THE CREDIT CRISISCAUSES, CONSEQUENCES & CURES
University of Nevada, RenoInstitute for the Study of Gambling & Commercial Gaming14th International Conference on Gambling & Risk Taking
Stateline, Nevada May 25-29, 2009
Mark SieversSievers & Sievers
P.O. Box 546Cripple Creek CO 80813
(719) [email protected]
MAY YOU LIVE IN INTERESTING TIMES MAY ALL OF YOUR DREAMS COME
TRUE 4 consecutive Qs of GDP declines
◦ 2.7% in 3d Q 08◦ 5.4% in 4th Q 08◦ 6.4% in 1st Q’09◦ 1% in 2nd Q ‘09
7.4 million jobs lost since Jan. 08◦ Unemployment rate = 9.7% (4.9%
in Jan 2008)◦ Unemployment projected to be
10.5% in Dec. 2009 Spending for business equipment
dropped 30% Industrial output dropped 20% in
1st Q 2009 (equal to 1998 levels) Industrial capacity used dropped
to 69% (lowest ever) Banks in trouble
◦ 89 bank failures in2009◦ 416 banks failed FDIC grading
system
Stock market (S&P 500) down about 40% from 2008
June ‘09 average housing prices down about 30% from Jan. ‘07
July ‘09 foreclosures 32% higher than July ’08◦ 800,000 homes in foreclosure –
expected to peak at 1.15 million in 2010
◦ Cure rates for defaulting mortgages:
◦ Prime loans - 6.6% from 45% (2006)
◦ Alt-A loans - 4.3% from 30%◦ Subprime – 5.3% from 19.4%
1.4 million bankruptciesexpected in 2009– 75% higher
than 2007
Gyp
sie
Cu
rses
LOCAL BUSINESS CONDITIONS20-30% BELOW 2001
ARE YOU COMING OR GOING?BUILDING PERMITS &
FORECLOSURES
INTERCONNECTED CAUSESEra of Easy/Cheap Money 2000-2005
◦ Greatly expanded the supply of loans Created a Real Estate Bubble
Rise of the Shadow Banking System◦ Highly leveraged, risk-seeking business model◦ Equal in size to traditional banking system
Securitization of loans◦ Expanded cheap/easy money◦ Agency problems – “loan to sale” business models◦ Gambling with Credit Default Swaps widespread◦ Inability to re-negotiate defaulting loans and loans
on property where value falls below loan principle
WHAT (WHO) CAUSED THIS MESS?BOOM & BUST MONETARY POLICY
2000-2004 – Fed reduces interest rates to combat 9/11 and dot-com recessions◦ Wave of cheap money Housing
price bubble caused by: Dramatically reduced mortgage rates
& sub-prime mortgages increase house prices
Securitized loan instruments makes even more money available for cheap mortgages
2005 – 2006 Fed increases interest rates and bursts the housing bubble◦ Falling House prices upside-down
loans◦ Collapse in the securitized loan
marketFed missed the rise of
securitization & highly-leveraged shadow banks
“May you come to the attention of higher
authorities.”
FEDERAL RESERVE MONETARY POLICY HOUSING PRICE BUBBLE
1/1/
1997
1/1/
1998
1/1/
1999
1/1/
2000
1/1/
2001
1/1/
2002
1/1/
2003
1/1/
2004
1/1/
2005
1/1/
2006
1/1/
2007
1/1/
2008
100%
120%
140%
160%
180%
200%
220%
240%
0%
1%
2%
3%
4%
5%
6%
7%U
S H
ou
sin
g P
rice
s -
- C
ase
-Sh
ille
r In
de
x
Fe
de
ral
Fu
nd
s R
ate
1% Reduction in Market Mortgage Rates Causes a 10-16% Increase in Housing Prices Robert Schiller – Irrational Exuberance
GREENSPAN’S BUBBLESFINE-TUNING THE ECONOMY WITH MONETARY POLICY
Source: Paul Krugman, The Return of Depression Economics (2009)
1999 Stock Market Bubble“Irrational Exuberance”
2006 Housing Price Bubble
US & Japanese Real Estate Bubbles
Japanese decline 65%
MAJOR CONTRIBUTOR – SECURITIZATIONBundling & selling loans in bond-like
instruments◦ 25% mortgages; 21% credit card loans; 13% auto loans; 15%
other (student loans, business loans)
Massive Boom & Bust Cycle◦ 1997 $300 billion 2006 $2 trillion 2007 $121 billion
Agency Problems◦ Borrowers are unknown to the bundled loan purchasers – loan
renegotiations are virtually impossible when borrower gets into trouble
◦ “Loan to sale” business models -- compensation based on # of loans not loan quality (rise of unregulated mortgage brokers & mortgage lenders)
Serious Structural Problems◦ Low quality (sub-prime) loans in securitized tranches carried
high returns, create incentives to make low-quality, risky loans
◦ Valuation grossly complex making after-market sales to 3d parties nearly impossible
◦ Insurance/Gambling via Credit Default Swaps
SECURITIZATION IN A NUTSHELLAKA TOXIC ASSETS, LEGACY ASSETS
Borrowers•Households•Businesses
Lenders•Banks•Credit Cards•Auto Lenders•Hedge Funds•Mortgage Lenders
Loans/Assets•Mortgages• Sub-Prime Loans• Alt-A Loans• FHA/VA Loans•Credit Cards•Auto Loans•Student Loans•Commercial Loans
Special Purpose Vehicle
Securitized Instrument•Collateralized Debt Obligations •Collateralized Loan Obligations •Asset Backed Securities •Mortgage Backed Securities
Arranger
Buyers (Highly Leveraged)•Investment Banks•Pension Funds•Hedge Funds•Private (Foreign) Investors
Rating Agency
Credit Default Swaps
Insurers •Insurance Companies•Investment Banks•Hedge Funds•Individuals
Speculators•Investment Banks•Hedge Funds•Investors
SECURITIZED LOAN INSTRUMENTSTHE WATERFALL
Loans/Assets•Mortgages• Sub-Prime Loans• Alt-A Loans• FHA/VA Loans•Credit Cards•Auto Loans•Student Loans•Commercial Loans
Senior Tranche•High quality loans•Priority on cash flow•Lower coupon
Prices determined by changes in :• Risk rating by rating agency• Interest rates (P when interest rates )• Loan to value ratio (Market price of assets)• Repayment patterns (Foreclosures)
MediumTranche•Medium quality loans•2d Priority on cash flow•Higher coupon
Junior Tranche•Lowest quality loans•Last priority on cash flow•Highest coupon
Securitized loan portfolio divided into tranches of bond-like instruments with different prices,interest rates and claims on cash flow
LEVERAGING & SHADOW BANKS(MAGNIFIES RETURNS & LOSSES)
$100 Million Security10.5% Return
Lender’s Money$95 Million
Hedge Fund Money$5 Million
Conservative Lenders10% Loan Terms
Hedge FundInvestors
$95 M
$5 M
$9.5 M
10% Return to
Conservative Lenders
$1 M 20% Return to Hedge
Fund InvestorsProblems:
• Moral Hazard – Hedge Fund gambles with Conservative Investors’ Money
• No Regulatory Oversight of Leveraging • Oct. 2004 -- SEC suspended net capital rule for
largest investment banks eliminating regulatory restrictions on leveraging
SHADOW BANK RUNPrice/Value of
securitized bonds/assets
falls.
Investors: “I ‘m outta here. I
want to withdraw my
money.”
We don’t have the cash to cover the
withdrawals
Sell securities. Reduce prices
to raise the cash.
Value of firm falls.
Federal Reserve Increases
Interest Rates Causes
Bond Prices to Fall
Credit Default Swaps:
Bets that firm will fail.
CONSEQUENCES – FORECLOSURES
HOW LONG THIS WILL LAST?CBO ESTIMATES – 2014 BEFORE GDP
GROWTH RETURNS TO NORMAL
Congressional Budget Office: A Preliminary Analysis of the President’s Budget and an Update of CBO’s Budget and Economic Outlook (March 2009).
Assumptions:• No exogenous shocks (e.g., no oil price , major
bankruptcies,)• Government solutions actually work -- do not create
other issues
LOCAL BUSINESSES’ FORECASTS
NOW, THE BAD NEWS Expects further declines in real estate prices
◦ Japan’s experience – 65% overall decline; 83% decline in commercial real estate
◦ Commercial real estate bubble expected to be as large as securitized mortgage losses
Alt-A and Jumbo mortgages (bigger than sub-prime) have begun to reset◦ Why renew a mortgage on a property worth less than the mortgage?
Potential bank-run from pre-existing lines of credit◦ Approximately $4.5 trillion outstanding
Large, high-profile insolvencies disrupting markets(GM, Citigroup)
State, local government shortfalls◦ State/Local governments cannot engage in deficit spending, so MUST
increase taxes or substantially decrease spending – both options retard economic growth
Political pressure to erect trade barriers to protect domestic industries◦ Replay of Smoot-Hawley disaster of the Great Depression
Return of Stagflation◦ Replay of the Great Inflation driven by dramatic increases in
government spending
◦ Unemployment > 15% (projection for Dec. 2009 = 10.5%)
Economic Policy Cures…Digging out of the Hole
Keynesian Policies◦ Spend LOTS of money
on stimulus projects Monetary Policies
◦ Federal funds rate = 0%
◦ Discount window = 0%
◦ Interest on reserve requirements
Trade Barriers◦ Not yet happened
Government Buys Toxic Assets Quasi-Nationalization
◦ Government invests in financial firms Government Guarantees
◦ Government issues auto warrantees, guarantees bank deposits
New Banking & Investment Regulations
Bans/Restrictions on Short Sales◦ Prevents runs on leveraged firms
Bankruptcy to Clean Up Illiquid Assets & Force Re-negotiation of Loan Terms◦ Bankruptcy courts empowered to
alter terms of mortgages◦ Pre-packaged bankruptcy of Chrysler
Fix the Credit Markets
Stimulate the Economy
PUTTING THE NUMBERS IN CONTEXT(TAKE A VERY DEEP BREATH BEFORE PROCEEDING …)Total Spending in Entire US Economy (GDP) $14.3
trillion
Total US Stock Market Capitalization $15.4 trillion
Total Value of US Housing StockTotal Outstanding Mortgage BalancesTotal Consumer Equity
$18.3 trillion
$10.4 trillion$2.6 trillion
Total Corporate Real EstateTotal Corporate Inventories & Equipment
$8.4 trillion$5.8 trillion
Total Federal, State & Local Government Spending Total Government spending on Health CareTotal Defense spendingTotal Federal, State & Local Education spending
$5.2 trillion$910 billion$729 billion$838 billion
Total US, State & Local Government Receipts (Taxes)
$4.2 trillion
Total Federal Government DebtTotal 50-State Government Debt
$10 trillion$2.5 trillion
Total US “Near-cash” Money Supply (M2) $8.2 trillion
US Spending on Military Conflicts (2008 dollars; CBO figures)
Iraq/Afghanistan (6 years)World War II (5-6 years)Vietnam (10-15 years)Korea (4 years)
$804 billion$3.9 trillion$518 billion$456 billion
BAILOUT & STIMULUS PROGRAMSProgram Commitment
Government as an Investor $ 4.8 trillion
Government as a Lender $ 2.3 trillion
Government as an Insurer/Guarantor $ 5.14 trillion
Stimulus Spending $1.2 trillion
As of May 8, 2009(changes daily)
GOVERNMENT AS AN INVESTORCOMMITMENT = $4. 8 TRILLION
Program Commitment
Commercial paperThe Fed is the buyer of last resort in the commercial paper market.
$1.6 trillion
Public-private investment fundFund seeks private investors and uses a combination of private and public money to guarantee and buy nonperforming assets.
$900 billion
Troubled Asset Relief Program (TARP) Treasury buys stock in banks, General Motors, Chrysler and AIG.
$700 billion
Federal Home Loan Bank SecuritiesGovernment buys mortgage-backed securities from Fannie Mae, Freddie Mac and Ginnie Mae.
$1.5 trillion
A.I.G. Fed provided seed money to create investment vehicles to buy, hold and possibly dispose of bad AIG securities.
$53 billion
Bear Stearns Fed bought distressed assets/securities from Bear Stearns to facilitate its sale to JPMorgan Chase
$29 billion
Reserve US Government FundGovernment buys assets to bailout troubled money market fund
$4 billion
The
govern
me
nt give
s
money a
t
risk o
f
loss.
HOW THE TARP WAS SPENT?ONLY ABOUT $467 MILLION REPAIDWho Received TARP Funds? How Much?
Banks $310.4 billion (44%)
Other Financial CompaniesAIGAmerican ExpressDiscover CardCapital OneGMACChrysler FinancialCIT GroupOther
(9%)$69.8 billion$ 3.4 billion$ 1.2 billion$ 3.6 billion$ 5 billion (+ $7.5 billion)$ 1.5 billion$ 2.3 billion$238 million
Automakers $24.8 billion (4%)
TALF Funding to provide loans using toxic assets as collateral
$100 billion (14%)
Homeowner Mortgage Re-negotiation Program
$50 billion (7%)
Public-Private Investment Fund to buy toxic assets
$100 billion (14%)
Uncommitted $52.6 billion (8%)
GOVERNMENT AS A LENDERCOMMITMENT = $2.3 TRILLION
Program Commitment
Term Asset-Backed Securities Loan Facility (TALF)Provides loans and accepts securities backed by consumer and small business loans as collateral.
$900 billion
Term Auction FacilityThe Federal Reserve makes low-interest, short term loans to financial institutions, allowing them to pledge asset-backed securities as collateral.
$900 billion
Discount Window LoansExtended time (90 days v. overnight), amount and eligibility (investment banks v. commercial banks) for Federal Reserve discount window loans.
$236 billion +
Debt Swaps (Term Securities Lending Facility)The Federal Reserve loans/swaps US Treasury notes in exchange for less liquid debt, mortgage-backed securities and investment-grade corporate debt.
$200 billion
AIG LoansA line of credit offered by the Federal Reserve. $60 billion
A pro
mise
to p
ay
back a
govern
me
nt loan
GOVERNMENT AS INSURER/GUARANTORCOMMITMENT = $5.14 TRILLION
Program Commitment
Bank Debt (Temporary Liquidity Guarantee Program)FDIC insures senior subordinated debt issued by banks and poorly performing assets owned by Fannie Mae and Freddie Mac.
$700 billion
Temporary Liquidity Guarantee ProgramFDIC insures non-interest bearing bank accounts. $684 billion
Citigroup GuaranteesGovernment guarantees that exclude the direct investments made through the TARP program
$249 billion
Fannie Mae/Freddie Mac GuaranteesTreasury pledged up to $200 billion each to cover their losses.
$400 billion
Bank of America GuaranteesGovernment guarantees that exclude direct investment through the TARP program
$98 billion
Money market fund guarantees $3 trillion
Morgan Stanley GuaranteesTreasury guarantees for a capital infusion by a Japanese bank
$9 billion
The
govern
me
nt
prom
ises
to p
ay if
things g
o
badly.
RAW GOVERNMENT SPENDING (PORK)COMMITMENT = $1.2 TRILLION
Program Commitment
Stimulus Bill (HR-1)All the pork you can eat.
$787 billion
Omnibus Budget Act 2009 (HR 1105)The remaining nine appropriations bills that the Congress failed to pass during the 2008 term
$410 billion
The
govern
me
nt just
spends
money.
Keynesian Economic Prescription Government deficit spending will stimulate economic growth
Gross Domestic Product = Consumer Spending + Government Spending - Taxes+ Business Investment+ Exports – Imports
THE STIMULUS “BUBBLES”HR-1 – AMERICAN RECOVERY & REINVESTMENT ACT
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
-$3.0
-$2.0
-$1.0
$0.0
$1.0
$2.0
$3.0
$4.0
$5.0
$6.0
-2%
0%
2%
4%
6%
8%
10%
Net
Go
verm
ent
Sp
end
ing
GD
P G
row
th R
ate
RECENT US EXPERIENCE 1990-2008NET GOVERNMENT SPENDING (SPENDING MINUS TAXES) VS. GDP GROWTH
DATA SOURCE: US BUREAU OF ECONOMIC ANALYSIS TIMESERIES: 1990(1Q) – 2008(4Q) IN CONSTANT 2000 DOLLARS (TRILLIONS OF $)
Government Surplus
Government Deficits
Government Deficits
DOES GOVERNMENT SPENDING STIMULATE ECONOMIC GROWTH?
Boom years when government ran a surplus and when spending dropped
“We’re all Keynesians, now.” Richard Nixon
-100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
HISTORICAL CORRELATION BETWEEN GDP GROWTH AND NET GOVERNMENT SPENDING (SPENDING MINUS TAXES)
DATA SOURCE: US BUREAU OF ECONOMIC ANALYSIS TIMESERIES: 1970(1Q) – 2008(4Q) IN CONSTANT 2000 DOLLARSVertical Axis: % Change in GDPHorizontal Axis: % Change in Net Government Spending w/6 month lag
Increase in net government spending
Decrease in net government spending
Correlation between GDP Growth and Net Government
Spending = 0.051 means perfect correlation
0 means no correlation
Decrease in GDP Growth
Increase in GDP Growth
If deficit spending was correlated with economic growth, points should be
clustered around a line like this.
DOES GOVERNMENT SPENDING STIMULATE ECONOMIC GROWTH?“We’re all Keynesians, now.” Richard Nixon
Looking into the Crystal Ball
Can we spend our way out of the crisis?◦ Didn’t work in Japan◦ No correlation (0.05) between
spending & economic growth◦ Sharp stimulus cutbacks will
hit state/local governments hard
How will we pay for the spending & debt?◦ Increase taxes◦ Devalue the currency
(inflation)◦ Collapse of foreign-
government lending to US
Zombies◦ Firms kept alive for
political reasons but that consume resources and slow the recovery GM, AIG, Citigroup, Chrysler
New Regulations◦ Expansion of bankruptcy
and government to intervene in private agreements
◦ End of high-flying investment banks & loan securitization
Top 10 Business Strategies
1. Be Realistic/Pessimistic This won’t turn around quickly.
2. Exogenous Shocks to Equities Finance for expansion by IPO or
new share issues is unrealistic.3. Right Size, Right Now
Don’t staff at levels in hopes that things will turn around soon.
Outsource as much as possible4. Investigate Your Lender
Assess likelihood of lender’s failure.
Draw down lines of credit (especially for critical projects)
5. Understand Landlord/Tenant Issues What happens if your landlord
owner becomes insolvent Tenants have strong economic
incentives to terminate leases
6. Shed Real Estate Investments Commercial real estate fell 83%
in Japan7. Keep your customers happy
It is easier to keep old customers than to attract new customers
8. Market Smart Cut everything before marketing Focus on how your product
meets the new economic reality (e.g., saves customers’ money)
9. Keep remaining employees happy Employee problems can spook
customers. 10. Review your vendors
Back-ups for critical vendors Contract review for insolvency,
force majeure and dispute resolution