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Thoughtful Capital

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NYSSA: Systemic Risk “Is it Fixed?” Dec 3. 2014

Moral Hazard & the US Residential Credit Process

Nick Gogerty ngogerty@thoughtfulcapital.com

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Goals

1. How to think about house prices & value

2. How the proper credit creation process works & how moral hazards can break it: I get paid today, risk hits others tomorrow

3. Impacts of the crisis in a historical context and where we are today

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Disclaimer & Data sourcesDisclaimer: This material has been prepared by Thoughtful Capital Group. This document is for information and illustrative purposes only and does not purport to show actual results. It is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Opinions expressed herein are current opinions as of the date appearing in this material only and are subject to change without notice. Reasonable people may disagree about the opinions expressed herein. In the event any of the assumptions used herein do not prove to be true, results are likely to vary substantially. All investments entail risks. There is no guarantee that investment strategies will achieve the desired results under all market conditions and each investor should evaluate its ability to invest for a long term especially during periods of a market downturn. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those discussed, if any. No part of this document may be reproduced in any manner, in whole or in part, without the prior written permission of Thoughtful Capital Group., other than to your employees. This information is provided with the understanding that with respect to the material provided herein, that you will make your own independent decision with respect to any course of action in connection herewith and as to whether such course of action is appropriate or proper based on your own judgment, and that you are capable of understanding and assessing the merits of a course of action. Thoughtful Capital Group does not purport to and does not, in any fashion, provide broker/dealer, consulting or any related services. You may not rely on the statements contained herein. Thoughtful Capital Group shall not have any liability for any damages of any kind whatsoever relating to this material. You should consult your advisors with respect to these areas. By accepting this material, you acknowledge, understand and accept the foregoing.

Data sources: St. Louis Federal Reserve Bank, New York Federal Reserve Bank, BIS (Bank for International Settlements), IMF, World Bank, BEA (Bureau for Economic Analysis), GOA (Govt. Accounting Office), Thoughtful Capital Group, S&P Case Shiller indeces, 3rd party consultants and sources.

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Housing is a positional good w/ value

normalizing to inflation & income densityAmsterdam home prices 1628–2009 in Real Euros.

Source: Prijsbewegingen op de Woningmarkt Introductie: Harry Boumeester, Harry van der Heijden, Paul de VriesOnderzoeksinstituut OTB/TUDelft

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Credit creation safety balance

Credit creation Safety R

isk

Ris

k

Normal

Broken

BonusCompetition

ROEPolitics

…

Lending standardsRegulationRisk exposure…

System design failures allow outsized credit creation due to moral hazards “heads I win, tails others lose.”

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US “credit creator” machine 2000’s

1. Individual

Home Owners

2. Originator

/Packager/Bank

3. GSEsDominant Holder

4. Politicians &

Regulators

5. Society

Su

pp

ly e

na

ble

rsD

em

an

d d

rive

rs

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Credit creation 2007

1. Home Owner

2. Originator /Packager

3. GSEUltimate Holder

4. Politicians

5. Society

Credit drivers Safety limiters

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1836 1839

1845

1847 1853

1857

1860

1865

1869

1873 1882

1887

1890

1893

1895

1899 1902

1907

1910

1913 1918

1920

1923

1926

1929

1937

1945

1948 1953

1957

1960 1969

1973 1980 1981

1990 2001

2007

-40%

-30%

-20%

-10%

0%

0 1 2 3 4 5 6

GD

P /

Bu

sin

ess a

ctivity p

re 1

92

6

Duration in years

US recessions* impact & duration 1836-2014

*Recessions are defined as declines in aggregate GDP or business activity for 2 quarters12 red recessions are associated with large bank failures or crisis

Th

en

atu

reo

fva

lue.c

om

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Credit creation actor process 2014

1. Home Owner

2. Originator /Packager/bank

3. GSEsUltimate Holder

4. Politicians

5. Society

Credit drivers Safety limitersCommon sense/ originatorHouse envy

Quick returns / market share / CDO, SIVs etc. Down stream consumer / ratings

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Gre

at

Depre

ssio

n

0

20

40

60

80

100

120

140

160

180

2001

88

0

190

0

192

0

194

0

196

0

198

0

200

0

202

0

Index

Year

Building Costs

WW

I

19

70

’s b

oo

m

19

80

’s b

oo

m

Home Prices

Home Prices 1880-2014Source data: Case Shiller, Thoughtful Capital Group

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Conclusion“…Title 2 of the Dodd Frank bill

enshrined and institutionalized those

bailouts while pretending to get rid of

them.”

p 502 Fragile by Design; Charles Calomiris &

Stephen H. Haber

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Appendix slides

• 20 Yrs. of flat incomes: Normalized incomes are low to negative to middle and lower class at 1995 levels

• 10 Yrs. rates at near record lows 1870-2014

• 10 Yrs. real rates are low

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average

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Incomes are back to the Future

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0%

2%

4%

6%

8%

10%

12%

14%

16%

18

71

18

81

18

91

19

01

19

11

19

21

19

31

19

41

19

51

19

61

19

71

19

81

19

91

20

01

20

11

10 Year US Rates

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Scenario game:

Shock Brittle bits Policy Responses

• Japanese deflation / inflation whipsaw

• China slowdown >credit crash>housing bust>social unrest

• France credit• Canada housing credit

bubble• US domestic deflation

increasing debt service burden

• Large hacking attack• Other political or

economic risks…

• Synthetic ETFs & swaps collateral

• Public & private pension funds

• Lower income housing clients

• Municipal Govt. debt service

• Domestic hard & soft infrastructure

• Swaps for liquidity responses

• Negative nominal rates• Increase in Fed Asset

purchases• Muni bailouts• Pension bailouts• Homeowner bailouts• Student debt bailouts