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T HE C REDIT C RISIS C AUSES, C ONSEQUENCES & C URES University of Nevada, Reno Institute for the Study of Gambling & Commercial Gaming 14th International.

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Presentation on theme: "T HE C REDIT C RISIS C AUSES, C ONSEQUENCES & C URES University of Nevada, Reno Institute for the Study of Gambling & Commercial Gaming 14th International."— Presentation transcript:

1 T HE C REDIT C RISIS C AUSES, C ONSEQUENCES & C URES University of Nevada, Reno Institute for the Study of Gambling & Commercial Gaming 14th International Conference on Gambling & Risk Taking Stateline, Nevada May 25-29, 2009 Mark Sievers Sievers & Sievers P.O. Box 546 Cripple Creek CO (719)

2 M AY Y OU L IVE IN I NTERESTING T IMES M AY ALL OF Y OUR D REAMS C OME T RUE 4 consecutive Qs of GDP declines ◦ 2.7% in 3 d Q 08 ◦ 5.4% in 4 th Q 08 ◦ 6.4% in 1 st Q’09 ◦ 1% in 2 nd Q ‘ million jobs lost since Jan. 08 ◦ Unemployment rate = 9.7% (4.9% in Jan 2008) ◦ Unemployment projected to be 10.5% in Dec Spending for business equipment dropped 30% Industrial output dropped 20% in 1 st Q 2009 (equal to 1998 levels) Industrial capacity used dropped to 69% (lowest ever) Banks in trouble ◦ 89 bank failures in2009 ◦ 416 banks failed FDIC grading system Stock market (S&P 500) down about 40% from 2008 June ‘09 average housing prices down about 30% from Jan. ‘07 July ‘09 foreclosures 32% higher than July ’08 ◦ 800,000 homes in foreclosure – expected to peak at 1.15 million in 2010 ◦ Cure rates for defaulting mortgages: ◦ Prime loans - 6.6% from 45% (2006) ◦ Alt-A loans - 4.3% from 30% ◦ Subprime – 5.3% from 19.4% 1.4 million bankruptcies expected in 2009 – 75% higher than 2007

3 L OCAL B USINESS C ONDITIONS 20-30% BELOW 2001

4 A RE YOU C OMING OR G OING ? B UILDING P ERMITS & F ORECLOSURES

5 I NTERCONNECTED C AUSES Era of Easy/Cheap Money Era of Easy/Cheap Money ◦ Greatly expanded the supply of loans  Created a Real Estate Bubble Rise of the Shadow Banking System Rise of the Shadow Banking System ◦ Highly leveraged, risk-seeking business model ◦ Equal in size to traditional banking system Securitization of loans Securitization of loans ◦ Expanded cheap/easy money ◦ Agency problems – “loan to sale” business models ◦ Gambling with Credit Default Swaps widespread ◦ Inability to re-negotiate defaulting loans and loans on property where value falls below loan principle

6 W HAT (W HO ) C AUSED THIS M ESS ? B OOM & B UST M ONETARY P OLICY – Fed reduces interest rates to combat 9/11 and dot-com recessions – Fed reduces interest rates to combat 9/11 and dot-com recessions ◦ Wave of cheap money  Housing price bubble caused by:  Dramatically reduced mortgage rates & sub- prime mortgages increase house prices  Securitized loan instruments makes even more money available for cheap mortgages 2005 – 2006 Fed increases interest rates and bursts the housing bubble 2005 – 2006 Fed increases interest rates and bursts the housing bubble ◦ Falling House prices  upside-down loans ◦ Collapse in the securitized loan market Fed missed the rise of securitization & highly-leveraged shadow banks Fed missed the rise of securitization & highly-leveraged shadow banks “May you come to the attention of higher authorities.”

7 F EDERAL R ESERVE M ONETARY P OLICY  H OUSING P RICE B UBBLE 1% Reduction in Market Mortgage Rates Causes a 10-16% Increase in Housing Prices Robert Schiller – Irrational Exuberance 1% Reduction in Market Mortgage Rates Causes a 10-16% Increase in Housing Prices Robert Schiller – Irrational Exuberance

8 G REENSPAN ’ S B UBBLES F INE -T UNING THE E CONOMY WITH M ONETARY P OLICY Source: Paul Krugman, The Return of Depression Economics (2009) 1999 Stock Market Bubble “Irrational Exuberance” 2006 Housing Price Bubble

9 US & Japanese Real Estate Bubbles Japanese decline  65 %

10 M AJOR C ONTRIBUTOR – S ECURITIZATION Bundling & selling loans in bond-like instruments Bundling & selling loans in bond-like instruments ◦ 25% mortgages; 21% credit card loans; 13% auto loans; 15% other (student loans, business loans) Massive Boom & Bust Cycle Massive Boom & Bust Cycle ◦ 1997  $300 billion  2006  $2 trillion  2007  $121 billion Agency Problems Agency Problems ◦ Borrowers are unknown to the bundled loan purchasers – loan renegotiations are virtually impossible when borrower gets into trouble ◦ “Loan to sale” business models -- compensation based on # of loans not loan quality (rise of unregulated mortgage brokers & mortgage lenders) Serious Structural Problems Serious Structural Problems ◦ Low quality (sub-prime) loans in securitized tranches carried high returns, create incentives to make low-quality, risky loans ◦ Valuation grossly complex making after-market sales to 3d parties nearly impossible ◦ Insurance/Gambling via Credit Default Swaps

11 S ECURITIZATION IN A N UTSHELL AKA T OXIC A SSETS, L EGACY A SSETS Borrowers Households Businesses Lenders Banks Credit Cards Auto Lenders Hedge Funds Mortgage Lenders Loans/Assets Mortgages Sub-Prime Loans Alt-A Loans FHA/VA Loans Credit Cards Auto Loans Student Loans Commercial Loans Special Purpose Vehicle Securitized Instrument Collateralized Debt Obligations Collateralized Loan Obligations Asset Backed Securities Mortgage Backed Securities Arranger Buyers (Highly Leveraged) Investment Banks Pension Funds Hedge Funds Private (Foreign) Investors Rating Agency Credit Default Swaps Insurers Insurance Companies Investment Banks Hedge Funds Individuals Speculators Investment Banks Hedge Funds Investors

12 S ECURITIZED L OAN I NSTRUMENTS T HE W ATERFALL Loans/Assets Mortgages Sub-Prime Loans Alt-A Loans FHA/VA Loans Credit Cards Auto Loans Student Loans Commercial Loans Senior Tranche High quality loans Priority on cash flow Lower coupon Prices determined by changes in : Risk rating by rating agency Interest rates (P  when interest rates  ) Loan to value ratio (Market price of assets) Repayment patterns (Foreclosures) MediumTranche Medium quality loans 2d Priority on cash flow Higher coupon Junior Tranche Lowest quality loans Last priority on cash flow Highest coupon Securitized loan portfolio divided into tranches of bond-like instruments with different prices, interest rates and claims on cash flow

13 L EVERAGING & S HADOW B ANKS (M AGNIFIES R ETURNS & L OSSES ) $100 Million Security 10.5% Return Lender’s Money $95 Million Hedge Fund Money $5 Million Conservative Lenders 10% Loan Terms Hedge Fund Investors $95 M $5 M $9.5 M 10% Return to Conservative Lenders $1 M 20% Return to Hedge Fund Investors Problems: Moral Hazard Moral Hazard – Hedge Fund gambles with Conservative Investors’ Money No Regulatory Oversight of Leveraging No Regulatory Oversight of Leveraging Oct SEC suspended net capital rule for largest investment banks eliminating regulatory restrictions on leveraging

14 S HADOW B ANK R UN Price/Value of securitized bonds/assets falls. Investors: “I ‘m outta here. I want to withdraw my money.” We don’t have the cash to cover the withdrawals Sell securities. Reduce prices to raise the cash. Value of firm falls. Federal Reserve Increases Interest Rates  Causes Bond Prices to Fall Federal Reserve Increases Interest Rates  Causes Bond Prices to Fall Credit Default Swaps: Bets that firm will fail. Credit Default Swaps: Bets that firm will fail.

15 C ONSEQUENCES – F ORECLOSURES

16 H OW L ONG THIS WILL L AST ? CBO E STIMATES – 2014 BEFORE GDP G ROWTH R ETURNS TO N ORMA L Congressional Budget Office: A Preliminary Analysis of the President’s Budget and an Update of CBO’s Budget and Economic Outlook (March 2009). Assumptions: No exogenous shocks (e.g., no oil price , major bankruptcies,) Government solutions actually work -- do not create other issues

17 L OCAL B USINESSES ’ F ORECASTS

18 N OW, THE B AD N EWS Expects further declines in real estate prices ◦ Japan’s experience – 65% overall decline; 83% decline in commercial real estate ◦ Commercial real estate bubble expected to be as large as securitized mortgage losses Alt-A and Jumbo mortgages (bigger than sub-prime) have begun to reset ◦ Why renew a mortgage on a property worth less than the mortgage? Potential bank-run from pre-existing lines of credit ◦ Approximately $4.5 trillion outstanding Large, high-profile insolvencies disrupting markets(GM, Citigroup) State, local government shortfalls ◦ State/Local governments cannot engage in deficit spending, so MUST increase taxes or substantially decrease spending – both options retard economic growth Political pressure to erect trade barriers to protect domestic industries ◦ Replay of Smoot-Hawley disaster of the Great Depression Return of Stagflation ◦ Replay of the Great Inflation driven by dramatic increases in government spending ◦ Unemployment > 15% (projection for Dec = 10.5%)

19 Economic Policy Cures… Digging out of the Hole Keynesian Policies Keynesian Policies ◦ Spend LOTS of money on stimulus projects Monetary Policies Monetary Policies ◦ Federal funds rate = 0% ◦ Discount window = 0% ◦ Interest on reserve requirements Trade Barriers Trade Barriers ◦ Not yet happened Government Buys Toxic Assets Government Buys Toxic Assets Quasi-Nationalization Quasi-Nationalization ◦ Government invests in financial firms Government Guarantees Government Guarantees ◦ Government issues auto warrantees, guarantees bank deposits New Banking & Investment Regulations New Banking & Investment Regulations Bans/Restrictions on Short Sales Bans/Restrictions on Short Sales ◦ Prevents runs on leveraged firms Bankruptcy to Clean Up Illiquid Assets & Force Re-negotiation of Loan Terms Bankruptcy to Clean Up Illiquid Assets & Force Re-negotiation of Loan Terms ◦ Bankruptcy courts empowered to alter terms of mortgages ◦ Pre-packaged bankruptcy of Chrysler Fix the Credit Markets Stimulate the Economy

20 P UTTING THE N UMBERS IN C ONTEXT (T AKE A VERY DEEP BREATH BEFORE PROCEEDING …) Total Spending in Entire US Economy (GDP)$14.3 trillion Total US Stock Market Capitalization $15.4 trillion Total Value of US Housing Stock Total Outstanding Mortgage Balances Total Consumer Equity $18.3 trillion $10.4 trillion $2.6 trillion Total Corporate Real Estate Total Corporate Inventories & Equipment $8.4 trillion $5.8 trillion Total Federal, State & Local Government Spending Total Government spending on Health Care Total Defense spending Total Federal, State & Local Education spending $5.2 trillion $910 billion $729 billion $838 billion Total US, State & Local Government Receipts (Taxes) $4.2 trillion Total Federal Government Debt Total 50-State Government Debt $10 trillion $2.5 trillion Total US “Near-cash” Money Supply (M2) $8.2 trillion US Spending on Military Conflicts (2008 dollars; CBO figures) Iraq/Afghanistan (6 years) World War II (5-6 years) Vietnam (10-15 years) Korea (4 years) $804 billion $3.9 trillion $518 billion $456 billion

21 B AILOUT & S TIMULUS P ROGRAMS ProgramCommitment Government as an Investor$ 4.8 trillion Government as a Lender$ 2.3 trillion Government as an Insurer/Guarantor$ 5.14 trillion Stimulus Spending$1.2 trillion As of May 8, 2009 (changes daily)

22 G OVERNMENT AS AN I NVESTOR C OMMITMENT = $4. 8 TRILLION ProgramCommitment Commercial paper The Fed is the buyer of last resort in the commercial paper market. $1.6 trillion Public-private investment fund Fund seeks private investors and uses a combination of private and public money to guarantee and buy nonperforming assets. $900 billion Troubled Asset Relief Program (TARP) Treasury buys stock in banks, General Motors, Chrysler and AIG. $700 billion Federal Home Loan Bank Securities Government buys mortgage-backed securities from Fannie Mae, Freddie Mac and Ginnie Mae. $1.5 trillion A.I.G. Fed provided seed money to create investment vehicles to buy, hold and possibly dispose of bad AIG securities. $53 billion Bear Stearns Fed bought distressed assets/securities from Bear Stearns to facilitate its sale to JPMorgan Chase $29 billion Reserve US Government Fund Government buys assets to bailout troubled money market fund $4 billion The government gives money at risk of loss.

23 H OW THE TARP W AS S PENT ? O NLY ABOUT $467 MILLION REPAID Who Received TARP Funds?How Much? Banks$310.4 billion (44%) Other Financial Companies AIG American Express Discover Card Capital One GMAC Chrysler Financial CIT Group Other (9%) $69.8 billion $ 3.4 billion $ 1.2 billion $ 3.6 billion $ 5 billion (+ $7.5 billion) $ 1.5 billion $ 2.3 billion $238 million Automakers$24.8 billion (4%) TALF Funding to provide loans using toxic assets as collateral $100 billion (14%) Homeowner Mortgage Re-negotiation Program$50 billion (7%) Public-Private Investment Fund to buy toxic assets$100 billion (14%) Uncommitted$52.6 billion (8%)

24 G OVERNMENT AS A L ENDER C OMMITMENT = $2.3 TRILLION ProgramCommitment Term Asset-Backed Securities Loan Facility (TALF) Provides loans and accepts securities backed by consumer and small business loans as collateral. $900 billion Term Auction Facility The Federal Reserve makes low-interest, short term loans to financial institutions, allowing them to pledge asset-backed securities as collateral. $900 billion Discount Window Loans Extended time (90 days v. overnight), amount and eligibility (investment banks v. commercial banks) for Federal Reserve discount window loans. $236 billion + Debt Swaps (Term Securities Lending Facility) The Federal Reserve loans/swaps US Treasury notes in exchange for less liquid debt, mortgage-backed securities and investment- grade corporate debt. $200 billion AIG Loans A line of credit offered by the Federal Reserve. $60 billion A promise to pay back a government loan

25 G OVERNMENT AS I NSURER /G UARANTOR C OMMITMENT = $5.14 TRILLION ProgramCommitment Bank Debt (Temporary Liquidity Guarantee Program) FDIC insures senior subordinated debt issued by banks and poorly performing assets owned by Fannie Mae and Freddie Mac. $700 billion Temporary Liquidity Guarantee Program FDIC insures non-interest bearing bank accounts. $684 billion Citigroup Guarantees Government guarantees that exclude the direct investments made through the TARP program $249 billion Fannie Mae/Freddie Mac Guarantees Treasury pledged up to $200 billion each to cover their losses. $400 billion Bank of America Guarantees Government guarantees that exclude direct investment through the TARP program $98 billion Money market fund guarantees$3 trillion Morgan Stanley Guarantees Treasury guarantees for a capital infusion by a Japanese bank $9 billion The government promises to pay if things go badly.

26 R AW G OVERNMENT S PENDING (P ORK ) C OMMITMENT = $1.2 TRILLION ProgramCommitment Stimulus Bill (HR-1) All the pork you can eat. $787 billion Omnibus Budget Act 2009 (HR 1105) The remaining nine appropriations bills that the Congress failed to pass during the 2008 term $410 billion The government just spends money. Keynesian Economic Prescription  Government deficit spending will stimulate economic growth Gross Domestic Product = Consumer Spending + Government Spending - Taxes + Business Investment + Exports – Imports

27 T HE S TIMULUS “B UBBLES ” HR-1 – A MERICAN R ECOVERY & R EINVESTMENT A CT

28 R ECENT US E XPERIENCE N ET G OVERNMENT S PENDING (S PENDING MINUS T AXES ) V S. GDP G ROWTH D ATA S OURCE : US B UREAU OF E CONOMIC A NALYSIS T IMESERIES : 1990(1 Q ) – 2008(4 Q ) IN CONSTANT 2000 DOLLARS (T RILLIONS OF $) Government Surplus Government Deficits D OES G OVERNMENT S PENDING S TIMULATE E CONOMIC G ROWTH ? Boom years when government ran a surplus and when spending dropped “We’re all Keynesians, now.” Richard Nixon

29 H ISTORICAL C ORRELATION BETWEEN GDP G ROWTH AND N ET G OVERNMENT S PENDING (S PENDING MINUS T AXES ) D ATA S OURCE : US B UREAU OF E CONOMIC A NALYSIS T IMESERIES : 1970(1 Q ) – 2008(4 Q ) IN CONSTANT 2000 DOLLARS Vertical Axis: % Change in GDP Horizontal Axis: % Change in Net Government Spending w/6 month lag Increase in net government spending Decrease in net government spending Correlation between GDP Growth and Net Government Spending = means perfect correlation 0 means no correlation Correlation between GDP Growth and Net Government Spending = means perfect correlation 0 means no correlation Decrease in GDP Growth Increase in GDP Growth If deficit spending was correlated with economic growth, points should be clustered around a line like this. D OES G OVERNMENT S PENDING S TIMULATE E CONOMIC G ROWTH ? “We’re all Keynesians, now.” Richard Nixon

30 Looking into the Crystal Ball Can we spend our way out of the crisis? Can we spend our way out of the crisis? ◦ Didn’t work in Japan ◦ No correlation (0.05) between spending & economic growth ◦ Sharp stimulus cutbacks will hit state/local governments hard How will we pay for the spending & debt? How will we pay for the spending & debt? ◦ Increase taxes ◦ Devalue the currency (inflation) ◦ Collapse of foreign- government lending to US Zombies Zombies ◦ Firms kept alive for political reasons but that consume resources and slow the recovery  GM, AIG, Citigroup, Chrysler New Regulations New Regulations ◦ Expansion of bankruptcy and government to intervene in private agreements ◦ End of high-flying investment banks & loan securitization

31 Top 10 Business Strategies 1. Be Realistic/Pessimistic  This won’t turn around quickly. 2. Exogenous Shocks to Equities  Finance for expansion by IPO or new share issues is unrealistic. 3. Right Size, Right Now  Don’t staff at levels in hopes that things will turn around soon.  Outsource as much as possible 4. Investigate Your Lender  Assess likelihood of lender’s failure.  Draw down lines of credit (especially for critical projects) 5. Understand Landlord/Tenant Issues  What happens if your landlord owner becomes insolvent  Tenants have strong economic incentives to terminate leases 6. Shed Real Estate Investments  Commercial real estate fell 83% in Japan 7. Keep your customers happy  It is easier to keep old customers than to attract new customers 8. Market Smart  Cut everything before marketing  Focus on how your product meets the new economic reality (e.g., saves customers’ money) 9. Keep remaining employees happy  Employee problems can spook customers. 10. Review your vendors  Back-ups for critical vendors  Contract review for insolvency, force majeure and dispute resolution


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