For Fox News, October 1, 2008
(~ $250,000) Hold it Sell it “ lending” Homeowner Originator
Mortgage Mortgage Mortgage Mortgage Mortgage Mortgage Mortgage Mortgage Mortgage Mortgage Mortgage MBS (~ $100 million) In...
MBS MBS MBS MBS  MBS  MBS  MBS  MBS  MBS  MBS  MBS  MBS  MBS  MBS MBS MBS MBS CMO (~ $2 billion) Institutional investor bu...
CMO AAA (low risk/low return) AA A B (higher risk/higher return) BBB BBB - “Credit enhanced” but credit insurance fails Un...
Assets (things ow N ed) Liabilities (things o W ed) Cash $1 billion Buildings $1 billion Treasury bonds $10 billion Other ...
Assets (things ow N ed) Liabilities (things o W ed) Cash $1 billion Buildings $1 billion Treasury bonds $10 billion Other ...
Assets (things ow N ed) Liabilities (things o W ed) Cash $1 billion Buildings $1 billion Treasury bonds $10 billion Other ...
Time U.S. Home Price Index ??? 1990 2002 2006 The “Bubble”
<ul><li>Poor underwriting practices: </li></ul><ul><ul><li>Mortgage originators were paid a commission upfront so they had...
<ul><li>Partisan  Democrats  say markets stink </li></ul><ul><li>Partisan  Republicans  claim regulators reek </li></ul><u...
<ul><li>The home price bubble </li></ul><ul><ul><li>People paid too much with the expectation that they could always “flip...
<ul><li>Various policies promoting high home ownership rates </li></ul><ul><ul><li>Low interest rates; mortgage interest d...
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  1. 1. For Fox News, October 1, 2008
  2. 2. (~ $250,000) Hold it Sell it “ lending” Homeowner Originator
  3. 3. Mortgage Mortgage Mortgage Mortgage Mortgage Mortgage Mortgage Mortgage Mortgage Mortgage Mortgage MBS (~ $100 million) Institutional investor buys and holds Investment bank pools it into a derivative “securitization”
  4. 4. MBS MBS MBS MBS MBS MBS MBS MBS MBS MBS MBS MBS MBS MBS MBS MBS MBS CMO (~ $2 billion) Institutional investor buys and holds safer parts Investment banks hold riskier parts “pooling”
  5. 5. CMO AAA (low risk/low return) AA A B (higher risk/higher return) BBB BBB - “Credit enhanced” but credit insurance fails Unexpectedly high default rates ~ 25% so prices plummet “repackaging”
  6. 6. Assets (things ow N ed) Liabilities (things o W ed) Cash $1 billion Buildings $1 billion Treasury bonds $10 billion Other assets $68 billion CMOs $20 billion _______________________ $100 billion Long term borrowings $50 billion Short term borrowings $40 billion ___________________________ $90 billion NET WORTH (A-L) = $10 billion
  7. 7. Assets (things ow N ed) Liabilities (things o W ed) Cash $1 billion Buildings $1 billion Treasury bonds $10 billion Other assets $68 billion CMOs $10 billion _______________________ $100 billion $90 billion Long term borrowings $50 billion Short term borrowings $40 billion ___________________________ $90 billion NET WORTH (A-L) = $0 *Short term creditors stop lending *Rating agencies downgrade so the IB can’t sell more long term debt *Regulators step in to ensure the IB does not become a “zombie”
  8. 8. Assets (things ow N ed) Liabilities (things o W ed) Cash $1 billion Buildings $1 billion Treasury bonds $10 billion Other assets $68 billion CMOs $??? billion _______________________ $100 billion $??? billion Long term borrowings $50 billion Short term borrowings $40 billion ___________________________ $90 billion NET WORTH (A-L) = $??? *Short and long term creditors stop lending *Bank must suspend new business *Economy begins to suffer: -real GDP declines -increased unemployment -more mortgage defaults …
  9. 9. Time U.S. Home Price Index ??? 1990 2002 2006 The “Bubble”
  10. 10. <ul><li>Poor underwriting practices: </li></ul><ul><ul><li>Mortgage originators were paid a commission upfront so they had an incentive to sign up literally anybody </li></ul></ul><ul><ul><li>Competition for business leads to “a race to the bottom” in terms of credit standards </li></ul></ul><ul><ul><li>RESULT = </li></ul></ul><ul><ul><li>NINJA loans </li></ul></ul><ul><ul><li>125% of equity </li></ul></ul><ul><ul><li>ARMs, etc. </li></ul></ul>
  11. 11. <ul><li>Partisan Democrats say markets stink </li></ul><ul><li>Partisan Republicans claim regulators reek </li></ul><ul><li>Statesmen and scholars know that both are right (wrong) </li></ul><ul><li>Hybrid failure = both market and government failures needed to create this stench </li></ul>
  12. 12. <ul><li>The home price bubble </li></ul><ul><ul><li>People paid too much with the expectation that they could always “flip” for a profit </li></ul></ul><ul><li>Asymmetric information </li></ul><ul><ul><li>Unclear which institutions are solvent and which are not so credit markets are frozen </li></ul></ul><ul><li>Uncertainty </li></ul><ul><ul><li>Nobody knows what the future will bring so there are wild swings in stock prices, spreads, and so forth </li></ul></ul>
  13. 13. <ul><li>Various policies promoting high home ownership rates </li></ul><ul><ul><li>Low interest rates; mortgage interest deduction; market meddling via Freddie, Fannie </li></ul></ul><ul><li>Too Big To Fail Policy </li></ul><ul><ul><li>Encouraged financial institutions to grow larger instead of stronger/safer </li></ul></ul><ul><li>Regulators’ neglect of history </li></ul><ul><ul><li>The 6 mortgage securitization schemes that blew up between the Civil War and W.W. II were forgotten. </li></ul></ul><ul><ul><li>Also ignored was the fact that the insurance industry and regulators worked together to fix a similar incentive problem. </li></ul></ul>

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