EXAM 1 CLASS NOTES The Recession Recession 2 consecutive quarters of negative growth in GDP Tuesday 6 28 11 Contributors Stock Market o Dow Jones Industrial Average 10 9 07 all time high Start to recognize value going down Sell all their stocks 3 9 09 all time low AIG collapsed Bailed out by US government worldwide drop in the market Housing Market o Around 2004 house prices taking off o 2006 house prices basically double Housing market begins to decline peak bottom in May 2009 Factors that influence overall economic activity Consumption expenditures represent roughly 2 3 of GDP o What determines CEs Household wealth net worth net wealth NW total assets total liabilities o Assets debts ie house value house mortgage o Assets the house investments in stock market mutual funds Between September 2007 and December 2008 the big declines in housing stock markets net worth of households fell by 20 o About of that was from the stock market the housing market o GDP falls sharply because Decline in consumption for households causes GDP to fall Firms see less consumption by households so they invest less 3 consecutive quarters of extremely negative growth 6 Unemployment Labor market has been very slow to catch up o Economy has to not only grow but has to grow fast enough to increase the jobs for people in the market Primary cause of this 2007 2009 Recession THE FINANCIAL MARKETS Components of the Financial Markets 1 Growth of financial derivatives a Their complexity i Hard to price can t find buyers what they were worth 1 When people all of a sudden tried to sell a lot nobody would buy because nobody knew ii Toxic assets b Systemic Risk market 1 i The spillover effect Failure in 1 firm market can lead to the collapse of other firms or an entire Ie when Lehman Brothers went under all their assets went bad affecting the rest of the market ii Need high regulation A lot of them weren t regulated 2 The Banking Industry a Banks financial intermediaries i Their role match up borrowers with lenders b A bank s balance sheet i Assets loans ii Liabilities 1 Need to balance these 2 Bank capital a Equity retained earnings b Other 3 Banks need to maintain a certain amount of capital order to keep their balances a Suppose capital requirements were 7 in and 4 in Europe Assets Loans Mortages others Investments Other Total Assets use of funds Liabilities Deposits Borrowings Other Total Liab in US c Role of the bank capital buffer i As a bank you d want to chase the 4 low capital requirements i Largely comprised of retained earnings income minus expenses dividends taxes 1 Over time retained earnings accumulate ii Acts as a buffer to absorb bad loans iii If a firm increase its bank capital it increases its ability to write off bad loans without threatening depositors funds 3 The Mortgage Markets a A traditional mortgage i Qualifications including Job source of income debt levels assets all the ability of the borrower to repay 1 2 Until recently banks have been good at evaluating the borrower ii Terms iii Foreclosures 1 20 down with 30 year fixed rate mortgage 1 An option for the bank on delinquent mortgages 2 Banks takes ownership of the house 3 TODAY S MARKET this is a huge problem b In early mid 2000 s many new types of loans including i Subprime loans 1 Lower standards to qualify for loans Means the people have less of an ability to repay 2 Often have relaxed terms Lower down payment got as low as 0 Lower monthly payments initially a a b i BUT with raised interest rates after a certain period of time 1 So when the rates were raised the people couldn t hold it But the mortgages were no longer in the hands of the original bank they were someone else s problem 3 These led to growth of the subprime market a Increased to 15 from 2 3 as a fraction of total mortgages between 1995 2005 i Housing market now 12 trillion Causes for the increase subprime market More aggressive lending as housing prices increase o House prices were going up So if banks lent more they thought they d have more equity in the house as the years went by Increase in mortgage originations by firms not always banks mortgage brokers too that had no vested interest in repayment o A lot of the lenders had no vested interest in the mortgages because they d push them out to the door to others Mortgage Backed Security MBS Probably the biggest problem Mortgages were used as financial collateral for complex financial derivatives o A bond issued to an investor with the repayment of the bond tied to mortgage payments from a pool of mortgages o Securitization see graph Purpose Vehicle Houses get loans from the banks banks pool the mortgages and give them to a SPV Special When put in SPV mortgages are taken off the books the bank s balance sheet and replaced with the actual funds that came in from when the SPV sold the funds 2 things happen for the banks o The banks are replacing risky assets with less risky assets Makes the banks capital position look better to regulators o The funds the bank receives can be used to make new loans By doing this they can get Origination fees fees from processing the loans Servicing rights they get the rights to process it o A source of income for the bank Pass Through MBS the simplest version of a mortgage backed security Mortgage Backed Securities Continued Each investor in the a MBS has claim on an equal share of the total mortgage payments made to the pool of mortgages o investors are basically buying a share of the mortgage payments o So losses and gains risks are equally shared by investors Example investor owns 10 of an MBS issued against the pool o This means every month as the payments come in the investor s going to get 10 of whatever Wednesday 6 29 11 payments are made Collateralized Mortgage Obligation CMO Separation into tranches o High tranche Paid first Low risk low interest rates Pay more for it with a lower expected return o Medium tranche Paid 2nd Medium risk higher interest rates o Low tranche aka the equity tranche Paid last Basically get the residual Highest risk Highest interest rate Highest expected return Pay less for it with a higher expected return Creates value IF they re structure properly by increasing efficiency o 1 Takes assets from a single risk classes ie pooled mortgages and creates and array of assets with different risk categories o 2 Matches risk preferences of investors with the level of risk of the assets the tranches of the CMOs Can t do that with PSMBS o 3 In the end increases the