3 financial crisis and credit crunch

8/2/2019 3 Financial Crisis and Credit Crunch

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By:

Eric Nelson

Jacob Payne

Samantha Duellman


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Financial Crisis: OverviewDownturn 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 triedto take corrective measures

Regulation

Problems with Regulation


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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


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http://upload.wikimedia.org/wikipedia/en/f/fb/Existing_Home_Sales_Chart_-_v_1.0.png


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Causes: Subprime Mortgage CrisisWhere did the subprime mortgage crisis start?

Banks used to operate on a fractional reserve system

Today almost no reserve is required due to new rulesthat the public doesnt even know about

Banks are able to issue more loans when they do nothave to keep a reserve on hand

When they run out of qualified candidates, they reducethe requirements, which leads to subprime mortgages

These loans slowly inflate the system, and createwealth that is not real


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Causes: Subprime Mortgage Crisis Mortgage originators sold the loans on the secondary

market

No risk for the originators so little effort went intoanalyzing the borrowers ability to repay

High risk and debt tolerance

Adjustable Rate Mortgages (ARMs)

Rates are beginning to increase from the lowintroductory rate


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Causes: Financial Innovation Financial innovation is the act of creating and then

popularizing new financial instruments as well as newfinancial technologies, institutions ,and markets.

Adjustable Rate Mortgages

Investment Vehicles that went wrong

Mortgage Backed Securities (MBS)

CDOs Collateralized debt obligations

Not understood by investors


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Causes: Financial Innovation Financial innovations are optimal responses to various

problems or opportunities

Many financial innovations that have been created inthe recent past to respond to the financial boom werenot fully understood

They were not adapted properly from the past, and whenthe financial sector crashed, these innovations

responded negatively


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Impacts Large corporations

Bankruptcy

Companies are trying to avoid bankruptcy because of theChapter 11 rule changes that took effect in 2005

Restructuring

Hedge fund owners might push these corporations intobankruptcy by forcing them to sell their assets

Insurance Companies Homeowners are turning to arson as a way to get out

from under their mortgages


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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


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Impacts Home Foreclosures

Over 1.5 million foreclosure proceedings began in 2007

Foreclosure filings increased 57 percent in Marchcompared to a year ago

Bernanke expects that number to increase further in2008

Increased foreclosures further depresses home prices,which can hurt the broader economy.


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Impacts Changes in the Market

Large re-evaluation of risk

Abstract ideas such as CDOs and MBSs are out thewindow

Know what you are holding

Maybe housing values dont always go up

Banks are much tighter with their cash, causing aliquidity shortage and the so-called credit crunch

Huge financial institutions are going broke and beingpurchased by competitors


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Events Bear Stearns Bailout

Bear Stearns is the fifth largest investment bank onWall 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 valueamid 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


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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 uppedthe buyout price to $10/share and reduced thegovernment guarantee by $1 billion.

Many saw this action by the Federal Reserve as agovernment bailout of an investment bank

Federal Reserve Chairman Ben Bernanke testified thatif Bear Stearns would have defaulted, there most likely

would have been severe consequences leading to apossible systemic financial crisis


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Events Northern Rock

On September 12, 2007, the Bank of England providedemergency funds to Northern Rock in the biggest bailout of aBritish bank in three decades.

The difficulties came from Northern Rock not being able toraise funds due to the subprime crisis in the US

http://maoxian.com/index.php?s=northern+rock


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Events Northern Rock

On September 14, 2007 customers waited outside thebranches 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 numberof people that were trying to log on

As of November 17, 2007 a total of 10 companies had putin 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 bankwould operate under a temporary period of publicownership


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Events Countrywide Financial Crisis

When Countrywide finances mortgage loans, theyusually package them for sale to large investors asmortgage backed securities

After the housing crisis began Countrywide was severelyaffected

On August 3, 2007 the secondary market stopped thesales of most non-conforming securities and days laterCountrywide announced that this disruption could hurtit financially


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Events Countrywide Financial Crisis

On August 12, 2007 Countrywide was cited as a possiblebankruptcy risk by Merrill Lynch

Countrywides stock fell from $21. 29 in August down to$8.64 in November

On January 11, 2008 Countrywide was bought out byBank of America for an all-stock $4 billion deal, downfrom a $24 billion value one year ago

Countrywide was the nations largest mortgage lender,so this deal is a landmark in the housing crisis


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Solutions Federal Reserve Actions

Bernanke and the Fed have been trying to stave off recessionvery actively

The Fed reduced the interest rate 7 times since lastSeptember, most recently on April 30th, when rates werereduced a quarter point to 2 percent

The Fed has been trying to boost the amount of liquidityavailable due to sharp declines in banks loaning to each other

The Fed began the Term Auction Facility in response to thecrisis on December 12th, 2007.

The TAF is a means of increasing liquidity by offering loans todepository institutions which otherwise could not borrowfrom the Fed


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Solutions Regulation

New plan unveiled by Treasury Secretary Henry Paulson

One agency in charge of business conduct and consumerprotection

Eliminate office of Thrift Supervision and Commodity TradingFutures Commission

Establish a federal Mortgage Origination Commission

Set minimum licensing standards for mortgage brokers Establish Office of Insurance Oversight inside Treasury

Department


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Solutions Issues with Regulation

Keeping good regulators is difficult because they earnmuch more in the private sector

Ensuring proper conduct of regulators is difficult

If banks were allowed to fail everyone would workharder not to and would assess risk better.

Due to bailouts of major banks (Bear Stearns, NorthernRock) the only viable option left is more and betterregulation in order to promote stability in the financialsystem.


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Solutions Bank Regulations

The amount of money owed to banks is more than allthe money in existence, so we cannot possibly get out ofdebt under this system

The bulk of this debt is in the form interest, which is anarbitrary amount of money banks demand in return, butnever gave

The public must demand that money must not becreated by loaning it into existence, which in the endcauses inflation


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Financial Crisis: Conclusion Causes

Multiple factors played a role in this financial crisis

Most of the emphasis has been placed on the subprimemortgage crisis

It has had effects that have stretched beyond the housingmarket

Impacts

The impact of this financial crisis can be felt on all levelsfrom individuals to large corporations


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Financial Crisis: Conclusion Events

The far reaching events can show how powerful thisfinancial crisis is

Bear Stearns was saved to prevent further damage to thefinancial market

It forced the nations largest mortgage lender into nearbankruptcy and an eventual buyout

Solutions The Federal Reserve has stepped in but to little avail

Regulation seems to be a popular answer but what typeof regulation still needs to be developed


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Financial Crisis: Conclusion In a statement from Countrywide to the SEC

Since the company is highly dependent on theavailability of credit to finance its operations,

disruptions in the debt markets or a reduction in ourcredit ratings could have an adverse impact on ourearnings and financial condition, particularly in theshort term Current conditions in the debt marketsinclude reduced liquidity and increased credit risk

premiums for certain market participants. Theseconditions, which increase the cost and reduce theavailability of debt, may continue or worsen in thefuture.


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http://upload.wikimedia.org/wikipedia/en/0/09/Subprime_diagram.png


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References Wall Streets 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

Jeffery D. Sachs. The Roots of Americas Financial Crisis. ProjectSyndicate. April 15, 2008 Tom Leonard. Henry Paulson unveils bank regulation plan. Daily

Telegraph. April 22, 2008.
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References Waiting for Armageddon. The Economist. March 27,

2008.

Mark Landler Housing Woes in U.S. Spread AroundGlobe. The New York Times. April 14, 2008.

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
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