Financial Crisis Presentation October 2008


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Presentation on the Financial Crisis for Clients Given in October 2008

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Financial Crisis Presentation October 2008

  1. 2. Labrador Investments, LLC The History and Future of the Housing and Finance Industries: Their Effect on the Economy and Your Investments
  2. 3. Housing as a Social Benefit <ul><li>Historically, people who owned their homes as opposed to renting were: </li></ul><ul><ul><li>Perceived to be more financially stable </li></ul></ul><ul><ul><li>Were more likely to have good credit ratings </li></ul></ul><ul><ul><li>Were more likely to have stable employment </li></ul></ul><ul><ul><li>Took pride in their home </li></ul></ul><ul><ul><li>The large percentage of households owning their homes in the US has benefited society. </li></ul></ul>
  3. 4. Policy Mix that Led to Crisis <ul><li>Federal Laws and Regulations </li></ul><ul><li>Accounting Flaws </li></ul><ul><li>Innovative Products </li></ul><ul><li>Lack of Discipline by Lenders </li></ul><ul><li>Congress unwilling to rein in Fannie Mae, Freddie Mac through increased regulation. </li></ul>
  4. 5. Financial Services Regulation
  5. 6. Office of the Comptroller of the Currency <ul><li>Created in 1863 as a bureau of the Department of the Treasury </li></ul><ul><li>Mission: Charters, regulates and supervises all national banks, federal branches and agencies of foreign banks. </li></ul><ul><li>Headed by the Comptroller who is appointed by the President and confirmed by the Senate for a 5-year term </li></ul><ul><li>Four district offices and an office in London to supervise international activities of national banks </li></ul>
  6. 7. Office of the Comptroller of the Currency <ul><li>Mission </li></ul><ul><ul><li>To ensure the safety and soundness of the national banking system </li></ul></ul><ul><ul><li>To foster competition by allowing banks to offer new products and services </li></ul></ul><ul><ul><li>To improve the efficiency and effectiveness of OCC supervision, including reducing regulatory burden. </li></ul></ul><ul><ul><li>To ensure fair and equal access to financial services to all Americans. </li></ul></ul>
  7. 8. Office of the Comptroller of the Currency -- Duties <ul><li>National Bank Examiners </li></ul><ul><ul><li>Analyze a bank’s loan and investment portfolios, funds management, capital, earnings, liquidity, sensitivity to market risk and compliance with consumer banking laws, including the Community Reinvestment Act </li></ul></ul><ul><ul><li>Review the bank’s internal controls, internal and external audit, and compliance with the law. </li></ul></ul><ul><ul><li>Evaluate bank management’s ability to identify and control risk. </li></ul></ul>
  8. 9. Office of the Comptroller of the Currency -- Powers <ul><li>Examine the banks </li></ul><ul><li>Approve or deny applications for new charters, branches, capital or other changes in corporate or banking structure. </li></ul><ul><li>Take supervisory actions against banks that do not comply with laws and regulations or that otherwise engage in unsound banking practices, and issue cease and desist orders and civil money penalties. </li></ul><ul><li>Issue rules and regulations governing bank investments, lending and other practices. </li></ul>
  9. 10. Office of the Comptroller of the Currency <ul><li>Scope </li></ul><ul><ul><li>Examines and supervises more than 1600 national banks and about 50 federal branches of foreign banks in the US </li></ul></ul><ul><ul><li>National banks pay a fee for their examinations and for the OCC’s processing of their corporate applications </li></ul></ul><ul><ul><li>No direct costs to taxpayers </li></ul></ul>
  10. 11. Federal Reserve System <ul><li>Created on December 23, 1913 by Congress under the Federal Reserve Act </li></ul><ul><li>Mission: Meet Monetary Policy Objectives </li></ul><ul><ul><li>maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to </li></ul></ul><ul><ul><li>increase production, so as to promote effectively the goals of </li></ul></ul><ul><ul><ul><li>maximum employment </li></ul></ul></ul><ul><ul><ul><li>stable prices </li></ul></ul></ul><ul><ul><ul><li>moderate long-term interest rates. </li></ul></ul></ul><ul><li>“ The Fed” also regulates banks </li></ul>
  11. 12. Federal Reserve System <ul><li>Board of Governors has 7 members </li></ul><ul><li>12 Federal Reserve Districts with Reserve Bank Presidents </li></ul><ul><li>The Federal Open Market Committee (FOMC) includes the 7-member Board of Governors and 5 of the 12 Reserve Bank Presidents (rotating in 1-year terms) </li></ul><ul><ul><li>Chair of the Board is also the Chairman of the FOMC </li></ul></ul><ul><ul><li>Vice Chairman of the FOMC is the President of the New York Bank (one of the 12 Federal Reserve Districts) </li></ul></ul><ul><li>Members are appointed by President and confirmed by the Senate </li></ul>
  12. 13. Federal Reserve System <ul><li>Members must be representative of financial, agricultural and industrial interests. </li></ul><ul><li>The Federal Reserve prints the money in our pockets </li></ul><ul><li>The 12-member FOMC sets the Discount Rate and the Fed Funds Rate </li></ul><ul><ul><li>Discount Rate is the interest rate at which the Fed lends to banks </li></ul></ul><ul><ul><li>Fed Funds Rate is a target interest rate that banks use to lend to each other </li></ul></ul>
  13. 14. Federal Deposit Insurance Corporation (FDIC) <ul><li>Mission </li></ul><ul><li>an independent agency created by the Congress as provided by the Banking Act of 1933 </li></ul><ul><li>maintains the stability and public confidence in the nation’s financial system by </li></ul><ul><ul><li>insuring deposits </li></ul></ul><ul><ul><li>examining and supervising financial institutions </li></ul></ul><ul><ul><li>managing receiverships. </li></ul></ul>
  14. 15. The Office of Federal Housing Enterprise Oversight <ul><li>Established as an independent entity within the Department of Housing and Urban Development by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 </li></ul><ul><li>Mission: </li></ul><ul><ul><li>to promote housing and a strong national housing finance system </li></ul></ul><ul><ul><li>ensure the safety and soundness of Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation). OFHEO works to ensure the capital adequacy and financial safety and soundness of two housing government-sponsored enterprises (GSEs) -- Fannie Mae and Freddie Mac. </li></ul></ul><ul><li>Funded through assessments of Fannie Mae and Freddie Mac </li></ul><ul><li>OFHEO's operations represent no direct cost to the taxpayer. </li></ul><ul><li>The Federal Housing Finance Agency will be OFHEO’s successor, and OFHEO will cease to exist next year. </li></ul>
  15. 16. Federal Housing Finance Board <ul><li>An independent agency of the US Government and a GSE </li></ul><ul><li>Replaced the Federal Home Loan Bank Board </li></ul><ul><li>The Board supervises the 12 regional Federal Home Loan Banks who insure that a source of funds is available to local lenders for the purpose of making home loans. </li></ul><ul><li>Will be merged with OFHEO into the Federal Housing Finance Agency in 2009. </li></ul>
  16. 17. The Office of Thrift Supervision <ul><li>Oversees the Savings and Loan (thrift) industry </li></ul><ul><li>Mission: </li></ul><ul><ul><li>To supervise savings associations and their holding companies </li></ul></ul><ul><ul><li>To maintain their safety and soundness </li></ul></ul><ul><ul><li>To maintain compliance with consumer laws </li></ul></ul><ul><ul><li>To encourage a competitive industry that meets America's financial services needs. </li></ul></ul>
  17. 18. Securities and Exchange Commission <ul><li>Established in 1934 as a result of the Securities Act of 1933 and the Securities Exchange Act of 1934 </li></ul><ul><li>Mission </li></ul><ul><ul><li>Interpret federal securities laws </li></ul></ul><ul><ul><li>Issue new rules and amend existing rules </li></ul></ul><ul><ul><li>Oversee the inspection of securities firms, brokers, investment advisors and ratings agencies </li></ul></ul><ul><ul><li>Oversee private regulatory organizations in the securities, accounting and auditing fields </li></ul></ul><ul><ul><li>Coordinate U.S. securities regulation with federal, state and foreign authorities </li></ul></ul>
  18. 19. Securities and Exchange Commission <ul><li>The Commission has 5 members appointed by the President and confirmed by the Senate. Only 3 of the 5 may be of one political party. </li></ul><ul><li>The SEC has the following Divisions </li></ul><ul><ul><li>Division of Corporate Finance </li></ul></ul><ul><ul><li>Division of Trading and Markets </li></ul></ul><ul><ul><li>Division of Investment Management </li></ul></ul><ul><ul><li>Division of Enforcement </li></ul></ul>
  19. 20. Securities and Exchange Commission <ul><li>The SEC has the following Offices </li></ul><ul><ul><li>Office of the General Counsel </li></ul></ul><ul><ul><li>Office of the Chief Accountant </li></ul></ul><ul><ul><li>Office of Economic Analysis </li></ul></ul><ul><ul><li>Office of Compliance Inspections and Examinations </li></ul></ul><ul><ul><li>Office of International Affairs </li></ul></ul><ul><ul><li>Office of Investor Education and Advocacy </li></ul></ul><ul><ul><li>Office of Information Technolgy </li></ul></ul>
  20. 21. Securities and Exchange Commission <ul><ul><li>Office of the Executive Director </li></ul></ul><ul><ul><li>Office of Risk Assessment </li></ul></ul><ul><ul><li>Office of Legislative Affairs and Intergovernmental Relations </li></ul></ul><ul><ul><li>Office of Public Affairs </li></ul></ul><ul><ul><li>Office of the Secretary </li></ul></ul><ul><ul><li>Office of Equal Employment Opportunity </li></ul></ul><ul><ul><li>Office of Administrative Law Judges </li></ul></ul>
  21. 22. Financial Accounting Standards Board <ul><li>A private, not-for-profit organization created in 1973 that sets Generally Accepted Accounting Principles in the US. </li></ul><ul><li>This power was granted by the SEC, but the SEC can override the FASB’s rulings. </li></ul><ul><li>Replaced the Accounting Principles Board. </li></ul><ul><li>7 member board with representation from public accountants, industry accountants, government accountants and investors. </li></ul>
  22. 23. The FASB <ul><li>Mission </li></ul><ul><ul><li>to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information. </li></ul></ul>
  23. 24. The FASB <ul><li>The FASB is subject to oversight by the Financial Accounting Foundation (FAF), which selects the members of the FASB and funds the FASB. The Board of Trustees of the FAF, in turn, is selected in part by a group of organizations including:) </li></ul><ul><ul><li>American Accounting Association </li></ul></ul><ul><ul><li>American Institute of Certified Public Accountants </li></ul></ul><ul><ul><li>CFA Institute </li></ul></ul><ul><ul><li>Financial Executives International </li></ul></ul><ul><ul><li>Government Finance Officers Association </li></ul></ul><ul><ul><li>Institute of Management Accountants </li></ul></ul><ul><ul><li>National Association of State Auditors, Comptrollers and Treasurers </li></ul></ul><ul><ul><li>Securities Industry Association </li></ul></ul>
  24. 25. Credit Rating Agencies <ul><li>Moody’s and Standard and Poor’s are two of the primary credit rating agencies designated by the SEC to make decisions on how financial assets are rated as to financial strength. </li></ul>
  25. 26. Comparison of Credit Rating Agencies <ul><li>Moody’s </li></ul><ul><li>Aaa </li></ul><ul><li>Aa </li></ul><ul><li>A </li></ul><ul><li>Baa </li></ul><ul><li>Ba </li></ul><ul><li>B </li></ul><ul><li>Caa </li></ul><ul><li>Ca </li></ul><ul><li>C </li></ul><ul><li>Uses 1-3 as a modifier, with 1 a higher quality than a 3. </li></ul><ul><li>Standard & Poor’s </li></ul><ul><li>AAA </li></ul><ul><li>AA </li></ul><ul><li>A </li></ul><ul><li>BBB </li></ul><ul><li>BB </li></ul><ul><li>B </li></ul><ul><li>CCC </li></ul><ul><li>CC </li></ul><ul><li>C </li></ul><ul><li>D </li></ul><ul><li>Uses + or – as a modifier, with + higher than a – or no modifier. </li></ul>
  26. 27. How Can We Possibly Believe That Banks are Underregulated?
  27. 28. The History of Housing Finance
  28. 29. US Housing Market is Different <ul><li>30-Year Fixed-Rate Mortgages – Only available in the US </li></ul><ul><li>Other countries use Adjustable Rate Mortgages (ARMs) exclusively </li></ul><ul><li>ARMs were a New Phenomenon in the US beginning circa the 1980’s when interest rates were in the ‘teens. </li></ul>
  29. 30. Fannie Mae <ul><li>Created in 1938 and was a part of the federal government </li></ul><ul><li>Mission: </li></ul><ul><ul><li>To help people obtain mortgages </li></ul></ul><ul><ul><li>To increase home ownership </li></ul></ul><ul><ul><li>To create a market in mortgages </li></ul></ul><ul><ul><li>To increase the amount of cash available for home mortgages </li></ul></ul>
  30. 31. Fannie Mae <ul><li>In 1965, President Johnson privatized Fannie Mae to get it out of the government’s budget </li></ul><ul><li>Note also that Johnson moved to a “unified budget” – added Social Security, which at that time was running a surplus, to the budget to reduce the deficit that was rising due to the Vietnam war and the Great Society programs </li></ul>
  31. 32. Fannie Mae <ul><li>In 1968, Fannie Mae was transformed into a quasi-private enterprise called a Government Sponsored Enterprise (GSE). At that time, shares of common stock were first sold to the general public to finance the Vietnam War and the Great Society programs.. </li></ul><ul><li>Fannie Mae does not lend directly to the public. </li></ul><ul><li>Fannie Mae only buys mortgages from banks and thrifts that originate the loans. </li></ul><ul><li>Fannie Mae therefore creates liquidity in the market and allows banks and thrifts to recycle their cash to fund new loans. </li></ul><ul><li>Fannie Mae also guarantees some loans and issues CMOs. </li></ul>
  32. 33. Freddie Mac <ul><li>Created by Congress in 1970 to provide a competitor to Fannie Mae </li></ul><ul><li>Mission identical to Fannie Mae’s. </li></ul>
  33. 34. Home Mortgage Lenders <ul><li>Savings and Loans (Thrifts) were the main source of home mortgage money until the late 1980’s </li></ul><ul><li>Insured by the Federal Savings and Loan Insurance Corporation (FSLIC) </li></ul><ul><li>Fannie Mae and Freddie Mac had a lower cost of funds than S&L’s due to their special status as Government Sponsored Enterprises. As Government Sponsored Enterprises, they had an implicit backing by the US Government’s taxing power. </li></ul><ul><li>Fannie Mae and Freddie Mac also fund themselves using long-term bonds with similar maturities (and call provisions) to the mortgages that they buy. </li></ul><ul><li>This made it easier for Fannie Mae and Freddie Mac to stay profitable even when thrifts were unprofitable. </li></ul>
  34. 35. Home Mortgage Money Was Not Always Available <ul><li>S&Ls lent out money for 30 years at a fixed interest rate. </li></ul><ul><li>The source of funds for S&Ls to lend was mostly checking and savings accounts. </li></ul><ul><li>The regulators prohibited S&L’s from paying interest on checking accounts (demand deposits), and savings accounts (time deposits) were limited to a 5% rate of interest due to Regulation Q – a federal regulation. </li></ul><ul><li>Historically, funding for house purchases was cut off every time interest rates rose above 5% due to Regulation Q. </li></ul><ul><li>When interest rates rose above 5%, depositors would move their money from S&L’s to institutions that paid more interest, creating a funding crisis for the S&Ls. </li></ul>
  35. 36. Why Did S&L’s Fail? <ul><li>When inflation reached double digits in the 1970’s and 1980’s, unregulated interest rates rose, with interest rates in the high ‘teens. </li></ul><ul><li>In the 1970’s an innovative product called the NOW account (called money market funds today) were created so that investors with small amounts of cash could benefit from interest rates higher than 5%. </li></ul><ul><li>Depositors withdrew their cash from the S&L’s and deposited them into the NOW and money market accounts. This forced a repeal of Reguation Q so that S&L’s could attract deposits at interest rates higher than 5%. </li></ul><ul><li>S&L’s could not find alternative funding at a profitable rate (i.e. below that of mortgages whose low rates were already locked in), and went bankrupt. </li></ul><ul><li>During the early 1980’s Adjustable Rate Mortgages were introduced as an alternative to 30-year fixed mortgages. They often had teaser rates that were below interest rates offered for 30-year fixed-rate mortgages. </li></ul><ul><li>But the introduction of ARMS was not enough to save the S&L’s because they were stuck with older fixed-rate mortgages on their books. </li></ul><ul><li>Economic weakness also created a spike in default rates in the early 1980’s. </li></ul>
  36. 37. Federal Government Intervention <ul><li>In 1989, a crisis in the S&L industry forced the US Government to bail out the industry. </li></ul><ul><li>Under the Federal Institution Reform Recovery and Enforcement Act (FIRREA), FSLIC ceased to exist and was merged into the FDIC </li></ul><ul><li>Thrifts are now insured by the FDIC </li></ul><ul><li>Under FIRREA, the Resolution Trust Corporation was created to purchase the assets of the failed S&L’s, and the RTC gradually sold off the assets. The current plan is reminiscent of the RTC but Treasury’s authority is much broader and sweeping this time. </li></ul>
  37. 38. Changes in Mortgage Lending
  38. 39. Quality of Home Mortgages Changed Over Time <ul><li>Historically, home purchasers would make a down payment of 20%. </li></ul><ul><li>Any home purchasers whose down payment fell short of 20% had to pay Private Mortgage Insurance. </li></ul><ul><li>Lenders reviewed a large amount of documentation to assure that the home owner’s income and assets were sufficient to support the mortgage payments. </li></ul>
  39. 40. Lending Standards Were Relaxed <ul><li>Historically, lenders required about a 10% down payment as a minimum in order to fund a loan using Private Mortgage Insurance (PMI) </li></ul><ul><li>Then this figure gradually diminished </li></ul><ul><ul><li>5% down payments </li></ul></ul><ul><ul><li>3% down payments </li></ul></ul><ul><ul><li>0% down payments </li></ul></ul>
  40. 41. Lending Standards Were Relaxed <ul><li>Low Documentation Loans morphed into No Documentation Loans </li></ul><ul><li>Some loans were originated with borrowers stating their income and providing no documentation </li></ul><ul><li>These loans were provided to </li></ul><ul><ul><li>CRA-quality borrowers </li></ul></ul><ul><ul><li>Speculators who were “flipping houses” for a quick profit during the housing bubble. </li></ul></ul>
  41. 42. Lending Standards Were Relaxed <ul><li>As interest rates declined from the historic levels that they reached during the early 1980’s, borrowers started refinancing their home mortgages into mortgages with lower rates. </li></ul><ul><li>Borrowers started doing “cash out refi” loans – taking equity out of their homes to fund their lifestyles or pay off higher-interest debt, such as credit card debt that was no longer deductible on their income taxes as of 1984. </li></ul><ul><li>It is certainly possible that the change in the tax law was a precipitating factor that accelerated this “cash out refi” trend. </li></ul><ul><li>There were also mortgages that offered interest-only repayments and even “negative amortization”! </li></ul>
  42. 43. CRA Encouraged Bad Choices <ul><li>Just because a bank is willing to make a loan to you of a given size and with a given interest rate, that does not mean that you will be able to pay it! </li></ul>
  43. 44. ARM Structures <ul><li>ARM structures often use “teaser rates” to make the initial payments more affordable. </li></ul><ul><li>As time passes, the interest rate reverts to a market rate </li></ul><ul><li>If the borrower is depending on a rise in his income to offset the increase in his mortgage payment , and the pay raise does not occur, the borrower is more likely to default. </li></ul>
  44. 45. Risks of Interest Rate Changes <ul><li>ARMs put the risks associated with future changes in interest rates on the borrower </li></ul><ul><ul><li>Borrower more likely to default </li></ul></ul><ul><li>30-year Fixed Rate Mortgages put the risks associated with future interest rate changes on the lender </li></ul><ul><ul><li>Lender more likely to fail if its funding costs rise during the 30-year mortgage term. </li></ul></ul>
  45. 46. Who Provides Money for Mortgages Today? <ul><li>Although Fannie Mae and Freddie Mac sustained losses during the S&L crisis, they changed their method of funding their business to more closely match their assets and liabilities so that they could lock in a profit. This was greatly helped by new, exotic derivatives products that were created during the last 30 years. </li></ul><ul><li>During the mid-1980’s, Collateralized Mortgage Obligations (CMOs) were invented by Wall Street to find an answer to the question of how to provide money for 30-year fixed-rate mortgages. </li></ul><ul><li>The power of personal computers made it possible for investment banks to keep track of the details of CMOs – who owned a mortgage, the payment streams and who purchased the bonds that backed the CMOs. </li></ul><ul><li>The CMO structure also allowed for the emergence of banks as a source of mortgage money. </li></ul>
  46. 47. How CMOs are Structured <ul><li> Mortgages Mortgage Mortgage CMO </li></ul><ul><li> Payments Servicer Tranches </li></ul>Home 1 Home 2 Home 3 $ $ $ Bank or Loan Originator AAA AA A BBB BB B $ Home mortgages are originated by mortgage brokers, S&Ls and banks. They are then sold to investment banks and pooled. The investment banks create bonds called CMOs and sell them to investors. The CMOs offer tranches that have different credit quality. The best quality bonds are also often insured to achieve the AAA rating. The high quality tranches are paid off first. The low quality tranches are called “support tranches”. They are also known as “toxic waste”.
  47. 48. How CMOs are Structured <ul><li>Mortgage brokers, thrifts and banks originate loans and sell them to investment banks </li></ul><ul><li>Investment banks pool the loans and sell them to investors </li></ul><ul><li>Investors have a choice of quality of bond that they buy – these are the different tranches </li></ul><ul><li>The AAA-quality bonds are paid off first and have a lower interest rate than the lower-rated bonds. </li></ul><ul><li>The lower-rated bonds are called “support tranches” </li></ul><ul><li>The lowest-rated tranches are mostly bought by hedge funds and are often called “toxic waste”. They provide a high yield – but only if the mortgages in the pool are high quality. Losses due to high default rates are first borne by the support tranches. </li></ul>
  48. 49. Banks Retain Servicing Rights <ul><li>Banks that originated the loans often retained the “servicing rights” – i.e. collected the mortgage payments and remitted them to the CMO owners. </li></ul><ul><li>Banks also retained a part of the mortgage payment for providing this service. </li></ul><ul><li>As long as banks kept recycling the same pool of capital to fund more and more mortgages, the value of their “servicing rights” grew ever larger and was a good source of income with low risk. </li></ul>
  49. 50. How Banks Operate
  50. 51. Bank Balance Sheets Debt (Fixed Income) Assets Equities (Common Stock)
  51. 52. Bank Balance Sheets <ul><li>Checking Accounts </li></ul><ul><li>Savings Accounts </li></ul><ul><li>Certificates of Deposit </li></ul><ul><li>Brokered CDs </li></ul><ul><li>Other Banks (@ Fed </li></ul><ul><li>Funds Rate) </li></ul><ul><li>Federal Reserve </li></ul><ul><li>(@ Discount Rate) </li></ul><ul><li>Cash </li></ul><ul><li>Loans to customers </li></ul><ul><li>Other Investments </li></ul><ul><ul><li>US Treasuries </li></ul></ul><ul><ul><li>Municipal Bonds </li></ul></ul><ul><ul><li>CMOs </li></ul></ul><ul><li>Loans to other banks (@ Fed Funds Rate) </li></ul><ul><li>Required deposits on reserve at the Fed </li></ul>Equities (Common Stock)
  52. 53. Leverage <ul><li>Leverage is defined as using debt to fund your operations. </li></ul><ul><li>The more debt a bank uses as a percentage of equity (ownership interest), the higher the leverage ratio. </li></ul><ul><li>Leverage ratios of banks typically fall in the range of 9 or 10 dollars to each dollar of equity. </li></ul><ul><li>Leverage is used to increase returns to the equity holders. </li></ul>
  53. 54. If Bank has no debt outstanding and is capitalized with $100,000 in equity…. Loan out $100,000 at 6%, with income of $6,000/year Expenses of $3,000/year Profit of $3,000 Shareholder Return is $3,000 on $100,000 investment, or 3%.
  54. 55. If Bank is capitalized with $90,000 debt with 1% interest rate and $10,000 in equity…. Loan out $100,000 at 6%, with income of $6,000/year Pay $900 interest on debt Expenses of $3,000/year Profit of $2,100 Shareholder Return is $2,100 on $10,000 investment, or 21%.
  55. 56. If Bank is capitalized with $90,000 debt with 1% interest rate and $10,000 in equity…. Loan out $100,000 at 6%, with income of $6,000/year Pay $900 interest on debt Expenses of $3,000/year 10% of Loans Default and are worthless -- $10,000 Loss of -$7900 Shareholder Return is -$7,900 on $10,000 investment, or a loss of 79% of their investment.
  56. 57. Banks are Conservative for a Reason <ul><li>This is why banks are careful about who they lend to. </li></ul><ul><li>If a small number of loans become worthless, bank stockholders lose a lot of their capital. </li></ul><ul><li>If the bank’s capital violates regulatory minimums, they must do one of 3 things </li></ul><ul><ul><li>Raise capital by selling stock </li></ul></ul><ul><ul><li>Merge with a stronger institution </li></ul></ul><ul><ul><li>Fail </li></ul></ul>
  57. 58. How Banks Make Money <ul><li>Lend at a higher rate than cost of funds </li></ul><ul><li>Borrow a lot, with equity being a small percentage of the bank’s capital. </li></ul><ul><li>Borrow short and lend long </li></ul><ul><ul><li>Short term interest rates are usually lower than long term interest rate </li></ul></ul>
  58. 59. How Banks Make Money <ul><li>Banks manage the maturity of their loan portfolio and sources of funds that are used to make loans </li></ul><ul><li>Some banks try to make more money by tweaking their books so that there is a mismatch between the maturity structures of assets and liabilities. </li></ul><ul><li>Banks who have an asset and liability mismatch are more likely to have volatile earnings and are riskier than those that are more conservatively managed. </li></ul><ul><li>Since CMOs have variable cash flows, this creates uncertainty about the true average maturity of the bank’s assets. </li></ul>
  59. 60. Flaws in Regulatory Structure
  60. 61. Federal Laws and Regulations <ul><li>Glass Steagall (1933) </li></ul><ul><ul><li>A populist, regulatory response to the Great Depression and the turmoil in the banking system. </li></ul></ul><ul><ul><li>Split commercial banks and investment banks </li></ul></ul><ul><ul><li>Commercial banks have a deposit base that is a source of strength in times of stress. </li></ul></ul><ul><ul><li>Investment banks are less regulated, have no deposit base, and can run their operations with higher leverage than banks are permitted to do. The Fed repealed the limits on leverage for investment banks, raising the risks associated with investment bank operations. </li></ul></ul>
  61. 62. FDIC Insurance <ul><li>Initially insured deposits up to $2500. This limit has been raised over time to $250,000 (temporarily through 2009, then it reverts back to $100,000). </li></ul><ul><li>Moral hazard: People will put their money in banks that pay a higher rate of interest than normal due to weak quality and poor prospects. </li></ul>
  62. 63. Federal Laws and Regulations <ul><li>Community Reinvestment Act of 1977 (amended in 1995) </li></ul><ul><ul><li>Initial idea was to eliminate “redlining” – requires banks to make loans in poor neighborhoods and prohibits discrimination against minorities. </li></ul></ul><ul><ul><li>OCC, FDIC and Fed examine banks and evaluate if banks are meeting their “affordable housing” goals </li></ul></ul><ul><ul><li>OCC can block bank mergers of banks whose CRA examination shows that the bank is not meeting their CRA “affordable housing” goals. </li></ul></ul><ul><ul><li>1995 Amendments had an “affordable housing” goal of 50% of loans – in other words, the target was for 50% of the loans owned by Fannie and Freddie to be subprime. </li></ul></ul>
  63. 64. SEC Overrules FASB <ul><li>Banks set aside reserves for loans that they expect to go into default in the future. </li></ul><ul><li>Accountants call this the “matching principle”. You want the expenses associated with each year’s earnings to reflect the actual and eventual economic outcome of your operations, rather than waiting to account for the loss when it actually happens several years in the future. </li></ul><ul><li>Banks used their own judgment and historical experience as a guide, based on various criteria. </li></ul><ul><li>The SEC, concerned that banks were setting aside too much in a “cookie jar reserve”, decreed that the figure must be calculated on actual losses sustained over the prior 5 years. </li></ul><ul><li>So in good times, banks under-reserved, and in bad times, they over-reserved. This is the opposite of good business practice. </li></ul><ul><li>This led to wide swings in the earnings and stock prices of banks. </li></ul>
  64. 65. Flaws in Accounting Rules
  65. 66. Historical Cost Accounting <ul><li>Prior to 1993, banks were permitted to use historical cost accounting and estimate their losses over time. </li></ul><ul><li>Historical cost accounting </li></ul><ul><ul><li>Used the purchase price of the mortgage as the beginning value for the mortgage. </li></ul></ul><ul><ul><li>Offered a limited amount of discretion to bank management to make changes to the values if they thought that the loan was permanently impaired. </li></ul></ul><ul><ul><li>Required banks to make estimates of the amount of loans that would go bad and write that amount off gradually over time. </li></ul></ul>
  66. 67. Changes in Accounting Rules <ul><li>Over time, the FASB started to favor marking assets and liabilities, to the extent possible, to their current market values and recognizing the unrealized gains and losses on assets and liabilities. </li></ul><ul><li>In 1993, FASB moved to mark-to-market accounting – the new rule was known as FAS 115. </li></ul><ul><li>Problems with the original rule caused it to be changed three times (FAS 119 in 1994, FAS 133 in 1998 and FAS 159 in Feb. 2007). </li></ul><ul><li>MTM accounting means that banks have to re-price the CMOs on their books based on recent prices at which the CMOs traded. This is true even if </li></ul><ul><ul><li>the loss is only expected to be temporary </li></ul></ul><ul><ul><li>The market value is based on a severely depressed price because the seller sold the CMO at a fire sale price. </li></ul></ul><ul><li>The problem is that the assets get marked down but the liabilities don’t. </li></ul>
  67. 68. Problem With MTM Accounting <ul><li>The result of marking assets to market while not marking the liabilities is that a mere temporary decline in the market value of the assets can make commercial and investment banks insolvent literally overnight. </li></ul><ul><li>This is not foreseeable by commercial bank and investment bank managers. </li></ul>
  68. 69. The Toxic Mix
  69. 70. Bank Balance Sheets <ul><li>Checking Accounts </li></ul><ul><li>Savings Accounts </li></ul><ul><li>Certificates of Deposit </li></ul><ul><li>Brokered CDs </li></ul><ul><li>Other Banks (@ Fed </li></ul><ul><li>Funds Rate) </li></ul><ul><li>Federal Reserve </li></ul><ul><li>(@ Discount Rate) </li></ul><ul><li>Cash </li></ul><ul><li>Loans to customers </li></ul><ul><li>Other Investments </li></ul><ul><ul><li>US Treasuries </li></ul></ul><ul><ul><li>Municipal Bonds </li></ul></ul><ul><ul><li>CMOs </li></ul></ul><ul><li>Loans to other banks (@ Fed Funds Rate) </li></ul><ul><li>Required deposits on reserve at the Fed </li></ul>Equities (Common Stock)
  70. 71. Quality of Bank Balance Sheets Deteriorated <ul><li>Banks traditionally would have loans, US Treasuries, Municipal Bonds, and funds lent to other banks and on deposit at the Fed, as the primary investments on their balance sheets. </li></ul><ul><li>Banks started buying AAA-rated MBS to increase their profits because MBS yield more than US Treasuries and Munis. </li></ul><ul><li>MBS are not as easy to sell at a fair price (i.e. they are not as “liquid”) as US Treasury securities, so added risk to the banks’ operating model. </li></ul>
  71. 72. Link of CRA to Mortgage Crisis <ul><li>The 1995 changes that required Fannie Mae and Freddie Mac to increase subprime loans to 50% of their newly-granted mortgages caused default rates to skyrocket. </li></ul><ul><li>Fannie and Freddie were operating at about a 98% debt and 2% equity ratio when they failed. </li></ul><ul><li>Franklin Raines, the former CEO of Fannie Mae, claimed in a Congressional hearing in 2004 that mortgages were so safe that such a high leverage ratio was prudent! </li></ul><ul><li>Raines’ statement might have been true had historical mortgage underwriting practices been used, but not in the modern era of MTM accounting, and subprime and ALT-A loans. </li></ul>
  72. 73. Link of CRA to Mortgage Crisis <ul><li>The relaxed lending standards probably would not have occurred had the CRA not forced the financial service industry to fund loans for non-qualified borrowers. </li></ul>
  73. 74. Lack of Discipline by Lenders “No Skin in the Game” <ul><li>The reduced down payment percentages allowed borrowers to default on their loans with little or no out of pocket risks. They put nothing down so had no “skin in the game”. </li></ul><ul><li>The mortgage originators sold the mortgages into the CMO market and did not retain any risks associated with the mortgages. They also had no “skin in the game”. </li></ul><ul><li>There have been some fraudulent loans made (“liar loans”). Some borrowers claim that they were duped into signing these mortgage contracts. </li></ul>
  74. 75. Link of Innovative Financial Products to Mortgage Crisis <ul><li>CMOs allowed mortgage originators to move the risks of their deteriorating mortgage underwriting standards to others. </li></ul><ul><li>The lower-quality CMO tranches were either retained by investment banks or sold to hedge funds who, in turn, funded their businesses with high leverage, hoping for high returns. </li></ul>
  75. 76. Link Between MTM Accounting and the Mortgage Crisis <ul><li>Some CMOs that were backed by subprime mortgages started losing value because of rising default rates on the mortgages that were backing the CMOs. </li></ul><ul><li>Other mortgages (whether backed by sound or subprime loans) began to lose value and were trading at “fire sale” prices – far below the value that the CMOs would ultimately be worth when all of the mortgages backing the CMO were paid. </li></ul><ul><li>Since it is difficult to find out which CMOs are backed by stronger credits and which ones are backed by weaker credits, all CMOs were marked down to “fire sale” prices. </li></ul><ul><li>Banks stopped lending to one another because they stopped trusting that their brethren would remain in business or that they would be bailed out by the Government. </li></ul>
  76. 77. Link of Innovative Financial Products to Mortgage Crisis <ul><li>Since it is hard to find out the quality of the mortgages in the CMOs, many of them are trading at a value far below what they are worth. </li></ul><ul><li>Banks do not trust each other since the leverage that banks use, coupled with MTM accounting, can make a bank insolvent overnight with no notice. </li></ul><ul><li>Banks are hoarding cash and not making loans to companies (employers) to fund their payrolls or equipment purchases. </li></ul><ul><li>Banks are also not making loans to individuals for homes, cars, etc. except for those with high credit ratings. </li></ul><ul><li>The purpose of the $700 million bailout package is to get the illiquid mortgages off of the banks’ balance sheets so that they have cash to make loans to businesses and individuals. </li></ul>
  77. 78. The Bailout/Rescue Package
  78. 79. Q: Why did Henry Paulson Choose $700 Billion? A: Because default rates on home mortgages are about 5%, and $700 billion is about 5% of the total amount of mortgage debt outstanding.
  79. 80. Failures and Forced Mergers Thus Far <ul><li>Bear Stearns – Acquired by JP Morgan </li></ul><ul><li>Fannie Mae and Freddie Mac – in Conservatorship </li></ul><ul><li>American International Group (AIG) --$123 Billion Bailout by the Federal Reserve Board </li></ul><ul><li>Lehman Brothers (Bankruptcy) </li></ul><ul><li>Merrill Lynch (Merger with Bank of America) </li></ul><ul><li>Washington Mutual (Failure, acquired by JP Morgan) </li></ul><ul><li>Wachovia (Failure, acquired Wells Fargo) </li></ul><ul><li>Important to note: All of the rescuing banks are commercial banks. They have the cash because they are managed more conservatively and have large, stable deposit bases (checking, savings) that investment banks were prohibited from providing. </li></ul>
  80. 81. Provisions of the Package <ul><li>Troubled Assets Relief Program ($700 Billion) </li></ul><ul><li>Extensions of the AMT patch, tax deductions on state and local sales taxes, tuition, teacher expenses and real property taxes and tax credits for business research and new market investors </li></ul><ul><li>Energy tax credits and incentives to encourage wind and refined coal production, new biomass facilities, wave and tide electricity generators, solar energy property improvements, CO2 capturing, plug-in electric drive vehicles, idling reduction units on truck engines, cellulosic biofuels ethanol production, energy efficient houses, offices, dishwashers, clothes washers and refrigerators, and fringe benefits for employees commuting by bicycle. </li></ul><ul><li>A requirement for private insurance plans to offer mental health benefits on par with medical-surgical benefits </li></ul>
  81. 82. Provisions of the Package <ul><li>Tax relief provisions for victims of this summer's Midwestern floods, and Hurricane Ike </li></ul><ul><li>Freezing of deductions for sale and exchange of oil and natural gas, mandatory basis reporting by brokers for transactions involving publicly traded securities and an extension of the oil spill tax </li></ul><ul><li>It also extends the following tax provisions: </li></ul><ul><li>Economic development credit to American Samoan businesses </li></ul><ul><li>$10,000 tax credit for training of mine rescue team members </li></ul><ul><li>50% immediate expensing for extra underground mine safety equipment </li></ul><ul><li>Tax credit for businesses with employees from an Indian reservation </li></ul><ul><li>Accelerated depreciation for property used mostly on an Indian reservation </li></ul>
  82. 83. Provisions of the Package <ul><li>50% tax credit for some expenditures on maintaining railroad tracks </li></ul><ul><li>7-year recovery period for motorsports racetrack property </li></ul><ul><li>Expensing of cleaning up &quot;brownfield&quot; contaminated sites </li></ul><ul><li>Enhanced deductions for businesses donating computers and books to schools, and for food donations </li></ul><ul><li>Deduction for income from domestic production in Puerto Rico </li></ul><ul><li>Tax credit for employees in Hurricane Katrina disaster area </li></ul><ul><li>Tax incentives for investments in poor neighborhoods in D.C. </li></ul><ul><li>Increased rehabilitation credit for buildings in Gulf area </li></ul><ul><li>Reduction of import duties on some imported wool fabrics, transfers other duties to Wool Trust Fund to promote competitiveness of American wool </li></ul><ul><li>Special expensing rules for film and TV productions </li></ul>
  83. 84. Provisions of the Package <ul><li>Increasing cover of rum excise tax revenues to Puerto Rico and the Virgin Islands </li></ul><ul><li>Making it easier for film and TV companies to use deduction for domestic production </li></ul><ul><li>Exempting children's wooden arrows from excise tax </li></ul><ul><li>Income averaging for Exxon Valdez litigants for tax purposes </li></ul>
  84. 85. Could this crisis have been prevented?
  85. 86. Reform Opportunities Lost <ul><li>April 2001 – President Bush’s first budget said that the GSEs were a “potential problem” and could cause “strong repercussions in the financial market” </li></ul><ul><li>2002 – The Wall Street Journal started editorializing about the dangers of the GSEs </li></ul><ul><li>September 2003 – President Bush suggested significant changes and more supervision. Barney Frank (Representative, D-MA) described the GSEs as “fundamentally safe”. “Affordable housing, and the GSEs meeting their “affordable housing goals” was the Democrats’ primary concern. </li></ul><ul><li>2004 – The GSEs were discovered to have been “cooking the books”, and the SEC is still investigating this matter. </li></ul><ul><li>February 2004 – Alan Greenspan suggested that strengthening regulation of the GSEs was warranted and that they “risked safe and sound financial markets” </li></ul>
  86. 87. Reform Opportunities Lost <ul><li>April 2005 – Charles Schumer (Senator, D-NY) says that “things are good in the housing market” and asked why people were “entertaining changes”. </li></ul><ul><li>April 2005 – Treasury Secretary John Snow testifies that the large portfolios of the GSEs, left unchecked in growth, posed a real problem. </li></ul><ul><li>April 2005, the Senate Banking Committee voted along party lines to do nothing. The Republicans voted to make changes and the Democrats voted to make no changes. The Democrats also blocked the reform measures proposed from being voted on by the Senate. </li></ul><ul><li>2006 – John McCain and other Congressmen sponsored a bill to rein in corporate welfare enjoyed by the GSEs. </li></ul><ul><li>The GSEs increased their CRA loans from $3 Trillion to $4 Trillion over the 3 year period ending January 2008 to prove to Congress that they still had value. </li></ul>
  87. 88. The Consequences of Failing to Act <ul><li>2007 – Oil prices rose and unemployment began to rise </li></ul><ul><li>The housing bubble started to burst as a small number of homeowners defaulted on their mortgages </li></ul><ul><li>January 2008 – Default rates hit 4% </li></ul><ul><li>January 2008 – Countrywide Financial failed and was acquired by Bank of America </li></ul><ul><li>March 2008 – Bear Stearns failed. Two of its hedge funds had failed in 2007 because a large percentage of their money had been invested in “toxic waste” tranches of CMOs backed by subprime mortgages. To avoid lawsuits, Bear had taken the mortgages out of the hedge funds and reimbursed investors for the losses. The government absorbed $29 billion of bad debt, and JP Morgan purchased Bear for $10/share. </li></ul>
  88. 89. The Consequences of Failing to Act <ul><li>July 2008 – IndyMac, a $38 Billion dollar thrift, is seized by the FDIC. There was a “run on the bank”, in part due to Charles Schumer’s remarks about the company, as $11 Billion was withdrawn from the thrift by depositors in 11 days. IndyMac had invested in a lot of Alt-A mortgages that require no documentation on income. </li></ul><ul><li>July 2008 – Warren Buffet says that “the scale of help needed can’t come from the private sector.” </li></ul><ul><li>9/7/08 – Fannie Mae and Freddie Mac are seized by the US Government </li></ul><ul><li>9/14/08 – Lehman Brothers files for bankruptcy when its discussions with Bank of America about a merger were terminated </li></ul><ul><li>9/14/08 – Merrill Lynch is acquired by B of A </li></ul>
  89. 90. The Consequences of Failing to Act <ul><li>9/16/08 – The Fed saves AIG with a $85 Billion loan and acquires an 80% stake in the firm. </li></ul><ul><li>9/17/08 – The stocks of Morgan Stanley and Goldman Sachs drop precipitously, and the SEC bans short selling in about 30 financial services firms, later increased to 799. Morgan and Goldman convert to commercial bank status so that they can access the Fed’s discount window permanently. </li></ul><ul><li>9/17/08 – Treasury Secretary Henry Paulson announces the $700 Billion bailout proposal. </li></ul><ul><li>During negotiations, House Republicans (represented by John Boehner and John McCain) object to $20 Billion of money going to ACORN and the provision is removed from the bill. </li></ul><ul><li>9/25/08 – The House rejects the bailout package after Nancy Pelosi (D-CA) blames the financial crisis on President Bush’s “failed economic policies” and the DJIA loses 778 points in one day. </li></ul>
  90. 91. The Consequences of Failing to Act <ul><li>9/29/08 – The Senate passes an expanded version of the bill (it went from 3 pages to over 100 pages to over 400 pages in its final version). </li></ul><ul><li>10/1/08 – The House passes the bill and President Bush signs it into law. </li></ul><ul><li>During the Presidential Debate, Sen. Obama blamed deregulation and Sen. McCain blamed government pushing the GSEs to make bad loans. Neither is entirely accurate. </li></ul>
  91. 92. Morals of the Story
  92. 93. <ul><li>A financial train wreck of this magnitude takes a long time to develop. This one took 75 years to come to a climax. </li></ul><ul><li>The conditions had to be just right – many things had to go wrong for a crisis of this magnitude to erupt. </li></ul><ul><li>When government substitutes its own judgments for those of capitalists who are putting their own money at risk, bad things happen. </li></ul><ul><li>Products that shift risk from one entity to another can be dangerous (in this case, the risk of mortgage defaults was shifted from banks to CMO purchasers.) </li></ul><ul><li>Subsidies for a specific sector of the economy (e.g. housing) will eventually create a bubble in pricing that in the long run comes to a bad end. </li></ul>
  93. 94. <ul><li>Regulatory bodies often can’t keep up with innovation in the capital markets. </li></ul><ul><li>Accountants often don’t understand (or care) about the consequences of their accounting rules. </li></ul><ul><li>Just because the bank is willing to make you a loan, you may not be wise to take it or be able to repay it. </li></ul><ul><li>Congressmen can make wrong choices because </li></ul><ul><ul><li>They are influenced by money </li></ul></ul><ul><ul><li>They are responding to pressure from their (ill-informed) constituents </li></ul></ul>
  94. 95. The Future
  95. 96. The Future – Near Term <ul><li>Treasury Secretary Paulson is acting quickly to buy up the MBS so that banks restore the cash in their coffers so that they will have money to lend. </li></ul><ul><li>Paulson also announced direct capital infusions to banks in the amount of $250 million – the money will be invested in preferred stock of the banks. </li></ul><ul><li>Federal Reserve will lower interest rates and keep them low. </li></ul><ul><ul><li>Discount Rate </li></ul></ul><ul><ul><li>Fed Funds Rate </li></ul></ul><ul><li>Initially, lower interest rates on CDs, savings accounts and other sources of funds for banks. </li></ul><ul><li>Hedge Funds have received many redemption requests from their limited partners. </li></ul><ul><li>Hedge Fund redemptions have been and may continue to be a main contributor to the weakness in the stock market, particularly since the beginning of October. </li></ul>
  96. 97. The Future – Near Term <ul><li>We may be nearing the end of the big stock market sell-off. </li></ul><ul><li>Economic Sector Effects </li></ul><ul><ul><li>Bad for Natural Resources stocks until economy improves (Metals, Chemicals, Oil and Gas) since people will use less energy and basic materials </li></ul></ul><ul><ul><li>Bad for Transportation stocks (slower economic activity means less to haul) </li></ul></ul><ul><ul><li>Bad for Consumer Durables (autos, housing, clothing, retailers) </li></ul></ul><ul><ul><li>Good for discount retailers (Wal-Mart, Target) </li></ul></ul><ul><ul><li>Good for Consumer Staples (P&G, Kimberly Clark, Kroger) </li></ul></ul><ul><ul><li>Good for Health Care (people always need health care services) </li></ul></ul><ul><ul><li>Possibly good for Telecommunications (high-yielding stocks), although they borrow a lot. </li></ul></ul><ul><ul><li>Possibly good for Utilities (high-yielding stocks), although they borrow a lot. </li></ul></ul><ul><ul><li>Bad for Industrials and Information Technology (slower growth means less infrastructure and business capital spending). </li></ul></ul><ul><ul><li>Bad for Financials (crisis means more regulation and a long time before confidence is restored; higher loan quality means less loan growth means lower profits; fewer CMOs means less servicing income). </li></ul></ul><ul><ul><li>Bad for any nation that sells to the US (Canada, China, other Asian countries). </li></ul></ul>
  97. 98. The Future – Near Term <ul><li>Earnings numbers for analysts have to come down. </li></ul><ul><ul><li>Strategists believe earnings will decline by 15.7% in 2008 and 1.6% in 2009. I believe that these numbers may be cut as more economic weakness occurs. </li></ul></ul><ul><ul><li>Analysts believe that earnings will decline by 6% in 2008 and rise by 34.2% in 2009. These are unrealistic expectations. </li></ul></ul><ul><ul><li>Strategists tend to be more accurate. </li></ul></ul><ul><ul><li>P/E multiple using strategist estimates is 13.1 and using analyst estimates is 8.6. Long term average is 14. Stocks are modestly undervalued whichever of the earnings numbers that you use. Stocks may way overshoot on the downside – it has happened before. </li></ul></ul><ul><ul><li>Lower P/Es may prevail due to more conservative banking practices and less leverage in the system to feed rising stock prices. </li></ul></ul><ul><ul><li>The aging US population requires more immigration. More immigrants means that our value systems may be altered. Also, we need immigrants to prop up the Social Security system if it the system is not changed (lower benefits, longer working careers, higher Social Security taxes). </li></ul></ul>
  98. 99. The Future – Near Term <ul><li>Other asset-backed securities may cause problems similar to those suffered by CMOs </li></ul><ul><ul><li>Credit card receivables </li></ul></ul><ul><ul><li>Auto loans </li></ul></ul><ul><ul><li>Student loans </li></ul></ul><ul><ul><li>Bank loans to businesses </li></ul></ul><ul><li>Countries may pursue “beggar-thy-neighbor” policies that grant unlimited government insurance for bank deposits in order to attract capital. Ireland and Germany are already doing this. </li></ul><ul><li>There will be increased regulation over hedge funds and other less-regulated financial entities. </li></ul>
  99. 100. The Future – Longer Term <ul><li>We are already in a recession, and it is likely to be 3-5 years minimum in duration. </li></ul><ul><li>We should avoid a depression. </li></ul><ul><li>Weakness will be global. </li></ul><ul><li>Europe is beginning to have problems with bank failures and illiquidity, but their central bank does not have the ability to help out troubled banks and any bailouts will have to be at the country/government level. </li></ul><ul><li>Investment and commercial banks will use less leverage. </li></ul><ul><li>The era of large independent investment banks is over – remember that there are still small, regional brokerage houses and investment banks that exist. </li></ul><ul><li>Accountants will cling to MTM accounting. </li></ul><ul><li>Fannie Mae and Freddie Mac probably should be permanently reabsorbed into the federal government. Housing subsidies for the poor should be a governmental activity. </li></ul>
  100. 101. The Future – Long Term <ul><li>The Fed will have to permanently increase the Federal Reserve Notes in circulation because the lower leverage of banks. Inflation may be in our future. </li></ul><ul><li>For banks to improve their rates of return with lower leverage, they will raise interest rates for borrowers </li></ul><ul><li>Probably bad, ineffective regulations will be established to placate unhappy voters, with bad results. </li></ul><ul><li>The capitalist system will have to figure out how to work around the inevitable new regulations to fund business activity and individuals’ needs for long-term credit. </li></ul><ul><li>30-year fixed mortgages will be funded by Fannie Mae and Freddie Mac, not banks. </li></ul><ul><li>Fannie and Freddie will continue to be used by Congressmen who have an eye on re-election to curry favor with voters. </li></ul>
  101. 102. The Future – Long Term <ul><li>We may have seen the peak of US hegemony in the world. Will China be the next superpower to lead the world? </li></ul><ul><li>How will we wean ourselves off of the higher FDIC limits and moral hazard that they and the $700 Billion bailout package have created? How will we restore prudent decision-making that is based on credit quality and the assumption that making a bad loan will result in a bank losing money, rather than being bailed out by the government? </li></ul><ul><ul><li>More government regulations </li></ul></ul><ul><ul><li>Perhaps legislated limits on the percentage of income that a person may have outstanding – both in total as well as just for a home mortgage? </li></ul></ul><ul><li>Government may have to step in to stop lawsuits from overwhelming the fragile banking system. </li></ul>
  102. 103. Conditions That Attract Business and Capital <ul><li>Low taxes </li></ul><ul><li>Minimal regulation and smart regulation </li></ul><ul><li>Educated workforce </li></ul><ul><li>Ample natural resources </li></ul><ul><li>Stable prices (little inflation) </li></ul><ul><li>Access to readily available capital at reasonable rates of return to quality borrowers </li></ul><ul><li>A legal system that </li></ul><ul><ul><li>Favors private property rights </li></ul></ul><ul><ul><li>Disfavors frivolous lawsuits </li></ul></ul>
  103. 104. We need to keep these concepts in mind as we work through this crisis in the financial services industry.
  104. 105. Final Thoughts <ul><li>Capitalism and democracy are a winning combination. </li></ul><ul><li>More capitalism tends to lead to more democratic values (e.g. China). </li></ul><ul><li>Future shooting wars will be with dictatorships and oligarchies with little respect for capitalism and democratic values. </li></ul><ul><li>Concern: Government-run pools of money (e.g. China’s) may buy in to US companies, buy our land, and try to dictate our future. Will economic wars be the wars of the future? </li></ul><ul><li>As other countries grow, the influence of the US will weaken. </li></ul><ul><li>It is hard to build a consensus when many countries are involved in decision-making. Power is becoming more diffuse. Government intervention and Federal Reserve intervention will be less effective in the future. </li></ul><ul><li>As international trade becomes a bigger and bigger percentage of our total economic activity, it will be harder for us to control our destiny. This is why it is critical for the US to spread capitalism and democracy abroad while we still own the mantle of leadership as a superpower. </li></ul>