The Financial Crisis and The Great RecessionRoots of the financial crisis can be understood through corporate financeWe’re still living in the aftermath of “The Great Recession”But how did it all begin?“Housing prices always rise”“Housing prices always rise”Slide Number 7Slide Number 8Slide Number 9Slide Number 10Slide Number 11Background (entering fall 2008)Background (continued)Background (continued)Problem!Solution for Fannie and Freddie …Slide Number 17First Big Government BailoutWhy Preferred Stock?What happens in markets?Market ReactionFurther concernsA Tale of Two Firms: Lehman Brothers and AIGLehman BrothersCredit Default Swaps (CDS)AIGWhat was going on at AIG?AIG FinancialsTumultuous Monday 9/15/08 for AIGAnother Gov’t BailoutWhy Bailout?Moral of StorySlide Number 33Many Government PoliciesWhy TARP (Troubled Asset Relief Program)?Short-Sale RestrictionsInsurance for Bank DepositsSlide Number 38THE FINANCIAL CRISIS AND THE GREAT RECESSION 1Roots of the financial crisis can be understood through corporate finance • High leverage —Especially among banks, but also households —Also, high reliance on short-term debt financing • Options compensation and incentives to take risks • “Too big to fail” put option • Moral hazard issuesWe’re still living in the aftermath of “The Great Recession” • Companies have record levels of cash but are unwilling to spend it — Why? • High unemployment • Record-low interest rates. Especially long term yields — Intentional policy by the Federal ReserveBut how did it all begin?“Housing prices always rise”“Housing prices always rise”89101112 Background (entering fall 2008) • Total mortgage debt in U.S. $10-12T • Fannie Mae and Freddie Mac are publicly-owned government sponsored enterprises (GSE) • They make home loan guarantees and “bundle” mortgages to provide liquidity to the mortgage market —Allows securitization of mortgages (a secondary market) —Allows more mortgages to be undertaken at lower interest rate • Fannie and Freddie own or guarantee about one half of the mortgage market!13 Background (continued) • Implicit government bailout guarantee – what if Fannie and Freddie fail? Will housing market be allowed to collapse? • How will this affect the rate at which these companies can borrow? • How will this affect capital structure choice of these companies?14 Background (continued) • In 2007, subprime-mortgage crisis begins • More and more borrowers defaulting on their mortgages (too lenient standards for the original loan and home equity evaporating with decline in housing prices) • Losses for Fannie and Freddie – have guaranteed that these mortgages would be paid (further losses from mortgage-backed securities they own)15 Problem! • Fannie and Freddie have extremely high leverage (debt ratio of roughly 95% at end of 2007) • Little room for error, vulnerable to write-downs in the value of assets, easy to get into a liquidity crisis • In August of 2008, rating agencies downgrade rating of the preferred stock of both companiesSolution for Fannie and Freddie … 1618 First Big Government Bailout • September 7, 2008 U.S. government takes over Fannie and Freddie • CEOs and Boards fired (but CEOs leave with “golden parachutes”) • U.S. buys $1B of preferred stock in each company (senior to existing preferred stock) with 10% annual dividend (rises to 12% if miss dividend payment) • U.S. gets warrants for purchase of common stock of each company • Dividends on common and old preferred stock eliminated • U.S. pledges to provide as much as $200B of additional capital as companies deal with more mortgage defaultsWhy Preferred Stock? • Why did the government ask for preferred stock in exchange for the capital infusion instead of bonds or common stock (at least right away)? 1920 What happens in markets? • Fannie and Freddie stock? • Fannie and Freddie preferred stock? • Fannie and Freddie debt? • U.S. equity market?21 Market Reaction • Fannie and Freddie common stock prices substantially lower on the Monday (9/8) following the Sunday gov’t takeover —Fannie falls from $7.04 to $0.73 ($37.46 on 1/2/08)! —Freddie falls from $5.10 to $0.88 ($32.74 on 1/2/08)! • Old preferred stock further downgraded (is at “junk” level) on takeover news • However, long-term Fannie and Freddie bonds maintain an S&P rating of AAA • U.S. equity markets up (S&P 500 up 2.1%) • But … market falls 3.4% the next day!22 Further concerns • Half of mortgage market backed up by Fannie and Freddie • But half is not! • The half that is not will typically be riskier mortgages • Financial institutions that sold or bought mortgage-backed securities of these riskier mortgages in really big trouble!23 A Tale of Two Firms: Lehman Brothers and AIG24 Lehman Brothers • Historic Wall Street investment bank • Extensive holdings of mortgage assets • Financial holdings fell substantially in value, still had to service its debt • Could not raise external capital and difficult to raise cash by selling off its depreciating financial assets • Government did not bail out with emergency loan • Declared bankruptcy (Chapter 11)25 Credit Default Swaps (CDS) • Credit default swaps are contracts that act like insurance against debt default • Buyers make regular payment to sellers, sellers in turn promise to make a big payout to the buyer if the underlying bonds go into default —100 times larger market than it was in 2000! • The CDS market has grown substantially —Grew 100 times from 2000 to 2008 to cover $62T worth of bonds26 AIG • American International Group Inc. (AIG) • One of the world’s biggest insurers, largest U.S. insurer by assets • Stock price plunged from around $56 at start of year to $3.75 at close 9/15/08 • Firm on verge of financial collapse27 What was going on at AIG? • AIG more aggressive than most insurance companies in expanding its operations beyond life and property/casualty insurance • AIG jumped into the market for “credit default swaps” (providing insurance to investors against default in a wide range of assets) • AIG had business unit that made mortgage loans to consumers and another that provided insurance to lenders if the borrower defaulted on the mortgage28 AIG Financials • AIG sold protection on $441B of fixed income assets ($58B in securities tied to subprime