U.S. Financial Crisis

Sarinee AchavanuntakulFringer | คนชายขอบ

http://www.fringer.org/10 November 2008

Most slides are taken from http://www.slideshare.net/econman/the-credit-crisis-of-2008a-presentation

The credit crisis, illustrated: the beginning

..when 2008 rolls around:

Roots of the crisis: the housing bubble

Fuelling the bubble: low interest rates

Mortgage securitization

Moral hazard “credit ease”• “Subprime” is defined as borrower who has FICO credit score less

than 620, but some lenders also define borrowers whose FICO score are as high as 680 as “subprime” if their down payment is <5%

• Typical subprime mortgage is “Adjustable-rate Mortgage” (ARM): a 2/28 ARM means fixed interest rate for the first 2 years, then floating rate (e.g. LIBOR + 6%) for the remaining 28 years

• Often requires no down payment, can borrow 100% of house value, and has no rigorous credit check – “NINJA” borrowers, “Liar loans”

• Zimmerman (2007) proves that subprime loan quality in 2007 is worse than in 2006, and 2006 were worse than 2005

• New subprime loans were $421,000 million in 2006 (S&P estimate); AMP Capital Investors estimates $1.4 trillion subprime loan outstanding in July 2007

• Fannie Mae estimates that 50% of those who were sold subprimeloans would have qualified for prime-rate loans

Credit Default Swap (CDS)• Investors seek insurance to cover unexpected

defaults on loans

• Fraud: – Unfair or misleading credit terms, e.g. ARM, universal default– Moody’s supposed “bug” in their credit rating model that

resulted in some bonds being overrated by 4 notches (5/2008)

• Over-leverage:– Many banks & hedge funds over-leverage to make easy money

on CDOs: 25-30x times their capital

• Non-transparency:– Financial institutions use off-balance-sheet vehicles e.g. Special-

Purpose Vehicle (SPV) to hide real exposure and evade taxes– Most subprime-linked derivatives are traded on 100% private,

OTC (“over-the-counter”) basis, so nobody knows the market size problem applies to the whole “shadow banking system”

Fraud, over-leverage, and non-transparency

Agency problems, wrong incentives• Problems at the top

– “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Citigroup’s Chuck Prince, in an interview with Financial Times, July 2007

– Retired in November 2007 with $38 million pay package

• Problems down below:– Traders are compensated for short-term performance – if they take

positions that have 5% chance of total catastrophe, they will be well rewarded year after year as long as that 5% never materializes

– What the traders receive are therefore just “insurance premiums”but they thought they are smart!

– Internal risk management gets weaker the more profits they make– Hard to separate true “alpha” (idiosyncratic, firm-specific) from

“beta” (systemic, overall market returns) risks

What went wrong…

Multiplied losses

“Those guys are good.”

How a bank works

Assets

Current assets $110Long-term assets

Investments $600Others $100

Total $810

Liabilities & Equity

Short-term debt $505Long-term debt $230Equity (shareholders) $75

Total $810

• Most bank “liabilities” are deposits which are short-term in nature (e.g. 2-year fixed deposits), while most “assets” are longer-term loans (e.g. mortgages or CDOs which are “investments”). Mortgages are the longest-term loans.

• Banks must mark-to-market the value of their investments.• Example: Wachovia balance sheet @ 30/6/08 (prior to

Citigroup takeover):

Why banks fail so dramaticallyAssets

Current assets -$90Long-term assets

Investments $500Others $100

Total $510

Liabilities & EquityShort-term debt $305Long-term debt $230Equity (shareholders) -$25

• Borrower defaults + house prices collapse market value of investments / mortgages collapse (ex. $100 in above example)

• Bank must record falling value of investments as losses erode bank capital until shareholder’s equity is negative insolvent

• Meanwhile, if bank’s debtors (depositors or other financial institutions) withdraw funds or demand loan prepayment, bank may face a severeliquidity crisis until it is bankrupt

• Bailout: buy toxic assets from banks (not a good idea: at what price & certain losses) or raise capital (better, but can Republicans accept?)

• If public funds are used, ex-shareholders should not reap benefits

Total $510

U.S. household debt problem is not over• Currently 8.8 million Americans have negative home equity

– a record figure• Total mortgage market in U.S. is approx $11 trillion (79%

of GDP). About 13% of these are subprime• U.S. households have $1 trillion credit card debt + $0.7

trillion auto loan. These debts often have no collateral –repayment depends solely on borrower’s ability to repay

• Tough & unfair credit terms + rising cost of living (oil, food, etc.) erode ability to repay

• Since mortgages are often the last kind of loans people would default (house = the most valued asset), the subprime crisis suggests that they have already defaulted on credit cards and other kinds of loans

• These loans have been securitized too. So… watch out!

The end of neoliberal economics?

What will happen next?