Change in Payroll Employment

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Change in Payroll Employment
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Unemployment Rate
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GDP Growth ( Billions)
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Paul KrugmanIn recent years
the finance sector accounted for 8 percent of
Americas G.D.P., up from less than 5 percent a
generation earlier. If that extra 3 percent was
money for nothing and it probably was were
talking about 400 billion a year in waste, fraud
and abuse.New York Times 19 Dec. 2008
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GDP Growth with Krugman Adjustment
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Growth in Real Median Household Income Across
Decades
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Real Median Household Income, 2000-07
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Key Points

• In a typical business cycle, the economy drops
  into a recession after a period of rapid growth
  and prosperity.
  
• Over the last decade, the U.S. economy has seen
  minimal growth in real GDP (aside from the
  financial sector), real income for middle class
  families and in jobs.
• The U.S. economy entered the current recession in
  relatively poor condition. This is likely to
  increase the severity of the recession and
  lengthen the duration.

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Consumption Growth ( Billions)
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(No Transcript)
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Key Points

• With the savings rate near zero, housing prices
  are likely to continue to decrease or remain
  stagnant and with the unemployment rate
  increasing, consumption will remain at a constant
  level or decline.
• A lack of consumer demand and tight credit will
  limit new business investment.
  
• A global economic contraction will do the same to
  U.S. exports.
  
• This leaves the federal government as the source
  of economic recovery in 2009.
  

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Pass Through Mortgages
Fannie Mae Freddie Mac Investment Banks


Home Buyer
Mortgage Payment
Bank
Mortgage Payment
Value of Loan
Loan
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Mortgage Backed Securities
Mortgage Payment
Fannie Mae Freddie Mac Investment Banks Pool
Mortgages
To create MBS
Savers Banks Foreign Wall Street
Sell as a Bond
Tranches AAA AA A BBB
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Key Points

• When banks make home loans, the risk of default
  has been passed on to the MBS owner. Banks make
  profits by originating loans.
  
• It is hard for the financial bailout to
  restructure home loans since the downstream MBS
  holder has a legal right to the mortgage payment.

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Collateralized Debt Obligation (C.D.O.)
Corporate Bonds
Pooled by Investment Banks to create CDOs
Wall Street Mutual Funds Hedge Funds Pens
ion Funds
Insurance Companies
Cash Flow
Cash Flow
Sold as Bond
Commercial Real Estate Loans
Cash Flow
Tranches AAA AA A BBB
Mortgage Backed Securities
Cash Flow
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Credit Default Swaps (CDS)

• An unregulated market where insurance is sold
  (CDS) against the income flows of CDOs and other
  fixed income assets such as corporate debt.
  
• Swap seller is not required to have cash reserves
  in case of CDO or bond default.
  
• Buyer of CDS makes a series of payments to the
  seller and should receive payment if CDO or bond
  income flow is interrupted.
  
• CDS trader does not have to own CDO or bond.

CDO Bond
Owner Of CDS
CDS Seller
Insurance Payment
Cash Flow
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Turning Hamburger into Steak

• Wall Street investment banks were able to pool
  subprime mortgages and BBB-rated MBS in a special
  purpose entity or trust, carved the trust into
  tranches of CDOs and up to 60 percent of the new
  CDOs were rated investment grade (generally AAA)
  by rating agencies such as Standard and Poors,
  Moodys, and Fitchs.
• New investment grade CDOs could be purchased by
  pension funds, insurance companies, mutual funds
  and other financial institutions that can only
  purchase highly rated securities.

Pooled by Investment Banks
CDO AAA AA A BBB
Pension Fund Mutual Fund
Subprime Mortgage
AAA
BBB Rated MBS
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Creative Finance

• When an investment bank created a CDO, it would
  often sell related credit default swaps.
  
• By selling a credit default swap, the sale
  enabled the investment bank to create another CDO
  bond identical in every respect but one to the
  original. While the original CDO derivative was
  backed by a flow of payments originating from a
  MBS, corporate bond or other asset, the only
  assets backing the new CDO were the payments made
  by the CDS buyer to the seller. The insurance
  payments for the CDS were the cash flow source
  for the new CDO.
• Allowed for the perpetual creation of new CDOs
  and related CDS without any need for an upsteam
  source of cash flow such as a mortgage, bond, or
  business loan.
• Total value of outstanding credit default swaps
  is estimated to be over 50 trillion - a
  significant multiple of the value of corporate
  debt and mortgages.

Investment Bank sells CDS
CDS Buyer
CDS payment used to create new CDO, using CDS
Payment as
source of cash flow
Payment For CDS
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Standard and Poors estimates that for U.S.
corporate debt, the three-year U.S. cumulative
default rate between 2008 and 2010 among
speculative-grade nonfinancials could reach
23.2.Deutsche Bank has a similar estimate for
Western European corporate debt.This could
result in substantial CDO payment
defaults.There has been a multiple of credit
default swaps written for the typical CDO with no
reserve requirements.Significant sellers of
these credit default swaps such as hedge funds,
banks and insurance companies may quickly go
bankrupt or require a government bailout to
remain solvent.
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By December the Federal Reserve and Treasury
have commited 8.5 trillion to the financial
bailout
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Key Points

• Krugman is right financial innovations created
  money from nothing.
  
• There is a high potential for continued financial
  shocks in 2009.
  
• We may be in the first phase of a recession
  inflationary recovery recession cycle.
  
• It may take four to seven years before the
  economy resumes a period of normal growth
  steady real GDP growth with low inflation.