The Root Causes of the Crisis:
What have We Learned?
Bob DeYoung
Capitol Federal Professor
University of Kansas School of Business
Summer Teacher Institute
University of Chicago
June 2009
1
Case-Shiller Home Price Index
250
From 1997 to 2006,
home prices increased
at a 9.1% annual rate.
200
150
100
Home prices
have declined
more than 25%
since 2006.
50
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
0
2
% of Jobs Lost in Past Recessions
2
1
1960
1969
1973
1981
1990
2001
2007
0
-1
-2
-3
-4
-5
0
2
4
6
8 10 12 14 16 18 20 22 24 26 28 30
months
3
% of Jobs Lost in Past Recessions
2
1
1960
1969
1973
1981
1990
2001
2007
0
-1
-2
-3
-4
-5
0
2
4
6
8 10 12 14 16 18 20 22 24 26 28 30
months
4
% of Jobs Lost in Past Recessions
2
1
1960
1969
1973
1981
1990
2001
2007
0
-1
-2
-3
-4
-5
0
2
4
6
8 10 12 14 16 18 20 22 24 26 28 30
months
5
% of Jobs Lost in Past Recessions
2
1
1960
1969
1973
1981
1990
2001
2007
0
-1
-2
-3
-4
-5
0
2
4
6
8 10 12 14 16 18 20 22 24 26 28 30
months
6
% of Jobs Lost in Past Recessions
2
1
1960
1969
1973
1981
1990
2001
2007
0
-1
-2
-3
-4
-5
0
2
4
6
8 10 12 14 16 18 20 22 24 26 28 30
months
7
% of Jobs Lost in Past Recessions
2
1
1960
1969
1973
1981
1990
2001
2007
0
-1
-2
-3
-4
-5
0
2
4
6
8 10 12 14 16 18 20 22 24 26 28 30
months
8
% of Jobs Lost in Past Recessions
2
1
1960
1969
1973
1981
1990
2001
2007
0
-1
-2
-3
-4
-5
0
2
4
6
8 10 12 14 16 18 20 22 24 26 28 30
months
9
My talk today
All recessions are different. This recession was caused
by a collapse in residential real estate values.
Real economy: Home prices fell  Housing sector
collapsed  Aggregate spending declined.
• This is a demand-side story.
• Reduced spending on houses and related items.
Financial sector: Mortgage defaults  Big losses on
mortgage-backed securities  Investor uncertainty.
• This is a supply-side story.
• Less credit available for businesses and households.
10
My talk today
1. Root causes of the recession:
– A bubble in the housing market.
– A new lending model (which performed poorly).
– A history of short-sighted economic, financial, and
social policies.
– Bad financial behavior by households.
2. What have we learned?
– Have the responses of policymakers been
appropriate?
– Have households changed behavior?
11
Root Causes of the Crisis:
• Housing bubble.
• A new banking model.
• Poor historical public policy.
• Poor household finance.
12
Rate of Homeownership in U.S.
75%
70%
65%
60%
55%
50%
• GI Bill
45%
• Automobile/Suburbs
40%
• High income tax rates.
2008
2006
2004
2002
2000
1980
1960
1940
1920
1900
35%
13
Rate of Homeownership in U.S.
75%
70%
65%
60%
55%
• Affordable home
policies.
50%
45%
• Easier access to
mortgage credit.
40%
2008
2006
2004
2002
2000
1980
1960
1940
1920
1900
35%
14
Case-Shiller Home Price Index
250
From 1997 to 2006,
home prices increased
at a 9.1% annual rate.
200
150
100
50
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
0
15
Home
Price
Increased House Demand
• Easy Federal Reserve
monetary policy.
• Mortgage interest tax
deduction.
• Policies to provide
"affordable housing."
• Ownership Society.
• Originate-to-Securitize
banking model.
Home
Sales
16
Distribution of Assets held at Financial
Intermediaries in the U.S.
1970
Depository Institutions
(banks, thrifts, credit unions)
Insurance Companies
(life, property & casualty)
Pension Funds
(public, private)
54.4%
Banks were the
center for:
17.4
• Personal savings
14.6
Mutual Funds
(stock, bond, money market)
Securities Firms
(brokers, dealers, funding corps.)
• Business credit
• Payments
Mortgage and Consumer Finance
(GSEs, finance companies,
REITs, securitized asset pools)
2007
8.8
3.7
1.2
17
Distribution of Assets held at Financial
Intermediaries in the U.S.
Depository Institutions
(banks, thrifts, credit unions)
Insurance Companies
(life, property & casualty)
Pension Funds
(public, private)
1970
2007
54.4%
22.8%
17.4
10.5
14.6
16.9
8.8
23.3
3.7
18.5
1.2
7.9
Mortgage and Consumer Finance
(GSEs, finance companies,
REITs, securitized asset pools)
Mutual Funds
(stock, bond, money market)
Securities Firms
(brokers, dealers, funding corps.)
18
1.5%
60%
Bank profits as % of GDP
50%
1.0%
40%
30%
0.5%
20%
10%
0.0%
0%
1970
1980
1990
2000
Asset share of banks, thrifts, credit unions
2007
19
Bank asset shares plunged, but bank
profits soared. Why?
• A new business model for large banks emerged.
• The new model exploits post-1980s information
technologies, financial products, and regulations.
– Much activity at banks moved off the balance sheet.
– Much income at banks now comes from fees, not from interest.
• This new model is highly efficient, highly profitable, but
riskier than most of us thought.
20
Traditional Mortgage Finance
Agents that
need funds
Agents with
excess funds
Home Buyers
Depositors
$ funds $
$ funds $
Bank or
Thrift
mortgages
deposits
Bank earns
profits from
interest margins.
21
Innovation: technology and deregulation
• Geographic deregulation (Riegle-Neal Act 1994)
– Permitted inter-state branching.
– Banks could exploit scale economies.
• Product deregulation (Gramm-Leach-Bliley Act 1999)
– Permitted commercial banks to engage in investment
banking, securities brokerage, and insurance sales.
– Largely fee-based, off-balance sheet activities.
• New technologies
– Credit bureaus and credit scores.
– Automated loan underwriting.
– Loan securitization.
– Deeper capital markets.
22
Traditional Mortgage Finance
Agents that
need funds
Agents with
excess funds
Home Buyers
Depositors
$ funds $
$ funds $
Bank or
Thrift
mortgages
deposits
Bank earns
profits from
interest margins.
23
Traditional Mortgage Finance
Agents that
need funds
Agents with
excess funds
Home Buyers
Depositors
$ funds $
$ funds $
Bank or
Thrift
mortgages
deposits
24
Mortgage Securitization
Bank or
Thrift
mortgages
deposits
25
Mortgage Securitization
Bank or
Thrift
mortgages
cash
deposits
$$$
mortgages
Mortgage Pool
(off-Balance Sheet)
mortgages
26
Mortgage Securitization
Institutional
Investors
Bank or
Thrift
mortgages
cash
deposits
MBSs
MBS
$$$
$$$
mortgages
MBS
Mortgage Pool
(off-Balance Sheet)
mortgages
mortgages
mortgage-backed
securities (MBS)
27
Mortgage Securitization
Institutional
Investors
Bank or
Thrift
mortgages
cash
deposits
Mortgage
payments
from
Households
MBSs
MBS
Loan servicer (often the
bank or the securitizer)
withholds a small fee from
each mortgage payment.
Mortgage Pool
(off-Balance Sheet)
mortgages
mortgages
Payments go to
investors based
on terms of the
MBS contract.
mortgage-backed
securities (MBS)
28
Mortgage Securitization
Bank or
Thrift
mortgages
cash
deposits
$$$
mortgages
Institutional
Investors
Bank earns profits
from origination fees,
securitization fees,
servicing fees.
Investors get the
principal & interest
payments.
MBSs
MBS
$$$
MBS
Mortgage Pool
(off-Balance Sheet)
Credit scoring
allows a bank
to make more
loans faster.
mortgages
mortgages
mortgage-backed
securities (MBS)
MBS rated
by Moody's,
S&P or Fitch.
29
This model increased risk at large banks.
• Increasing reliance on fee income.
– Fee income is often more volatile than interest income.
– Fee-based activities require higher operating leverage.
– Fee-based activities are off-balance sheet, allowing banks to use
more financial leverage.
– Fee income has not yielded expected diversification benefits.
• Increasing reliance on third-party information.
– All lenders have same information (credit bureaus).
– Investors (firms and funds that own the MBS) rely on bond raters.
• Fundamentally poor financial management.
–
–
–
–
–
A lack of diversification.
Excess reliance on financial leverage for earnings.
Too much interest rate risk.
Modeling risk without adequate historical data.
Why? Did large banks know they were Too-Big-To-Fail?
30
Model gives banks incentives to make
riskier loans…that others will hold!
• Credit underwriting separated from risk-bearing.
– Incentives for lenders to make riskier loans.
• Securitization separated from risk-bearing.
– Incentives for investment banks to engineer riskier MBS.
• Loan monitoring separated from risk-bearing.
– Investors must rely on opinions of rating firms…and the
rating firms get paid by the securitizing banks.
• Control rights separated from risk-bearing.
– Fractured ownership of mortgages impedes the
modification of nonperforming mortgage loans.
31
Bad banking model? Or bad policy?
• Regulation did not evolve with banking practices.
– Bank moved activity off of their balance sheets.
– This circumvented capital rules; increased leverage.
• SEC reduced capital requirements for largest five
investment banks in 2004.
• Regulators did nothing to rein in "Too-Big-To-Fail."
• SEC limits competition in securities rating business.
– Only three main NRSROs (Moodys, S&P, Fitch) have
been licensed to rate these securities.
32
Bad banking model? Or bad policy?
• Congress made sure that OFHEO was a weak
regulator of Fannie Mae and Freddie Mac.
– Congress wanted more "affordable mortgages."
– Pressured Fannie and Freddie into providing funds for
subprime mortgage securitizations.
33
Many households also at fault.
• Too much mortgage debt.
– Bigger houses
– Small down payments
– Home equity loans
34
Household Financial Obligations
(% of Disposable Income)
35%
30%
25%
Renters
All households
Homeowners
Mortgage Debt
20%
15%
10%
5%
2007
2004
2001
1998
1995
1992
1989
1986
1983
1980
0%
35
Subprime mortgage lending
• A typical subprime mortgage scenario in mid-2000s:
– Borrower cannot qualify for a conforming mortgage.
– Gets a 3-year ARM: 0% down and a teaser rate.
– Borrower can just afford the payments in years 1-3.
– Borrower cannot afford the payments after year 3.
• Deal works out only if home prices keep increasing.
– As prices rise, borrower builds up equity in home.
– Borrower builds credit rating with a good payment
record during first 3 years.
– At year 3, borrower refinances with a conforming loan
at a low fixed rate.
• But what if prices stop going up?
36
Case-Shiller Home Price Index
250
Home prices have
declined more than 25%
since 2006.
200
150
A profound effect on the
economy.
100
50
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
0
37
Excess Supply
Home
Price
Reduced House Demand
• Prices stop rising…
• Levered homeowners
stop building equity.
• Refinancing is no
longer possible.
• As these homeowners
default on mortgages…
• Investors wary and
stop financing MBS.
• Mortgage loans
become scarce.
Home • As prices fall, buyers
wait for a good deal. 38
Sales
Single-family Housing Starts
(thousands per quarter)
600
500
400
300
200
NAHB
estimates: Building one single-family
home generates about 3.5 jobs.
100
Rough calculation: The annual decline in
0
starts
since 2006 implies 4.2 million fewer
2002 approximate
2003
2004
2005
2006
jobs…an
3% reduction
in
jobs.
2007
2008
39
% Change in Aggregate Spending
(Annualized change from previous quarter, seasonally adjusted)
20%
15%
10%
5%
Consumption
Spending
Nonresidential
Investment
Residential
Investment
0%
-5%
-10%
-15%
-20%
-25%
-30%
2006
2007
2008
40
% Change in Aggregate Spending
(Annualized change from previous quarter, seasonally adjusted)
20%
15%
10%
5%
Consumption
Spending
Nonresidential
Investment
Residential
Investment
0%
-5%
-10%
-15%
-20%
-25%
-30%
2006
2007
2008
41
% Change in Aggregate Spending
(Annualized change from previous quarter, seasonally adjusted)
20%
15%
10%
5%
Consumption
Spending
Nonresidential
Investment
Residential
Investment
0%
-5%
-10%
-15%
-20%
-25%
-30%
2006
2007
2008
42
Impact on the Financial Sector
• Large capital losses at banks.
– U.S. banks will suffer at least $2 trillion from MBS losses.
– About $1 trillion of these losses remain to be taken.
– Based on estimates from IMF; Goldman Sachs; Nouriel Roubini.
– Largest U.S. banks propped up by the tax payers.
• Massive operating losses at mono-line mortgage firms.
– Novastar, Countrywide, American Century, WAMU,
IndyMac, and others have failed.
• Lender losses created uncertainty in financial markets.
– No new private mortgage securitizations in over a year.
– BX 2007 AAA-rated subprime trading at 24¢.
43
% Delinquencies at U.S. Commercial Banks
14%
12%
10%
Credit cards
8%
Business Loans
Single-family mortgages
6%
Commercial mortgages
4%
2%
2008Q3
2007Q2
2006Q1
2004Q4
2003Q3
2002Q2
2001Q1
1999Q4
1998Q3
1997Q2
1996Q1
1994Q4
1993Q3
1992Q2
1991Q1
0%
44
Subprime Mortgage Delinquencies
NOTE: Most subprime mortgages
written by non-banks.
45
Lending at U.S. Banks ($ billions)
$1,800
$1,600
$1,400
$1,200
$1,000
$800
$600
$400
$200
$0
Commercial
Loans
Interbank
Loans
Jan- Jul- Jan- Jul- Jan- Jul- Jan06 06 07 07 08 08 09
46
Rates on 3-month financial securities
7%
6%
5%
4%
Financial CP
Non-Financial CP
Treasury Bills
3%
2%
1%
2009-01
2008-01
2007-01
2006-01
2005-01
2004-01
2003-01
2002-01
2001-01
2000-01
1999-01
1998-01
1997-01
0%
47
2008-12-22
2008-10-30
2008-09-10
2008-07-22
2008-06-02
2008-04-14
2008-02-25
2008-01-07
2007-11-19
2007-10-01
2007-08-13
2007-06-25
2007-05-07
2007-03-19
2007-01-29
2006-12-11
2006-10-23
2006-09-04
2006-07-17
2006-05-29
2006-04-10
2006-02-20
2006-01-02
48
2009-02-10
Daily New Issues of Financial Commercial
Paper, 2006-2009
400
350
300
250
200
150
100
50
0
What Have We Learned?
• Have the policy responses been
appropriate?
• Have households responded
appropriately?
49
Congress
• Silly populist legislation:
– Tax AIG bonuses (ex post).
– Limit executive pay (ex post).
– Tank the corporate jet market.
• Efforts to modify mortgages.
– Gives households moral hazard incentives.
– OCC study: High recidivism rate.
• "TARP-plus" funding.
– A $115 billion ransom payment to get bill passed.
• Hair of the dog:
– $8,000 tax credit for first-time home buyers.
– 3% down payments for VA, FHA and FMHA loans.
50
SEC
• Largely a bystander in the post-crisis policy
response.
51
FDIC
• New FDIC guarantees:
– Deposits up to $250,000
– Pre-existing MMMF accounts
– Newly issued corporate debt
• Failed bank resolutions:
– Allowed historically large bank failures.
– An hour away from arranging a subsidized purchase of
Wachovia by CitiGroup.
• Financing the insurance fund:
– Increased deposit insurance premiums paid by banks.
– $500 billion line of credit from Treasury.
52
• Leading the charge on modifying mortgages.
Federal Reserve
• New lending facilities:
– Term Auction Facility
– Commercial Paper Funding Facility
– Term Securities Lending Facility
– Primary Dealer Credit Facility
• Aggressive monetary policy response
– Fed funds target rate is near 0%.
– M1 and M2 have exploded.
• Co-conspirator with Treasury on "bailouts"
– Fannie and Freddie (discount window loans)
– AIG ($152 billion credit facility)
– Bear Stearns ($29 billion loan to J.P.Morgan Chase) 53
Treasury
• Bailouts
– Fannie and Freddie; AIG; Bear Stearns…not Lehman?
• TARP (Troubled Asset Relief Program)
– Still hasn't bought a single $1 of troubled assets…but it
is keeping Citi and BofA afloat.
• The Hotel Geithner
• Son of TARP
1. Public-Private investment partnerships to purchase
troubled assets.
2. Inject more capital (as previous TARP is paid off).
3. Loan modifications
4. Provide funding in ABS markets (w/ FDIC and Fed)
54
The New Administration Proposal
• Announced on Wednesday, June 17.
• Five point plan:
– Federal Reserve becomes the regulator of all large or
systemically important financial firms.
– Requires reforms in securities markets (ratings firms,
securitized loans, derivatives).
– Creates the Consumer Financial Protection Agency
(CFPA).
– Established procedures for federal government to
takeover and "unwind" large failing financial firms.
– Encourages other countries to do this, too.
• Details to come…
55
First National Too-Big-To-Fail Bank
MBS
$100 ($25 market)
Loans $900
$1,000 Deposits
$
0 Equity
1. FNB marks MBS to market: Equity = -$75. Bank fails.
FDIC takes a $75 loss.
2. Treasury buys MBS for $100: Equity = $0 and Cash =
$100. Treasury takes a $75 loss when it sells MBS.
3. Treasury injects $75 of equity: Bank sells MBS and loses
$75. Equity = $0 and Cash = $100. Treasury takes a
loss of $75 on equity investment.
56
Household Behavior
A 14-year high
level of household
savings.
57
The Root Causes of the Crisis:
What have We Learned?
Bob DeYoung
Capitol Federal Professor
University of Kansas School of Business
Summer Teacher Institute
University of Chicago
June 2009
58