Yian Zhang Adam Clark Youngcheol Shin Clare Farnung Stephen Kuti

1. The Subprime Financial Crisis of 2007-2008 • Yian Zhang • Adam Clark • Youngcheol Shin • Clare Farnung • Stephen Kuti

2. Financial Innovations • Data Mining – increased evaluation of credit risk for riskier residential mortgages • Securitization – allows bundling together smaller loans into standard debt securities • Structured Credit Products – allowing investors to individually tailor the risk characteristics - Collateralized Debt Obligations

3. Housing Price Bubble Forms • After the recession, in 2001, subprime mortgage market starts to boom! Aided by cash flows from China and India. • With subprime mortgages unlikely to default, along with high returns, increased demand for houses fueling the boom in housing prices.

4. Agency Problems • Based on “originate to distribute” business model: mortgages originated by separate party and then distributed to an investor. • The agent has little reason to make sure the borrower is a good credit risk • The principal-agent problem gave mortgage brokers incentives to persuade households to assume more mortgages than they could handle. • Also incentive to falsify information on borrowers’ applications to make them qualify for more • Originators were not required to release information to borrowers that would have helped them judge whether they could afford the loan. • Commercial and Investment banks didn’t have much incentive to make sure the ultimate holders of the securities would be paid off. • Credit-rating agencies made money from rating securities, as well as advising clients on how to structure them to get the highest ratings.

5. Information Problems • CDOs, CDO2s, and CDO3s can get extremely complicated. • Difficult to value underlying assets for a security. Or even who owns it. • Increased complexity destroys information. • Makes asymmetric information more harmful and worsens the effects of adverse selection and moral hazard problems.

6. Housing Price Bubble Burst • Subprime mortgage increases U.S. home ownership rate and the overall demand. • Housing price bubble led to surplus of unsold homes –> housing price after peak 2006. • Value of the house fell below the amount of the mortgage loan. • Subprime borrowers have negative equity in their houses.

8. Crisis Spreads Globally • Loss of confidence by investors resulted as a liquidity crisis. • Substantial injection of capital into financial markets – US Federal Reserve, European Central Bank, and Bank of England • Treasury Bill to Eurodollar(TED) rate spread • Credit risk in the general economy spiked up • Crisis deepened, as the world financial markets • Banks, mortgage lenders and insurance companies bankrupted • The financial crisis has spread across the entire world

9. Banks’ Balance Sheets Deteriorate The decline in U.S housing prices, which now has accelerated, led to the rising defaults on mortgages. This caused the value of mortgage-backed securities and CDOs (collateralized debt obligations) to collapse, leading to ever-larger write-downs at banks and other financial institutions. The balance sheets of these institutions deteriorated because of the losses from their holdings of these securities. This caused many of these institutions to take back onto their balance sheets some of the SIVs (structured investment vehicles) they had sponsored. SIVs are similar to CDOs in that they help pay off cash flows from pools of assets such as mortgages; instead of long term debt like CDOs they issue asset-back commercial paper. When the banks have weaker balance sheets, they and other financial institutions began to deleverage, selling off assets and restricting the availability of credit to households and businesses. With no one else to step in and to collect information and make loans, more problems begin to increase. Such as moral hazard problems in the credit markets, which slows down the U.S economy, and unemployment levels begin to rise.

10. High-Profile Firms Fail • March of 2008, Bear Stearns, the 5th largest investment bank, which invested heavily in subprime-related securities, was forced to sell itself to J.P Morgan for less than 5% of what it was worth a year earlier.To broker the deal the Fed Reserve had to take over $30 billion of Bear Stearn’s hard-to-value assets. Then in July, Fannie Mae and Freddie Mac, 2 privately owned govtsponsered enterprises that insured over $5 trillion of mortgages or mortgage-backed assets had to be helped by the U.S Treasury and the Federal Reserve after suffering from substantial losses from their holdings of subprime securities. • This wasn’t the worst of it though. Monday, September 15,2008, Lehman Brothers the 4th largest investment bank by asset size with over $600 billion in assets and 25,000 employees. They had to file for bankruptcy making it the largest bankruptcy file in U.S history. • The next day Merrill Lynch, the third largest investment bank announced its sale to Bank of America for a price 60% below its price a year prior. • September 16, AIG, an insurance agent with assets over $1 trillion suffered from an extreme liquidity crisis when its credit rating was downgraded. It had written over $400 billion of insurance contracts called credit default swaps which had to make payouts on possible losses from subprime mortgage securities. The Fed Reserve stepped in to help with an $85 billion loan, which total loans later increased to $173 billion.

11. Cont. • September 16, as a result of its losses from exposure to Lehman Brothers’ debt, one large money market mutual fund, the reserve primary fund, with over $60 billion of assets, could no longer redeem its shared at par value $1. • The Treasury put in place a temporary guarantee for all money market mutual fund redemptions in order to stem withdrawals. • September 25,2008, Washington Mutual, the 6th largest bank in the U.S with over $300 billion in assets , was put into receivership by the FDIC and sold to J.P Morgan, which made it the largest bank failure in U.S History

12. Bailout Package Debated • The House of Representatives voted down a $700 billion dollar bailout package proposed by Bush administration on Sep 29, 2008. • The US senate finally passed this Emergency Economic Stabilization Act on Oct 3, 2008 • Increased bailout funds from $700 billion to $850 billion • Extension of tax cuts • Required more insurance for bank deposit, from $100 thousand to $250 thousand

13. Bailout Package Debated • The Financial Crisis became even more virulent after the debate: • The stock market crash accelerated: the week beginning on Oct 6, 2008, is the worst weekly decline in U.S. history

14. Bailout Package Debated • Credit spreads went through the roof over the next three weeks • Treasury Bill-to-Eurodollar rate (TED) spread going to the highest value in its history • The crisis spread to Europe with lots of failures of financial institutions

15. Recovery in Sight? • Adverse selection & Moral hazard problems increased in the credit markets, due to: • The increase in uncertainty from the failure of financial institutions • The deterioration in financial institutions' balance sheets • Over 40% decline in stock market • The U.S. unemployment rate increasing to above 7% at the end of 2008 by decreasing in lending

16. Recovery in Sight? • Moreover, • The financial crisis led to a slowing of a economic growth • A lot of government bailouts of financial institutions • So, in short-term, there was no obvious recovery in sight

17. Financial Innovations • Data Mining – increased evaluation of credit risk for riskier residential mortgages • Securitization – allows bundling together smaller loans into standard debt securities • Structured Credit Products – allowing investors to individually tailor the risk characteristics - Collateralized Debt Obligations

18. Housing Price Bubble Forms • After the recession, in 2001, subprime mortgage market starts to boom! Aided by cash flows from China and India. • With subprime mortgages unlikely to default, along with high returns, increased demand for houses fueling the boom in housing prices.