2. In early to 2001 the U.S. economy fell into a
recession in the wake of:
the “dot.com” bubble burst
9/11
the wars in Afghanistan and Iraq
To stimulate a slowing economy, the FED
reduced interest rates, reaching a record low
in 2003
3. Central bankers in other countries followed the
lead of the U.S. lowering their own interest rates
Commodity producing, countries such as
China, those in the Middle East, and Russia were
acquiring a large sum of U.S. dollars.
Many of these countries bought U.S. Treasury Bonds
Eventually, in search of a higher return, they
bought riskier financial instruments such as
bonds backed by subprime mortgages
4. An unprecedented period of financial innovation was spurred as interest
rates fell, demand for U.S. investments increased, and internet
technology improved
Complex new securities were developed:
Ex. Bonds based on pools of mortgages, auto loans, credit card debt, and
commercial bank loans were combined and then divided and sold based on
their risk levels
Mortgage payments no longer flowed from homeowners to the bank.
Instead payments were
pooled together and flowed
to investors who owned
mortgage backed bonds.
5. Mortgages and other loans were now bundled as tradable
securities based on risk.
Ex. Investors could buy a high risk bundle and earn a high return
or a low risk bundle and earn a low return.
These securities were popular because investors could
calculate the risk of their investments exactly and get
healthy returns.
Mortgage backed securities were especially popular
because:
American homeowners are particularly reliable mortgage
payers
Historically, homes in the U.S. have steadily climbed in value.
6. Buyers flooded the markets and squeezed
profits, as returns fell investors began to use
leverage to boost returns.
Leverage: investing with borrowed money
Ex. “Returns are falling but if I invest twice as
much, I can still earn a large profit. I’ll have to
invest with borrowed money.”
7. Traditionally, a borrower could only get a loan if
the banker considered the risk of default on the
loan to be low enough.
In the new scheme, as long as investors were
willing to buy risky assets people could still get
loans.
Banks and mortgage brokers no longer had to
bear the risk of a loan, (investors were bearing
the risk) so they could afford to make more and
more loans with increasing risk.
8. Since mortgage backed securities were so
popular, lenders avidly pursued home buyers.
Even people with a poor credit history could now
buy homes with a sizeable down payment and
reliable income.
Eventually they didn’t even need that.
In the wake of 9/11, Americans were reluctant to
travel. Instead they bought bigger, nicer homes.
9. Home sales took off, home prices rose quickly.
Homeowners could profit from the increasing
value of the homes.
Big mortgages meant big profits.
Housing speculators (flippers) began to buy and
sell homes quickly.
Everyone was caught up in the notion that
housing was a great investment.
10.
11. The monetary policy of lowering interest rates
until they bottomed out in 2003 had worked.
People were making loan-financed purchases
(such as homes).
Wealth increased, GDP increased.
It was time to turn off the stimulus and raise
interest rates.
12. As homes became less affordable, lenders couldn’t
continue to make loans to marginal borrowers.
After many years of rising housing prices and interest
rates, many home buyers simply couldn’t afford their
mortgages.
The demand for housing cooled off; home prices fell.
But home builders continued building a record
number of homes, ignoring the weakening market.
13. Trying to attract more home buyers and boost the declining housing
market, lenders began to offer adjustable-rate mortgage loans (ARMs).
ARMS came with a extremely low interest rate for the first two
years, then it increased to match market rates.
Most ARMS went to subprime borrowers who often:
had a poor credit history
put down little money, so they had little to lose in foreclosure
overstated their income
Subprime Mortgages
a loan made to someone with weak or troubled credit history
historically a very small market
now known as a major player in economic history
14. Federal and state regulators failed to intervene with run-away mortgage
lending.
Government regulators couldn’t keep up with lenders who were
constantly dodging regulation.
The Securities and Exchange Commission was distracted by insider
trading scandals.
The Federal Reserve exhibited distaste for regulation.
Small federal agencies such as the FDIC had little impact without backing
from The Fed.
Rating agencies (Moody’s and Standard and Poor) were limited by poor
data and out-of-date models that couldn’t accurately represent cutting
edge financial innovation.
15. Investors around the world began to grow weary of the
troubles in the U.S. housing market.
Bear Stearns announced that some of their hedge
funds, which had invested aggressively in mortgage-
related securities, were losing money and facing failure.
In the following weeks the damage from subprime
mortgages began to show itself throughout the financial
system.
Investors began running for the door and banks stopped
issuing other mortgage-backed bonds.
16. With U.S. mortgage security holdings so
widely dispersed, and with little information
about who was suffering losses and to what
extent, banks shrank from doing business
with each other.
Fewer thought it a good idea to borrow or
lend, and those that would demanded much
higher interest rates to compensate for the
greater risk they now believed to exist.
17. Banks’ mortgage holdings turned toxic.
Banks couldn’t even keep track of their losses.
Trading had collapsed in the mortgage securities
market.
They began feverishly writing down the value of
these assets
Investors grew wary of risk other parts of the
credit market showed signs of stress.
18. Financial guarantors are institutions that sell insurance on bonds.
Providing insurance on government bonds is their main service.
Governments almost never default so it has been a consistent and
profitable business.
These guarantors began to sell insurance on other types of
securities.
They promised to compensate buyers if their mortgage-related
bonds ever defaulted.
As the housing and mortgage markets fell into turmoil, these
insurance payments crippled the guarantors.
Ex. AIG
19. Broker dealers are investment firms that buy and sell securities
both for customers and for themselves.
They often borrow heavily to make large bets on securities
including securities backed by mortgages.
Bear Stearns bet big on the residential mortgage market.
As the housing and mortgage markets collapsed, confidence in the
firm’s viability weakened.
Bear Stearns invested with borrowedmoney, when the institutions
that lent them money begin withdrawing those funds, Bear only
had two options: bankruptcy or selling out.
20. Out of fear of what might happen to the
financial system if Bear failed, the FED
engineered the sale of Bear Stearns to
JPMorgan Chase.
To make the deal work, the FED agreed to
absorb any losses on tens of billions of dollars
in risky Bear Stearns securities that JPMorgan
Chase had acquired in its takeover of the
failed firm.
21. A few months after the Bear Stearns buy out things took a turn for the worse.
Fannie Mae and Freddie Mac were publicly traded companies with a federal
government charter to promote home-ownership by providing cheap credit to
minorities and disadvantaged groups.
During the height of the housing boom, with competition from other subprime
lenders, Fannie and Freddie started to push into the risky mortgage market.
Losses at Fannie and Freddie began to mount, their stock prices fell, and their
borrowing costs began to rise, increasing mortgage rates for home buyers.
The Bush Administration felt it had no choice but to take over Fannie and
Freddie.
This spooked investors.
22. Investors’ fears boiled over when policymakers allowed
broker-dealer Lehman Brothers to fail one week later
The FED tried to find a buyer for Lehman as they did for
Bear Stearns but no one stepped forward.
The FED couldn’t help because Lehman didn’t have enough
assets, and the Treasury said they couldn’t bail out everyone
and that the system had enough time to prepare for a Lehman
failure.
When Lehman failed, a major money market fund lost
value and investors started to withdraw.
23. Money market funds are large investors in
Commercial Paper—the short-term IOUs of
major businesses—but they had to stop buying
CP in order to pay investors.
This crippled large businesses trying to finance
their basic operations.
The entire financial system was brought to the
brink of collapse.
24. The Treasury Secretary and FED Chairman Bernanke
developed the Troubled Asset Relief Program to buy
the banking system’s toxic assets.
The plan was poorly explained and unpopular with
taxpayers.
Initially the plan didn’t pass in Congress and financial
markets suffered.
Congress voted again a few days later and passed
TARP.
used for direct capital injections for banks.
25. The entire financial system was hemorrhaging losses.
Loans to consumers, businesses, and even state and local
governments became scarcer and more costly.
Without credit home sales buckled and subprime borrowers who
hoped to refinance before their mortgage payments adjusted
higher could not do so.
Even businesses found themselves facing more stringent and
costly terms.
Without credit the economy crumbled. Stocks in commercial and
investment banks, mortgage insurers, and financial guarantors
collapsed.
