Troubled Times: How We Got Here and What May Lie Ahead

1. Troubled Times: How We Got Here and What May Lie Ahead Ned C. Hill National Advisory Council Professor of Finance Fellow of the Wheatley Institution Academic Director, H. Taylor Peery Institute of Financial Services Marriott School of Management Brigham Young University January 2010

2. Outline • Seeds of the economic crisis • Results—failures, mergers, credit squeeze • Remedies—government bailout efforts • Possible outcomes

3. Foundations of Our Strong U.S. Economy—mid 1970’s to 2007 • Strong entrepreneurial innovation generating business ideas (most jobs generated by start-ups, not big business) • Productivity increases (mostly due to computerization, including the Internet) • Low tax, interest and unemployment rates Growth in U.S. economy from 2002-2007 exceeded entire Chinese economy!

4. The Federal Reserve and other Regulators The Housing Market Creation of New Securities for Which Few Understood the Risks Rating Agencies Six Factors Contributing to the Crisis Huge Global Demand for Fixed-rate Debt Accounting Rules

5. 2008 2000 $70 Trillion $36 Trillion 1. The Global Fixed-Rate Investment Market Who Invests? Insurance companies, individuals, pension funds, mutual funds, governments, investment funds, banks, municipalities, etc., etc.

6. Sources of New Demand for Fixed Income Securities • Developing economies—where do they put their cash? • China • India • Brazil • Middle East • Southeast Asia • U.S. “Baby Boomers” putting more and more into fixed income securities

7. 2. The Federal Reserve and Deregulation • 2004 (in the wake of tech bubble bursting) the Fed (Alan Greenspan) thought economy was much weaker than it was—pumped money into the economy. • How? They buy treasury securities in the open market • That increases the money supply • This led to artificially low interest rates. • Fixed-rate investors hungering for a place to put their money—but U.S. short-term securities paid hardly anything. • Dollar sank in value relative to Yen, Euro, etc. • Many commodities are priced in USD • So commodity prices rose rapidly • Especially oil, steel, cement, etc. • Chinese and other countries also had a building boom, putting pressure on commodities

8. 2. …Deregulation (cont.) • 1999 Gramm-Leach-Bliley (Financial Services Modernization Act)—effectively repealing Glass-Steagall Act of 1933 that kept banks and investment banks separated • 2000 The Commodity Futures Modernization Act opened the doors to deregulate credit default swaps • 2002 Sarbanes-Oxley had the unintended consequence of making the issuance of corporate bonds more difficult • Lack of regulation regarding mortgage securities, other securitized bonds, swaps, hedge funds • Where was the SEC when Lehman went to 44:1 leverage? • Both administrations (Clinton and Bush) leaned on the Fed to extend home ownership to all Americans

9. 3. The Housing Market • Housing prices began rising rapidly. • Tax laws exempted home ownership from capital gains in most cases. • To satisfy huge demand from debt markets: new forms of mortgages created: • Interest only • Adjustable rate—many with low “teaser rates” • Easy qualifications (e.g., NINA loan = “no income, no assets” and NINJA = “no income, no job, no assets”) • Problem: issuers rarely hold mortgages now—they sell them up the chain where they are packaged for the final investors.

10. 3. The Housing Market—cont. • Fannie Mae and Freddie Mac were encouraged to become “more inclusive” in generating mortgages—led to huge growth in “sub-prime”, “alt-A” mortgages. • Home buyers, appraisers, mortgage processors, etc., all played a part. • The nation had about 2,000,000 more homes than needed to support the demand • “But that’s OK—Housing prices have never fallen by more than 5% in any year since the Great Depression!”

11. $70 Trillion Fixed-Income Market Mortgages from Start to Finish AAA CDS Tranche 1 AA Tranche 2 A Tranche 3 Tranche 4 BBB Grouped Mortgages Individual Mortgages CDOs CMOs

12. It’s Even More Complex A CDO is a “company” that owns a pool of mortgages and… • Has its own CUSIP number • May issue additional debt so investors can have their returns on the mortgages leveraged up (or down?) • Might invest in other CDOs (CDO2 , CDO3) • Usually offers investors different “tranches” with different characteristics, e.g., “interest only”, different mixes of prime, alt-A, subprime, etc. • May mix in other securitized debt, e.g., credit card, auto financing; and even corporate bonds

13. 4. Creation of New, Essentially Unregulated Securities • New mortgage investment instruments (CDO’s, CMO’s) • Credit default swaps (CDS’s)—some firms sell “insurance” that a bond will not default—if it does, they’ll trade it for a good bond or cash. AND you can buy a CDS even if you don’t own the bond... so some bonds have 10x (or more) volume of CDS’s issued against them. • AIG had over $1 trillion in CDS positions • Problem: we don’t have data for a really bad times in the economy, so pricing models don’t work for extreme situations like we’re in now!

14. 5. Rating Agencies • Standard & Poors, Moody’s and Fitch (perhaps using faulty data and models) • Gave their stamp of approval to these new investment securities (“AAA”, “AA”, “A”, “BBB”, etc.) • Charged $600,000 to rate a $500M CDO offering • In fact, they even packaged the mortgages for the investment banks! • Investment banks (esp. Bear, Lehman and Merrill Lynch) aggressively pushed these “safe” investments to satisfy the huge fixed-rate demand (and made good profits thereby). • But few really understood the risks. • E.g., a AAA-rated CDO in July 2006 yielded only 10-15 basis points higher than a Treasury bond of the same maturity!

15. Home Buyers Ethical Issues InvolvedThe Obvious Ones Government Officials and Elected Representatives Investment Funds Regulators Greed Dishonesty Short-term vs long-term “Not my problem” Chief Investment Officers, Treasurers Rating Agencies Investment & Commercial Banks Mortgage Packagers Mortgage Originators

16. Deeper Ethical Issues Raised • “Paying for Peril” • Bonuses now for future expected results • Upside reward but little downside risk • “Normalization of Bad Behavior” • Many new mortgage market in serious trouble—but investors (and salespeople) expect to “dance while the music’s playing.” • Lack of courage to act on better judgment • “Tech Shock”—CDOs, CMOs, CDSs all new • Since we didn’t understand the risks they posed, we based assumptions on past (and, therefore, inappropriate) data, incentives and processes • Gradually we found better ways of thinking about them Based on Dr. Thomas Donaldson, Wharton, comments from Wheatley Inst. Ethics Conference

17. 6. Additional Factor: Accounting Rules“Stabbing the Wounded” • Intent is to accurately report value of a firm’s assets, liabilities and equity. • “Mark-to-market” means that firms must record paper assets at today’s market value— whetherhigher or lower than yesterday. • But what if there is no market for a security or an artificially low market value? • Must use best estimates provided by bids, similar securities or mathematical models. • Difference between original price and market value must be written off.

18. Bank’s Balance Sheet Deposits, borrowings, other obligations Loans to customers, investments, cash Past profits/losses, stock purchases, adjustments Assets Liabilities “Good” = 8-12% Equity Capital

19. What Happens When We Have “Toxic” Assets on Our Books? “Toxic” Assets Liabilities Assets Equity Capital NOTE: These are “book write downs” and not actual losses. The bank may still hold the assets and it may still be receiving interest and principle payments.

20. What Happens When We Have “Toxic” Assets on Our Books? Assets Liabilities

21. Equity capital has turned negative! What Happens When We Have “Toxic” Assets on Our Books? Toxic Assets Assets Liabilities Not good - 3%

22. Then the InevitableThe Housing Bubble Burst • Early 2007, housing prices began to slip in key markets like Phoenix, Las Vegas, California, Florida, etc. • The actual risk of sub-prime and alt-A loans began to emerge. • Liquidity of mortgage-related securities became an issue—no one wanted to buy them, hence, very difficult to value. • This caused a precipitous drop in the prices of CMO’s and CDO’s—used to be “AAA” but now almost worthless. • Accounting rules—write them down!

23. We Can’t Let “Negative Equity” Stand—What to Do? Option 1: Close or sell the institution • Bear Stearns (founded 1923), on the failure of two of its hedge funds that heavily invested in CMOs and CDOs, sold 3/2008 to JPMorganChase for $2/sh (revised later to $10/sh)—previous year was $133/sh • Countrywide Financial was bought by Bank of America (7/2008) • IndyMac(Independent National Mortgage Corp.) seized (7/2008) and assets sold off • Lehman Brothers (founded in 1850) broken up, parts sold to Barclays (9/2008) and Nomura Holdings (10/2008) • Washington Mutual seized by FDIC, assets sold to JPMorganChase

24. We Can’t Let “Negative Equity” Stand—What to Do? Option 2: Find a stronger institution and merge • Merrill Lynch merged with Bank of America (9/2008) • Scandal about huge pay package of top management • Wachovia merged with Wells Fargo (10/2008) Option 3: Infuse more capital • Morgan Stanley—sold 21% of firm for $9B to Mitsubishi (10/2008) • Goldman Sachs—Warren Buffett’s Berkshire Hathaway bought $5B preferred stock Option 4: Government takeover • Government took over Freddie Mac and Fannie Mae • Government pumped $180 billion into AIG • Government bought common stock of GM

25. Result—A Credit Freeze • No institution wanted to loan money—even overnight—to another institution. They were afraid the borrower might be “next on the chopping block.” • The economy runs on credit—even healthy companies borrow frequently to meet short-term swings in cash flows. • Consumers feel poorer—401(k), equity in home, job uncertainty • We ran the risk of seeing the entire economy shut down. • We are inter-connected to the rest of the global economy • Many international banks, insurance companies, funds bought these CMOs, CDOs, CDSs • Iceland’s major banks failed—British savers lose $8B • Some European banks failing • Etc., etc.

26. Government Bailout Efforts—A • Federal Reserve infused massive amounts of cash into the system— how much?? • Allowed investment banks to borrow directly—even converted them into bank holding companies • Eased terms for loans for all institutions • Congress passed “Troubled Asset Relief Program” (TARP) 10/2008—government authorized Treasury to use $250B immediately, $100B subject to president’s approval and $350B if further authorized by Congress. Plan was to buy “toxic assets”—changed to purchase of preferred stock. • In addition, the FDIC is assisting in bank closures.

27. What Happens When We Infuse New Money into a Troubled Bank? Cash Liabilities Assets Equity Capital Now good! 10%

28. Government Bailout Efforts—B • “Obama Stimulus Package”—2/2009 • Aid to homeowners in danger of foreclosure • FDIC insurance on deposits increased to $250K and unlimited for corporate deposits • Bailing out of specific industries (auto industry and possibly others)

29. American Recovery and Reinvestment Act (ARRA) of 2009$787 B • 39% for Federal Agencies/Programs ($308.3 B) • 61% for Individuals and States (including tax cuts and credits) $478.9 B • Other provisions • Includes payroll-tax cut • Credits for first-time home purchases • Higher education • Unemployment-tax breaks • Help for car buyers • Tax provisions total $288 B • Funds go directly to states to help them narrow their deficits and bridge budget gaps

30. Categories of ARRA • Relief to states $90.0 B • Health, labor and education programs $71.3 B • Housing and transportation programs $61.2 B • Unemployment and low-wage assistance $58.1 B • Grants to states, mostly for education $53.6 B • Energy and water development $50.8 B • Agriculture, rural aid and FDA $26.4 B • Health insurance assistance $24.7 B • Medical record modernization $17.6 B • Commerce, justice and science programs $15.8 B • Interior Department and environmental aid $10.5 B • Government buildings and financial services $6.7 B • Defense Department $4.5 B • Military and Veterans Affairs $4.2 B • Homeland Security Department $2.7 B • State Department $0.6 B

31. Bailout Problems • Only 1/3 of the Obama package actually spent—the rest is forthcoming over several years • What happens in 2010 when the 2009 money is not repeated? • Moral hazard issue?

32. What Are Possible Outcomes? • Worst case—prolonged depression similar to the 1930’s (25% unemployment, no growth for 3-5 years, great personal hardship) • Best case—short recession (unemployment 6-8%, no/slow growth for 6-18 months) • Most likely case—serious recession (unemployment 7-12%, no/slow growth for 1-2 years) X

33. View of the Crisis from the DJIA Peak in October, 2007 14,100 -53% +57% Low in March, 2009 6,600

34. Other Outgrowths of the Crisis • More regulation of securities industry • Hedge funds • Packaging of mortgages/other structured products • Credit default swaps • Retention of some risk by lower levels in the chain • Reinstate separation wall between banks and investment banks? • Government could make a good return on much of the bailout investments: buying toxic assets, buying stock in troubled institutions, etc. • May see higher taxes to pay for bailout. (But we need to be cautious—high taxes generally not good for recoveries). • Inflation may be a problem in the recovery.

35. Recent Developments • Fannie Mae and Freddie Mac are requiring banks and other mortgage originators to buy back mortgages that were flawed (insufficient income, misstatements on applications, etc.). • Government is looking into how AIG used the $180B to pay back banks. May “claw back” some of those funds.

36. Suggestions for Individuals • Don’t panic—selling stock now may be the worst thing to do. • Remember the stock market is a “leading indicator”—it will pick up far before the rest of the economy. • In fact, now may be a good time to buy—most stocks are at “bargain basement” prices. • If you’re employed, become a very valuable employee, sharpen your skills, dust off your resume. • Now may be a good time to go back to school. • Make sure your food supply and your emergency cash supply is in good order. • Teach your children and grandchildren sound financial principles.

37. Most Important Suggestion Heed the words of the prophets.

38. Who Said This (and When)? “We wish the presidencies of the stakes and the bishops of the wards to urge, earnestly and always upon the people, the paramount necessity of living righteously; of avoiding extravagance; of cultivating habits of thrift, economy, and industry; of living strictly within their incomes; and of laying aside something, however small the amount may be, for the times of greater stress that may come to us. By no other course will our people place themselves in that position of helpful usefulness to the world which the Lord intends we shall take.” First Presidency, July 1933

39. Elder L. Tom PerryNovember 2008 “We have been encouraged at almost every general conference of the Church I can remember not to live beyond our means. Our income should determine the kind of housing we can afford, not the neighbor’s big home across the street. “President Heber J. Grant once said: ‘From my earliest recollections, from the days of Brigham Young until now, I have listened to men standing in the pulpit … urging thepeople not to run into debt; andI believe that the great majority of all our troubles today is caused through the failure to carry out that counsel.’” (in Conference Report, Oct. 1921, 3).

40. President Boyd K. PackerNovember 2008 “It is my purpose to show that in troubled times the Lord has always prepared a safe way ahead. We live in those‘perilous times’ which the Apostle Paul prophesied would come in the last days. If we are to be safe individually, as families, and secure as a church, it will be through ‘obedience to the laws and ordinances of the Gospel.’ ”

41. Read More about the Crisis • Andrew Sorkin—Too Big to Fail • Richard Bookstaber—A Demon of Our Own Design • Lawrence McDonald—A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers • Charles Morris—The Trillion Dollar Meltdown • William Cohan—House of Cards: A Tale of Hubris and Wretched Excess on Wall Street • Bill Bamber and Andrew Spencer—Bear Trap: The Fall of Bear Stearns and the Panic of 2008 • David Wessel—In Fed We Trust: Ben Bernanke’s War on the Great Panic