THE FINANCIAL CRISIS AND THE GREAT RECESSION 1 Roots 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 issues We 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 Reserve But how did it all begin Housing prices always rise Housing prices always rise 8 9 10 11 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 12 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 13 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 14 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 companies 15 Solution for Fannie and Freddie 16 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 defaults 18 Why 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 19 What happens in markets Fannie and Freddie stock Fannie and Freddie preferred stock Fannie and Freddie debt U S equity market 20 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 21 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 mortgagebacked securities of these riskier mortgages in really big trouble 22 A Tale of Two Firms Lehman Brothers and AIG 23 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 24 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 bonds 25 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 collapse 26 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 mortgage 27 AIG Financials AIG sold protection on 441B of fixed income assets 58B in securities tied to subprime mortgages Losses of 18B during last 3 quarters leading up to fall of 2008 At end of 2nd quarter of 2008 assets exceeded liabilities by 78B but most of assets held by insurance subsidiaries as reserve requirements for insurance claims 28 Tumultuous Monday 9 15 08 for AIG Credit downgraded by Moody s and S P 9 15 08 As a result may need to post an additional 14 5B in collateral and pay out 5 4B to terminate certain contracts Unable to receive private financing not enough time to liquidate assets to meet its liquidity crunch Need a lender investor of last resort 29 Another Gov t Bailout Federal Reserve Act 1913 allows the Federal Reserve to make loans to non banks under unusual and exigent circumstances Government bailout hammered out night of 9 16 08 Receives infusion of up to 85 billion dollars from U S gov t Two year loan with interest rate of Libor plus 8 5 percentage points U S also effectively gets 79 9 ownership of AIG equity through warrants received U S has right to veto any payments of dividends to common and preferred shareholders AIG must fire current CEO 30 Why Bailout Many mutual funds and banks in U S and abroad held CDSs sold by AIG and AIG bonds in their portfolios If AIG failed the value of these CDSs and bonds would fall substantially Purchasers of these bonds themselves could fall into financial distress e g Goldman Sachs And the downward