The Current State of the US. Financial Market

1. The Current State of the US. Financial Market

2. What caused the current financial situation? What happened next? The rescue of Fannie Mae and Freddie Mac A historical timeline of Fannie and Freddie What caused the rescue of Fannie and Freddie? Why will the rescue of Fannie and Freddie help? Where does the Community Reinvestment Act come in to play? The rescue of the US financial system Why will the rescue plan help? What will the rescue plan provide? What do the experts think of the current financial situation? What did the experts think of the economy before the present-day situation arose? Appendix Outline

3. What Caused the Current Financial Situation?

4. 1992 Legislation for Fannie Mae and Freddie Mac was enacted which loosened the lending standards for home ownership. 1999 The Financial Services Modernization Act (also known as the Gramm-Leach-Bliley Act) was passed. This act allowed for less government oversight of the banking industry and allowed for competition among banks, securities companies and insurance companies. 2000-2006 The use of nonprime mortgages such as subprime and near-prime (Alt-A) grew rapidly. This growth is attributed, in part, to mortgage lenders who adopted the credit-scoring techniques first used to make subprime auto loans in order to determine the creditworthiness of potential homebuyers. This caused the potential defaults on home loans to be under-predicted – they underestimated the risk. Events That Lead Up to the Current Situation

5. 2000-2007 The Credit Default Swaps (CDS) market, an insurance-like market that was invented in the mid-1990s as a way to offset risk in lending or bond portfolios, grew from $900 million in 2000 to more than $45.5 trillion in 2007. Warren Buffett called CDSs “financial weapons of mass destruction” because they existed in an unregulated market where investors traded contracts without ensuring that buyers had the resources to cover the losses if the security defaulted. As a result, the CDS market now far exceeds the face value of the corporate bonds underlying it. Further, because all the banks became linked together through deals made in the CDS market, if one bank had problems, they were all impacted. 2000-2008 The global pool of money in the world doubled as poor countries developed, banked money, and wished to invest in good, safe investments. In other words, there was too much money chasing too few good investments. 2003-2004 After events such as the dot.com bust and 9/11, Alan Greenspan made the decision to keep the US Fed fund rate at an extremely low level to prevent the US economy from weakening. As a result, global investors found they couldn’t make money with US Treasury Bonds and looked to invest in “safe” US residential mortgages, which had more favorable yield. Events That Lead Up to the Current Situation (cont.)

6. 2001-2005 The loosened lending standards for home ownership created demand which rapidly drove up home prices. July 2006 The housing market’s prices peaked. Once this happened, housing prices began a rapid decrease. 2006-Present As conditions in the housing market worsened, delinquencies and foreclosures rapidly increased and loans that Fannie and Freddie backed went bad. February 2007 President Bush signed Economic Stimulus Act of 2008 into law. The Act proposed to provide over $150 billion in direct aid to American households. 2007 The Collateralized Debt Obligation (CDO) market, an unregulated type of asset- backed security, began to freeze after major downgrades were made to mortgage-backed securities. These downgrades directly impacted the CDO market and caused unprecedented bank writedowns beginning in mid-2007. CDOs were collections of mortgage-backed securities (MBS) that were “sliced” and sold to investors. Many of these bonds initially received AAA ratings even though they were collateralized by MBS that were, in turn, collateralized by subprime mortgages. When these CDOs were downgraded, some of the AAA rated debt lost all of its value. Events That Lead Up to the Current Situation (cont.)

7. 2007-Present Financial institutions began to fail due to both large mortgage-related losses from defaults and the valuing of mortgage-backed securities at levels that were not considered representative of their fair value due to mark-to-market accounting rules. Some of the financial institution failures are: April 2007 – New Century Financial, the nation’s 2nd largest subprime mortgage lender, filed for chapter 11 bankruptcy August 2007 – Two Bear Stearns hedge funds filed for bankruptcy August 2007 – American Home Mortgage filed for chapter 11 bankruptcy August 2007 – Ameriquest, the one time largest subprime lender in the US went out of business. Sept 2008 The US government seized control of Freddie and Fannie in an attempt to keep the problems facing the two GSEs from affecting the global market. Present Financial companies began to question each other’s ability to pay off debts and stopped lending to one another, which kicked off a global credit crisis. Further worries exist that defaults now affecting other types of subprime lending (ex. auto loans) will hurt the economy. Events That Lead Up to the Current Situation (cont.)

8. What Happened Next?

9. Trouble in the Markets: Sept 2008 Bank of America acquired Merrill Lynch (2) Proposal rejected by the House. Dow Jones falls by 778 pts. (Biggest point-drop in history) (11) US Federal Reserve pumped $180 billion into money markets to combat seizing up of lending between banks (7) Govt. takeover: Fannie Mae and Freddie Mac (1)* Morgan Stanley and Goldman Sachs became bank holding companies (9) Govt. rescued AIG (5) Sept 7 Sept 14 Sept 15 Sept 16 Sept 17 Sept 18 Sept 20 Sep 22 Sep 25 Sept 29 Stocks fall. Worst drop (504.5 pts) on Dow Jones since 9/11 terrorist attacks (4) Lehman Brothers declared bankruptcy (3) Dow Jones fell 450 more pts. Markets around the world share confidence crisis. Russia shut down its market (6) Govt. proposed Emergency Economic Stabilization Act: Purchase up to $700 billion in mortgage-related assets (8) Washington Mutual is taken over by JP Morgan Chase (10) *See numbered corresponding explanations for each event on following page

10. Trouble in the Markets: Oct 2008 The Fed cut the Fed Funds rate to 1% in hopes of stimulating the economy (19) House approved revised proposal. President Bush signed into law (13) Wachovia acquired by Wells Fargo (16) Stocks rally (17) Oct 1 Oct 3 Oct 8 Oct 10 Oct 12 Oct 13 Oct 28 Oct 29 Oct 31 The Fed cut the Fed Funds rate by ½ a percentage point to 1.5% (14) Senate passed revised proposal (12) Dow continued to fall to 8451.49 (15) The Dow Jones climbed by 889 points – its 2nd biggest daily point surge ever (18) The end of October culminates the stock market’s worst month in 21 years (20) *See numbered corresponding explanations for each event on following page

11. Trouble in the Markets: Nov 2008 AIG rescue plan restructured (23) Oversight hearings scheduled for the House Financial Services Committee (26) Dow Jones Industrial Average plunged 445 points to close at 7552 (28) President-elect Barack Obama elected to the White House (21) The British government took over the Royal Bank of Scotland (30) Henry Paulson announced change in rescue program allocations (25) Nov 4 Nov 10 Nov 12 Nov 13 Nov 18 Nov 20 Nov 25 Nov 28 Circuit City declared bankruptcy (22) American Express received permission to become commercial bank (24) Continuation of oversight hearings scheduled for the House Financial Services Committee. Big Three Automakers attend congressional hearing for rescue funds (27) New plan unveiled to pump $800 billion into financial system to unfreeze consumer credit (29) *See numbered corresponding explanations for each event on following page

12. Trouble in the Markets: Dec 2008 Bernard Madoff charged by federal prosecutors for allegedly directing a massive Ponzi scheme (33) Wall Street closed its worst year since the Great Depression in 1931 (37) Economists announced that the US economy entered into a recession in December 2007 (31) Treasury Department announced its plan to give a $6 billion infusion to GMAC (36) Lyondell Basell announced it was considering filing for Chapter 11 bankruptcy (38) Fed cuts Fed Funds rate to near zero (34) Dec 1 Dec 4 Dec 11 Dec 16 Dec 24 Dec 29 Dec 31 GMAC received the infusion from the government and completed its multi-million dollar debt swap (39) Capital One announced that it plans to buy Chevy Chase Bank (32) GMAC awarded bank holding status by the Federal Reserve (35) *See numbered corresponding explanations for each event on following page

13. Trouble in the Markets: Jan 2009 The Federal Reserve began purchasing fixed-rate mortgage backed securities (40) Inauguration of President Barack Obama (44) Pfizer announced that it will acquire Wyeth for $68 billion (46) Announcement made that more US workers lost jobs last year than in any year since WWII in 1945 (42) Jan 5 Jan 7 Jan 9 Jan 16 Jan 20 Jan 26 The Congressional Budget Office announced that the federal budget deficit is projected to reach a record $1.2 trillion in 2009 (41) Citigroup reported a fourth-quarter loss of $8.29 billion and announced it will split into two businesses (43) Iceland's coalition government collapsed under the strain of an escalating economic crisis (45) *See numbered corresponding explanations for each event on following page

14. Trouble in the Markets: Feb 2009 Panasonic corporation announced that it will cut 15,000 jobs and shut 27 plants worldwide (47) JP Morgan Chase and Citigroup announced a moratorium on residential foreclosures (52) The Dow Jones Industrial Average and the S&P 500 dropped to levels not seen since 1997 (54) Nissan announced 20,000 job cuts and experienced its first annual loss in 9 years (49) Feb 4 Feb 6 Feb 9 Feb 10 Feb 13 Feb 17 Feb 23 Toyota forecast its first annual net loss since 1950 (48) The SEC’s enforcement chief resigned after being criticized by Congress for failing to detect the Ponzi scheme allegedly run by Bernard Madoff (50) GM announced a cut of 10,000 salaried jobs (51) The American Recovery and Reinvestment Act of 2009 was signed into law by President Barack Obama (53) *See numbered corresponding explanations for each event on following page

15. Trouble in the Markets: Mar 2009 Freddie Mac CEO David Moffett announced that he will resign and leave the board of directors (55) Merck announced deal to buy Schering-Plough in a stock and cash deal worth about $41.1 billion (58) House Financial Services Committee Chairman stated that expected bonuses at Fannie Mae & Freddie Mac should be cancelled (60) AIG employees agreed to give back $50 million in total of the bonuses previously distributed (62) The Sun-Times Media Group announced that it filed for bankruptcy protection (64) Mar 2 Mar 9 Mar 19 Mar 20 Mar 22 Mar 24 Mar 26 Mar 31 Dow Jones finished below 7,000 – the first time since 1997 (56) AIG reported a $62 billion fourth quarter loss (57) AIG distributed $165 million in bonuses to employees in its Financial Products division (59) US Stocks posted the first back-to-back weekly rally of the year (61) The government confirmed that GDP fell at an annual rate of 6.3% during the final 3 months of 2008 (63) *See numbered corresponding explanations for each event on following page

16. Trouble in the Markets: Apr 2009 Legislation passed in the House to control credit card company practices (75) An unemployment rate of 8.5% was reported by the Labor Department (65) Bank of America officially dropped the name “Countrywide Home Loans” from its mortgage operations (71) President Obama ordered his cabinet to decrease spending by $100 million (69) The Commerce Department announced that retail sales dropped 1.1% in March (67) Ken Lewis was ousted by shareholders as Chairman of Bank of America (73) Apr 3 Apr 9 Apr 15 Apr 16 Apr 20 Apr 21 Apr 27 Apr 29 Apr 30 General Growth Properties, the 2nd largest owner of shopping malls declared Chapter 11 bankruptcy (68) The Treasury Department announced that $109.6 billion remains in the government’s financial rescue fund (70) Chrysler forced into federal bankruptcy by President Obama (74) The Boston Globe’s owner, the New York Times Co., threatened to shut it down, as it is on track to lose $85 million this year (66) The Commerce Department reported that 1st quarter GDP declined 6.1% (72) *See numbered corresponding explanations for each event on following page

17. Trouble in the Markets: Sept 2008-Apr 2009 (Cont.)

18. Trouble in the Markets: Sept 2008-Apr 2009 (Cont.)

19. Trouble in the Markets: Sept 2008-Apr 2009 (Cont.)

20. Trouble in the Markets: Sept 2008-Apr 2009 (Cont.)

21. Trouble in the Markets: Sept 2008-Apr 2009 (Cont.)

22. Trouble in the Markets: Sept 2008-Apr 2009 (Cont.)

23. Trouble in the Markets: Sept 2008-Apr 2009 (Cont.)

24. Trouble in the Markets: Sept 2008-Apr 2009 (Cont.)

25. Trouble in the Markets: Sept 2008-Apr 2009 (Cont.)

26. Trouble in the Markets: Sept 2008-Apr 2009 (Cont.)

27. Trouble in the Markets: Sept 2008-Apr 2009 (Cont.)

28. Trouble in the Markets: Sept 2008-Apr 2009 (Cont.)

29. The Rescue of Fannie Mae and Freddie Mac

30. 1938 Fannie Mae was created as a government agency to keep a consistent supply of mortgage funds available across the United States in order to help raise levels of home ownership and available affordable housing. 1968 Fannie Mae began operating as a Government Sponsored Enterprise (GSE), meaning it was privately owned and operated by shareholders but was financially backed by the federal government. 1970 Freddie Mac was created as a GSE to provide competition to Fannie Mae, which had previously held a monopoly on the secondary mortgage market. 1992 Legislation was enacted to modernize the regulatory framework and set new affordable housing goals that were income-based and geographically targeted. Historical Background on Fannie Mae and Freddie Mac

31. 1999 Fannie Mae eased credit requirements on loans purchased from banks to encourage mortgages for individuals with sub par credit to expand home ownership. 2000 Fannie Mae announced its commitment to purchase $2 billion “My Community Mortgage” loans to expand the secondary market for affordable community-based mortgages. This announcement served as part of Fannie Mae’s “American Dream Commitment” to increase homeownership rates. Launched in 2000, this campaign was a ten-year pledge to provide $2 trillion in home financing for 18 million underserved families. It was designed to strengthen communities by narrowing homeownership gaps and increasing the availability of rental housing. Historical Background on Fannie Mae and Freddie Mac (cont.)

32. 2000 A Bill was introduced into House of Representatives to overhaul the relationship between the government and GSEs and reduce the systemic risk of Fannie and Freddie. The sub-committee never voted on the bill, so no legislation was produced. At the time, Peter J. Wallison, a resident fellow at the American Enterprise Institute, stated the following: “From the perspective of many people, including me, this is another thrift industry growing up around us. If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.” 2007 A GSE Reform bill known as the Federal Housing Finance Reform Act of 2007 was passed to reform the regulation of the housing- related GSEs. Historical Background on Fannie Mae and Freddie Mac (cont.)

33. July 2008 Shares in Fannie Mae and Freddie Mac dropped drastically once a report was released indicating that they accounted for 75% of new mortgages at the end of 2007. Rising defaults also contributed to speculation that a take-over of the GSEs would be required. Sept 2008 US government seized control of Fannie Mae and Freddie Mac to prevent the threat of failure facing the GSEs from impacting the housing market and global markets. Both companies were placed in a government conservatorship under the Federal Housing Finance Agency. The government’s plan will eliminate dividends for Fannie and Freddie and virtually wipe out any value that common or preferred stockholders had in the company. Historical Background on Fannie Mae and Freddie Mac (cont.)

34. Nov 2008 Fannie and Freddie, under the conservatorship held by the US government, announced a program to address the foreclosure crisis. The program will make many mortgages affordable for people who can’t currently meet their monthly payments and are at least 90 days delinquent in mortgage payments. These homeowners will be eligible to have their monthly payments reduced to 38% of gross income as long as they have not declared bankruptcy and can illustrate a hardship or change in financial circumstances Nov 2008 Freddie Mac reported a record $25.3 quarterly loss. As a result, it was necessary for the company to draw on a $100 billion Treasury Department lifeline. Freddie Mac’s regulator submitted a request to the Treasury Department to provide $13.8 billion after the quarterly loss caused its net worth to fall below zero. Historical Background on Fannie Mae and Freddie Mac (cont.)

35. Fannie and Freddie own or back almost half of all US. mortgages ($5.4 trillion). With the pressure of falling home prices and mortgage defaults, they did not have the capital to support the mortgages they held. Potential homebuyers are now put at a disadvantage with tighter lending guidelines as a result of what is going on in the secondary mortgage market. If Fannie and Freddie do not continue to operate in the secondary market, then the primary market could face extreme challenges that, in turn, will impact the global economy. Reasons for the Fannie and Freddie Rescue

36. Once the rescue of Fannie and Freddie is fully in place, the reduction of banks’ costs of financing mortgages will pass savings along to potential homebuyers. Let me explain… Once investors started pulling money out of the housing market, Fannie and Freddie needed more capital to take on many of the abandoned loans. They would have had to charge higher interest rates to banks that were selling the mortgages, who in turn, would have passed on higher rates to the potential homebuyers. So, as a result of the takeover, Fannie and Freddie will not have to charge these high premiums. Because the federal government will be in charge of Fannie and Freddie, it can decide when to infuse liquidity into the market. So, What Does the Fannie and Freddie Rescue Mean?

37. The rescue allows for the potential of an alternative way to provide mortgages by using a concept called a covered bond market. Here’s how that would work: The banks would borrows funds to lend to homeowners, hold the mortgages on their books, and then use the proceeds of the mortgages to repay investors. These covered bonds are considered more secure than mortgage-backed securities. And finally, with the direction from the Fed, Fannie and Freddie will move towards utilizing more sound underwriting standards. This change will move us back in the direction of a more sustainable and healthy housing market. So, What Does the Fannie and Freddie Rescue Mean? (cont.)

38. Short-Term Mortgage rates should trend down because the Federal Housing Finance Agency that now controls Fannie/Freddie has the authority to purchase more than the normal amount of mortgages to put into its portfolio holdings Lower interest rates could attract more potential buyers to buy a home What Could Happen Because of the Fannie & Freddie Rescue? Long-Term • Pro: Because it will have acquired the GSEs’ preferred stock and common stock at a nominal price, the Treasury could benefit monetarily if mortgage defaults slow down and housing prices reverse • Con: Taxpayers could end up picking up the tab if the government buys off the delinquent mortgages at an unreasonably high price

39. Passed in 1977, the purpose of the Community Reinvestment Act (CRA) was to discourage red-lining (the denial of credit based on perceived characteristics of the neighborhood rather than the quality of the borrowers), and instead, encourage institutions to meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods. The CRA addressed depository institutions, such as banks and thrifts. Mortgage companies were excluded from the act because they were not depository lenders. In 1995, the government streamlined the regulatory requirements for the CRA, emphasizing performance over process and rating the institutions on whether they met the credit needs of their communities. Fannie and Freddie securitized $394 billion in CRA loans between 2000-2002. Where Does the Community Reinvestment Act Come in?

40. Liberals tend to say that the CRA has nothing to do with the current crisis; conservatives tend to say the CRA has everything to do with the current crisis. The truth is the CRA’s role in the current crisis probably falls somewhere in the middle. While the policies of the CRA may be one of the many contributing factors that helped to shape our financial environment, it is not to blame for our current financial crisis. The CRA: It’s Role in the Crisis

41. Policy makers wanted to increase home-ownership rates. Here’s a breakdown of some of the policies that helped shape the housing market and contributed to the recent situation: A combination of the CRA and Fannie & Freddie meeting the goals set forth by Congress and HUD to purchase a growing number of “special affordable” loans helped to push up the demand for lower-priced property. The Taxpayer Relief Act of 1997 increased the demand for higher-valued property by expanding the availability and size of the capital-gains exclusion to $500,000 from $125,000 and made it easier to exclude capital gains from rental property. Each policy contributed to an increased demand for housing, which in turn, contributed to the increase in home prices. It is important to note that while the CRA can be credited for helping to create an environment where there was support for less stringent mortgages, the main offenders in the subprime lending crisis were independent mortgage companies, such as Countrywide, who were not subject to the rules of the CRA. In fact, half of the subprime mortgages made were by companies that weren’t covered by the CRA. The CRA: One of Many Policies that Helped Shape Our Current Environment

42. The Rescue of the US Financial System

43. The breakdown at the financial institution level now threatens the real economy. Companies depend on bank borrowings and short-term bonds to conduct every-day business. However, a lack of trust within the system which arose from the financial problems of mortgage-backed securities made banks and investment firms fearful of loans with one another. Banks and investment firms could not be sure about one another’s financial position and began to avoid transactions with one another. As a result, investors began to purchase Treasury bonds in place of short-term bonds. The lack of commercial paper began to freeze the credit market. If banks continued to stop lending to one another, there would not be enough credit available for consumers and firms. This potential financial situation would have far reaching implications that would affect businesses and consumers alike. Why Did the Government Need to Intervene with a Financial Rescue Plan?

44. $700 billion to be disbursed in stages - $250 billion to be made available immediately Protects taxpayers by proposing that the president requires financial industry to reimburse taxpayers for any net losses after 5 years Treasury allowed to take ownership stakes in participating companies Treasury to establish an insurance program to guarantee companies’ troubled assets Limits executive pay Two oversight committees Tax breaks for individuals and businesses Reinforces SEC’s power to change accounting rules on securities Temporarily raises FDIC insurance limit from $100,000 to $250,000 Encourages government agencies to influence loan servicers to modify troubled loans/mortgages Emergency Economic Stabilization ActKey Provisions

45. Pros Consumer/investor confidence in commercial paper may be restored Mortgage lending criteria may not be overly strict and mortgage rates should remain low May help restore the correct valuations of illiquid assets Potentially generate money for Treasury and taxpayers What Could Happen with the Federal Intervention? Cons • Officials may be seen as panicking due to broader instability across the entire economy • Risk of destroying confidence in financial institutions by not allowing the market to “fix itself” • Taxpayer funds may be at risk if the bad mortgages are purchased at high prices • Future mortgage defaults will be on the government books if housing market doesn’t recover • Potential for higher interest rates in the future as the US. tries to borrow money from other countries

46. A Simple Way to Look at It: The Making of the Current Situation Wall Street – Financial Institutions Buyer Demand Mortgage Broker GSEs • Loosened standards in 1999 • Normal qualified potential homebuyers • Subprime potential homebuyers • Normal investors • Speculative investors Rating Agencies Mortgage Backed Securities Everyone Investors *See following page for explanation

47. A Simple Way to Look at It: The Making of the Current Situation (cont.)

48. A Simple Way to Look at It: The Making of the Current Situation (cont.)

49. What do the Experts Think of the Current Financial Situation?

50. Warren Buffett: Chairman and CEO, Berkshire Hathaway Warned congressional leaders that if they did not act to secure the financial system, they would experience “the biggest financial meltdown in American History.” Warned that the financial crisis is “everybody’s problem.” What do the Financial Experts Think?