THE ROOTS of the CURRENT FINANCIAL MELTDOWN

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CURRENT

FINANCIAL

MELTDOWN

Gökhan Karahan, Ph.D.

November 7, 2008

Jackson, MS

July 2007

DJIA: Over 14,000

November 2008

DJIA: Less than 9,000

Early 2007

Irrational Exuberance

Home ownership/Credit

(ELC, HELOC, CC)

April 2007

New Century Financial

Declares Bankruptcy

March 2008

Investment bank, Bear

Sterns, gets bailed out

September 2008

US and global economic systems show greatest distress since the 1930s

---investment banks

---insurance companies

---banks

---corporations

---small businesses

---workers (1.2 million jobs lost in 2008)

---retired people and those about to retire

---and everybody else

Why?

“….subprime mortgage lending…..”

“The point of studying economics is so as not to be fooled by economists.”

Joan Robinson

NATURE of the PROBLEM

A very small niche of the American housing finance system, the subprime market, became collateralized and securitized and ended up with an extraordinary and very surprising level of outstanding mortgage-backed securities backed by subprime mortgages. I suspect, although I must admit I can't prove, that if there were never any collateralization of those securities issues specifically, I think that the level of originations of subprime would have been much lower because remember they were a very small segment of the market until the tail end of the housing bubble. We couldn't really judge at the time was that the original subprime were securitized, they weren't subprime and therefore had very, very high rates of return on them but at that point in the ... an odd situation where the issue of foreclosures or ... The demand for them, the hedge funds, pension funds, and everybody else looked to be an exceptionally high return, exceptionally low risk, became extraordinarily large the say hedge funds puts pressure on the ... basically the investment bankers in the United

States, and the security returns to the lenders say ‘we need more paper' and what they basically did, they said to the lenders effectively - although I'm sure contracts are involved - is whatever you can get we will take to securitize and the underwriting standards collapsed.

????????????????????!!!!!

LET THE STICKMEN SPEAK!

CLINTON YEARS:

We encourage the Fannie

Maes and the Freddie

Macs to provide mortgages to those who cannot afford.

BUSH YEARS:

Ownership society ownership society ownership society ownership society ownership society ownership society ownership society

OUR POLITICIANS

JOE PUBLIC at a Real Estate Agency

……………………

……………………

I would like you to show

……………………

………………….;\;;;

You do not strike me as someone who could afford it… but who cares if you somehow get your financing,

I am going to get my big fat real estate commission anyway!!!

BIG MANSION REALTY, INC.

JOE PUBLIC at an APPRAISAL AGENCY

………………………

…………….;\;;;;;;;;;;;;;; for it.

;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;

;;;

UP-RAISERS, INC.

A week or so later…..

JOE PUBLIC at the APPRAISAL AGENCY

……………………… appraise for?

………………………

…………….;\;;;;;;;;;;;;;; increased by $50,000 since last

;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;; yesterday!!!

;;;

OVER APPRAISERS, INC.

JOE PUBLIC is at a MORTGAGE BROKER

.

Gee, I would like to buy a house but I have not saved any money for a down payment and I do not think I can even afford monthly payments.

Can you help me?

Sure! Since the value of your house always goes up, we do not need down payments anymore!

Life is wonderful!…

Home prices always go up…

Buy a house at

$400,000 next year its value may be

$800,000…..

If you sell it next year, you have a hefty profit!!!

And we can give you a really really low interest rate for a few years just to give you a break….( We will raise it later!!!  )

Sure, no problem. Umm, there is one other thing…My boss is a really bad person and might not verify my employment. Would that be a problem?

Not at all. We can get you a “Liar’s Loan!”

AKA, Teaser Rates…. your LOW interest rate is fixed for a few years after which the interest rate can change every year to the index value plus the margin (subject to the interest rate caps ).

These programs are offered for borrowers with less-than-perfect credit. They allow you some years to rebuild your credit, at which point you may hopefully refinance at a better rate!!!

NINJA LOANS…No income, no job or assets loans!

Maybe, I should buy two-three more houses!!!

You guys are awesome!. You are really willing to work with me.

Well, we do not actually lend you the money---a bank will do that. (So, we really do not care if you repay the loan or not. We still get our fat commission!) 

Wow! Lets get started then!

ACE MORTGAGE BROKERS, INC.

A few weeks later at “Everyone Gets

Approved Bank” ……

……… I’d better get rid of these loans. They are starting to stink up my office. Thankfully, the really smart guys in NY (investment banks) will buy them and perform their financial magic and market them!

FYI, Joe Public loses the job he does not have, and, on account of excess supply of new homes and existing homes and the borrowers’ inability to pay their mortgages, home prices take a hit… In fact, Joe

Public’s new home is worth less than the amount he owes… He leaves his home’s key in the bank’s “drop key box” and walks away…..

Some times later in the office of “really smart guys”…..

rid of these bad mortgages before they start attracting flies!

these bad loans boss?

…………………………

……………………….

I got it! First, we will create a new security (financial instrument) and use these bad mortgages as collateral. We will call it a CDO (collaterized debt instruments)… We can sell these CDOs to investors and promise to pay them back as the mortgages are paid off.

……………….

.

Sure, individually they may be bad loans but if we pool them together, only some of them will go bad, certainly not all of them. Given that housing prices always go up, we’ll do just fine! The CDOs work like this: We will divide it into three pieces (TRANCHES) and we will call them “The Good”, “The Not-so-Good” , and “The Ugly.”

……………….

.

And, if some of the mortgages fail and some will surely fail, we will promise to pay the holders of “The Good” ones first, “The Not-so-

Good” ones second, and “The Ugly” ones last.

………………

..

I am starting to get it! Because “The Good” investors have the least risk, we will pay them a lower interest rate than the other guys, right? In fact, “The Ugly” ones will get the highest interest rate!

……………

…….

Exactly! But wait! It gets better! We will buy bond insurance for “The Good” ones so that the rating agencies will give us AAA rating. They will likely give

“The Not-so-Good” ones BBB rating. Btw, we won’t even bother asking them to rate “The Ugly” ones.

Now, if the bond insurer goes belly up, that would be really bad!!!!

AIG!!!!!!!!

Also, I am not really sure that these rating agencies understand what they are rating and if they do not get paid by the very companies they are rating..….

But hey that is not my problem!!!

So you have managed to create AAA and BBB securities out of these bad mortgage loans… You are a genius!

..

……………

I know!

Now, who are we going to sell these good ones to?

The regulators won’t let us sell these to the public…We sell them to big time investors..

Like who?

Like insurance companies, banks, small towns in Norway, Iceland (!), school boards in Kansas--to anyone who is looking for a high quality-safe investment

This is all great but we still have these “bad loans” on our books, on our balance sheet, don’t we?

………………

……………….

No, of course not. The guys who write the accounting rules allow us to set up a shell company somewhere in the Caribbean to take ownership of the mortgages. These bad mortgages go on their balance sheets, not ours. The fancy name for this is “Special

Purpose Vehicles, SPVs.”

That’s great, but why would they let us do that? Aren’t we just moving our “baddies” around?

Sure…but we have convinced the regulators that it is vitally important to the financial security of the United

States and the world that investors not know about these complex transactions and what is behind them.

But if push comes to shove, we can go to our reps in

Washington and ask for a bailout!

Let us drop to see the King of All

Regulations…

Office of the King of

All Regulations

Sir, as an investor and a concerned citizen, I demand that you force our financial institutions to show greater transparency, openness, and accountability in their financial reporting! How about some oversight!

Office of the King of

All Regulations

Uhmmmmm!!!

………………

…..

Office of the King of

All Regulations a big uhmmmmm!!!!!!!!!

………………

…..

Office of the King of

All Regulations

………………

…..

Meanwhile, the US financial chaos spreads overseas...

Hey man!. What is up?…

Why are we not receiving our monthly payments?

The regular Joes out there are not able to make their mortgage payments…

Hold on a minute! We bought the good piece, the AAA one, the safe one. We were supposed to get paid first !

Well unfortunately the loans were a little worse than we originally thought and there is very little cash coming in. Frankly, we are as disappointed as you are.

But you told me that housing prices always go up and that your borrowers could always refinance their mortgages!

Yes…it was a bad assumption…we really messed up… Sorry!!!!!

Bad assumption!!! ……….

What about the AAA ratings?

They messed up, too?

But this security was insured…

What happened to the insurers?

Are you kidding? They do not have that much money to cover this mess…In fact, if the government does not help, they are probably bankrupt as well..

That’s just great. Now what am I supposed to tell my villagers?

Tell them you messed up!

#%^^*9%4*!

Whatever… Look! I have to go now… We are having a spa party in the “Bailouts-R-4-US Resort” in CA… Your are welcome to invite your villagers to the party…

Who is going to pay for all this?

MY FELLOW CITIZENS, CHILDREN and GRAND

CHILDREN , and GREAT GRAND CHILDREN and…....

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……………

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Sources: The Economist, Ken Cyree, William F. Shughart II, http://www.mymoneyblog.com/archives/2008/02/subprime-loan-crisis-explainedby-cartoon-stick-figures.html

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