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Transcript
Subprime Crisis In US
Brief Banking History
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Mesopotamia, >3000 years ago, storehouses for
reserves of grain and animals, charged interest
much like today
Italy, Medici of Florence: first modern loan and
deposit system to handle multiple currency, later
improved by Dutch and British, imported to
American colonies
Growing pains through a period of minimal
regulation, legislation during Civil War: entire US
banking system under federal regulation
Brief Banking History (2)
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Credit crisis late in the 19th century and in 1907
The Great stock market crash of 1929: caused
by too many high-risk loans under the
assumptions that stock market would continue
to rise unabated
Bubble prop in October 1929, run in risky on
the nation’s banks. However, banks engaged in
risky investments themselves with depositors’
cash, only to lose it all
Brief Banking History (3)
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1933: banks basic function ceased:
Franklin Roosevelt put a few measures
Glass-Stegall Act: forbid commercial banks
(BofA, pre-Merrill) from offering services
of investment of insurance banks (AIG)
FDIC: promised to reimburse customers
should a bank go out of business
Brief Banking History (4)
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1913, Federal Reserve created: “lender of last
resort”, the central bank of US
Roosevelt polices slowly brought confidence in
the banking system back up and helped end the
Great Depression
1999, Glass-Stegall Act repealed; commercial
banks to re-enter stock biz
IB used to be big players for Gov’t and
corporations could own commercial banks
Brief Banking History (5)
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With a surging market, IBs made all kinds
of money
Until a few years ago, housing propelling
growth was unstoppable
Merrill Lynch and Lehman offered
mortgages left and right, many to people
with poor credit records, gambling that
housing prices would continue to rise
Micro Economic Overview
Homebuyers
Mortgage
Rating Agencies
Bond Insurers
Credit Providers
lend money
w/ propertyt collateral
Mortgage Lenders
MBS
Securitization
Fannie Mae/ Freddie Mac
CDO
Securitization
FDIC
Investment Bank
CDO
Speculation
Hedge Funds
Investors
S&L Crisis
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Not a new phenomenon
Historical S&L crisis dates back to the Great
Depression, Disintermedaition in the late 70’s,
S&L crisis in 1989
1989: 747 S&L bankruptcies with $160 billion of
bailout, caused recession in 1991-92
2008: In addition to $85 billion of bailout for
AIG, $700 billion more for Wall Street
How large is $700 billion?
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NASA fiscal year 2009: $17.6 billion
NSF annual budget: $6.1 billion
Military budget 2009: $481 billion
Social Security: $608 billion
$2,300 for each American
US national debt: $9 trillion
Can take 25,000 Rodriguez (NY Yankees)
The Forbes 400 richest people total $1.57 trillion
How big is subprime?
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2% of total loans in 2002 to 20% of total
loans in 2006
US economy: $ 60 trillion
Mortgage Market: $12 trillion
Subprime: $2.4 trillion
Massive write-offs by the commercial
banking and investment banking ($500 B)
Even Bigger Derivative
Ratio of CDS to Underlying Bonds
CDS Outstanding
500
70
400
50
300
40
%
Trillion Dollar
60
30
200
20
10
0
1999
100
2001
2003
2005
Year
2007
2009
0
1999
2001
2003
2005
Year
2007
2009
Subprime Mortgage
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Loans to less than perfect credit
Any late payments, bankruptcies, liens,
judgments, or other defaults blemish the
credit history
Borrower with blemished credit history or
no credit history does not qualify for the
Prime Mortgage Loans: falls to subprime
mortgage with high interest payments
Chronological Development
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Countrywide (acquired by Bank of America)
Bear Sterns (acquired by JP Morgan Chase)
Lehman Brothers (CDO/CDS exposure $600B)
Merrill Lynch (acquired by Bank of America)
AIG ($500B CDS exposure, $250B Liable)
Washington Mutual (acquired by JP Morgan Chase)
Wachovia (acquired by Citigroup)
Morgan Stanley, Goldman Sachs (subprime, CDS
exposure related to hedge funds): covert to chartered
bank holding companies (part of $700 billion of US Gov’t
bailout)
Chain of Reaction
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Burst of US housing bubble and high default
rates on “subprime” and “ARM”
Increase in defaults and foreclosure
Mortgage lenders and credit risk sellers were hit
hard
Tighter lending, and increased spreads on
interest rates
Contracted liquidity in the global credit markets
and banking system
Who to blame?
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Reagan Doctrine: Financial Deregulation ‘82
Democrats-led congress passed the law to
provide more affordable mortgages to low
income people (1992)
People who shouldn’t have been borrowing
These loans were packaged into CDOs rated
AAA (IBs and rating agencies)
Investment Bank purchase w/o due diligence
Distributed throughout the world
Greed
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Alpha generation: beat the market, theme
of portfolio managers/ hedge fund
managers
Earn higher mortgage or credit card rates
Bet on credit: three hedge funds
speculation funded by investment banks
High leverage bet
Issues
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Moral hazard
Conflicts of Interest
Regulation or deregulation
Quants: Fall of geniuses
Financial engineering without
comprehensive understanding of risk
management