Subprime Crisis In USSubprime Crisis In US

Brief Banking HistoryBrief Banking History

Mesopotamia, >3000 years ago, storehouses Mesopotamia, >3000 years ago, storehouses for reserves of grain and animals, charged for reserves of grain and animals, charged interest much like todayinterest much like today

Italy, Medici of Florence: first modern loan Italy, Medici of Florence: first modern loan and deposit system to handle multiple and deposit system to handle multiple currency, later improved by Dutch and currency, later improved by Dutch and British, imported to American coloniesBritish, imported to American colonies

Growing pains through a period of minimal Growing pains through a period of minimal regulation, legislation during Civil War: entire regulation, legislation during Civil War: entire US banking system under federal regulation US banking system under federal regulation

Brief Banking History (2)Brief Banking History (2)

Credit crisis late in the 19Credit crisis late in the 19thth century and in century and in 19071907

The Great stock market crash of 1929: caused The Great stock market crash of 1929: caused by too many high-risk loans under the by too many high-risk loans under the assumptions that stock market would assumptions that stock market would continue to rise unabatedcontinue to rise unabated

Bubble prop in October 1929, run in risky on Bubble prop in October 1929, run in risky on the nation’s banks. However, banks engaged the nation’s banks. However, banks engaged in risky investments themselves with in risky investments themselves with depositors’ cash, only to lose it all depositors’ cash, only to lose it all

Brief Banking History (3)Brief Banking History (3)

1933: banks basic function ceased: 1933: banks basic function ceased: Franklin Roosevelt put a few measuresFranklin Roosevelt put a few measures

Glass-Stegall Act: forbid commercial Glass-Stegall Act: forbid commercial banks (BofA, pre-Merrill) from offering banks (BofA, pre-Merrill) from offering services of investment of insurance services of investment of insurance banks (AIG)banks (AIG)

FDIC: promised to reimburse customers FDIC: promised to reimburse customers should a bank go out of businessshould a bank go out of business

Brief Banking History (4)Brief Banking History (4)

1913, Federal Reserve created: “lender of 1913, Federal Reserve created: “lender of last resort”, the central bank of USlast resort”, the central bank of US

Roosevelt polices slowly brought Roosevelt polices slowly brought confidence in the banking system back up confidence in the banking system back up and helped end the Great Depressionand helped end the Great Depression

1999, Glass-Stegall Act repealed; 1999, Glass-Stegall Act repealed; commercial banks to re-enter stock bizcommercial banks to re-enter stock biz

IB used to be big players for Gov’t and IB used to be big players for Gov’t and corporations could own commercial bankscorporations could own commercial banks

Brief Banking History (5)Brief Banking History (5)

With a surging market, IBs made all kinds With a surging market, IBs made all kinds of moneyof money

Until a few years ago, housing propelling Until a few years ago, housing propelling growth was unstoppablegrowth was unstoppable

Merrill Lynch and Lehman offered Merrill Lynch and Lehman offered mortgages left and right, many to people mortgages left and right, many to people with poor credit records, gambling that with poor credit records, gambling that housing prices would continue to risehousing prices would continue to rise

Micro Economic OverviewMicro Economic Overview

Homebuyers

Mortgage lend moneyw/ propertyt collateral

Mortgage LendersRating Agencies MBS

Securitization

Bond Insurers Fannie Mae/ Freddie MacCredit Providers CDO

SecuritizationFDIC

Investment BankCDO

Speculation Investors

Hedge Funds

S&L CrisisS&L Crisis

Not a new phenomenonNot a new phenomenon Historical S&L crisis dates back to the Historical S&L crisis dates back to the

Great Depression, Disintermedaition in the Great Depression, Disintermedaition in the late 70’s, S&L crisis in 1989late 70’s, S&L crisis in 1989

1989: 747 S&L bankruptcies with $160 1989: 747 S&L bankruptcies with $160 billion of bailout, caused recession in billion of bailout, caused recession in 1991-921991-92

2008: In addition to $85 billion of bailout 2008: In addition to $85 billion of bailout for AIG, $700 billion more for Wall Street for AIG, $700 billion more for Wall Street

How large is $700 billion?How large is $700 billion?

NASA fiscal year 2009: $17.6 billionNASA fiscal year 2009: $17.6 billion NSF annual budget: $6.1 billionNSF annual budget: $6.1 billion Military budget 2009: $481 billionMilitary budget 2009: $481 billion Social Security: $608 billionSocial Security: $608 billion $2,300 for each American$2,300 for each American US national debt: $9 trillionUS national debt: $9 trillion Can take 25,000 Rodriguez (NY Yankees)Can take 25,000 Rodriguez (NY Yankees) The Forbes 400 richest people total $1.57 The Forbes 400 richest people total $1.57

trillion trillion

How big is subprime?How big is subprime?

2% of total loans in 2002 to 20% of 2% of total loans in 2002 to 20% of total loans in 2006total loans in 2006

US economy: $ 60 trillionUS economy: $ 60 trillion Mortgage Market: $12 trillionMortgage Market: $12 trillion Subprime: $2.4 trillionSubprime: $2.4 trillion Massive write-offs by the commercial Massive write-offs by the commercial

banking and investment banking banking and investment banking ($500 B)($500 B)

Even Bigger DerivativeEven Bigger DerivativeCDS Outstanding

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70

1999 2001 2003 2005 2007 2009

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Ratio of CDS to Underlying Bonds

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1999 2001 2003 2005 2007 2009

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%

Subprime MortgageSubprime Mortgage

Loans to less than perfect creditLoans to less than perfect credit Any late payments, bankruptcies, liens, Any late payments, bankruptcies, liens,

judgments, or other defaults blemish the judgments, or other defaults blemish the credit historycredit history

Borrower with blemished credit history or Borrower with blemished credit history or no credit history does not qualify for the no credit history does not qualify for the Prime Mortgage Loans: falls to subprime Prime Mortgage Loans: falls to subprime mortgage with high interest paymentsmortgage with high interest payments

Chronological DevelopmentChronological Development

Countrywide (acquired by Bank of America) Countrywide (acquired by Bank of America) Bear Sterns (acquired by JP Morgan Chase)Bear Sterns (acquired by JP Morgan Chase) Lehman Brothers (CDO/CDS exposure $600B)Lehman Brothers (CDO/CDS exposure $600B) Merrill Lynch (acquired by Bank of America)Merrill Lynch (acquired by Bank of America) AIG ($500B CDS exposure, $250B Liable)AIG ($500B CDS exposure, $250B Liable) Washington Mutual (acquired by JP Morgan Washington Mutual (acquired by JP Morgan

Chase)Chase) Wachovia (acquired by Citigroup)Wachovia (acquired by Citigroup) Morgan Stanley, Goldman Sachs (subprime, CDS Morgan Stanley, Goldman Sachs (subprime, CDS

exposure related to hedge funds): covert to exposure related to hedge funds): covert to chartered bank holding companies (part of $700 chartered bank holding companies (part of $700 billion of US Gov’t bailout)billion of US Gov’t bailout)

Chain of ReactionChain of Reaction

Burst of US housing bubble and high Burst of US housing bubble and high default rates on “subprime” and “ARM”default rates on “subprime” and “ARM”

Increase in defaults and foreclosureIncrease in defaults and foreclosure Mortgage lenders and credit risk sellers Mortgage lenders and credit risk sellers

were hit hardwere hit hard Tighter lending, and increased spreads on Tighter lending, and increased spreads on

interest ratesinterest rates Contracted liquidity in the global credit Contracted liquidity in the global credit

markets and banking systemmarkets and banking system

Who to blame?Who to blame?

Reagan Doctrine: Financial Deregulation ‘82Reagan Doctrine: Financial Deregulation ‘82 Democrats-led congress passed the law to Democrats-led congress passed the law to

provide more affordable mortgages to low provide more affordable mortgages to low income people (1992)income people (1992)

People who shouldn’t have been borrowingPeople who shouldn’t have been borrowing These loans were packaged into CDOs These loans were packaged into CDOs

rated AAA (IBs and rating agencies)rated AAA (IBs and rating agencies) Investment Bank purchase w/o due Investment Bank purchase w/o due

diligencediligence Distributed throughout the worldDistributed throughout the world

GreedGreed

Alpha generation: beat the market, Alpha generation: beat the market, theme of portfolio managers/ hedge theme of portfolio managers/ hedge fund managersfund managers

Earn higher mortgage or credit card Earn higher mortgage or credit card ratesrates

Bet on credit: three hedge funds Bet on credit: three hedge funds speculation funded by investment banksspeculation funded by investment banks

High leverage betHigh leverage bet

IssuesIssues

Moral hazardMoral hazard Conflicts of InterestConflicts of Interest Regulation or deregulationRegulation or deregulation Quants: Fall of geniusesQuants: Fall of geniuses Financial engineering without Financial engineering without

comprehensive understanding of risk comprehensive understanding of risk managementmanagement