Transcript International business week 7 Financial Crisis and Credit Crunch

:04/11/2012
 http://www.youtube.com/watch?v=lXfnHM9QBjk
Financial Crisis: Overview
Downturn in the world economy
 Causes
 Housing Slump
 Subprime Mortgage Crisis
 Financial Innovation
 Impacts
 Bank Failures
 Home Foreclosures
 Federal Reserve Steps in
 Changes in the Market
 Events
 Bear Stearns Bailout
 Northern Rock/Bank of
England
 Countrywide
 Solutions
 The Federal Reserve has tried
to take corrective measures
 Regulation
 Problems with Regulation
Causes: Housing Slump
 Housing Boom
 Housing prices were on the rise
 People bought and built more and more
 Thought it was a good investment

Thought that home values would not decrease
 Took out second mortgages to use toward consumer spending
 Housing Bust
 Excess inventory
 Housing price correction
 Negative equity
 Foreclosures
Causes: Subprime Mortgage Crisis
 Where did the subprime mortgage crisis start?
 Banks used to operate on a fractional reserve system
 Today almost no reserve is required due to new rules
that the public doesn’t even know about
 Banks are able to issue more loans when they do not
have to keep a reserve on hand
 When they run out of qualified candidates, they reduce
the requirements, which leads to subprime mortgages
 These loans slowly inflate the system, and create
wealth that is not “real”
Causes: Subprime Mortgage Crisis
 Mortgage originators sold the loans on the secondary
market
 No risk for the originators so little effort went into
analyzing the borrower’s ability to repay
 High risk and debt tolerance
 Adjustable Rate Mortgages (ARMs)
 Rates are beginning to increase from the low
introductory rate
Causes: Financial Innovation
 Financial innovation is the act of creating and then
popularizing new financial instruments as well as new
financial technologies, institutions ,and markets.
 Adjustable Rate Mortgages
 Investment Vehicles that went wrong


Mortgage Backed Securities (MBS)
CDOs – Collateralized debt obligations
 Not understood by investors
Causes: Financial Innovation
 Financial innovations are optimal responses to various
problems or opportunities
 Many financial innovations that have been created in
the recent past to respond to the financial boom were
not fully understood
 They were not adapted properly from the past, and when
the financial sector crashed, these innovations
responded negatively
Impacts
 Large corporations
 Bankruptcy

Companies are trying to avoid bankruptcy because of the
Chapter 11 rule changes that took effect in 2005
 Restructuring

Hedge fund owners might push these corporations into
bankruptcy by forcing them to sell their assets
 Insurance Companies
 Homeowners are turning to arson as a way to get out
from under their mortgages
Impacts
 Subprime Mortgage Backed Securities (MBS) were in
portfolios and hedge funds around the world
 Investments turned out to be worth far less than what
was first thought
 Stiffer lending policies
 Banks lending only to the safest loan customers

Before almost anyone could qualify for a mortgage loan
 Federal Reserve takes action
 In August 2007, they put $100 billion into the money
supply for banks to borrow at a low rate
 Prime rate has been slowly decreasing over the past year
Impacts
 Home Foreclosures
 Over 1.5 million foreclosure proceedings began in 2007
 Foreclosure filings increased 57 percent in March
compared to a year ago
 Bernanke expects that number to increase further in
2008
 Increased foreclosures further depresses home prices,
which can hurt the broader economy.
Impacts
 Changes in the Market
 Large re-evaluation of risk
 Abstract ideas such as CDO’s and MBS’s are out the
window


Know what you are holding
Maybe housing values don’t always go up
 Banks are much tighter with their cash, causing a
liquidity shortage and the so-called “credit crunch”
 Huge financial institutions are going broke and being
purchased by competitors
Events
 Bear Stearns Bailout
 Bear Stearns is the fifth largest investment bank on
Wall Street, specializing in capital markets, wealth
management, and global clearing
 In July of 2007, Bear Stearns disclosed that the two
subprime hedge funds had lost nearly all of their value
amid a rapid decline in the market for subprime
mortgages.
 Stock for Bear Stearns fell from $100/share in December
2007 to $5/share in March 2008, just 3 months
Events
 Bear Stearns Bailout
 Bear Stearns and JP Morgan Chase came to a merger
agreement after the government agreed to guarantee
the merger at $2/share. JP Morgan Chase later upped
the buyout price to $10/share and reduced the
government guarantee by $1 billion.
 Many saw this action by the Federal Reserve as a
government bailout of an investment bank
 Federal Reserve Chairman Ben Bernanke testified that
if Bear Stearns would have defaulted, there most likely
would have been “severe consequences” leading to a
possible systemic financial crisis
Events
 Northern Rock
 On September 12, 2007, the Bank of England provided
emergency funds to Northern Rock in the biggest bailout of a
British bank in three decades.
 The difficulties came from Northern Rock not being able to
raise funds due to the subprime crisis in the US
http://maoxian.com/index.php?s=northern+rock
Events
 Northern Rock
 On September 14, 2007 customers waited outside the
branches to withdraw their savings


It is estimated that 5% of the total deposits were withdrawn
that day
The internet site became inaccessible due to the large number
of people that were trying to log on
 As of November 17, 2007 a total of 10 companies had put
in bids to buy out Northern Rock, but all the offers were
materially below the previous trading value
 On February 17, 2008 Northern Rock was bought by the
government and would be nationalized and the bank
would operate under a temporary period of public
ownership
Events
 Countrywide Financial Crisis
 When Countrywide finances mortgage loans, they
usually package them for sale to large investors as
mortgage backed securities
 After the housing crisis began Countrywide was severely
affected
 On August 3, 2007 the secondary market stopped the
sales of most non-conforming securities and days later
Countrywide announced that this disruption could hurt
it financially
Events
 Countrywide Financial Crisis
 On August 12, 2007 Countrywide was cited as a possible
bankruptcy risk by Merrill Lynch
 Countrywide’s stock fell from $21. 29 in August down to
$8.64 in November
 On January 11, 2008 Countrywide was bought out by
Bank of America for an all-stock $4 billion deal, down
from a $24 billion value one year ago
 Countrywide was the nation’s largest mortgage lender,
so this deal is a landmark in the housing crisis
Solutions
 Federal Reserve Actions
 Bernanke and the Fed have been trying to stave off recession
very actively
 The Fed reduced the interest rate 7 times since last
September, most recently on April 30th, when rates were
reduced a quarter point to 2 percent
 The Fed has been trying to boost the amount of liquidity
available due to sharp declines in banks loaning to each other
 The Fed began the Term Auction Facility in response to the
crisis on December 12th, 2007.
 The TAF is a means of increasing liquidity by offering loans to
depository institutions which otherwise could not borrow
from the Fed
Solutions
 Regulation
 New plan unveiled by Treasury Secretary Henry Paulson





One agency in charge of business conduct and consumer
protection
Eliminate office of Thrift Supervision and Commodity Trading
Futures Commission
Establish a federal Mortgage Origination Commission
Set minimum licensing standards for mortgage brokers
Establish Office of Insurance Oversight inside Treasury
Department
Solutions
 Issues with Regulation
 Keeping good regulators is difficult because they earn
much more in the private sector
 Ensuring proper conduct of regulators is difficult
 If banks were allowed to fail everyone would work
harder not to and would assess risk better.
 Due to bailouts of major banks (Bear Stearns, Northern
Rock) the only viable option left is more and better
regulation in order to promote stability in the financial
system.
Solutions
 Bank Regulations
 The amount of money owed to banks is more than all
the money in existence, so we cannot possibly get out of
debt under this system
 The bulk of this debt is in the form interest, which is an
arbitrary amount of money banks demand in return, but
never gave
 The public must demand that money must not be
created by loaning it into existence, which in the end
causes inflation
Financial Crisis: Conclusion
 Causes
 Multiple factors played a role in this financial crisis
 Most of the emphasis has been placed on the subprime
mortgage crisis

It has had effects that have stretched beyond the housing
market
 Impacts
 The impact of this financial crisis can be felt on all levels
from individuals to large corporations
Financial Crisis: Conclusion
 Events
 The far reaching events can show how powerful this
financial crisis is
 Bear Stearns was saved to prevent further damage to the
financial market
 It forced the nation’s largest mortgage lender into near
bankruptcy and an eventual buyout
 Solutions
 The Federal Reserve has stepped in but to little avail
 Regulation seems to be a popular answer but what type
of regulation still needs to be developed
Financial Crisis: Conclusion
 In a statement from Countrywide to the SEC
 “Since the company is highly dependent on the
availability of credit to finance its operations,
disruptions in the debt markets or a reduction in our
credit ratings could have an adverse impact on our
earnings and financial condition, particularly in the
short term… Current conditions in the debt markets
include reduced liquidity and increased credit risk
premiums for certain market participants. These
conditions, which increase the cost and reduce the
availability of debt, may continue or worsen in the
future….”
References
•
•
•
•
•
“Wall Street’s crisis.” The Economist. March 22-28, 2008: 11-12
“The $2 bail-out.” The Economist. March 22-28, 2008: 81-82
“What went wrong.” The Economist. March 22-28, 2008: 79-80
“The long hangover.” The Economist. April 12-18, 2008: 79-80
Scott Lanman and Alison Vekshin. “Bernanke Urges Action to Slow
Jump in U.S. Home Foreclosures.” Bloomberg. May 6, 2008
<http://www.bloomberg.com/apps/news?pid=20601087&sid=aojlbhOf
zPaM&refer=home>
• Jeffery D. Sachs. “The Roots of America’s Financial Crisis.” Project
Syndicate. April 15, 2008 <http://www.project-syndicate.org/
commentary/sachs139>
• Tom Leonard. “Henry Paulson unveils bank regulation plan.” Daily
Telegraph. April 22, 2008.
<http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/0
4/01/cnusbanks101.xml>
References
 “Waiting for Armageddon.” The Economist. March 27,
2008. <http://www.economist.com/business/
displaystory.cfm?story_id=10925548>
 Mark Landler “Housing Woes in U.S. Spread Around
Globe.” The New York Times. April 14, 2008.
<http://www.nytimes.com/2008/04/14/business/worldbusi
ness/14real.html?_r=1&em&ex=1208404800&en=ddcb233e7
e3b3153&ei=5087%0A&oref=slogin>
 Chris Isadore “Fears of long recession rising.”
CNNMoney.com April 14, 2008. http://money.cnn.com/
2008/04/14/news/economy/how_bad/index.htm?postversi
on=2008041415