Understanding the Sources and Way Out of the
Ongoing Financial Upheaval
PASEF
Susan M. Wachter
Richard B. Worley Professor of Financial Management
The Wharton School
University of Pennsylvania
Bank for International Settlements
Hong Kong Institute for Monetary Research
University of Pennsylvania
April 23, 2009
Global Downturn
• The economy is in the worst downturn since the Great Depression.
• Capital market crisis—more than a “recession” credit flow ended, globally
and global economy is withering.
• A self-reinforcing adverse cycle:
– The financial system crisis is upending the economy, putting further
pressure on the financial system
• US public policy response without precedent.
– Fiscal stimulus package
– Federal Reserve has vastly expanded its role
– What more is needed: for private credit flows to resume, confidence in
the financial system itself must be restored
– This requires understanding what went wrong and rebuilding the
architecture of the financial system
The Economic Backdrop
• Economy in “Great Recession”
– Unemployment at 8.5%
– 4th quarter decline in GDP at 6.2%, global decline 1.5%
• Volatility in global stock markets
– US and global stock prices are more than 40% down
• Angst in the banking system and credit markets remain badly
shaken
– Banks still not lending
The Economic Backdrop-Capital Markets
Source: Moody’s Economy.com
The Damage Is Not Over
• Real GDP began to fall in Q4 of 2007- fall continuing.
• 2.6 million jobs have already been lost and the unemployment rate is still
rising.
• Consumer confidence has crashed to its lowest reading ever
Source: Mark Zandi, Moody’s Economy.com
Response to the Crisis
• Fiscal Stimulus
– Unprecedented stimulus ($1 trillion)
• Monetary Stimulus
– Federal Funds Rate near zero
– Quantitative easing
• Banking Bailout
– TARP
• Missing: New Financial Architecture
– Need to understand what went wrong
Impact of Stimulus Measures
Source: Mark Zandi, Moody’s Economy.com
Monetary Stimulus
Source: Mark Zandi, Moody’s Economy.com
The state and local impacts
Source: Mark Zandi, Moody’s Economy.com
The Collapse-from housing to financial markets: still missing, the
new financial architecture
March, 2007
January, 2008
September, 2008
Global Financial Crisis: Made in the USA
• Triggered by actual and prospective losses on US
mortgages-leveraged losses far greater
• Global meltdown: Bad luck or inevitable?
• Boom-bust housing price cycle: Why?
• Reckless decline in mortgage lending standards (followed
by credit crisis and no private lending)
• Increased housing prices beyond sustainable heights
• Unprecedented house price rises hid problem loans-teaser
rates, no doc/low doc, option arm’s, NINJA loans
• Loans made that could not be repaid-betting on ever
increasing house price to rescue loans
A Severe National Housing Downturn
Figure 6: Price Appreciation Controlled for Volatility
2
1
0.5
-1
-1.5
-2
US Home Price
Canada Home Price
Australia Home Price
UK Home Price
France Home Price
Thailand Home Price
Japan Home Price
Hong Kong Home Price
20
08
20
06
20
04
20
02
20
00
19
98
19
96
19
94
-0.5
19
92
0
19
90
Annual Percent Change
1.5
WHY?
• Private label securitized mortgages, backed
leveraged derivatives, synthetics
• Decades of securitization—not the problem
• Interest rate risk securitized historically
• PLS securitized default risk, relied on
diversification—not Marked-to-Market, but
rather Marked-to-Model
• Expansion of toxic debt as asset, based on
collateral, and ever increasing house prices
Chronic imbalances
Sectoral contribution to U.S. gross debt
Percentage of GDP
Gross debt by U.S. sector
Percentage of GDP
140%
400%
350%
120%
Financial
Companies
300%
Financial
Companies
100%
Households
80%
Nonfinancial
Companies
250%
200%
Household
60%
150%
Government
40%
100%
Nonfinancial
Companies
20%
50%
Government
0%
1975
0%
1980
1985
1990
1995
2000
2005
1975
1985
1995
2005
15
Source: U.S. Federal Reserve, Bureau of Economic Analysis
Increased use of non-traditional
products
Mortgage originations by product
FHA/VA
Conv/Conf
Jumbo
Subprime
Alt A
HEL
2001
8%
57%
20%
7%
2%
5%
2002
7%
63%
21%
1%
2%
6%
2003
6%
62%
16%
8%
2%
6%
2004
4%
41%
17%
18%
6%
12%
2005
3%
35%
18%
20%
12%
12%
2006
3%
33%
16%
20%
13%
14%
2007
4%
48%
14%
8%
11%
15%
Deterioration of lending standards,
2002 to 2006: Leverage w/out Docs
Table 3
ARMS
Orig Yr
CLTV CLTV>80
Seconds
Full Doc
IO%
DTI FICO<700
Investor
WAC SpdtoWAC
Prime
2002
2003
2004
2005
2006
66.4
68.2
73.5
74.1
75.3
4.1
10.1
20.7
21.7
26.2
1.9
10.9
23.1
26.8
35.3
56.0
48.6
51.2
47.3
33.6
46
53
71
81
91
31.0
31.8
33.5
33.6
37.2
20.7
21.8
22.0
18.9
19.5
0.7
1.6
2.1
1.9
2.3
5.5
4.6
4.5
5.4
6.2
-
Alt A
2002
2003
2004
2005
2006
74.3
78.0
82.6
83.5
85.0
20.8
33.3
46.9
49.6
55.4
2.7
23.4
39.1
46.9
55.4
29.3
28.1
32.6
28.3
19.0
26
56
75
83
87
35.4
35.3
36.2
37.0
38.3
46.4
44.7
44.3
40.5
44.2
9.9
12.9
15.3
16.5
13.5
6.3
5.6
5.5
6.0
6.8
0.8
1.0
1.0
0.6
0.6
2002
2003
2004
2005
2006
81.2
83.5
85.3
86.6
86.7
46.8
55.6
61.1
64.4
64.0
3.7
9.9
19.1
28.1
31.0
66.9
63.5
59.9
55.9
54.6
1
5
20
32
20
40.0
40.2
40.6
41.2
42.1
93.4
91.6
90.6
89.7
91.8
4.7
4.9
5.3
5.4
5.7
8.5
7.5
7.1
7.3
8.2
3.0
2.9
2.6
1.9
2.0
Subprime
Spreads
declined
Source: Loan Performance data as of November 2006. UBS, April 16, 2007, Thomas Zimmerman, "How Did We Get Here and What Lies Ahead"
CLTV (leverage)
increases
% Full Doc
declined
18
Nonprime mortgage
lending replaced the
“American Mortgage”:
where and why?
A Housing Bubble Starting in 2003,
Especially in the “Sand States”
Prices by City (Case-Shiller)
300.00
250.00
200.00
phnx
150.00
la
100.00
miami
50.00
tampa
lv
February 13, 2009
Susan M. Wachter
September 2007
July 2006
May 2005
March 2004
January 2003
November 2001
September 2000
July 1999
May 1998
March 1997
January 1996
November 1994
September 1993
July 1992
May 1991
March 1990
January 1989
0.00
chicago
mnpls
20
Percent of All Loans—Adjustable Rate
1999
a r m_ p
0% t o
25%
February 13, 2009
>25% t o
50%
2006
>50% t o
75%
>75% t o
100%
a r m_ p
Susan M. Wachter
0% t o
25%
>25% t o
50%
>50% t o
75%
>75% t o
21
100%
Percent of All Loans—Low
Documentation- by 2006, 25% of loans
1999
l o wd o c _ p
0% t o
25%
February 13, 2009
>25% t o
50%
2006
>50% t o
75%
>75% t o
100%
l o wd o c _ p
Susan M. Wachter
0% t o
25%
>25% t o
50%
>50% t o
75%
>75% t o
22
100%
Percent of Adjustable Rate Loans—
Teaser (2006)
t easer _p
February 13, 2009
0% t o
25%
>25% t o
50%
Susan M. Wachter
>50% t o
75%
>75% t o
100%
23
Number of Subprime Loans
Source: www.newyorkfed.org/mortgagemaps
Increase in House Price Index
Source: www.newyorkfed.org/mortgagemaps
Projected Peak-to-Trough House Price
Decline, %
>-20%
-20<-10%
-10%<0%
No correction
Sources: Fiserv Lending Solutions, Moody's Economy.com, OFHEO
How did we get here?
Investors
•
Borrowers
Lack of short sales, CDS
Where does
the buck
stop?
Rating Agencies
•
•
Agency incentives misaligned“current conditions” out
Secondary Market
•
Securities marked to models not to
market/assignee liability exemption
Borrowed at teaser rates-not
able/expected(?) to pay at reset
Originators / Brokers
•
Originate to distribute
Deregulation and Regulatory Arbitrage:
“Competitive Regulation”
• Charter competition fueled a race to the
bottom in underwriting standards
• Migration to federal bank and thrift
charters
• At the federal level, regulation and
examinations of nonbank mortgage
lending subsidiaries were lax
February 13, 2009
Susan M. Wachter
29
Deregulation
• The proposed Federal Reserve Board Regulatory
Oversight of mortgages not implemented until
2008, HOEPA (Home Ownership and Equity
Protection Act, 1994) irrelevant,<1% loans
• 2004 act SEC allowed investment firms to
– increase leverage to 40 to 1
– to voluntarily measure their capital, and
– decrease SEC oversight
• 2000 State reserving for CDS issued by insurance
companies, Fed govt precludes
February 13, 2009
Susan M. Wachter
30
Market and Regulatory Failure
• Risk taking without accountability
– Too big to fail, too small to sue
• Underpriced risk is inevitable, compensation for
generating risk without accountability
WHY?
• Decades of securitization, 1980-2000—no problem
• Historically-interest rate risk securitized, default risk
controlled for and not priced, only prime mortgages
securitized
• “Innovation:” Private label securitization of default risk
• Private label mortgage backed securities did not trade
• Priced based on Marked-to-Model paradigm Not
Marked-to-Market,
• Market and regulatory discipline absent
New Financial Architecture
• Replace Basel II
– Basel II: regime of self-regulation
• End “Competitive Regulation”
– Race to the bottom
• Single Regulator
• Asset Bubbles
– What is a single regulator regulating?
– How do we regulate asset bubbles?
February 13, 2009
Susan M. Wachter
33
Perspective
The events of the past year or two have highlighted regulatory
gaps and deficiencies that we must address to improve the
structure of our markets and the resiliency of our economy.
As we recover from the current crisis, it will be important to
address these issues as soon as possible, to develop a
regulatory structure that will better respond to future
economic challenges.
--Ben Bernanke
Thank You
Susan M. Wachter
Richard B. Worley Professor of Financial
Management
Professor of Real Estate and Finance
The Wharton School
University of Pennsylvania
wachter@wharton.upenn.edu