The Credit Crisis of 2008 “You Fail, We Bail?” Southwest Chapter PLUS Educational Seminar

1. The Credit Crisis of 2008 “You Fail, We Bail?” Southwest Chapter PLUS Educational Seminar Seán Mooney, Chief Economist October 2, 2008

3. Emergency Economic Stabilization Act of 2008RIP September 29 • The Act • Treasury buys troubled loans • Helps lenders by reducing uncertainty about their balance sheets • Increases flow of credit in the economy • Insurance of troubled assets • Impact • Overall result not that different from before • Bail-outs on a case by case basis • Values still dependent on real estate recovery • Given uncertainties, Act could exacerbate the problem in the near-term • Lenders hold back until they see how current and/or future Treasury Secretary implements the plan

4. Emergency Economic Stabilization Act of 2008Insurance of Troubled Assets • Program to guarantee troubled assets, issued prior to March 14, 2008 • Treasury collects premiums, set at actuarial level to meet anticipated claims

5. Agenda • Overview of the Financial Market Debacle • how the problems developed, implications for the broader economy • Impacts on the insurance industry, ranging from credit enhancers, to D&O and E & O • Possible regulatory responses impacting our industry

6. The Evolution of the Crisis • First phase, 2007: The subprime mortgage fiasco. The figure of $400 billion from Bernanke still appears about correct. About $300 billion of this has been reported. • Second phase, 2008: The broader credit crisis. As lenders reshaped their finances to meet regulatory and accounting standards credit dried up in lot of areas, e.g., commercial paper, M & A financing and auto loans. The broader risk of Credit Default Swaps (CDS) emerged. • Third phase, August 2008: The insolvency phase. • Broader still. The first two phases create a world wide financial crisis, which, coupled with oil and food crises, triggered a longer term economic downturn. In Phase Three, but not heading to a depression

7. First Phase Subprime Fiasco: Why? • Housing boom • Investors cycle from tech stocks to housing, following technical bust of 2000 • “Free” money in first half of current decade • Price of homes has never declined (current dollars) • Secondary market creates break in link between debtor and ultimate mortgage holders. (Forget Bedford Falls!) • Hedge funds seeking outsized returns • Globalization increases flow of funds to the sector • A positive force, risk classification, turned into a negative, with no docs and option ARMs • A good word about subprime • Risk classification from an insurance perspective

8. First PhaseSubprime Fiasco…By The Numbers • US unemployment rate: 6.1% • GDP: $13 trillion • Financial Assets: $40 trillion+ • Financial impact • 2 million foreclosures @ $200,000 =$ 400 billion • Reported: $280 billion • Economic impact • Housing construction: 6% of economy • Wealth Effect: 6% of wealth change. • Drop in housing prices: 10% implies GDP cut by 0.5%

9. Long Upward Trend in Home Prices Price drops 1.4% in 2007, and 9.5% in 2008

10. The Evolution of the Crisis • Second phase: The broader credit crisis. As lenders reshaped their finances to meet regulatory and accounting standards, credit dried up in lot of areas, e.g., commercial paper, M & A financing and auto loans. The broader risk of Credit Default Swaps (CDS) emerged. “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Warren Buffett, Letter to Shareholders, 2002

11. Second Phase Pressures on banks • Subprime defaults • Credit Default Swaps: Notional Base of $62 trillion, up from $1 trillion in 2001 • Problems at GSEs: Debt of $1.5 trillion • Fair-Value Accounting • Off-balance items to on-balance (SIVs) • Other exposures Consumer debt at record levels: $2.5 trillion, 22% of Personal Income • A credit-quality crisis, not a deflationary policy. The Feds are pushing on a string. Last instance in 1990/91.

12. Banking: Tier 1 Risk-Based Capital Ratio (%), Second Quarter 2008

13. Second Phase:Recent Capital Market Crises

14. Phase Three: The insolvency phaseMuddle Through

15. Worst case scenarios • Depression • Not likely because: • Bernanke wrote the book on causes of the Great Depression. • Among most free market economists, the key cause of the great depression was a failure of monetary policy. Following the stock market crash of 1929, banks were threatened by runs. The Federal Reserve was limited in the loans it could make to member banks, partly by philosophy, but also because the law required partial gold backing of its credits to member banks. 9,000 banks failed (one third). This theory is supported by Bernanke, including a major academic article published in 1995. • Other factors: Cheap credit that fueled excess capacity for consumer goods, trade decline, dust bowl, and the Smoot Hawley tariff act. (June 1930). These factors are all well understood by policy makers so the probability of repeating is low.

16. Deflation Japanese style • Japan in 1990s: Economic growth at 1.3%, inflation at 0.2% • The causes of deflation include: • Aging of the population • By 2020, Japanese working age population will be 10 percent smaller, ours will be 30 % larger. • Young people needed for economic growth. • Cheap goods from China and other South East Asian nations. • Deflation as a self fulfilling prophecy (money in mattresses rather than in the bank.) • Bailout of banks and corporations • Need to rationalize Japanese banking system.

17. Oil DemandMillion Barrels Per Day

18. Agenda • Overview of the Financial Market Debacle • how the problems developed, implications for the broader economy • Impacts on the insurance industry, ranging from credit enhancers, to D&O and E & O • Possible regulatory responses impacting our industry

19. Impacts on Insurance • Direct relationships • Credit enhancers ($3,300 billion) • D & O and E & O • Economic relationships • Driving & auto insurance • Employment and WC • Recession and Fraud • Housing bust and arson (?) • Indirect relationships • Stock Market and Surplus • Interest rates and pricing (long tail)

20. Subprime Impact on Insurer Capital USD Billions

21. Miles Traveled Down in 2007 and 2008

22. Commercial LinesCompetition is heating up!

23. Rate Decreases Continue for Commercial Lines Source: Council of Insurance Agents & Brokers 2nd Qtr. 2008 Survey - Chart: Lehman Brothers Equity Research

24. Pressures on pricing • Reduced supply • Higher catastrophes in 2008 • Reduced investment income, as stock markets weaken • Write-downs for problem assets reduce capital These pressures may be offset to some extent by concerns of counter party credit quality and by possible increased move to self-insurance by well capitalized players

25. Agenda • Overview of the Financial Market Debacle • how the problems developed, implications for the broader economy • Impacts on the insurance industry, ranging from credit enhancers, to D&O and E & O • Possible regulatory responses impacting our industry

26. Regulatory response • Federal regulation • Knee jerk response (Senators Sununo and Johnson) • New York State action on CDS • Higher capital ratios • Raise costs of doing business • Disproportionate impact on newer more thinly capitalized ventures, such as Bermuda start-ups • Search for “Black Swans” • Earthquakes • Liability (Nano, Climate change) • Pressure on reserves

27. The Future • “Fasten your seat belts, it’s going to be a bumpy ride.”

28. Subprime Plus Southwest Chapter:PLUS Educational Seminar Seán Mooney, Chief Economist October 2, 2008