Finance 129

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Finance 129

• Background on the Financial Crisis
• And Current Economy

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The Big Picture
Problems in Mortgage Market
Global Credit Crisis / Bank failures / Equity
Losses
Declining Consumer Spending
Decreased Business Investment
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Whos to Blame?
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How Financial Markets EnabledKeeping up with
the Joneses

• New Products
• Poor Underwriting
• Public Policies Unintended Consequences
• Low Rates and International Capital Flows

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Average Size of Subprime Loans
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Credit Quality of Subprime Loans Originated each
year
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Impact of Subprime Loans on Home Ownership
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Fannie MaesGuarantee of Alt A Loans
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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

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International Capital Flows
Consumer Spending On Exports
Increased Foreign Holdings of
Increased Inflow of Dollars Helps Keep Long Term
Rates Low
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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

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Non Agency Mortgage Foreclosure Rates
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Response of Consumers

• Increased access to credit and delusional
  optimism resulted in
• Short-Term Speculative Focus
• Borrowing More and Saving Less

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Case Study Natalie Brandon

• 1985 Buys 105,000 house
• 30 Year fixed rate loan Payment 770
• 2000-2006
• Paid penalties to Refi 5 times in 5 years
• Yearly income 100,000
• 2006 New Loan 625,500 2/28 7.99 teaser
• Payment 4,585
• Fall 2007
• Home Value 450,000
• Attempt to Refi for 40 years at 6 Fails

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Borrowing More Saving Less
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Equity Prices Compared to Past Recessions
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Precautionary Saving
If you were to lose your job, for how long could
you afford to be out of work and still meet your
financial obligations including monthly expenses?
The 2009 MetLife Study of the American Dream
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Confidence in Having Enough Money to Live
Comfortably Throughout Retirement Years
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The Keys to Recovery The Big Picture

• Consumers
• Precautionary or Long Term Savings?
• Lost Faith in Investment Planning?
• View of home ownership
• Corporate Earnings
• Financial Markets and Regulation
• Regulatory Changes
• Long Term Inflation Fears
• Monetary and Fiscal Policy Interest Rates
• Global Concerns

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Consumer Credit Outstanding
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ISM Manufacturing Survey
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Employment Non Farm Payrolls
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Employment Non Farm Payrolls
Peak 138 M Jan 2009
Current 133.2 M July 2012
Min 129.2 M Feb 2010
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Employment

• Peak Employment Jan 2009 138.023 Million
• Current Employment July 2012 133.245 Million
• Average monthly gain needed in payrolls to return
  to peak level in
• 1 year 398,166 2 years 199,083
  3 years 132,722
• Feb 240,000 March 154,000
  April 77,000
• May 77,000 June 64,000
  July 164,000

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Other Forces

• Government
• Contraction
• Tight Credit
• Uncertainty
• US, Europe, China

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History of EU 1950

• The Schuman Declaration
• Plan for France and Germany to pool coal and
  steel production.
• European economic unity will make war Not merely
  unthinkable but materially impossible

Robert Schuman French Foreign Minister
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1951

• European Coal and Steel Community
• France, Germany, Italy, Netherlands, Belgium and
  Luxembourg
• High Authority (oversees coal and steel
  production)
• Common Assembly (future European Parliament)
• Council of Ministers

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Changing Landscape
1980 1997 2006
of GDP (PPP) produced by g-7 countries 54 46 40
OF GDP (PPP) produced by other G-20 Countries 21 30 36

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A Brief History of European Debt Crisis

• January 2001 Greece Joins Euro zone and adopts
  Euro.
• Nov 2004 Greece admits its deficit has been
  above the required EU limit (3 of GDP) since
  1999
• March 2005 Trade Unions impose 24 hour strike
  to protest austerity measures after cost of
  hosting Olympics causes high deficits

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2002

• Germanys Debt hits 60.7 in 2002 of GDP and is
  still above 60
• Germanys budget deficit hits 3.8 of GDP in 2002
  and remains above 3 until 2006
• Frances debt hits 63.3 of GDP in 2003 and is
  still above 60
• Frances budget deficit hits 3.3in 2002 and
  remains above 3 until 2006
• Neither country receives penalties from the
  European Union

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2005

• The 1997 Growth and Stability Pact is altered to
  allow exceptional circumstances and other
  relevant factors to be considered when the
  deficit and debt targets are missed.
• Memebers are allowed two year to correct the
  problem and could be given more time with an
  exception.

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Deficit as a of GDP
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Euro Area Debt
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Long Term Borrowing Costs (10 year debt) Jan
2010 May 2012
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Contagion

• November 28, 2010
• Ireland receives 67.5B in bailout loan
  commitments
• Given to 2015 to decrease deficit to 3 of GDP
• May 2011
• May 3 Portugal accepts 116B loan commitment
  package

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Public Debt Comparison
Country 1999 1999 1999 2004 2004 2004 2010 2010 2010
Country Unep Rate Debt of GDP Rev of GDP Unep Rate Debt of GDP Rev of GDP Unep Rate Debt of GDP Rev of GDP (2009)
Japan 4.7 97 26.3 4.7 156 26.3 5.1 183 28.1
Greece 12.1 103 32.8 10.5 108 31.1 12.6 147 29.4
Italy 11 106 42.5 8.1 96 40.9 8.4 109 43.5
US 4.2 38 29.1 5.5 36 25.7 9.6 61 23.9
Spain 15.6 52 34.1 11 39 34.6 10 51 30.7
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Treasury Bid to Cover Ratio
2 year 10 year
2005 Average 2.19 3.75
2012 Average 2.36 3.18
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Average Interest Expense
Title Average Interest Rates Average Interest Rates
Title June 30,2012 June 30,2011
Interest-bearing Debt Interest-bearing Debt Interest-bearing Debt
Marketable Marketable Marketable
  Treasury Bills 0.115 0.129
  Treasury Notes 2.077 2.385
  Treasury Bonds 5.452 5.860
  Treasury Inflation-Protected Securities 1.696 2.005
  Federal Financing Bank 4.625 4.625
Total Marketable 2.159 2.380
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GAO Baseline

• Revenues as a share of GDP increase and
  discretionary spending as a share of GDP decreases

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GAO Baseline
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GAO Alternative Scenario

• Revenue and Discretionary Spending are at
  historical averages over long term.
• Soc Sec, Medicare, Medicaid and interest exceed
  revenue by 2030

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GAO Alternative Scenario
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Fiscal Gap or Current Value of Future Primary
Deficits

• The sum of the present values of the difference,
  or gap, between revenue and noninterest spending
  over the next 75 years.
• Assumes the goal of having todays debt to GDP
  ratio at the end of the period

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Cost of Closing the Gap
Federal Fiscal Gap under GAOs Simulations Based upon Trustees Assumptions, 2011-2085 Federal Fiscal Gap under GAOs Simulations Based upon Trustees Assumptions, 2011-2085 Federal Fiscal Gap under GAOs Simulations Based upon Trustees Assumptions, 2011-2085 Federal Fiscal Gap under GAOs Simulations Based upon Trustees Assumptions, 2011-2085 Federal Fiscal Gap under GAOs Simulations Based upon Trustees Assumptions, 2011-2085 Federal Fiscal Gap under GAOs Simulations Based upon Trustees Assumptions, 2011-2085
Average change required to close gap Average change required to close gap Average change required to close gap Average change required to close gap
If action is taken today If action is taken today If action is taken in 2021 If action is taken in 2021
of GDP Solely through increase in revenue Solely through decreases in noninterest spending Solely through increases in revenue Solely through decreases in noninterest spending
Baseline 1.8 8.4 8.0 9.9 9.4
Alternative 8.2 45.7 32.2 54.3 37.0
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The World in 2050

• The G7 vs the E7 (Brazil, Russia, India, China,
  Indonesia, Mexico and Turkey)
• Emerging Middle Class in Developing Economies
• 2005 G7 is currently about 20 larger in
  Purchasing power parity (PPP) and 75 larger in
  terms of market exchange rates (MER)
• E7 will be 75 larger than G7 in PPP and 25
  larger in terms of the (MER)