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1

The Root Causes of the Crisis:What have We Learned?

Bob DeYoung Capitol Federal Professor

University of Kansas School of Business

Summer Teacher InstituteUniversity of Chicago

June 2009

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Case-Shiller Home Price Index

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25019

87

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2001

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2008

2009

From 1997 to 2006, home prices increased at a 9.1% annual rate.

Home prices have declined

more than 25% since 2006.

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% of Jobs Lost in Past Recessions

-5

-4

-3

-2

-1

0

1

2

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

months

1960

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1981

1990

2001

2007

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-5

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-1

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0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

months

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-5

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-1

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0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

months

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-5

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0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

months

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months

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months

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My talk today

All recessions are different. This recession was caused by a collapse in residential real estate values.

Real economy: Home prices fell Housing sector collapsed Aggregate spending declined.

• This is a demand-side story.

• Reduced spending on houses and related items.

Financial sector: Mortgage defaults Big losses on mortgage-backed securities Investor uncertainty.

• This is a supply-side story.

• Less credit available for businesses and households.

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My talk today

1. Root causes of the recession:– A bubble in the housing market.– A new lending model (which performed poorly).– A history of short-sighted economic, financial, and

social policies. – Bad financial behavior by households.

2. What have we learned? – Have the responses of policymakers been appropriate? – Have households changed behavior?

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Root Causes of the Crisis:

• Housing bubble.

• A new banking model.

• Poor historical public policy.

• Poor household finance.

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Rate of Homeownership in U.S.

35%

40%

45%

50%

55%

60%

65%

70%

75%19

00

1920

1940

1960

1980

2000

2002

2004

2006

2008

• GI Bill

• Automobile/Suburbs

• High income tax rates.

14

Rate of Homeownership in U.S.

35%

40%

45%

50%

55%

60%

65%

70%

75%19

00

1920

1940

1960

1980

2000

2002

2004

2006

2008

• Affordable home policies.

• Easier access to mortgage credit.

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0

50

100

150

200

25019

87

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

From 1997 to 2006, home prices increased at a 9.1% annual rate.

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Home Price

Home Sales

Increased House Demand

• Easy Federal Reserve monetary policy.

• Mortgage interest tax deduction.

• Policies to provide "affordable housing."

• Ownership Society.

• Originate-to-Securitize banking model.

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1970 2007

Depository Institutions(banks, thrifts, credit unions)

54.4%

Insurance Companies(life, property & casualty)

17.4

Pension Funds(public, private)

14.6

Mortgage and Consumer Finance(GSEs, finance companies,

REITs, securitized asset pools)8.8

Mutual Funds(stock, bond, money market)

3.7

Securities Firms(brokers, dealers, funding corps.)

1.2

Distribution of Assets held at Financial Intermediaries in the U.S.

Banks were the center for: • Personal savings

• Business credit

• Payments

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1970 2007

Depository Institutions(banks, thrifts, credit unions)

54.4% 22.8%

Insurance Companies(life, property & casualty)

17.4 10.5

Pension Funds(public, private)

14.6 16.9

Mortgage and Consumer Finance(GSEs, finance companies,

REITs, securitized asset pools)8.8 23.3

Mutual Funds(stock, bond, money market)

3.7 18.5

Securities Firms(brokers, dealers, funding corps.)

1.2 7.9

Distribution of Assets held at Financial Intermediaries in the U.S.

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0%

10%

20%

30%

40%

50%

60%

20072000199019801970

0.0%

0.5%

1.0%

1.5%

Asset share of banks, thrifts, credit unions

Bank profits as % of GDP

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Bank asset shares plunged, but bank profits soared. Why?

• A new business model for large banks emerged.

• The new model exploits post-1980s information technologies, financial products, and regulations.

– Much activity at banks moved off the balance sheet.

– Much income at banks now comes from fees, not from interest.

• This new model is highly efficient, highly profitable, but riskier than most of us thought.

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Traditional Mortgage Finance

Agents with excess funds

Agents that need funds

DepositorsHome Buyers

Bank or Thrift

mortgages deposits

$ funds $ $ funds $

Bank earns profits from

interest margins.

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Innovation: technology and deregulation

• Geographic deregulation (Riegle-Neal Act 1994) – Permitted inter-state branching.– Banks could exploit scale economies.

• Product deregulation (Gramm-Leach-Bliley Act 1999)– Permitted commercial banks to engage in investment

banking, securities brokerage, and insurance sales.– Largely fee-based, off-balance sheet activities.

• New technologies– Credit bureaus and credit scores.– Automated loan underwriting.– Loan securitization. – Deeper capital markets.

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Bank or Thrift

mortgages deposits

$ funds $ $ funds $

Bank earns profits from

interest margins.

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Bank or Thrift

mortgages deposits

$ funds $ $ funds $

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Mortgage SecuritizationBank or

Thrift

mortgages deposits

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Mortgage Securitization

Mortgage Pool(off-Balance Sheet)

$$$

mortgages

Bank or Thrift

mortgages depositscash

mortgages

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$$$

mortgages

$$$

MBS

Bank or Thrift

mortgages deposits

Institutional Investors

MBSscash

mortgages mortgage-backed securities (MBS)mortgages

MBS

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mortgages mortgage-backed securities (MBS)

Bank or Thrift

mortgages deposits

Loan servicer (often the bank or the securitizer)

withholds a small fee from each mortgage payment.

Mortgage payments

from Households

cash


mortgages


MBSsMBS

Payments go to investors based on terms of the MBS contract.

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$$$

mortgages

$$$

MBS

Bank or Thrift

mortgages deposits

Bank earns profits from origination fees, securitization fees,

servicing fees.

cash

MBS rated by Moody's,

S&P or Fitch.

mortgages mortgage-backed securities (MBS)mortgages

Investors get the principal & interest

payments.

Credit scoring allows a bank to make more loans faster.


MBSsMBS

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This model increased risk at large banks.• Increasing reliance on fee income.

– Fee income is often more volatile than interest income.– Fee-based activities require higher operating leverage.– Fee-based activities are off-balance sheet, allowing banks to use

more financial leverage. – Fee income has not yielded expected diversification benefits.

• Increasing reliance on third-party information.– All lenders have same information (credit bureaus).– Investors (firms and funds that own the MBS) rely on bond raters.

• Fundamentally poor financial management.– A lack of diversification.– Excess reliance on financial leverage for earnings.– Too much interest rate risk.– Modeling risk without adequate historical data. – Why? Did large banks know they were Too-Big-To-Fail?

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Model gives banks incentives to make riskier loans…that others will hold!

• Credit underwriting separated from risk-bearing.

– Incentives for lenders to make riskier loans.

• Securitization separated from risk-bearing.

– Incentives for investment banks to engineer riskier MBS.

• Loan monitoring separated from risk-bearing.

– Investors must rely on opinions of rating firms…and the rating firms get paid by the securitizing banks.

• Control rights separated from risk-bearing.

– Fractured ownership of mortgages impedes the modification of nonperforming mortgage loans.

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Bad banking model? Or bad policy?

• Regulation did not evolve with banking practices.– Bank moved activity off of their balance sheets.– This circumvented capital rules; increased leverage.

• SEC reduced capital requirements for largest five investment banks in 2004.

• Regulators did nothing to rein in "Too-Big-To-Fail."

• SEC limits competition in securities rating business.– Only three main NRSROs (Moodys, S&P, Fitch) have

been licensed to rate these securities.

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Bad banking model? Or bad policy?

• Congress made sure that OFHEO was a weak regulator of Fannie Mae and Freddie Mac.

– Congress wanted more "affordable mortgages."

– Pressured Fannie and Freddie into providing funds for subprime mortgage securitizations.

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Many households also at fault.

• Too much mortgage debt.

– Bigger houses

– Small down payments

– Home equity loans

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Household Financial Obligations(% of Disposable Income)

0%

5%

10%

15%

20%

25%

30%

35%1

98

0

19

83

19

86

19

89

19

92

19

95

19

98

20

01

20

04

20

07

Renters

All households

Homeowners

Mortgage Debt

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Subprime mortgage lending

• A typical subprime mortgage scenario in mid-2000s:

– Borrower cannot qualify for a conforming mortgage.

– Gets a 3-year ARM: 0% down and a teaser rate.

– Borrower can just afford the payments in years 1-3.

– Borrower cannot afford the payments after year 3.

• Deal works out only if home prices keep increasing.

– As prices rise, borrower builds up equity in home.

– Borrower builds credit rating with a good payment record during first 3 years.

– At year 3, borrower refinances with a conforming loan at a low fixed rate.

• But what if prices stop going up?

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0

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25019

87

1988

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1995

1996

1997

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2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Home prices have declined more than 25%

since 2006.

A profound effect on the economy.

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Reduced House Demand

• Prices stop rising…• Levered homeowners

stop building equity.• Refinancing is no

longer possible.

• As these homeowners default on mortgages…• Investors wary and

stop financing MBS.• Mortgage loans

become scarce.• As prices fall, buyers

wait for a good deal.

Home

Price

Home

Sales

Excess Supply

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Single-family Housing Starts(thousands per quarter)

0

100

200

300

400

500

600

2002 2003 2004 2005 2006 2007 2008

NAHB estimates: Building one single-family home generates about 3.5 jobs.

Rough calculation: The annual decline in starts since 2006 implies 4.2 million fewer jobs…an approximate 3% reduction in jobs.

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% Change in Aggregate Spending

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

2006 2007 2008

ConsumptionSpending

NonresidentialInvestment

ResidentialInvestment

(Annualized change from previous quarter, seasonally adjusted)

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-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

2006 2007 2008

ConsumptionSpending




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-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

2006 2007 2008

ConsumptionSpending




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Impact on the Financial Sector

• Large capital losses at banks.

– U.S. banks will suffer at least $2 trillion from MBS losses.

– About $1 trillion of these losses remain to be taken.– Based on estimates from IMF; Goldman Sachs; Nouriel Roubini.

– Largest U.S. banks propped up by the tax payers.

• Massive operating losses at mono-line mortgage firms.

– Novastar, Countrywide, American Century, WAMU, IndyMac, and others have failed.

• Lender losses created uncertainty in financial markets.

– No new private mortgage securitizations in over a year.

– BX 2007 AAA-rated subprime trading at 24¢.

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% Delinquencies at U.S. Commercial Banks

0%

2%

4%

6%

8%

10%

12%

14%

1991

Q1

1992

Q2

1993

Q3

1994

Q4

1996

Q1

1997

Q2

1998

Q3

1999

Q4

2001

Q1

2002

Q2

2003

Q3

2004

Q4

2006

Q1

2007

Q2

2008

Q3

Credit cards

Business Loans

Single-family mortgages

Commercial mortgages

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Subprime Mortgage Delinquencies

NOTE: Most subprime mortgages written by non-banks.

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Lending at U.S. Banks ($ billions)

$0$200$400$600$800

$1,000$1,200$1,400$1,600$1,800

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

CommercialLoans

InterbankLoans

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Rates on 3-month financial securities

0%

1%

2%

3%

4%

5%

6%

7%

1997

-01

1998

-01

1999

-01

2000

-01

2001

-01

2002

-01

2003

-01

2004

-01

2005

-01

2006

-01

2007

-01

2008

-01

2009

-01

Financial CP

Non-Financial CP

Treasury Bills

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Daily New Issues of Financial Commercial Paper, 2006-2009

0

50

100

150

200

250

300

350

400

2006

-01-

02

2006

-02-

20

2006

-04-

10

2006

-05-

29

2006

-07-

17

2006

-09-

04

2006

-10-

23

2006

-12-

11

2007

-01-

29

2007

-03-

19

2007

-05-

07

2007

-06-

25

2007

-08-

13

2007

-10-

01

2007

-11-

19

2008

-01-

07

2008

-02-

25

2008

-04-

14

2008

-06-

02

2008

-07-

22

2008

-09-

10

2008

-10-

30

2008

-12-

22

2009

-02-

10

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What Have We Learned?

• Have the policy responses been appropriate?

• Have households responded appropriately?

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Congress• Silly populist legislation:

– Tax AIG bonuses (ex post).

– Limit executive pay (ex post).

– Tank the corporate jet market.

• Efforts to modify mortgages.

– Gives households moral hazard incentives.

– OCC study: High recidivism rate.

• "TARP-plus" funding.

– A $115 billion ransom payment to get bill passed.

• Hair of the dog:

– $8,000 tax credit for first-time home buyers.

– 3% down payments for VA, FHA and FMHA loans.

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SEC

• Largely a bystander in the post-crisis policy response.

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FDIC

• New FDIC guarantees:

– Deposits up to $250,000

– Pre-existing MMMF accounts

– Newly issued corporate debt

• Failed bank resolutions:

– Allowed historically large bank failures.

– An hour away from arranging a subsidized purchase of Wachovia by CitiGroup.

• Financing the insurance fund:

– Increased deposit insurance premiums paid by banks.

– $500 billion line of credit from Treasury.

• Leading the charge on modifying mortgages.

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Federal Reserve

• New lending facilities:– Term Auction Facility– Commercial Paper Funding Facility– Term Securities Lending Facility– Primary Dealer Credit Facility

• Aggressive monetary policy response– Fed funds target rate is near 0%.– M1 and M2 have exploded.

• Co-conspirator with Treasury on "bailouts"– Fannie and Freddie (discount window loans)– AIG ($152 billion credit facility)– Bear Stearns ($29 billion loan to J.P.Morgan Chase)

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• Bailouts– Fannie and Freddie; AIG; Bear Stearns…not Lehman?

• TARP (Troubled Asset Relief Program)– Still hasn't bought a single $1 of troubled assets…but it

is keeping Citi and BofA afloat.

• The Hotel Geithner

• Son of TARP1.Public-Private investment partnerships to purchase

troubled assets.2. Inject more capital (as previous TARP is paid off).3.Loan modifications4.Provide funding in ABS markets (w/ FDIC and Fed)

Treasury

55

• Announced on Wednesday, June 17. • Five point plan:

– Federal Reserve becomes the regulator of all large or systemically important financial firms.

– Requires reforms in securities markets (ratings firms, securitized loans, derivatives).

– Creates the Consumer Financial Protection Agency (CFPA).

– Established procedures for federal government to takeover and "unwind" large failing financial firms.

– Encourages other countries to do this, too.• Details to come…

The New Administration Proposal

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MBS $100 $1,000 Deposits

Loans $900 $ 0 Equity

First National Too-Big-To-Fail Bank

1. FNB marks MBS to market: Equity = -$75. Bank fails. FDIC takes a $75 loss.

2. Treasury buys MBS for $100: Equity = $0 and Cash = $100. Treasury takes a $75 loss when it sells MBS.

3. Treasury injects $75 of equity: Bank sells MBS and loses $75. Equity = $0 and Cash = $100. Treasury takes a loss of $75 on equity investment.

MBS $100 ($25 market) $1,000 Deposits

Loans $900 $ 0 Equity

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Household Behavior

A 14-year high level of household

savings.

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The Root Causes of the Crisis:What have We Learned?

Bob DeYoung Capitol Federal Professor

University of Kansas School of Business

Summer Teacher InstituteUniversity of Chicago

June 2009