Financial CrisisJames Barth Powerpoints

March 2009

Complete presentation at http://business.auburn.edu/~barthjr/presentations.htm

Follow this link to Barth’s“Leverage and Risk in Financial Institutions”

presentation in Amsterdam, February 2009

2

Did the Fed lower interest rates too much and for too long? Federal funds rate vs. rates on FRMs and ARMs

Sources: Federal Reserve, Mortgage Bankers Association, Moody’s Economy.com, Milken Institute.

Target federal funds rate

0

1

2

3

4

5

6

7

8

2001 2002 2003 2004 2005 2006 2007 2008 2009

Percent

Record low from June 25, 2003 to June 30, 2004: 1%

30-year FRM rate

Apr. 30, 2008: 2%Oct. 8, 2008: 1.5%Oct. 29, 2008: 1%Dec. 16, 2008: 0-0.25%

1-year ARM rate

January 30, 200930-year FRM rate: 5.1%1-year ARM rate: 4.9%

3

Home mortgages: Who borrows, how much has been borrowed, and who funds them?

Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $700 billion

Government-controlled

46%

Privatesector-

controlled54%

Total value of housing stock = $19.3 trillion

Equity in housing stock$8.7 trillion

Mortgage debt $10.6 trillion

Total value of housing stock = $19.3 trillion

Prime 91.6%

Subprime8.4% Securitized

58%

Non-securitized42%

Sources: Federal Reserve, Milken Institute.

4

Subprime mortgages accounted for half or more of foreclosures since 2006

Sources: Mortgage Bankers Association, Milken Institute.

0

500

1,000

1,500

2,000

2,500

Q12003

Q32003

Q12004

Q32004

Q12005

Q32005

Q12006

Q32006

Q12007

Q32007

Q12008

Q32008

Subprime

FHA and VA

Prime (includes Alt-A)

Number of home mortgage loan foreclosures started (annualized rate in thousands)

Q3 2008Subprime: 12% of loans serviced

55

The mortgage model switches fromoriginate-to-hold to originate-to-distribute

Sources: Federal Reserve, Milken Institute.

Held in portfolio

84.4%

Securitized15.6%

Held in portfolio

41%

Securitized59%

Residential mortgage loans1980: Total = $958 billion

Residential mortgage loansQ3 2008: Total = $11.3 trillion

11%

89%

66

Mortgage-backed securities issued by issuer

Sources: Inside Mortgage Finance, Milken Institute.Note: 2008 data are annualized.

0

500

1,000

1,500

2,000

2,500

3,000

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Private label

Ginnie Mae

Freddie Mac

Fannie Mae

US$ billions

7

Home mortgages: Who borrows, how much has been borrowed, and who funds them?

Note: total residential and commercial mortgages = $14.7 trillion; 5 percent = $700 billion

Government-controlled

46%

Privatesector-

controlled54%

Total value of housing stock = $19.3 trillion

Equity in housing stock$8.7 trillion

Mortgage debt $10.6 trillion

Total value of housing stock = $19.3 trillion

Prime 91.6%

Subprime8.4% Securitized

58%

Non-securitized42%

Sources: Federal Reserve, Milken Institute.

…small events at times have large consequences. A liquidity crisis in a fractional reserve banking system is precisely the kind of event that can trigger – and often has triggered – a chain reaction. And economic collapse often has the character of a cumulative process. Let it go beyond a certain point, and it will tend for a time to gain strength from its own development as its effects spread and return to intensify the process of collapse. Because no great strength would be required to hold back the rock that starts a landslide, it does not follow that the landslide will not be of major proportions.

Friedman and SchwartzA Monetary History of the United

States

9

Subprime mortgage meltdown timelineDecember 2006–October 2008

Sources: BusinessWeek, S&P, Global Insight, Milken Institute.

Oct. 12, 2008: Finance leaders endorse G7 plan to calm markets.

Oct. 27, 2008: Down Jones U.S. Financial Index=230

Oct. 31, 2008:Dow Jones U.S. Financial Index=269

200

300

400

500

600

700

12/2006 02/2007 04/2007 06/2007 08/2007 10/2007 12/2007 02/2008 04/2008 06/2008 08/2008 10/2008

Dow Jones U.S. Financial Index

June 9, 2008:Lehman announces a $2.8 billion loss.

July 11, 2008: IndyMac is seized by FDIC.

Aug. 1, 2008: First Priority Bank closes.

Mar. 11, 2008: Fed offers troubled banks as much as $200 billion in loans; Fed introduces Term Securities Lending Facility.

Oct. 24, 2007: Merrill announces $7.9 billion in subprime write-downs, surpassing Citi’s $6.5 billion.

Feburary–March 2007: More than 25 subprime lenders declare bankruptcy.

Aug. 6, 2007: American Home Mortgage files for bankruptcy.

Sept. 30, 2007: NetBank goes bankrupt.

July 30, 2008: President Bush signs a housing rescue law.

Sept. 7, 2008: U.S. seizes Fannie Mae and Freddie Mac.

Dec. 2006: Ownit Mortgage, a subprime lender, files for bankruptcy.

Apr. 2007: New Century, a mortgage broker, files for bankruptcy.

Feb. 2007: HSBC sets aside $10.6 billion for bad loans, including subprime.

July 31, 2007: Two Bear Stearns hedge funds file for bankruptcy.

Aug. 17, 2007: Fed cuts discount rate to 5.75%; Fed introduces Term Discount Window Program.

Jan. 11, 2008: Bank of America agrees to buy Countrywide.Jan. 30, 2008: Fed cuts discount rate to 3.5%.

Dec. 12, 2007: Fed introduces Term Auction Facility.

Feb. 13, 2008: President Bush introduces tax rebate stimulus program of $168 billion.

Aug. 16, 2007: Countrywide gets emergency loan of $11 billion from a group of banks.

Sept. 14, 2008: Lehman files for bankruptcy.

Mar. 18, 2008: Fed cuts discount rate to 2.5%; Fed funds rate to 2.25%.

Mar. 16, 2008: JP Morgan Chase offers to buy Bear Stearns; Fed introduces Primary Dealer Credit Facility.

April. 30, 2008: Fed cuts discount rate to 2.25%; Fed funds rate to 2%.

Oct. 3, 2008: President Bush signs Emergency Economic Stabilization Act, authorizing bailout of $700 billion.Also, Citigroup sues after Wachovia agrees tie-up with Wells Fargo.

Sept. 16, 2008: Fed loans AIG $85 billion.

Sept. 23, 2008: Washington Mutual is seized by FDIC.

Sept. 29, 2008: Citigroup agrees to buy Wachovia.

Oct. 8, 2008: Fed cuts discount rate to 1.75%; Fed funds rate to 1.5%.

-21.4-23.9

-40.1-41.4

-42.9-45.1

-47.9

-54.7-63.7-64.1

-72.3-96.6

-112.9

-169.2-197.9

Bear StearnsCountrywideWells Fargo

Lehman BrothersWashington mutualFreddie Mac

Goldman SachsFannie MaeMorgan Stanley

Merrill LynchJP Morgan & ChaseWachovia

UBS EquityAIGBank of America

US$ billions

Total loss in market value: $1,094 billion, December 2006–January 2009

1010

Financial market capitalization takes big hit

Note: Bear Stearns stock price is to May 2008. Countrywide stock price is to June 2008. Merrill Lynch stock price is to December 2008. Wachovia stock price is to December 2008. Sources: Bloomberg, Milken Institute.

11

Counterparty risk increases

Note: Counterparty Risk index averages the market spreads of the credit default swaps (CDS) of fifteen major credit derivatives dealers, including ABN Amro, Bank of America, BNP Paribas, Barclays Bank, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs Group, HSBC, Lehman Brothers, JPMorgan Chase, Merrill Lynch, Morgan Stanley, UBS, and Wachovia. Sources: Datastream, Milken Institute.

0

100

200

300

400

500

600

700

07/2007 09/2007 11/2007 01/2008 03/2008 05/2008 07/2008 09/2008 11/2008 01/2009

Average CDS spread, basis points

Bear Stearns acquired

Government announces support for Fannie Mae and Freddie Mac

Lehman Brother files for bankruptcy and Merrill Lynch acquired

AIG rescued

Citigroup agreed to buy Wachovia

October 10, 2008: 607 bps

January 30, 2009: 422 bps

12

Federal Reserve assets increased but asset quality deteriorated

Sources: Federal Reserve, Milken Institute.

0

400

800

1,200

1,600

2,000

2,400

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

US$ billions

Total assets of Federal Reserve banks

U.S. Treasury securities held outright

11/12/2008: $2.21 trillion

12/17/2008: $2.31 trillion

1/28/2009: $1.93 trillion

1/28/2009: $475 billion

13

Balance sheet information on FDIC-insured institutions

Sources: FDIC, Milken Institute.

Cash-to-asset ratio (left axis)

Borrowed funds-to-asset ratio (left axis)

Deposits-to-asset ratio (right axis)

Equity capital-to-asset ratio (right axis)

Insured deposits-to-asset ratio (right axis)

0

2

4

6

8

10

12

14

16

18

20

1992 1994 1996 1998 2000 2002 2004 2006 Q3 2008

0

10

20

30

40

50

60

70

80

90Percent Percent

1414

U.S. regulatory capital requirements and prompt corrective action categories

Tier 1leverage

Tier 1 risk-based

Total risk-based

Well capitalized >= 5% and >= 6% and >= 10%

Adequately capitalized

>= 4% and >= 4% and >= 8%

Undercapitalized < 4% or < 4% or < 8%

Significantly undercapitalized

< 3% or < 3% or < 6%

Critically undercapitalized

Tangible equity capital ratio that is <= 2%

Source: FDIC.

1515

Leverage ratio for commercial banks

Sources: Historical Statistics of the United States, FDIC, Milken Institute.Note: The leverage ratio is the reciprocal of the capital-asset ratio.

0

2

4

6

8

10

12

14

16

18

20

1896 1905 1914 1923 1932 1941 1950 1959 1968 1977 1986 1995 2004

Asset/equity capital ratio

Average, 1896 - Q3 2008: 11.0x

1945: 18.2x 1979: 17.4x

1932: 6.2xQ3 2008: 10.3x

1896: 3.6x

16

XI. When will we hit bottom?

Conservatorship of Fannie Mae and Freddie Mac…

Bailing out AIG…

Capital Purchase Program under the TARP…

Automotive Industry Financing Program…

Targeted Investment Program and Asset Guaranty Program…

And Still……

23

The U.S. regulatory regime: In need of reform?

Sources: Financial Services Roundtable (2007), Milken Institute.

National banks State commercial and savings banks

Federal savings banks

Insurance companies

Securities brokers/dealers

Other financial companies, including mortgage

companies and brokers

• Fed• OTS

• OCC• FDIC

• State bank regulators• FDIC• Fed--state member commerical banks

• OTS• FDIC

• 50 State insurance regulators plus District of Columbia and Puerto Rico

• FINRA• SEC• CFTC• State securities regulators

• Fed• State licensing (if needed)• U.S. Treasury for some products

• OCC• Host county regulator

• Fed• Host county regulator

• OTS• Host county regulator

Federal branch

Foreign branch

Limited foreign branch

Fed is the umbrella or consolidated regulator

Primary/secondaryfunctionalregulator

Notes:Justice Department: Assesses effects of mergers and acquisitions on competitionFederal Courts: Ultimate decider of banking, securities, and insurance productsCFTC: Commodity Futures Trading CommissionFDIC: Federal Deposit Insurance CorporationFed: Federal ReserveFINRA: Financial Industry Regulatory Authority GSEs: Government Sponsored Enterprises OCC: Comptroller of the CurrencyOTS: Office of Thrift SupervisionSEC: Securities and Exchange Commission

• Federal Housing Finance Agency

Fannie Mae, Freddie Mac, and Federal Home Loan Banks

Financial, bank and thrift holding companies

Justice Department• Assesses effects of mergers and acquisitions on competition

Federal courts• Ultimate decider of banking, securities, and insurance products