THE CREDIT CRISISCAUSES, CONSEQUENCES & CURES

University of Nevada, RenoInstitute for the Study of Gambling & Commercial Gaming14th International Conference on Gambling & Risk Taking

Stateline, Nevada May 25-29, 2009

Mark SieversSievers & Sievers

P.O. Box 546Cripple Creek CO 80813

(719) 659-7580MarkSievers@Skybeam.com

MAY YOU LIVE IN INTERESTING TIMES MAY ALL OF YOUR DREAMS COME

TRUE 4 consecutive Qs of GDP declines

◦ 2.7% in 3d Q 08◦ 5.4% in 4th Q 08◦ 6.4% in 1st Q’09◦ 1% in 2nd Q ‘09

7.4 million jobs lost since Jan. 08◦ Unemployment rate = 9.7% (4.9%

in Jan 2008)◦ Unemployment projected to be

10.5% in Dec. 2009 Spending for business equipment

dropped 30% Industrial output dropped 20% in

1st Q 2009 (equal to 1998 levels) Industrial capacity used dropped

to 69% (lowest ever) Banks in trouble

◦ 89 bank failures in2009◦ 416 banks failed FDIC grading

system

Stock market (S&P 500) down about 40% from 2008

June ‘09 average housing prices down about 30% from Jan. ‘07

July ‘09 foreclosures 32% higher than July ’08◦ 800,000 homes in foreclosure –

expected to peak at 1.15 million in 2010

◦ Cure rates for defaulting mortgages:

◦ Prime loans - 6.6% from 45% (2006)

◦ Alt-A loans - 4.3% from 30%◦ Subprime – 5.3% from 19.4%

1.4 million bankruptciesexpected in 2009– 75% higher

than 2007

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LOCAL BUSINESS CONDITIONS20-30% BELOW 2001

ARE YOU COMING OR GOING?BUILDING PERMITS &

FORECLOSURES

INTERCONNECTED CAUSESEra of Easy/Cheap Money 2000-2005

◦ Greatly expanded the supply of loans Created a Real Estate Bubble

Rise of the Shadow Banking System◦ Highly leveraged, risk-seeking business model◦ Equal in size to traditional banking system

Securitization of loans◦ Expanded cheap/easy money◦ Agency problems – “loan to sale” business models◦ Gambling with Credit Default Swaps widespread◦ Inability to re-negotiate defaulting loans and loans

on property where value falls below loan principle

WHAT (WHO) CAUSED THIS MESS?BOOM & BUST MONETARY POLICY

2000-2004 – Fed reduces interest rates to combat 9/11 and dot-com recessions◦ Wave of cheap money Housing

price bubble caused by: Dramatically reduced mortgage rates

& sub-prime mortgages increase house prices

Securitized loan instruments makes even more money available for cheap mortgages

2005 – 2006 Fed increases interest rates and bursts the housing bubble◦ Falling House prices upside-down

loans◦ Collapse in the securitized loan

marketFed missed the rise of

securitization & highly-leveraged shadow banks

“May you come to the attention of higher

authorities.”

FEDERAL RESERVE MONETARY POLICY HOUSING PRICE BUBBLE

1/1/

1997

1/1/

1998

1/1/

1999

1/1/

2000

1/1/

2001

1/1/

2002

1/1/

2003

1/1/

2004

1/1/

2005

1/1/

2006

1/1/

2007

1/1/

2008

100%

120%

140%

160%

180%

200%

220%

240%

0%

1%

2%

3%

4%

5%

6%

7%U

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1% Reduction in Market Mortgage Rates Causes a 10-16% Increase in Housing Prices Robert Schiller – Irrational Exuberance

GREENSPAN’S BUBBLESFINE-TUNING THE ECONOMY WITH MONETARY POLICY

Source: Paul Krugman, The Return of Depression Economics (2009)

1999 Stock Market Bubble“Irrational Exuberance”

2006 Housing Price Bubble

US & Japanese Real Estate Bubbles

Japanese decline 65%

MAJOR CONTRIBUTOR – SECURITIZATIONBundling & selling loans in bond-like

instruments◦ 25% mortgages; 21% credit card loans; 13% auto loans; 15%

other (student loans, business loans)

Massive Boom & Bust Cycle◦ 1997 $300 billion 2006 $2 trillion 2007 $121 billion

Agency Problems◦ Borrowers are unknown to the bundled loan purchasers – loan

renegotiations are virtually impossible when borrower gets into trouble

◦ “Loan to sale” business models -- compensation based on # of loans not loan quality (rise of unregulated mortgage brokers & mortgage lenders)

Serious Structural Problems◦ Low quality (sub-prime) loans in securitized tranches carried

high returns, create incentives to make low-quality, risky loans

◦ Valuation grossly complex making after-market sales to 3d parties nearly impossible

◦ Insurance/Gambling via Credit Default Swaps

SECURITIZATION IN A NUTSHELLAKA TOXIC ASSETS, LEGACY ASSETS

Borrowers•Households•Businesses

Lenders•Banks•Credit Cards•Auto Lenders•Hedge Funds•Mortgage Lenders

Loans/Assets•Mortgages• Sub-Prime Loans• Alt-A Loans• FHA/VA Loans•Credit Cards•Auto Loans•Student Loans•Commercial Loans

Special Purpose Vehicle

Securitized Instrument•Collateralized Debt Obligations •Collateralized Loan Obligations •Asset Backed Securities •Mortgage Backed Securities

Arranger

Buyers (Highly Leveraged)•Investment Banks•Pension Funds•Hedge Funds•Private (Foreign) Investors

Rating Agency

Credit Default Swaps

Insurers •Insurance Companies•Investment Banks•Hedge Funds•Individuals

Speculators•Investment Banks•Hedge Funds•Investors

SECURITIZED LOAN INSTRUMENTSTHE WATERFALL

Loans/Assets•Mortgages• Sub-Prime Loans• Alt-A Loans• FHA/VA Loans•Credit Cards•Auto Loans•Student Loans•Commercial Loans

Senior Tranche•High quality loans•Priority on cash flow•Lower coupon

Prices determined by changes in :• Risk rating by rating agency• Interest rates (P when interest rates )• Loan to value ratio (Market price of assets)• Repayment patterns (Foreclosures)

MediumTranche•Medium quality loans•2d Priority on cash flow•Higher coupon

Junior Tranche•Lowest quality loans•Last priority on cash flow•Highest coupon

Securitized loan portfolio divided into tranches of bond-like instruments with different prices,interest rates and claims on cash flow

LEVERAGING & SHADOW BANKS(MAGNIFIES RETURNS & LOSSES)

$100 Million Security10.5% Return

Lender’s Money$95 Million

Hedge Fund Money$5 Million

Conservative Lenders10% Loan Terms

Hedge FundInvestors

$95 M

$5 M

$9.5 M

10% Return to

Conservative Lenders

$1 M 20% Return to Hedge

Fund InvestorsProblems:

• Moral Hazard – Hedge Fund gambles with Conservative Investors’ Money

• No Regulatory Oversight of Leveraging • Oct. 2004 -- SEC suspended net capital rule for

largest investment banks eliminating regulatory restrictions on leveraging

SHADOW BANK RUNPrice/Value of

securitized bonds/assets

falls.

Investors: “I ‘m outta here. I

want to withdraw my

money.”

We don’t have the cash to cover the

withdrawals

Sell securities. Reduce prices

to raise the cash.

Value of firm falls.

Federal Reserve Increases

Interest Rates Causes

Bond Prices to Fall

Credit Default Swaps:

Bets that firm will fail.

CONSEQUENCES – FORECLOSURES

HOW LONG THIS WILL LAST?CBO ESTIMATES – 2014 BEFORE GDP

GROWTH RETURNS TO NORMAL

Congressional Budget Office: A Preliminary Analysis of the President’s Budget and an Update of CBO’s Budget and Economic Outlook (March 2009).

Assumptions:• No exogenous shocks (e.g., no oil price , major

bankruptcies,)• Government solutions actually work -- do not create

other issues

LOCAL BUSINESSES’ FORECASTS

NOW, THE BAD NEWS Expects further declines in real estate prices

◦ Japan’s experience – 65% overall decline; 83% decline in commercial real estate

◦ Commercial real estate bubble expected to be as large as securitized mortgage losses

Alt-A and Jumbo mortgages (bigger than sub-prime) have begun to reset◦ Why renew a mortgage on a property worth less than the mortgage?

Potential bank-run from pre-existing lines of credit◦ Approximately $4.5 trillion outstanding

Large, high-profile insolvencies disrupting markets(GM, Citigroup)

State, local government shortfalls◦ State/Local governments cannot engage in deficit spending, so MUST

increase taxes or substantially decrease spending – both options retard economic growth

Political pressure to erect trade barriers to protect domestic industries◦ Replay of Smoot-Hawley disaster of the Great Depression

Return of Stagflation◦ Replay of the Great Inflation driven by dramatic increases in

government spending

◦ Unemployment > 15% (projection for Dec. 2009 = 10.5%)

Economic Policy Cures…Digging out of the Hole

Keynesian Policies◦ Spend LOTS of money

on stimulus projects Monetary Policies

◦ Federal funds rate = 0%

◦ Discount window = 0%

◦ Interest on reserve requirements

Trade Barriers◦ Not yet happened

Government Buys Toxic Assets Quasi-Nationalization

◦ Government invests in financial firms Government Guarantees

◦ Government issues auto warrantees, guarantees bank deposits

New Banking & Investment Regulations

Bans/Restrictions on Short Sales◦ Prevents runs on leveraged firms

Bankruptcy to Clean Up Illiquid Assets & Force Re-negotiation of Loan Terms◦ Bankruptcy courts empowered to

alter terms of mortgages◦ Pre-packaged bankruptcy of Chrysler

Fix the Credit Markets

Stimulate the Economy

PUTTING THE NUMBERS IN CONTEXT(TAKE A VERY DEEP BREATH BEFORE PROCEEDING …)Total Spending in Entire US Economy (GDP) $14.3

trillion

Total US Stock Market Capitalization $15.4 trillion

Total Value of US Housing StockTotal Outstanding Mortgage BalancesTotal Consumer Equity

$18.3 trillion

$10.4 trillion$2.6 trillion

Total Corporate Real EstateTotal Corporate Inventories & Equipment

$8.4 trillion$5.8 trillion

Total Federal, State & Local Government Spending Total Government spending on Health CareTotal Defense spendingTotal Federal, State & Local Education spending

$5.2 trillion$910 billion$729 billion$838 billion

Total US, State & Local Government Receipts (Taxes)

$4.2 trillion

Total Federal Government DebtTotal 50-State Government Debt

$10 trillion$2.5 trillion

Total US “Near-cash” Money Supply (M2) $8.2 trillion

US Spending on Military Conflicts (2008 dollars; CBO figures)

Iraq/Afghanistan (6 years)World War II (5-6 years)Vietnam (10-15 years)Korea (4 years)

$804 billion$3.9 trillion$518 billion$456 billion

BAILOUT & STIMULUS PROGRAMSProgram Commitment

Government as an Investor $ 4.8 trillion

Government as a Lender $ 2.3 trillion

Government as an Insurer/Guarantor $ 5.14 trillion

Stimulus Spending $1.2 trillion

As of May 8, 2009(changes daily)

GOVERNMENT AS AN INVESTORCOMMITMENT = $4. 8 TRILLION

Program Commitment

Commercial paperThe Fed is the buyer of last resort in the commercial paper market.

$1.6 trillion

Public-private investment fundFund seeks private investors and uses a combination of private and public money to guarantee and buy nonperforming assets.

$900 billion

Troubled Asset Relief Program (TARP) Treasury buys stock in banks, General Motors, Chrysler and AIG.

$700 billion

Federal Home Loan Bank SecuritiesGovernment buys mortgage-backed securities from Fannie Mae, Freddie Mac and Ginnie Mae.

$1.5 trillion

A.I.G. Fed provided seed money to create investment vehicles to buy, hold and possibly dispose of bad AIG securities.

$53 billion

Bear Stearns Fed bought distressed assets/securities from Bear Stearns to facilitate its sale to JPMorgan Chase

$29 billion

Reserve US Government FundGovernment buys assets to bailout troubled money market fund

$4 billion

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HOW THE TARP WAS SPENT?ONLY ABOUT $467 MILLION REPAIDWho Received TARP Funds? How Much?

Banks $310.4 billion (44%)

Other Financial CompaniesAIGAmerican ExpressDiscover CardCapital OneGMACChrysler FinancialCIT GroupOther

(9%)$69.8 billion$ 3.4 billion$ 1.2 billion$ 3.6 billion$ 5 billion (+ $7.5 billion)$ 1.5 billion$ 2.3 billion$238 million

Automakers $24.8 billion (4%)

TALF Funding to provide loans using toxic assets as collateral

$100 billion (14%)

Homeowner Mortgage Re-negotiation Program

$50 billion (7%)

Public-Private Investment Fund to buy toxic assets

$100 billion (14%)

Uncommitted $52.6 billion (8%)

GOVERNMENT AS A LENDERCOMMITMENT = $2.3 TRILLION

Program Commitment

Term Asset-Backed Securities Loan Facility (TALF)Provides loans and accepts securities backed by consumer and small business loans as collateral.

$900 billion

Term Auction FacilityThe Federal Reserve makes low-interest, short term loans to financial institutions, allowing them to pledge asset-backed securities as collateral.

$900 billion

Discount Window LoansExtended time (90 days v. overnight), amount and eligibility (investment banks v. commercial banks) for Federal Reserve discount window loans.

$236 billion +

Debt Swaps (Term Securities Lending Facility)The Federal Reserve loans/swaps US Treasury notes in exchange for less liquid debt, mortgage-backed securities and investment-grade corporate debt.

$200 billion

AIG LoansA line of credit offered by the Federal Reserve. $60 billion

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GOVERNMENT AS INSURER/GUARANTORCOMMITMENT = $5.14 TRILLION

Program Commitment

Bank Debt (Temporary Liquidity Guarantee Program)FDIC insures senior subordinated debt issued by banks and poorly performing assets owned by Fannie Mae and Freddie Mac.

$700 billion

Temporary Liquidity Guarantee ProgramFDIC insures non-interest bearing bank accounts. $684 billion

Citigroup GuaranteesGovernment guarantees that exclude the direct investments made through the TARP program

$249 billion

Fannie Mae/Freddie Mac GuaranteesTreasury pledged up to $200 billion each to cover their losses.

$400 billion

Bank of America GuaranteesGovernment guarantees that exclude direct investment through the TARP program

$98 billion

Money market fund guarantees $3 trillion

Morgan Stanley GuaranteesTreasury guarantees for a capital infusion by a Japanese bank

$9 billion

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RAW GOVERNMENT SPENDING (PORK)COMMITMENT = $1.2 TRILLION

Program Commitment

Stimulus Bill (HR-1)All the pork you can eat.

$787 billion

Omnibus Budget Act 2009 (HR 1105)The remaining nine appropriations bills that the Congress failed to pass during the 2008 term

$410 billion

The

govern

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spends

money.

Keynesian Economic Prescription Government deficit spending will stimulate economic growth

Gross Domestic Product = Consumer Spending + Government Spending - Taxes+ Business Investment+ Exports – Imports

THE STIMULUS “BUBBLES”HR-1 – AMERICAN RECOVERY & REINVESTMENT ACT

1990

1991

1992

1993

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1996

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2008

-$3.0

-$2.0

-$1.0

$0.0

$1.0

$2.0

$3.0

$4.0

$5.0

$6.0

-2%

0%

2%

4%

6%

8%

10%

Net

Go

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ent

Sp

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GD

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RECENT US EXPERIENCE 1990-2008NET GOVERNMENT SPENDING (SPENDING MINUS TAXES) VS. GDP GROWTH

DATA SOURCE: US BUREAU OF ECONOMIC ANALYSIS TIMESERIES: 1990(1Q) – 2008(4Q) IN CONSTANT 2000 DOLLARS (TRILLIONS OF $)

Government Surplus

Government Deficits

Government Deficits

DOES GOVERNMENT SPENDING STIMULATE ECONOMIC GROWTH?

Boom years when government ran a surplus and when spending dropped

“We’re all Keynesians, now.” Richard Nixon

-100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

HISTORICAL CORRELATION BETWEEN GDP GROWTH AND NET GOVERNMENT SPENDING (SPENDING MINUS TAXES)

DATA SOURCE: US BUREAU OF ECONOMIC ANALYSIS TIMESERIES: 1970(1Q) – 2008(4Q) IN CONSTANT 2000 DOLLARSVertical Axis: % Change in GDPHorizontal Axis: % Change in Net Government Spending w/6 month lag

Increase in net government spending

Decrease in net government spending

Correlation between GDP Growth and Net Government

Spending = 0.051 means perfect correlation

0 means no correlation

Decrease in GDP Growth

Increase in GDP Growth

If deficit spending was correlated with economic growth, points should be

clustered around a line like this.

DOES GOVERNMENT SPENDING STIMULATE ECONOMIC GROWTH?“We’re all Keynesians, now.” Richard Nixon

Looking into the Crystal Ball

Can we spend our way out of the crisis?◦ Didn’t work in Japan◦ No correlation (0.05) between

spending & economic growth◦ Sharp stimulus cutbacks will

hit state/local governments hard

How will we pay for the spending & debt?◦ Increase taxes◦ Devalue the currency

(inflation)◦ Collapse of foreign-

government lending to US

Zombies◦ Firms kept alive for

political reasons but that consume resources and slow the recovery GM, AIG, Citigroup, Chrysler

New Regulations◦ Expansion of bankruptcy

and government to intervene in private agreements

◦ End of high-flying investment banks & loan securitization

Top 10 Business Strategies

1. Be Realistic/Pessimistic This won’t turn around quickly.

2. Exogenous Shocks to Equities Finance for expansion by IPO or

new share issues is unrealistic.3. Right Size, Right Now

Don’t staff at levels in hopes that things will turn around soon.

Outsource as much as possible4. Investigate Your Lender

Assess likelihood of lender’s failure.

Draw down lines of credit (especially for critical projects)

5. Understand Landlord/Tenant Issues What happens if your landlord

owner becomes insolvent Tenants have strong economic

incentives to terminate leases

6. Shed Real Estate Investments Commercial real estate fell 83%

in Japan7. Keep your customers happy

It is easier to keep old customers than to attract new customers

8. Market Smart Cut everything before marketing Focus on how your product

meets the new economic reality (e.g., saves customers’ money)

9. Keep remaining employees happy Employee problems can spook

customers. 10. Review your vendors

Back-ups for critical vendors Contract review for insolvency,

force majeure and dispute resolution