The Financial CrisisThe Financial Crisis

MortgagesMortgages

• Mortgages are financial instruments that allow people to buy houses when they don’t have the full price.

• Traditionally, people place some portion of the price, say between 5% to 20% down and borrow the rest.

• So if you wanted to by a house for $500,000:– You put up 50, 000– You get a mortgage for 450,000– You make payments to the Bank or Savings and Load on

the 450K. (Plus you pay for ins. And taxes)

Secondary lendersSecondary lenders

• Banks would soon run out of money for mortgages if there was a large demand, which there is in the U.S.– Regular banks accept deposits and lend out that

money and– Lend money for everything from credit cards to home

mortgages.• So, secondary lenders were established to buy the

mortgages in bulk from the Banks to replenish the money in the banks. These packages of loans are called mortgage backed securities.

• Now the banks have more money to relend.

Fannie and FreddieFannie and Freddie

• Two Quasi-government sceondary banks are Fannie Mae and Freddie Mac– They are suppose to have rules about the quality of

the people who make the mortgages that they purchase.

– They buy loans in bulk from the mortgage bankers and regular banks. They hold these loans long-term and collect interest to make their profits. Or turn them into Mortgaged backed securities they sell to investors.

– Fannie and Freddie guarantee their securities making them very safe.

Default and ForeclosureDefault and Foreclosure

• If you stop making payments on your mortgage you are defaulting.

• After three months of non-payment, the bank goes to court and files for Foreclosure.

• They then toss you out of the house, resell it, and hopefully get most of their money back.

FDICFDIC

• If a bank makes too many bad loans and can’t pay back its depositors, the Federal Deposit Insurance Company steps in and takes over the bank and gives depositors it’s money back. (FDIC is asking the government for cash to replenish their cushion)

• Pretty safe system.

Sub Prime MortgagesSub Prime Mortgages

• In about 2000:• To encourage more home ownership, particularly to low

income people, the government reduced regulations on who could make mortgages and the rules for Qualifying for mortgages.

• After All, the more homes that are owned in neighborhoods, the nicer the neighborhoods. Homeowners have an incentive to keep the neighborhood up, mow their lawn, have good schools, watch out for bad guys. It makes their property values go up.

Sub Prme MortgagesSub Prme Mortgages

• Mortgage Bankers, banks, and Savings and Loans began making loans to people who could not afford them:– No money down, financing 100% of the cost.– No Documentation of income: (People were

even encouraged to lie, because mortgage bankers get paid (an incentive) when they make loans, whether they are good or not, nothing if they don’t make loans.).

– These are called Sub-Prime Mortgages

Sub Prime MortgagesSub Prime Mortgages

• These loans were often adjustable rate loans. That means they reset yearly, going up from very low interest rates, called “teaser rates” like 2% to very high ones like 12 or 13 percent. Raising payments by huge amounts over a short period of time.

– ON our $450, 000 mortgage:At 2% $1663 per month

At 13% $4997 Per Month

$3600 Dollars a month difference

• The idea was people could refinance them and pay the sub primes off before they reset or take the money from the refinance and pay the payment for a year..

Sub Prime MarketsSub Prime Markets

• Targeted the poor and minority neighborhoods.

• Black people with incomes exceeding $100k per year were more likely to be placed in sub primes than whites making under $40k.

• Racism or redlining of neighborhoods?

The Bubble Gets BiggerThe Bubble Gets Bigger

• The system worked great, the huge increase demand of the unqualified buyers made the housing market skyrocket.

• Housing prices were going up Fast.

• Remember: in real estate, if the price goes up, it goes up based on the whole price of the house, not just your investment. Our 500 k house, if it goes up by 10%, goes up 50k. Our investment was only 50K, therefore our return on our investment is 100% IN ONE YEAR.

Get Rich QuickGet Rich Quick

• If our 500,000 House goes up (appreciates )10% per year:– I make $50,000 per year. Even if I have to pay the

adjusted mortgage of 5k per month, that’s only 60,000. So I live in the house for $ 800 per mth. Less than rent.

– But at the “teaser rate” I only pay 12k per year, living free and making 38K.

– I can sell and make 38k or refinance with a Prime mortgage.

• Or I buy a few houses and flip them, sell them, and make CASH$$$$$$

ConsumersConsumers

• Who had made normal mortgages saw their house price skyrocket too.

• They refinanced or placed home equity loans on their houses and bought lots of cars and flat screen TVs, everybody was happy.

• And prices climbed and climbed. • Home owners got rich and mortgage

bankers got really rich.

Shadow BanksShadow Banks• Are Wall street banks that invest huge sums of

money from pension funds, insurance companies and even foreign governments, Bear Sterns, Goldman Sachs and Lehman Bros are examples into all sorts of businesses.

• The are lightly regulated.• They wanted to tap the huge mortgage business

and began buying up mortgage packages like Fannie and Freddie did

• But they wanted to turn their money around quick, so they don’t hold their’s

Shadow BanksShadow Banks

• Unli.ke Freddie and Fannie, they don’t guarantee their MBS.

• But hey, the more risk, the more gain.

Securitization.Securitization.

• So the Shadow banks did something called securitization of the Mortgage Backed Security….a little detailed for our purpose but basically…

• Shadow banks did not guarantee their securities.

• People used derivatives to leverage these securities, putting little in, to control large amounts of these mortgage backed securities.

• It meant that shadow banks could turn their cash around quickly, instead of holding mortgages for the life of the mortgage, they sold the securities and reinvested the CASH, making a profit at each turn.

Shadow BanksShadow Banks

• At their height they held 10 Trillion in Assets, compared to 6 Trillion in regular banks.

• These banks are very important to move paper around the world, keeping international money flowing to where it’s needed.

Shadow BanksShadow Banks

• They began to funnel huge sums into the mortgage market, encouraging mortgage bankers to make more loans, so they could get paid and their international partners could get paid.

• The were hungry, so they pressured mortgage bankers to make loans any way they could…..

Shadow BankingShadow Banking

• The Shadow Banks then repackaged those mortgages and sold them to the insurance companies, foreign governments, foreign companies and pensions funds. These packages are called Mortgage Backed Securities.

• The pressure on the mortgage bankers increased to get more mortgages, so they got riskier and riskier borrowers. (Can I get some JAWS music)

Bond Raters rate the quality of Bond Raters rate the quality of bonds so they know how good of bonds so they know how good of

an investment they are.an investment they are.• The are suppose to be independent, but only get business if bond

sellers come to them to get rated. If you rate bonds toughly, they won’t come.

• The friendly bond raters, said the bonds were AAA, dead locks to be repaid, after all, they were based on U.S. Real Estate,

• With Triple AAA ratings, the shadow banks couldn’t sell the Mortgage Back Securities fast enough.

• Securities bankers made millions and millions, Bond raters made millions, mortgage bankers made millions, homeowners made millions, flat screen makers made million.

AIGAIG

• If you were worried about you Mortgaged Back Securities, you could buy insurance in case they failed. For a small premium, AIG would sell you an insurance policy.

• AND get this, EVEN if you didn’t own any Mortgaged Backed Securities, you could bet that they might fail, and buy an insurance policy on Securities you didn’t even own. These were call credit default swaps and they used to be illegal, until deregulation. Basically Vegas, baby.

Regular BanksRegular Banks

• Couldn’t let a good thing go by so.

• They bought small financial money lenders, like the Money Store.

• These weren’t regulated, so they were separate entities owned by the banks, but got their investment capital from Wall Street shadow banks.

• So now they’re in trouble.

The BubbleThe Bubble• Securities bankers made billions and billions• AIG made billions and billion• Bond raters made millions, and maybe billions • Mortgage bankers made millions and millions, • Homeowners made millions, • Flat screen makers made million.• And Prices of houses went up and up as

demand went up and up.

The CrashThe Crash

UNTIL Eventually two things happened:– The adjustable rates reset and people

couldn’t make the payments and sold their houses

– Prices got so high, NO one could afford the houses even with the teaser rates. (of course that was predictable, houses can’t keep going up at that rate, if incomes don’t, duh)

– Demand went down, and when demand goes down…..

Crash and BurnCrash and Burn

• When prices went down, people owed more on their mortgages than the house was now worth.

• Our $500,000 house was now worth $400,000, but remember we owe 450,000 on our mortgage. NO bank will lend us more than the house is worth. So we can’t refinance or sell, without losing a ton of money.

• …so now our payment resets from $1669 to $5000 per month and we can’t afford that!!!!

Moral HazardMoral Hazard: the idea that when : the idea that when you use Other People’s Money, you use Other People’s Money,

you’ll take more risks.you’ll take more risks.

• Sub prime borrowers who had invested none of their money in the houses walked away, mailed the keys in (some trashed the places and stole the appliances)

Supply goes up, demand goes Supply goes up, demand goes down, Prices go way down.down, Prices go way down.

• This increased the supply of houses, coupled with the lack of demand, dropped the houses WAAAY down in price.

• Builders quit building, mortgage bankers left the building, Home Depot laid of employees as did builders, decorators, appliance guys, plumbers etc….

• The now unemployed couldn’t pay for their houses…put them on the market…more supply, less demand, higher prices.

Crash and BurnCrash and Burn

• Remember the housing prices went down for all houses, including people who had made good loans, they couldn’t refinance to pay off their flat screens either.

• Plus they couldn’t sell their houses if they had to move, because they owed more than the house was worth further dropping demand, AND PRICES!

Downward SpiralDownward Spiral

• Now consumers started saving in case of the worst and quit buying, which hurt stores and other businesses.

• Banks didn’t know how many bad loans they had: they quit lending…tightened up credit, so those homeowners who needed to borrow COULDN”T get loans

Crash and BurnCrash and Burn

• So people who worked in the housing business, carpenters, plumbers, real estate agents, brick makers, truck drivers etc…all lost their jobs.

• So they couldn’t buy stuff…so stores laid off employees…. So they couldn’t buy stuff

• And manufacturers laid off employees so they couldn’t buy stuff

• and so on…• Unemployment jumps us to near 10%, 40% in

some places.

Recession!!!Recession!!!

• The Gross Domestic Product: the cumulative amount of all we produce, goods and services.

• It contracted (got smaller) for six straight months, we are now in an official recession, heading for another…

• MAJOR DEPRESSION– 30% unemployment.

Remember the Shadow Banks?Remember the Shadow Banks?

• They were holding all those Mortgaged Backed Securities, as were their clients.

• So was Fannie and Freddie and they had guaranteed their investors they’d pay them back if they securities tanked, and they had.

• The MBS were now worthless, as no one was paying them back.

• Iceland goes under, Lehman Bros goes under, Bear Stearns has to be sold to stay afloat, Merrill Lynch is married to Bank of America, the government bails our Freddie and Fannie.

• No money in the mortgage industry…can’t sell houses without mortgage banks.

Shadow BankingShadow Banking

• Now these banks also lend to business to buy their raw materials and pay employees and stuff, until the business can sell their product.

• The Shadow banks quit lending. Banks freaked out and quit lending. Credit markets froze up…businesses laid off more and more workers trying to keep head above water, making matters worse.

InsuranceInsurance

• The Shadow banks and investors were also insured by a private company AIG.

• AIG did not have enough money to pay off all the policies that they had written, so they were ready to go under, taking with it Trillions of dollars of wealth and the entire world banking system.

• REMEMBER THE Credit Default Swaps, they had to pay them off too.

Too Big to FAILToo Big to FAIL

• If AIG goes under…there is no one to pay off the losers (the bankers and other gamblers with our money) in this whole thing, the whole world’s financial market goes under…

• We become hunter gathers.• The BIG BANKS, SHADOW BANKS and AIG

are said to be TOO BIG TO FAIL.• The Government buys 80% of AIG, infuses

money into other “big banks”

OH yeah, the Stock Market OH yeah, the Stock Market CrashedCrashed

• The stock market is where the ownership and investment in U.S. business is traded every day. It’s health is measured by the Dow Industrial Averages, the Nasdaq and the SandP 500.

• The Dow dropped from about 14000, to about 6000, losing half the wealth of a majority of businesses. And all the retirement income of people who own 401k retirement plans)

The Government to the RescueThe Government to the Rescue

• Now with consumers not spending and banks not lending, something has to be done. The consumer of last resort is the government.

• During the 30s depression, the government responded by raising interest rates and trying to balance the budget, cutting spending, which depressed spending and made matter worse.

Bush and TreasuryBush and Treasury

• Passed the TARP, Trouble Assets Rescue Plan (Those nasty MBS). – Problem was no one knew who owned which

mortgage because they were sliced and diced into so many securities. Much has gone unspent.

• However it did give banks some confidence that the government would do something to save the world.

• Bush leaves office, Obama comes in with Tim Geitner at Treasury and

• Larry Summers: head of economic advisors.

STIMULUS NOWSTIMULUS NOW

• EVERY Sane economist says the government has to stimulate the economy through spending. The deficit be damned!!!

• But first you’ve got to get the banks lending again

The Federal Reserve The Federal Reserve Bank: Bank:

Chairman Ben Bernanke Chairman Ben Bernanke • The independent government bank has

two main jobs:• To control how much money is in the economy by:

– Setting the Prime Interest rate, the rate that banks lend to other banks.

• Basically the lower that rate is the cheaper it is for all of us to borrow money: stimulates the economy.

– Increased inflations, lowers unemployment. • The higher that rate, the higher the cost of borrowing slows the

economy.– Lowers inflation – Increases unemployment.

– Increasing or decreasing the money supply, either adding or subtracting the amount of money in the economy:

• The more money the more stimulation: chance of inflation• The less money the less stimulation: chance of higher unemployment.

The FedThe Fed

• And regulating banks.

• Under Fed Chairman Alan Greenspan, they let the markets regulate themselves.

• They were warned repeatedly by consumer groups that the sub prime market was built on sand.

The FedThe Fed

• Lowers the Prime Rate to 0. the best it can do….banks still won’t lend: Liquidity Trap

• Borrows and Prints money to prop up the banks and pay for new stimulus money.

Obama and CongressObama and Congress

• Passed $900 Billion dollar stimulus package.• It is loaded heavily into the second and third

year, so most is currently unspent.• Cash for Clunkers was part of it.• Gave money to State government, so they didn’t

collapse…although the jury is still out on that…States incomes will lag as unemployment raises, so will their income taxes.– They will have to cut services like roads, welfare,

teacher salaries, college subsidies etc….look out for your college tuition.

Stimulus PackageStimulus Package

• Localities are hurting, they get money from Real Estate taxes, as property values decline, so do those taxes.

• Money goes to states for “shovel ready” projects like building bridges, roads and schools…similar to the WPA during the depression.

• Provided money to help with the bad mortgages. Didn’t work out well

InvestmentInvestment

• Much of the money unspent is for credits “Green Technology” and other pet projects of the Obama team.

• But in general, the economy is growing again, so for now…the stimulus has been a success.

• However, we will have to pay the money back, as it has added to the money the government owes, know as a budget deficit.

• But it the economy grows, we’ll have more money in taxes to pay it back….

Stock MarketStock Market

• Rebounds to 9500, lots of people with money in 401ks breathe a sigh of relief.

A “W” recoveryA “W” recovery

• Refers to a steep drop and then a seeming recovery that is followed by another deep drop….that’s what economists are afraid of this time.

• A Jobless recovery….even though the stock market is going up and the economy is technically growing, people aren’t being rehired at a fast enough rate.

• Without new jobs, whose going to buy stuff?• Buying stuff ends recessions.

Oh YeahOh Yeah

• No one knows where all those pesky Mortgaged Backed Securities and CDOs are, who owes what, who owns which, and what’s going to happen to them all…– And how many more will be bad with the

current housing situation.

Bankers are at it againBankers are at it again

• Some say, the bankers are borrowing the money from the fed at the O interest rates, but not passing on the savings to business and consumers.

• Instead, they are taking the money and buying stocks in businesses, artificially raising stock prices (OH no another bubble!!!)

It won’t be over til it’s overIt won’t be over til it’s over

• You’ll know it’s over when:• Unemployment drops at a consistent rate to a

point of about 5 or 6 percent.• The economy begins to grown at a consistent

rate of 4 or 5 percent per year.• Inflation stays below a couple of percentage

points a year (with all this stimulus, this could be a problem down the road).

• Teachers start getting raises. AND

You’ll know it’s overYou’ll know it’s over

• When we soak up all the foreclosed houses that linger on the market, starting selling new and existing homes.And when consumers start spending like the Russians are in Baltimore (sorry old school reference)….maybe as if “The Taliban is in Baltimore”….

• Be like my wife…Spend us out of the recession….