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The Big Picture
Problems in Mortgage Market
Global Credit Crisis / Bank failures / Equity Losses
Declining Consumer Spending Decreased Business Investment
Contributing Factors
Consumer Debt and “Keeping up with the Joneses”
International Capital Flows
Congressional Unintended Consequences
The Housing Market and “The American Dream”
Regulatory Changes
The Big Picture
Problems in Mortgage Market
Global Credit Crisis / Bank failures / Equity Losses
Declining Consumer Spending Decreased Business Investment
Mortgage Market Developments
New Participants
Increased Credit Access and New Loan Types
SubprimeAlt A“Teaser Rates”Option ARMs
Securitization
Securitization
Loan Bank B
Financial IntermediaryBuys Loans, Forms a “Pool”
and Issues MBS
Loan Bank A Loan Bank Z
Insurance Firm, Banks, Pension Funds etc.Buy MBS – Cash Flows “Guaranteed” by Original Mortgages
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 marketsTarget for the Federal Funds Rate
6.5% May 16, 20001.75% Dec 11, 20011% June 25, 2003
*NY Time Oct 4 2008 "Pressured to Take More Risk, Fannie Mae Hit a Tipping Point*NY Time Oct 4 2008 "Pressured to Take More Risk, Fannie Mae Hit a Tipping Point
Federal Funds Rate
Interbank lending – very short term – provides liquidity
Market determines the actual rate
Target set by Federal Reserve Board
“Base Rate”
The Basics of Banking
Borrowing Short-Term and Lending Long-Term
Deposit $1,000 Bank pays 1% or $10 to depositor
Home Equity Loan $1,000Bank charges 5% or $50 to borrower
Bank “profit” = $40
Reserves
The bank must keep a portion of deposits in reserve
WithdrawsTransactions“Lending Reserves” and Federal Funds Market
Bank Balance Sheet
AssetsUse of funds to generate income
Liabilities and EquitySource of fundsLiabilities (borrowing)Equity (ownership stake)
Bank Balance Sheet
Assets (Income)LoansCashTreasury SecuritiesMort. Back SecuritiesCorporate BondsStocks
Liabilities (costs)DepositsS-T BorrowingL-T Borrowing
Equity (ownership)
Monetary Policy
Federal Reserve Board“Lender of Last Resort”
Managing Cash available for lendingMore cash available lowers interest ratesLess cash available increases interest rates(rates impact borrowing / spending and growth)
Monetary Policy Tools
Reserve Requirements
Discount Window Lending
Open Market OperationsBuying and selling Treasury SecuritiesReplacing illiquid assets with cash and vice versa
Impact of Low Rates 2001-2004
Strong economic growth without inflationHousing boom pushed housing prices up
New loan standardsSpeculation on home prices by “average consumers”Increased availability of international fundsStrong demand for MBS
Congressional pressure to increase lending to under served markets
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.”
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***
*"Housing and the Macroeconomy" Speech at Office of Federal Housing Enterprise Oversight Symposium http://www.stls.frb.org/news/speeches/2003/3/10/03.html **Christmas for Fannie, WSJ 9/9/08 ***"Fran and
Fred Get The Business WSJ 2003 3/10/03
Missed Opportunities2003 Accounting Scandals at GSEs
2004 Market Developments
SEC lowers capital requirement rules for largest financial firms.*Deterioration of underwriting standards.**August - Moody’s and S&P 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%* NY Times Oct 3, 2008 Agency's '04 Rule Let Bank Pile Up New Debt **President's Working on Financial Markets, US Treasury Dept March 2008 ***Smith, Elliot, "Race to the Bottom at Moody's, S&P Secured Subprime's Boom and Bust" Bloomberg.com, Sept 2008
**** How HUD Mortgage Policy Fed the Crisis, Washington Post, June 10, 2008
NY Times October 4 "Pressured to Take More Risk Fannie Hit a Tipping Point"
Fannie Mae’sGuarantee of Alt A Loans
0
50
100
150
200
250
300
$ B
illions o
f Alt
A L
oans G
uara
nte
ed
2005$58
Billion Added
2006$87
BillionAdded
2007$79
BillionAdded
2004 & Before$77 Billion Total
Blaming Fannie and Freddie?
No - Fannie and Freddie were small relative to the entire market.
Combined Subprime Purchases (% of Market)**Consumer demand created rapid prince increase
Yes – Overall Size put them at risk for any mortgage market problem
Securitizing more risky loans opened door for private securitization
Gramlich, E. "Subprime Loans: America's Latest Boom an Bust" 2007 ** "how HUD Mortgage Policy Fed the Crisis", Washington Post June 10, 2008
Impact of Subprime Loans on Home Ownership
"SubPrime Lending: A Net Drain on Homeownership," Center for Responsible Lending: March 2007
“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 securitization.
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
Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans, over
50% to total subprime
Credit Quality of Subprime Loans Originated each year
Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans,
over 50% to total subprime
Structure of Subprime Loans Originated each year
Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans,
over 50% to total subprime
The Big Picture
Problems in Mortgage Market
Global Credit Crisis / Bank failures / Equity Losses
Declining Consumer Spending Decreased Business Investment
Impact on Financial Institutions
Foreclosures cause value of MBS securities to decrease raising concerns about stability of banks and financial institutions
Banks start to keep cashProtect against withdrawsUncertainty about borrowers ability to repayInterest rates start to increase
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
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 business
Bank Balance Sheet
Assets (income)LoansCashTreasury SecuritiesMort. Back SecuritiesCorporate BondsStocks
Liabilities (costs)DepositsS-T BorrowingL-T Borrowing
Equity (ownership)
2008 Financial Institution Failures
January – Bank of America buys CountrywideMarch - Bear Stearns is bought by JP Morgan in deal brokered by Fed, approved 5/29/08 7/12/08 IndyMac Bank Fails9/8/08 Fannie and Freddie are taken over by government9/14/2008 Lehman Bros is allowed to fail & Merrill Lynch is bought by Bank of America 9/17/08 AIG is bailed out by government9/21/08 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
The Big Picture
Problems in Mortgage Market
Global Credit Crisis / Bank failures / Equity Losses
Declining Consumer Spending Decreased Business Investment
Spillover
Failure of Financial InstitutionsUncertainty about value of assetsFear of Liquidity (Runs on banks)Loss of Lehman – Commercial paper and CDS
Consumer Confidence shakenRetirement account uncertainty
Sale of assetsDecreasing share priceDecrease 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 FacilityMarch 16, 2008. Primary Credit Dealer FacilitySeptember 14, 2008. TSLF expanded to $200 billionSeptember 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
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