Understanding the Sources and Way Out of the Ongoing Financial Upheaval

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Understanding the Sources and Way Out of
theOngoing Financial Upheaval
PASEF
Susan M. Wachter Richard B. Worley Professor of
Financial Management The Wharton
School University of Pennsylvania Bank for
International Settlements Hong Kong Institute
for Monetary Research
University of Pennsylvania April 23, 2009
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Global Downturn

• The economy is in the worst downturn since the
  Great Depression.
• Capital market crisismore than a recession
  credit flow ended, globally and global economy
  is withering.
• A self-reinforcing adverse cycle
• The financial system crisis is upending the
  economy, putting further pressure on the
  financial system
• US public policy response without precedent.
• Fiscal stimulus package
• Federal Reserve has vastly expanded its role
• What more is needed for private credit flows to
  resume, confidence in the financial system itself
  must be restored
• This requires understanding what went wrong and
  rebuilding the architecture of the financial
  system

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The Economic Backdrop

• Economy in Great Recession
• Unemployment at 8.5
• 4th quarter decline in GDP at 6.2, global
  decline 1.5
• Volatility in global stock markets
• US and global stock prices are more than 40 down
• Angst in the banking system and credit markets
  remain badly shaken
• Banks still not lending

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The Economic Backdrop-Capital Markets
Source Moodys Economy.com
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The Damage Is Not Over

• Real GDP began to fall in Q4 of 2007- fall
  continuing.
• 2.6 million jobs have already been lost and the
  unemployment rate is still rising.
• Consumer confidence has crashed to its lowest
  reading ever

Source Mark Zandi, Moodys Economy.com
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Response to the Crisis

• Fiscal Stimulus
• Unprecedented stimulus (1 trillion)
• Monetary Stimulus
• Federal Funds Rate near zero
• Quantitative easing
• Banking Bailout
• TARP
• Missing New Financial Architecture
• Need to understand what went wrong

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Impact of Stimulus Measures
Source Mark Zandi, Moodys Economy.com
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Monetary Stimulus
Source Mark Zandi, Moodys Economy.com
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The state and local impacts
Source Mark Zandi, Moodys Economy.com
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The Collapse-from housing to financial markets
still missing, the new financial architecture
March, 2007
January, 2008
September, 2008
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Global Financial Crisis Made in the USA

• Triggered by actual and prospective losses on US
  mortgages-leveraged losses far greater
• Global meltdown Bad luck or inevitable?
• Boom-bust housing price cycle Why?
• Reckless decline in mortgage lending standards
  (followed by credit crisis and no private
  lending)
• Increased housing prices beyond sustainable
  heights
• Unprecedented house price rises hid problem
  loans-teaser rates, no doc/low doc, option arms,
  NINJA loans
• Loans made that could not be repaid-betting on
  ever increasing house price to rescue loans

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A Severe National Housing Downturn
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WHY?

• Private label securitized mortgages, backed
  leveraged derivatives, synthetics
• Decades of securitizationnot the problem
• Interest rate risk securitized historically
• PLS securitized default risk, relied on
  diversificationnot Marked-to-Market, but rather
  Marked-to-Model
• Expansion of toxic debt as asset, based on
  collateral, and ever increasing house prices

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Chronic imbalances
Gross debt by U.S. sector Percentage of GDP
Sectoral contribution to U.S. gross
debt Percentage of GDP
Financial Companies
Households
Financial Companies
Nonfinancial Companies
Household
Government
Nonfinancial Companies
Government
Source U.S. Federal Reserve, Bureau of Economic
Analysis
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Increased use of non-traditional products
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Mortgage originations by product
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Deterioration of lending standards, 2002 to 2006
Leverage w/out Docs
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Nonprime mortgage lending replaced the American
Mortgage where and why?
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A Housing Bubble Starting in 2003, Especially in
the Sand States
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Percent of All LoansAdjustable Rate
1999
2006
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Percent of All LoansLow Documentation- by 2006,
25 of loans
1999
2006
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Percent of Adjustable Rate LoansTeaser (2006)
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Number of Subprime Loans
Source www.newyorkfed.org/mortgagemaps
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Increase in House Price Index
Source www.newyorkfed.org/mortgagemaps
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Projected Peak-to-Trough House Price Decline,
Sources Fiserv Lending Solutions, Moody's
Economy.com, OFHEO
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How did we get here?
Investors
Borrowers

• Borrowed at teaser rates-not able/expected(?) to
  pay at reset

• Lack of short sales, CDS

Where does the buck stop?
Originators / Brokers
Rating Agencies

• Originate to distribute

• Agency incentives misaligned- current
  conditions out

Secondary Market

• Securities marked to models not to
  market/assignee liability exemption

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Deregulation and Regulatory Arbitrage
Competitive Regulation

• Charter competition fueled a race to the bottom
  in underwriting standards
• Migration to federal bank and thrift charters
• At the federal level, regulation and examinations
  of nonbank mortgage lending subsidiaries were lax

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Deregulation

• The proposed Federal Reserve Board Regulatory
  Oversight of mortgages not implemented until
  2008, HOEPA (Home Ownership and Equity Protection
  Act, 1994) irrelevant,
• 2004 act SEC allowed investment firms to
• increase leverage to 40 to 1
• to voluntarily measure their capital, and
• decrease SEC oversight
• 2000 State reserving for CDS issued by insurance
  companies, Fed govt precludes

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Market and Regulatory Failure

• Risk taking without accountability
• Too big to fail, too small to sue
• Underpriced risk is inevitable, compensation for
  generating risk without accountability

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WHY?

• Decades of securitization, 1980-2000no problem
• Historically-interest rate risk securitized,
  default risk controlled for and not priced, only
  prime mortgages securitized
• Innovation Private label securitization of
  default risk
• Private label mortgage backed securities did not
  trade
• Priced based on Marked-to-Model paradigm Not
  Marked-to-Market,
• Market and regulatory discipline absent

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New Financial Architecture

• Replace Basel II
• Basel II regime of self-regulation
• End Competitive Regulation
• Race to the bottom
• Single Regulator
• Asset Bubbles
• What is a single regulator regulating?
• How do we regulate asset bubbles?

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Perspective

• The events of the past year or two have
  highlighted regulatory gaps and deficiencies that
  we must address to improve the structure of our
  markets and the resiliency of our economy. As we
  recover from the current crisis, it will be
  important to address these issues as soon as
  possible, to develop a regulatory structure that
  will better respond to future economic
  challenges.
• --Ben Bernanke

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• Thank You
• Susan M. Wachter
• Richard B. Worley Professor of Financial
  Management
• Professor of Real Estate and Finance
• The Wharton School
• University of Pennsylvania
• wachter_at_wharton.upenn.edu