By:Eric NelsonJacob Payne

Samantha Duellman

Financial Crisis: OverviewDownturn in the world economyCauses

Housing SlumpSubprime Mortgage

CrisisFinancial Innovation

ImpactsBank FailuresHome ForeclosuresFederal Reserve Steps

inChanges in the Market

EventsBear Stearns BailoutNorthern Rock/Bank of

EnglandCountrywide

SolutionsThe Federal Reserve has

tried to take corrective measures

RegulationProblems with Regulation

Causes: Housing SlumpHousing Boom

Housing prices were on the risePeople bought and built more and moreThought it was a good investment

Thought that home values would not decreaseTook out second mortgages to use toward

consumer spendingHousing Bust

Excess inventoryHousing price correctionNegative equityForeclosures

Causes: Subprime Mortgage CrisisWhere did the subprime mortgage crisis start?

Banks used to operate on a fractional reserve systemToday almost no reserve is required due to new

rules that the public doesn’t even know aboutBanks are able to issue more loans when they do not

have to keep a reserve on handWhen they run out of qualified candidates, they

reduce the requirements, which leads to subprime mortgages

These loans slowly inflate the system, and create wealth that is not “real”

Causes: Subprime Mortgage CrisisMortgage originators sold the loans on the

secondary marketNo risk for the originators so little effort went

into analyzing the borrower’s ability to repayHigh risk and debt tolerance

Adjustable Rate Mortgages (ARMs)Rates are beginning to increase from the low

introductory rate

Causes: Financial InnovationFinancial innovation is the act of creating and

then popularizing new financial instruments as well as new financial technologies, institutions ,and markets.Adjustable Rate MortgagesInvestment Vehicles that went wrong

Mortgage Backed Securities (MBS) CDOs – Collateralized debt obligations

Not understood by investors

Causes: Financial InnovationFinancial innovations are optimal responses

to various problems or opportunitiesMany financial innovations that have been

created in the recent past to respond to the financial boom were not fully understood

They were not adapted properly from the past, and when the financial sector crashed, these innovations responded negatively

ImpactsLarge corporations

Bankruptcy Companies are trying to avoid bankruptcy because

of the Chapter 11 rule changes that took effect in 2005

Restructuring Hedge fund owners might push these corporations

into bankruptcy by forcing them to sell their assets

Insurance CompaniesHomeowners are turning to arson as a way to

get out from under their mortgages

ImpactsSubprime Mortgage Backed Securities (MBS) were

in portfolios and hedge funds around the worldInvestments turned out to be worth far less than

what was first thought Stiffer lending policies

Banks lending only to the safest loan customers Before almost anyone could qualify for a mortgage loan

Federal Reserve takes actionIn August 2007, they put $100 billion into the money

supply for banks to borrow at a low ratePrime rate has been slowly decreasing over the past

year

ImpactsHome Foreclosures

Over 1.5 million foreclosure proceedings began in 2007

Foreclosure filings increased 57 percent in March compared to a year ago

Bernanke expects that number to increase further in 2008

Increased foreclosures further depresses home prices, which can hurt the broader economy.

ImpactsChanges in the Market

Large re-evaluation of riskAbstract ideas such as CDO’s and MBS’s are

out the window Know what you are holding Maybe housing values don’t always go up

Banks are much tighter with their cash, causing a liquidity shortage and the so-called “credit crunch”

Huge financial institutions are going broke and being purchased by competitors

EventsBear Stearns Bailout

Bear Stearns is the fifth largest investment bank on Wall Street, specializing in capital markets, wealth management, and global clearing

In July of 2007, Bear Stearns disclosed that the two subprime hedge funds had lost nearly all of their value amid a rapid decline in the market for subprime mortgages.

Stock for Bear Stearns fell from $100/share in December 2007 to $5/share in March 2008, just 3 months

EventsBear Stearns Bailout

Bear Stearns and JP Morgan Chase came to a merger agreement after the government agreed to guarantee the merger at $2/share. JP Morgan Chase later upped the buyout price to $10/share and reduced the government guarantee by $1 billion.

Many saw this action by the Federal Reserve as a government bailout of an investment bank

Federal Reserve Chairman Ben Bernanke testified that if Bear Stearns would have defaulted, there most likely would have been “severe consequences” leading to a possible systemic financial crisis

EventsNorthern Rock

On September 12, 2007, the Bank of England provided emergency funds to Northern Rock in the biggest bailout of a British bank in three decades.

The difficulties came from Northern Rock not being able to raise funds due to the subprime crisis in the US

http://maoxian.com/index.php?s=northern+rock

EventsNorthern Rock

On September 14, 2007 customers waited outside the branches to withdraw their savings It is estimated that 5% of the total deposits were

withdrawn that day The internet site became inaccessible due to the large

number of people that were trying to log on As of November 17, 2007 a total of 10 companies

had put in bids to buy out Northern Rock, but all the offers were materially below the previous trading value

On February 17, 2008 Northern Rock was bought by the government and would be nationalized and the bank would operate under a temporary period of public ownership

EventsCountrywide Financial Crisis

When Countrywide finances mortgage loans, they usually package them for sale to large investors as mortgage backed securities

After the housing crisis began Countrywide was severely affected

On August 3, 2007 the secondary market stopped the sales of most non-conforming securities and days later Countrywide announced that this disruption could hurt it financially

EventsCountrywide Financial Crisis

On August 12, 2007 Countrywide was cited as a possible bankruptcy risk by Merrill Lynch

Countrywide’s stock fell from $21. 29 in August down to $8.64 in November

On January 11, 2008 Countrywide was bought out by Bank of America for an all-stock $4 billion deal, down from a $24 billion value one year ago

Countrywide was the nation’s largest mortgage lender, so this deal is a landmark in the housing crisis

SolutionsFederal Reserve Actions

Bernanke and the Fed have been trying to stave off recession very actively

The Fed reduced the interest rate 7 times since last September, most recently on April 30th, when rates were reduced a quarter point to 2 percent

The Fed has been trying to boost the amount of liquidity available due to sharp declines in banks loaning to each other

The Fed began the Term Auction Facility in response to the crisis on December 12th, 2007. The TAF is a means of increasing liquidity by offering

loans to depository institutions which otherwise could not borrow from the Fed

SolutionsRegulation

New plan unveiled by Treasury Secretary Henry Paulson One agency in charge of business conduct and

consumer protection Eliminate office of Thrift Supervision and Commodity

Trading Futures Commission Establish a federal Mortgage Origination Commission Set minimum licensing standards for mortgage brokers Establish Office of Insurance Oversight inside Treasury

Department

SolutionsIssues with Regulation

Keeping good regulators is difficult because they earn much more in the private sector

Ensuring proper conduct of regulators is difficultIf banks were allowed to fail everyone would work

harder not to and would assess risk better.Due to bailouts of major banks (Bear Stearns,

Northern Rock) the only viable option left is more and better regulation in order to promote stability in the financial system.

SolutionsBank Regulations

The amount of money owed to banks is more than all the money in existence, so we cannot possibly get out of debt under this system

The bulk of this debt is in the form interest, which is an arbitrary amount of money banks demand in return, but never gave

The public must demand that money must not be created by loaning it into existence, which in the end causes inflation

Financial Crisis: ConclusionCauses

Multiple factors played a role in this financial crisis

Most of the emphasis has been placed on the subprime mortgage crisis It has had effects that have stretched beyond the

housing market

ImpactsThe impact of this financial crisis can be felt on

all levels from individuals to large corporations

Financial Crisis: ConclusionEvents

The far reaching events can show how powerful this financial crisis is

Bear Stearns was saved to prevent further damage to the financial market

It forced the nation’s largest mortgage lender into near bankruptcy and an eventual buyout

SolutionsThe Federal Reserve has stepped in but to little

avail Regulation seems to be a popular answer but

what type of regulation still needs to be developed

Financial Crisis: ConclusionIn a statement from Countrywide to the SEC

“Since the company is highly dependent on the availability of credit to finance its operations, disruptions in the debt markets or a reduction in our credit ratings could have an adverse impact on our earnings and financial condition, particularly in the short term… Current conditions in the debt markets include reduced liquidity and increased credit risk premiums for certain market participants. These conditions, which increase the cost and reduce the availability of debt, may continue or worsen in the future….”

References• “Wall Street’s crisis.” The Economist. March 22-28, 2008: 11-12• “The $2 bail-out.” The Economist. March 22-28, 2008: 81-82• “What went wrong.” The Economist. March 22-28, 2008: 79-80• “The long hangover.” The Economist. April 12-18, 2008: 79-80• Scott Lanman and Alison Vekshin. “Bernanke Urges Action to

Slow Jump in U.S. Home Foreclosures.” Bloomberg. May 6, 2008 <http://www.bloomberg.com/apps/news?pid=20601087&sid=aojlbhOfzPaM&refer=home>

• Jeffery D. Sachs. “The Roots of America’s Financial Crisis.” Project Syndicate. April 15, 2008 <http://www.project-syndicate.org/ commentary/sachs139>

• Tom Leonard. “Henry Paulson unveils bank regulation plan.” Daily Telegraph. April 22, 2008. <http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/04/01/cnusbanks101.xml>

References“Waiting for Armageddon.” The Economist. March

27, 2008. <http://www.economist.com/business/ displaystory.cfm?story_id=10925548>

Mark Landler “Housing Woes in U.S. Spread Around Globe.” The New York Times. April 14, 2008. <http://www.nytimes.com/2008/04/14/business/worldbusiness/14real.html?_r=1&em&ex=1208404800&en=ddcb233e7e3b3153&ei=5087%0A&oref=slogin>

Chris Isadore “Fears of long recession rising.” CNNMoney.com April 14, 2008. http://money.cnn.com/ 2008/04/14/news/economy/how_bad/index.htm?postversion=2008041415