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© 2004 Sand Hill Econometrics. All rights reserved. 1 The Subprime Financial Crisis Roots of the Crisis Susan Woodward, Sand Hill Econometrics
© 2004 Sand Hill Econometrics. All rights reserved. 2 Prelude 1980 – change in Usury laws Depository Institutions Deregulatory and Monetary Control Act 1990 to 1996 – introduction of credit scores 1998 – clearing-house for derivatives killed by bi-partisan leaders (clearing-house would know gross and net exposure of buyers & sellers) 2004 – SEC eliminated capital rules for investment banks Average ibank ratios of capital to assets: before 2004: 1 to 12 after 2004: 1 to 33
© 2004 Sand Hill Econometrics. All rights reserved. 3 Real Residential Construction, 1968-2008
© 2004 Sand Hill Econometrics. All rights reserved. 4 Residential Construction Has always been volatile. Is very sensitive to the level of nominal interest rates – when rates rise, construction contracts Construction is such a large sector that when it contracts, it can create a recession all by itself Has had a major role in most recessions (obvious in the chart), but not in 2001 As of 2008q3, more than all of the shortfall in GDP was accounted for by the decline in residential construction (roughly $350bn)
© 2004 Sand Hill Econometrics. All rights reserved. 5 Mortgage Interest Rates, 1987-2009 by 2003, the big refi boom was over
© 2004 Sand Hill Econometrics. All rights reserved. 6 Housing market experience, 1990-2003 1990-2004: high LTV loans to borrowers with good credit had low default rates 50 years (maybe more) of rising dollar house prices 20 years of low, 2-3%, and mean-reverting inflation, 20 years of (mostly) declining mortgage interest rates A recession in 2001 with virtually no housing component Lower volatility everywhere: stock market, the bond market, business income, residential construction, real activity, personal income, and more… By 2003, when 30-year fixed mortgage rates reached 5.25%, the mortgage refi boom had to end, and new lending either had to contract a lot, or lenders had to think of something new to do.
© 2004 Sand Hill Econometrics. All rights reserved. 7 Mortgage Originations, 2001-2007, $ trillions
© 2004 Sand Hill Econometrics. All rights reserved. 8 Note that 2003 Was the last year of the refi boom. The decline in originations would have been even bigger in 2004 if lenders had not begun chasing subprime borrowers aggressively. In 2006, subprime loans were nearly 40% of all originations.
© 2004 Sand Hill Econometrics. All rights reserved. 9 Little signs that all was not well…
© 2004 Sand Hill Econometrics. All rights reserved. 10 Vacancies The vacancy data are very telling. Note that we have quite a long history for this series– back to 1956. In the fourth quarter of 2005, the vacancy rate for owner-occupied homes reached 2% for the first time since we began keeping track of vacancies. These vacancy rates are for owner-occupied dwellings. Vacancy rates for rentals are much higher (5-8%) and also more volatile.
© 2004 Sand Hill Econometrics. All rights reserved. 11 Who had a problem? Many investment banks were big holders bad pieces of subprime loans and became insolvent. All lenders stopped trusting them. Some large commercial banks were big holders of subprime loans, and close to insolvent. Other banks stopped trusting them. Sellers of insurance (AIG) (especially insurance not regulated as insurance, such as credit default swaps) to subprime lenders and investors were under-capitalized and close to insolvent, lenders stopped trusting them, too. Some households defaulted on their loans. Some households felt poorer because the value of their houses and portfolios were down, so they spent less.
© 2004 Sand Hill Econometrics. All rights reserved. 12 Crisis was mainly a Large Bank crisis
© 2004 Sand Hill Econometrics. All rights reserved. 13 Was the financial crisis the precipitating event of the recession? No – it was the crash in house prices. Residential construction – just under 5% of GDP. If it falls 40%, that’s a recession. As of 2008q3, more than all of the shortfall in GDP was accounted for by residential construction. Q4 shortfall in GDP is broader. Credit spreads always widen in recessions, bank crisis or not. But the bank crisis cannot have made things better. It could have made things much worse if the Fed had not moved to shore up bank capital.
© 2004 Sand Hill Econometrics. All rights reserved. 14 Stuff done right Inject capital into banks increased inter-bank trust interbank lending resumed
© 2004 Sand Hill Econometrics. All rights reserved. 15 Stuff not done right Initial Focus on auctioning (pricing) assets Allowing markets to suspect Fannie and Freddie were without federal backing F&F borrowing rates were 140 basis points> treasuries No fiscal stimulus put in place in 2008
© 2004 Sand Hill Econometrics. All rights reserved. 16 What can we do now? Short-run: Fiscal Stimulus -- expected GDP shortfall $900 bn in 2009 tax cuts or rebates investment tax credit public works subsidy (or tax relief) to employers negative (or zero, with Federal govt paying states) sales tax inflate
© 2004 Sand Hill Econometrics. All rights reserved. 17 Tax cuts or rebates Tried in 2008 - no detectable impact - consistent with theory (people smooth consumption over time, if they can) - consistent with other studies of windfalls
© 2004 Sand Hill Econometrics. All rights reserved. 18 Investment Tax Credit PRO Experience suggests it does move investment forward in time CON Money goes mainly to manufacturers of capital goods and to skilled labor
© 2004 Sand Hill Econometrics. All rights reserved. 19 Public works PRO Large body of research suggests multiplier lies between 1 and 1.5 (for each $1 spent, GDP rises by $1 to $1.50) CON Impact cannot be as quick as sales tax cuts or employment subsidies Benefits go mainly to contractors and skilled labor Government is generally not too good at choosing construction projects. Let the States do it.
© 2004 Sand Hill Econometrics. All rights reserved. 20 Subsidies to Employers PRO impact is directly on employment can be done quickly numbers are big: Businesses pay $500 bn/yr in payroll (social security) taxes CON Money goes to businesses directly, not households Impact on GDP is much disputed, multiplier could be well under 1.0, suggesting disproportionate benefits to business owners and a net cost to taxpayers
© 2004 Sand Hill Econometrics. All rights reserved. 21 Negative -- or zero -- Sales Tax PRO Evidence says it will raise GDP Can be done quickly (all but 5 states have a sales tax) Numbers are big – about $400 bn per year CON Political bonus points are smaller because beneficiaries are so diffuse Works best if it is a surprise
© 2004 Sand Hill Econometrics. All rights reserved. 22 Inflate PRO Higher inflation does stimulate real activity CON It takes about 1.5 years for the impact to be complete Inflation above 4% would ruin our reputation for a national commitment to low and stable inflation, a reputation we have spent 20 years building.
© 2004 Sand Hill Econometrics. All rights reserved. 23 The short evaluation … Timid – GDP shortfall is forecast to be more than $900 bn in 2009. – only $200 bn of the stimulus is to be spent in 2009 Inappropriate – most of the money is spent in 2010 rather than 2009 – money is spent on public works, much of which is pork, instead of by people
© 2004 Sand Hill Econometrics. All rights reserved. 24 The Details 200920102011 Increased outlays by federal agencies 34.8110.776.3 Grants to individuals and state-local governments 85.3108.649.9 Tax cuts 64.8180.18.2 Total 184.9399.4134.4 Stimulus, billions of dollars, by fiscal year (October to September), figures from CBO
© 2004 Sand Hill Econometrics. All rights reserved. 25 After another several months of bad employment figures, they will be back for more…
© 2004 Sand Hill Econometrics. All rights reserved. 26 How bad do things look now?
© 2004 Sand Hill Econometrics. All rights reserved. 27 What would be a more direct stimulus? 1.Federal govt pays state sales taxes, 100% for the first quarter, 2/3 next quarter, 1/3 the next, then done. ($400 bn per year, only 6 states without a sales tax) 2.Increase level and duration of unemployment benefits 3.Investment tax credit to businesses 4.Pay employees’ part of payroll (social security) tax ($450 bn), perhaps also employers’ part
© 2004 Sand Hill Econometrics. All rights reserved. 28 What about banks? Good bank/Bad bank proposals most proposals suggesting separating floundering institutions into two entirely separate entities. Put assets of questionable value and all long-term debt into the “bad” bank. Two problems: 1. The bad bank will almost surely be insolvent 2. The debt-holders would unquestionably be worse off, because they would see a smaller pool of assets from which to recover.
© 2004 Sand Hill Econometrics. All rights reserved. 29 Another idea… Make the good bank an asset of the bad bank. Debtholders still can recover from the total pool of assets
© 2004 Sand Hill Econometrics. All rights reserved. 30 Example: Citi Citi nowGood bankBad bank Assets Loans 1,935 1,325 610 Equity in other bank - - 427 Total assets 1,935 1,325 1,037 Liabilities Deposits 780 - Bonds 1,144 118 1,026 Equity 11 427 11 Capital ratio0.5%32.2%1.0%
© 2004 Sand Hill Econometrics. All rights reserved. 31 What’s the point? Change incentives – low risk v. high risk lending Make the next steps for reorganization clear Reassure depositors (including foreign deposits) that the good bank is solvent so that they don’t run PROBLEMS Still a blow to the long-term debt-holders (are they pension plans and insurance companies?) though not as large as other good/bad bank plans Ambiguity of standing of long-term debt-holders and foreign deposits Provides little guidance regarding entities like AIG
© 2004 Sand Hill Econometrics. All rights reserved. 32 What next? Short-term another stimulus bill, more targeted at consumption and employment Longer-term less levered financial institution, especially depositories, likely ibanks also, if there are any some arrangement for keeping track of CDS re-thinking of retirement schemes (British usage) limitations on activities of insured depositories, both active (subprime lending) and passive (purchase of CDS on assets held) Regulate everything that is insurance (like CDS) as insurance, with capital requirements
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