Transcript Financial CrisisBlow by Blow of what happened.

The Financial Crisis
Mortgages
• Mortgages are financial instruments that allow
people to buy houses when they don’t have the
full price.
• Traditionally, people place some portion of the
price, say between 5% to 20% down and borrow
the rest.
• So if you wanted to by a house for $500,000:
– You put up 50, 000
– You get a mortgage for 450,000
– You make payments to the Bank or Savings and Load
on the 450K. (Plus you pay for ins. And taxes)
Secondary lenders
• Banks would soon run out of money for mortgages if
there was a large demand, which there is in the U.S.
– Regular banks accept deposits and lend out that
money and
– Lend money for everything from credit cards to home
mortgages.
• So, secondary lenders were established to buy the
mortgages in bulk from the Banks to replenish the
money in the banks. These packages of loans are called
mortgage backed securities.
• Now the banks have more money to relend.
Fannie and Freddie
• Two Quasi-government secondary banks are
Fannie Mae and Freddie Mac
– They are suppose to have rules about the quality of
the people who make the mortgages that they
purchase.
– They buy loans in bulk from the mortgage bankers
and regular banks. They hold these loans long-term
and collect interest to make their profits. Or turn them
into Mortgaged backed securities they sell to
investors.
– Fannie and Freddie guarantee their securities making
them very safe.
Default and Foreclosure
• If you stop making payments on your
mortgage you are defaulting.
• After three months of non-payment, the
bank goes to court and files for
Foreclosure.
• They then toss you out of the house, resell
it, and hopefully get most of their money
back.
FDIC
• If a bank makes too many bad loans and
can’t pay back its depositors, the Federal
Deposit Insurance Company steps in and
takes over the bank and gives depositors
it’s money back. (FDIC is asking the
government for cash to replenish their
cushion)
• Pretty safe system.
Sub Prime Mortgages
• In about 2000:
• To encourage more home ownership, particularly to low
income people, the government reduced regulations on
who could make mortgages and the rules for Qualifying
for mortgages.
• After All, the more homes that are owned in
neighborhoods, the nicer the neighborhoods.
Homeowners have an incentive to keep the
neighborhood up, mow their lawn, have good schools,
watch out for bad guys. It makes their property values go
up.
Sub Prme Mortgages
• Mortgage Bankers, banks, and Savings
and Loans began making loans to people
who could not afford them:
– No money down, financing 100% of the cost.
– No Documentation of income: (People were
even encouraged to lie, because mortgage
bankers get paid (an incentive) when they
make loans, whether they are good or not,
nothing if they don’t make loans.).
– These are called Sub-Prime Mortgages
Sub Prime Mortgages
• These loans were often adjustable rate loans.
That means they reset yearly, going up from very low interest rates, called
“teaser rates” like 2%, that would go up in a year to a very high ones like 12
or 13 percent. Raising payments by huge amounts over a short period of
time.
– ON our $450, 000 mortgage:
At 2% $1663 per month
At 13% $4997 Per Month
$3600 Dollars a month difference
• The idea was people could refinance them and
pay the sub primes off before they reset, or take
the money from the refinance and pay the
payment for a year..
• This would work beautifully as long as the
price and value of houses continued to
rise. You could just borrow from Peter to
pay Paul, as the old saying goes.
Sub Prime Markets
• Targeted the poor and minority
neighborhoods.
• Black people with incomes exceeding
$100k per year were more likely to be
placed in sub primes than whites making
under $40k.
• Racism or redlining of neighborhoods?
The Bubble Gets Bigger
• The system worked great, the huge
increase in demand created by this new
pool of unqualified buyers made the
housing market skyrocket.
• Housing prices went up Fast.
Prices went up WAY faster than
incomes: how’s that possible?
• Remember: in real estate, if the price goes
up, it goes up based on the whole price of
the house, not just your investment. Our
500 k house, if it goes up by 10%, goes up
50k. Our investment was only 50K,
therefore our return on our investment is
100% IN ONE YEAR.
Get Rich Quick
• If our 500,000 House goes up (appreciates
)10% per year:
– I make $50,000 per year in PURE PROFIT.
– At the “teaser rate” I only pay 12k per year,
living free and making 38K.
– I can sell and make 38k or refinance with a
Prime mortgage.
• Or I buy a few houses and flip them, sell
them, and make CASH$$$$$$
Consumers
• Who had made normal mortgages saw
their house price skyrocket too.
• They refinanced or placed home equity
loans on their houses and bought lots of
cars and flat screen TVs, everybody was
happy.
• And prices climbed and climbed.
• Home owners got rich and mortgage
bankers got really rich.
Shadow Investment Banks
• Are Wall street banks that invest huge sums of
money from pension funds, insurance companies
and even foreign governments,( Bear Sterns,
Goldman Sachs and Lehman Bros are examples)
into all sorts of businesses.
• The are lightly regulated.(even more lightly during
the Bush Administration)
• They wanted to tap the huge mortgage business
and began buying up mortgage packages like
Fannie and Freddie did
• But they wanted to turn their money around quick,
so they don’t hold their’s, they sell them to others
Wall Street (Shadow) Banks
• Unlike Freddie and Fannie, they don’t
guarantee their MBS.
• But hey, the more risk, the more gain.
Securitization
Securities/Derivatives
• So the Shadow banks did something called securitization
of the Mortgage Backed Security….a little detailed for
our purpose but basically…
• Shadow banks did not guarantee their securities.
• A security/derivative derives its value from something
else. So if I buy a bag of loans, the security/derivative
derives its value from the ability for the borrowers to
repay. The security/derivative is only as good as the
borrowers who make the loans.
• The Shadow makes sold trillions of dollars of these
securities/derivatives.
Shadow Banks
• At their height they held 10 Trillion in
Assets, compared to 6 Trillion in regular
banks.
• These banks are very important to move
paper around the world, keeping
international money flowing to where it’s
needed.
Shadow Banks
• They began to funnel huge sums into
the mortgage market, encouraging
mortgage bankers to make more
loans, so they could get paid and their
international partners could get paid.
• The were hungry, so they pressured
mortgage bankers to make loans any
way they could…..
Shadow Banking
• The Shadow Banks then repackaged those
mortgages and sold them to the insurance
companies, foreign governments, foreign
companies and pensions funds. These
packages are called Mortgage Backed
Securities.
• The pressure on the mortgage bankers
increased to get more mortgages, so they
got riskier and riskier borrowers. (Can I get
some JAWS music)
Bond Raters rate the quality of bonds so
they know how good of an investment they
are.
• The are suppose to be independent, but only get business if bond
sellers come to them to get rated. If you rate bonds toughly, they
won’t come.
• The friendly bond raters, said the bonds were AAA, dead locks to be
repaid, after all, they were based on U.S. Real Estate,
• With Triple AAA ratings, the shadow banks couldn’t sell the
Mortgage Back Securities fast enough.
• Securities bankers made millions and millions, Bond raters made
millions, mortgage bankers made millions, homeowners made
millions, flat screen makers made million.
AIG
• If you were worried about you Mortgaged Back
Securities, you could buy insurance in case they
failed. For a small premium, AIG would sell you
an insurance policy called a Credit Default Swap
• AND get this, EVEN if you didn’t own any
Mortgaged Backed Securities, you could bet that
they might fail, and buy an insurance policy on
Securities you didn’t even own. These were call
credit default swaps and they used to be illegal,
until deregulation. Basically Vegas, baby.
Regular Banks
• Couldn’t let a good thing go by so.
• They bought small financial money
lenders, like the Money Store.
• These weren’t regulated, so they were
separate entities owned by the banks, but
got their investment capital from Wall
Street shadow banks.
• So now they’re in trouble.
The Bubble
• Securities bankers made billions and billions
• AIG made billions and billions selling insurance on the
securities
• Bond raters made millions, and maybe billions rating the
securities.
• Mortgage bankers made millions and millions, placing
loans to those who couldn’t afford them.
• Homeowners made millions,
• Flat screen makers made millions.
• And Prices of houses went up and up as demand went
up and up.
The Crash
UNTIL Eventually two things happened:
– The adjustable rates reset and people couldn’t make
the payments and sold their houses, creating too
much SUPPLY.
– Prices got so high, NO one could afford the houses
even with the teaser rates. (of course that was
predictable, houses can’t keep going up at that rate, if
incomes don’t, duh)
– Demand went down and Supply went up and
when demand goes down and supply up…..
• The Bottom fell out, and prices went down
down down down down……but the
mortgages and payments didn’t
Crash and Burn
• When prices went down, people owed more on
their mortgages than the house was now worth.
• Our $500,000 house was now worth $400,000,
but remember we owe 450,000 on our
mortgage. NO bank will lend us more than the
house is worth. So we can’t refinance or sell,
without losing a ton of money.
• …so now our payment resets from $1669 to
$5000 per month and we can’t afford that!!!!
Moral Hazard: the idea that when
you use Other People’s Money,
you’ll take more risks.
• Sub prime borrowers who had invested
none of their money in the houses walked
away, mailed the keys in (some trashed
the places and stole the appliances)
Supply goes up, demand goes
down, Prices go way down.
• This increased the supply of houses, coupled
with the lack of demand, dropped the houses
WAAAY down in price.
• Builders quit building, mortgage bankers left the
building, Home Depot laid of employees as did
builders, decorators, appliance guys, plumbers
etc….
• The now unemployed couldn’t pay for their
houses…put them on the market…more supply,
less demand, higher prices.
Crash and Burn
• Remember the housing prices went down
for all houses, including people who had
made good loans, they couldn’t refinance
to pay off their flat screens either.
• Plus they couldn’t sell their houses if they
had to move, because they owed more
than the house was worth further dropping
demand, AND PRICES!
Downward Spiral
• Now consumers started saving in case of
the worst and quit buying, which hurt
stores and other businesses.
• Banks didn’t know how many bad loans
they had: they quit lending…tightened up
credit, so those homeowners who needed
to borrow COULDN”T get loans
Crash and Burn
• So people who worked in the housing business,
carpenters, plumbers, real estate agents, brick
makers, truck drivers etc…all lost their jobs.
• So they couldn’t buy stuff…so stores laid off
employees…. So they couldn’t buy stuff
• And manufacturers laid off employees so they
couldn’t buy stuff
• and so on…
• Unemployment jumps us to near 10%, 40% in
some places.
Recession!!!
• The Gross Domestic Product: the
cumulative amount of all we produce,
goods and services.
• It contracted (got smaller) for six straight
months, we are now in an official
recession, heading for another…
• MAJOR DEPRESSION
– 30% unemployment.
Remember the Shadow Banks?
• They were holding all those Mortgaged Backed
Securities, as were their clients.
• So was Fannie and Freddie and the government had
guaranteed their investors they’d pay them back if they
securities tanked, and they had.
• The MBS were now worthless, as no one was paying
them back.
• Iceland goes under, Lehman Bros goes under, Bear
Stearns has to be sold to stay afloat, Merrill Lynch is
married to Bank of America, the government bails our
Freddie and Fannie.
• No money in the mortgage industry…can’t sell houses
without mortgage banks.
Shadow Banking
• Now these banks also lend to business to
buy their raw materials and pay
employees and stuff, until the business
can sell their product.
• The Shadow banks quit lending. Banks
freaked out and quit lending. Credit
markets froze up…businesses laid off
more and more workers trying to keep
head above water, making matters worse.
Insurance
• The Shadow banks and investors were
also insured by a private company AIG.
• AIG did not have enough money to pay off
all the policies that they had written, so
they were ready to go under, taking with it
Trillions of dollars of wealth and the entire
world banking system.
• REMEMBER THE Credit Default Swaps,
they had to pay them off too.
Too Big to FAIL
• If AIG goes under…there is no one to pay off the
losers (the bankers and other gamblers with our
money) in this whole thing, the whole world’s
financial market goes under…
• We become hunter gathers.
• The BIG BANKS, SHADOW BANKS and AIG
are said to be TOO BIG TO FAIL.
• The Government buys 80% of AIG, infuses
money into other “big banks”
OH yeah, the Stock Market
Crashed
• The stock market is where the ownership and
investment in U.S. business is traded every day.
It’s health is measured by the Dow Industrial
Averages, the Nasdaq and the SandP 500.
• The Dow dropped from about 14000, to about
6000, losing half the wealth of a majority of
businesses. And all the retirement income of
people who own 401k retirement plans)
The Government to the Rescue
• Now with consumers not spending and
banks not lending (Liquidity trap),
something has to be done. The consumer
of last resort is the government.
• During the 30s depression, the
government responded by raising interest
rates and trying to balance the budget,
cutting spending, which depressed
spending and made matter worse.
Bush and Treasury
• Passed the TARP, Trouble Assets Rescue Plan
(Those nasty MBS).
– Problem was no one knew who owned which
mortgage because they were sliced and diced into so
many securities. Much has gone unspent.
• However it did give banks some confidence that
the government would do something to save the
world.
• Bush leaves office, Obama comes in with
Tim Geitner at Treasury and
• Larry Summers: head of economic advisors.
STIMULUS NOW
• EVERY Sane economist says the
government has to stimulate the economy
through spending. The deficit be
damned!!!
• But first you’ve got to get the banks
lending again
The Federal Reserve
Bank:
Chairman Ben Bernanke
• The independent government bank
• It has two main jobs:
• To control how much money is in the economy by:
– 1, Setting the Prime Interest rate, the rate
that banks can borrow money from the Fed.
• Basically the lower that rate is the cheaper it is for all of us to borrow
money: it stimulates the economy.
The Fed
• 2. Regulating banks. Now that’s banks that
accept deposits. NOT shadow banks on
Wall Street, they can do what they want.
– Under Fed Chairman Alan Greenspan, they
let the markets regulate themselves.
– They were warned repeatedly by consumer
groups that the sub prime market was built on
sand.
The Fed
• Lowers the Prime Rate to 0. the best it can
do….banks still won’t lend: Liquidity Trap
• Borrows and Prints money to prop up
the banks and pay for new stimulus
money.
Obama and Congress
• Passed $900 Billion dollar stimulus package.
– It is loaded heavily into the second and third year, so
most is currently unspent.
– Cash for Clunkers was part of it.
– Gave money to State government, so they didn’t
collapse…although the jury is still out on that…States
incomes will lag as unemployment raises, so will their
income taxes.
• They will have to cut services like roads, welfare, teacher
salaries, college subsidies etc….look out for your college
tuition.
Stimulus Package
• Localities are hurting, they get money from
Real Estate taxes, as property values
decline, so do those taxes.
– Money goes to states for “shovel ready”
projects like building bridges, roads and
schools…similar to the WPA during the
depression.
– Provided money to help with the bad
mortgages. Didn’t work out well
Investment
• Much of the money unspent is for credits “Green
Technology” and other pet projects of the
Obama team.
• But in general, the economy is growing again, so
for now…the stimulus has been a success.
• However, we will have to pay the money back,
as it has added to the money the government
owes, know as a budget deficit.
• But it the economy grows, we’ll have more
money in taxes to pay it back….
Stock Market
• Rebounds to 9500, lots of people with
money in 401ks breathe a sigh of relief.
A “W” recovery
• Refers to a steep drop and then a seeming
recovery that is followed by another deep
drop….that’s what economists are afraid of this
time.
• A Jobless recovery….even though the stock
market is going up and the economy is
technically growing, people aren’t being rehired
at a fast enough rate.
• Without new jobs, whose going to buy stuff?
• Buying stuff ends recessions.
Jobless recovery: Oct 2nd
• U.S. Economy Lost 263,000 Jobs in
September; Jobless Rate Rises to 9.8%
American employers cut 263,000 jobs last
month, far more than
forecast, and the unemployment rate rose
to 9.8 percent from
9.7 percent in August, the Labor
Department said.
Oh Yeah
• No one knows where all those pesky
Mortgaged Backed Securities and CDOs
are, who owes what, who owns which, and
what’s going to happen to them all…
– And how many more will be bad with the
current housing situation.
Many Banks, including the Too Big
to Fail ones are unsolvent
• Which means they don’t have enough
cash on hand to buy off their depositors.
• The only reason they haven’t collapsed?
– Government bailout money that gave them
reserves.
– The haven’t been made to account for the fall
in value of their bad mortgages (Toxic Assets).
If they did that, they’d have to fold and the
FDIC would have to pick up the pieces (read:
taxpayers)
Bankers are at it again
• Some say, the bankers are borrowing the
money from the fed at the O interest rates,
but not passing on the savings to business
and consumers.
• Instead, they are taking the money and
buying stocks in businesses, artificially
raising stock prices (OH no another
bubble!!!)
It won’t be over til it’s over
• You’ll know it’s over when:
• Unemployment drops at a consistent rate to a
point of about 5 or 6 percent.
• The economy begins to grown at a consistent
rate of 4 or 5 percent per year.
• Inflation stays below a couple of percentage
points a year (with all this stimulus, this could be
a problem down the road).
• Teachers start getting raises. AND
You’ll know it’s over
• When we soak up all the foreclosed
houses that linger on the market, starting
selling new and existing homes.
And when consumers start spending like
the Russians are in Baltimore (sorry old
school reference)….maybe as if “The
Taliban is in Baltimore”….
• Be like my wife…Spend us out of the
recession….