The U.S. Financial Crisis Sara Hsu October 3, 2008

1. The U.S. Financial Crisis Sara Hsu October 3, 2008

2. It all started with US mortgages…

3. Families just wanted to pursue the American dream of home ownership…

4. But now many families are in danger of losing the homes they worked so hard for.

5. People are also losing money in their 401Ks, and may not be able to get a home or car loan. • In this talk, we will answer the following questions: How did this begin? What exactly is going on, and where is it leading?

6. What happened? • The crisis began in the subprime mortgage area, hitting the U.S. and triggering a global financial crisis in 2008. ■ ■ ■ • The crisis began with the bursting of the US housing bubble and high default rates on "subprime" mortgages made to higher-risk borrowers with lower income or lesser credit history.

7. What is subprime? • The term subprime lending refers to the practice of making loans to borrowers who do not qualify for market interest rates. Interest rates for these borrowers are usually higher.

8. “Credit Crunch” • Banks are all facing a problem of having less credit for lending money, since so many people cannot pay back the mortgage loans, and since other financial institutions have failed. Other banks now will not lend to them. This is a “credit crunch.”

9. When did this begin? • The stock market & dot-com crashin 2000 resulted in many people taking their money out of the stock market and purchasing real estate, which many believed to be a more reliable investment. ■ ■ ■ • At the same time, the Federal Reserve cut short-term interest rates to historically low levels, from about 6.5% to just 1%, which allowed more people to purchase homes for a lower cost.

10. Subprime borrowing was a major contributor to an increase in home ownership rates and the demand for housing. • Some homeowners used increased property valuesfrom the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending.

11. Then the bubble burst. Overbuilding during the boom period, increasing foreclosure rates and unwillingness of many homeowners to sell their homes at reduced market prices have significantly increased the supply of housing inventory available, driving down prices. • More homeowners are now at risk of default and foreclosure.

12. Foreclosure has hit some Americans very hard.

13. Borrowing Climate Changed • Borrowers took out loans under terms that were not so great, since they thought they would be able to refinance at more favorable terms later. ■ ■ ■ • But once housing prices started to drop moderately in 2006-2007, refinancing became more difficult. Defaults and foreclosure activity increased dramatically as interest rates reset higher.

15. The mortgage lenders that retained credit risk were the first to be affected, as borrowers became unable to make payments. • Major banks and other financial institutions around the world reported major losses, with Lehman Brothers recently declaring bankruptcy and other major lenders, including Fannie and Freddie, seeking shelter.

16. Securitization • Owing to securitization, many mortgage lenders had passed the rights to the mortgage payments and related credit & default risk to third-party investors via mortgage-backed securities (MBS) and collateralized debt obligations (CDO). ■ ■ ■ • Corporate, individual and institutional investors holding MBS or CDO faced significant losses, as the value of the underlying mortgage assets declined.

17. Financial Institutions • A variety of factors caused lenders to offer an increasing array of higher-risk loans to higher-risk borrowers. ■ ■ ■ • The risk premium required by lenders to offer a subprime loan declined. This occurred even though subprime borrower and loan characteristics declined overall during the 2001-2006 period.

18. Mortgage Brokers • Mortgage brokers do not lend their own money. There is not a direct relationship between actual loan performance and income for mortgage brokerages. ■ ■ ■ • They have big financial incentives for selling complex adjustable rate mortgages (ARMs), since they earn higher commissions.

19. Mortgage Underwriters • Underwriters determine if the risk of lending to a particular borrower meet their criteria of credit, capacity and collateral, but these were not closely looked at leading up to the lending crisis.

20. CreditRating Agencies • Credit rating agencies are now under scrutiny for giving high ratings to the securities based on subprime mortgage loans. Rating agencies are paid by investment banks, so they had a financial incentive for marking up the ratings.

21. Central Banks • The US central bank, the Federal Reserve, lowered interest rates just after the dot-com crash to counter the risk of deflation, but this encouraged borrowers to take out more home loans.

22. Federal Reserve Response to Crisis • At first, the Fed lowered interest rates and then sent a call out to banks to negotiate mortgage terms with their borrowers, to prevent foreclosures. ■ ■ ■ • When the crisis deepened, the Fed bailed out Fannie Mae and Freddie Mac, let Lehman Brothers go bankrupt, and purchased equity in AIG. The Fed also persuaded the President and Congress to pass a $700 billion bailout for banks.

23. The $700 Billion Bailout • Sets up a Troubled Assets Relief Fund to purchase banks’ troubled assets at low price • Raises FDIC to $250,000 to aid small businesses • Underlying mortgage holders’ rights remain the same; encouraged to contact HOPE • Subject to management/auditing oversight • Renewal of R&D tax breaks for businesses for spending on renewable energy

24. Regulatory Responses • The Fed has promised to tighten regulation of financial institutions. Goldman Sachs and Merrill Lynch jumped the gun by voluntarily transforming themselves into regular banks, which face tighter regulations.

25. Effect on Stock Markets • Stock markets have been volatile as various events of the crisis have played out. Over the past year, the Dow Jones Industrial Average has fallen by over 3,000 points, over 20%.

26. Effect on Stock Markets • Crisis has caused panic in financial markets and encouraged investors to take their money out of risky mortgage bonds and shaky equities and put it into commodities like corn and oil as "stores of value".

27. Effect on Financial Institutions • Financial institutions have suffered greatly, with Lehman Brothers going bankrupt and Fannie Mae and Freddie Mac being taken under government control. Other banks will struggle to renew their competitiveness.

28. Effect on Home Owners • Housing prices are expected to continue declining until the inventory of surplus homes is reduced to more typical levels.

29. Effect on Businesses • The effect on businesses has yet to be seen, since the “real” economy is next to be affected by the financial crisis. • Lower supplies of consumer credit mean demand for goods and services will fall. • We have seen unemployment increase in September, and will likely increase more in October, as workers from the financial and then real sector are laid off, as demand falls.

30. Transmission to Global Economies • International banks that bought securities based on US subprime mortgages have been caught up in the crisis. • The crisis has also spread as international financial markets have become volatile and vulnerable to the credit crunch. • The global economy faces an enormous slowdown.

31. Anger at American Financiers • At a summit meeting on the US financial crisis, Brazilian President Luiz Inacio Lula da Silva said “the euphoria of speculators has spawned the anguish of entire peoples, in the wake of successive financial disasters that threaten the world's economy.We must not allow the burden of the boundless greed of a few to be shouldered by all.''

32. Transmission to Global Economies • Increase in world food and commodity prices has resulted from the transfer of investment from housing to commodities such as wheat and corn. Prices of food are much higher in every country.

33. Future Possibilities • How long it will take markets to overcome the financial crisis and portending recession has yet to be seen. Effects on consumers and businesses continue as credit becomes less available. • Those who wanted to retire now must wait until later or cope with having less in their 401K than they had planned. • Current and future generations face a prodigious tax burden.