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Finance 129
Background on the Financial Crisis
And Current Economy
The Big Picture
Problems in Mortgage Market
Global Credit Crisis / Bank failures / Equity Losses
Declining Consumer Spending
Decreased Business Investment
Who’s to Blame?
Economic
Environment
Congress
Consumers
Mortgage
Originators
Regulators
Wall Street
GSEs
Rating
Agencies
International
Flows
How Financial Markets Enabled
“Keeping up with the Joneses”
New Products
Poor Underwriting
Public Policies Unintended Consequences
Low Rates and International Capital Flows
Average Size of
Subprime Loans
Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 200705, August 2008 (sample represents approximately 85% of securitized subprime loans, over 50% to total subprime
Credit Quality of Subprime Loans
Originated each year
Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper
2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans, over 50% to total subprime
Impact of Subprime Loans
on Home Ownership
"SubPrime Lending: A Net Drain on Homeownership," Center for Responsible Lending: March 2007
Fannie Mae’s
Guarantee of Alt A Loans
$ Billions of Alt A Loans Guaranteed
300
2007
$79
Billion
Added
250
2006
$87
Billion
Added
200
150
2005
$58
Billion Added
100
50
2004 & Before
$77 Billion Total
0
NY Times October 4 "Pressured to Take More Risk Fannie Hit a Tipping Point"
Blaming Fannie and Freddie?
No - Fannie and Freddie were small relative to
the entire market.
Combined Subprime Purchases (% of Market)**
Consumer demand created rapid prince increase
Yes – Overall Size put them at risk for any
Mortgage Market problem
Securitizing more risky loans opened door for
Private securitization
Gramlich, E. "Subprime Loans: America's Latest Boom an Bust" 2007 ** "how HUD Mortgage Policy Fed
the Crisis", Washington Post June 10, 2008
International Capital Flows
Consumer Spending On Exports
Increased Foreign Holdings of $
Increased Inflow of Dollars
Helps Keep Long Term Rates Low
“The Perfect Storm”
2004 - 2007
Domestic and global institutions buy MBS in attempt
to increase margins on “safe” securities, incorrectly
rated.
Institutions use higher debt levels for securitization.
Underwriting standards deteriorate.
Increased interest rate environment makes loans
more likely to default
Increasing Home Prices encourage consumers to
overextend and speculate in housing market
Non Agency Mortgage
Foreclosure Rates
Response of Consumers
Increased access to credit and delusional
optimism resulted in:
Short-Term Speculative Focus
Borrowing More and Saving Less
Case Study: Natalie Brandon
1985 Buys $105,000 house
30 Year fixed rate loan
2000-2006
Payment = $770
Paid penalties to Refi 5 times in 5 years
Yearly income = $100,000
2006 New Loan $625,500 2/28 7.99% teaser
Payment = $4,585
Fall 2007
Home Value = $450,000
Attempt to Refi for 40 years at 6% Fails
Borrowing More & Saving Less
Equity Prices
Compared to Past Recessions
Precautionary Saving
If you were to lose your job, for how long could you afford to be out of
work and still meet your financial obligations including monthly expenses?
Less than 2 weeks
2 weeks to a month
2 to 3 months
4 to 6 months
7 months to a year
More than a year
All
28%
22%
22%
14%
5%
10%
Silents
11%
17%
23%
15%
7%
27%
Boomers
25%
21%
24%
11%
5%
14%
Gen X
31%
21%
19%
17%
6%
5%
The 2009 MetLife Study of the American Dream
Gen Y
32%
27%
22%
12%
2%
6%
Confidence in Having Enough Money to Live
Comfortably Throughout Retirement Years
Employee Benefits Research Institute – Retirement Confidence Survey
The Keys to Recovery – The Big Picture
Consumers
Precautionary or Long Term Savings?
Lost Faith in Investment Planning?
View of home ownership
Corporate Earnings
Financial Markets and Regulation
Regulatory Changes
Long Term Inflation Fears
Monetary and Fiscal Policy & Interest Rates
Global Concerns
Consumer Credit Outstanding
ISM Manufacturing Survey
Employment: Non Farm Payrolls
Employment: Non Farm Payrolls
Peak = 138 M
Jan 2009
Min = 129.2 M
Feb 2010
Current = 133.2 M
July 2012
Employment
Peak Employment Jan 2009 = 138.023 Million
Current Employment July 2012 = 133.245 Million
Average monthly gain needed in payrolls to
return to peak level in:
1 year 398,166
2 years 199,083
3 years 132,722
Feb 240,000
May 77,000
March 154,000
June 64,000
April 77,000
July 164,000
Other Forces
Government
Contraction
Tight Credit
Uncertainty
US, Europe, China
The Slow Recovery: It’s No Just Housing FRBSF Economic Letter April 9, 2012
History of EU 1950
The Schuman Declaration
Plan for France and Germany
to pool coal and steel
production.
European economic unity will
make war “Not merely
unthinkable but materially
impossible”
Robert Schuman
French Foreign Minister
1951
European Coal and Steel Community
France, Germany, Italy,
Netherlands, Belgium and
Luxembourg
High Authority (oversees coal and
steel production)
Common Assembly (future
European Parliament)
Council of Ministers
Changing Landscape
1980 1997 2006
% of GDP (PPP) produced by g-7
countries
54% 46% 40%
% OF GDP (PPP) produced by
other G-20 Countries
21% 30% 36%
The Group of Twenty a History www.g20.org
A Brief History of European Debt Crisis
January 2001 – Greece Joins Euro zone and adopts
Euro.
Nov 2004 – Greece admits its deficit has been
above the required EU limit (3% of GDP) since
1999
March 2005 – Trade Unions impose 24 hour strike
to protest austerity measures after cost of hosting
Olympics causes high deficits
Greek timeline on this and future slides from news.bbc.co.uk/2/hi/Europe/country_profiles/1014812.stm
2002
Germany’s Debt hits 60.7% in 2002 of GDP and is still
above 60%
Germany’s budget deficit hits 3.8% of GDP in 2002 and
remains above 3% until 2006
France’s debt hits 63.3% of GDP in 2003 and is still above
60%
France’s budget deficit hits 3.3%in 2002 and remains above
3% until 2006
Neither country receives penalties from the European Union
2005
The 1997 Growth and Stability Pact is altered to
allow “exceptional circumstances” and “other
relevant factors” to be considered when the
deficit and debt targets are missed.
Memebers are allowed two year to correct the
problem and could be given more time with an
exception.
Deficit as a % of GDP
ECB http://www.ecb.int/stats/gov/html/dashboard.en.html
Euro Area Debt
Long Term Borrowing Costs
(10 year debt) Jan 2010 – May 2012
Contagion
November 28, 2010
Ireland receives €67.5B in bailout loan
commitments
Given to 2015 to decrease deficit to 3% of GDP
May 2011
May 3 Portugal accepts €116B loan commitment
package
shttp://www.huffingtonpost.com/2010/11/28/ireland-bailout-european-union_n_788922.html
Public Debt Comparison
1999
2004
2010
Country
Unep
Rate
Debt
% of
GDP
Rev %
of GDP
Unep
Rate
Debt
% of
GDP
Rev %
of GDP
Unep
Rate
Debt
% of
GDP
Rev %
of GDP
(2009)
Japan
4.7%
97%
26.3%
4.7%
156%
26.3%
5.1%
183%*
28.1%
Greece
12.1%
103%
32.8%
10.5%
108%
31.1%
12.6%
147%
29.4%
Italy
11%
106%
42.5%
8.1%
96%
40.9%
8.4%
109%
43.5%
US
4.2%
38%
29.1%
5.5%
36%
25.7%
9.6%
61%
23.9%
Spain
15.6%
52%
34.1%
11%
39%
34.6%
10%
51%
30.7%
Treasury Bid to Cover Ratio
2 year
10 year
2005 Average
2.19
3.75
2012 Average
2.36
3.18
Average Interest Expense
Average Interest Rates
Title
June 30,
2012
June 30,
2011
Treasury Bills
0.115
0.129
Treasury Notes
2.077
2.385
Treasury Bonds
5.452
5.860
1.696
2.005
4.625
4.625
2.159*
2.380
Interest-bearing Debt:
Marketable:
Treasury InflationProtected Securities
Federal Financing Bank
Total Marketable
GAO Baseline
Revenues as a share of GDP increase and
discretionary spending as a share of GDP
decreases
GAO Baseline
GAO Alternative Scenario
Revenue and Discretionary Spending are at
historical averages over long term.
Soc Sec, Medicare, Medicaid and interest
exceed revenue by 2030
GAO Alternative Scenario
Fiscal Gap or
Current Value of Future Primary Deficits
The sum of the present values of the
difference, or gap, between revenue and
noninterest spending over the next 75 years.
Assumes the goal of having today’s debt to
GDP ratio at the end of the period
Cost of Closing the Gap
Federal Fiscal Gap under GAO’s Simulations Based upon Trustees
Assumptions, 2011-2085
Average % change required to close gap
If action is taken today
If action is taken in 2021
% of
GDP
Solely
through
increase in
revenue
Solely through
Solely
decreases in
through
noninterest
increases in
spending
revenue
Solely
through
decreases in
noninterest
spending
Baseline
1.8
8.4
8.0
9.9
9.4
Alternative
8.2
45.7
32.2
54.3
37.0
www.gao.gov The Federal Government's Long-Term Fiscal Outlook January 2012
The World in 2050
The G7 vs the E7 (Brazil, Russia, India, China,
Indonesia, Mexico and Turkey)
Emerging Middle Class in Developing Economies
2005 G7 is currently about 20% larger in
Purchasing power parity (PPP) and 75% larger in
terms of market exchange rates (MER)
E7 will be 75% larger than G7 in PPP and 25%
larger in terms of the (MER)
The World in 2050, Price Waterhouse Coopers, March 2006