U S Financial Crisis Sarinee Achavanuntakul Fringer http

U. S. Financial Crisis Sarinee Achavanuntakul Fringer | ���� http: //www. fringer. org/ Last update: 8 December 2008 Most slides are taken from http: //www. slideshare. net/econman/the-credit-crisis-of 2008 a-presentation

The credit crisis, illustrated: the beginning

. . when 2008 rolls around:

Root of the crisis: the housing bubble

Fuelling the bubble: low interest rates

Mortgage securitization

Moral hazard “credit ease” • “Subprime” is defined as borrower who has FICO credit score less than 620, but some lenders also define borrowers whose FICO score as high as 680 as “subprime” if their down payment is <5% • Typical subprime mortgage is “Adjustable-rate Mortgage” (ARM): a 2/28 ARM means fixed interest rate for the first 2 years, then floating rate (e. g. LIBOR + 6%) for the remaining 28 years • Often requires no down payment, can borrow 100% of house value, and has no rigorous credit check – “NINJA” borrowers, “Liar loans” • Zimmerman (2007) proves that subprime loan quality in 2007 is worse than in 2006, and 2006 were worse than 2005 • New subprime loans were $421, 000 million in 2006 (S&P estimate); AMP Capital Investors estimates $1. 4 trillion subprime loan outstanding in July 2007 • Fannie Mae estimates that 50% of those who were sold subprime loans would have qualified for prime-rate loans

Credit Default Swap (CDS) • Investors seek insurance to cover unexpected defaults on loans

Fraud, over-leverage, and non-transparency • Fraud: – Unfair or misleading credit terms, e. g. ARM, universal default – Moody’s supposed “bug” in their credit rating model that resulted in some bonds being overrated by 4 notches (5/2008) • Over-leverage: – Many banks & hedge funds over-leverage to make easy money on CDOs: 25 -30 x times their capital • Non-transparency: – Financial institutions use off-balance-sheet vehicles e. g. Special. Purpose Vehicle (SPV) to hide real exposure and evade taxes – Most subprime-linked derivatives are traded on 100% private, OTC (“over-the-counter”) basis, so nobody knows the market size problem applies to the whole “shadow banking system”

Agency problems, wrong incentives • Problems at the top – “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing. ” Citigroup’s Chuck Prince, in an interview with Financial Times, July 2007 – Retired in November 2007 with $38 million pay package • Problems down below: – Traders are compensated for short-term performance – if they take positions that have 5% chance of total catastrophe, they will be well rewarded year after year as long as that 5% never materializes – What the traders receive are therefore just “insurance premiums” but they thought they are smart! – Internal risk management gets weaker the more profits they make – Hard to separate true “alpha” (idiosyncratic, firm-specific) from “beta” (systemic, overall market returns) risks

What went wrong…

Multiplied losses

Compounded systemic risks • Sellers of CDS who see that companies they sold CDS for are having trouble will short bonds and stocks of those companies to make money to cover what they have to pay CDS buyers • So this makes bonds and stocks of companies spiral downward very quickly when companies show first sign of trouble: a “domino effect” • This strategic makes sense for individual investor, but collectively this increases systemic risk • Nassim Taleb: in financial markets, risks in crisis situation are much higher than in “normal” situations • Also, because of size and interconnected transactions, many Wall Street firms are really “too big to fail”

“Those guys are good. ”

How a bank works • Most bank “liabilities” are deposits which are short-term in nature (e. g. 2 -year fixed deposits), while most “assets” are longer-term loans (e. g. mortgages or CDOs which are “investments”). Mortgages are the longest-term loans. • Banks must mark-to-market the value of their investments. • Example: Wachovia balance sheet @ 30/6/08 (prior to Citigroup takeover): Assets Liabilities & Equity Current assets Long-term assets Investments Others $110 Total $810 $600 $100 Short-term debt Long-term debt Equity (shareholders) $505 $230 $75 Total $810

Why banks fail so dramatically Assets Current assets Long-term assets Investments Others $500 $100 Total $510 -$90 Liabilities & Equity Short-term debt $305 Long-term debt $230 Equity (shareholders) -$25 Total $510 • Borrower defaults + house prices collapse market value of investments / mortgages collapse (ex. $100 in above example) • Bank must record falling value of investments as losses erode bank capital until shareholder’s equity is negative insolvent • Meanwhile, if bank’s debtors (depositors or other financial institutions) withdraw funds or demand loan prepayment, bank may face a severe liquidity crisis until it is bankrupt • Bailout: buy toxic assets from banks (not a good idea: at what price & certain losses) or raise capital (better, but can Republicans accept? ) • If public funds are used, ex-shareholders should not reap benefits

U. S. household debt problem is not over • Currently 8. 8 million Americans have negative home equity – a record figure • Total mortgage market in U. S. is approx $11 trillion (79% of GDP). About 13% of these are subprime • U. S. households have $1 trillion credit card debt + $0. 7 trillion auto loan. These debts often have no collateral – repayment depends solely on borrower’s ability to repay • Tough & unfair credit terms + rising cost of living (oil, food, etc. ) erode ability to repay • These loans have been securitized too. So… watch out!

The end of neoliberal economics?

What will happen next?