The Subprime Financial Crisis

© 2004 Sand Hill Econometrics. All rights reserved.

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The Subprime Financial Crisis

Roots of the Crisis

Susan Woodward, Sand Hill Econometrics


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Prelude

1980 – change in Usury laws Depository Institutions Deregulatory and Monetary Control Act

1990 to 1996 – introduction of credit scores

1998 – clearing-house for derivatives killed by bi-partisan leaders (clearing-house would know gross and net exposure of buyers & sellers)

2004 – SEC eliminated capital rules for investment banks

Average ibank ratios of capital to assets:

before 2004: 1 to 12

after 2004: 1 to 33


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Real Residential Construction, 1968-2008

Residential Construction, 1968-2008

0

500

1,000

1,500

2,000

2,500

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Year


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Residential Construction

Has always been volatile.

Is very sensitive to the level of nominal interest rates – when rates rise, construction contracts

Construction is such a large sector that when it contracts, it can create a recession all by itself

Has had a major role in most recessions (obvious in the chart), but not in 2001

As of 2008q3, more than all of the shortfall in GDP was accounted for by the decline in residential construction (roughly $350bn)


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Mortgage Interest Rates, 1987-2009 by 2003, the big refi boom was over


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Housing market experience, 1990-2003

1990-2004: high LTV loans to borrowers with good credit had low default rates

50 years (maybe more) of rising dollar house prices

20 years of low, 2-3%, and mean-reverting inflation,

20 years of (mostly) declining mortgage interest rates

A recession in 2001 with virtually no housing component

Lower volatility everywhere: stock market, the bond market, business income, residential construction, real activity, personal income, and more…

By 2003, when 30-year fixed mortgage rates reached 5.25%, the mortgage refi boom had to end, and new lending either had to contract a lot, or lenders had to think of something new to do.


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Mortgage Originations, 2001-2007, $ trillions

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

2001 2002 2003 2004 2005 2006 2007

subprime

prime


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Note that 2003

Was the last year of the refi boom. The decline in originations would have been even bigger in 2004 if lenders had not begun chasing subprime borrowers aggressively. In 2006, subprime loans were nearly 40% of all originations.


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Little signs that all was not well…


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Vacancies

The vacancy data are very telling. Note that we have quite a long history for this series– back to 1956. In the fourth quarter of 2005, the vacancy rate for owner-occupied homes reached 2% for the first time since we began keeping track of vacancies.

These vacancy rates are for owner-occupied dwellings. Vacancy rates for rentals are much higher (5-8%) and also more volatile.


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Who had a problem?

Many investment banks were big holders bad pieces of subprime loans and became insolvent. All lenders stopped trusting them.

Some large commercial banks were big holders of subprime loans, and close to insolvent. Other banks stopped trusting them.

Sellers of insurance (AIG) (especially insurance not regulated as insurance, such as credit default swaps) to subprime lenders and investors were under-capitalized and close to insolvent, lenders stopped trusting them, too.

Some households defaulted on their loans.

Some households felt poorer because the value of their houses and portfolios were down, so they spent less.


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Crisis was mainly a Large Bank crisis


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Was the financial crisis the precipitating event of the recession?

No – it was the crash in house prices. Residential construction – just under 5% of GDP. If it falls 40%, that’s a recession.

As of 2008q3, more than all of the shortfall in GDP was accounted for by residential construction. Q4 shortfall in GDP is broader.

Credit spreads always widen in recessions, bank crisis or not.

But the bank crisis cannot have made things better. It could have made things much worse if the Fed had not moved to shore up bank capital.


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Stuff done right

Inject capital into banks

increased inter-bank trust

interbank lending resumed


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Stuff not done right

Initial Focus on auctioning (pricing) assets

Allowing markets to suspect Fannie and Freddie were without federal backing

F&F borrowing rates were 140 basis points> treasuries

No fiscal stimulus put in place in 2008


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What can we do now?

Short-run: Fiscal Stimulus --

expected GDP shortfall $900 bn in 2009

tax cuts or rebates

investment tax credit

public works

subsidy (or tax relief) to employers

negative (or zero, with Federal govt paying states) sales tax

inflate


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Tax cuts or rebates

Tried in 2008

- no detectable impact

- consistent with theory (people smooth consumption over time, if they can)

- consistent with other studies of windfalls


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Investment Tax Credit

PRO

Experience suggests it does move investment forward in time

CON

Money goes mainly to manufacturers of capital goods and to skilled labor


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Public works

PRO

Large body of research suggests multiplier lies between 1 and 1.5 (for each $1 spent, GDP rises by $1 to $1.50)

CON

Impact cannot be as quick as sales tax cuts or employment subsidies

Benefits go mainly to contractors and skilled labor

Government is generally not too good at choosing construction projects. Let the States do it.


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Subsidies to Employers

PRO

impact is directly on employment

can be done quickly

numbers are big: Businesses pay $500 bn/yr in payroll (social security) taxes

CON

Money goes to businesses directly, not households

Impact on GDP is much disputed, multiplier could be well under 1.0, suggesting disproportionate benefits to business owners and a net cost to taxpayers


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Negative -- or zero -- Sales Tax

PRO

Evidence says it will raise GDP

Can be done quickly (all but 5 states have a sales tax)

Numbers are big – about $400 bn per year

CON

Political bonus points are smaller because beneficiaries are so diffuse

Works best if it is a surprise


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Inflate

PRO

Higher inflation does stimulate real activity

CON

It takes about 1.5 years for the impact to be complete

Inflation above 4% would ruin our reputation for a national commitment to low and stable inflation, a reputation we have spent 20 years building.


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The short evaluation …

Timid

– GDP shortfall is forecast to be more than $900 bn in 2009.

– only $200 bn of the stimulus is to be spent in 2009

Inappropriate

– most of the money is spent in 2010 rather than 2009

– money is spent on public works, much of which is pork, instead of by people


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The Details

2009 2010 2011

Increased outlays by federal agencies34.8 110.7 76.3

Grants to individuals and state-local governments85.3 108.6 49.9

Tax cuts64.8 180.1 8.2

Total184.9 399.4 134.4

Stimulus, billions of dollars, by fiscal year (October to September), figures from CBO


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After another several months of bad employment figures, they will be back for more…


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How bad do things look now?


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What would be a more direct stimulus?

1. Federal govt pays state sales taxes, 100% for the first quarter, 2/3 next quarter, 1/3 the next, then done. ($400 bn per year, only 6 states without a sales tax)

2. Increase level and duration of unemployment benefits

3. Investment tax credit to businesses

4. Pay employees’ part of payroll (social security) tax ($450 bn), perhaps also employers’ part


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What about banks?

Good bank/Bad bank proposals

most proposals suggesting separating floundering institutions into two entirely separate entities. Put assets of questionable value and all long-term debt into the “bad” bank.

Two problems:

1. The bad bank will almost surely be insolvent

2. The debt-holders would unquestionably be worse off, because they would see a smaller pool of assets from which to recover.


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Another idea…

Make the good bank an asset of the bad bank.

Debtholders still can recover from the total pool of assets


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Example: Citi Citi now Good bank Bad bank

Assets

Loans 1,935 1,325 610

Equity in other bank - - 427

Total assets 1,935 1,325 1,037

Liabilities

Deposits 780 780 -

Bonds 1,144 118 1,026

Equity 11 427 11

Capital ratio 0.5% 32.2% 1.0%


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What’s the point?

Change incentives – low risk v. high risk lending

Make the next steps for reorganization clear

Reassure depositors (including foreign deposits) that the good bank is solvent so that they don’t run

PROBLEMS

Still a blow to the long-term debt-holders (are they pension plans and insurance companies?) though not as large as other good/bad bank plans

Ambiguity of standing of long-term debt-holders and foreign deposits

Provides little guidance regarding entities like AIG


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What next?Short-term

another stimulus bill, more targeted at consumption and employment

Longer-term

less levered financial institution, especially depositories, likely ibanks also, if there are any

some arrangement for keeping track of CDS

re-thinking of retirement schemes (British usage)

limitations on activities of insured depositories, both active (subprime lending) and passive (purchase of CDS on assets held)

Regulate everything that is insurance (like CDS) as insurance, with capital requirements

Documents

The Subprime Financial Crisis