2008 Financial Crisis
2003-2007 Real Estate and Financial Boom
·
2003-2007 The U.S. economy grows
for more than five years
·
Since
World War II, the average time between recessions has been just 57 months. On
the other hand, the last period of sustained economic growth lasted 10 years,
from 1991 to 2001. And the one before that lasted 92 months, from 1982 to 1990.
·
2001-2007 The US budget deficit
and trade deficit continue to grow
·
Developing countries will not be prepared to go on financing America’s
massive current-account deficit for much longer. At some point, therefore,
America’s cost of capital could rise sharply. There is a risk that the American
economy will face a sharp financial shock and a recession, or an extended
period of sluggish growth. Falling house prices would add to Americans’
existing concerns about stagnant real wages, creating more support for
protectionism.
·
In
a speech in 2004, then Federal Reserve Chairman Alan Greenspan said: "It
is difficult to imagine that we can continue indefinitely to borrow savings
from abroad at a rate equivalent to 5% of U.S. gross domestic product." By
the third quarter of 2006, the U.S. was dependent on foreign lending to the
tune of more than $860 billion, or about 6.5% of gdp, and the need for foreign
money will most likely hang above 6% through 2007. The big question: Can the
U.S. continue to count on this massive amount of foreign capital to fund its
overseas obligations and finance its economic growth
·
2001-2005 US
Housing/Real Estate Boom
·
The real estate boom is encouraged by low interest
rates, and declines as interest rates rise in 2004-2006
·
Subprime lending is loans to borrowers who
do not qualify for the best market interest rates because of their deficient
credit history or lack of documentable income. Subprime lending includes
mortgages, car loans, and credit cards, among others. 25% of the population of
the United States falls into this category (FICO credit score < 620)
·
Subprime
Mortgage Market: The value of U.S. subprime mortgages was estimated at
$1.3 trillion (from 7.5 million mortgages outstanding).
·
In 2006, subprime originations accounted for 20% of all
mortgages. Subprime lending volume was at an unsustainably high level.
Historically, subprime mortgages have represented 10% to 12% of the total
mortgage market. – BW
·
Factors in the subprime mortgage market boom:
o
Mortgage
Securitization led to increase in subprime loans as risk was diffused.
§
Mortgage lenders (e.g. banks or specialty mortgage
companies) sold their loans to third parties (e.g. investment banks) who
packaged them into securities (e.g.
mortgage-backed securities or collateralized debt obligations) and sold them to
investors (e.g. hedge funds or pension funds)
§
80% of mortgages are now sold off by the original
lenders. This lessens the risk to the loan originators (mortgage brokers and
lenders like banks)
§
Personal links between lenders and their creditors were
severed. When subprime loan payers defaulted on their obligation, foreclosure
was perceived as the only recourse for investors in the loan.
o
Automated lending
processes,
designed to prohibit discrimination during the lending process, limits the
analysis of a potential borrower's financial condition to the credit score and
just three criteria: the applicant's income, the appraised value of property
that served as collateral for the mortgage, and the ratio between the loan
sought and the property value.
o
Low interest rates from 2001 to 2005 led investors to
seek riskier, high-yield investments
o
Subprime lenders lowered their lending standards in 2006
as they competed for business – BW
§
Regulators
first noticed credit standards deteriorating late in 2003. By then, Fitch
Ratings had already placed one major subprime lender on “credit watch.” In
fact, data collected by the Federal Reserve Board clearly indicated that
lenders had started to ease their lending standards by early 2004. Despite
those warning signals, in February of 2004 the leadership of the Federal
Reserve Board seemed to encourage the development and use of adjustable rate
mortgages. The then-Chairman of the Fed said, in a speech to the National
Credit Union Administration, said: “American consumers might benefit if lenders
provided greater mortgage product alternatives to the traditional fixed-rate
mortgage.”
Shortly thereafter, the Fed went on a series of 17 interest rate hikes in a
row, taking the fed funds rate from 1% to 5.25%. – Christopher Dodd, 3/22/2007
o
Thomas Sowell claimed that government policy actually
encouraged the development of the subprime debacle through legislation like the
Community Reinvestment Act, which they say forces banks to lend to otherwise
uncreditworthy consumers.
o
In 1995, Fannie Mae and Freddie Mac began receiving
affordable housing credit for purchasing mortgage bank securities which
included loans to low income borrowers, including subprime securities. As of
November 2007 Fannie Mae a held a total of $55.9 billion of subprime securities
and $324.7 billion of Alt-A securities in their portfolios. As of the 2008Q2
Freddie Mac had $190 billion in Alt-A mortgages. Together they have more than
half of the $1 trillion of Alt-A mortgages.
·
Participants
in the Subprime Crisis:
o
Subprime
lenders: some of whom use predatory practices as the demand for mortgage backed
securities rise
o
Government:
lack of oversight.
§
In June 2008 Conde Nast Portfolio reported that numerous
Washington, DC politicians over recent years had received mortgage financing at
noncompetitive rates at Countrywide Financial because the corporation
considered for the officeholders under a program called
"FOA's"--"Friends of Angelo". Angelo being Countrywide's
CEO Angelo Mozilo. ACongressional ethics panel started examining allegations
that chairman of the Senate Banking Committee, Christopher Dodd (D-CT), and the
chairman of the Senate Budget Committee, Kent Conrad (D-ND) received
preferential loans by Countrywide. Two former CEOs of Fannie Mae also received
preferential loans from the troubled mortgage lender. Fannie Mae was the
biggest buyer of Countrywide's mortgages.
o
Mortgage
brokers: illegally steered borrowers to unaffordable loans in
order to obtain commission.
§
The
huge increase in mortgage originations during the first half of the 2000s
attracted a flood of new mortgage brokers into the industry. Despite a lack of
experience, many were soon earning six-figure incomes. When business slowed
near the end of 2005, brokers had to find new ways to make deals. Lenders
offered brokers bonuses for exotic mortgages. Licensing
standards for mortgage brokers were almost nonexistent in many states. – CNN
Money
o
Appraisers:
inflating housing values. Previously independent, more were picked by mortgage
brokers or real estate agents, leading to conflicts of interest
o
Credit
rating agencies: inaccurate ratings of securities containing subprime
mortgages. Payment by investment banks led to conflicts of interest
o
Wall
Street investors: backing subprime mortgage securities without verifying
the strength of the underlying loans
o
Borrowers:
entering into loan agreements they could not meet.
·
Subprime borrowers more often qualified through “exotic mortgages”, including:
o
Interest-only
mortgages allow borrowers to pay only interest for a period of
time (typically 5-10 years);
o Adjustable-rate mortgages (ARMs) after a time
(usually 2 years) switch from an introductory low interest rate to a higher
rate based on a benchmark interest rate. Prepayment
penalties, were added to more than two-thirds of the adjustable-rate loans
o Option
ARMs allowed
borrowers to pay less than the minimum payment, creating negative amortization,
while the lenders reported the difference as income - BW
o
Down
payments, traditionally 20%, were reduced - to zero in some cases
o
In 2006, 40% of adjustable-rate and interest-only loans
were subprime.
o 80% of
subprime mortgages are ARMs. As many as 30% of the prime and 60% of the Alt-A
mortgages taken out in the last few years were also ARMs.
o From 2000
to 2005, a large component of consumer spending came from the refinancing boom
as many consumers took out home equity loans to finance spending. This
refinancing was largely done with ARMs.
o Mortgage brokers received bonuses for
originating exotic mortgages with high penalties. In
2004 banks began offering fatter sales commissions on option ARMs to encourage
brokers to push them. – BW
o The housing boom led
people to buy investment properties with interest-only or option-ARM loans to
reduce their out-of-pocket expense, with the expectation of being able to sell
the properties quickly at a profit.
·
2006- Real Estate
Depression
o
The plunge in existing-home sales is the steepest since
the Great Depression.
o
Rising interest rates increased the monthly payments on
adjustable rate mortgages and property values declined, leaving home owners
unable to meet financial commitments and lenders without a means to recoup
their losses.
o
Declining home prices made re-financing more difficult.
As housing prices rose from 2000 to 2005, borrowers having difficulty meeting
their payments were still building equity, thus making it easier for them to
refinance or sell their homes
o
About $1 trillion of ARMs began to reset in 2007.
o
During 2007, nearly 1.3 million U.S. housing properties
were subject to foreclosure activity, up 79% from 2006
§
By May 2008 the subprime ARM loan default rate was 25%
§
The $12 trillion U.S. mortgage market had 9.2% of loans
either delinquent or in foreclosure through August 2008.
o
The crisis spread to the so-called Alternative-A (Alt-A) mortgage sector, which makes loans (“liar’s
loans”) to borrowers, usually unable to document their income but with better
credit than subprime borrowers. Alt-A
loans qualified for the "A-rating" by Moody's or other rating firms,
albeit for an "alternative" means.
o
Consumer rights attorney Irv Ackelsberg predicted in
testimony to the U.S. Senate Banking Committee that five million foreclosures
may occur as interest rates on subprime mortgages issued in 2004 and 2005
reset
o
Increasing foreclosures and fewer borrowers qualifying for loans further
depress the housing market and the prime mortgage market declines
2007-2008 Financial
Crisis
·
Corporate, individual
and institutional investors holding MBS or CDO faced significant losses, as the
value of the underlying mortgage assets declined.
·
When homeowners default, the amount of cash flowing into
MBS declines and becomes uncertain.
·
Mortgage-backed
securities were used as collateral for the issuance of debt and the use of
leverage by financial institutions.
·
Major banks and other financial institutions around the
world have reported losses of approximately US$501 billion as of August 2008.
·
Profits at U.S. banks declined from $35.2 billion to $646
million (89 percent) during the fourth quarter of 2007 versus the prior year,
due to soaring loan defaults and provisions for loan losses. It was the worst
bank and thrift quarterly performance since 1990. For all of 2007, these banks
earned approximately $100 billion, down 31 percent from a record profit of $145
billion in 2006.
·
The
losses in MBS are magnified by the use of leverage by financial firms
·
In
2004 the SEC issued an exemption to 5 investment banks, Goldman Sachs, Merrill
Lynch, Lehman Brothers, Bear Sterns and Morgan Stanley, allowing them to
leverage up to 30 or even 40 to 1.
§ Under Europe's Basel accords,
brokerages would be able to use in-house, risk-measuring computer models to
figure how much net capital they need to set aside.
§ SEC Commissioner Paul Atkins said
monitoring the sophisticated models used by the brokerages under the CSE rules
-- and stepping in where net capital falls too low -- "is going to present
a real management challenge" for the SEC. Since the new CSE rules will apply
to the largest brokerages without bank affiliates, SEC Commissioner Harvey
Goldschmid said, "If anything goes wrong, it's going to be an awfully big
mess."
·
The repeal of the Glass-Steagall Act by the
Gramm-Leach-Bliley Act of 1999 has been cited as contributing to the MBS
meltdown. The repeal enabled commercial lenders such as Citigroup, the largest
U.S. bank by assets, to underwrite and trade instruments such as mortgage-backed
securities and collateralized debt obligations and establish structured
investment vehicles, or SIVs, that bought those securities. Citigroup played a
major part in the repeal.
·
The MBS crisis results in a severe credit crunch.
·
Risk aversion in the mortgage capital markets rises to an
all-time high.
·
Risk aversion spreads to other asset classes, and the
resulting liquidity crunch is affects the pricing of all credit, not just
mortgages and mortgage-backed securities (MBS). – BW
·
The amount of commercial paper issued drops and the
interest rate charged by investors to provide loans for commercial paper has
increased substantially above historical levels.
·
Liquidity concerns drive central banks around the world
to provide funds to member banks to encourage lending and to restore faith in
the commercial paper markets.
·
The U.S. government also bailed out key financial
institutions, assuming significant additional financial commitments.
·
The credit crunch reduces business investment and
consumer spending, resulting in downward pressure on economic growth and
international recessions.
·
Stock markets in many countries decline significantly.
·
The net worth of U.S. consumers dropped by $1.7 trillion
during the first quarter of 2008 due to stock market and housing price declines
2007-2008 Financial CrisisTimeline
·
February 2007: the $10.5 billion writedown of HSBC is the
first major CDO or MBO related loss to be reported
·
Beginning in March 2007, more than 100 subprime mortgage
lenders fail or file for bankruptcy, most prominently New Century Financial
Corporation, previously the nation's second biggest subprime lender.
·
The largest specialty finance subprime lenders were New
Century Financial and Fremont General.
·
April 2: New Century Financial, largest U.S. subprime lender,
files for chapter 11 bankruptcy.
·
Other large subprime lenders include large banks and
mortgage lenders such as HSBC, Citigroup, Countrywide, and Washington Mutual.
These were thought to possess more diversified mortgage-banking businesses that
would shield them from the subprime crisis. – BW
·
The failure of these companies caused prices in the $6.5
trillion mortgage backed securities (MBS) market to collapse.
·
March 2007: Democratic Senator Charles Schumer of New
York proposes that the OFHEO raise Fannie Mae and Freddie Mac's conforming loan
("affordable") limits from $417,000 to $625,000, thereby allowing
these GSEs to back mortgages on homes prices up to $780,000 with a 20% down
payment.
·
Schumer also proposes a federal government bailout of
subprime borrowers in order to save homeowners from losing their residences.
·
Others are quick to point out that such a
"bailout" would primarily benefit lenders and Wall Street bankers,
who make large campaign contributions to congressmen; Schumer's top nine
campaign contributors are all financial institutions who have contributed over
$2.5 million to the senator.
·
March 2007: The Senate Banking Committee holds hearings
in which executives from the top five subprime mortgage companies to testify
and explain their lending practices.
·
June 2007: Merrill Lynch seizes $800 million in assets
from two Bear Stearns hedge funds that were involved in subprime MBS.
·
September
2007: At the Fed Economic Symposium in Jackson Hole, WY Yale
University economist Robert Shiller warned of possible home price declines of
fifty percent
·
September 2007: British bank Northern Rock applied to the
Bank of England for emergency funds caused by liquidity problems. The bank
essentially becomes nationalized.
·
October 2007: Merrill Lynch announces a US$8.4 billion
loss and fires its CEO.
·
July-August
2007: Stock markets drop, although they stage a recovery lasting until
October/November
·
August 2007: President Bush and Fed Chairman Ben Bernanke
announced a limited bailout of the U.S. housing market for homeowners unable to
pay their mortgage debts
·
President Bush's largest campaign contributor was Roland
E. Arnall, the former CEO of the largest subprime lender in the U.S.,
Ameriquest, which has since gone out of business. Bush nominated Arnall as the
U.S. Ambassador to the Netherlands.
·
September 2007: Secretary of the Treasury Henry Paulson met with
executives of big financial companies to seek their help in making sure that
homeowners with subprime mortgages received assistance in dealing with sharply
rising payments as their initial low adjustable rates were reset to higher levels.
·
September 2007-April 2008: The target Federal funds rate is lowered by the FOMC from 5.25% to 2% and
the discount rate is lowered from 5.75% to 2.25%, through six separate actions
·
October 9, 2007: the DJIA peaks at 14,280 (S&P
500 would peak at 1576 and NASDAQ at 2861)