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The Credit Crunch An explanation by Joseph Stenard
The Credit Crunch – a house of cards implodes • Economist of the Day • Mortgage Market foundation • Fannie Mae Involvement • Institutional Investors and Bond Holders • Derivatives as a hedge against default • Derivatives as a concentration of risk • Mortgage Brokers and Predatory Lending • Moral Hazard
A.K. Hart • Student of Economics • Valedictorian, Harvard University 2010 • Musical Prodigy – Studied Violin at Juilliard for a year deferring her Harvard admission • Senior Thesis on CDO’s Collateralized Debt Obligations & CDS’s Credit Default Swaps written from an insider’s perspective thanks to her internship on Wall Street • Next door neighbor to Prof. Stenard’s sister • "I'm coming into the middle of the financial crisis saying, 'I want to write about the financial crisis.'" • "I saw no point in changing my topic to something I wasn't as interested in — so I used contacts from my internship to gather original data my advisers said I couldn't get.”
Enter Fannie Mae • Provides liquidity • Increases availability of home mortgages • Involves Government inefficiencies • Dictates conformity • Acts algorithmically • Insulates banks from risks • Creates Moral Hazard
Moral Hazard • When the terms of a contract encourage actions which are counter to the principles assumed at the time of contract • If “Plan B” is attractive then “Plan A” can be more risky • Fire Insurance, Bail Money, Air Bags
Savings and Loan Crisis 1980’s • S&L’s were restricted to low interest home loans • Rising interest rates put a strain on the S & L’s • Deregulation permitted risky investing • S&L managers used Bank money to buy junk bonds • 747 Savings and Loans went bankrupt • Cost of crisis $160 Billion • Taxpayer portion was $124 Billion
Down payment of 20% Shopped around for the best interest rates Paid off the mortgage to own the home Very Reliable No Money Down Mortgage Brokers sought them out Leveraged properties to maximize consumption Unreliable Homeowners
Competed with other banks and lenders Were responsible to the depositors Cautious – would avoid lending to risky clients Foreclosure meant loss for the bank Acted as an Agent of Fannie Mae FDIC and Secondary Mortgage Market created Moral Hazard Overextended Origination fees and Servicing of loans were additional revenue Banks and Lending Institutions
Fannie Mae and Freddie Mac • Created in 1938 and 1970 respectively • At the center of the Credit Crunch • Buy Mortgages from Banks and other lenders • Bundle the mortgages into Bonds (Mortgage Backed Securities) • Algorithmically follow policy • Drones motivated by keeping job
Institutional Investors • Pension Funds, Capital Accounts, Trust Funds and Endowments • Administrators are very risk-adverse • Motivated by protecting assets • Bought Fannie Mae Bonds, the Collateralized Debt Obligations which were as good as the underlying mortgages • Purchased Derivatives for “insurance”
Mortgage Brokers • Paid by lenders for closing deals on mortgages, refinances, home equity loans. • Commission paid was percentage of the loan amount • Different loans paid different rates • Predatory Loans – Adjustable rate mortgages • Aggressive selling with preference to higher paying loans • The ultimate Agency Problem
Derivatives Market • The issuer of the derivative is effectively making a “side-bet”, which will pay in the event of the bond defaulting. • The cost of the derivative can be likened to an insurance premium. The cost should fluctuate with risk. • The issuer, competing with other issuers, collects premiums and pays out according to the contract
Derivatives Market • Institutional Investors purchased Derivatives • Commercial banks like Lehman Brothers issued the derivatives • Very lucrative in good times • Incredible overexposure wasn’t discovered until too late • Followed the crowd instead of analyzing the data
The collapse • The Derivatives were under priced • Derivatives on top of derivatives • Homeowners miss payments • Fannie Mae bonds default • Institutional investors call the derivatives • Insufficient funds on the part of issuers – they declare bankruptcy • The financial markets dry up.
CREDIT CRUNCH Part 2 The Implications
Michael Lewis • The author of Liar's Poker, The Blind Side and a new book about the collapse, The Big Short, Lewis contacted A.K. Hart about the paper and wound up dropping her name in the book. • Called her paper "more interesting than any single piece of Wall Street research on the subject."
WINNERS Mortgage Brokers Banks LOSERS Fannie Mae The taxpayers Banks Homeowners Derivatives Market Institutional Investors Winners and Losers
Congress and Treasury arrange a Bailout • Government (the American People) buys the most toxic mortgages • Government stock ownership of companies “too big to fail” • Billions paid out to AIG • Nearly $1 Trillion • http://www.youtube.com/watch?v=zfTld4mo1FM
How Much is a Trillion? • It is a Million Millions • Spend one dollar per second for 32,000 years • Can pay the rent for every renter in the US for 3 years • Enough to cover every mortgage in America for 14 months • Enough to buy 40,000,000 new cars • More than the entire defense spending since 9/11