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Subprime Crisis In US. Brief Banking History. Mesopotamia, >3000 years ago, storehouses for reserves of grain and animals, charged interest much like today

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Brief banking history
Brief Banking History

  • Mesopotamia, >3000 years ago, storehouses for reserves of grain and animals, charged interest much like today

  • Italy, Medici of Florence: first modern loan and deposit system to handle multiple currency, later improved by Dutch and British, imported to American colonies

  • Growing pains through a period of minimal regulation, legislation during Civil War: entire US banking system under federal regulation

Brief banking history 2
Brief Banking History (2)

  • Credit crisis late in the 19th century and in 1907

  • The Great stock market crash of 1929: caused by too many high-risk loans under the assumptions that stock market would continue to rise unabated

  • Bubble prop in October 1929, run in risky on the nation’s banks. However, banks engaged in risky investments themselves with depositors’ cash, only to lose it all

Brief banking history 3
Brief Banking History (3)

  • 1933: banks basic function ceased: Franklin Roosevelt put a few measures

  • Glass-Stegall Act: forbid commercial banks (BofA, pre-Merrill) from offering services of investment of insurance banks (AIG)

  • FDIC: promised to reimburse customers should a bank go out of business

Brief banking history 4
Brief Banking History (4)

  • 1913, Federal Reserve created: “lender of last resort”, the central bank of US

  • Roosevelt polices slowly brought confidence in the banking system back up and helped end the Great Depression

  • 1999, Glass-Stegall Act repealed; commercial banks to re-enter stock biz

  • IB used to be big players for Gov’t and corporations could own commercial banks

Brief banking history 5
Brief Banking History (5)

  • With a surging market, IBs made all kinds of money

  • Until a few years ago, housing propelling growth was unstoppable

  • Merrill Lynch and Lehman offered mortgages left and right, many to people with poor credit records, gambling that housing prices would continue to rise

S l crisis
S&L Crisis

  • Not a new phenomenon

  • Historical S&L crisis dates back to the Great Depression, Disintermedaition in the late 70’s, S&L crisis in 1989

  • 1989: 747 S&L bankruptcies with $160 billion of bailout, caused recession in 1991-92

  • 2008: In addition to $85 billion of bailout for AIG, $700 billion more for Wall Street

How large is 700 billion
How large is $700 billion?

  • NASA fiscal year 2009: $17.6 billion

  • NSF annual budget: $6.1 billion

  • Military budget 2009: $481 billion

  • Social Security: $608 billion

  • $2,300 for each American

  • US national debt: $9 trillion

  • Can take 25,000 Rodriguez (NY Yankees)

  • The Forbes 400 richest people total $1.57 trillion

How big is subprime
How big is subprime?

  • 2% of total loans in 2002 to 20% of total loans in 2006

  • US economy: $ 60 trillion

  • Mortgage Market: $12 trillion

  • Subprime: $2.4 trillion

  • Massive write-offs by the commercial banking and investment banking ($500 B)

Subprime mortgage
Subprime Mortgage

  • Loans to less than perfect credit

  • Any late payments, bankruptcies, liens, judgments, or other defaults blemish the credit history

  • Borrower with blemished credit history or no credit history does not qualify for the Prime Mortgage Loans: falls to subprime mortgage with high interest payments

Chronological development
Chronological Development

  • Countrywide (acquired by Bank of America)

  • Bear Sterns (acquired by JP Morgan Chase)

  • Lehman Brothers (CDO/CDS exposure $600B)

  • Merrill Lynch (acquired by Bank of America)

  • AIG ($500B CDS exposure, $250B Liable)

  • Washington Mutual (acquired by JP Morgan Chase)

  • Wachovia (acquired by Citigroup)

  • Morgan Stanley, Goldman Sachs (subprime, CDS exposure related to hedge funds): covert to chartered bank holding companies (part of $700 billion of US Gov’t bailout)

Chain of reaction
Chain of Reaction

  • Burst of US housing bubble and high default rates on “subprime” and “ARM”

  • Increase in defaults and foreclosure

  • Mortgage lenders and credit risk sellers were hit hard

  • Tighter lending, and increased spreads on interest rates

  • Contracted liquidity in the global credit markets and banking system

Who to blame
Who to blame?

  • Reagan Doctrine: Financial Deregulation ‘82

  • Democrats-led congress passed the law to provide more affordable mortgages to low income people (1992)

  • People who shouldn’t have been borrowing

  • These loans were packaged into CDOs rated AAA (IBs and rating agencies)

  • Investment Bank purchase w/o due diligence

  • Distributed throughout the world


  • Alpha generation: beat the market, theme of portfolio managers/ hedge fund managers

  • Earn higher mortgage or credit card rates

  • Bet on credit: three hedge funds speculation funded by investment banks

  • High leverage bet


  • Moral hazard

  • Conflicts of Interest

  • Regulation or deregulation

  • Quants: Fall of geniuses

  • Financial engineering without comprehensive understanding of risk management