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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