The U.S. Financial Crisis

1. The U.S. Financial Crisis Charles Weber

2. The Seeds of the Crisis • An era of de-regulation and encouragement of risk • Subprime (risky) loans are encouraged and widespread- specifically 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”

3. The Subprime Picture

4. How Housing Bubble’s are created • 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.

5. Jupiter High Grade V CDOs • 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.

6. A glimpse into how stacking of CDOs work • 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.

7. How Housing Bubbles Burst 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.

8. In past recession periods, housing prices remained stable. A clear drop in the average medium home price is clear in the current economy unlike other recessions.

9. Mortgage Delinquency Rates

10. Mortgage Defaults and Investment Banking Troubles • 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

11. The Bond Multiplier and total losses • Mortgage Bonds: Losses 4.4%, when these loans go bad, mortgage-backed 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.

12. Banking Crisis and Bankruptcies • 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

16. Bailouts • 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

17. A $787 Billion Stimulus • 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

18. The Future • 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?

19. Questions…