Anatomy of the Subprime

Crisis

Stephen L. Parente
Econ 509
Outline

Timing of the Crisis

Cause of the Crisis

Reactions to the Crisis- Fed and Treasury
Rescues

Bear Stern and Lehman Brothers

Freddie Mac, Fannie Mae, AIG

Economic Implications of the Crisis
Timing

2001- 2005 Housing Bubble
Housing prices increase by 10% nationally; 25 % per
year in California

Cheaper Credit –
Dot.com bubble bursts in 2001.
Faced with recession - Federal Reserve Lowers the
federal Funds Rate from 6.5% to 1.75 % between
May 2000 and December 2001

Greater Access to Credit Sub-Prime Market –

mortgages to risky individuals. Most had fixed interest
rate first 2-3 years, and then adjustable thereafter.
Timing

Bubble Bursts 2006-
Slowdown in US Economy-
2006 inflation brings 4% interest rate, and
with adjustable rates on mortgages, default
increases.
New Housing continues to increase up until in
2007.
Demand falls, Supply still increasing;
Prices falll
Timing

Bankruptcies - 2007

February – March Subprime Market Collapses
25

April 2, Larges US Subprime Lender New
Century Financial files for Bankruptcy
Timing

US Government Interventions 2007

August 17th , September 18th , Oct 1st Fed
lowers discount rate

New Hope Alliance created by US government
to help some subprime lenders

November 1- Fed injects $41Billion into Money
Supply for banks to Borrow
Timing 2008

March 14- Bear Sterns gets Funding from Fed and
March 16th is acquired by JP Morgan

Sept 7th, Federal Reserve takes over Fannie Mae
and Freddie Mac

September 14- Merrill Lynch sold to Bank of America

September 15th Lehman Bros. files for Bankruptcy

Sept 17- Fed loans AIG $85 Billions

Sept 19. Paulson unveils Financial Rescue Plan
II. Sub-Prime Loans

Subprime mortgage is granted to borrowers
whose credit history is not sufficient to get a
conventional mortgage. Often these
borrowers have impaired or even no credit
history. High Risk!
Subprime Mortgages

Typical mortgage had adjustable interest rate

Often had “introductory offers” (i.e., first two
years close to zero interest.
Subprime Mortgages

Most Issuers of Sub-Prime Mortgages sold
the mortgages to financial institutions (private
and semi-public).

Higher rates or return.

Bought by banks, traders, hedge funds,
school boards, town all over the world

As long as house prices increase, default by
single individual is not problematic as
financial institution can sell house for a higher
amount than mortgage amount.
Subprime Lending

In 2006, with steep rise in default on
subprime mortgages,

Investments were nearly worthless

Difficulty of financial institutions to raise new
capital/borrow- assets were almost worthless,
or hard to assess actual value

Risk of bank runs-
Subprime Lending

Mortgage companies sold blocks of these
subprime loans to Fannie Mae, Freddie Mac,
private banks in the form of Collateralized
debt obligations.

Because mortgages were bought by
responsible banks, risk agencies gave the
CDOs high ratings.
Federal Reserve and Treasury

Rescues of Bear Sterns, Freddie Mac, Fannie
Mae, AIG

Lets Lehman Brothers fail (Largest
Bankruptcy $600 Billion in Assets, 25,000
employees)
Fed and Treasury Actions

Fannie Mae and Freddie Mac

Support housing markets- guarantee
mortgages, issue own bonds (which were
implicitly backed by US government.)

Government guarantee allows FM and FC to
borrow at lower rates.
Freddie Mac and Fannie Mae

Fannie Mae chartered in 1938 by Federal
Housing Administration – codify the national
commitment to housing and address the
inability of unwillingness of private lenders to
ensure a reliable supply of mortgage credit.

Primary role was to purchase, hold or sell
FHA –insured mortgage loans originated by
private lenders
Fannie Mae and Freddie Mac

1954 Charter – Federal government still had direct
controlled by stipulated how secondary market
operations would be transformed to private sector.

1968 Charter – split into Fannie Mae and Ginnie
Mae. GM was to remain a federal agency, FM was a
government sponsored private corporation.
Regulatory framework overseen by Department of
Housing and Urban development

FM authorized to issue Mortgage Backed securities.
Fannie Mae and Freddie Mac

1970 Emergency Home Finance Act created
Freddie Mac

Remove monopoly power of Fannie Mae in
secondary market

1984 Secondary Mortgage Market
Enhancement Act updated Department of
Housing and Urban Development oversight
Fannie Mae and Freddie Mac

1989 Financial Institutions Reform Act

1992 Federal Enterprises Financial Safety
and Soundness Act - Office of Federal
Housing Enterprise Oversight oversee Fannie
Mae and Freddie Mac independent of HUD.

More importantly, it established HUD
imposed housing goals for affordable
housing. - certain percentage of FM holdings
had to be in low and moderate
income,underserved, and special affordable.
Fannie Mae and Freddie Mac

1977 Community Reinvestment Act – each
government authority use it supervising
authority to get banks to lend to poor, local
communities.

Say if bank wanted to open up a new branch,
merge, then CRA could be used as a criterio
for approval.
Fannie Mae and Freddie Mac

CRA was too vague.

Federal Housing Enterprise Financial Safety
and Soundness Act of 1992 to address
problems.
Fannie Mae and Freddie Mac

Consequences of 1992 Act

Before 1992, if lending institution wrote a
subprime loan, it had to bear the risk since it
didn’t meet guidelines of FM.

With 1992 Act, they could sell them to FMs.

Lending companies could make money on
commissions, and pass off risk to FM

After 1992, subprime market exploded.
Fannie Mae and Freddie Mac

Attempt in 2003, to change regulation of FM
to treasury Department

Bill was defeated in Congress.

2004 Office of Federal Housing Enterprise
Oversight imposed greater capital
requirements

Opened up the market to private banks – they
created their own Freddie Macs and Fannie
Maes Structured Investment Vehicles and
Collaterized Debt Obligations
Freddie Mac and Fannie Mae

Strayed from core mission by buying
mortgages that were below standards.

Did not have enough capital to pay off bonds
it issued.

Massive amount of debt held - repercussion
in the world financial sector.

Treasury agrees to guarantee debt (and wipe
out shareholders if it does).

No investor wants to lend more to FM an FM.

Taken over by Treasury
Other Regulation Blunders 2004

SEC allows Investment Banks to have higher
leverage rate if they (15 to 1 debt/equity ratio
to 40 to 1 if they agreed to voluntary oversight

BASIL II accord on international bank
regulation opened an arbitrage opportunity
Other Regulation Blunders 2004

The business activities of a savings association that
generally do not involve booking assets (loans) and
taking deposits. Off-balance sheet activities normally
generate fees, but produce liabilities or assets that
are deferred or contingent and thus, under GAAP, do
not appear on the institution's balance sheet until or
unless they become actual assets or liabilities with a
value or cost that can be determined. Examples
include guarantees substituting the institution's own
credit for a third party such as in standby letters of
credit; interest rate swaps; foreign exchange forward
options; repurchase agreements; loan commitments;
and recourse associated with sales of assets.
Lehmans

Bad investments in real estates.

Rolling over $100 billion a month to finance
its investments and assets.

Short-lending to Lehman, but assets were
long maturity.

People/institutions stopped lending when they
realized how large the loss in real estate
portfolio. Also, lower credit rating that
prevented certain parties from lending to it.
American Insurance

Had to raise money because it had written
$57billion in insurance contracts whose
payouts depended on loss in real-estate
related investments. (Credit Default Swaps)

Lower credit ratings meant that needed to
raise collateral. ($15 billion). Without
collateral, it would be considered to have
defaulted on the CDS. S.

$160 Billion in bonds issued through the
world.
American Insurance Guarantee

No one willing to lend the new collateral.

Other large financial institutions had
guaranteed AIG’s bonds.

Fed Loans $85 billion.

Fed has the option of buying up to 80% of
AIG’s shares; is replacing its management; is
nearly wiping out all of its shareholders;
assets will be sold over next few years
(Manchester United).
Bear Sterns

Bear Sterns was similar to Lehman but saved.

Fed had imperfect information.

Occurred earlier on, and counterparties were not
prepared for demise of BS- ripple effect.

Also, Fed had modified its lending facility so that it
could prevent runs on banks affected by a
bankruptcy.

Fed had announced that the Bear Intervention was
essentially a one time event.

Warning to other banks
Cash for Trash

Treasury Secretary Paulson proposes to create $700
Billion fund to buy troubled assets

Congress wants to amend it so that government gets
some shares in company that sells bad debt to US
government.

Paul Krugman favors this ammendment. The
financial sector desperately needs new capital/funds.
If you give funds, you should get a share of
ownership. Also, this prevents the people who mad
the mess getting super rich from it.
Federal Reserve Monetary Policy

Federal Funds Rate is close to zero

Provide short term credit- commercial paper.
To do this, it first sold off Treasury Bills. Then
it had treasury issue new bonds to effectively
pay for this.

Start paying interest equal to federal funds
rate on bank excess reserves
Monetary Policy

Expansion of Fed’s Balance Sheet ($880
Billion in July 2007 to 1.9 Trillion Feb 2009,
and now $2.1 Trillion)

1. discount window lending

2. Central Bank Liquidity Swaps

3. Liquidity Facilities

A. Commercial Paper Funding Facility

B. Asset Backed Commercial Paper Money
Market

C. Term Asset Backed Securities Loan System

D. Mortgage and Agency Securities Lending
Implications

Lack of confidence means people less likely
to put their savings in banks.

Less funding in banks, means harder to
obtain credit/loans for both households and
consumers.

Less investment and slower growth in the
future.
Troubled Asset Relief Program

Allow US Treasury to buy up to $700 Billion in
troubled assets – primarily mortgages and
Collaterized Debt Obligations

Original plan was for treasury to buy
assetsand then sell them

On October 14, 2008 revised plan to buy
preferred stock- payed a fixed dividend at 5.1
perdent and then higher if not bought bak in
2 years
TARP

In December 2009, George Bush extends
use of TARP funds for any use that would
help avert the financial Crises (automotive
industry)

February 2009, Congress sets restictions on
executive bonuses of firms that receive TARP
Money

March 23, 2009 Newly appointed Treasury
Secretary Geitner outlines Private Public
Invesmtment Progroam P-PIP
TARP

P-PIP

Legacy Loans Program- buy residential loans
from Banksre

FDIC provides loan guaranteees up to 85
percent of the

Legacy Securiies programs – buy mortgage
backed securities (RMB) originally rated AAA
The Process for Purchasing Assets

Banks Identify the Assets They Wish to Sell:

To start the process, banks will decide which assets
– usually a pool of loans – they would like to sell.
The FDIC will conduct an analysis to determine the
amount of funding it is willing to guarantee. Leverage
will not exceed a 6-to-1 debt-to-equity ratio.
Assets eligible for purchase will be determined by the
participating banks, their primary regulators, the FDIC
and Treasury. Financial institutions of all sizes will be
eligible to sell assets.
PPIP

Pools Are Auctioned Off to the Highest Bidder:
The FDIC will conduct an auction for these pools of loans. The
highest bidder will have access to the Public-Private Investment
Program to fund 50 percent of the equity requirement of their
purchase.

Financing Is Provided Through FDIC Guarantee:
If the seller accepts the purchase price, the buyer would
receive financing by issuing debt guaranteed by the FDIC.
The FDIC-guaranteed debt would be collateralized by the
purchased assets and the FDIC would receive a fee in return
for its guarantee.
PPIP

Private Sector Partners Manage the Assets:
Once the assets have been sold, private fund
managers will control and manage the assets
until final liquidation, subject to strict FDIC
oversight.
PPIP – Sample Investment

Step 1: If a bank has a pool of residential mortgages with $100 face
value that it is seeking to divest, the bank would approach the FDIC.
Step 2: The FDIC would determine, according to the above process,
that they would be willing to leverage the pool at a 6-to-1 debt-to-equity
ratio.
Step 3: The pool would then be auctioned by the FDIC, with several
private sector bidders submitting bids. The highest bid from the private
sector – in this example, $84 – would be the winner and would form a
Public-Private Investment Fund to purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees
for $72 of financing, leaving $12 of equity.
Step 5: The Treasury would then provide 50% of the equity funding
required on a side-by-side basis with the investor. In this example,
Treasury would invest approximately $6, with the private investor
contributing $6.
Step 6: The private investor would then manage the servicing of the
asset pool and the timing of its disposition on an ongoing basis – using
asset managers approved and subject to oversight by the FDIC.
Regulation of Financial Sector

Glass-Steagall Act is repealled in 1999

Glass-Steagall Act of 1933 – separation of
banks between commercial and investment
banks.

Commercial banks- take in deposits and lend
to businesses.

An investment bank is a financial institution that
assists corporations and governments in raising
capital by underwriting and acting as the agent in the
issuance of securities. An investment bank also
assists companies involved in mergers and
acquisitions, divestitures, etc. Further it provides
ancillary services such as market making and the
trading of derivatives, fixed income instruments,
foreign exchange, commodity, and equity securities.

Unlike commercial banks and retail banks,
investment banks do not take deposits.
Financial Sector Reform

Gives government more authority to monitor
banking industry

Decrease debt to equity ratio- akin to making
you put down a bigger down payment when
you buy a house

Government can seize a failing firm, run it for
a period, and sell of its pieces

Regulations on derivatives