Housing Market FinanceHousing Market FinanceFinancial Crisis Cont.Elias YannopoulosNovember 14, 2012Elias Yannopoulos Financial Crisis Cont.Housing Market FinanceHousing BubbleLast time we were in the middle of the housing bubbleThere was a belief that housing prices could only go upPeople with bad credit were getting large mortgages withsmall down paymentsIn addition, people are buying houses on leverage to makemoney of the price increaseNow if that was the end then when the housing marketcrashed the people who made these unsafe loans would bestuck with devalued housesBut at the same time the financial market formortgage-backed securities also had a bubble on top of thehousing bubbleElias Yannopoulos Financial Crisis Cont.Housing Market FinanceSecuritization of MortgagesPrior to 2000, local banks made well documented loans tosafe borrowers with good creditSometimes they kept the loans and sometimes they sold themon the secondary marketThis secondary market was dominated by two companiesFannie Mae and Freddie MacThese companies were originally founded as governmententerprises but were later privatized, but still are treated asgovernment-sponsoredThey buy conforming mortgages (safe mortgages), theycompile these mortgages form all over the country in tomortgage-backed securitiesElias Yannopoulos Financial Crisis Cont.Housing Market FinanceSecuritization ContSecuritization has two big advantages: diversification andliquidityDiversification - that act of combining different financialinstruments, whose prices are not expected to go in the samedirection Ex: sunny and rainyLiquidity - the ability to convert an asset into cashFannie and Freddie were not allowed by law to buy the newmortgages in the 2000s, but there was no such law forinvestments banksSo mortgage originators approve and make loans then sell theloans off to investment banks, they no longer have to worryabout how risky it isThen investment banks package these into securities and sellthem, the rating agencies (who get paid to rate securities)give these a safe rating because they deem them diversifiedElias Yannopoulos Financial Crisis Cont.Housing Market FinanceDerivativesThere were a lot of people will to supply financing for thesenew MBS, so investment banks began creating all kinds ofnew securities from the MBSThese assets are called derivatives - an asset whose valuedepends on the value of some other assetInvestment banks just mixed together all types of assets tomake a diversified security to sell to investorsSure investors had no idea what the actual underlying assetswere, but it didn’t matter as long as they could sell it later fora higher priceInsurance companies also got in on the action, they made lotsof money selling Credit Default Swaps - insurance againstthe default of a financial assetIf the company I bought a security from defaults then theCDS will get me my money back I just pay a premiumElias Yannopoulos Financial Crisis Cont.Housing Market FinanceThe Bubble BurstsFirst lets look at 1929, the stock prices start to fall, and thenpeople start to sell before the price falls further, putting moredownward pressure on the pricesAs stocks are falling the people who made loans for investingin the stock market are worried about getting their money,they start deleveragingFirst the stockbrokers who let on margin start to ask for theirmoney back, which means people have to sell the stocks toget the money to pay them which leads to further pricedecline, leading to more calls on loansIn 2007, the housing prices start to fall, not as fast as thestock because unlike other financial assets it has its owndemandBut the market for MBS and derivatives of MBS, there was ahuge crashElias Yannopoulos Financial Crisis Cont.Housing Market FinanceFinancial MeltdownAgain the bursting of the housing bubble means people lose alot of money but the economy can recover, as long as thefinancial sector stays in tactIn the 1930s the meltdown was because people did not trustthe banks, and so held their money in cashIn 2008, we had learned that these things are risky and sopeople diversified and bought CDS and so they felt theirassets were safeBut there are different types of risk, insurance can onlyprotect against non systematic risk - risks of one event thatare offset by another event elsewhereHolding mortgages from all parts of the country will offset therisk that any one housing market dropsBut it does not protect against a national housing marketcrash, or systematic risk - the risks of a problem happeningin all parts of an economy simultaneouslyElias Yannopoulos Financial Crisis Cont.Housing Market FinanceGetting out of a CrisisGetting out of a Crisis is done in three stages, similar torecovering from a heart attackThe first stage is triage, you have to stabilize the economy soit’s not getting worse (bailouts)GD: Bank holiday, 2008: TARP and QEThen you can begin the treatment phase, involves moreexpansionary monetary and fiscal policyGD: New Deal 2008: Monetary policy to the max and $800billion stimulusAnd finally rehabilitation, where measures are taken to reducethe likely hood of a crisis happening again (or at leasthappening in the same way)GD: FDIC and tightly controlled banks 2008: TBDElias Yannopoulos Financial Crisis
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