October 2010
Special Talk for PBL
The Great Recession:
How did it happen & where do we go from
here?
David Robinson
© D. Robinson, 2010
Disclaimer: This lecture contains
opinion—your interpretation
may differ
Many Causes to the Current Recession
1. Government overspending
2. Misjudging interest rates
3. The housing “bubble” and the underlying
mortgage crisis
How Mortgages are supposed to work
• Mortgages are essential for home ownership
• Why they are considered safe investments
• How securitization increased the availability of
mortgages
• Expanding mortgages further
Mortgages help people buy
houses
Home ownership is part of the
American Dream
Mortgages help people buy houses
• Definition: Mortgage—a loan secured by real
estate.
• If you don’t pay, you get thrown out and the
bank takes the house (repossession) then resells the house and pays off the loan
Without Mortgages
• Without mortgages, you
have to save and save
and save and buy a
smaller house when
you are in your 50s
Why Conventional Mortgages
were very safe: “Conforming Loans”
• Historically, you had to
have good credit to buy
a house
• Loan payments could
not be more than 28
percent of your income
• The loan-to-value had
to be 80 percent
Why 90 percent made
sense for “First Time
Borrowers”
Introduction to
Securitization of Mortgages
Without the “Secondary Mortgage” Market
Depositors put money
into the bank that the
bank loans as a
mortgage
Mortgage
Game
over !
With the “Secondary Mortgage” Market
Sell the mortgage to
an investor—now the
bank has more money
to lend!
Mortgage
The Mortgage Process
Conforming Loans
Originator
Local bank
or
mortgage
company
Fannie &
Freddie
Investment
Banks
Bond
holders
The Mortgage Process
Conforming Loans
Originator
Fannie &
Freddie
Bond
money
Investment
Banks
Bond
holders
Were they/weren’t they
“Government bonds”?
Introducing
Fannie, Freddie & Ginnie
Government Sponsored Enterprises
(GSEs) Fannie Mae, Freddie Mac and
Ginnie Mae
GSE’s were set up to purchase and
“securitize” the loans
• “Fannie Mae” Federal National Mortgage
Association
• Depression era Government agency
• Set up to buy mortgages, so banks had money to lend
• In 1968, Johnson “sold” FNMA off as a publicly
traded company
• “Backed by the US Government”
• Reason:
To get rid of their debt from the Federal Budget (!)
More “GSEs” (Government Sponsored
Enterprises)
• Federal Home Loan Mortgage Corporation
(“Freddie Mac”) created 1970 to purchase
mortgages from “Savings & Loans”
• (There are no more S&Ls, they are now converted to
banks)
• Ginnie Mae is part of HUD (not a corporation)
• Manages government program mortgages, such as
– Veterans loans,
– First-time homeowner programs, etc
The GSEs bought “conforming” loans—
but others could be sold to banks
Conforming Loans
Originator
Packaged
& sold, say
5,000 mortgages
Fannie &
Freddie
Non-conforming
loans
Investment
Banks
Bond
holders
The Mortgage Process
Originator
Fannie &
Freddie
Investment
Banks
Who are the bond holders?
“Institutions” (= life insurance,
pensions, government agencies),
other countries + a few wealthy
individuals
Bond
holders
The Mortgage Process
How do I know if this
stuff is any good?
Bond
holders
Investor
The Mortgage Process
How do I know if this
stuff is any good?
Bond
holders
Investor
Ratings Agencies
Standard & Poors,
Moody’s and Fitch
Securitization of mortgages
Bank
Loans
Investors
Securitization of mortgages
These are
bonds “I
promise to
repay”
Bank
Loans
Investors
If one loan goes bad, it’s made up for by a
pretty good interest rate on the other loans
Bank
Loans
Investors
If one loan goes bad, plus we can foreclose,
resell the property and get our money back
Bank
Loans
Investors
So How Do I Know if this Stuff is Safe?
How do I know if
this stuff is any
good?
Bond
holders
Investor
Ratings Agencies
Standard & Poors,
Moody’s and Fitch
The Mortgage Process
How do I know if this
stuff is any good?
Bond
holders
Investor
Ratings Agencies
Standard & Poors,
Moody’s and Fitch
Ratings Agencies:
Hey! This stuff is as safe as houses!
Ratings Agencies
“It’s AAA rated!”
Investor
Ratings Agencies
Standard & Poors,
Moody’s and Fitch
Expansion of Mortgage Credit
Easier to get a loan
• Home ownership is considered
good for society
• Why?
• Clinton administration relaxed
the rules, specifically to get
more minority home ownership
• Even George Bush preached
“The Ownership Society”
Easier to get a loan
• No longer 20
percent down
• Not perfect
credit—no
worries!
• Can’t quite afford
to repay all? We’ll
add what you owe
to the principal
Faulty Assumptions
• No longer 20 percent
down
• Not perfect credit—no
worries!
• Can’t quite afford to
repay all? We’ll add
what you owe to the
principal
• House prices will grow
so fast, the low
downpayment won’t
matter
• People with poor credit
will become Boy Scouts
once they are in a home
• Everyone’s income will
go up like an intern MD
Summary about Mortgages
• Home ownership is generally considered to be
a societal “good thing”
• Mortgages are essential for broad home
ownership
• Securitization makes funds from investors
available for mortgages
• Regulations were relaxed to encourage more
people to own homes
Credit Default Swaps
Why did Warren Buffet famously
describe these as “financial weapons
of mass destruction”?
Credit Default Swaps (CDS)
Originator
Fannie &
Freddie
Investment
Banks
Bond
holders
Hmm… what if these
guys default ?
Credit Default Swaps (CDS)
Originator
Fannie &
Freddie
No problem! We’ll
write you a CDS
Investment
Banks
Bond
holders
Hmm… what if these
guys default ?
Credit Default Swaps (CDS)
Who are these
guys?
Other banks,
Insurance Cos
(AIG), Hedge
funds
No problem! We’ll
write you a CDS
Investment
Banks
Bond
holders
Hmm… what if these
guys default ?
How a CDS works
• Investor “A” owns $1 million of bonds of bank
“B”
• There’s a 2 percent chance that bank B won’t payoff
and A would have a loss of $1 million.
• A is prepared to pay 0.02 X $1 million = $20,000 for
“insurance” (a CDS) that says:
• “If Bank B goes into default, then entity C will
pay investor A the sum of $1 million.
• C gets $20,000 as “pure profit” right now
Definitions
• Hedge fund:
• A financial management firm that takes money from big investors
and seeks out long-term high-risk (& potentially high reward)
investments
» Buying up and fixing failing companies
» Trading across different markets
• Derivative
• By definition, a financial instrument whose value depends on the
value of another financial product.
» Example, a “Future” the right to buy a stock at a specific price
» In general, listed and regulated by certain stock or commodity
exchanges
Credit Default Swaps (CDFs)
C
Hmm, is this
Insurance or a
“derivative”?
Who are these
guys?
Other banks,
Insurance Cos
(AIG), Hedge
funds
No problem! We’ll
write you a CDS
B
Investment
Banks
A
Bond
holders
Hmm… what if these
guys default ?
Fade to black
How it all went wrong
Credit Default Swaps
Why did Warren Buffet famously
describe these as “financial weapons
of mass destruction”?
Credit Default Swaps (CDFs)
Who are these
guys?
Other banks,
Insurance Cos
(AIG), Hedge
funds
No problem! We’ll
write you a CDS
Investment
Banks
Bond
holders
Hmm… what if these
guys default ?
How CDSs Blew Up
• So many firms laid off risk to each other that there
were $60 Trillion (Yes! Trillion) of Swaps trading when
the music stopped
• [The whole US economy is about $14 Trillion, the GDP of the
whole World is about $69 Trillion]
• No one had priced in “event risk”—that something
would go wrong
• No one had factored in declining house prices (guess
what? It’s happened before!)
How it went wrong when the
music stopped
House prices didn’t go up & up
forever and ever
Securitization of mortgages
These are
bonds “I
promise to
repay”
Bank
Loans
Investors
If one loan goes bad, it’s made up for by a
pretty good interest rate on the other loans
Bank
Loans
Investors
Fannie and Freddie went on a
drunken binge
Fannie and Freddie grew too big
• 70 percent of all
mortages
• ? Public “guarantee”
• But! Private $alaries
• Lots of commissions to
Wall Street Banks
• Huge lobbying
expenditures to congress
Why were people buying this junk?
1. Interest rates were very low—everyone was
looking for a “good return”—why not
mortgages?
2. They were sold as AAA rated—as safe as
houses
Breakdown of the Mortgage Process
More
business =
more
commissions!
Conforming Loans
weakened!
Originator
Outright
fraud—
why?
Fannie &
Freddie
Investment
Banks
Bigger
means
more
bonuses!
Ratings
agencies
offered
false
reassurance
Bond
holders
Desperate
for “a
return”
Interest rates were too low
“I was wrong in
my assumptions”
• Why?
• Y2K then dot.com
meltdown
• Avoided a recession,
but . . .
• Huge “asset bubble”
(house prices)
• Why? Because loans
were cheap
What assumptions were wrong?
“I was wrong in
my assumptions”
• [Alan Greenspan,
long-term Chairman
of the Federal
Reserve]
Result of too-low interest rates
1. Asset bubble—rise
in house prices much
faster than the
general rate of
inflation
2. Vast overbuilding of
housing stock
Result of loan standards that were
too lax: Everyone could buy
•
Good news! It’s
really easy to get a
loan!
• Bad news—my
hairdresser just got
approved
for $700K!
• Prices bid up
Housing prices became
a classic “bubble”
• We all know what
happens to bubbles . . .
• Define bubble?
• Prices go up faster than
value
• Then everyone wants to
buy—even at high
price—in the hope of
making even more
money
Investors—including other nations(!) —
were encouraged to buy
Bank
Loans
“Hey these things return a
bit more interest, and are
very highly rated . . .”
Investors
If more than a few loans go bad,
you’ve got big trouble
Bank
Loans
Investors
Then, as house prices fall, the loans are
bigger than what the house is worth!
Bank
Loans
Investors
What happens
when the bubble bursts?
• When the loan is larger than the house, why keep
making the payments?
• It takes at least 6 months to get someone out of a
foreclosed home
• With prices dropping, you can no longer recover the
amount loaned on the mortgage
(More) What happens
when the bubble bursts?
• Whole neighborhoods have too many foreclosed
homes—who would want to buy there?
• Impact for cities: Unpaid taxes, but huge public
safety burdens
(More)Why it was impossible to
quickly resolve the “Sub-prime Crisis”
• People with poor credit have poor judgment
•
•
•
•
As house prices went up, they borrowed more and
Spent it on consumption (vacations)
That money is gone
They may not have the ability to service the debt
It gets worse: Tranches
“Tranche 1”
Bank
Loans
Investors
“Tranches”
• I-bank issues a bond, split into five
“tranches”
• “Tranche 1” accepts the first 10
percent of defaults (and gets more
of the interest)
• The I-Banks kept a lot of these—that’s
why they’re in trouble
• “Tranche 2” gets hit with the next
10 percent of defaults, etc
• The Tranches mean it’s almost
impossible to unwind these loans—
who owns which loan?
Why it was impossible to quickly
resolve the “Sub-prime Crisis”
• Each mortgage was owned (in part) by up to
5,000 investors
• How do you get them to agree to a “restatement”, a
“short sale” or a “haircut”?
• Definitions:
Preview:
None of
these are
going to
work
• Restatement: Bank agrees borrower can pay less per month
• “Short sale”: Bank agrees house can be sold for less than the
mortgage is worth
• “Haircut”: Bank keeps homeowner in the home and agrees they
owe less money
Update! (Fall 2010):
The MERS Mess
• But aren’t the mortgages
backed by real houses?
• Can’t you just sell them
off and make the
bondholders happy?
Update! (Fall 2010):
The MERS Mess
1. It’s very unclear who owns
which mortgage (It’s been
sliced and diced into so
many bonds and tranches)
2. Selling all the houses
(about 25+ percent of the
US housing stock) is
depressing prices
3. In some cases, banks can’t
find the signed paperwork
• But aren’t the
mortgages backed by
real houses?
• Can’t you just sell them
off and make the
bondholders happy?
The Executive Branch Response
The Executive Branch Response
First: Bush II
The “End of Wall Street “
• Bear Stearns: A “sweetheart” deal sold to JP
Morgan/Chase
• The government agreed to “back” some of BS’s losses
• AIG—it’s an insurance company!
• $85 Billion in loans from the NY Fed (why?)
• Whoops, another $38.6 billion
• Lehman Bros
• Tough luck! File for bankruptcy
Lurching, inconsistent and
incomprehensible
1.
2.
3.
4.
5.
Nationalized Fannie and Freddie after
swearing that they weren’t really
government owned
Bailed out Bear Stearns, but threw
Lehman under the bus
AIG is not a bank
$700 Bn [Tarp] is not nearly enough to
mop up the bad loans
None—none!—of the “mortgage
modification” programs worked
The Executive Branch Response
Now: Obama
Well-intentioned, but not bearing
the pain to work this through
1.
2.
3.
Fannie and Freddie have grown from
monster-sized to “the great blob”
(The government owns your
mortgage)
Super-low interest rates have allowed
the Banks to make a profit—but they
aren’t loaning to business
Haven’t yet realized: None—none!—
of the “mortgage modification”
programs will work
The Housing crisis is not-much
improved since 10/2009
Hoping for a
miracle?
Where do we go from here?
I: Managing the mortgage mess
President Obama began
calling people out:
• “This crisis is neither the
result of a normal turn of the
business cycle nor an
accident of history. We
arrived at this point as a
result of an era of profound
irresponsibility . . .”
75
1. Keep people in their homes
• Less social disruption
• Tends to preserve the
value of the
neighborhood
1. Keep people in their homes
• Less social disruption
• Tends to preserve the
value of the
neighborhood
• Non-payment on
mortgages hurts the
bondholders
• That’s your grandma, your
state’s pension plan
• Uncertain homeowners
won’t (or don’t have
the money to) keep the
place up
2. Renegotiate the Principal
• You bought too high!
• Let’s just make your
$800K mortgage now
$400K—that’s all you
owe!
2. Renegotiate the Principal
• You bought too high!
• Let’s just make your
$800K mortgage now
$400K—that’s all you
owe!
• Punishes prudent
borrowers who bought
within their means
• Enriches the foolish
• Violates contract law—
it can’t happen
• Robs from the bond
holders (your grandma)
3. Lower the interest rate so much that the
monthly mortgage payment is cheaper
• This is the current
approach
• Mortgage rates are
their lowest for 50 years
• About 4.5 percent
(6.0 is typical—often
more)
• The “good”
homeowners are all
refinancing
3. Lower the interest rate so much that the
monthly mortgage payment is cheaper
• This is the current
approach
• Mortgage rates are
their lowest for 50 years
• About 4.5 percent
(6.0 is typical—often
more)
• The “good”
homeowners are all
refinancing
• Doesn’t help those who’ve lost
their jobs
• Doesn’t help those who really
couldn’t afford a house anyway
• Government now owns 90
percent of all new mortgages!
• These are low going to pay a low
return for a long time
• Immobility: Once mortgage rates
return to normal, people will be
reluctant to move for job changes
4. Pop the Bubble: Foreclose on everything
• Prices will drop low
enough that investors
will buy the houses
• Rent out to people who
used to own
• (House prices are
already back to 2003
levels in SF Bay Area)
4. Pop the Bubble: Foreclose on everything
• Prices will drop low
enough that investors
will buy the houses
• Rent out to people who
used to own
• (House prices are
already back to 2003
levels in SF Bay Area)
• Massive social
disruption
• Families move
• Angry voters
• Kids moved from schools
• Many bonds will lose
much of their value
when the houses are
sold at less than the
mortgage
Where do we go from here?
I: What will happen to the Economy?
The Economic Outlook
• Stimulus funding has staved off a huge “crash”
• But it’s led to the “jobless recovery”
• Longer we wait to process all the “underwater
homes” the longer the recession will continue
• Popping the zit will hurt, yes
• We are looking to at least 2 – 3 more years before
there’s a turn-around
Reasons to be Pessimistic
• Earlier this year I gave a talk with the title:
Reasons to be Pessimistic
• Earlier this year I gave a talk with the title:
Why We Are Toast
Possible Scenarios
A. Mortgage crisis + fear of the National Debt
total = Double dip “W-shaped” recession
B. Second round stimulus and eventually we
grow out of it
A. Unlikely to happen if you don’t deal with housing
C. Endless stimulus and overspending = We
become Japan: 1 percent or less growth for 2
decades (3 percent is typical for the US)
• No jobs for college grads
Summary
• The “melt-down” was no surprise—you have
to pay the piper sometime
• Nearly a decade of Federal fiscal
irresponsibility is catching up with us
• We can work out these problems over a
decade or so. . . if we have the political will to
address them
• It won’t be easy