Epilogue

Financial Crisis of 2008

Objectives of Learning UnitYou have learned various topics in Money & Banking and acquired tools and methods to analyze issues in the financial system throughout this Money & Banking course. On this Learning Unit, we examine the financial crisis on 2008 and apply knowledge learned in this course to•Identify the origin of the problem from the historical perspective.•Understand how the financial crisis developed in context of our financial system.•Find possible solutions for the financial crisis.

Harbingers of Financial Crisis

• Savings & Loan Associations crisis and development of securitization in 1980s

• Irrational exuberant in 1990s• Financial Deregulation in late 1990s• Moral hazard problems in the financial

industry in 2000s• Financial engineering in 1990s and 2000s• Excessive expansionary monetary policy in

2000s

S&Ls and Mortgage Loans

• Until 1980s, S&Ls and commercial banks originated significant shares of mortgage loans.

• Most S&Ls held mortgage loans in their portfolio. Since S&Ls held long-term liabilities, as long as the yield curve is upward-sloping and stable, they earned stable profits with low liquidity risk.

• S&Ls must manage default risk on mortgage loans. S&Ls screened potential borrowers to reduce adverse selection and moral hazard problems to prevent default of mortgage loans.

S&Ls Crisis and Development of Securitization• In 1980s, majority of S&Ls in nation went out of business.• Commercial banks, which own short-term liquidity (e.g.

checking deposits), are reluctant to hold too many mortgage loans for its liquidity management.

• The mortgage firms earn profits by reselling the mortgage loans to others, since they do not hold large funds like commercial banks (e.g. deposits).

• A greater share of mortgage loans became underwritten by commercial banks and mortgage firms as S&Ls failed.

• Commercial banks and mortgage firms sold them to public and private securitizing firms (e.g. Fannie Mae, Freddie Mac, SIVs).

• Commercial banks remain as servicers of mortgage loans.

Securitization and Moral Hazard• Since commercial banks and mortgage firms do

not keep mortgage loans, they were concerned with default risk of mortgage loans that they underwrite.

• Lack of incentive to manage default risk lead to lending to riskier borrowers – less (no) screening, less (no) monitoring.

• This later led to a creation of high-risk mortgage loans (e.g. subprime, Alt-A, NINJA).

• Moral hazard problems of commercial banks and mortgage firms later put securitizing firms at risk.

Irrational Exuberance• The longest economic expansion in the U.S. history from

1992 to 2001.• Technological advancement: Development of more

powerful and cheaper PCs and Internet led to birth and expansion of many technology firms.

• Day traders: Development of online trading created risk-raking ill-informed novice investors (noise traders) who trade day and night.

• Irrational exuberance: Speculation by day traders resulted in stock market boom in 1990s.

• Speculative bubble and crash: The stock market crashed in 1987 and 2001.

Financial Deregulation• Financial deregulation in late 1990s– Created nationwide megabanks like Bank of America and

Wachovia Bank– Created universal banks like Citibank and J.P. Morgan Chase.

• Megabanks became too big to fail.– A failure of one of megabank or universal banks will have

devastating ripple effects in the financial system, and eventually to the entire economy.

• Universal banks involved in risky activities.– Non-bank units of universal banks could engage in riskier

activities than traditional commercial banks without regulation and supervision of the federal government.

– A failure in non-bank unit of the universal banks could lead to collapse of the entire universal banks and affect depositors.

Moral Hazard in Financial IndustryWith deregulation and less supervision of financial service firms, many firms created problems of moral hazard, principal-agent, and conflict of interest.•Principal-agent problem: Self-dealing of CEOs and senior managers at Fannie Mae and Freddie Mac in expense of shareholders•Conflict of interest problem: Rating agencies such as Moody’s and Standard & Poor’s giving higher ratings to CDOs issued by their clients than actually they are. •Moral hazard problem: Mortgage firms made loans to risky borrowers and sold the mortgage loans for fees (profits) to securitizing firms (e.g. Fannie Mae) without disclosing their risk. Once sold, it is not a problem of mortgage firms, but of securitizing firms if borrowers default. More they gave loans and sold to securitization firms, more profits they made!

Financial Engineering• Advancement in financial economics and computer

technology led to creation of new types of financial instruments – derivatives – and new investment strategies – hedging and program trading/portfolio insurance.

• New types of derivatives such as credit-default swaps were created by nonbank financial institutions and not regulated by the federal government or the Federal Reserves.

• Derivatives valuation and hedging strategies are based on “rocket science” financial engineering and executed by computer, and opened up opportunities to make million dollar profits in seconds (so as million dollar losses in seconds).

• CEOs and traders did not have full understanding on them, and little was known of its systemic risk.

• LTCM (Long Term Capital management), which dealt with hedging, collapsed in 1998, and led to the stock market crash of 1998.

AIG and Credit Default Swaps (CDSs)• AIG insured CDOs and CMOs through credit default swaps.• On CDSs, AIG was supposed to hold Treasury securities

and swap interest payment flows. If AIG purchased and held Treasury securities, AIG’s funds would be tied to Treasury securities and AIG could not provide more CDSs.

• AIG decided not to hold Treasury securities, but swap interest payments out of its cash reserves as if it held Treasury securities. This allowed AIG to issue unlimited amount of CDSs and to make huge profits as long as interest payments on CDOs and CMOs were more than those of Treasury securities.

• Without government oversight of CDS market and through accounting manipulation, AIG was able to hide huge potential loss on CDSs. This put AIG shareholders at risk, while CEO and managers received huge bonuses.

Excessive Expansionary Monetary Policy• U.S. economy fell in a recession in 2002 due to– Technology stock market crash in 2001– 9/11 terrorist attach in NYC and DC

• The Federal Reserves, led by Chairman Alan Greenspan, took aggressive expansionary monetary policy to stimulate the economy.– Interest rates fell to the historical low over long

period of time, while the federal government ran huge budget deficit through increased spending and tax cuts.

Globalization and Chimerica• China became major exporter of inexpensive

goods to the U.S.• With low interest rate and fiscal stimulus, U.S.

consumers began to borrow and spend more (saving rate became negative).

• With huge surplus of U.S. dollars, China invested dollars in the U.S. financial market – purchased Treasury bonds and CMOs issued by Fannie Mae and Freddie Mac.

• Funds invested by China were used to provide more mortgage loans through Fannie Mae and Freddie Mac.

Real Estate Market Boom• Low interest rates ignited real estate market boom in

mid-2000s.• Deregulation and securitization encouraged mortgage

firms to extend mortgage loans to riskier borrowers.• Many risky borrowers did not fully understand repayment

schedules and took the adjustable rate mortgage loans because of extremely low initial interest rate (e.g. zero percent introductory rate, no down payment, interest only loan, reverse mortgage).

• Many real estate speculators knowingly took adjustable rate mortgage (ARM) loans (at almost zero introductory rate) in hope of making profits from rising real estate prices and selling houses at higher prices before the ARM loan rates are reset to higher interest rates.

False Belief of Safe Securities• Securitization process was considered to reduce risk on

CDOs and CMOs through diversification.• Rating agencies gave AAA ratings to CDOs and CMOs.• Bond insurers insured many CDOs and CMOs, and also

AIG insured other CDOs and CMOs through credit default swaps (CDS).

• Although Fannie Mae and Fannie Mae are independent government-sponsored agencies and there was no explicit guarantee by the federal government, securities issued by Fannie Mae and Freddie Mac were thought to be backed by the U.S. government and were thought almost as safe as Treasury securities.

Financial Crisis of 2008

The U.S. financial system faced its greatest threat since the stock market crash of 1929.•Real estate market crash•Subprime mortgage loan market meltdown•Investment bank and commercial bank failures•Credit –default swap crash and AIG bailout •Stock market free fall

Changes in Economic Climate• In mid-2000s the economic conditions in the U.S.

improved significantly and enjoyed another expansion.

• The Federal Reserves started rising the market interest rates to slow down excessive spending of consumers and to prevent inflation.

• Global economic expansion, in particular China and India, lead to sudden rise in commodity prices (e.g. high oil and food prices in 2007), which made U.S. households cut in spending, affecting some firms like GM and pushing the U.S. economy down.

Real Estate Market Crash• In mid-2000s, some ARM loans became to reset their

interest rates to much higher rates. Many risky borrowers found out themselves not being able to continue to pay back their mortgage loans and turned to foreclose their houses.

• With higher interest rates, suddenly demand for real estates declined throughout the nation and the market prices of real estates fell.

• Many real estate speculators became insolvent (the market value of house fell below the mortgage loan balance – “underwater”) and chose to foreclose rather than pay back.

• Increasing number of foreclosures led to real estate market crash in 2007.

Failure of Mortgage Firms

• With drop in demand for real estates, mortgage firms could not underwrite any more mortgage loans.

• Realizing high default risk of mortgage loans underwritten by mortgage firms, the securitizing firms no longer purchased risky subprime loans from mortgage firms.

• Loss of revenues brought mortgage firms, which stuck with underwritten risky mortgage loans, to bankruptcy (e.g. Countrywide, Golden West Financial).

Collapse of CDO Markets• With mortgage loan defaults spread across the

nation, investors who purchased the mortgage-backed securities (CMOs) realized that CMOs were riskier than they thought and their value fell.

• Many other CDOs backed by CMOs also became risky and their value fell together.

• Without anyone willing to purchase risky CMOs and CDOs, the market of CDOs and CMOs collapsed and it became impossible to sell them – lack of liquidity.

Failures of Bond Insurers• Traditionally, bond insurers insured municipal bonds

with low risk.• As CDO and CMO markets developed and expanded,

the bond insurers began to insure AAA-rated CDOs and CMOs which seem less risky that corporate bonds.

• As many CDOs and CMOs defaulted, most bond insurers were overwhelmed with their obligation and became insolvent (e.g. ACA Financial Guaranty Corp. and Ambac Financial Group Inc.)

• Most bond insurers stopped underwrite any more insurance to even municipal bonds, resulting in higher cost of borrowing for state governments or even unable to borrow (e.g. State of California).

Credit & Liquidity Crisis of SIVs• Most of SIVs (structured investment vehicles) holding

large amounts of CDOs and CMOs became insolvent as value of CDOs and CMOs fell.

• SIVs financed through short-term commercial papers (CPs) to purchase CDOs and CMOs. As existing CPs became matured, SIVs must issue another CPs (roll over its debt).

• Credit crunch: Because of insolvency, no investors wanted to purchase CPs issued by SIVs

• Liquidity problem: Because of collapse of CDO and CMO markets, SIVs could not sell their CDOs or CMOs, either.

• Defaulting CPs led SIVs to become bankrupted.

Failures of GSE• Government-sponsored entities such as Fannie Mae and

Freddie Mac became insolvent as a result of large numbers of default of mortgage loans.

• Defaulting securities issued by Fannie Mae and Freddie Mac would lead to inability and unwillingness of China to continue to lend to the U.S.

• The U.S. government ran huge deficit to help failing financial institutions and to support the U.S. economy and must continue to issue more Treasury securities to finance its deficit.

• If China were to stop purchasing Treasury securities, it would have affected the federal government’s ability to tackle the on-going financial crisis.

Investment Bank Failures• Most SIVs are owned and operated by investment

banks, which had to absorb losses made by their SIV subsidiaries.

• Bear Stern faced liquidity problem in March 2008 and acquired by J.P. Morgan Chase with arrangement by the Federal Reserves.

• Lehman Brothers went bankruptcy in September 2008, seen as the federal government and the Federal Reserves' punishment to moral hazard behavior.

• Merrill Lynch was merged with Bank of America in December 2009.

• Goldman Sacks and Morgan Stanley formed bank-holding companies to become eligible for help from the Federal Reserves in case of liquidity problem.

Commercial Bank Failures• Many large and medium commercial banks (e.g.

IndyMac Bank in CA, Washington Mutual Bank – Wamu in WA) which invested in CDOs and CMOs also became insolvent and bankrupted.

• Megabanks acquired failing mortgage firms (e.g. Countrywide acquired by Bank of America, and Golden West Financial by Wachovia Bank). Subsequently, Bank of America and Wachovia became insolvent as their mortgage units faced too many default of mortgage loans, but they were “too big to fail.”

• Many medium and small local and community banks (e.g. Colonial Bank in AL) suffered massive default of commercial real estate loans due to the recession and, subsequently, went bankruptcy.

Money Market Crisis• Money market mutual funds were thought most liquid

and least risky money market instrument, since they primarily purchase Treasury bills and short-maturity Treasury bonds.

• Without proper supervision and regulation, Reserve management purchased and held commercial papers issued by Lehman Brothers.

• After Lehman Brother’s failure, Primary fund by Reserve management, money market mutual funds, became insolvent.

• Investors got in panic, and attempted to withdraw funds from money market mutual funds, which might lead to liquidity crisis to all money market mutual funds and their management firms (financial institutions such as Merrill Lynch, T. Rowe Price, Fidelity).

Hedge Funds Failures

• Many hedge funds bet on commodities, real estates, stocks, and derivatives.

• When prices of commodities such as oil and corn, prices of financial assets, and prices of real estates fell in 2008, many hedge funds suffered huge losses and many of them went under (in 2008, 1,471 hedge funds went bankruptcy).

Recession• Insolvent banks became very conservative in

assets management to avoid bankruptcy. – They built up reserves to meet unexpected deposit

outflows. – They turned down most loan requests from

businesses and households.• Lack of access to bank loans created liquidity

problems to many business firms.• Real estate market crash caused households to

cut back their spending (negative wealth effect).• Many small and large business firms suffered

losses and laid off workers, causing downward spiral of recession.

Collapse of Credit Default Swap Market• Massive default of CDOs and CMOs as a result of default

of mortgage loans and bankruptcy of SVIs forced AIG to honor its CDS contract – continue to pay Treasury interest payments while not receiving interest payments from CDOs and CMOs.

• Without holding enough Treasury securities, AIG found itself making huge losses and its obligation exceeding its assets.

• After the collapse of Lehman Brothers, it became impossible for AIG to raise funds to honor its CDS obligation.

• AIG was about to bankruptcy, but it was “too big to fail.”• A failure of AIG would affect all other counter parties of

CDSs (mostly large financial institutions) and could bring them insolvency and bankruptcy.

Worldwide Financial Crisis• Major international banks in the world also invested into

CMOs and CDOs issued by American SIVs, and became insolvent after massive default of CMOs and CDOs in the U.S. (e.g. USB)

• Some countries also had real estate bubble like the U.S. (e.g. U.K. and Spain) and suffered the real estate market crash, and caused bank run (e.g. Northern Rock in U.K.)

• Global liquidity problem initiated by major banks spread further.

• Worldwide volatility in financial (currency, derivative) markets led further global financial and economic problems. (e.g. Iceland’s currency crisis; $7.1 billion loss of Société Générale, French financial service firm )

Stock Market Crash of 2008

• As the problem in financial institutions grew and many of them became insolvent, investors fled from stock markets and sought safety in Treasury bonds.

• As the U.S. economy got into recession, the stock market went down.

• DJIA fell from 14,000 in October 2007 to 6,500 in March 2009.

Financial Bailout

The federal government and the Federal Reserves made joint efforts to prevent the U.S. and global economy from full-scale financial crisis spiral and another great depression.•Fiscal stimulus•Bailout of failing financial institutions•Lenders of last resort to all financial institutions

Federal Government Actions• The Congress passed $700 billion bailout bill

(Emergency Economic Stabilization Act of 2008) on October 2008, which loaned to insolvent financial institutions (e.g. Citibank, bank of America, AIG) and GM and Chrysler.

• PPIP (Public-Private Investment Program) in 2009 was intended to encourage investors to purchase CDOs and CMOs from banks.

• ARRA (American Recovery and Reinvestment Act) in 2009 is a $789 billion stimulus bill that includes tax cuts and spending on education, infrastructure (e.g. road construction), energy (e.g. green energy and smart grid), low-income aid, etc.

Federal Reserves Actions• The Federal Reserves stood by to provide

emergency loans to any insolvent banks which faced liquidity problem or potential bank run.

• The Federal Reserves initiated TALF (Temporary Asset-Backed Securities Loan Facility) to make loans to banks and bank-holding companies.

• CPFF (Commercial Paper Funding Facility) provided liquidity in commercial paper markets.

• MMIEF (Money Market Investor Funding Facility) helped restore liquidity in the money market funds.

Actions by FDIC• FDIC has arranged many mergers and acquisitions

of failed banks (e.g. IndyMac Bank in CA, Washington Mutual Bank in WA, Colonial Bank in AL, Cooperative Bank in NC).

• FDIC has paid tens of billion dollars of insured deposits to depositors of hundred of failed banks.

• FDIC raised its deposit insurance cap to $250,000 per account from $100, 000 per account to prevent large deposit outflows from insolvent commercial banks and bank run.

Actions by SEC• SEC allowed banks to switch from mark-to-market

accounting (all assets must be valued at current market price) to hold-to-maturity accounting (original purchase price). The mark-to-market accounting forces banks to write down as market prices of CDOs and CMOs fell, causing them insolvent.

• SEC tightened its supervision and investigation of Ponzi schemes (e.g. Bernard Madoff, Allen Stanford) to protect investors.

• SEC put a temporary ban of short sales which put downward pressure on stock prices.

Financial Regulatory Reform• The financial crisis was a result of unregulated risk-

taking activities by financial firms, speculation by investors, and moral hazard problems in the financial system under weak supervision.

• The government’s financial regulatory reform is intended to regulate those unregulated previously, to reduce moral hazard problem through more supervision, make financial institutions more prone to liquidity and systematic risk, and reorganize regulatory agencies to have more effective supervision and clearer responsibilities.

Disclaimer

Please do not copy, modify, or distribute this presentation without author’s consent.

This presentation was created and owned byDr. Ryoichi Sakano

North Carolina A&T State University