Liquidity in Crisis Charles R. Morris October 20, 2008

1. Liquidity in CrisisCharles R. MorrisOctober 20, 2008

2. Where We Are Now • Bank systemic solvency no longer at issue • Serious recession inevitable • Big in drop Personal Consumption share of GDP both essential and inevitable • Post-crash economy likely to be quite different from recent experience

3. How We Got Here

4. Debt and GDP: The Last Quarter-Century

5. The Leverage Factory in 2007 Fed Funds lower than inflation rate for 31 months from mid-2002 to early 2005. Spreads over all risky instruments dropped like a stone

6. Shift from Lending to Trading: Big Increase in Leverage IMF IMF

7. CDOs Show ‘High Preference for Subprime… In CDO Collateral….for Yield in Mezzanine’ Tranches. (S&P) Subprime and Alt-A = 41% New Mtgs in 2006. BIS Fannie and Freddie involvement in subprime and Alt-A markets was actually fairly modest, although it bounced up sharply in the second half of 2007, when ABS issuers exited rapidly

8. From Countrywide 2007 10-K: On pay-option loans: “ Our borrowers’ ability to defer [payment]… may expose us to increased credit risk…. Our underwriting standards include [various strict rules]… However, most of of the pay-option loans we hold were underwritten with stated or limited income documentation.”

9. Risk Compounded by MassiveEmbedded Leverage RMBS The Tireless Search For ‘Alpha’ RMBS 78% Senior CDO Bonds Hedge Fund RMBS HF Banks: $4 HF LPs: $1 RMBS RMBS AAA HF Leverage 5:1 AA A BBB BBB- 33:1 Leverage Mortgages HF Leverage: 165:1 Adapted from Fitch (2006)

10. Set-up for Disaster • The risk paradigm • Very large embedded leverage • Illiquid assets • Mismatched funding • Underlying assets highly default-prone • Tight coupling (rapid transmission) through CDS • Plus late-stage bubble-baroque • Synthetic CDOs with multiple asset classes • CDOs-squared and CDOs-cubed

11. High-Risk/Leverage => Disproportionate Profits Financial Sector Share of Corporate Profits and Value Add 1980-2007 NIPA Profits FRB Profits NIPA Profits NIPA Value-Add NIPA Value Add BEA-NIPA/FRB NB: Very high nominal services productivity in 2000s driven by financial sector profits Should we retro-fix economic data?

12. Picking up the Pieces

13. Prosperity in the 2000s Total G&S Trade Deficit, 2000-07: $4.5T; 4.8% GDP Home Equity Extraction for PCE, 2000-2007: $4.2 T; 6.1% of Disp. Personal Income Federal Reserve; BEA. PCE = Personal Consumption Expenditure

14. Fixing the Problem? The Federal Reserve’s Balance Sheet Federal Reserve Board

15. Loss of assets to the depositary system has been episodic and crisis-driven. If a policy objective is to preserve depositary banks’ asset shares, selective re-equitizations may be more efficient. Govt responses more typically to suspend accounting rules and infuse liquidity

16. Sectors Not Yet Heard From: - PE Takeover Loans - Corporate Bonds - CRE - CDS Defaults NB: Banks cumulative asset write-downs $600 B, through Sept. 30

17. Restarting the Economy

18. Realities • Can’t be a consumer-based recovery • Need to rebuild savings => higher rates • Can’t be trade-deficit dependent • Ideally, will attract back overseas dollar holdings

19. Privatized Infrastructure Push? • Private project finance for infrastructure rebuilds • Attractive to SWF dollars (bond revenues)? • Jolt to a US heavy equipment industry • One of best export opportunities • Some complexities • Fragmented electrical grid • Adverse consequences of high road tolls

20. And Health Care…..Really

21. Improvement Over 1968 Heart Disease Death Rate Saves ~1 million Lives a Year NHLBI Required huge infrastructure and technology expenditure (EMT, ER, Drugs, CBG, Stents, etc. And now millions of people are walking around who have had heart attacks.

22. The Myth of Medical ‘Crowding Out’ BEA/NIPA Economic historians call this ‘Progress’

23. Canny Investors Love Health Care “…So financials are going to shrink as an important part of the S&P 500, and the question is, "What's going to expand?" Two areas that have potential to expand are technology and health care.” -- Byron Wien, Barron’s August 25, 2008 Life Sciences (biotechnology and medical devices) accounted for 28% of all venture capital investing in the first half of 2008 “in line with its dominant position in recent years.” --PricewaterhouseCoopers Health Care second largest sector of S&P 500, at 13%; Financial Services, 20% -- Wall Street Journal Medical Device Industry (Imaging and Devices) ~$250 billion in Global Sales. U.S. Considered Technology Leader -- European Commission 2004

24. The Cyclicality of American Politics • 25-30 year cycles: • Keynesianism: • Religion of intelligent governors • First wide cachet late 1950s • High point in 1960s • Excess and burn-out in 1970s • Reagan/Thatcherism • Religion of infallible markets • First wide cachet late 1970s • High point in 1980s • Excess and burn-out 1997-2007 • Followed By????