Transcript Troubled Times: How We Got There and What Lies Ahead

Troubled Times: How We Got
Here and What May Lie Ahead
Ned C. Hill
National Advisory Council Professor of Finance
Fellow of the Wheatley Institution
Academic Director, H. Taylor Peery Institute of Financial Services
Marriott School of Management
Brigham Young University
January 2010
Outline
Seeds of the economic crisis
Results—failures, mergers, credit squeeze
Remedies—government bailout efforts
Possible outcomes
Foundations of Our Strong U.S.
Economy—mid 1970’s to 2007
Strong entrepreneurial innovation
generating business ideas (most jobs
generated by start-ups, not big business)
Productivity increases (mostly due to
computerization, including the Internet)
Low tax, interest and unemployment rates
Growth in U.S. economy from 2002-2007
exceeded entire Chinese economy!
Six Factors Contributing to the Crisis
Huge Global Demand for Fixed-rate Debt
The Federal
Reserve and
other Regulators
Creation of
New Securities
for Which Few
Understood
the Risks
The
Housing
Market
Rating Agencies
Accounting Rules
1. The Global Fixed-Rate Investment Market
Who Invests? Insurance
companies, individuals, pension
funds, mutual funds,
governments, investment funds,
banks, municipalities, etc., etc.
2008
2000
$36 Trillion
$70 Trillion
Sources of New Demand for
Fixed Income Securities
Developing economies—where do they
put their cash?
– China
– India
– Brazil
– Middle East
– Southeast Asia
U.S. “Baby Boomers” putting more and
more into fixed income securities
2. The Federal Reserve and Deregulation
2004 (in the wake of tech bubble bursting) the Fed (Alan
Greenspan) thought economy was much weaker than it
was—pumped money into the economy.
– How? They buy treasury securities in the open market
– That increases the money supply
This led to artificially low interest rates.
Fixed-rate investors hungering for a place to put their
money—but U.S. short-term securities paid hardly
anything.
Dollar sank in value relative to Yen, Euro, etc.
Many commodities are priced in USD
– So commodity prices rose rapidly
– Especially oil, steel, cement, etc.
– Chinese and other countries also had a building boom, putting
pressure on commodities
2. …Deregulation (cont.)
1999 Gramm-Leach-Bliley (Financial Services
Modernization Act)—effectively repealing Glass-Steagall
Act of 1933 that kept banks and investment banks
separated
2000 The Commodity Futures Modernization Act opened
the doors to deregulate credit default swaps
2002 Sarbanes-Oxley had the unintended consequence
of making the issuance of corporate bonds more difficult
Lack of regulation regarding mortgage securities, other
securitized bonds, swaps, hedge funds
Where was the SEC when Lehman went to 44:1
leverage?
Both administrations (Clinton and Bush) leaned on the
Fed to extend home ownership to all Americans
3. The Housing Market
Housing prices began rising rapidly.
Tax laws exempted home ownership from
capital gains in most cases.
To satisfy huge demand from debt markets: new
forms of mortgages created:
– Interest only
– Adjustable rate—many with low “teaser rates”
– Easy qualifications (e.g., NINA loan = “no income, no
assets” and NINJA = “no income, no job, no assets”)
Problem: issuers rarely hold mortgages now—
they sell them up the chain where they are
packaged for the final investors.
3. The Housing Market—cont.
Fannie Mae and Freddie Mac were encouraged
to become “more inclusive” in generating
mortgages—led to huge growth in “sub-prime”,
“alt-A” mortgages.
Home buyers, appraisers, mortgage processors,
etc., all played a part.
The nation had about 2,000,000 more homes
than needed to support the demand
“But that’s OK—Housing prices have never
fallen by more than 5% in any year since the
Great Depression!”
Mortgages from Start to Finish
Tranche 1
CDS
Tranche 2
Tranche 3
Tranche 4
$70 Trillion
Fixed-Income Market
It’s Even More Complex
A CDO is a “company” that owns a pool of
mortgages and…
– Has its own CUSIP number
– May issue additional debt so investors can have their
returns on the mortgages leveraged up (or down?)
– Might invest in other CDOs (CDO2 , CDO3)
– Usually offers investors different “tranches” with
different characteristics, e.g., “interest only”, different
mixes of prime, alt-A, subprime, etc.
– May mix in other securitized debt, e.g., credit card,
auto financing; and even corporate bonds
4. Creation of New, Essentially
Unregulated Securities
New mortgage investment instruments (CDO’s,
CMO’s)
Credit default swaps (CDS’s)—some firms sell
“insurance” that a bond will not default—if it does,
they’ll trade it for a good bond or cash. AND you
can buy a CDS even if you don’t own the bond...
so some bonds have 10x (or more) volume of
CDS’s issued against them.
AIG had over $1 trillion in CDS positions
Problem: we don’t have data for a really bad
times in the economy, so pricing models don’t
work for extreme situations like we’re in now!
5. Rating Agencies
Standard & Poors, Moody’s and Fitch (perhaps using
faulty data and models)
– Gave their stamp of approval to these new investment securities
(“AAA”, “AA”, “A”, “BBB”, etc.)
– Charged $600,000 to rate a $500M CDO offering
In fact, they even packaged the mortgages for the
investment banks!
Investment banks (esp. Bear, Lehman and Merrill Lynch)
aggressively pushed these “safe” investments to satisfy
the huge fixed-rate demand (and made good profits
thereby).
But few really understood the risks.
– E.g., a AAA-rated CDO in July 2006 yielded only 10-15 basis
points higher than a Treasury bond of the same maturity!
Ethical Issues Involved
The Obvious Ones
Government Officials and
Elected Representatives
Greed
Investment Funds
Dishonesty
Short-term vs long-term
“Not my problem”
Regulators
Chief Investment
Officers, Treasurers
Rating Agencies
Investment &
Commercial Banks
Home Buyers
Mortgage
Originators
Mortgage
Packagers
Deeper Ethical Issues Raised
“Paying for Peril”
– Bonuses now for future expected results
– Upside reward but little downside risk
“Normalization of Bad Behavior”
– Many new mortgage market in serious trouble—but investors
(and salespeople) expect to “dance while the music’s playing.”
– Lack of courage to act on better judgment
“Tech Shock”—CDOs, CMOs, CDSs all new
– Since we didn’t understand the risks they posed, we based
assumptions on past (and, therefore, inappropriate) data,
incentives and processes
– Gradually we found better ways of thinking about them
Based on Dr. Thomas Donaldson, Wharton, comments from Wheatley Inst. Ethics Conference
6. Additional Factor: Accounting Rules
“Stabbing the Wounded”
Intent is to accurately report value of a firm’s
assets, liabilities and equity.
“Mark-to-market” means that firms must record
paper assets at today’s market value—
whether higher or lower than yesterday.
But what if there is no market for a security or
an artificially low market value?
Must use best estimates provided by bids,
similar securities or mathematical models.
Difference between original price and market
value must be written off.
Bank’s Balance Sheet
Deposits, borrowings,
other obligations
Assets
Liabilities
Equity Capital
Loans to customers,
investments, cash
Past profits/losses,
stock purchases,
adjustments
“Good”
= 8-12%
What Happens When We Have
“Toxic” Assets on Our Books?
“Toxic” Assets
Liabilities
Assets
Equity Capital
NOTE: These are “book write
downs” and not actual losses. The
bank may still hold the assets and
it may still be receiving interest
and principle payments.
What Happens When We Have
“Toxic” Assets on Our Books?
Assets
Liabilities
What Happens When We Have
“Toxic” Assets on Our Books?
Toxic Assets
Assets
Liabilities
Not good
- 3%
Equity capital has turned
negative!
Then the Inevitable
The Housing Bubble Burst
Early 2007, housing prices began to slip in key
markets like Phoenix, Las Vegas, California,
Florida, etc.
The actual risk of sub-prime and alt-A loans
began to emerge.
Liquidity of mortgage-related securities became
an issue—no one wanted to buy them, hence,
very difficult to value.
This caused a precipitous drop in the prices of
CMO’s and CDO’s—used to be “AAA” but now
almost worthless.
Accounting rules—write them down!
We Can’t Let “Negative Equity”
Stand—What to Do?
Option 1: Close or sell the institution
– Bear Stearns (founded 1923), on the failure of two of
its hedge funds that heavily invested in CMOs and
CDOs, sold 3/2008 to JPMorganChase for $2/sh
(revised later to $10/sh)—previous year was $133/sh
– Countrywide Financial was bought by Bank of
America (7/2008)
– IndyMac (Independent National Mortgage Corp.)
seized (7/2008) and assets sold off
– Lehman Brothers (founded in 1850) broken up, parts
sold to Barclays (9/2008) and Nomura Holdings
(10/2008)
– Washington Mutual seized by FDIC, assets sold to
JPMorganChase
We Can’t Let “Negative Equity”
Stand—What to Do?
Option 2: Find a stronger institution and merge
– Merrill Lynch merged with Bank of America (9/2008)
Scandal about huge pay package of top management
– Wachovia merged with Wells Fargo (10/2008)
Option 3: Infuse more capital
– Morgan Stanley—sold 21% of firm for $9B to
Mitsubishi (10/2008)
– Goldman Sachs—Warren Buffett’s Berkshire
Hathaway bought $5B preferred stock
Option 4: Government takeover
– Government took over Freddie Mac and Fannie Mae
– Government pumped $180 billion into AIG
– Government bought common stock of GM
Result—A Credit Freeze
No institution wanted to loan money—even overnight—to
another institution. They were afraid the borrower might
be “next on the chopping block.”
The economy runs on credit—even healthy companies
borrow frequently to meet short-term swings in cash
flows.
Consumers feel poorer—401(k), equity in home, job
uncertainty
We ran the risk of seeing the entire economy shut down.
We are inter-connected to the rest of the global economy
– Many international banks, insurance companies, funds bought
these CMOs, CDOs, CDSs
– Iceland’s major banks failed—British savers lose $8B
– Some European banks failing
– Etc., etc.
Government Bailout Efforts—A
1. Federal Reserve infused massive amounts of
cash into the system— how much??
– Allowed investment banks to borrow directly—even
converted them into bank holding companies
– Eased terms for loans for all institutions
2. Congress passed “Troubled Asset Relief
Program” (TARP) 10/2008—government
authorized Treasury to use $250B immediately,
$100B subject to president’s approval and
$350B if further authorized by Congress. Plan
was to buy “toxic assets”—changed to
purchase of preferred stock.
3. In addition, the FDIC is assisting in bank
closures.
What Happens When We Infuse
New Money into a Troubled Bank?
Cash
Liabilities
Assets
Equity Capital
Now good!
10%
Government Bailout Efforts—B
“Obama Stimulus Package”—2/2009
Aid to homeowners in danger of foreclosure
FDIC insurance on deposits increased to $250K
and unlimited for corporate deposits
Bailing out of specific industries (auto industry
and possibly others)
American Recovery and
Reinvestment Act (ARRA) of 2009
$787 B
39% for Federal Agencies/Programs ($308.3 B)
61% for Individuals and States (including tax cuts and
credits) $478.9 B
Other provisions
–
–
–
–
–
Includes payroll-tax cut
Credits for first-time home purchases
Higher education
Unemployment-tax breaks
Help for car buyers
Tax provisions total $288 B
Funds go directly to states to help them narrow their
deficits and bridge budget gaps
Categories of ARRA
Relief to states
Health, labor and education programs
Housing and transportation programs
Unemployment and low-wage assistance
Grants to states, mostly for education
Energy and water development
Agriculture, rural aid and FDA
Health insurance assistance
Medical record modernization
Commerce, justice and science programs
Interior Department and environmental aid
Government buildings and financial services
Defense Department
Military and Veterans Affairs
Homeland Security Department
State Department
$90.0 B
$71.3 B
$61.2 B
$58.1 B
$53.6 B
$50.8 B
$26.4 B
$24.7 B
$17.6 B
$15.8 B
$10.5 B
$6.7 B
$4.5 B
$4.2 B
$2.7 B
$0.6 B
Bailout Problems
Only 1/3 of the Obama package actually
spent—the rest is forthcoming over
several years
What happens in 2010 when the 2009
money is not repeated?
Moral hazard issue?
What Are Possible Outcomes?
Worst case—prolonged depression similar to
the 1930’s (25% unemployment, no growth for
3-5 years, great personal hardship)
Best case—short recession (unemployment 68%, no/slow growth for 6-18 months)
Most likely case—serious recession
(unemployment 7-12%, no/slow growth for 1-2
years)
X
View of the Crisis from the DJIA
Peak in October, 2007 14,100
-53%
+57%
Low in March, 2009 6,600
Other Outgrowths of the Crisis
More regulation of securities industry
–
–
–
–
Hedge funds
Packaging of mortgages/other structured products
Credit default swaps
Retention of some risk by lower levels in the chain
Reinstate separation wall between banks and investment
banks?
Government could make a good return on much of the
bailout investments: buying toxic assets, buying stock in
troubled institutions, etc.
May see higher taxes to pay for bailout. (But we need to
be cautious—high taxes generally not good for
recoveries).
Inflation may be a problem in the recovery.
Recent Developments
Fannie Mae and Freddie Mac are requiring
banks and other mortgage originators to
buy back mortgages that were flawed
(insufficient income, misstatements on
applications, etc.).
Government is looking into how AIG used
the $180B to pay back banks. May “claw
back” some of those funds.
Suggestions for Individuals
1. Don’t panic—selling stock now may be the worst thing
to do.
2. Remember the stock market is a “leading indicator”—it
will pick up far before the rest of the economy.
3. In fact, now may be a good time to buy—most stocks
are at “bargain basement” prices.
4. If you’re employed, become a very valuable employee,
sharpen your skills, dust off your resume.
5. Now may be a good time to go back to school.
6. Make sure your food supply and your emergency cash
supply is in good order.
7. Teach your children and grandchildren sound financial
principles.
Most Important Suggestion
Heed the words of the prophets.
Who Said This (and When)?
“We wish the presidencies of the stakes and the
bishops of the wards to urge, earnestly and
always upon the people, the paramount
necessity of living righteously; of avoiding
extravagance; of cultivating habits of thrift,
economy, and industry; of living strictly within
their incomes; and of laying aside something,
however small the amount may be, for the times
of greater stress that may come to us. By no
other course will our people place themselves in
that position of helpful usefulness to the world
which the Lord intends we shall take.”
First Presidency, July 1933
Elder L. Tom Perry
November 2008
“We have been encouraged at almost every general
conference of the Church I can remember not to live
beyond our means. Our income should determine the kind
of housing we can afford, not the neighbor’s big home
across the street.
“President Heber J. Grant once said: ‘From my earliest
recollections, from the days of Brigham Young until now, I
have listened to men standing in the pulpit … urging the
people not to run into debt; and
I believe that the great majority of
all our troubles today is caused
through the failure to carry
out that counsel.’” (in Conference
Report, Oct. 1921, 3).
President Boyd K. Packer
November 2008
“It is my purpose to show that
in troubled times the Lord
has always prepared a safe
way ahead. We live in those
‘perilous times’ which the
Apostle Paul prophesied
would come in the last days. If we are to
be safe individually, as families, and
secure as a church, it will be through
‘obedience to the laws and ordinances of
the Gospel.’ ”
Read More about the Crisis
Andrew Sorkin—Too Big to Fail
Richard Bookstaber—A Demon of Our Own Design
Lawrence McDonald—A Colossal Failure of Common
Sense: The Inside Story of the Collapse of Lehman
Brothers
Charles Morris—The Trillion Dollar Meltdown
William Cohan—House of Cards: A Tale of Hubris and
Wretched Excess on Wall Street
Bill Bamber and Andrew Spencer—Bear Trap: The Fall
of Bear Stearns and the Panic of 2008
David Wessel—In Fed We Trust: Ben Bernanke’s War
on the Great Panic