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The Subprime Financial Crisis

The Subprime Financial Crisis. Roots of the Crisis Susan Woodward, Sand Hill Econometrics. Prelude. 1980 – change in Usury laws Depository Institutions Deregulatory and Monetary Control Act 1990 to 1996 – introduction of credit scores

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The Subprime Financial Crisis

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  1. The Subprime Financial Crisis • Roots of the Crisis • Susan Woodward, Sand Hill Econometrics

  2. Prelude • 1980 – change in Usury laws Depository Institutions Deregulatory and Monetary Control Act • 1990 to 1996 – introduction of credit scores • 1998 – clearing-house for derivatives killed by bi-partisan leaders (clearing-house would know gross and net exposure of buyers & sellers) • 2004 – SEC eliminated capital rules for investment banks • Average ibank ratios of capital to assets: • before 2004: 1 to 12 • after 2004: 1 to 33

  3. Real Residential Construction, 1968-2008

  4. Residential Construction • Has always been volatile. • Is very sensitive to the level of nominal interest rates – when rates rise, construction contracts • Construction is such a large sector that when it contracts, it can create a recession all by itself • Has had a major role in most recessions (obvious in the chart), but not in 2001 • As of 2008q3, more than all of the shortfall in GDP was accounted for by the decline in residential construction (roughly $350bn)

  5. Mortgage Interest Rates, 1987-2009by 2003, the big refi boom was over

  6. Housing market experience, 1990-2003 • 1990-2004: high LTV loans to borrowers with good credit had low default rates • 50 years (maybe more) of rising dollar house prices • 20 years of low, 2-3%, and mean-reverting inflation, • 20 years of (mostly) declining mortgage interest rates • A recession in 2001 with virtually no housing component • Lower volatility everywhere: stock market, the bond market, business income, residential construction, real activity, personal income, and more… • By 2003, when 30-year fixed mortgage rates reached 5.25%, the mortgage refi boom had to end, and new lending either had to contract a lot, or lenders had to think of something new to do.

  7. Mortgage Originations, 2001-2007, $ trillions

  8. Note that 2003 • Was the last year of the refi boom. The decline in originations would have been even bigger in 2004 if lenders had not begun chasing subprime borrowers aggressively. In 2006, subprime loans were nearly 40% of all originations.

  9. Little signs that all was not well…

  10. Vacancies • The vacancy data are very telling. Note that we have quite a long history for this series– back to 1956. In the fourth quarter of 2005, the vacancy rate for owner-occupied homes reached 2% for the first time since we began keeping track of vacancies. • These vacancy rates are for owner-occupied dwellings. Vacancy rates for rentals are much higher (5-8%) and also more volatile.

  11. Who had a problem? • Many investment banks were big holders bad pieces of subprime loans and became insolvent. All lenders stopped trusting them. • Some large commercial banks were big holders of subprime loans, and close to insolvent. Other banks stopped trusting them. • Sellers of insurance (AIG) (especially insurance not regulated as insurance, such as credit default swaps) to subprime lenders and investors were under-capitalized and close to insolvent, lenders stopped trusting them, too. • Some households defaulted on their loans. • Some households felt poorer because the value of their houses and portfolios were down, so they spent less.

  12. Crisis was mainly a Large Bank crisis

  13. Was the financial crisis the precipitating event of the recession? • No – it was the crash in house prices. Residential construction – just under 5% of GDP. If it falls 40%, that’s a recession. • As of 2008q3, more than allof the shortfall in GDP was accounted for by residential construction. Q4 shortfall in GDP is broader. • Credit spreads always widen in recessions, bank crisis or not. • But the bank crisis cannot have made things better. It could have made things much worse if the Fed had not moved to shore up bank capital.

  14. Stuff done right • Inject capital into banks • increased inter-bank trust • interbank lending resumed

  15. Stuff not done right • Initial Focus on auctioning (pricing) assets • Allowing markets to suspect Fannie and Freddie were without federal backing • F&F borrowing rates were 140 basis points> treasuries • No fiscal stimulus put in place in 2008

  16. What can we do now? • Short-run: Fiscal Stimulus -- • expected GDP shortfall $900 bn in 2009 • tax cuts or rebates • investment tax credit • public works • subsidy (or tax relief) to employers • negative (or zero, with Federal govt paying states) sales tax • inflate

  17. Tax cuts or rebates • Tried in 2008 • - no detectable impact • - consistent with theory (people smooth consumption over time, if they can) • - consistent with other studies of windfalls

  18. Investment Tax Credit • PRO • Experience suggests it does move investment forward in time • CON • Money goes mainly to manufacturers of capital goods and to skilled labor

  19. Public works • PRO • Large body of research suggests multiplier lies between 1 and 1.5 (for each $1 spent, GDP rises by $1 to $1.50) • CON • Impact cannot be as quick as sales tax cuts or employment subsidies • Benefits go mainly to contractors and skilled labor • Government is generally not too good at choosing construction projects. Let the States do it.

  20. Subsidies to Employers • PRO • impact is directly on employment • can be done quickly • numbers are big: Businesses pay $500 bn/yr in payroll (social security) taxes • CON • Money goes to businesses directly, not households • Impact on GDP is much disputed, multiplier could be well under 1.0, suggesting disproportionate benefits to business owners and a net cost to taxpayers

  21. Negative -- or zero -- Sales Tax • PRO • Evidence says it will raise GDP • Can be done quickly (all but 5 states have a sales tax) • Numbers are big – about $400 bn per year • CON • Political bonus points are smaller because beneficiaries are so diffuse • Works best if it is a surprise

  22. Inflate • PRO • Higher inflation does stimulate real activity • CON • It takes about 1.5 years for the impact to be complete • Inflation above 4% would ruin our reputation for a national commitment to low and stable inflation, a reputation we have spent 20 years building.

  23. The short evaluation … • Timid • – GDP shortfall is forecast to be more than $900 bn in 2009. • – only $200 bn of the stimulus is to be spent in 2009 • Inappropriate • – most of the money is spent in 2010 rather than 2009 • – money is spent on public works, much of which is pork, instead of by people

  24. The Details

  25. After another several months of bad employment figures, they will be back for more…

  26. How bad do things look now?

  27. What would be a more direct stimulus? • Federal govt pays state sales taxes, 100% for the first quarter, 2/3 next quarter, 1/3 the next, then done. ($400 bn per year, only 6 states without a sales tax) • Increase level and duration of unemployment benefits • Investment tax credit to businesses • Pay employees’ part of payroll (social security) tax ($450 bn), perhaps also employers’ part

  28. What about banks? • Good bank/Bad bank proposals • most proposals suggesting separating floundering institutions into two entirely separate entities. Put assets of questionable value and all long-term debt into the “bad” bank. • Two problems: • 1. The bad bank will almost surely be insolvent • 2. The debt-holders would unquestionably be worse off, because they would see a smaller pool of assets from which to recover.

  29. Another idea… • Make the good bank an asset of the bad bank. • Debtholders still can recover from the total pool of assets

  30. Example: Citi

  31. What’s the point? • Change incentives – low risk v. high risk lending • Make the next steps for reorganization clear • Reassure depositors (including foreign deposits) that the good bank is solvent so that they don’t run • PROBLEMS • Still a blow to the long-term debt-holders (are they pension plans and insurance companies?) though not as large as other good/bad bank plans • Ambiguity of standing of long-term debt-holders and foreign deposits • Provides little guidance regarding entities like AIG

  32. What next? • Short-term • another stimulus bill, more targeted at consumption and employment • Longer-term • less levered financial institution, especially depositories, likely ibanks also, if there are any • some arrangement for keeping track of CDS • re-thinking of retirement schemes (British usage) • limitations on activities of insured depositories, both active (subprime lending) and passive (purchase of CDS on assets held) • Regulate everything that is insurance (like CDS) as insurance, with capital requirements

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