Subprime Crisis In US

Brief Banking History Mesopotamia, >3000 years ago, storehouses for reserves of grain and animals, charged interest much like today Mesopotamia, >3000 years ago, storehouses for reserves of grain and animals, charged interest much like today Italy, Medici of Florence: first modern loan and deposit system to handle multiple currency, later improved by Dutch and British, imported to American colonies Italy, Medici of Florence: first modern loan and deposit system to handle multiple currency, later improved by Dutch and British, imported to American colonies Growing pains through a period of minimal regulation, legislation during Civil War: entire US banking system under federal regulation Growing pains through a period of minimal regulation, legislation during Civil War: entire US banking system under federal regulation

Brief Banking History (2) Credit crisis late in the 19 th century and in 1907 Credit crisis late in the 19 th century and in 1907 The Great stock market crash of 1929: caused by too many high-risk loans under the assumptions that stock market would continue to rise unabated The Great stock market crash of 1929: caused by too many high-risk loans under the assumptions that stock market would continue to rise unabated Bubble prop in October 1929, run in risky on the nation’s banks. However, banks engaged in risky investments themselves with depositors’ cash, only to lose it all Bubble prop in October 1929, run in risky on the nation’s banks. However, banks engaged in risky investments themselves with depositors’ cash, only to lose it all

Brief Banking History (3) 1933: banks basic function ceased: Franklin Roosevelt put a few measures 1933: banks basic function ceased: Franklin Roosevelt put a few measures Glass-Stegall Act: forbid commercial banks (BofA, pre-Merrill) from offering services of investment of insurance banks (AIG) Glass-Stegall Act: forbid commercial banks (BofA, pre-Merrill) from offering services of investment of insurance banks (AIG) FDIC: promised to reimburse customers should a bank go out of business FDIC: promised to reimburse customers should a bank go out of business

Brief Banking History (4) 1913, Federal Reserve created: “lender of last resort”, the central bank of US 1913, Federal Reserve created: “lender of last resort”, the central bank of US Roosevelt polices slowly brought confidence in the banking system back up and helped end the Great Depression Roosevelt polices slowly brought confidence in the banking system back up and helped end the Great Depression 1999, Glass-Stegall Act repealed; commercial banks to re-enter stock biz 1999, Glass-Stegall Act repealed; commercial banks to re-enter stock biz IB used to be big players for Gov’t and corporations could own commercial banks IB used to be big players for Gov’t and corporations could own commercial banks

Brief Banking History (5) With a surging market, IBs made all kinds of money With a surging market, IBs made all kinds of money Until a few years ago, housing propelling growth was unstoppable Until a few years ago, housing propelling growth was unstoppable Merrill Lynch and Lehman offered mortgages left and right, many to people with poor credit records, gambling that housing prices would continue to rise Merrill Lynch and Lehman offered mortgages left and right, many to people with poor credit records, gambling that housing prices would continue to rise

Micro Economic Overview

S&L Crisis Not a new phenomenon Not a new phenomenon Historical S&L crisis dates back to the Great Depression, Disintermedaition in the late 70’s, S&L crisis in 1989 Historical S&L crisis dates back to the Great Depression, Disintermedaition in the late 70’s, S&L crisis in : 747 S&L bankruptcies with $160 billion of bailout, caused recession in : 747 S&L bankruptcies with $160 billion of bailout, caused recession in : In addition to $85 billion of bailout for AIG, $700 billion more for Wall Street 2008: In addition to $85 billion of bailout for AIG, $700 billion more for Wall Street

How large is $700 billion? NASA fiscal year 2009: $17.6 billion NASA fiscal year 2009: $17.6 billion NSF annual budget: $6.1 billion NSF annual budget: $6.1 billion Military budget 2009: $481 billion Military budget 2009: $481 billion Social Security: $608 billion Social Security: $608 billion $2,300 for each American $2,300 for each American US national debt: $9 trillion US 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 trillion The Forbes 400 richest people total $1.57 trillion

How big is subprime? 2% of total loans in 2002 to 20% of total loans in % of total loans in 2002 to 20% of total loans in 2006 US economy: $ 60 trillion US economy: $ 60 trillion Mortgage Market: $12 trillion Mortgage Market: $12 trillion Subprime: $2.4 trillion Subprime: $2.4 trillion Massive write-offs by the commercial banking and investment banking ($500 B) Massive write-offs by the commercial banking and investment banking ($500 B)

Even Bigger Derivative

Subprime Mortgage Loans to less than perfect credit Loans to less than perfect credit Any late payments, bankruptcies, liens, judgments, or other defaults blemish the credit history Any late payments, bankruptcies, liens, judgments, or other defaults blemish the credit history Borrower with blemished credit history or no credit history does not qualify for the Prime Mortgage Loans: falls to subprime mortgage with high interest payments Borrower with blemished credit history or no credit history does not qualify for the Prime Mortgage Loans: falls to subprime mortgage with high interest payments

Chronological 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 Chase) Washington Mutual (acquired by JP Morgan Chase) Wachovia (acquired by Citigroup) Wachovia (acquired by Citigroup) Morgan Stanley, Goldman Sachs (subprime, CDS exposure related to hedge funds): covert to chartered bank holding companies (part of $700 billion of US Gov’t bailout) Morgan Stanley, Goldman Sachs (subprime, CDS exposure related to hedge funds): covert to chartered bank holding companies (part of $700 billion of US Gov’t bailout)

Chain of Reaction Burst of US housing bubble and high default rates on “subprime” and “ARM” Burst of US housing bubble and high default rates on “subprime” and “ARM” Increase in defaults and foreclosure Increase in defaults and foreclosure Mortgage lenders and credit risk sellers were hit hard Mortgage lenders and credit risk sellers were hit hard Tighter lending, and increased spreads on interest rates Tighter lending, and increased spreads on interest rates Contracted liquidity in the global credit markets and banking system Contracted liquidity in the global credit markets and banking system

Who to blame? Reagan Doctrine: Financial Deregulation ‘82 Reagan Doctrine: Financial Deregulation ‘82 Democrats-led congress passed the law to provide more affordable mortgages to low income people (1992) Democrats-led congress passed the law to provide more affordable mortgages to low income people (1992) People who shouldn’t have been borrowing People who shouldn’t have been borrowing These loans were packaged into CDOs rated AAA (IBs and rating agencies) These loans were packaged into CDOs rated AAA (IBs and rating agencies) Investment Bank purchase w/o due diligence Investment Bank purchase w/o due diligence Distributed throughout the world Distributed throughout the world

Greed Alpha generation: beat the market, theme of portfolio managers/ hedge fund managers Alpha generation: beat the market, theme of portfolio managers/ hedge fund managers Earn higher mortgage or credit card rates Earn higher mortgage or credit card rates Bet on credit: three hedge funds speculation funded by investment banks Bet on credit: three hedge funds speculation funded by investment banks High leverage bet High leverage bet

Issues Moral hazard Moral hazard Conflicts of Interest Conflicts of Interest Regulation or deregulation Regulation or deregulation Quants: Fall of geniuses Quants: Fall of geniuses Financial engineering without comprehensive understanding of risk management Financial engineering without comprehensive understanding of risk management