Leverage and Risk of Financial Institutions

Transcription

1 Leverage and Risk of Financial Institutions James R. Barth Auburn University and Milken Institute Conference on Procyclicality in the Financial System Amsterdam, Netherlands February 9-10,

2 Any real estate investment is a good investment 2

3 Any real estate investment is a good investment Really?! 3

4 Dow Jones U.S. Financial Index Feburary March 2007: More than 25 subprime lenders declare bankruptcy. Dec. 2006: Ownit Mortgage, a subprime lender, files for bankruptcy. Feb. 2007: HSBC sets aside $10.6 billion for bad loans, including subprime. Subprime mortgage meltdown timeline December 2006 October 2008 Aug. 6, 2007: American Home Mortgage files for bankruptcy. Apr. 2007: New Century, a mortgage broker, files for bankruptcy. July 31, 2007: Two Bear Stearns hedge funds file for bankruptcy. Sept. 30, 2007: NetBank goes bankrupt. Aug. 16, 2007: Countrywide gets emergency loan of $11 billion from a group of banks. Oct. 24, 2007: Merrill announces $7.9 billion in subprime writedowns, surpassing Citi s $6.5 billion. 12/ / / / / / / / / / / /2008 Sources: BusinessWeek, S&P, Global Insight, Milken Institute. Dec. 12, 2007: Fed introduces Term Auction Facility. Jan. 11, 2008: Bank of America agrees to buy Countrywide. Jan. 30, 2008: Fed cuts discount rate to 3.5%. Mar. 11, 2008: Fed offers troubled banks as much as $200 billion in loans; Fed introduces Term Securities Lending Facility. Aug. 17, 2007: Fed cuts discount rate Feb. 13, 2008: to 5.75%; Fed introduces President Bush Term Discount Window introduces tax rebate Program. stimulus program of $168 billion. Mar. 16, 2008: JP Morgan Chase offers to buy Bear Stearns; Fed introduces Primary Dealer Credit Facility. June 9, 2008: Lehman announces a $2.8 billion loss. July 11, 2008: IndyMac is seized by FDIC. July 30, 2008: President Bush signs a housing rescue law. Mar. 18, 2008: Fed cuts discount rate to 2.5%; Fed funds rate to 2.25%. April. 30, 2008: Fed cuts discount rate to 2.25%; Fed funds rate to 2%. Aug. 1, 2008: First Priority Bank closes. Sept. 29, 2008: Citigroup agrees to buy W achovia. Sept. 23, 2008: Washington Mutual is seized by FDIC. Sept. 16, 2008: Fed loans AIG $85 billion. Oct. 8, 2008: Fed cuts discount rate to 1.75%; Fed funds rate to 1.5%. Oct. 3, 2008: President Bush signs Emergency Economic Stabilization Act, authorizing bailout of $700 billion. Also, Citigroup sues after Wachovia agrees tie-up with Wells Fargo. Sept. 7, 2008: U.S. seizes Fannie Mae Sept. 14, 2008: and Freddie Mac. Lehman files for bankruptcy. Oct. 12, 2008: Finance leaders endorse G7 plan to calm markets. Oct. 27, 2008: Down Jones U.S. Financial Index=230 Oct. 31, 2008: Dow Jones U.S. Financial Index=269 4

5 Overview 5

6 Home mortgages: Who borrows, how much has been borrowed, and who funds them? Total value of housing stock = $19.3 trillion Mortgage debt $10.6 trillion Equity in housing stock $8.7 trillion Subprime 8.4% Securitized 58% Prime 91.6% Non-securitized 42% Governmentcontrolled 46% Private sectorcontrolled 54% Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $700 billion Sources: Federal Reserve, Milken Institute. 6

7 The mortgage problem in perspective 80 million houses 27 million are paid off 53 million have mortgages 48 million are paying on time 5 million are behind (10% of 53 million with 3% in foreclosure) This compares to 50% seriously delinquent in the 1930s. Sources: U.S. Treasury, Milken Institute. 7

8 I. Low interest rates and a lending boom 8

9 Did the Fed lower interest rates too much and for too long? Percent Federal funds rate vs. rates on FRMs and ARMs Record low from June 25, 2003 to June 30, 2004: 1% 30-year FRM rate 1-year ARM rate Target federal funds rate January 30, year FRM rate: 5.1% 1-year ARM rate: 4.9% Apr. 30, 2008: 2% Oct. 8, 2008: 1.5% Oct. 29, 2008: 1% Dec. 16, 2008: % Sources: Federal Reserve, Mortgage Bankers Association, Moody s Economy.com, Milken Institute. 9

10 US$ trillions 4.0 Low interest rates and credit boom Percent 6.0 Home price bubble and credit boom US$ trillions Index, January 2000 = Year ARM mortgage rate (right axis) Home mortgage originations (left axis) Q Note: Data for Q1-Q are annualized. Sources: Inside Mortgage Finance, Mortgage Bankers Association, Moody s Economy.com, S&P/Case-Shiller, Milken Institute S&P/Case-Shiller National Home Price Index (right axis) Home mortgage originations (left axis) Q

11 II. Homeownership, prices, starts and sales take off 11

12 Credit boom pushes homeownership rate to historic high Home price bubble peaks in 2006 California and national home prices reach record highs Percent Q2 2004: 69.2% Q4 2008: 67.5% Average, 1965 Q4 2008: 65.2% Index, January 1987 = S&P/ 330 Case-Shiller National Hom e 280 Price Index OFHEO Hom e Price Inde x US$ thousands California m edian home price California average $230,599 U.S. m e dian hom e price U.S. average, : $121, Sources: U.S. Census Bureau, OFHEO, Moody s Economy.com, S&P/Case-Shiller, California Association of Realtors, Milken Institute. 12

13 Housing starts hit a record in 2005 Housing units, millions January 2006: 1.8 m illion 3 Homes for sale Millions 4 Existing homes for sale (left axis) Millions Millions 7.0 Existing home sales (left axis) Homes sales reach a new high Millions Average starts, 1959 Oct. 2008: 1.1 m illion Oct. 2008: 536, New homes for sale (right axis) New home sales (right axis) Sources: U.S. Census Bureau, OFHEO, Moody s Economy.com, Milken Institute. 13

14 III. Subprime borrowers and subprime mortgages 14

15 Who is a subprime borrower? National FICO scores display wide distribution Percentage of population 40 Prime = 79% What goes into a FICO score? Types of credit in use Subprime = 21% New credit 10% Length of credit history 15% 10% Payment history 35% 0 up to Amounts owed 30% Sources: myfico.com, Milken Institute. 15

16 Subprime Prime Percent of total originations Prime and subprime mortgage originations by FICO score reveal substantial overlaps FICO below 620 Prime: 6.6% Subprime: 45.2% FICO above 620 Prime: 93.4% Subprime: 54.8% FICO score Sources: LoanPerformance, Milken Institute.

17 ARMs look attractive to many borrowers Percent year FRM rate January 30, year FRM rate: 5.1% 1-year ARM rate: 4.9% year ARM rate Sources: Mortgage Bankers Association, Moody s Economy.com, Milken Institute. 17

18 ARM share grows, following low interest rates Percent of all outstanding home mortgages Sources: Mortgage Bankers Association, Moody s Economy.com, Milken Institute. 18

19 Largest share of ARMs go to subprime borrowers Percent of mortgage type 60 FHA ARM Prime ARM Subprime ARM Sources: Mortgage Bankers Association, Moody s Economy.com, Milken Institute. 19

20 US$ trillions Subprime's share: 7.8% Subprimes take an increasing share of all home mortgage originations 7.4% 8.4% 18.2% 21.3% 20.1% 7.9% Subprime Prime 1.3% Q1-Q Sources: Inside Mortgage Finance, Milken Institute. 20

21 Subprime mortgages increase rapidly before big decline US$ billions Originations US$ billions 1,400 1,200 1,000 Outstandings Average annual growth rates : 14% 1,200 1, Q1 2008: -23% Q2 H Sources: Inside Mortgage Finance, Milken Institute Q

22 IV. Mortgage product innovation 22

23 Subprime and Alt-A shares quadruple between 2001 and 2006, then fall in % 20% 2001, $2.2 trillion 2% 5% 7.9% 57.1% 13% 2006, $3.0 trillion 14% 2.7% 33.2% 20% 16% 11% FHA & VA Conventional, conforming prime Jumbo prime 8% 2007, $2.4 trillion 14% 14% 4.9% 47.3% Q1 2008, $480 billion 4% 9% 2% 8% p Subprime Alt-A Home equity loans 9.6% 67.2% Sources: Inside Mortgage Finance, Milken Institute. 23

24 ARM hybrids dominate subprime originations (2006) Prime conventional Alt-A Subprime Other ARM 7% ARM hybrids 23% Fixed 70% Other ARM 23% Fixed 31% Fixed 9% 30-year ARM balloon with 40- to 50-year amortization 26% ARM hybrids 46% Other ARM 4% 2- and 3-year hybrids 61% Sources: Freddie Mac, Milken Institute. 24

25 V. Securitization 25

26 The mortgage model switches from originate-to-hold to originate-to-distribute Residential mortgage loans 1980: Total = $958 billion Residential mortgage loans Q3 2008: Total = $11.3 trillion Securitized 15.6% Held in portfolio 41% Held in portfolio 84.4% Securitized 59% Sources: Federal Reserve, Milken Institute. 26

27 Securitization becomes the dominant funding source for subprime mortgages Percent of all subprime mortgages securitized since Q Q Sources: Inside Mortgage Finance, Milken Institute. 27

28 The rise and fall of private-label securitizers New securities issuance 21% 2% 42% 20% 13% 56% 4% 18% 5% 19% 1985 Total = $110B 2001 Total = $1.4T 2006 Total = $2.0T Q1 Q Total = $1.0T 35% 38% 29% 22% 45% 31% Ginnie Mae Freddie Mac Fannie Mae Private-label Sources: Inside Mortgage Finance, Milken Institute. 28

29 The rise and fall of private-label securitizers Outstanding securities 13% 6% 55% 14% 18% 35% 7% 25% 30% 7% 26% 1985 Total = $390B 2001 Total = $3.3T 2006 Total = $5.9T First half 2008 Total = $6.8T 26% 39% 29% 33% 37% Ginnie Mae Freddie Mac Fannie Mae Private-label Sources: Inside Mortgage Finance, Milken Institute. 29

30 US$ billions 3,000 Mortgage-backed securities issued by issuer 2,500 2,000 1,500 Private label Ginnie Mae Freddie Mac Fannie Mae 1, Sources: Inside Mortgage Finance, Milken Institute. Note: 2008 data are annualized. 30

31 VI. Affordability 31

32 Ratio of home price to household income surges Debt-to-income ratio of households has increased rapidly Home mortgage share of household debts reaches a new high in 2007 Median home price/ median household income : 4.69 Home mortgage debt/disposable personal income 150 Q4 2007: 139.5% Percent 75 Q2 2007: 73.7% Q2 2008: 73.4% : Average, : 79.7% Average, : Average, : 64.2% Sources: U.S. Census Bureau, OFHEO, Federal Reserve, Moody s Economy.com, Milken Institute. 32

33 VII. Collapse 33

34 The recent run-up of home prices was extraordinary Index, 2000 = Annualized growth rate of nominal home index, 1890 June 2008: 3.3% World War I Great Depression World War II 1970 s boom 1980 s boom Current boom Long-term trend line Sources: Robert Shiller, Milken Institute. 34

35 Home prices don t go up forever Change in home prices in 100-plus years Percentage change in nominal home price, year ago 30 World Great World 25 War I Depression War II 1970 s Boom 1980 s Boom Current Boom Average, 1890 June 2008: 3.6% /- one standard deviation Sources: Robert Shiller, Milken Institute. 35

36 2005: The collapse begins Home price indices, percent change on a year earlier 25 S&P/Case-Shiller 10-city 20 S&P/Case-Shiller national OFHEO Sources: S&P/Case-Shiller, OFHEO, Moody s Economy.com, Milken Institute. 36

37 Forty-six states had falling prices in the fourth quarter 2007 United States: - 9.3% (fourth-quarter annualized growth) Source: Freddie Mac. 37

38 One year ago If you bought your house Five years ago % change in price, August % change in price, August Sources: S&P/Case-Shiller, Milken Institute Dallas Charlotte Boston Denver Cleveland New York Portland Atlanta Seattle Chicago Minneapolis Washington Composite-20 Detroit Composite-10 Tampa San Diego Los Angeles San Francisco Miami Las Vegas Phoenix Seattle Portland Tampa New York Washington Charlotte Miami Phoenix Los Angeles Composite-10 Las Vegas Composite-20 Chicago Dallas Atlanta Boston Denver San Francisco San Diego Minneapolis Cleveland Detroit 38

39 Housing starts sharply decline Percent change, year ago Sept. 2008: -41.2% Oct. 2008: -39.4% Homes sit longer on the market Number of months that hom e s sit on the m a rke t 12 Existing homes New homes as home appreciation slows Percent Percentage change from 20 year ago in median home sales price (left axis) 10 Number of months homes stay on market (right axis) Months Note: Shaded area represents fluctuation within one standard deviation from mean (1.15%) Sources: Mortgage Bankers Association, OFHEO, Moody s Economy.com, Milken Institute. 39

40 VIII. Delinquencies and foreclosures 40

41 2,150 1,900 1,650 1,400 1, Q Q Foreclosures are nothing new, but Thousands of foreclosures per year Average 661,362 annual foreclosures from Q to Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Sources: Mortgage Bankers Association, Milken Institute.

42 Thousands of foreclosures per year 2,400 their numbers have doubled 2,150 1,900 Average 1,412,656 annual forclosures from Q to Q ,650 1,400 1,150 Average 661,362 annual foreclosures from Q to Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Sources: Mortgage Bankers Association, Milken Institute. 42

43 Subprime mortgages accounted for half or more of foreclosures since 2006 Number of home mortgage loan foreclosures started (annualized rate in thousands) 2,500 2,000 1,500 Subprime FHA and VA Prime (includes Alt-A) Q Subprime: 12% of loans serviced 1, Q Q Q Q Q Q Q Q Q Q Q Q Sources: Mortgage Bankers Association, Milken Institute. 43

44 Subprime ARMs have the worst default record Home mortgage loans delinquent or in foreclosure (percent of number) 40 Q3 2008, Subprime ARM: 35.3% 35 Subprime FRM: 13.5% 30 FHA and VA: 6.3% Prime: 3.5% Q Q Q Q Q Q Q Q Q Q Q Q Q Q Sources: Mortgage Bankers Association, Milken Institute. 44

45 Percentage of homes purchased between Q and Q that now have negative equity United States = 44.8% < 20% >= 20% and < 35% >= 35% and < 50% >= 50% Sources: Zillow.com, Milken Institute. 45

46 Percentage of homes sold for a loss (Q2 2008) United States = 32.7% < 15% >= 15% and < 30% >= 30% and < 45% >= 45% Sources: Zillow.com, Milken Institute. 46

47 Percentage of homes sold that were in foreclosure (Q2 2008) United States = 18.6% Sources: Zillow.com, Milken Institute. < 1% >= 1% and < 25% >= 25% and < 40% >= 40% 47

48 IX. Damages scorecard 48

49 US$ billions Losses/write-downs, capital raised, and jobs cut by financial institutions worldwide Prior quarters Capital raised (left axis) Losses/write-downs (left axis) Jobs cut (right axis) Number of jobs cut (thousands) 120 Q Q Q Q Q Q Through Feb. 4, Sources: Bloomberg, Milken Institute. 49

50 US$ billions 1,200 1,000 What is the cumulative damage? Cumulative losses/write-downs, capital raised, and jobs cut by financial institutions worldwide Jobs cut (right axis) February 4, 2009: thousand Number of jobs cut 300, , Capital raised (left axis) February 4, 2009: $969.2 billion Losses/write-downs (left axis) February 4, 2009: $ billion 200, , ,000 50,000 0 Prior quarters Sources: Bloomberg, Milken Institute. Q Q Q Q Q Q Through Feb. 4,

51 Recent losses/write-downs and capital raised by selected financial institutions US$ billions, through February 4, 2009 Losses /write-downs Capital raised Wachovia, United States Citigroup, United States AIG, United States Freddie Mac, United States Fannie Mae, United States Merrill Lynch, United States UBS, Switzerland Washington Mutual, United States Bank of America, United States HSBC, United Kingdom Others Grand total (US$ billions) 1, Sources: Bloomberg, Milken Institute. 51

52 Worldwide capital raised by source July 2007 July 2008 July 2007 December 2007 Total = $56 billion January 2008 July 2008 Total = $300 billion Other institutional investors 28% Other institutional investors 24% Sovereign wealth funds 7% Public investors 12% Sovereign wealth funds 60% Public investors 69% Source: International Monetary Fund. 52

53 Financial stock prices take big hits Percentage change in stock price, December 2006 January Note: Bear Stearns stock price is to May Countrywide stock price is to June Merrill Lynch stock price is to December Wachovia stock price is to December Sources: Bloomberg, Milken Institute. Lehman Brothers Washington mutual Freddie Mac Fannie Mae AIG Bear Stearns Wachovia Countrywide Bank of America Merrill Lynch UBS Equity Morgan Stanley Goldman Sachs JP Morgan & Chase W ells Fargo 53

54 Financial market capitalization takes big hit Total loss in market value: $1,094 billion, December 2006 January US$ billions Note: Bear Stearns stock price is to May Countrywide stock price is to June Merrill Lynch stock price is to December Wachovia stock price is to December Sources: Bloomberg, Milken Institute Bank of America AIG UBS Equity Wachovia JP Morgan & Chase Merrill Lynch Morgan Stanley Fannie Mae Goldman Sachs Freddie Mac Washington mutual Lehman Brothers W ells Fargo Countrywide Bear Stearns 54

55 X. Credit crunch and liquidity freeze 55

56 Tightened standards for real estate loans Net percentage of domestic respondents tightening standards for commercial real estate loans The end of S&L crisis LTCM Dotcom Subprime Sources: Federal Reserve, Milken Institute. 56

57 4,000 3,500 3,000 2,500 2,000 1,500 1, Widening spreads between mortgage-backed and high-yield bonds Basis points, spread over 10-year Treasury bond 5,000 Maximum spread: 01/30/2009: 3,647 bps 4,500 Merrill Lynch Mortgage-Backed Securities Index Average, 2004 Januray 30, 2009: 503 bps Merrill Lynch High-Yield Bond Index Average, 2004 Januray 30, 2009: 426 bps 01/ / / / / / / / / / /2009 Sources: Merrill Lynch, Bloomberg, Milken Institute. 57

58 Spread between 3-month LIBOR and T-bill rate Basis points October 10, 2008: bps August 20, 2007: 240 bps Average since August 2007: 150 bps Average since 1985: 92 bps Sources: Bloomberg, Milken Institute. Liquidity freeze Spread between 3-month LIBOR and overnight index swap rate Basis points October 10, 2008: 364 bps Average since August 2007: 97 bps Average since December 2001: 29 bps

59 Average CDS spread, basis points Counterparty risk increases Government announces support for Fannie Mae and Freddie Mac Citigroup agreed to buy Wachovia AIG rescued Lehman Brother files for bankruptcy and Merrill Lynch acquired October 10, 2008: 607 bps January 30, 2009: 422 bps 200 Bear Stearns acquired / / / / / / / / / /2009 Note: Counterparty Risk index averages the market spreads of the credit default swaps (CDS) of fifteen major credit derivatives dealers, including ABN Amro, Bank of America, BNP Paribas, Barclays Bank, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs Group, HSBC, Lehman Brothers, JPMorgan Chase, Merrill Lynch, Morgan Stanley, UBS, and Wachovia. Sources: Datastream, Milken Institute. 59

60 Rising risk: The credit default swap market nearly doubled each year from June 2001 through October 2008 Notional amount of credit default swaps outstanding, US$ trillions 70 Annualized growth rate 60 H H2 2007: 102% 50 H H1 2008: 89% June 2001 Dec June 2002 Dec June 2003 Dec June 2004 Sources: International Swaps and Derivatives Association, Milken Institute. 8.4 Dec June Dec June 2006 Dec June 2007 Dec June 2008 Oct

61 Commercial paper issuance dries up Quarterly change in outstanding amount, US$ billions Issuers of asset-backed securities Other issuers Q Q Q Q Q Q Q Q Q Q Sources: Federal Reserve, Milken Institute. 61

62 Federal Reserve responds by cutting Fed funds rate, but mortgage rates remain relatively flat Percent 10 Percent year FRM rate (left axis) Federal funds rate (left axis) Spread (right axis) / / / / / / / / / / Sources: Freddie Mac, Federal Reserve, Moody s Economy.com, Milken Institute. 62

63 Increasing spreads between corporate bonds, mortgage securities, and target federal funds rate Percent High yield corporate bonds yield Freddie Mac 30-year fixed mortgage rate 4 0 Federal intented funds rate AAA corporate bonds yield 01/ / / / / / / / /2009 Sources: Federal Reserve, Freddie Mac, Merrill Lynch, Bloomberg, Milken Institute. 63

64 US$ billions 2,400 2,000 1,600 1,200 Federal Reserve assets increased but asset quality deteriorated Total assets of Federal Reserve banks U.S. Treasury securities held outright 11/12/2008: $2.21 trillion 12/17/2008: $2.31 trillion 1/28/2009: $1.93 trillion /28/2009: $475 billion Sources: Federal Reserve, Milken Institute. 64

65 Federal Reserve has little maneuvering room Percent 3 2 Effective federal funds rate Target federal funds rate Apr. 30, 2008: 2% Oct. 8, 2008: 1.5% Oct. 29, 2008: 1% Dec. 16, 2008: % /01/08 07/01/08 07/31/08 08/30/08 09/29/08 10/29/08 11/28/08 12/28/08 01/27/09 Sources: Federal Reserve, Milken Institute. 65

66 Federal Government Comes to the Rescue of Main Street and Wall Street Federal Reserve 4,549 Congress and White House 1,149 Federal Deposit Insurance Corporation 1,465 Treasury, Federal Deposit Insurance Corporation and Federal Reserve 362 Total amount committed (US$ billions) 7,525 Upper limit to total funds provided/cost under these programs $7.52 trillion plus? 66

67 Program Term Discount Window Program (TDWP) Federal Reserve programs Amount committed (US$ billions) Term Auction Facility (TAF) Term Securities Lending Facility (TSLF) Bear Stearns 29 Description Announced on 10/17/2007. Extends the term of discount window loans from overnight to up to 90 days. Announced on 12/12/2007. The Fed auctions off loans under the TAF every Thursday for a term of 28 days. Outstanding TAF credit may potentially be expanded up to $900 billion. Announced on 3/11/2008. Establishes term swaps between the Fed and primary dealers. Collateral can be Treasury securities, federal agency securities, and other highly rated debt securities. On December 2, 2008, TSLF was extended through April 30, Announced on 3/14/2008. The Fed acquired $29 billion in mortgage backed securities from JPMorgan Chase to fund its purchase of Bear Stearns. As of January 21, 2009, the market value of these mortgage-backed securities is $27.2 billion. 67

68 Federal Reserve programs Program Amount committed (US$ billions) Description Primary Dealer Credit Facility (PDCF) 58 AIG Announced on 3/16/2008. Extends overnight borrowing from the Federal Reserve to primary dealers. On December 2, 2008, PDCF was extended through April 30, As of January 21, 2009, credit extended under PDCF was less than $33.3 billion. First announced on 9/16/2008. AIG received an $85 billion, two-year secured loan on September 16, 2008, in exchange for warrants for a 79.9 percent equity stake in the firm. It was given an additional $37.8 billion on October 8, and another $20.9 billion credit line under CPFF on October 30, On November 10, Treasury purchased $40 billion of newly issued AIG preferred stock under the TARP (potentially reducing the original loan from $85 billion to $60 billion), terminated the $37.8 billion lending facility previously established, created a new lending facility to purchase up to $22.5 billion MBS from AIG, and another facility to lend up to $30 billion to purchase CDOs on which AIG had written CDSs. As of January 21, 2009, $79.6 billion of credit was extended to AIG, $19.8 billion was extended to purchase MBSs, and $26.9 billion was extended to purchase CDOs. 68

69 Program Federal Reserve programs Amount committed (US$ billions) Description Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) 53 Announced on 9/19/2008. Loans to banks so that they can buy asset-backed commercial paper from money market funds. On December 2, 2008, AMLF was extended through April 30, As of January 21, 2009, credit extended under AMLF was $14.8 billion. Expansion of the Federal Open Market's temporary reciprocal currency arrangements (swap lines) 620 Announced on 9/29/2008. The Federal Open Market Committee authorized a $330 billion expansion of its swap lines for U.S. dollar liquidity operations by other central banks, raising the total cap to $620 billion (up to $30 billion by the Bank of Canada, $80 billion by the Bank of England, $120 billion by the Bank of Japan, $15 billion by Danmarks Nationalbank, $240 billion by the ECB, $15 billion by the Norges Bank, $30 billion by the Reserve Bank of Australia, $30 billion by the Sveriges Riksbank, and $60 billion by the Swiss National Bank). 69

70 Program Commercial Paper Funding Facility (CPFF) Federal Reserve programs Amount committed (US$ billions) Description Announced on 10/7/2008. The CPFF is a credit facility to a special purpose vehicle (SPV). The SPV purchases from eligible issuers three-month U.S. dollar-denominated commercial paper through the New York Fed's primary dealers. Eligible issuers are U.S. issuers of commercial paper, including U.S. issuers with a foreign parent company. The SPV only purchases U.S. dollar-denominated commercial paper (including asset-backed commercial paper (ABCP)) that is rated at least A-1/P-1/F1 by a major nationally recognized statistical rating organization (NRSRO) and, if rated by multiple major NRSROs, is rated at least A-1/P-1/F1 by two or more major NRSROs. The maximum amount of a single issuer's commercial paper the SPV may own at any time is greatest amount of U.S. dollardenominated commercial paper the issuer had outstanding on any day between January 1 and August 31, The SPV does not purchase additional commercial paper from an issuer whose total commercial paper outstanding to all investors (including the SPV) equals or exceeds the issuer's limit. As of 1/21/2009, $350 billion was outstanding. 70

71 Federal Reserve programs Program Money Market Investor Funding Facility (MMIFF) Amount committed (US$ billions) 540 Description Announced on 10/21/2008. The MMIFF provides assurance that money market mutual funds can liquidate their investments if cash is needed to cover withdrawals from customers. On 1/7/2009, the set of eligible institutions was expanded to also include a number of other money market investors, including U.S. based securities-lending cashcollateral reinvestment funds, portfolios, and accounts; and U.S. based investment funds that operate in a manner similar to money market mutual funds such as certain local government investment pools, common trust funds, and collective investment funds. As of 1/21/2009, outstanding amount was zero. 71

72 Program Term Asset- Backed Securities Loan Facility (TALF) Federal Reserve programs Amount committed (US$ billions) 200 Description Announced on 11/25/2008. TALF loans will have a one-year term, will be non-recourse to the borrower, and will be fully secured by eligible ABS. Treasury will provide $20 billion of credit protection to the Fed in connection with the TALF. Eligible collateral will include U.S. dollar-denominated cash (that is, not synthetic) ABS that have a long-term credit rating in the highest investment-grade rating category (for example, AAA) from two or more major nationally recognized statistical rating organizations (NRSROs) and do not have a long-term credit rating of below the highest investment-grade rating category from a major NRSRO. The underlying credit exposures of eligible ABS initially must be auto loans, student loans, credit card loans, or small business loans guaranteed by the U.S. Small Business Administration. All U.S. persons that own eligible collateral may participate in the TALF. Collateral haircuts will be established by the FRBNY for each class of eligible collateral. Haircuts will be determined based on the price volatility of each class of eligible collateral. On December 19, 2008, it was announced that TALF loan maturity was extended from one to three years, and TALF loans would be provided to all eligible borrowers with eligible collateral rather than distributed through an auction. 72

73 Federal Reserve programs Program Purchase of GSE direct obligations and MBS Amount committed (US$ billions) 600 Description Announced on 11/25/2008. The Fed will purchase the direct obligations of housing-related government-sponsored enterprises (GSEs)--Fannie Mae, Freddie Mac, and the Federal Home Loan Banks--and mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Purchases of up to $100 billion in GSE direct obligations under the program will be conducted with the Fed's primary dealers through a series of competitive auctions and will begin in the first week of December. Purchases of up to $500 billion in MBS will be conducted by asset managers selected via a competitive process with a goal of beginning these purchases before year-end Purchases of both direct obligations and MBS are expected to take place over several quarters.

74 Congress and White House Program Amount committed (US$ billions) Description FHA Secure 50 Announced on 8/31/2007. Guarantees $50 billion in mortgages. Economic Stimulus Act 124 Announced on 2/13/2008. Provided tax rebates in Most taxpayers below the income limit received rebates of $300-$600. Also gave businesses a one-time depreciation tax deduction on specific new investment and raised the limits on the value of new productive capital that may be classified as business expenses during The Congressional Budget Office (CBO) estimates the net cost of the stimulus to be $124 billion. Housing and Economic Recovery Act of 2008 Purchase of GSE Debt and Equity HOPE for Homeowners 300 Announced on 7/30/2008. The CBO estimates that the Act will increase budget deficits by about $24.9 billion over the 2008 to 2018 period. Announced on 7/30/2008. Designed to shore up Fannie Mae and Freddie Mac. Announced on 7/30/2008. This voluntary program encourages lenders to write down the loan balances of borrowers in exchange for FHA-guaranteed loans up to 90 percent of the newly appraised home value. Program runs through September

75 Program Conservatorship of Fannie Mae and Freddie Mac Congress and White House Amount committed (US$ billions) 200 Description Announced on 9/7/2008. Treasury and FHFA established contractual agreements to ensure that each company maintains a positive net worth. They are indefinite in duration and have a capacity of $100 billion each. Treasury also established a new secured lending credit facility, available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Funding is provided directly by Treasury in exchange for eligible collateral from the GSEs (guaranteed mortgage backed securities issued by Freddie Mac and Fannie Mae, as well as advances made by the Federal Home Loan Banks). To further support the availability of mortgage financing, Treasury is initiating a temporary program to purchase GSE MBS, with the size and timing subject to the discretion of the Treasury Secretary. Guaranty Program for Money Market Funds 50 Announced on 9/19/2008. To restore confidence in money market funds, Treasury made available up to $50 billion from the Exchange Stabilization Fund. 75

76 Program Congress and White House Amount committed (US$ billions) IRS Notice ? Emergency Economic Stabilization Act Troubled Assets Relief Program (TARP) Description Announced on 9/30/2008. Allows banks to offset their profits with losses from the loan portfolio of banks they acquire. Initial media reports indicate that Wells Fargo alone may be able to claim more than $70 billion in losses from its acquisition of Wachovia, obtaining tax savings that exceed the market value of Wachovia as of November 7, Announced on 10/3/2008. Empowers Treasury to use up to $700 billion to inject capital into financial institutions, to purchase or insure mortgage assets, and to purchase any other troubled assets necessary to promote financial market stability. Announced on 10/14/2008 as part of the EESA. On November 25, Treasury purchased $40 billion of preferred shares from AIG. As of December 31, 2008, there are four programs under the TARP: Capital Purchase Program (CPP), Automobile Industry Financing Program (AIFP), Targeted Investment Program (TIP), and Asset Guarantee Program (AGP). TARP also includes on initiative: providing $20 billion to support the Fed's Term Asset-Backed Securities Loan Facility 76

77 Program Capital Purchase Program (CPP) Automotive Industry Financing Program (AIFP) Congress and White House Amount committed (US$ billions) Description Under CPP, Treasury was allowed to purchase up to $250 billion of senior preferred shares in selected banks. The first $125 billion was allocated to nine of the nation's largest financial institutions on October 28, As of January 23, 2009, $192 billion has been distributed to 296 institutions. On 12/19/2008,Treasury announced a plan to make emergency loans available to General Motors and Chrysler. GM was provided with up to a total of $13.4 billion in short-term financing. Treasury funded $4 billion of this loan immediately, and an additional $5.4 billon on 1/16/2009. Treasury will provide an additional $4 billion on 2/17/2009. On 12/29/2008, Treasury also purchased $5 billion of senior preferred equity from GMAC. Additionally, Treasury agreed to lend up to $1 billion of TARP funds to GM so that GM can participate in a rights offering by GMAC in support of GMAC s reorganization as a bank holding company. On 1/2/2009, Treasury provided a 3-year $4 billion loan to Chrysler, secured by various collateral, including parts inventory, real estate, and certain equity interests. On 1/19/2008, Treasury announced that a $1.5 billion loan to a SPV created by Chrysler Financial to finance the extension of new consumer auto loans as part of a broader program to assist the domestic automotive industry in becoming financially viable.

78 Program Congress and White House Amount committed (US$ billions) Description Targeted Investment Program (TIP) Asset Guarantee Program (AGP) 20? Treasury may invest in any financial instrument, including debt, equity, or warrants, that the Secretary of the Treasury determines to be a troubled asset, after consultation with the Chairman of the Board of Governors of the Federal Reserve System and notice to Congress. Institutions participating in this program are required to provide Treasury with warrants or alternative consideration as necessary. They also need to adhere to rigorous executive compensation standards. In addition, Treasury will consider other measures, including limitations on the institution's expenditures, or other corporate governance requirements. The $20 billion investment in Citigroup that was announced on Nov. 23 was made under the TIP. On 12/31/ 2008, Treasury transmitted to Congress a report that describes the Asset Guarantee Program (AGP). This program provides guarantees for assets held by systemically significant financial institutions that face a risk of losing market confidence due in large part to a portfolio of distressed or illiquid assets.

79 Program Increase FDIC insurance coverage Temporary Liquidity Guarantee Program (TLGP) Federal Deposit Insurance Corporation Amount committed (US$ billions)? 1465 Description Announced on 10/3/2008. A provision of EESA temporarily raised the basic limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor. Limits are scheduled to return to $100,000 after December 31, Announced on 10/14/2008. Temporarily guarantees the senior debt of all FDICinsured institutions and their holding companies, as well as deposits in noninterest bearing deposit transaction accounts. Certain newly issued senior unsecured debt issued on or before June 30, 2009, would be fully protected in the event the issuing institution subsequently fails, or its holding company files for bankruptcy. This includes promissory notes, commercial paper, interbank funding, and any unsecured portion of secured debt. Coverage would be limited to June 30, On November 21, 2008, FDIC strengthened TLGP. Chief among the changes is that the debt guarantee will be triggered by payment default rather than bankruptcy or receivership. Another change is that short-term debt issued for one month or less will not be included in the TLGP. Eligible entities will have until December 5, 2008 to opt out of TLGP. The other part of the program provides for a temporary unlimited guarantee of funds in noninterest-bearing transactions accounts (the Transaction Account Guarantee Program, or TAG) 79

80 Treasury, Federal Deposit Insurance Corporation and Federal Reserve Program Guarantee a portion of an asset pool of loans and securities backed by residential and commercial real estate and other such assets on Citigroup's balance sheet Amount committed (US$ billions) Description Announced on 11/23/2008. Up to $306 billion of Citigroup's assets are guaranteed. Citigroup takes the first loss up to $29 billion, and any loss in excess of that amount is shared by the government (90%) and Citigroup (10%). Treasury (via TARP) takes the second loss up to $5 billion, while FDIC takes the third loss up to $10 billion. The Federal Reserve funds the remaining pool of assets with a nonrecourse loan, subject to Citigroup's 10 percent loss sharing, at a floating rate of overnight interest swap plus 300 basis points. 80

81 Treasury, Federal Deposit Insurance Corporation and Federal Reserve Program Amount committed (US$ billions) Description Provide a package of guarantees, liquidity access, and capital to the Bank of America 138 Announced on 1/16/2009. Treasury and FDIC will provide protection against the possibility of unusually large losses on an asset pool of approximately $118 billion of loans, securities backed by residential and commercial real estate loans, and other such assets, all of which have been marked to market value. The large majority of these assets were assumed by BOA as a result of its acquisition of Merrill Lynch. The assets will remain on BOA s balance sheet. As a fee for this arrangement, BOA will issue preferred shares to the Treasury and FDIC. In addition and if necessary, The Federal Reserve stands ready to backstop residual risk in the asset pool through a non-recourse loan. In addition, Treasury will invest $20 billion in BOA from the TARP program in exchange for preferred stock with an 8 percent dividend to the Treasury. The investment was made under the Targeted Investment Program. Loans, guarantees and investments committed (US$ billions) The final tab for taxpayers will only become known once the crisis is over.

82 XI. When will we hit bottom? 82

83 Looking for a bottom? Economists say the economy isn t at its low point yet, and house prices likely won t get there until 2009 Does this feel like the bottom to a downturn? When will home prices hit bottom? Yes 27% 1st half % 2nd half % 1st half % No 73% 2nd half st half % 17% Source: Wall Street Journal. 83

84 How far do home prices have to fall? Annual rents as percent of home prices 6.5 Q2 1971: 6.08% 4.5 Q1 2008: 3.93% Average, 1960 Q1 2008: 5.04% Average, 2000 Q1 2008: 4.06% 3.0 Q4 2006: 3.48% Sources: Davisa, Lehnertb, Martin (2007), Milken Institute. 84

85 Declines in home prices and the time it takes to get the rent-to-price ratio to a targeted value (5.04 is the longer-run average ratio) Annual Annual home home price price decline decline required -2.0% -5.0% -10.0% -15.0% -20.0% Rent-to-price ratio 3.80% 2010 Q Q Q Q Q2 4.00% 2013 Q Q Q Q Q2 5.00% 2024 Q Q Q Q Q1 5.04% average 2024 Q Q Q Q Q1 6.00% 2026 Q Q Q Q Q4 Sources: Davisa, Lehnertb, Martin (2007), Milken Institute. 85

86 US$/month 4,000 3,500 3,000 2,500 2,000 1,500 1, Alternative measures of the affordability of mortgage debt for California Payment with 100% LTV Payment with 90% LTV Payment with 80% LTV Mortgage payment assumptions: Every month, a home is purchased at median price, buyer takes out a 30-year conforming, fixed-rate loan with 80% LTV. Payment also includes 1% property tax per year, 0.1% property insurance. Maximum affortablility limit is 38% of median household Sources: Moody s Economy.com, Milken Institute. 86

87 XII. What went wrong 87

88 The importance of Fannie Mae and Freddie Mac US$ billions 3,000 2,500 2,000 2,443 2,067 1,500 1, , Fannie Mae: total assets Fannie Mae: total MBS outstanding Freddie Mac: total assets Freddie Mac: total MBS outstanding Commercial Savings banks: total institutions: residential real total estate assets residential real estate assets Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute. 88

89 Fannie Mae and Freddie Mac: Too big with too little capital? US$ billions 3,000 2,500 Fannie Mae 2,278 Freddie Mac 2,000 1,778 1,500 1,000 1,022 1, , , Q Q Total assets Total MBS outstanding Sources: Freddie Mac, Fannie Mae, Milken Institute. 89

90 Fannie Mae and Freddie Mac are highly leveraged Mortgage book of business over capital measures Fannie Mae 185x 81x 60x 60x 64x 56x 58x 48x 52x 56x 55x 57x Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute. Freddie Mac 203x 167x Core capital Fair value Core capital Fair value -66x -52x Q

91 Freddie Mac s and Fannie Mae's retained private-label portfolios Subprime Alt-A All others Fannie Mae, Q $85.7 billion 30.3% 33.4% 36.4% Fannie Mae, 2007 $94.8 billion 33.8% 34.3% 32.0% Fannie Mae, 2006 $97.3 billion 46.4% 36.1% 17.5% Fannie Mae, 2005 $86.9 billion 32.1% 37.4% 30.5% Freddie Mac, Q % 24.0% 34.3% Freddie Mac, % 23.4% 30.3% Freddie Mac, % 25.0% 20.6% Sources: Freddie Mac, Fannie Mae, FDIC, Milken Institute. $191.5 billion $218.9 billion $224.6 billion 91

92 Leverage ratios of different types of financial firms (June 2008) Leverage ratio, total assets/common equtity Freddie Mac 67.9 Fannie Mae Federal Home Loan Banks Brokers/hedge funds 31.6 Savings institutions Commercial banks Credit unions Sources: Federal Deposit Insurance Corporation, Office of Federal Housing Enterprise Oversight, National Credit Union Administration, Bloomberg, Google Finance, Milken Institute. 92

93 28 Too much dependence on debt? Leverage ratios at biggest investment banks Total assets/total shareholder equity Sept n.a June 2008 Bear Stearns Merrill Lynch Morgan Stanley Lehman Brothers Goldman Sachs Sources: Bloomberg, Milken Institute. 93

94 Debt dependence Leverage ratios at bank holding companies Total assets/total shareholder equity Sept Sources: Bloomberg, Milken Institute. Citigroup Bank of America JP Morgan Chase 94

95 Fitch long term issuer default rating AAA 24 AA+ 23 AA22 AA- 21 A+ 20 A 19 A-18 Bank of America JP Morgan Sources: Bloomberg, Milken Institute. Leverage vs. issuer rating Citigroup Merrill Lynch Merrill Lynch Goldman Sachs Morgan Stanley Lehman Brothers Morgan Stanley Merrill Lynch Bear Stearns Total assets/total equity capital 95

96 Leverage vs. issuer rating Total assets/ total shareholder equity Fitch long term issuer default rating Bear Stearns A+ A+ A+ Merrill Lynch AA AA- A+ Morgan Stanley AA AA- AA- Lehman Brothers A A+ AA- Goldman Sachs AA- AA- AA- Citigroup AA AA+ AA Bank of America AA- AA- AA JP Morgan Chase AA- A+ AA- Sources: Bloomberg, Milken Institute. 96

97 CDS premiums vs. issuer rating Fitch long term issuer default rating AAA AA+ AA Bank of America Citigroup Morgan Stanley Merrill Lynch Lehman Brothers AA- A+ JPMorgan Goldman Sachs Merrill Lynch A A- Lehman Brothers Average CDS premium, basis points Sources: Datastream, Milken Institute. Bear Stearns 97

98 Credit default swap premiums basis points Bear Stearns Merrill Lynch Morgan Stanley Lehman Brothers Goldman Sachs Citigroup Bank of America JP Morgan Chase Sources:Datastream, Milken Institute. 98

99 Average CDS premium, basis points Leverage vs. CDS premiums Bear Stearns 80 Lehman Brothers Merrill Lynch 60 Goldman Sachs JP Morgan Morgan Stanley 40 Morgan Stanley 20 0 Bank of America Total assets/total equity capital Sources: Datastream, Bloomberg, Milken Institute. Merrill Lynch Citigroup Lehman Brothers Bear Stearns

100 Leverage vs. CDS premium Total assets/ total shareholder equity Average CDS premium basis points Bear Stearns Merrill Lynch Morgan Stanley Lehman Brothers Goldman Sachs Citigroup Bank of America JP Morgan Chase Sources: Datastream, Bloomberg, Milken Institute.

101 Credit default swap premiums for large banks Credit default swap premium, basis points JP Morgan Chase Wells Fargo Bank of America Citigroup / / / / / / / / / /2008 Sources: Datastream, Milken Institute. 101

102 Standard & Poor s ratings New issues: 1/1/2000 to 9/30/2008 Investment-grade securities AAA 16,907 AA+ 240 AA 2,098 AA- 3,414 A+ 2,623 A 2,602 A- 2,027 BBB+ 903 BBB 1,371 BBB- 1,359 Sources: Bloomberg, Milken Institute. Non-investment-grade securities BB+ 238 BB 313 BB- 331 B+ 339 B 330 B- 1,189 CCC+ 293 CCC 214 CCC- 104 CC 36 C 11 D

103 56 percent of MBS issued from 2005 to 2007 were eventually downgraded S&P Total Downgraded Downgraded as a percentage of total AAA 1, % AA(+/-) 3,495 1, % A(+/-) 2,983 1, % BBB(+/-) 2,954 2, % BB(+/-) % B(+/-) % Total 11,261 6, % Sources: Inside Mortgage Finance, Milken Institute. Note: A bond is considered investment grade if its credit rating is BBB- or higher by S&P. 103