© 2004 Sand Hill Econometrics. All rights reserved.
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The Subprime Financial Crisis
Roots of the Crisis
Susan Woodward, Sand Hill Econometrics
© 2004 Sand Hill Econometrics. All rights reserved.
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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
© 2004 Sand Hill Econometrics. All rights reserved.
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Real Residential Construction, 1968-2008
Residential Construction, 1968-2008
0
500
1,000
1,500
2,000
2,500
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Year
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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)
© 2004 Sand Hill Econometrics. All rights reserved.
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Mortgage Interest Rates, 1987-2009 by 2003, the big refi boom was over
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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.
© 2004 Sand Hill Econometrics. All rights reserved.
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Mortgage Originations, 2001-2007, $ trillions
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
2001 2002 2003 2004 2005 2006 2007
subprime
prime
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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.
© 2004 Sand Hill Econometrics. All rights reserved.
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Little signs that all was not well…
© 2004 Sand Hill Econometrics. All rights reserved.
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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.
© 2004 Sand Hill Econometrics. All rights reserved.
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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.
© 2004 Sand Hill Econometrics. All rights reserved.
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Crisis was mainly a Large Bank crisis
© 2004 Sand Hill Econometrics. All rights reserved.
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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 all of 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.
© 2004 Sand Hill Econometrics. All rights reserved.
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Stuff done right
Inject capital into banks
increased inter-bank trust
interbank lending resumed
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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
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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
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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
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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
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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.
© 2004 Sand Hill Econometrics. All rights reserved.
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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
© 2004 Sand Hill Econometrics. All rights reserved.
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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
© 2004 Sand Hill Econometrics. All rights reserved.
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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.
© 2004 Sand Hill Econometrics. All rights reserved.
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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
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The Details
2009 2010 2011
Increased outlays by federal agencies34.8 110.7 76.3
Grants to individuals and state-local governments85.3 108.6 49.9
Tax cuts64.8 180.1 8.2
Total184.9 399.4 134.4
Stimulus, billions of dollars, by fiscal year (October to September), figures from CBO
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After another several months of bad employment figures, they will be back for more…
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How bad do things look now?
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What would be a more direct stimulus?
1. 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)
2. Increase level and duration of unemployment benefits
3. Investment tax credit to businesses
4. Pay employees’ part of payroll (social security) tax ($450 bn), perhaps also employers’ part
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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.
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Another idea…
Make the good bank an asset of the bad bank.
Debtholders still can recover from the total pool of assets
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Example: Citi Citi now Good bank Bad bank
Assets
Loans 1,935 1,325 610
Equity in other bank - - 427
Total assets 1,935 1,325 1,037
Liabilities
Deposits 780 780 -
Bonds 1,144 118 1,026
Equity 11 427 11
Capital ratio 0.5% 32.2% 1.0%
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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
© 2004 Sand Hill Econometrics. All rights reserved.
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