Short primer on US financial crisis

1. U.S. Financial Crisis
Sarinee Achavanuntakul
Fringer | คนชายขอบ
http://www.fringer.org/
10 November 2008
Most slides are taken from http://www.slideshare.net/econman/the-credit-crisis-of-
2008a-presentation

2. The credit crisis, illustrated: the beginning

3. ..when 2008 rolls around:

4. Roots of the crisis: the housing bubble

5. Fuelling the bubble: low interest rates

6. Mortgage securitization

7. Moral hazard “credit ease”
• “Subprime” is defined as borrower who has FICO credit score less
than 620, but some lenders also define borrowers whose FICO score
are as high as 680 as “subprime” if their down payment is <5%
• Typical subprime mortgage is “Adjustable-rate Mortgage” (ARM): a
2/28 ARM means fixed interest rate for the first 2 years, then floating
rate (e.g. LIBOR + 6%) for the remaining 28 years
• Often requires no down payment, can borrow 100% of house value,
and has no rigorous credit check – “NINJA” borrowers, “Liar loans”
• Zimmerman (2007) proves that subprime loan quality in 2007 is worse
than in 2006, and 2006 were worse than 2005
• New subprime loans were $421,000 million in 2006 (S&P estimate);
AMP Capital Investors estimates $1.4 trillion subprime loan
outstanding in July 2007
• Fannie Mae estimates that 50% of those who were sold subprime
loans would have qualified for prime-rate loans

8. Credit Default Swap (CDS)
• Investors seek insurance to cover unexpected
defaults on loans

9. Fraud, over-leverage, and non-transparency
• Fraud:
– Unfair or misleading credit terms, e.g. ARM, universal default
– Moody’s supposed “bug” in their credit rating model that
resulted in some bonds being overrated by 4 notches (5/2008)
• Over-leverage:
– Many banks & hedge funds over-leverage to make easy money
on CDOs: 25-30x times their capital
• Non-transparency:
– Financial institutions use off-balance-sheet vehicles e.g. Special-
Purpose Vehicle (SPV) to hide real exposure and evade taxes
– Most subprime-linked derivatives are traded on 100% private,
OTC (“over-the-counter”) basis, so nobody knows the market
size problem applies to the whole “shadow banking system”

10. Agency problems, wrong incentives
• Problems at the top
– “When the music stops, in terms of liquidity, things will be
complicated. But as long as the music is playing, you’ve got to get
up and dance. We’re still dancing.” Citigroup’s Chuck Prince, in an
interview with Financial Times, July 2007
– Retired in November 2007 with $38 million pay package
• Problems down below:
– Traders are compensated for short-term performance – if they take
positions that have 5% chance of total catastrophe, they will be well
rewarded year after year as long as that 5% never materializes
– What the traders receive are therefore just “insurance premiums”
but they thought they are smart!
– Internal risk management gets weaker the more profits they make
– Hard to separate true “alpha” (idiosyncratic, firm-specific) from
“beta” (systemic, overall market returns) risks

11. What went wrong…

12. Multiplied losses

13. “Those guys are good.”

14. How a bank works
• Most bank “liabilities” are deposits which are short-term in
nature (e.g. 2-year fixed deposits), while most “assets” are
longer-term loans (e.g. mortgages or CDOs which are
“investments”). Mortgages are the longest-term loans.
• Banks must mark-to-market the value of their investments.
• Example: Wachovia balance sheet @ 30/6/08 (prior to
Citigroup takeover):
Assets Liabilities & Equity
Current assets $110 Short-term debt $505
Long-term assets Long-term debt $230
Investments $600 Equity (shareholders) $75
Others $100
Total $810 Total $810

15. Why banks fail so dramatically
Assets Liabilities & Equity
Current assets -$90 Short-term debt $305
Long-term assets Long-term debt $230
Investments $500 Equity (shareholders) -$25
Others $100
Total $510 Total $510
• Borrower defaults + house prices collapse market value of
investments / mortgages collapse (ex. $100 in above example)
• Bank must record falling value of investments as losses erode bank
capital until shareholder’s equity is negative insolvent
• Meanwhile, if bank’s debtors (depositors or other financial institutions)
withdraw funds or demand loan prepayment, bank may face a severe
liquidity crisis until it is bankrupt
• Bailout: buy toxic assets from banks (not a good idea: at what price &
certain losses) or raise capital (better, but can Republicans accept?)
• If public funds are used, ex-shareholders should not reap benefits

16. U.S. household debt problem is not over
• Currently 8.8 million Americans have negative home equity
– a record figure
• Total mortgage market in U.S. is approx $11 trillion (79%
of GDP). About 13% of these are subprime
• U.S. households have $1 trillion credit card debt + $0.7
trillion auto loan. These debts often have no collateral –
repayment depends solely on borrower’s ability to repay
• Tough & unfair credit terms + rising cost of living (oil, food,
etc.) erode ability to repay
• Since mortgages are often the last kind of loans people
would default (house = the most valued asset), the
subprime crisis suggests that they have already defaulted
on credit cards and other kinds of loans
• These loans have been securitized too. So… watch out!

17. The end of neoliberal economics?

18. What will happen next?