The Current State of the Economy
Iowa Association of Electric Cooperatives
Tom Root, PhD
The Big Picture
Problems in Mortgage Market
Global Credit Crisis / Bank failures / Equity Losses
Declining Consumer Spending
Decreased Business Investment
Whose to Blame?
Economic
Environment
Congress
Consumers
Mortgage
Originators
Regulators
Wall Street
GSEs
Rating
Agencies
Contributing Factors
Consumer Debt and “Keeping up with the
Joneses”
International Capital Flows
Congressional Unintended Consequences
The Housing Market and “The American Dream”
Regulatory Changes
The Big Picture
Problems in Mortgage Market
Global Credit Crisis / Bank failures / Equity Losses
Declining Consumer Spending
Decreased Business Investment
Mortgage Market Developments
New Participants
Increased Credit Access and New Loan Types
Subprime
Alt A
“Teaser Rates”
Option ARMs
Securitization
Securitization
Loan Bank A Loan Bank B
Loan Bank Z
Financial Intermediary
Buys Loans, Forms a “Pool”
and Issues MBS
Insurance Firm, Banks, Pension Funds etc.
Buy MBS – Cash Flows “Guaranteed” by Original Mortgages
2000 - 2003
Fannie Mae announces it will buy $2 Trillion of
loans from low income, minority and risky
borrowers by 2010*.
Subprime Loans = 3% of mortgage markets
Target for the Federal Funds Rate
6.5% May 16, 2000
1.75% Dec 11, 2001
1% June 25, 2003
*NY Time Oct 4 2008 "Pressured to Take More Risk, Fannie Mae Hit a Tipping Point
Federal Funds Rate
Interbank lending – very short term – provides
liquidity
Market determines the actual rate
Target set by Federal Reserve Board
“Base Rate”
The Basics of Banking
Borrowing Short-Term and Lending Long-Term
Deposit $1,000
Bank pays 1% or $10 to depositor
Home Equity Loan $1,000
Bank charges 5% or $50 to borrower
Bank “profit” = $40
Reserves
The bank must keep a portion of deposits in
reserve
Withdraws
Transactions
“Lending Reserves” and Federal Funds Market
Bank Balance Sheet
Assets
Use of funds to generate income
Liabilities and Equity
Source of funds
Liabilities (borrowing)
Equity (ownership stake)
Bank Balance Sheet
Assets (Income)
Loans
Cash
Treasury Securities
Mort. Back Securities
Corporate Bonds
Stocks
Liabilities (costs)
Deposits
S-T Borrowing
L-T Borrowing
Equity (ownership)
Monetary Policy
Federal Reserve Board
“Lender of Last Resort”
Managing Cash available for lending
More cash available lowers interest rates
Less cash available increases interest rates
(rates impact borrowing / spending and growth)
Monetary Policy Tools
Reserve Requirements
Discount Window Lending
Open Market Operations
Buying and selling Treasury Securities
Replacing illiquid assets with cash and vice versa
Impact of Low Rates 2001-2004
Strong economic growth without inflation
Housing boom pushed housing prices up
New loan standards
Speculation on home prices by “average
consumers”
Increased availability of international funds
Strong demand for MBS
Congressional pressure to increase lending to
under served markets
Missed Opportunities
2003 Accounting Scandals at GSEs
W. Poole, Pres. Fed Reserve Bank of St Louis*
“If the market value of GSE debt were to fall sharply, because of ambiguity
about the financial soundness of GSEs and about the willingness of the
federal government to backstop the debt, what would happen? I do not
know, and neither does anyone else.”
Dec 2003 Fed Reserve releases study showing GSEs
have not lowered lending rates.**
February 2004 – Alan Greenspan calls for reform &
removal of the implicit government guarantee***
*"Housing and the Macroeconomy" Speech at Office of Federal Housing Enterprise Oversight Symposium
http://www.stls.frb.org/news/speeches/2003/3/10/03.html **Christmas for Fannie, WSJ 9/9/08 ***"Fran and Fred Get
The Business WSJ 2003 3/10/03
2004 Market Developments
SEC lowers capital requirement rules for largest
financial firms.*
Deterioration of underwriting standards.**
August - Moody’s and S&P change rating standards for
MBS, incorrectly rate many MBS AAA***
2004 HUD increases Fannie and Freddie mandate from
50% “affordable housing” to 56%****
Target for Fed Funds starts to increase
June 30, 2004 1.25%, December 13, 2004 2.25%
* NY Times Oct 3, 2008 Agency's '04 Rule Let Bank Pile Up New Debt **President's Working on Financial Markets, US Treasury Dept March 2008
***Smith, Elliot, "Race to the Bottom at Moody's, S&P Secured Subprime's Boom and Bust" Bloomberg.com, Sept 2008 **** How HUD Mortgage
Policy Fed the Crisis, Washington Post, June 10, 2008
Fannie Mae’s
Guarantee of Alt A Loans
$ Billions of Alt A Loans Guaranteed
300
2007
$79
Billion
Added
250
2006
$87
Billion
Added
200
150
2005
$58
Billion Added
100
50
2004 & Before
$77 Billion Total
0
NY Times October 4 "Pressured to Take More Risk Fannie Hit a Tipping Point"
Blaming Fannie and Freddie?
No - Fannie and Freddie were small relative to
the entire market.
Combined Subprime Purchases (% of Market)**
Consumer demand created rapid prince increase
Yes – Overall Size put them at risk for any
mortgage market problem
Securitizing more risky loans opened door for
private securitization
Gramlich, E. "Subprime Loans: America's Latest Boom an Bust" 2007 ** "how HUD Mortgage Policy Fed
the Crisis", Washington Post June 10, 2008
Impact of Subprime Loans
on Home Ownership
"SubPrime Lending: A Net Drain on Homeownership," Center for Responsible Lending: March 2007
“The Perfect Storm”
2004 - 2007
Domestic and global institutions buy MBS in attempt
to increase margins on “safe” securities, incorrectly
rated.
Institutions use higher debt levels for securitization.
Underwriting standards deteriorate.
Increased interest rate environment makes loans
more likely to default
Increasing Home Prices encourage consumers to
overextend and speculate in housing market
Average Size of
Subprime Loan
Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper 200705, August 2008 (sample represents approximately 85% of securitized subprime loans, over 50% to total subprime
Credit Quality of Subprime Loans
Originated each year
Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper
2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans, over 50% to total subprime
Structure of Subprime
Loans Originated each year
Demyanyk and Van Hermert, "Understanding the Subprime Mortgage Crisis" Federal Reserve Bank of St. Louis, Working paper
2007-05, August 2008 (sample represents approximately 85% of securitized subprime loans, over 50% to total subprime
Home Sales and Home Prices
Non Agency Mortgage Foreclosure Rates
The Big Picture
Problems in Mortgage Market
Global Credit Crisis / Bank failures / Equity Losses
Declining Consumer Spending
Decreased Business Investment
Impact on Financial Institutions
Foreclosures cause value of MBS securities to
decrease raising concerns about stability of
banks and financial institutions
Banks start to keep cash
Protect against withdraws
Uncertainty about borrowers ability to repay
Interest rates start to increase
2007 Market News
Consumer Confidence starts to decline in July
2007 (Conference Board)
Late 2007 over 20% of all adjustable rate
subprime loans and 8% of fixed rate subprime
loans are delinquent
Dec 12 – Fed Reserve announces Term Auction
Facility allowing depository institutions to bid for
short term (28 to 84 day) loans
August / September 2008
Financial Markets
Global concerns increase, European banks have
liquidity concerns
Measures of confidence decrease and credit
spreads increase
Banks keep cash in fear of runs on liquidity and
make fewer loans
Cost of short term borrowing increases for
business
Bank Balance Sheet
Assets (income)
Loans
Cash
Treasury Securities
Mort. Back Securities
Corporate Bonds
Stocks
Liabilities (costs)
Deposits
S-T Borrowing
L-T Borrowing
Equity (ownership)
2008
Financial Institution Failures
January – Bank of America buys Countrywide
March - Bear Stearns is bought by JP Morgan in deal
brokered by Fed, approved 5/29/08
7/12/08 IndyMac Bank Fails
9/8/08 Fannie and Freddie are taken over by government
9/14/2008 Lehman Bros is allowed to fail & Merrill Lynch is
bought by Bank of America
9/17/08 AIG is bailed out by government
9/21/08 Goldman Sachs and Morgan Stanley become
commercial banks as opposed to investment banks
10/3/08 Wachovia is bought by Wells Fargo after backing
out of deal with Citigroup
Lehman Brothers
Largest Issuer of Commercial Paper
Large player in Fixed Income
Active in Credit Default Swaps
The Big Picture
Problems in Mortgage Market
Global Credit Crisis / Bank failures / Equity Losses
Declining Consumer Spending
Decreased Business Investment
Spillover
Failure of Financial Institutions
Uncertainty about value of assets
Fear of Liquidity (Runs on banks)
Loss of Lehman – Commercial paper and CDS
Consumer Confidence shaken
Retirement account uncertainty
Sale of assets
Decreasing share price
Decrease asset values
Supplemental
Federal Reserve Actions
December 12, 2007: Term Auction Facility (TAF)
December 12, 2007: New FX swap lines with the ECB and
SNB announced.
March 11, 2008. Term Securities Lending Facility
March 16, 2008. Primary Credit Dealer Facility
September 14, 2008. TSLF expanded to $200 billion
September 24, 2008. FX swap lines to $277B
September 29, 2008 Federal Reserve coordinate with other
central banks to expand significantly the capacity to provide
U.S. dollar liquidity
Supplemental
Federal Reserve Actions - Oct
October 6, 2008 Board announces that it will begin to pay
interest on depository institutions' required and excess
reserve balances
October 7, 2008 Board announces creation of the
Commercial Paper Funding Facility (CPFF) to help provide
liquidity to term funding markets
October 21, 2008 Federal Reserve announces the creation
of the Money Market Investor Funding Facility (MMIFF)
Nov 10, 2008 American Express becomes bank holding
company
Assets on Fed Res Balance Sheet
Aug 2008 – April 2009