Review Of The Market Crisis As Of 10 13 08

An overview of the market crisis
As of October 13, 2008

What has happened?

• The capital markets are going through a significant
structural correction…
• Investment bankers have been dealt a punishing blow for
their excessive leverage and inadequate risk management
• Insurers have had to reckon with their likely inability to
cover potential claims
• Credit markets have over-adjusted their risk tolerances,
causing a liquidity crisis
• Stock markets have reacted to the possible consequences
of a credit market shut-down
• Governments have taken, and will continue to take,
extreme and costly action steps to stabilize markets and
head off the domino effect

Who has been affected?

• Investment Banks
• Bear Stearns is bankrupt and has been absorbed by JP
Morgan Chase
• Lehman Brothers is bankrupt and their assets are being
liquidated
• Merrill Lynch has agreed to be acquired by Bank of America
• Goldman Sachs is now a bank holding company, subject to
the same regulations as commercial banking firms
• Commercial Banks
• Many commercial banks with comparable risk profiles have
suffered as well: Indy Mac Bank, WAMU, Wachovia,
National City… more to come


• Insurers
• AIG, the largest insurer in the world and second largest in
the USA has been bailed out by the Federal Reserve who
lent the insurer $85 billion
• Fannie Mae and Freddie Mac, two quasi-government,
publically traded mortgage insurers were placed into
conservatorship and have become governmental agencies,
under the control of the Federal Housing Finance Agency.
Each agency will have access to $100 billion of credit to
support them through a rescue period


• Credit Markets
• Borrowers of all types have felt the effects of tighter credit.
• Commercial paper markets have declined by $230 billion
since the beginning of the year, off 13%.
• Short term commercial paper rates (A2-P2) have risen from
under 5% to 6.2% since the beginning of the year.
• Mortgage applications fell 23% in August as consumers and
creditors took a conservative turn.
• In a flight to quality, investors have placed such heavy
demand on risk-free Treasury securities that yields on these
securities have fallen from 3.25% at the start of the year to
.26% as of mid-October.


• Stock Markets
• In the USA, stock market indices have fallen significantly on
worries about global liquidity. Losses in US markets are
valued at over $7.2 trillion by The Wall Street Journal
• Dow Jones Industrial Average – down 36.8% YTD
• NASDAQ Index – down 39.2% YTD
• S&P 500 Index – down 39.5% YTD
• International indexes have followed US trends as worries
are evenly shared around the world
• London FTSE – down 37.7% YTD
• German DAX – down 43.7% YTD
• Japanese NIKKEI – down 45.9% YTD
• Chinese HANG SENG – down 46.8% YTD
• Gold, the universal parking lot for worrisome investors, has
risen by 34.6% since the beginning of 2007
Data as of 10/10/08 @ 11:00 AM


• Governments
• The US Government finds itself as the largest creditor in history as
the “Emergency Economic Stabilization Act of 2008” provides
funding to stabilize the system.
• Critics mistakenly call the program a “bailout” when it actually
serves as a market stabilization vehicle that creates a
government-assisted flow of capital in an otherwise “too scared to
trade” securities market
• Provisions of the Act restrict compensation programs for
executives of troubled companies and create warrants on the
stock of many benefiting companies, thereby providing for public
sector gains as firms benefit from the plan
• Federal Reserve cuts the Fed funds rate by 50 basis points (1/2
%) to increase the level and cut the cost of liquidity in the system


• Governments (global theater)
• Numerous sovereign states have followed the Federal Reserve
lead and cut short term interest rates
• Financial institution rescue packages have taken the form of direct
government investment and government assisted bailouts from
the private sector
• British government invests over $80 billion (50 billion pounds) to partially
nationalize major banks
• The governments of Belgium and Luxembourg partnered with French bank BNP
Paribas to acquire Fortis NV
• Iceland’s banking system is nearly collapsed and the government has assumed
control of Kaupthing and Landsbanki, two of the largest institutions. The English
has guaranteed some deposits in Icelandic banks and the Swedish government
has provided an emergency credit line. In both cases these sovereign actions
were taken to protect citizens deposits.
• Germany agreed to a 15 billion Euro bailout of Hypo Real Estate Holding AG after
initially providing a 30 billion Euro rescue package


• Governments (global theater)
• Sovereign investment funds have been approached (mostly
unsuccessfully) by financial institutions in an effort to raise equity
capital to strengthen balance sheets
• The Russian stock market has suspended trading on several
occasions to reduce the impact of high volume sell-offs
• The G7 economic powers agree to a set of common guidelines for
supporting a rescue to troubled financial institutions.

What is the root cause? Who should we blame?

• The Government
• Insufficient regulation?
• Asset classes, capital requirements, product sets,
disclosure requirements, credit enhancement
• Public and economic policy?
• Housing finance, mortgage guarantees, low interest
rates, weak dollar
• Indecision and Political maneuvering?
• Initial defeat of Emergency Plan added to uncertainty
• Regulatory mishaps?
• Sarbanes Oxley + Fair Value Accounting (FASB 157)


• The Bankers?
• Proliferation of cheap credit
• Short-cuts in credit decision process
• Exotic product development
• Excessive leverage and associated risk
• Inadequate capital to absorb losses


• The People
• Revision to “The American Dream”
• Before:
• Own you own home and pay off the mortgage.
• After:
• Leverage up to the highest home you can afford.
• Take out the equity that you build and use it as a down
payment on a second property.
• Capitalize on property and investment asset appreciation
to propagate the cycle.
• Treat yourself to a few extra luxuries with any remaining
equity that you can refinance.
• Never consider paying off the debt!

Case Study
EVOLUTION OF A MORTGAGE TRANSACTION

Evolution of a mortgage transaction

Home buyers secure
Depositors maintain
mortgage financing
a stable supply of
at a fixed rate for a
funds to finance
long term
lending activities

Commercial Bank
or other mortgage lender

Homeowners make monthly
payments and slowly retire
mortgage debt


Home buyers secure
Depositors maintain
mortgage financing
a stable supply of
funds to finance
long term
lending activities

Commercial Bank

Payments and slowly retire
Fannie Mae and Freddie Mac mortgage debt
support homeownership
through mortgage guarantees


Home buyers secure
Depositors maintain
mortgage financing
a stable supply of
funds to finance
long term
lending activities

Commercial Bank

Investment bankers
offer “asset
securitization” to create
more liquidity in the
mortgage market


Home buyers secure
Depositors maintain
mortgage financing
a stable supply of
funds to finance
long term
lending activities

Commercial Bank

As a consequence,
retail mortgage lenders Homeowners make monthly
Fannie Mae and more capacity,
have Freddie Mac mortgage debt
create more products,
Investment bankers
through mortgage guaranteesand
compete on price
offer “asset
make more loans
mortgage market


Home buyers secure
Depositors maintain
a stable supply of Federal
Reserve mortgage financing
funds to finance
introduces
easy money long term
lending activities
policy as an economic
stimulus,Commercial Bank
causing short term
rates or other mortgage lender
to fall to historical lows

Investment bankers
offer “asset
mortgage market


Consumers respond to buyers secure
Home
Depositors maintain
widespread credit mortgage financing
a stable supply of
availability, low interest term for a
at a fixed rate
funds to finance
long
lending activities
rates and easy approval
Commercial Bankmore
by borrowing

Investment bankers
offer “asset
mortgage market


Home buyers secure
Depositors maintain
mortgage financing
a stable supply of
funds to finance
long term
lending activities

Commercial Bank
Bankers respond
with more competitive
products, led by the
affordable “variable rate
loan”
Investment bankers
offer “asset
mortgage market


Depositors maintain Consumers take Home buyers secure
advantage of low interest at a fixed rate for a
mortgage financing
a stable supply of
funds to finance
lending activities and affordable payments
rates long term
by upgrading to larger homes
Commercial Bank

through mortgage guarantees Investment bankers
offer “asset
mortgage market


Home buyers secure
Depositors maintain
mortgage financing
a stable supply of
funds to finance
lending activities …and second homes long term

Commercial Bank

Investment bankers
offer “asset
mortgage market


Home buyers secure
Depositors maintain
mortgage financing
a stable supply of
funds to finance
long term
lending activities

Commercial Bank

Banks respond again to the Payments and slowly retire
Fannie Mae in demand, this time
surge and Freddie Mac mortgage debt
relaxing credit standards
Investment bankers
and relying on credit scores
offer “asset
instead of traditional
mortgage lending procedures.
Subprime lending was born.
mortgage market


Not too
surprisingly,
home prices
escalated as
a result of
increased
demand.


Potential
homeowners
race to buy
in fear of
never being
able to
afford a
home!!!!
Others who
never owned
a home
before now
find it
possible to
finance a
home.


Low variable
rate mortgages make
this possible by keeping
payments low. “And
besides, property
values are rising! If
rates rise, I can sell
my house at a profit.”

“Maybe I should buy
another house as an
investment. They
keep going up in
After a few value and I can use
years the house is the equity in my
worth even more. home to finance
Your banker the down payment!”
suggests that you
“take some equity
out of the home.”


Meanwhile, back at the Investment Banks…

“Securitized”
mortgage portfolios
are packaged and
sold to investor
groups to generate
ongoing liquidity.
At first, all is well,
then creativity sets
in!


Meanwhile, back at the Investment Bank…

“Securitized”
mortgage portfolios
are packaged and
sold to investor
groups to generate
ongoing liquidity.
Mortgage portfolios are
At first, all is well,
broken into “tranches,”
then creativity sets
“credit enhancement” is
in!
purchased and high risk
portfolios suddenly become
Investment Grade


What’s not to love? A mortgage
loan portfolio, guaranteed by a
quasi-government agency like
Fannie Mae, backed up with
credit enhancement from AIG
(the largest insurer in the
world), and collateralized by
homes that are rising in value!


“I’ll take three trillion
dollars worth!”


1. Short term interest rates begin to rise


1. Short term interest rates begin to rise.

2. Housing demand (especially speculative demand)
begins to deplete.



begins to deplete.

3. Housing prices begin to fall.



begins to deplete.


4. Monthly mortgage payments begin to reset (upwards)



begins to deplete.



5. The theory of “I can sell the appreciated house if I can’t
afford the payments” is put to the ultimate test as…



begins to deplete.



afford the payments” is put to the ultimate test as…

6. A wave of houses are put on the market, all at once



begins to deplete.



afford the payment” is put to the ultimate test as…

6. A wave of houses are put on the market, all at once

7. Home prices fall further


Homeowners and real estate speculators realize that their
debts are greater than the value of the houses they own.
The easiest solution is to declare bankruptcy.

Interest rates rise and
home values fall.
Home owners fall
Consumer spending behind on payments Asset backed securities
falls and economy and some declare begin to lose value as
enters a recession, bankruptcy the mortgage payments
placing further risk of fall behind or go into
mortgage defaults and default
housing price declines

The market for these
securities evaporate as
Stock markets decline
most investment banks
over fears of liquidity
share the same
crunch and high
problem
degrees of uncertainty

Investment banks
Credit markets tighten
must “mark securities
as investors of all sizes
to market.” With no
reset their risk Investment banks active markets,
tolerance and move to begin to fail as losses securities have to be
avoid losses absorb all of their valued at or near zero
limited equity capital
base


Unwinding the situation will not be easy


Titles to assets, roles of
guarantors, financial
status of players, the
global nature of the
problem and other
transaction
complexities make
unwinding the situation
difficult


Nobody know what the paper is worth,
and there are no buyers!


Nobody know what the paper is worth,
and there are no buyers!

The Federal Government is working to create
a market for the securities through the $700
Billion “Emergency Economic Stability Act
Of 2008”


Private sector, inter-institutional
credit has evaporated since
everyone has reset their
institutional risk tolerance level to
an abundantly cautious level


Private sector, inter-institutional
credit has evaporated since
everyone has reset their
institutional risk tolerance level to
an abundantly cautious level

This affects banks, corporations,
small businesses and consumers alike


Which explains why even the stock market
has reacted so badly. How far away can
a recession be?


The First Step: “The Emergency Economic
Stabilization Act of 2008”
•Creates a market for illiquid securities
•Creates an insurance pool for troubled assets
•Creates a vehicle for managing these assets
•Creates a provision for capital infusion into US Banks
•Limits financial executives compensation programs
•Provides for addressing accounting issues
•Provides assistance for homeowners
•Increases deposit insurance maximums
Which explains why even the stock market
has reacted so badly. How far away can
a recession be?


EESA will take some time to have an effect!

Will There be a Sequel?

• Credit Card Debt
• Auction Rate Securities
• Credit Default Swaps
• Hedge Funds
• Further Credit Deterioration Caused by a Recession
• Corporate Bankruptcy Caused by Liquidity Crunch
• Small Business Loan Failures
• More Commercial Bank Failures
• Sovereign Bankruptcies

Where do we go from here?

• Recession? Very Likely
• Jobs? Tight market
• Housing? Long term recovery
• Banking? Long term recovery with an industry
transformation
• Stock Markets? Slow recovery, with an initial
spurt if/as liquidity is re-established. Rate of
recovery will vary by sector
• Commodities? Suppressed prices but reductions in
output may put a floor on downward spiral

Where do we go from here?

Bright spots Dark spots
• Rental housing • Consumer spending
• Infrastructure • Consumer credit
• Energy • Housing finance
• Healthcare demand • Financial services
• Education • Auto industry
• Global demand • Healthcare Costs
• Risk tolerance • Public Policy Issues
• Welfare
• Public Policy Issues • Medicare
• Returns from “bailout” • Tax Policy
• Tighter controls on financial • Mortgage guarantees
engineering
• The end of Political entitlement?

Discussion

• Who is to blame for this situation?
• Are we victims of public ignorance?
• Have there been any ethical or legal
violations?
• Could the crisis have been prevented?
• Can controls be put in place to prevent a re-
occurrence?
• Will these controls have unintended
consequences?
• How will society pay for this?

Review Of The Market Crisis As Of 10 13 08

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