The Current State of the US. Financial Market

2. Outline 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? 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

4. Events That Lead Up to the Current Situation 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.

5. Events That Lead Up to the Current Situation (cont.) 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.

6. Events That Lead Up to the Current Situation (cont.) 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. 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.

7. Events That Lead Up to the Current Situation (cont.) 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 have started 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. Wall Street is beginning to worry that subprime lending, currently unraveling in the mortgage industry, will deliver a double whammy to the economy as more and more consumers, who financed their cars with subprime loans, default. Wall Street is beginning to worry that subprime lending, currently unraveling in the mortgage industry, will deliver a double whammy to the economy as more and more consumers, who financed their cars with subprime loans, default.

9. 9 Trouble in the Markets: Sept-Oct 2008

10. 10 Trouble in the Markets: Sept-Oct 2008 (Cont.)

11. 11 Trouble in the Markets: Sept-Oct 2008 (Cont.)

13. Historical Background on Fannie Mae and Freddie Mac 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.

14. Historical Background on Fannie Mae and Freddie Mac (cont.) 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. The Community Reinvestment Act (CRA) law was enacted in 1977 to halt the decline of American cities, particularly low-income and minority neighborhoods "redlined" by the federal government and private lenders as too risky for home and business loans. The announcement is part of Fannie Mae�s goal to purchase $20 billion in Community Reinvestment Act (CRA)-eligible loans over the next 10 years. Signed into law in 1977, the Community Reinvestment Act was designed to encourage commercial banks and savings associations to meet the needs of borrowers, including those with low and moderate income.The Community Reinvestment Act (CRA) law was enacted in 1977 to halt the decline of American cities, particularly low-income and minority neighborhoods "redlined" by the federal government and private lenders as too risky for home and business loans. The announcement is part of Fannie Mae�s goal to purchase $20 billion in Community Reinvestment Act (CRA)-eligible loans over the next 10 years. Signed into law in 1977, the Community Reinvestment Act was designed to encourage commercial banks and savings associations to meet the needs of borrowers, including those with low and moderate income.

15. Historical Background on Fannie Mae and Freddie Mac (cont.) 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.

16. Historical Background on Fannie Mae and Freddie Mac (cont.) 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.

17. Reasons for the Fannie and Freddie Rescue 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.

18. So, What Does the Fannie and Freddie Rescue Mean? 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.

19. 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.)

20. What Could Happen Because of the Fannie & Freddie Rescue? 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

22. Why Did the Government Need to Intervene with a Financial Rescue Plan? 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.

23. Emergency Economic Stabilization ActKey Provisions $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

24. What Could Happen with the Federal Intervention? 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

25. 25 A Simple Way to Look at It: The Making of the Current Situation

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29. What do the Financial Experts Think? 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.�

30. What do the Financial Experts Think? Harry S. Dent, Jr.: Demographic Economist; author of The Roaring 2000s and upcoming book, The Great Depression of 2010-2012 �The subprime crisis as well as recent high oil prices are phase I of this. We�ve been saying for a long time that it gets more serious when this massive baby boom generation finally gets past their growing spending trends which we think is going to happen by 2010. So we are really at a plateau of a long-term demographic cycle and of course, coming with that, came the peak of their house buying and this whole house bubble and all the excess borrowing�Yes, this has been difficult so far�Well, the worst is yet to come��

31. What do the Financial Experts Think? Alan Greenspan: Chairman of the Federal Reserve, 1987-2006 Believes that the situation is a �Once-in-a-century� financial crisis and is �in the process of outstripping anything I�ve seen, and it is still not resolved and it still has a way to go.� Believes that the situation will �continue to be a corrosive force until the price of homes in the United States stabilizes.� Believes that the odds of a US. recession has increased.

32. What do the Financial Experts Think? Bernard Baumohl: Chief Global Economist and Managing Director of The Economic Outlook Group A supporter of the stabilization plan, he believes that �credit is the lifeblood, the oxygen this economy needs.� He also says that ��At this point in time, there�s a crisis in confidence in the financial sector and on Main Street.�

33. What do the Financial Experts Think? David Wyss: Chief Economist at Standard & Poor�s In regards to the potential of an interest rate cut by the Federal Reserve, he said �given the meltdown in markets, a rate cut is becoming fairly possible.�

34. What do the Financial Experts Think? Dave Ramsey: Financial writer and syndicated show host Prior to the bill�s first vote in the House of Representatives he said that he �will not support any congressperson who votes to implement� the rescue plan. Announced an �alternative plan� on his personal website which he calls the Common Sense plan.

35. What do the Financial Experts Think? Suze Orman: Financial advisor and writer Says �We still have serious trouble on the horizon so until it�s been settled, until things have cleared out, until unemployment starts to go down again and until they figure out how to secure these mortgages and get money into the system, we have trouble�This is the beginning of the solution to the problems.�

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37. What did the Financial Experts Think? Nouriel Roubini: NYU Professor of Economics Stated on February 5, 2008 in �The Rising Risk of a Systemic Financial Meltdown� The Twelve Steps to Financial Disaster� Said, ��Sixth, it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt.[...]Ninth, the "shadow banking system" (as defined by the PIMCO folks) or more precisely the "shadow financial system" (as it is composed by non-bank financial institutions) will soon get into serious trouble.[...]Tenth, stock markets in the US and abroad will start pricing a severe US recession - rather than a mild recession - and a sharp global economic slowdown.[...]A near global economic recession will ensue as the financial and credit losses and the credit crunch spread around the world. Panic, fire sales, cascading fall in asset prices will exacerbate the financial and real economic distress as a number of large and systemically important financial institutions go bankrupt. A 1987 style stock market crash could occur leading to further panic and severe financial and economic distress. In this meltdown scenario US and global financial markets will experience their most severe crisis in the last quarter of a century.� "The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster" "The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster"

38. What did the Financial Experts Think? Warren Buffett: Chairman and CEO, Berkshire Hathaway Stated on March 4, 2003 on BBC News, �Buffet Warns on Investment �Time Bomb�� Said, �[Derivatives are] financial weapons of mass destruction.[...]Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years.[...]Large amounts of risk have becomes concentrated in the hands of relatively few derivatives dealers ... which can trigger serious systematic problems.�

39. What did the Financial Experts Think? Nassim Nicholas Taleb: Financial Trader and author Stated in April 2007 in his book, �The Black Swan: The Impact of the Highly Improbable� Said, �Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial Institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks - when one fails, they all fall. The increased concentration among banks seems to have the effect of making financial crises less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur ....I shiver at the thought.[...]The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deemed these events 'unlikely'.�

40. What did the Financial Experts Think? Byron Dorgan: Senator (D-ND) Stated on September 26, 2008 in the New York Times article, �Washington�s Invisible Hand� Dorgan's comment on McCain adviser Phil Gramm's deregulation efforts back in 1999: �I think we will look back in 10 years' time and say we should not have done this, but we did because we forgot the lessons of the past and that that which is true in the 1930s is true in 2010. �

41. What did the Financial Experts Think? Joseph Stiglitz: Nobel Prize-winning Economist Stated in March 9, 2008 Washington Post article, �The Iraq War Will Cost Us $3 Trillion, and Much More� Said, �We face an economic downturn that's likely to be the worst in more than a quarter-century.Until recently, many marveled at the way the United States could spend hundreds of billions of dollars on oil and blow through hundreds of billions more in Iraq with what seemed to be strikingly little short-run impact on the economy. But there's no great mystery here. The economy's weaknesses were concealed by the Federal Reserve, which pumped in liquidity, and by regulators that looked away as loans were handed out well beyond borrowers' ability to repay them. Meanwhile, banks and credit-rating agencies pretended that financial alchemy could convert bad mortgages into AAA assets, and the Fed looked the other way as the U.S. household-savings rate plummeted to zero.�

42. What did the Financial Experts Think? Paul Krugman: New York Times columnist Stated on August 29, 2005 Said, �These days Mr. Greenspan expresses concern about the financial risks created by "the prevalence of interest-only loans and the introduction of more-exotic forms of adjustable-rate mortgages." But last year he encouraged families to take on those very risks, touting the advantages of adjustable-rate mortgages and declaring that "American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. If Mr. Greenspan had said two years ago what he's saying now, people might have borrowed less and bought more wisely. But he didn't, and now it's too late. There are signs that the housing market either has peaked already or soon will. And it will be up to Mr. Greenspan's successor to manage the bubble's aftermath. How bad will that aftermath be? The U.S. economy is currently suffering from twin imbalances. On one side, domestic spending is swollen by the housing bubble, which has led both to a huge surge in construction and to high consumer spending, as people extract equity from their homes. On the other side, we have a huge trade deficit, which we cover by selling bonds to foreigners. As I like to say, these days Americans make a living by selling each other houses, paid for with money borrowed from China. One way or another, the economy will eventually eliminate both imbalances.�

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45. 45 Glossary of Terms

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56. Subprime and Alt A Mortgages Increased Dramatically �How did we get into such a mess� Source: YouTube: http://www.youtube.com/watch?v=jSH-wLVH2Iw� �How did we get into such a mess� Source: YouTube: http://www.youtube.com/watch?v=jSH-wLVH2Iw�