11

The U.S. Financial CrisisThe U.S. Financial Crisis

Sara HsuSara Hsu

October 3, 2008October 3, 2008

22

It all started with US It all started with US mortgages…mortgages…

33

Families just wanted to Families just wanted to

pursue the American pursue the American

dream of home ownership…dream of home ownership…

44

But now many families are in danger But now many families are in danger of losing the homes they worked so of losing the homes they worked so

hard for.hard for.

55

People are also losing money in their People are also losing money in their 401Ks, and may not be able to get a 401Ks, and may not be able to get a home or car loan.home or car loan.

In this talk, we will answer the In this talk, we will answer the following questions: How did this following questions: How did this begin? What exactly is going on, and begin? What exactly is going on, and where is it leading?where is it leading?

66

What happened?What happened?

The The crisis began in the subprime crisis began in the subprime mortgage area, hitting the U.S. and mortgage area, hitting the U.S. and triggeringtriggering a global financial crisis a global financial crisis inin 2008.2008.

■■ ■■ ■■ The crisis began with the The crisis began with the bursting of bursting of

the US housing bubblethe US housing bubble and high default and high default rates on "subprime" mortgages made rates on "subprime" mortgages made to higher-risk borrowers with lower to higher-risk borrowers with lower income or lesser credit historyincome or lesser credit history..

77

What is subprime?What is subprime?

The term subprime lending refers to The term subprime lending refers to the practice of making loans to the practice of making loans to borrowers who do not qualify for borrowers who do not qualify for market interest ratesmarket interest rates. . Interest rates Interest rates for these borrowers are usually for these borrowers are usually higher.higher.

88

““Credit Crunch”Credit Crunch” Banks are all facing a Banks are all facing a

problem of having less problem of having less credit for lending credit for lending money, since so many money, since so many people cannot pay people cannot pay back the mortgage back the mortgage loans, and since other loans, and since other financial institutions financial institutions have failed. Other have failed. Other banks now will not lend banks now will not lend to them. This is a to them. This is a “credit crunch.”“credit crunch.”

99

When did this begin?When did this begin? TThe he stock marketstock market & dot-com & dot-com crash crash in in

2000 resulted in many people taking 2000 resulted in many people taking their money out of the stock market their money out of the stock market and purchasing real estate, which and purchasing real estate, which many believed to be a more reliable many believed to be a more reliable investment. investment.

■■ ■■ ■■ At the same time, the At the same time, the Federal Reserve Federal Reserve

cut short-term interest ratescut short-term interest rates to to historically low levels, from about 6.5% historically low levels, from about 6.5% to just 1%to just 1%, which allowed more people , which allowed more people to purchase homes for a lower cost.to purchase homes for a lower cost.

1010

Subprime borrowing was a Subprime borrowing was a major contributor to an major contributor to an increase in home ownership increase in home ownership rates and the demand for rates and the demand for housing. housing.

Some homeowners used Some homeowners used increased property valueincreased property valuess fromfrom the housing bubble to the housing bubble to refinance their homes with refinance their homes with lower interest rates and take lower interest rates and take out second mortgages against out second mortgages against the added value to use the the added value to use the funds for consumer spending. funds for consumer spending.

1111

Then the bubble burst. OThen the bubble burst. Overbuilding verbuilding during the boom period, increasing during the boom period, increasing foreclosure rates and unwillingness of foreclosure rates and unwillingness of many homeowners to sell their homes at many homeowners to sell their homes at reduced market prices have significantly reduced market prices have significantly increased the supply of housing increased the supply of housing inventory availableinventory available, driving down prices, driving down prices. .

MMore homeowners are ore homeowners are now now at risk of at risk of default and foreclosure. default and foreclosure.

1212

Foreclosure has hit some Americans very hard.Foreclosure has hit some Americans very hard.

1313

Borrowing Climate ChangedBorrowing Climate Changed Borrowers took out loans under terms Borrowers took out loans under terms

that were not so great, since they that were not so great, since they thought theythought they would be able to refinance would be able to refinance at more favorable terms laterat more favorable terms later. .

■■ ■■ ■■ ButBut once housing prices started to drop once housing prices started to drop

moderately in 2006-2007moderately in 2006-2007, , refinancing refinancing became more difficult. Defaults and became more difficult. Defaults and foreclosure activity increased foreclosure activity increased dramatically as interest rates reset dramatically as interest rates reset higher. higher.

1414

1515

The mortgage lenders that The mortgage lenders that retained credit risk were the retained credit risk were the first to be affected, as first to be affected, as borrowers became unable to borrowers became unable to make payments. make payments.

Major banks and other Major banks and other financial institutions around financial institutions around the world reported major the world reported major losses, with Lehman losses, with Lehman Brothers recently declaring Brothers recently declaring bankruptcy and other major bankruptcy and other major lenders, including Fannie lenders, including Fannie and Freddie, seeking shelter.and Freddie, seeking shelter.

1616

SecuritizationSecuritization Owing to securitization, many Owing to securitization, many

mortgage lenders had passed the mortgage lenders had passed the rights to the mortgage payments and rights to the mortgage payments and related creditrelated credit & & default risk to third-default risk to third-party investors via mortgage-backed party investors via mortgage-backed securities (MBS) and collateralized securities (MBS) and collateralized debt obligations (CDO).debt obligations (CDO).

■■ ■■ ■■ Corporate, individual and institutional Corporate, individual and institutional

investors holding MBS or CDO faced investors holding MBS or CDO faced significant losses, as the value of the significant losses, as the value of the underlying mortgage assets declined. underlying mortgage assets declined.

1717

Financial InstitutionsFinancial InstitutionsA variety of factors caused lenders A variety of factors caused lenders

to offer an increasing array of to offer an increasing array of higher-risk loanshigher-risk loans to higher-risk to higher-risk borrowers. borrowers.

■■ ■■ ■■TThe risk premium required by he risk premium required by

lenders to offer a subprime loan lenders to offer a subprime loan declined. This occurred even declined. This occurred even though subprime borrower and loan though subprime borrower and loan characteristics declined overall characteristics declined overall during the 2001-2006 periodduring the 2001-2006 period..

1818

Mortgage BrokersMortgage Brokers

Mortgage brokers Mortgage brokers dodo not not lend their lend their own moneyown money. There is not a direct . There is not a direct relationshiprelationship between between actual actual loan loan performance and incomeperformance and income for for mortgage brokeragesmortgage brokerages. .

■■ ■■ ■■ They have big financial incentives for They have big financial incentives for

selling complex adjustable rate selling complex adjustable rate mortgages (ARMs), since they earn mortgages (ARMs), since they earn higher commissions. higher commissions.

1919

Mortgage UnderwritersMortgage Underwriters

Underwriters determine if the risk of Underwriters determine if the risk of lending to a particular borrower lending to a particular borrower meet meet their criteria oftheir criteria of credit, capacity and credit, capacity and collateralcollateral, but these were not closely , but these were not closely looked at leading up to the lending looked at leading up to the lending crisiscrisis. .

2020

CreditCredit RRating ating AAgenciesgencies Credit rating agencies Credit rating agencies

are now under scrutiny are now under scrutiny for for giving giving high ratings high ratings to the securities to the securities based based on subprimeon subprime mortgage mortgage loans. loans. RRating agencies ating agencies are paid by investment are paid by investment banksbanks, so they had a , so they had a financial incentive for financial incentive for marking up the ratingsmarking up the ratings..

2121

Central BanksCentral Banks The US central bank, the Federal The US central bank, the Federal

Reserve, lowered interest rates just Reserve, lowered interest rates just after the dot-com crash to counter after the dot-com crash to counter the risk of deflationthe risk of deflation, but this , but this encouraged borrowers to take out encouraged borrowers to take out more home loansmore home loans..

2222

Federal Reserve Response to Federal Reserve Response to CrisisCrisis

At first, the Fed lowered interest rates At first, the Fed lowered interest rates and then sent a call out to banks to and then sent a call out to banks to negotiate mortgage terms with their negotiate mortgage terms with their borrowers, to prevent foreclosures.borrowers, to prevent foreclosures.

■■ ■■ ■■ When the crisis deepened, the Fed When the crisis deepened, the Fed

bailed out Fannie Mae and Freddie Mac, bailed out Fannie Mae and Freddie Mac, let Lehman Brothers go bankrupt, and let Lehman Brothers go bankrupt, and purchased equity in AIG. The Fed also purchased equity in AIG. The Fed also persuaded the President and Congress persuaded the President and Congress to pass a $700 billion bailout for banks.to pass a $700 billion bailout for banks.

2323

The $700 Billion BailoutThe $700 Billion Bailout Sets up a Troubled Assets Relief Fund to Sets up a Troubled Assets Relief Fund to

purchase banks’ troubled assets at low pricepurchase banks’ troubled assets at low price Raises FDIC to $250,000 to aid small Raises FDIC to $250,000 to aid small

businessesbusinesses Underlying mortgage holders’ rights remain Underlying mortgage holders’ rights remain

the same; encouraged to contact HOPEthe same; encouraged to contact HOPE Subject to management/auditing oversightSubject to management/auditing oversight Renewal of R&D tax breaks for businesses Renewal of R&D tax breaks for businesses

for spending on renewable energyfor spending on renewable energy

2424

Regulatory ResponsesRegulatory Responses

The Fed has promised The Fed has promised to tighten regulation of to tighten regulation of financial institutions. financial institutions. Goldman Sachs and Goldman Sachs and Merrill Lynch jumped Merrill Lynch jumped the gun by voluntarily the gun by voluntarily transforming transforming themselves into regular themselves into regular banks, which face banks, which face tighter regulations.tighter regulations.

2525

Effect on Stock MarketsEffect on Stock Markets

Stock markets have Stock markets have been volatile as been volatile as various events of various events of the crisis have the crisis have played out. Over played out. Over the past year, the the past year, the Dow Jones Industrial Dow Jones Industrial Average has fallen Average has fallen by over 3,000 by over 3,000 points, over 20%.points, over 20%.

2626

Effect on Stock MarketsEffect on Stock Markets

Crisis has caused Crisis has caused panic in financial panic in financial markets and markets and encouraged investors encouraged investors to take their money to take their money out of risky mortgage out of risky mortgage bonds and shaky bonds and shaky equities and put it equities and put it into commoditiesinto commodities like like corn and oilcorn and oil as as "stores of value". "stores of value".

2727

Effect on Financial Effect on Financial InstitutionsInstitutions

Financial institutions Financial institutions have suffered greatly, have suffered greatly, with Lehman Brothers with Lehman Brothers going bankrupt and going bankrupt and Fannie Mae and Fannie Mae and Freddie Mac being Freddie Mac being taken under taken under government control. government control. Other banks will Other banks will struggle to renew struggle to renew their competitiveness.their competitiveness.

2828

Effect on Home OwnersEffect on Home Owners Housing prices are expected to Housing prices are expected to

continue declining until thcontinue declining until thee inventory of surplus homes is inventory of surplus homes is reduced to more typical levels. reduced to more typical levels.

2929

Effect on BusinessesEffect on Businesses

The effect on businesses has yet to be The effect on businesses has yet to be seen, since the “real” economy is next seen, since the “real” economy is next to be affected by the financial crisis.to be affected by the financial crisis.

Lower supplies of consumer credit mean Lower supplies of consumer credit mean demand for goods and services will fall.demand for goods and services will fall.

We have seen unemployment increase We have seen unemployment increase in September, and will likely increase in September, and will likely increase more in October, as workers from the more in October, as workers from the financial and then real sector are laid financial and then real sector are laid off, as demand falls.off, as demand falls.

3030

Transmission to Global Transmission to Global EconomiesEconomies

International International bbanksanks that that bought securities based bought securities based on US subprime on US subprime mortgages have been mortgages have been caught up in the crisis. caught up in the crisis.

The crisis has also spread The crisis has also spread as international financial as international financial markets have become markets have become volatile and vulnerable to volatile and vulnerable to the credit crunch.the credit crunch.

The global economy The global economy faces an enormous faces an enormous slowdown.slowdown.

3131

Anger at American Anger at American FinanciersFinanciers

At a summit meeting on the US financial At a summit meeting on the US financial crisis, crisis, Brazilian PresidentBrazilian President Luiz Inacio Luiz Inacio LulaLula da Silva said da Silva said “t “the euphoria of he euphoria of speculators has spawned the anguish of speculators has spawned the anguish of entire peoples, in the wake of entire peoples, in the wake of successive financial disasters that successive financial disasters that threaten the world's economy.threaten the world's economy. We must We must not allow the burden of the boundless not allow the burden of the boundless greed of a few to be shouldered by all.'' greed of a few to be shouldered by all.''

3232

Transmission to Global Transmission to Global EconomiesEconomies

Increase in world food Increase in world food and commodity pricesand commodity prices has resulted from the has resulted from the transfer of investment transfer of investment from housing to from housing to commodities such as commodities such as wheat and corn. wheat and corn. Prices of food are Prices of food are much higher in every much higher in every country.country.

3333

Future PossibilitiesFuture Possibilities How long it will take markets to How long it will take markets to

overcome the financial crisis and overcome the financial crisis and portending recession has yet to be portending recession has yet to be seen. Effects on consumers and seen. Effects on consumers and businesses continue as credit businesses continue as credit becomes less available.becomes less available.

Those who wanted to retire now Those who wanted to retire now must wait until later or cope with must wait until later or cope with having less in their 401K than they having less in their 401K than they had planned.had planned.

Current and future generations Current and future generations face a prodigious tax burden.face a prodigious tax burden.