dollars in risky loans. A positive aspect of the bill though is the provision of $150 million in financing to expand counselling for borrowers to prevent foreclosure and would establish stricter disclosure rules to require lenders to make plain the maximum monthly payment for a borrower with an adjustable rate loan. ACCOUNTABILITY Who did it? In terms of accountability, there appear to be a few guilty parties… Wall Street…. Why burst the bubble if you can pull in the money! Financial innovations of the last decade have primarily focused on transforming the liabilities of dubious mortgage applicants into complex debt instruments which are enhanced with massive amounts of leverage and exotically-named derivatives. Investment banks and brokerage houses fought hard to establish the present system which they call “structured finance”. Page 4 of 6 / July 3rd 2008
  5. 5. Wall Street made billions and today they’re hardly paying anything at all for their role in the subprime crisis – other than lost executive bonuses! The SEC….. (Securities and Exchange Commission) who conveniently ignored all warning signs. SEC Chairman, Christopher Cox has come under violent attack from Senator Christopher Dodd who chairs the Banking Committee and who accuses the SEC of sleeping on the job! In 2007, the SEC had been mandated to probe into the subprime mortgage collateralised debt obligations (CDOs). Their conclusions – Leave the markets alone! No further action needed! Senator Dodd says that the SEC “needs to help restore investor confidence in the markets by more vigorous enforcement, by more comprehensive regulation of credit rating agencies and increased accountability and transparency of publicly traded companies.” (Financial Week) The Bush government…. The Bush administration is philosophically opposed to oversight measures; they have basically relegated this task to the banking industry themselves. Some say that the Bush Administration will be judged by history as a “willing accomplice” to the subprime collapse. The Bankers…. Bankers had spent over $100,000 million lobbying congress to remove the legislative firewall which kept investment and commercial banks separate, i.e., particularly the Glass Steagall law. Mortgage brokers and lending institutions are highly responsible for the financial disaster we see today in the USA. They certainly had a good business going selling off their mortgages to the major banks and institutions. They knew it was just a matter of time before the loans would default. Interestingly enough, when the effects started to hit the bankers, they began pressuring Congress to react…. It is mainly the bankers who are behind the current $837 billion bailout before the Senate. Another important detail is that in the late 1990s, when individual states began introducing measures and new laws to curtail predatory lending practices, they met up with severe opposition from bank lobby groups who also happened to be Campaign financers… And finally according to some secure and liberal-leaning market economy proponents…. The individual borrower who should have known better! Litigation has started and successfully! In “Weathering the Subprime Storm”, an article presented at the American Bar Association Section of Litigation Annual Conference, April 2008, some of the larger financial institutions are being sued successfully. Page 5 of 6 / July 3rd 2008
  6. 6. Case in point: A United States Court of Appeals for the Ninth Circuit upheld a decision making “secondary mortgage market participants” responsible for having willingly supported fraudulent mortgage lenders. A secondary mortgage market participant is one who buys and sells mortgages and mortgage-backed securities. In 2007, Lehman Brothers was held liable for the predatory lending practices of a mortgage originator under an aiding and abetting theory and were successfully sued by mortgagors to the tune of $5 million. In California of course! How about a CLASS ACTION against ??? Ending on a positively European note - ONLY IN AMERICA you say, What a pity! FRENCH POINT OF VIEW See Express articles / 22 May 2008 According to COFACE, the credit insurers, present in 65 countries, they have observed a 45% increase in payment defaults over the first 4 months of 2008. They see this as an indication of a credit crisis. However they feel that the current crisis will not be as important as the one in years 2001-2002. They have also observed difficulties in various industry segments: Electronic components, the paper industry, supermarkets, automotive, construction, air travel and the textile and clothing industries. According to COFACE the crisis has made its way into the economy through reduced American demand and more difficult access to bank loans. 14 May 2008 The major world banks are now affected by the Subprime Crisis…such as American Giants Citigroup or Merrill Lynch but also European institutions like UBS. They are drawing upon Asian and Middle East resources to raise capital. A climate of mistrust has come upon the banks who seem incapable of assessing their levels of risk with regard to the subprime fiasco. They are no longer loaning to each other. The State had to intervene for the English Northern Rock due to a liquidity problem. Hedge funds are affected …frozen by liquidity problems. The world’s stock markets are caught in the downturn due to falling prices. Summary of press clippings for 2008 PARIS Judicial Summer Camp Compiled by Louise Roussel / Business Interface Consultant France / English-speaking countries / 33 (0)6 76 47 18 90 Sources: The New York Times, Mike Whitney Stock-Markets, ABA, The American Prospect, BestWaytoInvest, City Economist, Jean Freed, MBA, Election 2008, and other Internet press. Page 6 of 6 / July 3rd 2008