Financial Crises: Past, Present and Future

James J. Angel, PhD, CFA Georgetown University McDonough School of Business

About me

B.S. Caltech MBA Harvard Ph.D. Berkeley At Georgetown since 1991 Studies financial markets and regulation

Visited over 50 exchanges around the world Inventor of two patents for trading systems Testified four times before US Congress Former Chair of Nasdaq Economic Advisory Board On board of directors of Direct Edge stock exchanges
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Overview

Financial crises occur with regularity

Typical pattern Asset bubble + bust Excessive leverage Failure of financial institutions Recession Aftershocks still occurring
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Current mess started in US housing finance.

Financial Crises

Have happened many times Currency crisis

Fixed exchange rate systems usually blow up in a crisis

Thailand 1998 European Rate Mechanism 1992 Mexico 1994

Financial system crisis

Too much debt

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Basic instability of banks

Highly leveraged institutions

Borrow money from depositors to lend to borrowers Little room for error Most liabilities short term Assets mostly illiquid bank loans Very hard to determine quality of assets

Fundamental liquidity mismatch

Bank balance sheets are opaque

This is why banks are highly regulated!

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Typical bank balance sheet

Assets $100 Loans Liabilities + Equity $90 Debt (Deposits and other debt)

$10 Equity
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Why runs on banks?

Consider payoff matrix to the depositors dilemma: Should they withdraw or not?
Bank Assets Good Withdraw deposits Leave deposits in bank Have money no losses Have money no losses Bank Assets Bad Have money no losses LOSE MONEY

If there is any doubt, WITHDRAW!!!!

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But what happened this time?

Worried depositors at Indymac

The Subprime Tsunami:

The mortgage value chain

Loan origination

Financing of loan

Bearing of credit risk

Bearing of interest rate risk

Bearing of prepayment risk

Servicing loan

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Strategic considerations

Few firms are the best at every step in the mortgage value chain. What the strategists say:

Concentrate on what you do best

OUTSOURCE THE REST!

We unbundled the value chain

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The modern mortgage industry

Mortgage originator arranges loan.

Mortgage broker, bank, S&L, online Fannie Mae, Freddie Mac, Wall Street Fannie and Freddie

Broker sells loans to intermediary

Created by Congress

Known as Government Sponsored Enterprises (GSEs) Then sort of privatized

Intermediary repackages cash flows from loans into Mortgage Backed Securities (MBS)

This is one type of asset-backed security. Same can be done with credit cards and car loans.
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Securities sold to investors

The magic of diversification

A single random variable might be risky

Like a mortgage

But a pool of random variables is often far more predictable.

Principle on which insurance rests.

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Cash flows can be repackaged

Not many private investors like individual mortgages The cash flows to a pool of mortgages can be repackaged into securities that investors want. Investors buy a slice (tranche) of the pool that fits their taste

Size Maturity Risk

Pension funds and other institutional investors now willing to invest

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Generic mortgage backed structure balance sheet

Assets Pool of Mortgages Liabilities + Equity Tranche #1: Looks like one year bond Gets all money that flows into pool until the bond is paid off. Rated AAA Tranche #2: Looks like a five year bond. Gets all of the money that flows into pool after Tranche #1 is satisfied. Rated AAA Tranche #3: Riskier stuff that bears some of the credit risk and prepayment risk: Rated B

The residual: also known as Toxic Waste: Unrated

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The beauty of securitization

Connects end investors more directly to borrowers.

Without needing a highly leveraged and risky financial institution in between!

Repackaging gives both borrowers and investors what they really want. This is GOOD!

It can REDUCE systemic risk in the economy. IF the securities are made out of high quality loans. IF the securities are not concentrated in the portfolios of highly leveraged investors (e.g. banks)
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Weak link in system

All these products flowed through rating agencies.

Standard and Poors, Moodys, Fitch Long history of doing a good job rating corporate debt.

Investors relied too much on ratings Rating agencies relied too much on issuers computer models of losses.

Did not take into account what would happen if housing prices fell substantially nationwide.

Had not happened since Great Depression.

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Rationale for lending to subprime borrowers

By making deadbeats into homeowners, they become more responsible. High interest rates

Offset expected losses. Give borrowers an incentive to refinance as soon as their credit improves.

Original-issue subprime mortgages picked up steam in the mid 1990s.

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Innovations in lending

In early 1990s, US borrowers needed good credit to get a mortgage.

Had to document all income in detail. Had to have big (~20%) down payment. Thought computer models could predict losses.

Lenders started loosening standards

And that computerized credit reports could replace documentation of income.

Thought risk was passed on to others.

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The subprime lending bubble

Just like other speculative bubbles in history

Tulips, internet, etc. Subprimes could always sell or refi rather than be foreclosed if they ran into trouble. Creators of subprime MBS only looked at a few years of data. Rating agencies fell asleep and mistakenly labeled securities as AAA when they should not have.

Generally rising house prices obscured risk.

It seemed for a while that the subprime lenders were making lots of money.
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Risk bearing?

Major players thought that either

Someone else was bearing the risk, or Someone else figured out that the risk was low. Thought that house prices would go up, and/or They could refinance at a better rate when the ARM reset.

Borrowers:

Originators: sold subprime mortgages to Wall Street firms. Wall Street: Repackaged mortgages and sold to investors worldwide Regulators: Fragmented regulators thought other regulators had jurisdiction.
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Demand for subprime

Fannie Mae and Freddie Mac bought tens of billions of subprime backed paper.

Their government mission was to make housing more widely available. They were highly leveraged

Required to have less capital than normal banks

Demand for subprime paper caused lending standards to deteriorate further Easy availability of funding inflated housing bubble.
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The Panic of 2008

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The crisis unfolded in 2007/2008

Gradual realization of extent of problem.

Various subprime related businesses fail. Markets began to freeze up.

Leaders panicked in ways that made problem worse.

US nationalized Fannie Mae and Freddie Mac in a clumsy way.

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Paulson Panic

Clumsy handling of Fannie and Freddie sets off crisis of confidence Government message:

Things are much, much worse than we said they were

Fannies and Freddies housing related assets are worth much less than expected.

Financial markets interpret message:

All housing related assets are worth less then before Fear that other financial institutions will follow
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More dominoes fall!

Lehman Brothers AIG

Very large insurance company

Money Market funds At this point, all <bleep> breaks loose.

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Paulson Panic II

Leaders panicked Send panicky message to world: Unprecedented Uncharted

Translation: We dont know what we are doing.

Give me $700 billion to spend TODAY or the world collapses

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The consumer panic

Up until September 2008, most consumers did not pay attention to the brewing storm on Wall Street. When the government panicked, the uncertainty caused everyone to stop all discretionary spending. Consumer and business confidence plummeted.
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From a financial panic to a spending strike

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The ripples spread

Consumers defer big ticket items.

Auto sales plummet

Christmas sales plummet. Retailers are stuck with excess inventory and cut back. Collapse of buying ripples through supply chain in a chain reaction. Dizzying drop in orders creates further gloom.
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Meanwhile..Global dominoes fall

European banks in trouble

Governments step in Royal Bank of Scotland fails. Country not big enough to bail them out

Icelandic banks fail

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Global response to recession

Standard Keynesian and Monetarist prescriptions Governments run deficits: Stimulus

Unemployment is output lost forever. It makes sense for governments to borrow money to put people to work. But: Should spend efficiently so there is something to show for it.

Central bank keeps financial system afloat

Lender of last resort to illiquid but otherwise OK institutions.

Prevents damaging runs on system.

Prevent money supply from collapsing like in Great Depression.

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Meanwhile at the Fed

Bernanke increases money supply

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Auto sales sputter

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Unemployment sky rockets

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Ripples continue to spread

Realization that Euro-zone countries dont have unlimited spending power.

Countries cant print money to spend their way out of the recession. This means they will have to reduce fiscal stimulus in order to balance budgets.

Will slow down recovery.

Fear over the breakup of the Euro-zone Uncertainty about who bears losses from Greek default depresses economy.

Similar concerns about state and local governments in the U.S.

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Future crises

Human nature has not changed. Lenders and investors are too optimistic in good times.

And too pessimistic in bad times.

Each generation has its bubbles Look out for highly leveraged institutions

Seem to be making lots of money in good times. But look out when the market turns!

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Any questions?

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