Finance 129

Background on the Financial Crisis

And Current Economy

The Big Picture

Problems in Mortgage Market

Global Credit Crisis / Bank failures / Equity Losses

Declining Consumer Spending Decreased Business Investment

Who’s to Blame?

How Financial Markets Enabled“Keeping up with the Joneses”

New Products

Poor Underwriting

Public Policies Unintended Consequences

Low Rates and International Capital Flows

Average Size of Subprime Loans

Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, 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 Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans, over

50% to total subprime50% 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, 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, Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans,

over 50% to total subprimeover 50% to total subprime

Impact of Subprime Loans on Home Ownership

"SubPrime Lending: A Net Drain on Homeownership," Center for Responsible Lending: March 2007"SubPrime Lending: A Net Drain on Homeownership," Center for Responsible Lending: March 2007

NY Times October 4 "Pressured to Take More Risk Fannie Hit a Tipping Point"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 Gramlich, E. "Subprime Loans: America's Latest Boom an Bust" 2007 ** "how HUD Mortgage Policy Fed the Crisis", Washington Post June 10, 2008Policy Fed the Crisis", Washington Post June 10, 2008

International Capital Flows

Consumer Spending On Exports

Increased Foreign Holdings of $

Increased Inflow of Dollars Helps Keep Long Term Rates Low

“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

Non Agency Mortgage Foreclosure Rates

Response of Consumers

Increased access to credit and delusional optimism resulted in:

Short-Term Speculative FocusBorrowing More and Saving Less

Case Study: Natalie Brandon

1985 Buys $105,000 house 30 Year fixed rate loan Payment = $770

2000-2006Paid penalties to Refi 5 times in 5 years Yearly income = $100,000 2006 New Loan $625,500 2/28 7.99% teaserPayment = $4,585

Fall 2007Home Value = $450,000Attempt to Refi for 40 years at 6% Fails

Borrowing More & Saving Less

Equity Prices Compared to Past Recessions

Precautionary Saving

All Silents Boomers Gen X Gen YLess than 2 weeks 28% 11% 25% 31% 32%2 weeks to a month 22% 17% 21% 21% 27%2 to 3 months 22% 23% 24% 19% 22%4 to 6 months 14% 15% 11% 17% 12%7 months to a year 5% 7% 5% 6% 2%More than a year 10% 27% 14% 5% 6%

If you were to lose your job, for how long could you afford to be out of work and still meet your financial obligations including monthly expenses?

The 2009 MetLife Study of the American Dream

Confidence in Having Enough Money to Live Comfortably Throughout Retirement Years

Employee Benefits Research Institute – Retirement Confidence Survey

The Keys to Recovery – The Big Picture

ConsumersPrecautionary or Long Term Savings?Lost Faith in Investment Planning?View of home ownership

Corporate EarningsFinancial Markets and Regulation

Regulatory ChangesLong Term Inflation FearsMonetary and Fiscal Policy & Interest Rates

Global Concerns

Consumer Credit Outstanding

ISM Manufacturing Survey

Employment: Non Farm Payrolls

Employment: Non Farm Payrolls

Peak = 138 MJan 2009

Current = 133.2 MJuly 2012

Min = 129.2 MFeb 2010

Employment

Peak Employment Jan 2009 = 138.023 MillionCurrent Employment July 2012 = 133.245 Million

Average monthly gain needed in payrolls to return to peak level in:

1 year 398,166 2 years 199,083 3 years 132,722

Feb 240,000 March 154,000 April 77,000 May 77,000 June 64,000 July 164,000

Other Forces

Government Contraction

Tight Credit

Uncertainty US, Europe, China

The Slow Recovery: It’s No Just Housing FRBSF Economic Letter April 9, 2012

History of EU 1950

The Schuman DeclarationPlan for France and Germany to pool coal and steel production. European economic unity will make war “Not merely unthinkable but materially impossible” Robert Schuman

French Foreign Minister

1951

European Coal and Steel Community

France, Germany, Italy, Netherlands, Belgium and LuxembourgHigh Authority (oversees coal and steel production)Common Assembly (future European Parliament)Council of Ministers

The Group of Twenty a History www.g20.orgThe Group of Twenty a History www.g20.org

Changing Landscape

1980

1997

2006

% of GDP (PPP) produced by g-7 countries

54% 46% 40%

% OF GDP (PPP) produced by other G-20 Countries

21% 30% 36%

A Brief History of European Debt Crisis

January 2001 – Greece Joins Euro zone and adopts Euro. Nov 2004 – Greece admits its deficit has been above the required EU limit (3% of GDP) since 1999March 2005 – Trade Unions impose 24 hour strike to protest austerity measures after cost of hosting Olympics causes high deficits

  Greek timeline on this and future slides from news.bbc.co.uk/2/hi/Europe/country_profiles/1014812.stm

2002

Germany’s Debt hits 60.7% in 2002 of GDP and is still above 60% Germany’s budget deficit hits 3.8% of GDP in 2002 and remains above 3% until 2006 France’s debt hits 63.3% of GDP in 2003 and is still above 60%France’s budget deficit hits 3.3%in 2002 and remains above 3% until 2006Neither country receives penalties from the European Union

2005

The 1997 Growth and Stability Pact is altered to allow “exceptional circumstances” and “other relevant factors” to be considered when the deficit and debt targets are missed.Memebers are allowed two year to correct the problem and could be given more time with an exception.

Deficit as a % of GDP

ECB http://www.ecb.int/stats/gov/html/dashboard.en.html

Euro Area Debt

Long Term Borrowing Costs (10 year debt) Jan 2010 – May 2012

Contagion

November 28, 2010Ireland receives €67.5B in bailout loan commitmentsGiven to 2015 to decrease deficit to 3% of GDP

May 2011May 3 Portugal accepts €116B loan commitment package

shttp://www.huffingtonpost.com/2010/11/28/ireland-bailout-european-union_n_788922.htmlshttp://www.huffingtonpost.com/2010/11/28/ireland-bailout-european-union_n_788922.html

Public Debt Comparison

Country

1999 2004 2010

Unep Rate

Debt % of GDP

Rev % of GDP

Unep Rate

Debt % of GDP

Rev % of GDP

Unep Rate

Debt % of GDP

Rev % of GDP

(2009)

Japan 4.7% 97% 26.3% 4.7% 156% 26.3% 5.1% 183%* 28.1%

Greece

12.1%

103% 32.8% 10.5% 108% 31.1% 12.6% 147% 29.4%

Italy 11% 106% 42.5% 8.1% 96% 40.9% 8.4% 109% 43.5%

US 4.2% 38% 29.1% 5.5% 36% 25.7% 9.6% 61% 23.9%

Spain 15.6%

52% 34.1% 11% 39% 34.6% 10% 51% 30.7%

Treasury Bid to Cover Ratio

2 year 10 year

2005 Average

2.19 3.75

2012 Average

2.36 3.18

Average Interest Expense

TitleAverage Interest Rates

June 30,2012

June 30,2011

Interest-bearing Debt:

Marketable:

  Treasury Bills 0.115 0.129

  Treasury Notes 2.077 2.385

  Treasury Bonds 5.452 5.860

  Treasury Inflation-Protected Securities

1.696 2.005

  Federal Financing Bank

4.625 4.625

Total Marketable 2.159* 2.380

GAO Baseline

Revenues as a share of GDP increase and discretionary spending as a share of GDP decreases

GAO Baseline

GAO Alternative Scenario

Revenue and Discretionary Spending are at historical averages over long term.Soc Sec, Medicare, Medicaid and interest exceed revenue by 2030

GAO Alternative Scenario

Fiscal Gap or Current Value of Future Primary

Deficits

The sum of the present values of the difference, or gap, between revenue and noninterest spending over the next 75 years.Assumes the goal of having today’s debt to GDP ratio at the end of the period

Cost of Closing the Gap

Federal Fiscal Gap under GAO’s Simulations Based upon Trustees Assumptions, 2011-2085

Average % change required to close gap

If action is taken today If action is taken in 2021

% of GDP

Solely through increase

in revenue

Solely through

decreases in noninterest spending

Solely through

increases in revenue

Solely through

decreases in

noninterest spending

Baseline 1.8 8.4 8.0 9.9 9.4

Alternative 8.2 45.7 32.2 54.3 37.0www.gao.gov The Federal Government's Long-Term Fiscal Outlook January 2012www.gao.gov The Federal Government's Long-Term Fiscal Outlook January 2012

The World in 2050

The G7 vs the E7 (Brazil, Russia, India, China, Indonesia, Mexico and Turkey) Emerging Middle Class in Developing Economies

2005 G7 is currently about 20% larger in Purchasing power parity (PPP) and 75% larger in terms of market exchange rates (MER)E7 will be 75% larger than G7 in PPP and 25% larger in terms of the (MER)

The World in 2050, Price Waterhouse Coopers, March 2006The World in 2050, Price Waterhouse Coopers, March 2006