Current Issue: Financial Crisis and Credit Crunch

1. Current Issue: Financial Crisis and Credit Crunch By: Eric Nelson Jacob Payne Samantha Duellman

2. Financial Crisis: Overview Downturn in the world economy • Causes • Housing Slump • Subprime Mortgage Crisis • Financial Innovation • Impacts • Bank Failures • Home Foreclosures • Federal Reserve Steps in • Changes in the Market • Events • Bear Stearns Bailout • Northern Rock/Bank of England • Countrywide • Solutions • The Federal Reserve has tried to take corrective measures • Regulation • Problems with Regulation

3. Causes: Housing Slump • Housing Boom • Housing prices were on the rise • People bought and built more and more • Thought it was a good investment • Thought that home values would not decrease • Took out second mortgages to use toward consumer spending • Housing Bust • Excess inventory • Housing price correction • Negative equity • Foreclosures

5. Causes: Subprime Mortgage Crisis • Where did the subprime mortgage crisis start? • Banks used to operate on a fractional reserve system • Today almost no reserve is required due to new rules that the public doesn’t even know about • Banks are able to issue more loans when they do not have to keep a reserve on hand • When they run out of qualified candidates, they reduce the requirements, which leads to subprime mortgages • These loans slowly inflate the system, and create wealth that is not “real”

6. Causes: Subprime Mortgage Crisis • Mortgage originators sold the loans on the secondary market • No risk for the originators so little effort went into analyzing the borrower’s ability to repay • High risk and debt tolerance • Adjustable Rate Mortgages (ARMs) • Rates are beginning to increase from the low introductory rate

7. Causes: Financial Innovation • Financial innovation is the act of creating and then popularizing new financial instruments as well as new financial technologies, institutions ,and markets. • Adjustable Rate Mortgages • Investment Vehicles that went wrong • Mortgage Backed Securities (MBS) • CDOs – Collateralized debt obligations • Not understood by investors

8. Causes: Financial Innovation • Financial innovations are optimal responses to various problems or opportunities • Many financial innovations that have been created in the recent past to respond to the financial boom were not fully understood • They were not adapted properly from the past, and when the financial sector crashed, these innovations responded negatively

9. Impacts • Large corporations • Bankruptcy • Companies are trying to avoid bankruptcy because of the Chapter 11 rule changes that took effect in 2005 • Restructuring • Hedge fund owners might push these corporations into bankruptcy by forcing them to sell their assets • Insurance Companies • Homeowners are turning to arson as a way to get out from under their mortgages

10. Impacts • Subprime Mortgage Backed Securities (MBS) were in portfolios and hedge funds around the world • Investments turned out to be worth far less than what was first thought • Stiffer lending policies • Banks lending only to the safest loan customers • Before almost anyone could qualify for a mortgage loan • Federal Reserve takes action • In August 2007, they put $100 billion into the money supply for banks to borrow at a low rate • Prime rate has been slowly decreasing over the past year

11. Impacts • Home Foreclosures • Over 1.5 million foreclosure proceedings began in 2007 • Foreclosure filings increased 57 percent in March compared to a year ago • Bernanke expects that number to increase further in 2008 • Increased foreclosures further depresses home prices, which can hurt the broader economy.

12. Impacts • Changes in the Market • Large re-evaluation of risk • Abstract ideas such as CDO’s and MBS’s are out the window • Know what you are holding • Maybe housing values don’t always go up • Banks are much tighter with their cash, causing a liquidity shortage and the so-called “credit crunch” • Huge financial institutions are going broke and being purchased by competitors

13. Events • Bear Stearns Bailout • Bear Stearns is the fifth largest investment bank on Wall Street, specializing in capital markets, wealth management, and global clearing • In July of 2007, Bear Stearns disclosed that the two subprime hedge funds had lost nearly all of their value amid a rapid decline in the market for subprime mortgages. • Stock for Bear Stearns fell from $100/share in December 2007 to $5/share in March 2008, just 3 months

14. Events • Bear Stearns Bailout • Bear Stearns and JP Morgan Chase came to a merger agreement after the government agreed to guarantee the merger at $2/share. JP Morgan Chase later upped the buyout price to $10/share and reduced the government guarantee by $1 billion. • Many saw this action by the Federal Reserve as a government bailout of an investment bank • Federal Reserve Chairman Ben Bernanke testified that if Bear Stearns would have defaulted, there most likely would have been “severe consequences” leading to a possible systemic financial crisis

15. Events • Northern Rock • On September 12, 2007, the Bank of England provided emergency funds to Northern Rock in the biggest bailout of a British bank in three decades. • The difficulties came from Northern Rock not being able to raise funds due to the subprime crisis in the US http://maoxian.com/index.php?s=northern+rock

16. Events • Northern Rock • On September 14, 2007 customers waited outside the branches to withdraw their savings • It is estimated that 5% of the total deposits were withdrawn that day • The internet site became inaccessible due to the large number of people that were trying to log on • As of November 17, 2007 a total of 10 companies had put in bids to buy out Northern Rock, but all the offers were materially below the previous trading value • On February 17, 2008 Northern Rock was bought by the government and would be nationalized and the bank would operate under a temporary period of public ownership

17. Events • Countrywide Financial Crisis • When Countrywide finances mortgage loans, they usually package them for sale to large investors as mortgage backed securities • After the housing crisis began Countrywide was severely affected • On August 3, 2007 the secondary market stopped the sales of most non-conforming securities and days later Countrywide announced that this disruption could hurt it financially

18. Events • Countrywide Financial Crisis • On August 12, 2007 Countrywide was cited as a possible bankruptcy risk by Merrill Lynch • Countrywide’s stock fell from $21. 29 in August down to $8.64 in November • On January 11, 2008 Countrywide was bought out by Bank of America for an all-stock $4 billion deal, down from a $24 billion value one year ago • Countrywide was the nation’s largest mortgage lender, so this deal is a landmark in the housing crisis

19. Solutions • Federal Reserve Actions • Bernanke and the Fed have been trying to stave off recession very actively • The Fed reduced the interest rate 7 times since last September, most recently on April 30th, when rates were reduced a quarter point to 2 percent • The Fed has been trying to boost the amount of liquidity available due to sharp declines in banks loaning to each other • The Fed began the Term Auction Facility in response to the crisis on December 12th, 2007. • The TAF is a means of increasing liquidity by offering loans to depository institutions which otherwise could not borrow from the Fed

20. Solutions • Regulation • New plan unveiled by Treasury Secretary Henry Paulson • One agency in charge of business conduct and consumer protection • Eliminate office of Thrift Supervision and Commodity Trading Futures Commission • Establish a federal Mortgage Origination Commission • Set minimum licensing standards for mortgage brokers • Establish Office of Insurance Oversight inside Treasury Department

21. Solutions • Issues with Regulation • Keeping good regulators is difficult because they earn much more in the private sector • Ensuring proper conduct of regulators is difficult • If banks were allowed to fail everyone would work harder not to and would assess risk better. • Due to bailouts of major banks (Bear Stearns, Northern Rock) the only viable option left is more and better regulation in order to promote stability in the financial system.

22. Solutions • Bank Regulations • The amount of money owed to banks is more than all the money in existence, so we cannot possibly get out of debt under this system • The bulk of this debt is in the form interest, which is an arbitrary amount of money banks demand in return, but never gave • The public must demand that money must not be created by loaning it into existence, which in the end causes inflation

23. Financial Crisis: Conclusion • Causes • Multiple factors played a role in this financial crisis • Most of the emphasis has been placed on the subprime mortgage crisis • It has had effects that have stretched beyond the housing market • Impacts • The impact of this financial crisis can be felt on all levels from individuals to large corporations

24. Financial Crisis: Conclusion • Events • The far reaching events can show how powerful this financial crisis is • Bear Stearns was saved to prevent further damage to the financial market • It forced the nation’s largest mortgage lender into near bankruptcy and an eventual buyout • Solutions • The Federal Reserve has stepped in but to little avail • Regulation seems to be a popular answer but what type of regulation still needs to be developed

25. Financial Crisis: Conclusion • In a statement from Countrywide to the SEC • “Since the company is highly dependent on the availability of credit to finance its operations, disruptions in the debt markets or a reduction in our credit ratings could have an adverse impact on our earnings and financial condition, particularly in the short term… Current conditions in the debt markets include reduced liquidity and increased credit risk premiums for certain market participants. These conditions, which increase the cost and reduce the availability of debt, may continue or worsen in the future….”

27. References • “Wall Street’s crisis.” The Economist. March 22-28, 2008: 11-12 • “The $2 bail-out.” The Economist. March 22-28, 2008: 81-82 • “What went wrong.” The Economist. March 22-28, 2008: 79-80 • “The long hangover.” The Economist. April 12-18, 2008: 79-80 • Scott Lanman and Alison Vekshin. “Bernanke Urges Action to Slow Jump in U.S. Home Foreclosures.” Bloomberg. May 6, 2008 <http://www.bloomberg.com/apps/news?pid=20601087&sid=aojlbhOfzPaM&refer=home> • Jeffery D. Sachs. “The Roots of America’s Financial Crisis.” Project Syndicate. April 15, 2008 <http://www.project-syndicate.org/ commentary/sachs139> • Tom Leonard. “Henry Paulson unveils bank regulation plan.” Daily Telegraph. April 22, 2008. <http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/04/01/cnusbanks101.xml>

28. References • “Waiting for Armageddon.” The Economist. March 27, 2008. <http://www.economist.com/business/ displaystory.cfm?story_id=10925548> • Mark Landler “Housing Woes in U.S. Spread Around Globe.” The New York Times. April 14, 2008. <http://www.nytimes.com/2008/04/14/business/worldbusiness/14real.html?_r=1&em&ex=1208404800&en=ddcb233e7e3b3153&ei=5087%0A&oref=slogin> • Chris Isadore “Fears of long recession rising.” CNNMoney.com April 14, 2008. http://money.cnn.com/ 2008/04/14/news/economy/how_bad/index.htm?postversion=2008041415