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The 2008 Credit Crisis Causes and Consequences


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Title: The 2008 Credit Crisis Causes and Consequences

The 2008 Credit Crisis Causes and Consequences
  • Tom Root, PhD

  • Sustainable Economic Outcomes
  • How did we get here? The roots of the crisis
  • The impact on the Iowa economy
  • Looking ahead - Sustainability

Sustainable Economic Outcomes
  • Meeting the needs of the present generation
    without compromising the ability of future
    generations to meet their needs.
  • Public Policy Goals
  • Affordable housing, access to credit / working
    capital, health care, etc.

Possible Impact of Increased Home Ownership
  • Empirically Strong
  • Increased Political Involvement (Voting),
    Increased Wealth Accumulation, Increased
    Childhood outcomes, Decreased Mobility
  • Empirically Moderate
  • Increased Satisfaction, Increased Labor Force
  • Weak Empirically
  • Increased Household Saving, Decreased Crime,
    Increased Property Improvements, Improved
    Property Improvement

Credit Crisis Whose to Blame?
Key Regulatory Changes 2000 and Before
  • 1999 Graham Leach Bliley Financial Modernization
  • 2000 Commodity Futures Modernization Act

2000 - 2003
  • Fannie Mae announces it will buy 2 Trillion of
    loans from low income, minority and risky
    borrowers by 2010.
  • Subprime Loans 3 of mortgage markets
  • Target for the Federal Funds Rate
  • 6.5 May 16, 2000
  • 1.75 Dec 11, 2001
  • 1 June 25, 2003

Missed Opportunities
  • 2000 Reform bill increasing oversight of Fannie
    and Freddie fails (Richard Baker sponsor)
  • July 2003 Accounting scandals at Fannie Mae
    make headlines not resolved until 2004

Missed Opportunities
  • W. Poole, Pres. Fed Reserve Bank of St Louis
  • If the market value of GSE debt were to fall
    sharply, because of ambiguity about the financial
    soundness of GSEs and about the willingness of
    the federal government to backstop the debt, what
    would happen? I do not know, and neither does
    anyone else.
  • July 2003 Accounting Scandals at GSEs
  • Dec 2003 Fed Reserve releases study showing GSEs
    have not lowered lending rates.
  • February 2004 Alan Greenspan calls for reform
    removal of the implicit government guarantee

2004 Market Developments
  • SEC lowers capital requirement rules for largest
    financial firms.
  • Deterioration of underwriting standards starts.
  • August Moodys and SP change rating standards
    for MBS, incorrectly rate many MBS AAA
  • 2004 HUD increases Fannie and Freddie mandate
    from 50 affordable housing to 56
  • Target for Fed Funds starts to increase
  • June 30, 2004 1.25, December 13, 2004 2.25

Fannie Maes Guarantee of Alt A Loans
Blaming Fannie and Freddie?
  • NO --Fannie and Freddie were small relative to
    the entire market.
  • Combined Subprime Purchases ( of Market)
  • 2004 175B (44)
  • 2005 169B (33)
  • 2006 90B (20)
  • Consumer demand for housing created rapid
    increase in home prices.

Blaming Fannie and Freddie ?
  • YES -- The size of their overall position, prime
    and subprime, put them at risk of any mortgage
    market problems. Securitizing some risky loans
    sent a signal to the market.

Impact of Subprime Loans on Home Ownership
The Perfect Storm 2004 - 2007
  • Domestic and global institutions buy MBS in
    attempt to increase margins on safe securities,
    incorrectly rated.
  • Institutions use higher debt levels for
  • Underwriting standards deteriorate.
  • Increased interest rate environment makes loans
    more likely to default
  • Increasing Home Prices encourage consumers to
    overextend and speculate in housing market

Average Size of Subprime Loan
Credit Quality of Subprime Loans Originated each
Structure of Subprime Loans Originated each year
Home Sales and Home Prices
Non Agency Mortgage Foreclosure Rates
March 2007
  • A stunning 85 of borrowers are 90 days past due
    on 2-28 hybrid loans within 6 months of
  • It is predicted that for every 1 decline in home
    value an additional 70,000 homes will be lost to
    foreclosure, 32 of teaser loans will be lost to

Impact of Interest Rate Levels
  • Rate resets and increasing rates played a
    contributing factor, but less than expected.
  • State Foreclosure Working Group Feb 2008
  • Payment resets on hybrid ARMs have not yet been
    a driving force in foreclosures. A significant
    percentage of subprime adjustable rate loans are
    delinquent before they experience payment shock
    from their first adjustment, reflecting weak
    underwriting or fraud in the origination of the
    loan. With so many homeowners struggling to stay
    afloat prior to rate resets, we need to act
    quickly to address these hybrid ARM loans before
    the payment shock due to the rate reset triggers
    further foreclosures.

The Delinquent Homeowner
  • Why do Defaults occur
  • Job Loss 47
  • Medical 28
  • Income Reduction 20
  • Unfair Loan Terms 20
  • Injury 19
  • Death in Family 18

Cost Burden of Disposable Income Spent on
2007 Market News
  • Consumer Confidence starts to decline in July
    2007 (Conference Board)
  • Late 2007 over 20 of all adjustable rate
    subprime loans and 8 of fixed rate subprime
    loans are delinquent
  • Dec 12 Fed Reserve announces Term Auction
    Facility allowing depository institutions to bid
    for short term (28 to 84 day) loans

2007 Congressional Response to Mortgage Problems
  • Homeownership Preservation and Protection Act
  • Introduced Dec 12, 2007 not passed
  • Expand HOEPA to cover more loans
  • New designation of mortgage classes
  • Requires good faith and fair dealing in
  • Requires good faith and fair dealing in home loan
  • Foreclosure prevention counseling
  • Requires analysis of ability to repay on
    nontraditional subprime loans

August / September 2008 Financial Markets
  • Global concerns increase, European banks have
    liquidity concerns
  • Measures of confidence decrease and credit
    spreads increase
  • Banks keep cash in fear of runs on liquidity and
    make fewer loans
  • Cost of short term borrowing increases for

2008 Financial Institution Failures
  • January Bank of America buys Countrywide
  • March - Bear Stearns is bought by JP Morgan in
    deal brokered by Fed, approved 5/29/08
  • 7/12/08 IndyMac Bank Fails
  • 9/8/08 Fannie and Freddie are taken over by
  • 9/14/2008 Lehman Bros is allowed to fail
    Merrill Lynch is bought by Bank of America
  • 9/17/08 AIG is bailed out by government
  • 9/21/08 Goldman Sachs and Morgan Stanley become
    commercial banks as opposed to investment banks
  • 10/3/08 Wachovia is bought by Wells Fargo after
    backing out of deal with Citigroup

Lehman Brothers
  • Largest Issuer of Commercial Paper
  • Large player in Fixed Income
  • Active in Credit Default Swaps

  • Failure of Financial Institutions
  • Uncertainty about value of assets
  • Fear of Liquidity (Runs on banks)
  • Loss of Lehman Commercial paper and CDS
  • Consumer Confidence shaken
  • Retirement account uncertainty
  • Sale of assets
  • Decreasing share price
  • Decrease asset values

Supplemental Federal Reserve Actions
  • December 12, 2007 Term Auction Facility (TAF)
  • December 12, 2007 New FX swap lines with the ECB
    and SNB announced.
  • March 11, 2008. Term Securities Lending Facility
  • March 16, 2008. Primary Credit Dealer Facility
  • September 14, 2008. TSLF expanded to 200 billion
  • September 24, 2008. FX swap lines to 277B
  • September 29, 2008 Federal Reserve coordinate
    with other central banks to expand significantly
    the capacity to provide U.S. dollar liquidity

October 3, 2008 Troubled Asset Rescue Plan
  • 700 Billion for Government to purchase troubled
    securities from financial institutions
  • Participating institutions required to provide
    equity stake
  • Limits on executive compensation for
    participating institutions

October 6, 2008
  • Global Markets see large decreases prior to
    opening of US markets
  • European markets react fear of Europe bank
    failures and lack of coordination among
    governments to help
  • Asian markets slide on fears of decreased demand
    from the rest of the world
  • Fed Reserve announces it will pay interest on
    reserves and increase limit on short term (28 to
    84 days) borrowing
  • Dow down 500 points (5) in first hour of trading

Buying Equity vs. Buying Securities
  • US Treasury announces plan to purchase 250
    Billion in bank equity
  • Increases solvency of banks
  • Allows market to price assets
  • Preferred Stock 5 dividend for 5 years, 9 after
    5 years
  • Warrants on bank stock
  • Limits on executive compensation

Current Spending TARP
  • The First 350 Billion
  • 250 Billion - Helping the banks
  • 40 Billion AIG
  • 60 Billion Available
  • The Second 350 Billion waiting approval

Supplemental Federal Reserve Actions - Oct
  • October 6, 2008 Board announces that it will
    begin to pay interest on depository institutions'
    required and excess reserve balances
  • October 7, 2008 Board announces creation of the
    Commercial Paper Funding Facility (CPFF) to help
    provide liquidity to term funding markets
  • October 21, 2008 Federal Reserve announces the
    creation of the Money Market Investor Funding
    Facility (MMIFF)
  • Nov 10, 2008 American Express becomes bank
    holding company

Fed Reserve Assets
Fed Balance Sheet Aug 2008 Nov 2008
Current State of the Economy
  • Improving Credit Markets
  • Increase in Commercial Paper
  • Decline in 2nd Qtr GDP / 6.5 unemployment
  • Industrial Production increased 1.3 in Oct (down
    4.1 YoY Decline in Sept and Oct removing
    hurricanes and strikes)
  • Consumer Confidence Lagging
  • Large drop in Sept. lowest level since 1970s
  • Large declines in retail sales

US 3 Month LBOR
U of Michigan Consumer Sentiment
Industrial Production YOY Change
Initial Jobless Claims
Continuing Jobless Claims
VIX Index
MBA Weekly change
MBA Mortgage Applications (Volume)
Housing Starts
Iowas Economy
  • Slight decline in Iowa Unemployment in Sept to
    4.2 vs. National Average of 6.1
  • Loss of 2,600 manufacturing jobs in the last year

Iowas Housing Market
  • Just 1.3 of Iowa households are subprime
  • MN, IL, IN, MI, MO all over 2.0
  • FL, NV, CA, AZ nearly 4
  • 95 of Iowa Subprime loans are owner occupied
  • Highest percent in U.S.
  • Outstanding balance 92K
  • second lowest (US average is 180K)

Housing Bubble IA less than 20
Iowas Housing Market The Bad News
  • Over 50 of the 17,000 subprime loans have
    experienced late payment during last year
  • Higher LTV ratio of 88.39 vs. US 84.77
  • 12 of Iowa subprime mortgages are in foreclosure
    (but only 0.1 of 1 of all housing is in
    foreclosure) vs. national average of 10.7
  • FL is tops with 20 of Subprime 0.7 of all
    housing units in foreclosure

Iowa -Projected Foreclosures and Home Values
Long-Term Sustainability of US Economy
  • Moral Hazard in Financial Markets and Business
  • Balance Sheet of Federal Reserve
  • Support for Housing
  • Impact on Government Spending

Future Policy Moves
  • Federal Funds Rate Cuts
  • More Bank Security
  • Purchasing of MBS and Troubled Assets
  • Fiscal Stimulus Package
  • Helping Homeowners
  • Aid for Auto makers