The U.S Financial Crisis

1
The U.S Financial Crisis
THE DYNAMIC OF THE PROBLEM
HOUSING MARKET FINANCIAL MARKETS GENERAL
ECONOMY
CAUSES
EFFECTS
?
CAUSES
EFFECTS
?
CAUSES
EFFECTS
2
The U.S Financial Crisis

1. Housing Price Bubble Followed by Decline in
   Housing Prices

HOUSING MARKET FINANCIAL MARKETS GENERAL
ECONOMY
3
The U.S Financial Crisis

1. Housing Price Bubble Followed by Decline in
   Housing Prices
2. Inadequate Financial Capital (Assets/Liabilities)
   
3. Credit Squeeze
4. Deleveraging Company Failures

HOUSING MARKET FINANCIAL MARKETS GENERAL
ECONOMY
4
The U.S Financial Crisis

1. Housing Price Bubble Followed by Decline in
   Housing Prices
2. Inadequate Financial Capital (Assets/Liabilities)
   
3. Credit Squeeze
4. Deleveraging Company Failures
5. Credit Squeeze for Businesses and Households
6. Diminished U.S. and Global Growth/ Recession

HOUSING MARKET FINANCIAL MARKETS GENERAL
ECONOMY
5
The U.S Financial Crisis

1. Housing Price Bubble Followed by Decline in
   Housing Prices

HOUSING MARKET FINANCIAL MARKETS GENERAL
ECONOMY
5
6
Housing Market

• Over the past two decades U.S. consumer spending
  has increased significantly, both in absolute
  terms and as a of GDP, driven partially by
  significant declines in savings rates.

Personal Savings Rate
of Disposable income
6
Source Bureau of Economic Analysis, Sequoia
Capital
7
Housing Market

• Low and stable inflation rates combined with low
  borrowing costs have also fueled consumer
  consumption increases.

Source Bureau of Labor Statistics, Federal
Reserve, Sequoia Capital
7
8
Housing Market

• Much of the increased US consumer spending has
  been targeted at homeownership. Mortgage debt has
  increased more than threefold since 1995, from
  3.5 trillion to 11.1 trillion in 2007

Source Current Population Survey/Housing Vacancy
Survey, Series H-111 Reports, Bureau of the
Census, Washington, D.C. Sequoia Capital
8
9
Housing Market

• The fraction of US disposable personal income
  spent on mortgages and other forms of consumer
  debt has increased from roughly 11 in 1994 to
  over 14 in late 2007.

Debt Service Ratio Debt Payments on Outstanding
Mortgages and Consumer Debt Disposable
Personal income
Source Bureau of Economic Analysis, Sequoia
Capital
9
10
Housing Market

• During the growth in homeownership, the use of
  Adjustable Rate Mortgages in the subprime
  mortgage market increased significantly.

10
Source Bhardwaj and Sengupta, Federal Reserve
Bank of St. Louis, Oct. 2008
11
Housing Market

• The weakening economy including increased
  unemployment, combined with the reset of
  adjustable rate mortgages, resulted in home
  prices dropping and mortgage delinquencies
  increasing.

MORTGAGE EQUITY WIHDRAWALS DECREASE
Source Bureau of Economic Analysis, Sequoia
Capital
11
12
Housing Market
Home Prices
13
Housing Market
Example California Foreclosure Starts (Notices
of Default) and Sales (Trustee Deeds)
14
Housing Market
There is a large and growing number of U.S.
homeowners with no or negative equity in their
homes potentially 1 out of every 5 homes given
the total US housing inventory of 128 million
homes at the end of 2007.

• Estimated U.S. Homeowners with No or Negative
  Equity

23,588
20,491
15,433
8,155
3,561
Source James Hamilton, UCSD (2008)
14
15
The U.S Financial Crisis

1. Housing Price Bubble Followed by Decline in
   Housing Prices
2. Inadequate Financial Capital (Assets/Liabilities)
   
3. Credit Squeeze
4. Deleveraging Company Failures

HOUSING MARKET FINANCIAL MARKETS GENERAL
ECONOMY
15
16
Financial Markets

• Development of new forms of securities redefined
  and broadened the market for mortgages, and
  amplified the impact of falling home prices and
  subprime mortgage defaults
• Purchase of mortgage and other assets by non-bank
  entities (e.g., broker/dealers), utilizing low
  interest credit.
• Repackaging into derivative securities with
  tranches carrying different debt ratings and
  associated risk (e.g., Collateralized Debt
  Obligations or CDOs).
• Use of off-balance-sheet vehicles (e.g.,
  Structured Investment Vehicles or SIVs) to
  invest in illiquid long-term assets while issuing
  short-maturity paper in the form of Asset Backed
  Commercial Paper (ABCP).
• Enormous growth in credit default insurance
  (e.g., Credit Default Swaps or CDSs) enabled
  poor credits to be given much higher ratings,
  often including AAA.
• Sale of the new securities to institutions
  previously constrained from holding debt rated
  low (e.g., Pension Funds).

17
Financial Markets
Financial Institutions Mortgage Holdings
Agency and GSE Mortgage Pools
Asset Backed Security Issuers
Commercial Banks
Source Shin, 2008
18
Financial Markets
Source Shin, 2008
19
Financial Markets

• There has been a massive increase in the use of
  derivatives as a means of securitizing mortgages.
  In the 1st half of 1988 there were approximately
  1.2 Trillion in outstanding derivative
  contracts. Today there are over 531 Trillion.

531 Trillion
37 Trillion
19
Source International Swaps and Derivatives Assoc.
20
Financial Markets

• Securitization
• Pooling of Mortgages
• Tranching (Collateralized Debt Obligations or
  CDOs)
• Insuring (Credit Default Swaps or CDSs)
• Shortening of Maturities
• Off-Balance sheet SIVs, et.al.
• Buy long-term assets
• Sell and roll over short-term assets (Asset
  Backed Commercial Paper or ABCP)
• On-Balance Sheet Overnight Repos

Source Brunnermeier, 2008
20
21
Financial Markets

• Subprime Exposures ( Billions)

Institution Total Reported Subprime Exposure Percent of Reported Exposure
U.S. Investment Banks 75 5
US Commercial banks 250 18
US GSEs 112 8
US Hedge Funds 233 17
Total 671 49

Foreign Banks 167 12
Foreign Hedge Funds 58 4
Insurance Companies 319 23
Finance Companies 95 7
Mutual and Pension 57 4
Total 697 51

Total 1,368 100
Note The total for US commercial banks includes
95 billion of mortgage exposures by Household
Finance, the US subprime subsidiary of HSBC.
Moreover, the calculation assumes that US hedge
funds account for four-fifths of all hedge fund
exposures to subprime mortgages. Source
Goldman Sachs, Authors calculations Greenlaw,
Hatzius, Kashyap and Shin (2008)
21
22
Financial Markets

• Estimates of the Mortgage Credit losses written
  off to date are approximately 480 billion,
  roughly equal to the total losses projected if
  housing prices remain flat at mid-2008 levels.

Total
472
636
867
Source Goldman Sachs, Authors Calculations
Greenlaw, Hatzius, Kashyap and Shin (2008)
23
Financial Markets
TRENDS IN BANK LEVERAGE
24
Financial Markets
Source SEC Goldman Sachs, Authors Calculations
Greenlaw, Hatzius, Kashyap and Shin (2008)
25
Financial Markets
TOTAL ASSETS AND LEVERAGE
Source Shin (2008)
26
Financial Markets
Financial Services Company Balance Sheet
ASSETS Good Assets 80Toxic Assets
20 TOTAL ASSETS 100
LIABILITIES Short-Term Debt and Liabilities
to Customers 80Long-Term Debt to Bondholders
17 Shareholder Equity 3TOTAL
LIABILITIES AND SHAREHOLDER EQUITY
100
e.g., Includes long-term assets such as
mortgages
e.g., Repos (1 day) and Commercial Paper (3
months)
27
Financial Markets
Source Bear Stearns
28
Financial Markets

• Investment Banks Main Financing in 2007
• Repos 1,151 B
• Security Credit
• Margin Accounts from HH or Non-Profits 854 B
• From Banks 336 B
• Financial Equity 49 B

Overnight Repos are ¼ of the Investment Banks
Assets!
Source Brunnermeier, 2008
29
Financial Markets

• 1. Subprime crisis hits

ASSETS Good Assets 80Toxic Assets
20 TOTAL ASSETS 95
LIABILITIES Shareholder Equity
3 Short-Term Debt and Liabilities to
Customers 80Long-Term Debt to Bondholders
17 TOTAL LIABILITIES AND SHAREHOLDER EQUITY
100
15
e.g., Includes long-term assets such as
mortgages
e.g., Repos (1 day) and Commercial Paper (3
months)
30
Financial Markets
CREDIT DEFAULT SWAPS

• Broker/Dealers thought they had insured against
  the decline in value of their mortgage assets
  through Credit Default Swaps (CDS)

NYT - February 17, 2008
Credit Default Swaps are not regulated as
insurance, often carried in off-balance sheet
Special Purpose Vehicles, hence there are
limited regulations and no reserve requirements
as there are for insurance companies.
31
Financial Markets
CREDIT DEFAULT SWAPS

• American Insurance Group (AIG)
• AIG unraveled as the worst housing crisis since
  the Great Depression led to more than 18 billion
  of losses in the past year. A meltdown could
  have cost the financial industry 180 billion,
  according to RBC Capital Markets, because AIG
  provided insurance i.e., credit default swaps
  on more than 441 billion of fixed-income
  investments held by the worlds biggest
  institutions, including 57.8 billion in
  securities tied to subprime mortgages. -
  Bloomberg, September 17, 2008
• Wachovia
• The cost to protect against a default by
  Wachovia Corp., the fourth-largest U.S. bank,
  soared to distressed levels after Washington
  Mutual Inc. was seized by regulators and its
  deposits sold off to JPMorgan Chase Co.
  Credit-default swaps protecting 10 million of
  Wachovia bonds from default for five years traded
  for as much as the equivalent of 3.5 million
  initially and 500,000 a year, according to
  broker Phoenix Partners Group. That compares with
  670,000 a year and no upfront payment
  yesterday.
• - Bloomberg, September 26, 2008

32
Financial Markets
CREDIT DEFAULT SWAPS OUTSTANDING
( in Trillions)
54.6 T
World GDP 54.3 T
50.5 T
U.S. Natl. Debt
U.S. GDP
Value of All Stocks on the NYSE
630 B
Year-end 2007 2Q 2008
Source International Swaps and Derivatives Assoc.
33
Financial Markets

• 1. Subprime crisis hits

2. Equity shrinks volatility increases
ASSETS Good Assets 80Toxic Assets
20 TOTAL ASSETS 95
LIABILITIES Shareholder Equity
3 Short-Term Debt and Liabilities to
Customers 80Long-Term Debt to Bondholders
17 TOTAL LIABILITIES AND SHAREHOLDER EQUITY
100
0
15
e.g., Includes long-term assets such as
mortgages
97
e.g., Repos (1 day) and Commercial Paper (3
months)
34
Financial Markets

• Lehmans stock price collapsed from 16.20 per
  share on September 5th to .13 at the close of
  markets on September 18th. It had been trading
  at over 30 per share 1 year earlier.

Lehman filed for bankruptcy on Sept. 15, 2008
Source EODData
34
35
Financial Markets

• 1. Subprime crisis hits

3. Short-term financing is harder to obtain
2. Equity shrinks volatility increases
ASSETS Good Assets 80Toxic Assets
20 TOTAL ASSETS 95
LIABILITIES Shareholder Equity
3 Short-Term Debt and Liabilities to
Customers 80Long-Term Debt to Bondholders
17 TOTAL LIABILITIES AND SHAREHOLDER EQUITY
100
0
15
e.g., Includes long-term assets such as
mortgages
97
e.g., Repos (1 day) and Commercial Paper (3
months)
36
Financial Markets
36
Source Brunnermeier, 2008
37
Financial Markets

• COUNTER_PARTY CREDIT RISK - Credit Default Swap
  (CDS) Example
• Everything can be netted out . . .. . . But each
  party only knows his obligations
• As asset base of the counter party is diminished
  (i.e., subprime assets decline), and credit
  duration mismatches on the balance sheet of the
  counter party are known to exist but are of
  uncertain magnitude, bank has concerns about
  Counter-Party Credit Risks,. . . . . . banks buy
  Credit Default Swap protection. . . but CDS
  Spreads Widen. . . and rating agencies downgrade
  the debt
• Banks cash flow diminishes
• INTER-BANK LENDING FREEZES

3. Bear Stearns offsets its obligation with a
Swap with a hedge fund
2. Private Equity Fund offsets its obligation
through a Swap with Bear Stearns
1. Interest Rate Swap Goldman and a Private
Equity Fund swap the difference between a
floating interest rate and a fixed to manage the
risk in their respective portfolios.
4. Hedge Fund offsets its obligation with a Swap
with Goldman
Source Brunnermeier, 2008
38
Financial Markets

• 1. Subprime crisis hits

3. Short-term financing is harder to obtain
2. Equity shrinks volatility increases
ASSETS Good Assets 80Toxic Assets
20 TOTAL ASSETS 95
LIABILITIES Shareholder Equity
3 Short-Term Debt and Liabilities to
Customers 80Long-Term Debt to Bondholders
17 TOTAL LIABILITIES AND SHAREHOLDER EQUITY
100
0
15
e.g., Includes long-term assets such as
mortgages
97
e.g., Repos (1 day) and Commercial Paper (3
months)
4. No roll over (margin/hair cut widens)
39
Financial Markets

• Recently, the ratio of 3 month LIBOR/Expected
  Fed Funds Spread has widened to almost 400 Basis
  Points!

40
Financial Markets

• Bear Stearns failed because of run by creditors,
  not defaults by borrowers.
• (Immediate) problem was on the liabilities side
  of balance sheet.

Bear Stearns Liquidity Pool (US billions)
7 DAYS!
Source SEC
41
Financial Markets
THE INSOLVENCY SPIRAL

• 1. Subprime crisis hits

3. Short-term financing is harder to obtain
2. Equity shrinks volatility increases
ASSETS Good Assets 80Toxic Assets
20 TOTAL ASSETS 85
LIABILITIES Shareholder Equity
3 Short-Term Debt and Liabilities to
Customers 80Long-Term Debt to Bondholders
17 TOTAL LIABILITIES AND SHAREHOLDER EQUITY
100
0
70
15
70
e.g., Includes long-term assets such as
mortgages
87
e.g., Repos (1 day) and Commercial Paper (3
months)
5. Sell assets at fire-sale prices deleverage
but not fast enough!
4. No roll over (margin/hair cut widen)
42
Financial Markets

• We are watching the disintegration of the
  financial system. Finance is the web of
  intermediation binding economic agents to one
  another, across both space and time. Without it,
  no modern economy can survive. - Martin Wolf,
  Financial Times, October 1, 2008
• Bear Stearns In a shocking deal reached on
  Sunday to save Bear Stearns, JPMorgan Chase
  agreed to pay a mere 2 a share to buy all of
  Bear less than one-tenth the firms market
  price on Friday.
• Fannie Mae and Freddie Mac The Bush
  administration seized control of the nations two
  largest mortgage finance companies on Sunday,
  seeking to shrink drastically their outsize
  influence on Wall Street and on Capitol Hill
  while at the same time counting on them to pull
  the nation out of its worst housing crisis in
  decades.
• Merrill Lynch Merrill Lynch, which has lost
  more than 45 billion on its mortgage
  investments, agreed to sell itself on Sunday to
  Bank of America for 50.3 billion in stock,
• Lehman Bros. Lehman, staggered by losses on
  its commercial and residential real estate
  assets, filed for bankruptcy protection of its
  holding company Monday morning.
• AIG The U.S. government took control of AIG in
  an 85 billion bailout to prevent bankruptcy of
  the nations biggest insurer and the worst
  financial collapse in history.

March 17, 2008
Sept. 7, 2008
Sept. 13, 2008
Sept. 15, 2008
Sept. 17, 2008
Source NYT, Bloomberg
43
Financial Crisis

1. Housing Price Bubble Followed by Decline in
   Housing Prices
2. Inadequate Financial Capital (Assets/Liabilities)
   
3. Credit Squeeze
4. Deleveraging Company Failures
5. Credit Squeeze for Businesses and Households
6. Diminished U.S. and Global Growth/ Recession

HOUSING MARKET FINANCIAL MARKETS GENERAL
ECONOMY
43
44
General Economy

• If the financial system ceases to function
  properly and a range of financial institutions
  collapses, everybody will be hurt, as businesses
  and households are starved of credit. - Martin
  Wolf, Financial Times, October 1, 2008
• ATT Chairman and CEO Randall Stephenson said
  Tuesday that his company was unable to sell any
  commercial paper last week for terms longer than
  overnight. Its loosened up a bit, but its
  day-to-day right now. I mean literally its
  day-to-day in terms of what our access to the
  capital markets looks lie, Stephenson said.
• General Electric G.E. is selling 3 billion of
  preferred stock in a private offering to Mr.
  Buffetts company, Berkshire Hathaway. Besides
  the Buffett investment, G.E. announced that it
  planned to sell at least 12 billion in common
  stock to the public. The offering is expected to
  be priced just before the opening of the stock
  market on Thursday.G.E. portrayed its financing
  plans as a kind of insurance policy, giving the
  company ballast in extremely uncertain times.
  Last Thursday, G.E. announced that it would
  report lower-than-expected profits for the third
  quarter, citing unprecedented weakness and
  volatility in the financial services markets.
  The company also lowered its earnings outlook for
  the year.The company also outlined steps to
  bolster its finance arm, GE Capital, by reducing
  the dividend it pays to the parent company,
  halting G.E.s stock buyback program and becoming
  less dependent on short-term commercial paper
  borrowings. Last Thursday, Jeffrey R. Immelt,
  G.E.s chief executive, called those steps tough
  decisions to further reduce risk and strengthen
  our balance sheet.

October 1, 2008
45
General Economy
As assets become increasingly intertwined on a
global basis, the financial crisis is not just a
U.S. crisis, but a global crisis.

• Increasing Financial Globalization

Source Krugman, 2008
46
General Economy

• In particular, foreign ownership of US Treasuries
  has increased from approximately 20 in 1988 to
  almost 60 in 2008.

46
Source Bridgewater, Sequoia Capital
47
General Economy

• Goldman Sachs - Investment Strategy Group
• October 5, 2008
• We have no doubt that the bursting of the real
  estate bubble not just in the U.S., but in the
  UK, Spain, Dubai, Mumbai, and Shanghai and the
  ensuing global credit crisis and ongoing
  deleveraging, will take a significant toll on the
  U.S. and other economies. . . .
• The length and depth of this credit crisis has
  prompted us to adjust our economic outlook
  accordingly.
• We expect 3-4 quarters of negative growth in the
  US with a cumulative decline of about 5.
• In all likelihood, the next two quarters will be
  in the negative 2 range.
• Unemployment in the US will exceed 7, maybe even
  reach 8.
• However, looking past mid-2009, we think the
  economy will slowly recover, as the combination
  of government measures both monetary and fiscal
  will reverse the economic downdraft sometime in
  the next 12 months.

48
General Economy

• The concerns about the economy have manifested
  themselves in significant declines in stock
  prices.

Oct. 23, 2008
Oct. 23, 2007
Dow Jones Industrial Average
49
General Economy

• Many economists believe there is a very real
  possibility that the economic recovery could take
  many years.

49
Source Bureau of Labor Statistics
50
General Economy

• Ben S Bernanke Stabilizing the Financial
  Markets and the Economy
• This financial crisis has been with us for more
  than a year. It was sparked by the end of the
  U.S. housing boom, which revealed the weaknesses
  and excesses that had occurred in subprime
  mortgage lending. However, as subsequent events
  have demonstrated, the problem was much broader
  than subprime lending. Large inflows of capital
  into the United States and other countries
  stimulated a reaching for yield, an underpricing
  of risk, excessive leverage, and the development
  of complex and opaque financial instruments that
  seemed to work well during the credit boom but
  have been shown to be fragile under stress. The
  unwinding of these developments, including a
  sharp deleveraging and a headlong retreat from
  credit risk, led to highly strained conditions in
  financial markets and a tightening of credit that
  has hamstrung economic growth. . . .
• The financial crisis intensified over the
  summer 2008 as mortgage-related assets
  deteriorated further, economic growth slowed, and
  uncertainty about the financial and economic
  outlook increased. As investors and creditors
  lost confidence in the ability of certain firms
  to meet their obligations, their access to
  capital markets as well as to short-term funding
  markets became increasingly impaired, and their
  stock prices fell sharply. Prominent companies
  that experienced this dynamic most acutely
  included the government-sponsored enterprises
  (GSEs) Fannie Mae and Freddie Mac, the investment
  bank Lehman Brothers, and the insurance company
  American International Group (AIG).
• Speech by Mr Ben S Bernanke, Chairman of the
  Board of Governors of the US Federal Reserve
  System, at the Economic Club of New York, New
  York, 15 October 2008.

50
51
The U.S Financial Crisis

1. Housing Price Bubble Followed by Decline in
   Housing Prices
2. Inadequate Financial Capital (Assets/Liabilities)
   
3. Credit Squeeze
4. Deleveraging Company Failures
5. Credit Squeeze for Businesses and Households
6. Diminished U.S. and Global Growth/ Recession

HOUSING MARKET FINANCIAL MARKETS GENERAL
ECONOMY
ALTERNATIVES WHAT PUBLIC VALUE ARE WE TRYING TO
CREATE?
52
Financial Crisis
ALTERNATIVES WHAT PUBLIC VALUE ARE WE TRYING TO
CREATE?

• Ben S Bernanke Stabilizing the Financial
  Markets and the Economy
• The Federal Reserve believes that, whenever
  possible, the difficulties experienced by firms
  in financial distress should be addressed through
  private-sector arrangements for example, by
  raising new equity capital, as many firms have
  done by negotiations leading to a merger or
  acquisition or by an orderly wind-down.
  Government assistance should be provided with the
  greatest reluctance and only when the stability
  of the financial system, and thus the health of
  the broader economy, is at risk. In those cases
  when financial stability is broadly threatened,
  however, intervention to protect the public
  interest is not only justified but must be
  undertaken forcefully and without hesitation.
• Speech by Mr Ben S Bernanke, Chairman of the
  Board of Governors of the US Federal Reserve
  System, at the Economic Club of New York, New
  York, 15 October 2008.

52
53
The U.S Financial Crisis
PUBLIC VALUE?
STABILIZE THE HOUSING MARKET? STABILIZE
FINANCIAL INSTITUTIONS AND FINANCIAL
MARKETS? STABILIZE THE ECONOMY?

1. Housing Price Bubble Followed by Decline in
   Housing Prices
2. Inadequate Financial Capital (Assets/Liabilities)
   
3. Credit Squeeze
4. Deleveraging Company Failures
5. Credit Squeeze for Businesses and Households
6. Diminished U.S. and Global Growth/ Recession

HOUSING MARKET FINANCIAL MARKETS GENERAL
ECONOMY
54
Financial Crisis
PUBLIC VALUE?
ALTERNATIVES

• There is a remarkable degree of consensus on
  what must be done. Policy makers must move to
  stabilize the financial system. To be sure,
  there are also other urgent tasks for the future.
  There must be regulatory reform and, more than
  that, a fundamental rethinking of the financial
  architecture to prevent an equally devastating
  crisis from occurring again.
• Social programs will need to be ramped up to
  provide assistance to the innocent victims of the
  crisis. The damage done to pensions, retirement
  accounts, and the housing market will need to be
  repaired.
• But these are tasks for tomorrow. Today, . . .
  the urgent task is to contain the panic and
  staunch the bleeding in the financial system.
• - Barry Eichengreen and Richard Baldwin, Oct. 9,
  2008

STABILIZE THE HOUSING MARKET? STABILIZE
FINANCIAL INSTITUTIONS AND FINANCIAL
MARKETS? STABILIZE THE ECONOMY?
55
Financial Crisis
PUBLIC VALUE?
ALTERNATIVES

• FOUR MEASURES TO STABILIZE FINANCIAL MARKETS
• RECAPITALIZE BANKS
• RESTART THE INTERBANK LENDING MARKET
• ABSORB SIGNIFICANT AMOUNTS OF TOXIC ASSETS
• PREVENT BANK RUNS

STABILIZE THE HOUSING MARKET? STABILIZE
FINANCIAL INSTITUTIONS AND FINANCIAL
MARKETS? STABILIZE THE ECONOMY?
56
Financial Crisis

• GOVERNMENT PROGRAMS
• What assets/liabilities should be purchased?
  Guaranteed?
• At what prices and under what terms?

ASSETS Good Assets 80Toxic Assets
20 TOTAL ASSETS 95
LIABILITIES Shareholder Equity
3 Short-Term Debt and Liabilities to
Customers 80Long-Term Debt to Bondholders
17 TOTAL LIABILITIES AND SHAREHOLDER EQUITY
100
0
15
e.g., Includes long-term assets such as
mortgages
97
e.g., Repos (1 day) and Commercial Paper (3
months)
57
Financial Crisis
PUBLIC VALUE?
OPTIONS PURSUED TO DATE
STABILIZE THE HOUSING MARKET? STABILIZE
FINANCIAL INSTITUTIONS AND FINANCIAL
MARKETS? STABILIZE THE ECONOMY?

• Conservatorship of Fannie Mae and Freddie Mac
  Eliminates the fear that they will be unable to
  issue debt and/or continue to buy home mortgages
  (Treasury)
• Backstopping Customer DepositsMitigating runs on
  banks (100k increased to 250k) (FDIC)
• Insuring Money Market FundsStem the outflow of
  money (Exchange Rate Stabilization Fund of 1934)
• Interest Rate PolicyReductions in Fed Funds Rate
  to ease borrowing (Federal Reserve)
• Acquisition of AIGManaging Credit Default Swap
  risk and interbank lending (Counter-party credit
  risk) (Treasury)
• Government Liquidity Measures Currently totaling
  approximately 1.5 trillion (Federal Reserve)
• Troubled Asset Relief Program - TARPThe
  Emergency Economic Stabilization Act of 2008 -
  700 billion to purchase securities (Treasury)
• Unemployment Benefits (Social Security System)
• Altering the Alternative Minimum Tax Tax
  relief for 22 million Americans providing fiscal
  stimulus (Tax System)

58
Financial Crisis
OPTIONS PURSUED TO DATE
New York Times, October 9, 2008
58
59
Financial Crisis

• New York Times October 14, 2008

The Treasury Department, in its boldest move yet,
is expected to announce a plan on Tuesday to
invest up to 250 billion in banks, according to
officials. The United States is also expected to
guarantee new debt issued by banks for three
years a measure meant to encourage the banks to
resume lending to one another and to customers,
officials said. And the Federal Deposit
Insurance Corporation will offer an unlimited
guarantee on bank deposits in accounts that do
not bear interest typically those of businesses
bringing the United States in line with several
European countries, which have adopted such
blanket guarantees. . . . Treasury Secretary
Henry M. Paulson Jr. outlined the plan to nine of
the nations leading bankers at an afternoon
meeting, officials said. He essentially told the
participants that they would have to accept
government investment for the good of the
American financial system. Of the 250 billion,
which will come from the 700 billion bailout
approved by Congress, half is to be injected into
nine big banks, including Citigroup, Bank of
America, Wells Fargo, Goldman Sachs and JPMorgan
Chase, officials said. The other half is to go to
smaller banks and thrifts. The investments will
be structured so that the government can benefit
from a rebound in the banks fortunes. . . .
Over the weekend, central banks flooded the
system with billions of dollars in liquidity,
throwing out the traditional financial playbook
in favor of a series of moves that officials
hoped would get banks lending again. European
countries including Britain, France, Germany
and Spain announced aggressive plans to
guarantee bank debt, take ownership stakes in
banks or prop up ailing companies with billions
in taxpayer funds. The Treasurys plan would
help the United States catch up to Europe in what
has become a footrace between countries to
reassure investors that their banks will not
default or that other countries will not one-up
their rescue plans and, in so doing, siphon off
bank deposits or investment capital. - Mark
Landler
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The U.S Financial Crisis

• Government Actions
• What assets/liabilities should be purchased?
  Guaranteed?
• At what prices and under what terms?

Guarantee New Debt
Invest in Banks
Guarantee on Deposits
ASSETS Good Assets 80Toxic Assets
20 TOTAL ASSETS 95
LIABILITIES Shareholder Equity
3 Short-Term Debt and Liabilities to
Customers 80Long-Term Debt to Bondholders
17 TOTAL LIABILITIES AND SHAREHOLDER EQUITY
100
0
15
e.g., Includes long-term assets such as
mortgages
97
Flood the system with liquidity
e.g., Repos (1 day) and Commercial Paper (3
months)
61
The U.S Financial Crisis
U.S. GOVERNMENT ACTIONS

• Stabilizing the Financial Markets and the
  Economy
• The Federal Reserve responded to these
  developments in two broad ways.
• First, following classic tenets of central
  banking, the Fed has provided large amounts of
  liquidity to the financial system to cushion the
  effects of tight conditions in short-term funding
  markets.
• Second, to reduce the downside risks to growth
  emanating from the tightening of credit, the Fed,
  in a series of moves that began last September,
  has significantly lowered its target for the
  federal funds rate. Indeed, last week, in an
  unprecedented joint action with five other major
  central banks and in response to the adverse
  implications of the deepening crisis for the
  economic outlook, the Federal Reserve again eased
  the stance of monetary policy.
• We will continue to use all the tools at our
  disposal to improve market functioning and
  liquidity, to reduce pressures in key credit and
  funding markets, and to complement the steps the
  Treasury and foreign governments will be taking
  to strengthen the financial system.
• Speech by Mr Ben S Bernanke, Chairman of the
  Board of Governors of the US Federal Reserve
  System, at the Economic Club of New York, New
  York, 15 October 2008.

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62
The U.S Financial Crisis
U.S. GOVERNMENT ACTIONS

• The Troubled Asset Relief Program (TARP)
  authorized by the legislation will allow the
  Treasury, under the supervision of an oversight
  board that I Ben Bernanke will head, to
  undertake two highly complementary activities.
• First, the Treasury will use the TARP funds to
  help recapitalize our banking system by
  purchasing non-voting equity in financial
  institutions. Details of this program were
  announced yesterday. Initially, the Treasury will
  dedicate 250 billion toward purchases of
  preferred shares in banks and thrifts of all
  sizes. The program is voluntary and designed both
  to encourage participation by healthy
  institutions and to make it attractive for
  private capital to come in along with public
  capital. We look to strong institutions to
  participate in this capital program, because
  today even strong institutions are reluctant to
  expand their balance sheets to extend credit
  with fresh capital, that constraint will be
  eased. The terms offered under the TARP include
  the acquisition by the Treasury of warrants to
  ensure that taxpayers receive a share of the
  upside as the financial system recovers.
  Moreover, as required by the legislation,
  institutions that receive capital will have to
  meet certain standards regarding executive
  compensation practices.
• Second, the Treasury will use some of the
  resources provided under the bill to purchase
  troubled assets from banks and other financial
  institutions, in most cases using market-based
  mechanisms. Mortgage-related assets, including
  mortgage-backed securities and whole loans, will
  be the focus of the program, although the law
  permits flexibility in the types of assets
  purchased as needed to promote financial
  stability. Removing these assets from private
  balance sheets should increase liquidity and
  promote price discovery in the markets for these
  assets, thereby reducing investor uncertainty
  about the current value and prospects of
  financial institutions. Unclogging the markets
  for mortgage-related assets should put banks and
  other institutions in a better position to raise
  capital from the private sector and increase the
  willingness of counterparties to engage. With
  time, the provision of equity capital to the
  banking system and the purchase of troubled
  assets will help credit flow more freely, thus
  supporting economic growth.
• Speech by Mr Ben S Bernanke, Chairman of the
  Board of Governors of the US Federal Reserve
  System, at the Economic Club of New York, New
  York, 15 October 2008. (Emphasis added).

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63
The U.S Financial Crisis
U.S. GOVERNMENT ACTIONS

• To address illiquidity and impaired functioning
  in commercial paper markets, the Treasury
  implemented a temporary guarantee program for
  balances held in money market mutual funds to
  help stem the outflows from these funds. The
  Federal Reserve put in place a temporary lending
  facility that provides financing for banks to
  purchase high-quality asset-backed commercial
  paper from money market funds, thus reducing
  their need to sell the commercial paper into
  already distressed markets. Moreover, we soon
  will implement a new, temporary Commercial Paper
  Funding Facility that will provide a backstop to
  commercial paper markets by purchasing highly
  rated commercial paper directly from issuers at a
  term of three months when those markets are
  illiquid.
• To address ongoing problems in interbank funding
  markets, the Federal Reserve has significantly
  increased the quantity of term funds it auctions
  to banks and accommodated heightened demands for
  temporary funding from banks and primary dealers.
  Also, to try to mitigate dollar funding pressures
  worldwide, we have greatly expanded reciprocal
  currency arrangements (so-called swap agreements)
  with other central banks. Indeed, this week we
  agreed to extend unlimited dollar funding to the
  European Central Bank, the Bank of England, the
  Bank of Japan, and the Swiss National Bank. These
  agreements enable foreign central banks to
  provide dollars to financial institutions in
  their jurisdictions, which helps improve the
  functioning of dollar funding markets globally
  and relieve pressures on U.S. funding markets. It
  bears noting that these arrangements carry no
  risk to the U.S. taxpayer, as our loans are to
  the foreign central banks themselves, who take
  responsibility for the extension of dollar credit
  within their jurisdictions.

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64
The U.S Financial Crisis
U.S. GOVERNMENT ACTIONS

• These measures will lead to a much stronger
  financial system over time, but steps are also
  necessary to address the immediate problem of
  lack of trust and confidence. Accordingly, also
  announced yesterday was a plan by the Federal
  Deposit Insurance Corporation (FDIC) to provide a
  broad range of guarantees of the liabilities of
  FDIC-insured depository institutions, including
  their associated holding companies. The guarantee
  covers all newly issued senior unsecured debt,
  including commercial paper and interbank funding,
  and it will also cover all funds held in
  non-interest-bearing transactions accounts, such
  as payroll accounts. This broad guarantee will be
  effectively immediately, and fees for coverage
  will be waived for 30 days. After the 30-day
  grace period, banks may continue to participate
  in the guarantee program by paying reasonable
  fees.
• Speech by Mr Ben S Bernanke, Chairman of the
  Board of Governors of the US Federal Reserve
  System, at the Economic Club of New York, New
  York, 15 October 2008. (Emphasis added).

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65
The U.S Financial Crisis
PUBLIC VALUE?
ALTERNATIVES

• WHAT GOVERNMENT ACTIONS ARE NECESSARY TO
  STABILIZE THE HOUSING MARKET?
• E.G., HOUSING AND ECONOMIC RECOVERY ACT OF 2008
  (July 30, 2008) 300 BILLION INCREASE IN FHA
  LOAN GUARANTEES TO ENCOURAGE LENDERS TO REFINANCE
  DELINQUENT HOME MORTGAGES
• Directing Fannie Mae and Freddie Mac to refinance
  mortgages
• Permitting states to refinance loans at risk of
  foreclosure through issuance of federal
  tax-exempt mortgage revenue bonds
• Creating a new federal corporation to purchase
  distressed mortgages from investors and convert
  them to long-term fixed-rate mortgages.

STABILIZE THE HOUSING MARKET? STABILIZE
FINANCIAL INSTITUTIONS AND FINANCIAL
MARKETS? STABILIZE THE ECONOMY?

• FOUR MEASURES TO STABILIZE FINANCIAL MARKETS?
• RECAPITALIZE BANKS
• RESTART THE INTERBANK LENDING MARKET
• ABSORB SIGNIFICANT AMOUNTS OF TOXIC ASSETS
• PREVENT BANK RUNS

65
66
The U.S Financial Crisis
PUBLIC VALUE?
ALTERNATIVES

• WHAT GOVERNMENT ACTIONS ARE NECESSARY TO
  STABILIZE THE HOUSING MARKET?
• HOUSING AND ECONOMIC RECOVERY ACT OF 2008 (July
  30, 2008) 300 BILLION INCREASE IN FHA LOAN
  GUARANTEES TO ENCOURAGE LENDERS TO REFINANCE
  DELINQUENT HOME MORTGAGES

STABILIZE THE HOUSING MARKET? STABILIZE
FINANCIAL INSTITUTIONS AND FINANCIAL
MARKETS? STABILIZE THE ECONOMY?

• FOUR MEASURES TO STABILIZE FINANCIAL MARKETS?
• RECAPITALIZE BANKS
• RESTART THE INTERBANK LENDING MARKET
• ABSORB SIGNIFICANT AMOUNTS OF TOXIC ASSETS
• PREVENT BANK RUNS

• WHAT GOVERNMENT ACTIONS ARE NECESSARY TO
  STABILIZE THE ECONOMY and CUSHION THE IMPACT OF
  RECESSION?
• FISCAL STIMULUS PACKAGE?

66
67
The U.S Financial Crisis
PUBLIC VALUE?
ALTERNATIVES
WHAT GOVERNMENT ACTIONS ARE NECESSARY TO
STABILIZE THE HOUSING MARKET?
STABILIZE THE HOUSING MARKET? STABILIZE
FINANCIAL INSTITUTIONS AND FINANCIAL
MARKETS? STABILIZE THE ECONOMY?

• WHAT GOVERNMENT ACTIONS ARE NECESSARY FOR
  LONG-TERM STABILITY?
• REGULATORY REFORM?
• PUBLIC/PRIVATE ENTITIES?
• ??????

FOUR MEASURES TO STABILIZE FINANCIAL MARKETS?
WHAT GOVERNMENT ACTIONS ARE NECESSARY TO
STABILIZE THE ECONOMY and CUSHION THE IMPACT OF
RECESSION?
67