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US Financial Crisis
1. U.S. Financial Crisis
Sarinee Achavanuntakul
Fringer | ŕ¸ŕ¸ŕ¸ŕ¸˛ŕ¸˘ŕ¸ŕ¸ŕ¸
http://www.fringer.org/
10 November 2008
Most slides are taken from http://www.slideshare.net/econman/the-credit-crisis-of-
2008a-presentation
7. Moral hazard âcredit easeâ
⢠âSubprimeâ is defined as borrower who has FICO credit score less
than 620, but some lenders also define borrowers whose FICO score
are as high as 680 as âsubprimeâ if their down payment is <5%
⢠Typical subprime mortgage is âAdjustable-rate Mortgageâ (ARM): a
2/28 ARM means fixed interest rate for the first 2 years, then floating
rate (e.g. LIBOR + 6%) for the remaining 28 years
⢠Often requires no down payment, can borrow 100% of house value,
and has no rigorous credit check â âNINJAâ borrowers, âLiar loansâ
⢠Zimmerman (2007) proves that subprime loan quality in 2007 is worse
than in 2006, and 2006 were worse than 2005
⢠New subprime loans were $421,000 million in 2006 (S&P estimate);
AMP Capital Investors estimates $1.4 trillion subprime loan
outstanding in July 2007
⢠Fannie Mae estimates that 50% of those who were sold subprime
loans would have qualified for prime-rate loans
8. Credit Default Swap (CDS)
⢠Investors seek insurance to cover unexpected
defaults on loans
9. Fraud, over-leverage, and non-transparency
⢠Fraud:
â Unfair or misleading credit terms, e.g. ARM, universal default
â Moodyâs supposed âbugâ in their credit rating model that
resulted in some bonds being overrated by 4 notches (5/2008)
⢠Over-leverage:
â Many banks & hedge funds over-leverage to make easy money
on CDOs: 25-30x times their capital
⢠Non-transparency:
â Financial institutions use off-balance-sheet vehicles e.g. Special-
Purpose Vehicle (SPV) to hide real exposure and evade taxes
â Most subprime-linked derivatives are traded on 100% private,
OTC (âover-the-counterâ) basis, so nobody knows the market
size problem applies to the whole âshadow banking systemâ
10. Agency problems, wrong incentives
⢠Problems at the top
â âWhen the music stops, in terms of liquidity, things will be
complicated. But as long as the music is playing, youâve got to get
up and dance. Weâre still dancing.â Citigroupâs Chuck Prince, in an
interview with Financial Times, July 2007
â Retired in November 2007 with $38 million pay package
⢠Problems down below:
â Traders are compensated for short-term performance â if they take
positions that have 5% chance of total catastrophe, they will be well
rewarded year after year as long as that 5% never materializes
â What the traders receive are therefore just âinsurance premiumsâ
but they thought they are smart!
â Internal risk management gets weaker the more profits they make
â Hard to separate true âalphaâ (idiosyncratic, firm-specific) from
âbetaâ (systemic, overall market returns) risks
14. How a bank works
⢠Most bank âliabilitiesâ are deposits which are short-term in
nature (e.g. 2-year fixed deposits), while most âassetsâ are
longer-term loans (e.g. mortgages or CDOs which are
âinvestmentsâ). Mortgages are the longest-term loans.
⢠Banks must mark-to-market the value of their investments.
⢠Example: Wachovia balance sheet @ 30/6/08 (prior to
Citigroup takeover):
Assets Liabilities & Equity
Current assets $110 Short-term debt $505
Long-term assets Long-term debt $230
Investments $600 Equity (shareholders) $75
Others $100
Total $810 Total $810
15. Why banks fail so dramatically
Assets Liabilities & Equity
Current assets -$90 Short-term debt $305
Long-term assets Long-term debt $230
Investments $500 Equity (shareholders) -$25
Others $100
Total $510 Total $510
⢠Borrower defaults + house prices collapse market value of
investments / mortgages collapse (ex. $100 in above example)
⢠Bank must record falling value of investments as losses erode bank
capital until shareholderâs equity is negative insolvent
⢠Meanwhile, if bankâs debtors (depositors or other financial institutions)
withdraw funds or demand loan prepayment, bank may face a severe
liquidity crisis until it is bankrupt
⢠Bailout: buy toxic assets from banks (not a good idea: at what price &
certain losses) or raise capital (better, but can Republicans accept?)
⢠If public funds are used, ex-shareholders should not reap benefits
16. U.S. household debt problem is not over
⢠Currently 8.8 million Americans have negative home equity
â a record figure
⢠Total mortgage market in U.S. is approx $11 trillion (79%
of GDP). About 13% of these are subprime
⢠U.S. households have $1 trillion credit card debt + $0.7
trillion auto loan. These debts often have no collateral â
repayment depends solely on borrowerâs ability to repay
⢠Tough & unfair credit terms + rising cost of living (oil, food,
etc.) erode ability to repay
⢠Since mortgages are often the last kind of loans people
would default (house = the most valued asset), the
subprime crisis suggests that they have already defaulted
on credit cards and other kinds of loans
⢠These loans have been securitized too. So⌠watch out!