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U.S. Financial Crisis

                       Sarinee Achavanuntakul
                         Fringer | คนชายขอบ
                       http://www.fringer.org/
                                10 November 2008
Most slides are taken from http://www.slideshare.net/econman/the-credit-crisis-of-
                                2008a-presentation
The credit crisis, illustrated: the beginning
..when 2008 rolls around:
Roots of the crisis: the housing bubble
Fuelling the bubble: low interest rates
Mortgage securitization
Moral hazard                  “credit ease”
• “Subprime” is defined as borrower who has FICO credit score less
  than 620, but some lenders also define borrowers whose FICO score
  are as high as 680 as “subprime” if their down payment is <5%
• Typical subprime mortgage is “Adjustable-rate Mortgage” (ARM): a
  2/28 ARM means fixed interest rate for the first 2 years, then floating
  rate (e.g. LIBOR + 6%) for the remaining 28 years
• Often requires no down payment, can borrow 100% of house value,
  and has no rigorous credit check – “NINJA” borrowers, “Liar loans”
• Zimmerman (2007) proves that subprime loan quality in 2007 is worse
  than in 2006, and 2006 were worse than 2005
• New subprime loans were $421,000 million in 2006 (S&P estimate);
  AMP Capital Investors estimates $1.4 trillion subprime loan
  outstanding in July 2007
• Fannie Mae estimates that 50% of those who were sold subprime
  loans would have qualified for prime-rate loans
Credit Default Swap (CDS)
• Investors seek insurance to cover unexpected
  defaults on loans
Fraud, over-leverage, and non-transparency
 • Fraud:
    – Unfair or misleading credit terms, e.g. ARM, universal default
    – Moody’s supposed “bug” in their credit rating model that
      resulted in some bonds being overrated by 4 notches (5/2008)
 • Over-leverage:
    – Many banks & hedge funds over-leverage to make easy money
      on CDOs: 25-30x times their capital
 • Non-transparency:
    – Financial institutions use off-balance-sheet vehicles e.g. Special-
      Purpose Vehicle (SPV) to hide real exposure and evade taxes
    – Most subprime-linked derivatives are traded on 100% private,
      OTC (“over-the-counter”) basis, so nobody knows the market
      size   problem applies to the whole “shadow banking system”
Agency problems, wrong incentives
• Problems at the top
   – “When the music stops, in terms of liquidity, things will be
     complicated. But as long as the music is playing, you’ve got to get
     up and dance. We’re still dancing.” Citigroup’s Chuck Prince, in an
     interview with Financial Times, July 2007
   – Retired in November 2007 with $38 million pay package
• Problems down below:
   – Traders are compensated for short-term performance – if they take
     positions that have 5% chance of total catastrophe, they will be well
     rewarded year after year as long as that 5% never materializes
   – What the traders receive are therefore just “insurance premiums”
     but they thought they are smart!
   – Internal risk management gets weaker the more profits they make
   – Hard to separate true “alpha” (idiosyncratic, firm-specific) from
     “beta” (systemic, overall market returns) risks
What went wrong…
Multiplied losses
“Those guys are good.”
How a bank works
• Most bank “liabilities” are deposits which are short-term in
  nature (e.g. 2-year fixed deposits), while most “assets” are
  longer-term loans (e.g. mortgages or CDOs which are
  “investments”). Mortgages are the longest-term loans.
• Banks must mark-to-market the value of their investments.
• Example: Wachovia balance sheet @ 30/6/08 (prior to
  Citigroup takeover):
              Assets                       Liabilities & Equity

  Current assets       $110        Short-term debt            $505
  Long-term assets                 Long-term debt             $230
     Investments       $600        Equity (shareholders)       $75
     Others            $100

  Total                $810        Total                      $810
Why banks fail so dramatically
               Assets                           Liabilities & Equity
  Current assets           -$90          Short-term debt           $305
  Long-term assets                       Long-term debt            $230
     Investments           $500          Equity (shareholders)      -$25
     Others                $100

  Total                    $510          Total                    $510
• Borrower defaults + house prices collapse        market value of
  investments / mortgages collapse (ex. $100 in above example)
• Bank must record falling value of investments as losses      erode bank
  capital until shareholder’s equity is negative    insolvent
• Meanwhile, if bank’s debtors (depositors or other financial institutions)
  withdraw funds or demand loan prepayment, bank may face a severe
  liquidity crisis until it is bankrupt
• Bailout: buy toxic assets from banks (not a good idea: at what price &
  certain losses) or raise capital (better, but can Republicans accept?)
• If public funds are used, ex-shareholders should not reap benefits
U.S. household debt problem is not over
• Currently 8.8 million Americans have negative home equity
  – a record figure
• Total mortgage market in U.S. is approx $11 trillion (79%
  of GDP). About 13% of these are subprime
• U.S. households have $1 trillion credit card debt + $0.7
  trillion auto loan. These debts often have no collateral –
  repayment depends solely on borrower’s ability to repay
• Tough & unfair credit terms + rising cost of living (oil, food,
  etc.) erode ability to repay
• Since mortgages are often the last kind of loans people
  would default (house = the most valued asset), the
  subprime crisis suggests that they have already defaulted
  on credit cards and other kinds of loans
• These loans have been securitized too. So… watch out!
The end of neoliberal economics?
What will happen next?

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US Financial Crisis

  • 1. U.S. Financial Crisis Sarinee Achavanuntakul Fringer | คนชายขอบ http://www.fringer.org/ 10 November 2008 Most slides are taken from http://www.slideshare.net/econman/the-credit-crisis-of- 2008a-presentation
  • 2. The credit crisis, illustrated: the beginning
  • 4. Roots of the crisis: the housing bubble
  • 5. Fuelling the bubble: low interest rates
  • 7. Moral hazard “credit ease” • “Subprime” is defined as borrower who has FICO credit score less than 620, but some lenders also define borrowers whose FICO score are as high as 680 as “subprime” if their down payment is <5% • Typical subprime mortgage is “Adjustable-rate Mortgage” (ARM): a 2/28 ARM means fixed interest rate for the first 2 years, then floating rate (e.g. LIBOR + 6%) for the remaining 28 years • Often requires no down payment, can borrow 100% of house value, and has no rigorous credit check – “NINJA” borrowers, “Liar loans” • Zimmerman (2007) proves that subprime loan quality in 2007 is worse than in 2006, and 2006 were worse than 2005 • New subprime loans were $421,000 million in 2006 (S&P estimate); AMP Capital Investors estimates $1.4 trillion subprime loan outstanding in July 2007 • Fannie Mae estimates that 50% of those who were sold subprime loans would have qualified for prime-rate loans
  • 8. Credit Default Swap (CDS) • Investors seek insurance to cover unexpected defaults on loans
  • 9. Fraud, over-leverage, and non-transparency • Fraud: – Unfair or misleading credit terms, e.g. ARM, universal default – Moody’s supposed “bug” in their credit rating model that resulted in some bonds being overrated by 4 notches (5/2008) • Over-leverage: – Many banks & hedge funds over-leverage to make easy money on CDOs: 25-30x times their capital • Non-transparency: – Financial institutions use off-balance-sheet vehicles e.g. Special- Purpose Vehicle (SPV) to hide real exposure and evade taxes – Most subprime-linked derivatives are traded on 100% private, OTC (“over-the-counter”) basis, so nobody knows the market size problem applies to the whole “shadow banking system”
  • 10. Agency problems, wrong incentives • Problems at the top – “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Citigroup’s Chuck Prince, in an interview with Financial Times, July 2007 – Retired in November 2007 with $38 million pay package • Problems down below: – Traders are compensated for short-term performance – if they take positions that have 5% chance of total catastrophe, they will be well rewarded year after year as long as that 5% never materializes – What the traders receive are therefore just “insurance premiums” but they thought they are smart! – Internal risk management gets weaker the more profits they make – Hard to separate true “alpha” (idiosyncratic, firm-specific) from “beta” (systemic, overall market returns) risks
  • 13. “Those guys are good.”
  • 14. How a bank works • Most bank “liabilities” are deposits which are short-term in nature (e.g. 2-year fixed deposits), while most “assets” are longer-term loans (e.g. mortgages or CDOs which are “investments”). Mortgages are the longest-term loans. • Banks must mark-to-market the value of their investments. • Example: Wachovia balance sheet @ 30/6/08 (prior to Citigroup takeover): Assets Liabilities & Equity Current assets $110 Short-term debt $505 Long-term assets Long-term debt $230 Investments $600 Equity (shareholders) $75 Others $100 Total $810 Total $810
  • 15. Why banks fail so dramatically Assets Liabilities & Equity Current assets -$90 Short-term debt $305 Long-term assets Long-term debt $230 Investments $500 Equity (shareholders) -$25 Others $100 Total $510 Total $510 • Borrower defaults + house prices collapse market value of investments / mortgages collapse (ex. $100 in above example) • Bank must record falling value of investments as losses erode bank capital until shareholder’s equity is negative insolvent • Meanwhile, if bank’s debtors (depositors or other financial institutions) withdraw funds or demand loan prepayment, bank may face a severe liquidity crisis until it is bankrupt • Bailout: buy toxic assets from banks (not a good idea: at what price & certain losses) or raise capital (better, but can Republicans accept?) • If public funds are used, ex-shareholders should not reap benefits
  • 16. U.S. household debt problem is not over • Currently 8.8 million Americans have negative home equity – a record figure • Total mortgage market in U.S. is approx $11 trillion (79% of GDP). About 13% of these are subprime • U.S. households have $1 trillion credit card debt + $0.7 trillion auto loan. These debts often have no collateral – repayment depends solely on borrower’s ability to repay • Tough & unfair credit terms + rising cost of living (oil, food, etc.) erode ability to repay • Since mortgages are often the last kind of loans people would default (house = the most valued asset), the subprime crisis suggests that they have already defaulted on credit cards and other kinds of loans • These loans have been securitized too. So… watch out!
  • 17. The end of neoliberal economics?