The Current State of the Economy

Iowa Association of Electric Cooperatives

Tom Root, PhD

The Big Picture

Problems in Mortgage Market

Global Credit Crisis / Bank failures / Equity Losses

Declining Consumer Spending Decreased Business Investment

Whose to Blame?

Contributing Factors

Consumer Debt and “Keeping up with the Joneses”

International Capital Flows

Congressional Unintended Consequences

The Housing Market and “The American Dream”

Regulatory Changes

The Big Picture

Problems in Mortgage Market

Global Credit Crisis / Bank failures / Equity Losses

Declining Consumer Spending Decreased Business Investment

Mortgage Market Developments

New Participants

Increased Credit Access and New Loan Types

SubprimeAlt A“Teaser Rates”Option ARMs

Securitization

Securitization

Loan Bank B

Financial IntermediaryBuys Loans, Forms a “Pool”

and Issues MBS

Loan Bank A Loan Bank Z

Insurance Firm, Banks, Pension Funds etc.Buy MBS – Cash Flows “Guaranteed” by Original Mortgages

2000 - 2003

Fannie Mae announces it will buy $2 Trillion of loans from low income, minority and risky borrowers by 2010*. Subprime Loans = 3% of mortgage marketsTarget for the Federal Funds Rate

6.5% May 16, 20001.75% Dec 11, 20011% June 25, 2003

*NY Time Oct 4 2008 "Pressured to Take More Risk, Fannie Mae Hit a Tipping Point*NY Time Oct 4 2008 "Pressured to Take More Risk, Fannie Mae Hit a Tipping Point

Federal Funds Rate

Interbank lending – very short term – provides liquidity

Market determines the actual rate

Target set by Federal Reserve Board

“Base Rate”

The Basics of Banking

Borrowing Short-Term and Lending Long-Term

Deposit $1,000 Bank pays 1% or $10 to depositor

Home Equity Loan $1,000Bank charges 5% or $50 to borrower

Bank “profit” = $40

Reserves

The bank must keep a portion of deposits in reserve

WithdrawsTransactions“Lending Reserves” and Federal Funds Market

Bank Balance Sheet

AssetsUse of funds to generate income

Liabilities and EquitySource of fundsLiabilities (borrowing)Equity (ownership stake)

Bank Balance Sheet

Assets (Income)LoansCashTreasury SecuritiesMort. Back SecuritiesCorporate BondsStocks

Liabilities (costs)DepositsS-T BorrowingL-T Borrowing

Equity (ownership)

Monetary Policy

Federal Reserve Board“Lender of Last Resort”

Managing Cash available for lendingMore cash available lowers interest ratesLess cash available increases interest rates(rates impact borrowing / spending and growth)

Monetary Policy Tools

Reserve Requirements

Discount Window Lending

Open Market OperationsBuying and selling Treasury SecuritiesReplacing illiquid assets with cash and vice versa

Impact of Low Rates 2001-2004

Strong economic growth without inflationHousing boom pushed housing prices up

New loan standardsSpeculation on home prices by “average consumers”Increased availability of international fundsStrong demand for MBS

Congressional pressure to increase lending to under served markets

W. Poole, Pres. Fed Reserve Bank of St Louis*“If the market value of GSE debt were to fall sharply, because of ambiguity about the financial soundness of GSEs and about the willingness of the federal government to backstop the debt, what would happen? I do not know, and neither does anyone else.”

Dec 2003 Fed Reserve releases study showing GSEs have not lowered lending rates.**February 2004 – Alan Greenspan calls for reform & removal of the implicit government guarantee***

*"Housing and the Macroeconomy" Speech at Office of Federal Housing Enterprise Oversight Symposium http://www.stls.frb.org/news/speeches/2003/3/10/03.html **Christmas for Fannie, WSJ 9/9/08 ***"Fran and

Fred Get The Business WSJ 2003 3/10/03

Missed Opportunities2003 Accounting Scandals at GSEs

2004 Market Developments

SEC lowers capital requirement rules for largest financial firms.*Deterioration of underwriting standards.**August - Moody’s and S&P change rating standards for MBS, incorrectly rate many MBS AAA***2004 HUD increases Fannie and Freddie mandate from 50% “affordable housing” to 56%**** Target for Fed Funds starts to increase

June 30, 2004 1.25%, December 13, 2004 2.25%* NY Times Oct 3, 2008 Agency's '04 Rule Let Bank Pile Up New Debt **President's Working on Financial Markets, US Treasury Dept March 2008 ***Smith, Elliot, "Race to the Bottom at Moody's, S&P Secured Subprime's Boom and Bust" Bloomberg.com, Sept 2008

**** How HUD Mortgage Policy Fed the Crisis, Washington Post, June 10, 2008

NY Times October 4 "Pressured to Take More Risk Fannie Hit a Tipping Point"

Fannie Mae’sGuarantee of Alt A Loans

0

50

100

150

200

250

300

$ B

illions o

f Alt

A L

oans G

uara

nte

ed

2005$58

Billion Added

2006$87

BillionAdded

2007$79

BillionAdded

2004 & Before$77 Billion Total

Blaming Fannie and Freddie?

No - Fannie and Freddie were small relative to the entire market.

Combined Subprime Purchases (% of Market)**Consumer demand created rapid prince increase

Yes – Overall Size put them at risk for any mortgage market problem

Securitizing more risky loans opened door for private securitization

Gramlich, E. "Subprime Loans: America's Latest Boom an Bust" 2007 ** "how HUD Mortgage Policy Fed the Crisis", Washington Post June 10, 2008

Impact of Subprime Loans on Home Ownership

"SubPrime Lending: A Net Drain on Homeownership," Center for Responsible Lending: March 2007

“The Perfect Storm” 2004 - 2007

Domestic and global institutions buy MBS in attempt to increase margins on “safe” securities, incorrectly rated.

Institutions use higher debt levels for securitization.

Underwriting standards deteriorate.

Increased interest rate environment makes loans more likely to default

Increasing Home Prices encourage consumers to overextend and speculate in housing market

Average Size of Subprime Loan

Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans, over

50% to total subprime

Credit Quality of Subprime Loans Originated each year

Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans,

over 50% to total subprime

Structure of Subprime Loans Originated each year

Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans,

over 50% to total subprime

Home Sales and Home Prices

Non Agency Mortgage Foreclosure Rates

The Big Picture

Problems in Mortgage Market

Global Credit Crisis / Bank failures / Equity Losses

Declining Consumer Spending Decreased Business Investment

Impact on Financial Institutions

Foreclosures cause value of MBS securities to decrease raising concerns about stability of banks and financial institutions

Banks start to keep cashProtect against withdrawsUncertainty about borrowers ability to repayInterest rates start to increase

2007 Market News

Consumer Confidence starts to decline in July 2007 (Conference Board)

Late 2007 over 20% of all adjustable rate subprime loans and 8% of fixed rate subprime loans are delinquent

Dec 12 – Fed Reserve announces Term Auction Facility allowing depository institutions to bid for short term (28 to 84 day) loans

August / September 2008 Financial Markets

Global concerns increase, European banks have liquidity concerns

Measures of confidence decrease and credit spreads increase

Banks keep cash in fear of runs on liquidity and make fewer loans

Cost of short term borrowing increases for business

Bank Balance Sheet

Assets (income)LoansCashTreasury SecuritiesMort. Back SecuritiesCorporate BondsStocks

Liabilities (costs)DepositsS-T BorrowingL-T Borrowing

Equity (ownership)

2008 Financial Institution Failures

January – Bank of America buys CountrywideMarch - Bear Stearns is bought by JP Morgan in deal brokered by Fed, approved 5/29/08 7/12/08 IndyMac Bank Fails9/8/08 Fannie and Freddie are taken over by government9/14/2008 Lehman Bros is allowed to fail & Merrill Lynch is bought by Bank of America 9/17/08 AIG is bailed out by government9/21/08 Goldman Sachs and Morgan Stanley become commercial banks as opposed to investment banks 10/3/08 Wachovia is bought by Wells Fargo after backing out of deal with Citigroup

Lehman Brothers

Largest Issuer of Commercial Paper

Large player in Fixed Income

Active in Credit Default Swaps

The Big Picture

Problems in Mortgage Market

Global Credit Crisis / Bank failures / Equity Losses

Declining Consumer Spending Decreased Business Investment

Spillover

Failure of Financial InstitutionsUncertainty about value of assetsFear of Liquidity (Runs on banks)Loss of Lehman – Commercial paper and CDS

Consumer Confidence shakenRetirement account uncertainty

Sale of assetsDecreasing share priceDecrease asset values

Supplemental Federal Reserve Actions

December 12, 2007: Term Auction Facility (TAF)December 12, 2007: New FX swap lines with the ECB and SNB announced.March 11, 2008. Term Securities Lending FacilityMarch 16, 2008. Primary Credit Dealer FacilitySeptember 14, 2008. TSLF expanded to $200 billionSeptember 24, 2008. FX swap lines to $277B September 29, 2008 Federal Reserve coordinate with other central banks to expand significantly the capacity to provide U.S. dollar liquidity

Supplemental Federal Reserve Actions - Oct

October 6, 2008 Board announces that it will begin to pay interest on depository institutions' required and excess reserve balances

October 7, 2008 Board announces creation of the Commercial Paper Funding Facility (CPFF) to help provide liquidity to term funding markets

October 21, 2008 Federal Reserve announces the creation of the Money Market Investor Funding Facility (MMIFF)

Nov 10, 2008 American Express becomes bank holding company

Assets on Fed Res Balance Sheet Aug 2008 – April 2009