Understanding the Sources and Way Out of the Ongoing Financial Upheaval

1. PASEF Understanding the Sources and Way Out of theOngoing Financial Upheaval Susan M. Wachter Richard B. Worley Professor of Financial Management The Wharton School University of Pennsylvania Bank for International Settlements Hong Kong Institute for Monetary Research University of Pennsylvania April 23, 2009

2. Global Downturn • The economy is in the worst downturn since the Great Depression. • Capital market crisis—more than a “recession” credit flow ended, globally and global economy is withering. • A self-reinforcing adverse cycle: • The financial system crisis is upending the economy, putting further pressure on the financial system • US public policy response without precedent. • Fiscal stimulus package • Federal Reserve has vastly expanded its role • What more is needed: for private credit flows to resume, confidence in the financial system itself must be restored • This requires understanding what went wrong and rebuilding the architecture of the financial system

3. The Economic Backdrop • Economy in “Great Recession” • Unemployment at 8.5% • 4th quarter decline in GDP at 6.2%, global decline 1.5% • Volatility in global stock markets • US and global stock prices are more than 40% down • Angst in the banking system and credit markets remain badly shaken • Banks still not lending

4. The Economic Backdrop-Capital Markets Source: Moody’s Economy.com

5. The Damage Is Not Over • Real GDP began to fall in Q4 of 2007- fall continuing. • 2.6 million jobs have already been lost and the unemployment rate is still rising. • Consumer confidence has crashed to its lowest reading ever Source: Mark Zandi, Moody’s Economy.com

6. Response to the Crisis • Fiscal Stimulus • Unprecedented stimulus ($1 trillion) • Monetary Stimulus • Federal Funds Rate near zero • Quantitative easing • Banking Bailout • TARP • Missing: New Financial Architecture • Need to understand what went wrong

7. Impact of Stimulus Measures Source: Mark Zandi, Moody’s Economy.com

8. Monetary Stimulus Source: Mark Zandi, Moody’s Economy.com

9. The state and local impacts Source: Mark Zandi, Moody’s Economy.com

10. The Collapse-from housing to financial markets: still missing, the new financial architecture March, 2007 January, 2008 September, 2008

11. Global Financial Crisis: Made in the USA • Triggered by actual and prospective losses on US mortgages-leveraged losses far greater • Global meltdown: Bad luck or inevitable? • Boom-bust housing price cycle: Why? • Reckless decline in mortgage lending standards (followed by credit crisis and no private lending) • Increased housing prices beyond sustainable heights • Unprecedented house price rises hid problem loans-teaser rates, no doc/low doc, option arm’s, NINJA loans • Loans made that could not be repaid-betting on ever increasing house price to rescue loans

12. A Severe National Housing Downturn

14. WHY? • Private label securitized mortgages, backed leveraged derivatives, synthetics • Decades of securitization—not the problem • Interest rate risk securitized historically • PLS securitized default risk, relied on diversification—not Marked-to-Market, but rather Marked-to-Model • Expansion of toxic debt as asset, based on collateral, and ever increasing house prices

15. Chronic imbalances Sectoral contribution to U.S. gross debt Percentage of GDP Gross debt by U.S. sector Percentage of GDP Financial Companies Households Financial Companies Nonfinancial Companies Household Government Nonfinancial Companies Government Source: U.S. Federal Reserve, Bureau of Economic Analysis

16. Increased use of non-traditional products

17. Mortgage originations by product

18. Deterioration of lending standards, 2002 to 2006: Leverage w/out Docs Spreads declined CLTV (leverage) increases % Full Doc declined

19. Nonprime mortgage lending replaced the “American Mortgage”: where and why?

20. A Housing Bubble Starting in 2003, Especially in the “Sand States” 20 Susan M. Wachter

21. Percent of All Loans—Adjustable Rate 1999 2006 21 Susan M. Wachter

22. Percent of All Loans—Low Documentation- by 2006, 25% of loans 1999 2006 22 Susan M. Wachter

23. Percent of Adjustable Rate Loans—Teaser (2006) 23 Susan M. Wachter

24. Number of Subprime Loans Source: www.newyorkfed.org/mortgagemaps

25. Increase in House Price Index Source: www.newyorkfed.org/mortgagemaps

26. Projected Peak-to-Trough House Price Decline, % >-20% -20<-10% -10%<0% No correction Sources: Fiserv Lending Solutions, Moody's Economy.com, OFHEO

27. How did we get here? Investors Borrowers • Lack of short sales, CDS • Borrowed at teaser rates-not able/expected(?) to pay at reset Where does the buck stop? Rating Agencies Originators / Brokers • Agency incentives misaligned- “current conditions” out • Originate to distribute Secondary Market • Securities marked to models not to market/assignee liability exemption

29. Deregulation and Regulatory Arbitrage: “Competitive Regulation” • Charter competition fueled a race to the bottom in underwriting standards • Migration to federal bank and thrift charters • At the federal level, regulation and examinations of nonbank mortgage lending subsidiaries were lax Susan M. Wachter

30. Deregulation • The proposed Federal Reserve Board Regulatory Oversight of mortgages not implemented until 2008, HOEPA (Home Ownership and Equity Protection Act, 1994) irrelevant,<1% loans • 2004 act SEC allowed investment firms to • increase leverage to 40 to 1 • to voluntarily measure their capital, and • decrease SEC oversight • 2000 State reserving for CDS issued by insurance companies, Fed govt precludes Susan M. Wachter

31. Market and Regulatory Failure • Risk taking without accountability • Too big to fail, too small to sue • Underpriced risk is inevitable, compensation for generating risk without accountability

32. WHY? • Decades of securitization, 1980-2000—no problem • Historically-interest rate risk securitized, default risk controlled for and not priced, only prime mortgages securitized • “Innovation:” Private label securitization of default risk • Private label mortgage backed securities did not trade • Priced based on Marked-to-Model paradigm Not Marked-to-Market, • Market and regulatory discipline absent

33. New Financial Architecture • Replace Basel II • Basel II: regime of self-regulation • End “Competitive Regulation” • Race to the bottom • Single Regulator • Asset Bubbles • What is a single regulator regulating? • How do we regulate asset bubbles? Susan M. Wachter

34. Perspective The events of the past year or two have highlighted regulatory gaps and deficiencies that we must address to improve the structure of our markets and the resiliency of our economy. As we recover from the current crisis, it will be important to address these issues as soon as possible, to develop a regulatory structure that will better respond to future economic challenges. --Ben Bernanke

35. Thank You Susan M. Wachter Richard B. Worley Professor of Financial Management Professor of Real Estate and Finance The Wharton School University of Pennsylvania wachter@wharton.upenn.edu