Transcript Mortgage-backed securities

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Common elements of financial crises worldwide throughout history
 Lesson 1 – compares 1907 & 2007 crises
 Lesson 2 – compares 2007 crisis with: (emphasis on reading eco. Data)
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Recession of 2001
Recession of 1990-1991
Recession of 1981-82
Recession of 1973-75
Great Depression 1929-38
(Dot-Com bubble burst, Enron, Worldcom, et.)
(oil price shock due to Gulf War)
(tight money to control inflation)
(stagflation; OPEC oil embargo spiked oil prices)
(stock market crash; falling demand)
 Lesson 3 – a historical look at five bubbles & panics:
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Tulipmania in the Dutch Republic – 1630’s
The South Sea Bubble – Great Britain 1711-1721
The Roaring 20’s Stock Bubble – 1920’s
Japan’s Bubble Economy – 1985-90
The Dot-Com Bubble – 1990’s
 Lesson 4 – comparison to Lost Decade in Japan
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THE PANIC OF 1907
THE FINANCIAL CRISIS OF
2007
THE WORLD MADE HUGE INVESTMENTS IN
THE U.S. HOUSING MARKET
……….AND LOST!!
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By ignoring risk, remaining
irrationally optimistic, and forgoing
transparency through an array of
fantastically complicated
investment vehicles, the world’s
financial markets were extremely
dependent on housing prices.
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The underlying assumptions were
(1) that housing prices never fall and
(2) homeowners almost always pay
their mortgages.
STRONGLY PROMOTED
HOMEOWNERSHIP
FORMER PRESIDENT GEORGE
BUSH
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“We can put light where there’s
darkness, and hope where
there’s despondency in this
country. And part of it is
working together as a nation to
encourage folks to own their
own home” –President Bush,
October 15, 2002.
HIGHLY COMPLEX FORMS OF
FINANCING
The momentum behind the
expansion of
homeownership led the
government to reduce
regulations and capital
requirements for making
loans.
 This led to a dizzying
number of innovative ways
to get less-qualified
borrowers a mortgage and
seemed to reduce risk for
the lender.
 Mortgages could be
bundled and sold around
the world as securities.
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THIS WAS TOO TEMPTING FOR
THE FINANCIAL INSTUTIONS
TRUSTED AGENCIES FAILED TO
WARN INVESTORS
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Mortgage-backed securities were
constructed of mortgages of
differing quality levels.
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The obligations of solid and subprime borrowers were mixed in a
manner that made it very difficult
for experts to calculate risk.
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The assumption that U.S. housing
prices would continue to rise and
incentives to provide good ratings
led agencies to rate these
securities as AAA, lowering
investors’ concerns.
RISK-RATING AGENCIES
THE PERFECT STORM
WHAT WERE WE THINKING?
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Homeownership peaks in early 2005
at 70% of households.
The Fed raises interest rates.
Home prices fall.
Higher adjustable interest rates
increase payments for borrowers.
Borrowers default in waves.
Dozens of subprime lenders file for
bankruptcy.
Mortgage-backed securities lose
value as investors question their
contents.
Financial institutions struggle to find
buyers for the MBSs.
“FINANCIAL
WEAPONS OF
MASS
DESTRUCTION”
Financial institutions could
purchase credit default
swaps.
A CDS is a private
insurance contract that
paid off if the investment
failed.
One did not actually have
to own the investment to
collect on the insurance.
These promises were
unregulated, and the
sellers did not have to set
aside money to pay for
losses.
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Bank failures: 183 (2%) 12/072/10 (No deposits lost)
Unemployment rate: 10.1%
(10/09)
Economic decline: -4.1% (4Q
2007-2Q 2009)
Biggest drop in DJIA: -53.8%
(12/07-3/09)
Emergency spending and tax
reduction programs: 2.5% of
GDP in 2008 and in 2009
Aggressive increase in
monetary stimulus by the Fed
THE FINANCIAL CRISIS OF 2007-2009
6.7 million jobs lost in
2008 and 2009
Capital investment levels
lowest in 50 years
Domestic demand declines
11 consecutive quarters
Industrial production
down worldwide: Japan
31%, South Korea 26% ,
Russia 16% , Brazil 15% ,
Italy 14%, Germany 12%
The federal government
unleashed a series of
remedies in an attempt
to limit the contagion.
Massive sums of bank
reserves were created to
ease fears.
In the process, the
taxpayers took over or
funded several familiar
financial and
nonfinancial companies.
This time the government
bails out the economy and
business leaders and bankers
are criticized.
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The rise in housing prices represented a bubble.
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A price bubble is a situation where increases in price are not justified by
fundamental factors affecting supply or demand, and therefore not
sustainable.
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A price bubble is often caused by contagion, which is prices increasing
because people observe them going up and think they will continue to go
up.
 At one point, people who couldn’t pay their mortgages were taking out home
equity lines of credit and using the cash to pay the mortgages! They could do
this because equity in homes rose as home prices rose, and “personal bankers”
were pushing home equity lines of credit.
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This causes people to purchase houses with the expectation that they
will be able to sell them for a higher price in a relatively short time.
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It was a speculative bubble.
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When the bubble burst in 2006, house prices tumbled.
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U.S. Homeownership rate:
2000
2004
2010
67.4%
69.0%
66.9%
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Positives:
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Spreads risk. Not all eggs in one basket. Diversified.
Made a liquid investment from an illiquid investment.
Allowed smaller investors to invest in housing.
Meant more money flowed into mortgage markets.
Negatives:
 Reduced the incentive for investors to be concerned about the
creditworthiness of borrowers.
 Reduced the incentive for banks and mortgage brokers to be
concerned with creditworthiness.
 Exported the risk around the world because the MBS securities
were stamped AAA by the ratings agencies and sold worldwide.
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▪ Tulipmania in the Dutch Republic – 1630’s
▪ The South Sea Bubble – Great Britain 1711-1721
▪ The Roaring 20’s Stock Bubble – 1920’s
▪ Japan’s Bubble Economy – 1985-90
▪ The Dot-Com Bubble – 1990’s
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http://www.library.hbs.edu/hc/historicalreturns/fb/movie.html
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Hyman Minsky’s phases of a bubble:
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Displacement
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Boom
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A few insiders begin to take profits and get out, and price increases begin to level out.
Panic
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People take more risk as more credit is offered. High profits repeat the cycle, and at some point rational decision-making
succumbs to manic behavior.
Profit-taking
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Rapid rise in prices of a financial or physical asset as investors and speculators earn profits
Euphoria
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Crisis begins with an outside shock to the system—war, new invention, political event, etc.
The failure of a large institution, the realization of a swindle, or an increase in the supply of the asset bring everyone back
to their senses. People scramble to sell as the price falls.
Bailout (not a part of Minsky’s description)
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A central bank may expand the money supply to salvage essential financial institutions.
Rationale: don’t make the whole economy pay for the actions of a few.
Negative externality: the anticipation of a bailout may indirectly add to the problem because people may take greater
risks if they know there is a safety net—this is known as a moral hazard.
John Kenneth Galbraith suggests investors have a short financial memory and investors have a tendency to attribute
greater intelligence to individuals who have higher income or control more wealth.
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The Case-Schiller Price
Index represents the real
price of housing
throughout the country,
so it is inflation-adjusted.
The index equals 100 for
the price of housing in
1980.
Prices peaked in 2006.
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In the fall of 2007, the “subprime crisis” was a
concern, and we began to realize the real estate
bubble had burst. (Home prices peaked in 2006.)
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However, the stock market peaked, and GDP in the
2nd & 3rd quarters of 2007 was especially strong.
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Generally, people deeply involved in finance began
to talk about problems in the credit markets and a
lack of liquidity.
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December, 2007
 Dec. 11 – Fed begins lending to banks for longer than overnight. (By
October 2008, many banks are on Fed life support.)
January
 Jan. 12 – Bank of America agrees to buy Countrywide Financial, the
largest mortgage lender, and casualty of the mortgage-default crisis.
February
 Feb. 8 – Congress approves a $168 billion economic stimulus plan.
 Feb. 29 – Dollar hits record low against euro.
March
 March 17 – Bear Stearns, which traded at a share price of nearly $90
per share in January, sells itself to J.P. Morgan Chase for $2 per
share, with the Fed providing special financing. Mortgage-backed
securities took them down.
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April
 April 18, 19 – Merrill Lynch posts a $1.96 billion loss; Citigroup posts a $5.1
billion quarterly loss.
 April 30 – Countrywide Financial posts a $893 million loss.
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May
 May 9 – AIG posts $7.8 billion quarterly loss.
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June
 June 9 – Average price of gasoline in U.S. first hits $4 a gallon.
 June 21 – Bond insurers MBIA and Ambac lose AAA ratings from Moody’s.
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July
 July 12 – Regulators seize IndyMac bank.
 July 14 – Treasury and Fed place Fannie Mae and Freddie Mac under govt.
control.
 July 31 – Pres. Bush signs a housing-rescue bill.
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August
 August 7 – Freddie Mac posts an $821 million loss; AIG reports a $5.4 billion loss.
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September – Wall Street Journal calls Sept. 14 – 21, “The Week That Wall Street
Died”
 Sept. 7 – Govt. seizes Fannie and Freddie; Treasury replaces CEOs and buys $1 billion
of preferred shares in each.
 Sept. 14 – Merrill Lynch sells itself to Bank of America .
 Sept. 15 – Lehman Brothers files for bankruptcy. Fed and Treasury choose to let
Lehman fail. (In hindsight, probably a disastrous decision.)
 Sept. 16 – Banks stop lending to each other.
 Sept. 17 - Govt. seizes control of AIG, makes $85 billion loan and receives warrants in
exchange.
 Sept 21 – Fed converts the last two major investment banks, Morgan Stanley and
Goldman Sachs into traditional bank-holding companies.
 Sept. 24 – Goldman Sachs gets $5 billion investment from Warren Buffett.
 Sept. 26 – Feds seize Washington Mutual and sell it to J.P. Morgan Chase—largest
bank failure in U.S. history.
 Sept. 30 – Citigroup agrees to acquire Wachovia, and Wells Fargo makes higher bid.
Congress passes the bailout bill.
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October
 Oct. 4 - President Bush signs $700 billion bailout bill.
 Oct. 8 – Fed says it will lend directly to U.S. corporations for the first time since the
Great Depression.
 Oct. 9 – World Central Banks coordinate lowering of short-term rates.
 Dow down 14% in October, worst month in % terms in 10 years.
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November
 Nov. 10 – Govt. scraps $123 billion deal with AIG and replaces it with a $150 billion
package on better terms.
 Govt. injects $20 billion into Citigroup and guarantees $300 billion of its troubled
assets.
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December
 Dec. 9 – On this date, only McDonald’s and Walmart in the Dow have higher stock
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prices that this date last year.
Dec. 12 – Fund advisor Bernie Madoff is arrested by federal agents in a $50 billion Ponzi
scheme.
Dec. 17 – Fed funds rate cut to 0 - .25%.
Dec. 17 – Goldman Sachs posts $2.12 billion loss, first since going public in 1999.
Dec. 20 – White House agrees to lend GM and Chrysler $17.4 billion.
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Sample of Bankruptcy filings in 2008:
 Sharper Image
 Lillian Vernon
 Aloha Airgroup, ATA Airlines, Skybus Airlines,
Frontier Airlines
 Linens ‘N Things
 Tropicana Entertainment (casino operator)
 Circuit City
 Pilgrim’s Pride (chicken processor)
 Tribune (newspaper publisher)
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One of the very few beneficiaries of the Recession
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Unintended consequence of low rates since 2009: when interest rates are low,
corresponding investment yields are low and investors move to riskier assets trying
to find yield.
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1.
Misery Index: The sum of the unemployment rate
and the inflation rate.
2. Real Per Capita GDP Growth Rate: The percentage
change in real GDP per person
Think, Pair, Share
1. 1. What do you see on the chart?
2. 2. What year since 1957 has the unemployment
rate been the highest?
3. 3. What year had the highest inflation rate?
4. What year had the highest Misery Index?
Do economics play a role in
presidential elections?