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Understanding the Sources and Way Out of theOngoing Financial Upheaval
Susan M. WachterRichard B. Worley Professor of Financial Management
The Wharton SchoolUniversity of Pennsylvania
Bank for International Settlements Hong Kong Institute for Monetary Research
University of Pennsylvania
April 23, 2009
PASEF
Global Downturn• The economy is in the worst downturn since the Great
Depression.• Capital market crisis—more than a “recession” credit flow
ended, globally and global economy is withering.• A self-reinforcing adverse cycle:
– The financial system crisis is upending the economy, putting further pressure on the financial system
• US public policy response without precedent.– Fiscal stimulus package– Federal Reserve has vastly expanded its role– What more is needed: for private credit flows to resume,
confidence in the financial system itself must be restored– This requires understanding what went wrong and
rebuilding the architecture of the financial system
The Economic Backdrop• Economy in “Great Recession”
– Unemployment at 8.5%– 4th quarter decline in GDP at 6.2%, global
decline 1.5%• Volatility in global stock markets
– US and global stock prices are more than 40% down
• Angst in the banking system and credit markets remain badly shaken– Banks still not lending
The Economic Backdrop-Capital Markets
Source: Moody’s Economy.com
The Damage Is Not Over• Real GDP began to fall in Q4 of 2007- fall continuing.• 2.6 million jobs have already been lost and the
unemployment rate is still rising. • Consumer confidence has crashed to its lowest reading
ever
Source: Mark Zandi, Moody’s Economy.com
Response to the Crisis• Fiscal Stimulus
– Unprecedented stimulus ($1 trillion)
• Monetary Stimulus– Federal Funds Rate near zero– Quantitative easing
• Banking Bailout– TARP
• Missing: New Financial Architecture
– Need to understand what went wrong
Impact of Stimulus Measures
Source: Mark Zandi, Moody’s Economy.com
Monetary Stimulus
Source: Mark Zandi, Moody’s Economy.com
The state and local impacts
Source: Mark Zandi, Moody’s Economy.com
March, 2007 January, 2008 September, 2008
The Collapse-from housing to financial markets: still missing, the new financial architecture
Global Financial Crisis: Made in the USA• Triggered by actual and prospective losses on
US mortgages-leveraged losses far greater• Global meltdown: Bad luck or inevitable?• Boom-bust housing price cycle: Why?• Reckless decline in mortgage lending standards
(followed by credit crisis and no private lending)• Increased housing prices beyond sustainable
heights• Unprecedented house price rises hid problem
loans-teaser rates, no doc/low doc, option arm’s, NINJA loans
• Loans made that could not be repaid-betting on ever increasing house price to rescue loans
A Severe National Housing Downturn
Figure 6: Price Appreciation Controlled for Volatility
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2An
nual
Per
cent
Cha
nge
US Home Price Canada Home Price
Australia Home Price UK Home Price
France Home Price Thailand Home Price
Japan Home Price Hong Kong Home Price
WHY?• Private label securitized mortgages, backed
leveraged derivatives, synthetics• Decades of securitization—not the problem• Interest rate risk securitized historically• PLS securitized default risk, relied on
diversification—not Marked-to-Market, but rather Marked-to-Model
• Expansion of toxic debt as asset, based on collateral, and ever increasing house prices
0%
50%
100%
150%
200%
250%
300%
350%
400%
1975 1980 1985 1990 1995 2000 2005
Chronic imbalances
15
0%
20%
40%
60%
80%
100%
120%
140%
1975 1985 1995 2005
NonfinancialCompanies
Government
FinancialCompanies
Gross debt by U.S. sectorPercentage of GDP
Source: U.S. Federal Reserve, Bureau of Economic Analysis
Sectoral contribution to U.S. gross debtPercentage of GDP
NonfinancialCompanies
FinancialCompanies
Household
Government
Households
Increased use of non-traditional products
FHA/VA Conv/Conf Jumbo Subprime Alt A HEL
2001 8% 57% 20% 7% 2% 5%
2002 7% 63% 21% 1% 2% 6%
2003 6% 62% 16% 8% 2% 6%
2004 4% 41% 17% 18% 6% 12%
2005 3% 35% 18% 20% 12% 12%
2006 3% 33% 16% 20% 13% 14%
2007 4% 48% 14% 8% 11% 15%
Mortgage originations by product
18
Deterioration of lending standards, 2002 to 2006: Leverage w/out Docs Table 3
ARMS
Orig Yr CLTV CLTV>80 Seconds Full Doc IO% DTI FICO<700 Investor WAC SpdtoWAC
Prime 2002 66.4 4.1 1.9 56.0 46 31.0 20.7 0.7 5.5 - 2003 68.2 10.1 10.9 48.6 53 31.8 21.8 1.6 4.6 - 2004 73.5 20.7 23.1 51.2 71 33.5 22.0 2.1 4.5 - 2005 74.1 21.7 26.8 47.3 81 33.6 18.9 1.9 5.4 - 2006 75.3 26.2 35.3 33.6 91 37.2 19.5 2.3 6.2 -
Alt A 2002 74.3 20.8 2.7 29.3 26 35.4 46.4 9.9 6.3 0.82003 78.0 33.3 23.4 28.1 56 35.3 44.7 12.9 5.6 1.02004 82.6 46.9 39.1 32.6 75 36.2 44.3 15.3 5.5 1.02005 83.5 49.6 46.9 28.3 83 37.0 40.5 16.5 6.0 0.62006 85.0 55.4 55.4 19.0 87 38.3 44.2 13.5 6.8 0.6
Subprime 2002 81.2 46.8 3.7 66.9 1 40.0 93.4 4.7 8.5 3.02003 83.5 55.6 9.9 63.5 5 40.2 91.6 4.9 7.5 2.92004 85.3 61.1 19.1 59.9 20 40.6 90.6 5.3 7.1 2.62005 86.6 64.4 28.1 55.9 32 41.2 89.7 5.4 7.3 1.92006 86.7 64.0 31.0 54.6 20 42.1 91.8 5.7 8.2 2.0
Source: Loan Performance data as of November 2006. UBS, April 16, 2007, Thomas Zimmerman, "How Did We Get Here and What Lies Ahead"
Spreads declined
CLTV (leverage) increases
% Full Doc declined
Nonprime mortgage lending replaced the
“American Mortgage”: where and why?
February 13, 2009 Susan M. Wachter 2020
A Housing Bubble Starting in 2003, Especially in the “Sand States”
Prices by City (Case-Shiller)
0.00
50.00
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Janu
ary 1
989
Mar
ch 1
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ly 1
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embe
r 199
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ovem
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Janu
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Mar
ch 1
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May
199
8Ju
ly 1
999
Sept
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r 200
0N
ovem
ber 2
001
Janu
ary 2
003
Mar
ch 2
004
May
200
5Ju
ly 2
006
Sept
embe
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7
phnxlamiamitampalvchicagomnpls
ar m_p 0% t o 25% >25% t o 50% >50% t o 75% >75% t o 100%ar m_ p 0% t o 25% >25% t o 50% >50% t o 75% >75% t o 100%
February 13, 2009 Susan M. Wachter 2121
Percent of All Loans—Adjustable Rate
1999 2006
February 13, 2009 Susan M. Wachter 2222
Percent of All Loans—Low Documentation- by 2006, 25% of loans
l owdoc_ p 0% t o 25% >25% t o 50% >50% t o 75% >75% t o 100% l owdoc_p 0% t o 25% >25% t o 50% >50% t o 75% >75% t o 100%
1999 2006
t easer _ p 0% t o 25% >25% t o 50% >50% t o 75% >75% t o 100%
February 13, 2009 Susan M. Wachter 2323
Percent of Adjustable Rate Loans—Teaser (2006)
Source: www.newyorkfed.org/mortgagemaps
Number of Subprime Loans
Source: www.newyorkfed.org/mortgagemaps
Increase in House Price Index
-20<-10%
No correction
>-20%
-10%<0%
Sources: Fiserv Lending Solutions, Moody's Economy.com, OFHEO
Projected Peak-to-Trough House Price Decline, %
Originators / Brokers
Secondary Market
Investors• Borrowed at teaser rates-
not able/expected(?) to pay at reset
Borrowers
Rating Agencies• Originate to
distribute
• Securities marked to models not to market/assignee liability exemption
• Agency incentives misaligned- “current conditions” out
• Lack of short sales, CDS
Where does the
buck stop?
How did we get here?
February 13, 2009 Susan M. Wachter 29
Deregulation and Regulatory Arbitrage: “Competitive Regulation”• Charter competition fueled a race to
the bottom in underwriting standards
• Migration to federal bank and thrift charters
• At the federal level, regulation and examinations of nonbank mortgage lending subsidiaries were lax
February 13, 2009 Susan M. Wachter 30
Deregulation• The proposed Federal Reserve Board
Regulatory Oversight of mortgages not implemented until 2008, HOEPA (Home Ownership and Equity Protection Act, 1994) irrelevant,<1% loans
• 2004 act SEC allowed investment firms to – increase leverage to 40 to 1 – to voluntarily measure their capital, and – decrease SEC oversight
• 2000 State reserving for CDS issued by insurance companies, Fed govt precludes
Market and Regulatory Failure• Risk taking without accountability
– Too big to fail, too small to sue• Underpriced risk is inevitable,
compensation for generating risk without accountability
WHY?• Decades of securitization, 1980-2000—no problem• Historically-interest rate risk securitized, default
risk controlled for and not priced, only prime mortgages securitized
• “Innovation:” Private label securitization of default risk
• Private label mortgage backed securities did not trade
• Priced based on Marked-to-Model paradigm Not Marked-to-Market,
• Market and regulatory discipline absent
February 13, 2009 Susan M. Wachter 33
New Financial Architecture• Replace Basel II
– Basel II: regime of self-regulation
• End “Competitive Regulation”– Race to the bottom
• Single Regulator
• Asset Bubbles– What is a single regulator regulating?– How do we regulate asset bubbles?
PerspectiveThe events of the past year or two have highlighted regulatory gaps and deficiencies that we must address to improve the structure of our markets and the resiliency of our economy. As we recover from the current crisis, it will be important to address these issues as soon as possible, to develop a regulatory structure that will better respond to future economic challenges.--Ben Bernanke
Thank You
Susan M. WachterRichard B. Worley Professor of Financial
ManagementProfessor of Real Estate and Finance
The Wharton SchoolUniversity of Pennsylvania
wachter@wharton.upenn.edu