Financial Crises: Past, Present and Future: James J. Angel, PHD, Cfa Georgetown University Mcdonough School of Business
Financial Crises: Past, Present and Future: James J. Angel, PHD, Cfa Georgetown University Mcdonough School of Business
Financial Crises: Past, Present and Future: James J. Angel, PHD, Cfa Georgetown University Mcdonough School of Business
About me
B.S. Caltech MBA Harvard Ph.D. Berkeley At Georgetown since 1991 Studies financial markets and regulation
Visited over 50 exchanges around the world Inventor of two patents for trading systems Testified four times before US Congress Former Chair of Nasdaq Economic Advisory Board On board of directors of Direct Edge stock exchanges
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Overview
Typical pattern Asset bubble + bust Excessive leverage Failure of financial institutions Recession Aftershocks still occurring
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Financial Crises
Borrow money from depositors to lend to borrowers Little room for error Most liabilities short term Assets mostly illiquid bank loans Very hard to determine quality of assets
$10 Equity
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Consider payoff matrix to the depositors dilemma: Should they withdraw or not?
Bank Assets Good Withdraw deposits Leave deposits in bank Have money no losses Have money no losses Bank Assets Bad Have money no losses LOSE MONEY
Loan origination
Financing of loan
Servicing loan
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Strategic considerations
Few firms are the best at every step in the mortgage value chain. What the strategists say:
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Mortgage broker, bank, S&L, online Fannie Mae, Freddie Mac, Wall Street Fannie and Freddie
Created by Congress
Intermediary repackages cash flows from loans into Mortgage Backed Securities (MBS)
This is one type of asset-backed security. Same can be done with credit cards and car loans.
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Like a mortgage
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Not many private investors like individual mortgages The cash flows to a pool of mortgages can be repackaged into securities that investors want. Investors buy a slice (tranche) of the pool that fits their taste
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Repackaging gives both borrowers and investors what they really want. This is GOOD!
It can REDUCE systemic risk in the economy. IF the securities are made out of high quality loans. IF the securities are not concentrated in the portfolios of highly leveraged investors (e.g. banks)
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Standard and Poors, Moodys, Fitch Long history of doing a good job rating corporate debt.
Investors relied too much on ratings Rating agencies relied too much on issuers computer models of losses.
Did not take into account what would happen if housing prices fell substantially nationwide.
By making deadbeats into homeowners, they become more responsible. High interest rates
Offset expected losses. Give borrowers an incentive to refinance as soon as their credit improves.
Innovations in lending
Had to document all income in detail. Had to have big (~20%) down payment. Thought computer models could predict losses.
Tulips, internet, etc. Subprimes could always sell or refi rather than be foreclosed if they ran into trouble. Creators of subprime MBS only looked at a few years of data. Rating agencies fell asleep and mistakenly labeled securities as AAA when they should not have.
It seemed for a while that the subprime lenders were making lots of money.
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Risk bearing?
Someone else was bearing the risk, or Someone else figured out that the risk was low. Thought that house prices would go up, and/or They could refinance at a better rate when the ARM reset.
Borrowers:
Originators: sold subprime mortgages to Wall Street firms. Wall Street: Repackaged mortgages and sold to investors worldwide Regulators: Fragmented regulators thought other regulators had jurisdiction.
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Fannie Mae and Freddie Mac bought tens of billions of subprime backed paper.
Their government mission was to make housing more widely available. They were highly leveraged
Demand for subprime paper caused lending standards to deteriorate further Easy availability of funding inflated housing bubble.
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Paulson Panic
Clumsy handling of Fannie and Freddie sets off crisis of confidence Government message:
Fannies and Freddies housing related assets are worth much less than expected.
All housing related assets are worth less then before Fear that other financial institutions will follow
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Paulson Panic II
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Up until September 2008, most consumers did not pay attention to the brewing storm on Wall Street. When the government panicked, the uncertainty caused everyone to stop all discretionary spending. Consumer and business confidence plummeted.
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Christmas sales plummet. Retailers are stuck with excess inventory and cut back. Collapse of buying ripples through supply chain in a chain reaction. Dizzying drop in orders creates further gloom.
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Governments step in Royal Bank of Scotland fails. Country not big enough to bail them out
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Unemployment is output lost forever. It makes sense for governments to borrow money to put people to work. But: Should spend efficiently so there is something to show for it.
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Countries cant print money to spend their way out of the recession. This means they will have to reduce fiscal stimulus in order to balance budgets.
Fear over the breakup of the Euro-zone Uncertainty about who bears losses from Greek default depresses economy.
Future crises
Human nature has not changed. Lenders and investors are too optimistic in good times.
Each generation has its bubbles Look out for highly leveraged institutions
Seem to be making lots of money in good times. But look out when the market turns!
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Any questions?
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