Gambling With Other Peoples Money Made by Danny

Gambling With Other People’s Money Made by: Danny Miller Dmitry Zavyalov, Jack Puisis, Rachel

I. Introduction • During the mid 1990’s American home prices began a decade long climb that was irresistible to investors • By the end of the first decade of the twenty first century, many investments turned out to be more risky than people though • Homeowners lost their houses, financial institutions imploded, and the entire financial system was in turmoil

Intro continued… • In this commonly held view, the housing market collapse and the subsequent financial crisis were a perfect storm of private and public mistakes. • People bought houses they couldn’t afford. • Firms bundled the mortgages for these houses into complex securities. • Investors and financial institutions bought these securities thinking they were less risky than they actually were. • Regulators who might have prevented the mess were asleep on the job. • Greed and hubris ran amok. • Capitalism ran amok.

Intro continued… • Public policy over the last three decades has distorted the natural feedback loops of profit and loss • Milton Friedman • Capitalism is a profit and loss system • The profits encourage risk taking. • The losses encourage prudence. • When taxpayers absorb the losses, the distorted result is reckless and imprudent risk taking.

II. Gambling With Other People’s Money • Poker Player example • You lend money to a friend (poker player) with Uncle Sam watching. • You • Lend $97 out of $100 • Take the risk • Trust your friend because he always makes due on his debt • Friend (Poker Player) • Puts up $3 out of $100 to gamble with • Upside • Minimal risk only putting up $3 • Increase amount of winnings by betting more • Uncle Sam has been known to bail poker players out • Knowing this the friend can take big chances

III. Did Creditors Expect to Get Rescued?

III. Did Creditors Expect to Get Rescued? Bailed Out • 1984 Continental Illinois • 1995 Mexico • 1998 Long Term Capital Management (LTCM) • 2008 • Merged J. P. MC with Bear Sterns • Nationalized Fannie and Freddie • Bought large stake of AIG Not Bailed Out • 1990 Drexel Burnham • Lehman Brothers • Expected bailout like Bear Sterns • Blame Gov’t for not rescuing and causing panic • Highly leveraged balance sheet

IV. What about Equity Holders? • Equity holders care about two things • Upside • Downside • Equity holders did not rebel against high leveraged creditors…why? • They had well diversified portfolio • They had good foresight into the future • Made high returns on stocks and sold early before companies failed

V. Heads and Tails • limited liability protected the managers from the consequences of any losses beyond the bank equity. • How does this work? • Owners borrow money to increase leverage and finance their salaries creating a cushion in case of bank failure. • Many CEOs lost large sums of money when value of stock prices dropped. • Previous large compensations provided cushion for CEOs • Bottom line: Depositors got their money back, CEOs never paid the price for their risky decisions, and Taxpayers paid (still paying) the bill.

VI. Blowing up the Housing Market • Too much leverage and borrowed money • 3 % down payment on the housing market • Allowed people who normally wouldn’t have accumulated sufficient down payment to buy a home. • Encouraged homeowners to bid on larger, more expensive houses rather than cheaper ones. • Encouraged prospective buyers to bid more than a house is currently worth if the house is expected to appreciate. • 1997 Tax Payer Relief Act • First $250, 000 ($500, 000 for married couples) of capital gains from the sale of a primary residence to be tax exempt. • No longer had to roll profits over into a new purchase of equal or greater value. • Capital gains on a second home to be tax free as long as you lived in that home for 2 years.

VII. Fannie and Freddie • • “Conduit” Implicit guarantee – F for Federal Business Model Federal Governments role changed fundamentally in the 1990 s. • Political policy • Loosening the restraints – 1993 • Increase in Loan purchases to be loans to borrowers below median income • Low Down Payment Loans • “Flexible” – relaxed their underwriting standards • Birth of Originate and Sell – 1995 • Fannie and Freddie’s approach to the down payment • 1998 – 2003 number of loans with less than 5% down quadrupled • Significantly increased risk of both Fannie and Freddie

VII. Steering the Conduit • Politicians found it easy and beneficial to steer the conduit. • Fannie and Freddie found it profitable to be steered. • “Channeling precious capital into housing meant it didn’t flow into other areas that were more valuable but that were artificially made less attractive. So we got more and bigger houses and less of something else—less money going to fund new medical devices, cars that get better gas mileage, more creative enter tainment, or something else creative people could have done with more capital. ” • Who’s stuck with paying the bill? Taxpayers.

VIII. Fannie and Freddie – Cause or Effect? • Victims of the Crisis • Freddie and Fannie were followers. • Put up affordable housing mandates because they were involved in loans to low income borrowers. • Loosened credit standards between 1998 – 2003 to keep market share. • Involved in Alt A subprime loans in 2005 and 2006 for the same reason.

VIII. Cause or Effect? Cont. • Helped create the market for sub prime • “Made their own weather. ” – hedge fund manager • Fannie and Fannie made up such a large part of the market that they were the underlying cause of what went wrong. • Created the originate and sell market. • Controlled the mortgage lending business with their automated underwriting systems. • Encouraged by HUD, poured billions of dollars into home purchases of subprime securities (purchases they used to satisfy their HUD affordable housing goals).

VIII. Cause or Effect? Cont. Some Truths to Both • Important to distinguish between two periods • Mid 1990 s – 2000 s • High availability of mortgage credit • Lenders were making bad loans • Irrational exuberance and national homeownership policy • Fannie and Freddie became more aggressive to achieve goals • Mainly through expansion of credit to low income borrowers • Piggyback Loans • 2000 Onward • Purchased 1 million home loans year to borrowers below median incomes • 2004 Purchased 268, 000 loans with less than 5% down • 2006 400, 000 loans were made • 2007 600, 000

IX. Commercial and Investment Banks • Bank of America, Bear Stearns, Lehman Brothers, Merrill Lynch, and the others weren’t government sponsored enterprises. • Issued private label mortgage backed securities. • Borrow low, lend high • Borrowing low • Very short term • Implicit guarantee • The rising prices of houses created the opportu nity for subprime securitization and the financing of riskier mortgages generally • In 2006, Alt A and subprime mortgages were one third of all originations.

IX. Commercial and Investment Banks continued…

X. Picking Up Nickels • High risk, high return has many drawbacks. • What is the Ideal Investment? • Investments that have a small risk of failure (even though the consequences of failure are catastrophic) and a small return. Small return, but leverage improves the overall return of the portfolio. • Picking up nickels • Long Term Capital Management’s strategy was picking up nickels —making very small amounts on arbitrage opportunities with very high leverage. • The taxpayers ultimately fund picking up of nickels, and the taxpayers get flattened while the executives earn money.

XI. Basel II • Required banks to hold more capital for riskier investments but less capital for the safest classes. • created an opportunity to achieve high profits, but limited in number. • Made AAA rated investments out of loans that were highly risky. • Many observers blamed rating agencies, gave AAA rating to tranches of MBS that were toxic assets. • How did this happen? Issuers were paying for ratings. • Assets very complex, agencies lacked skill to analyze • Commercial and investment banks still bought them, highly profitable and easy to lend against. • Lenders lent them since they could be rescued. • Many took advantage of this deregulation.

XII. Where do we go from here? • Policy to reduce the size of financial institutions to make them small enough to be able to fail, to restrict executive pay to reduce the potential for looting, and to increase capital requirements to reduce the fragility of the system induced by leverage • No recreation or improvement of current system – but natural development • Get the government out of the business of hidden subsidies to mortgage interest rates. The government should fund any government programs to increase homeownership out of current tax dollars where the costs are visible.

XII. Where do we go from here? • Restrain rather than empower the Fed. It has played a major role in exacerbating the moral hazard problem. • Stop enabling obscene transfers of wealth claiming they are necessary for stability. Reduce the number of bailouts. • A ceiling of 50 cents on the dollar for creditors and lenders when the institutions they fund become insolvent. Even this may be too difficult for politicians to stomach. But economists should be able to support such a move and preach its virtues.