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Charles Weber
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An era of de-regulation and encouragement of risk
Subprime (risky) loans are encouraged and widespreadspecifically through Countrywide, Fannie Mae and Freddie Mac
Housing bubble gives home buyers false hope that their home will
continue to appreciate in value
Many mortgage and mortgage securities owned by Fannie Mae
and Freddie Mac were bought by foreign central banks who
wanted higher returns then US Treasury Bonds
AIG is one of the creators of Credit-Default Swaps which offers a
type insurance against companies defaulting on their obligations
Jupiter High Grade CDO’s are considered acceptable risks
In 2003, Warren Buffet calls derivatives such as Credit-Default
Swaps “Weapons of financial mass destruction”
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1) Upturn in economy
2) Increase in population entering housing market
3) A low level of interest rates
4) Innovative mortgage products with low initial monthly
payments
5) Easy access to credit
6) High yielding structured mortgage bonds that make mortgage
available to borrowers
7) A potential of mispricing of risk by mortgage lenders and
mortgage bond investors that expands the availability of credit
to borrowers
8) The short term relationship between a mortgage and a
borrower under which borrowers are sometime’s encouraged to
take excessive risks
9) A lack of financial literacy and excessive risk-taking by
mortgage borrowers,
10) Speculative and risky behavior by home buyers and
property investors fueled by unrealistic and unsustainable
home price appreciation estimates.
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Collateralized Debt Obligations (CDOs): a type of structured
asset-backed security (ABS) whose value and payments are
derived from a portfolio of fixed-income underlying assets- in
Jupiter’s case home equity lines of credit
Issuers and Underwriters typically are Investment Banks
Jupiter’s underwriters do not buy peoples mortgages, or collect
payments to pass them to the investors; but, instead, hold other
mortgage bonds. Specifically the investments that are made up of
the riskiest investment portions of other bonds some of which are
a collection of poorly rated bonds.
Credit rating agencies failed to adequately account for large risks
when rating CDO’s
In March of 2007, 93% of the Jupiter deal was rated AAA
In a rising real estate environment such risks are deemed
acceptable.
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Mortgage Bonds: Investment Bankers create these by pooling
thousands of home loans
CDO No. 1: To create collateralized debt obligations the bankers
bought the unwanted, lower rated pieces of other mortgage bonds
(about 15%).
CDO No. 2: Often called CDO-squared, these bonds buy up the
riskiest parts of other CDOs- lots of them (about 40% or less).
CDO No. 3 or Jupiter High Grade V: (over 50%) Pools home
equity lines of credit. Issued in March of 2007 the CDO sold nearly
$1.5 billion in bonds to investors. At the time credit rating
agencies liked it’s diversification and gave 93% of Jupiter’s Bonds
a AAA rating. With this mess it makes it impossible to know the
what Jupiter is worth.
1) The bubble bursts when excessive risk-taking becomes
pervasive throughout the system
2) An increase in interest rates that puts homeownership out of
reach for some buyers and, in some instances, makes the
home a person currently owns unaffordable, leading to
default and foreclosure
3) A downturn in the general economic activity that leads to
less disposable income, job loss and/or fewer available jobs
4) Demand is exhausted, bringing supply and demand into
equilibrium and slowing the rapid pace of home price
appreciation that some homeowners, particularly
speculators, count on to make their purchases affordable or
profitable. When rapid price appreciation stagnates, those
who count on it to afford their homes long term might lose
their homes, bringing more supply to the market.
In past recession
periods, housing prices
remained stable.
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A clear drop in the
average medium home
price is clear in the
current economy unlike
other recessions.
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As many subprime variable loans began to
default, CDOs began to feel the effect
With only 7% of total borrowers behind on
their loans, hundreds of billions of mortgage
bonds are nearly worthless because of a
multiplier effect
These defaults create huge losses for Investors,
Investment Banks, Depositor Banks and
Mortgage Brokerages
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Mortgage Bonds: Losses 4.4%, when these loans go bad, mortgagebacked securities fall too, but since these bonds are one step removed
from loans, they have lost less then 5% of their worth.
CDO No. 1: Losses 14%, The loss grows because these bonds are
stacked, so the lowest rated bonds take the first losses. CDOs buy the
bottom 30% of other bonds. The result: the lower 30% of the mortgage
bonds become 100% of the CDO. So the losses begin to multiply with
these instruments losing three times as much value as the original
bonds.
CDO No. 2: Losses 36%, CDO-squared generally consist of pieces of
the lower 40% of other bonds. A CDO-squared would see losses more
then double.
CDO No. 3, Jupiter: Losses 59%, Jupiter appears to have some value
left. But how much? Jupiter’s junk bonds have already defaulted. A
portion of it’s top piece is worth 40% less than what original investors
paid. Some argue it’s only worth 5% of its original value- meaning .05
cents on the dollar.
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With escalating defaults and foreclosures,
investment banks collapse from losses
AIG becomes unable to pay for all its “insured”
defaulting bonds
With a banking system in shock and
hemorrhaging money, the credit system freezes
Without credit available many companies and
banks are faced with severe cash flow
shortages leading to increasing layoffs and
bankruptcies
Unemployment rates jump sharply especially
where foreclosure rates are highest
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Investment Banks are either left to go bankrupt and
close, absorbed by depositor banks, or are forced to
turn into depositor banks
Fannie Mae and Freddie Mac are placed into
conservatorship while Countrywide is purchased by
Bank of America
US government will not let AIG go under out of fear of
losing foreign investment
Depositor banks, AIG and others are granted bailout
money to save them with the hopes of sparing the
world from economic disaster
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The Breakdown: 61% to individual states, 31%
to federal agencies and programs
$288.3 Billion- Tax Provisions: payroll tax cuts, credit for first time
home purchases, higher education and more, also unemployment
tax breaks, and help for car buyers
$90 billion- Relief for states: goes directly to states
$71.3 billion- Health, labor, and education programs
$61.2 billion- Housing and transportation programs
$58.1 billion- Unemployment and low wage assistance
$53.6 billion- Grants to states, mostly for education
$50.8 billion- Energy and water development
$26.4 billion- Agriculture, rural aid and FDA
$24.7 billion- Health insurance assistance
$62.6 billion- Other programs
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Toxic Assets like CDOs need to be priced
accurately so investors get a fair deal
Government potentially could buy up these
assets with Nationalization being mentioned
Should the Government continue to bailout
companies that are non- competitive?
Who is to blame for this financial mess?
Could Vallejo California be the future for other
towns and cities?