Transcript A Demon Of Our Own Design The Financial Melt-Down Of 2008-2009 www.econseminars.com

The Financial Melt-Down Of 2008-2009
A Demon Of Our Own Design
Online Economic Seminars
www.econseminars.com
March 30, 2009
1
Capitalism Without Failure Is like
Religion without Sin
Alan Meltzer
The Foot Bone’s Connected To The Leg Bone
The Leg Bone’s Connected To The Knee Bone
The Knee Bone’s Connected To The Thigh Bone
Now Hear The Word Of The Lord!
Gospel Song
2
The Great Depression:
Is It…
BAAAAACCCCKKKKK?!
3
A Decade Of Deflation And No Growth…
4
With High Real Interest Rates In The Worst Years…
5
And A Stock Market That Sucked!
6
Will It Happen Now?
The Answer Is An Emphatic NO – Probably Not – Maybe Not
¶ Better Fiscal Actions Now
 Hoover – And FDR – Tried To Balance The Federal Budget
 The Smoot-Hawley Tariff Deadened Int’l Trade
¶ Better Monetary Actions Now
 The Fed Failed To Aggressively Intervene
 Real Interest Rates Remained High Through 1933
¶ Better Industrial Policy Now
 The National Recovery Administration Strangled
Business With Regulation AND Wage-Price Controls
 NRA Found Unconstitutional After 2 Years But Labor
Relations Legislation Quickly Passed
7
The Financial Instruments
8
Collateralized Debt Obligations (CDOs)
¶ Mortgage Pools (RMBSs) Were Sliced Into As Many As
15 “Tranches”
 Senior Tranches--First Claim On All Payments
(Given AAA Rating By Rating Agencies)
 Mezzanine Tranches—First Claim On Remaining
Income (Given BB To AA Ratings)
 Equity Tranches—Last Claim On Income (Not Rated)
¶ CDOs Difficult To Price
 Repayments Uncertain In Amount And Timing
 Especially Difficult For Lower-Quality Tranches
9
Collateralized Debt Obligations (CDOs)
¶ Sponsors (Securitizers) Sold
 Senior And High Mezzanine Tranches To Hedge
Funds
 Equity and Low Mezzanine Tranches To Special
Investment Vehicles (SIVs)
¶ SIVs Were “Independent” Entities
 Unregulated And Off Of The Sponsor’s Balance Sheet
 Financed Largely By Short-Term Commercial
Paper (90%), With Some Equity And Senior Debt(10%)
 Sponsors Were Obligated To Provide Short-Term
Loans If Commercial Paper Couldn’t Be Rolled Over
 Sponsors Gave SIVs A Free “Reputational Put”
10
Mortgage-Backed Securities (MBSs)
¶ Primary Source of Funds For GSEs: Two Forms
 Straight Bonds: Long-Term Bonds, Fixed Coupon
 Pass-Through Securities: GSE Forms Mortgage
Pools Like RMBss, Sells Securities Paying Whatever
Income Is Received By The Pool
 Borrower Repayments (Home Sales, Refinancing,
Optional Pre-Payments) Create Uncertainty About
The Income Stream
11
Credit Default Swaps (CDSs)
¶ CDSs Are Insurance Contracts For “Credit Events”
 Unregulated Over-The-Counter (OTC) Contracts
 Customized, Not Standardized
 Bilateral Contracts, Not Clearing House Contracts
 Definition of “Credit Event” Is Contract-Specific
 Settlement Might Be “Physical” (Purchase At Face Value)
Or “Cash” (Payment Of Difference Between Face Value
And Fair Value
¶ CDSs Sold By Investment Banks To Holders Of CDOs And
Corporate Or Municipal Bonds
 Sellers Had Little Capital
 Potentially High Counter-Party Risk Existed
12
The Participants
13
Government-Sponsored Entities (GSEs)
¶ Federal National Mortgage association (Fanny Mae)
 Formed in 1938 To Buy FHA-Insured Loans
 Privatized” In 1968 To Remove It From The Federal
Budget
 FNMA Mandate Broadened To All Mortgages In 1968;
(GNMA Formed To Take Buy FHA Loans)
¶ Federal Home Loan Mortgage Corp (Freddy Mac)
 Formed in 1970 To Buy Conventional Mortgages
 Designed To Provide Competition In Secondary
Mortgage Market
14
Government-Sponsored Entities (GSEs)
¶ FNMA And FHLMC Bought Mortgage Loans And
 Held Them For Own Portfolio, Selling Bonds To
Finance Them OR
 Sold And Serviced Mortgage-Backed Securities
15
Investment Banks
¶ Bear Sterns, CitiGroup, And Others Began To Securitize
Mortgages In 1997
 Placed Mortgages Into Pools Called Residential Mortgage
Backed Securities (RMBSs)
 Split Each RMBS Into Risk Categories, Called “Tranches”
 Sold Each Tranch As A CDO To Hedge/Private Equity
Funds
 CDO Funds Were Long-Term Risky CDOs Financed With
Short-Term Commercial Paper
16
The U.S. Congress
¶ The Community Reinvestment Act (1977)
 Required Banks To Meet The “Credit Needs” Of Their
Local Communities
 CRA Had No Clear Criteria Or Monitoring Process
¶ FIRREA (1989)
 Created Four CRA “Grades” For Banks
 Required CRA Grades Be Made Public
¶ Federal Housing Enterprises Safety and Soundness Act
(1992)
 Lending Goals for GSE Lending to Low-Income and
Underserved Areas
 Created the Office of Hosing Enterprise Oversight (OFHEO)
To Set Risk-Based Minimum Capital Requirements for GSEs
17
The U.S. Congress
¶ The Gramm-Leach-Bliley Act (1999)
 Repealed Glass-Steagall Act of 1938 That Prohibited
Commercial Banks From Buying Investment Banks
And Insurance Companies
 Required Banks Acquiring Insurance Companies Or
Investment Banks To Have An Acceptable CRA Status
18
Regulatory Agencies
¶ Department Of Housing And Urban Development (HUD)
 Defined “Special Affordable Loans” As Loans To
Borrowers With Income Less Than 60% Of Local
Median Income
 Applied SAL Quotas For FNMA and FHLMC
 Raised Quotas From 12% in 1996, 20% n 2000, 22% In
2005, 28% in 2008 (not implemented)
¶ The Securities And Exchange Commission (SEC)
 Abolished “Net Capital Rule” For Broker-Dealers In 2004
 Investment Banks Divert Capital From Broker-Dealer
Division To Trading Division
 Investment Bank Traders Buy CDOs, Helping Fuel The
Subprime Market
19
The Origins Of
The Melt-Down
20
After the mid-1990s There Was A Foreign Savings Glut
Looking For Investment Opportunities In The U.S.
21
Almost All Coming From Asia And The Middle East, Areas
That Had Overvalued Their Currencies vs. The Dollar
22
The Easy Money From The China Syndrome Was
Accompanied By Unusually Easy Monetary Policy
23
External Financing By U.S. Businesses And The U.S.
Treasury Were Meager After The Dot-Com Crash
24
So, With Few Other U.S. Investment Outlets, The
Saving Glut Was Channeled Into Residential Mortgages
25
Since “Good” Creditors Already Had Mortgages, A
“Subprime” Mortgage Market Was Created…
¶ Characteristics Of A Subprime Mortgage
 Borrower Has One Or More Of Following:
• High Debt-Service-To-Income Ratio (50% Or More)
• High Loan-To-Value Ratio (Perhaps 100%)
• Low FICO Credit Score (640 Or Less)
• Recent Delinquencies In Credit Payments
• Declared Bankruptcy In The Past
 Subprime Mortgage Contracts Had
• Low Fixed Rate For A Few Years, Reset To Higher And
Variable Rate For Remainder (e.g., a 3/27 Mortgage)
• Reset Rate Is Based On Premium Over UST Or LIBOR
• Significant Prepayment Penalties
26
The Subprime Mortgage Structure Favored Lenders
¶ The “Lender’s Lock”
 Lenders Assumed House Prices Will Increase, Creating
More Equity In The Subprime Borrower’s Home
 High Reset Rate Will Force Borrower To Seek New Terms
From The Original Lender
 Prepayment Penalties Will Discourage Refinancing With
Other Lenders
 Giving The Original Lender A Valuable Option—To
Renegotiate The Loan Or To Foreclose
27
The Easy Credit Led To An Explosion Of Mortgage Lending
28
Of Which About 12 Per Cent Was Subprime, Much Of It
Adjustable Rate And Half Of It From GSE’s
29
Subprimes Covered A Wide Range Of Credit Scores
30
…And An Array Of New-Style Mortgages
31
Banks Were Happy To Help – With The Aid Of New
Risk Management Technology
Residential Mortgage-Backed Securities
(RMBSs)
CDO Senior
Tranches
(RMBSs)
“Natural”
AAA – AA
Rated
CDO Mezzanine
Tranches
CDO Equity
Tranches
(RMBSs)
“Natural”
A - BB
Rated
(RMBSs)
Unrated
(Toxic)
(RMBSs)
(RMBSs)
Artificial AAA
Rating
Mezzanine
Tranches
AAACredit Default Swap
Regulated Insurers
(RMBSs) Sellers
(ANBAC)
(Bear, Merrill, Wachovia, AIG)
32
Enhanced By A New Market Structure That Separated
Lenders And Borrowers
Home Buyers
Mortgage Bankers
Securitizers
(RMBSs)
Stearns)
GSEs
(FNMA, FHLMC)
CDOs
Cash or
Synthetic
MBSs
Bonds
2
CDO s
Cash or
Synthetic
PassThroughs
Investors
33
Bank Eagerness Was Aided By A Steep Yield Curve That
Encouraged Use Of Short-Term Borrowing To Finance
Long-Term Assets
34
With The Consequence Of Extremely High Leverage
And Unmatched Balance Sheets
¶ $30-$40 Of Debt For Each Dollar Of Capital
Was Common (eg., Bear, Lehman, GSEs)
¶ The Debt Was Largely Short-Term
 Subject To Interest Rate Fluctuations
 Subject To Non-Renewal If Lenders Balked
Or Contracts Were Violated
35
The Effect On Housing Prices Was Impressive
36
The Downfall:
The Devil Is In The Details
37
How Can Such Devastation Start From Such Small
Beginnings?
¶ Subprimes are Part Of A Spectrum Of Qualities
¶ The Effects Of Falling Home Prices Are Magnified
By Credit Derivatives
¶ The Butterfly Effect: Small Disturbanced Can Create
Large Responses in Highly Interactive Systems
38
The Butterfly Effect:
Mountains From Molehills
Click Camera To Play Video
(Requires Internet Connection And Windows Media Player)
39
In 2006-2007 Short-To-Intermediate Term Interest
Rates Rose, The Yield Curve Flattened, And
Profitability Declined For Mortgage Holders
Relying On Short-Term Financing
40
ARM Resets Increased As Interest Rates Rose, And
In Mid-2006 House Prices Began To Fall…
41
Accompanied By Increasing Mortgage Delinquencies,
Especially For Subprime Mortgages…
42
Resulting Foreclosures Were Concentrated
Both Geographically…
43
… And By Quality Of Mortgage
44
In 2007 Prices Of Subprime Mortgage Credit Default
Swaps Began To Fall, Particularly At Lower Ratings
45
Creating Impaired Capital, A “Run” On Commercial
Paper And A Severe Credit Crunch
46
And A Rise In Anticipated Stock Market Volatility
47
All This In Spite Of A Massive Federal Reserve Action
To Increase Bank Reserves And Restart Lending
48
The Credit Crunch Kicked Off A Chain Of Events…
¶ A Downward Spiral In CDO/MSB Ratings
 Security Insurers (Including CDSs) Were Downgraded
 Insurers’ Rating Declines Created “Credit Events” As
Defined In CDS Contracts
 CDS Buyers Called For More Collateral
¶ Massive Asset Sales By Hedge Funds, Investment
Banks, And Other Financial Institutions (“De-Leveraging”)
 Impaired Capital Couldn’t Support Asset Levels
 Loss Of Access To Commercial Paper Market
¶ Forced Liquidations Of Collateralized Securities
 Margin Loans And Personal Loans On Security Collateral
 Redemptions At Mutual Funds And Hedge Funds
 Runs On Banks (WAMU)
49
And The Fog Of War Set In…
¶ Uncertainty About Prices Of Mortgage Pools, Especially Equity
Tranches
 Prepayment / Repayment / Default Schedule Uncertainty
 CDOs and MSBs Were “Priced-to-Model,” Creating Inherently
Uncertain Prices As Models Differed Wildly
 As CDO/MSB Holders Sold, Bids Dried Up
 Investment Banks Were Forced To “Mark-to-Market,”
By FASB 157 Effective In 2007
¶ Creating Even Greater Price Declines…
¶ Resulting In Evden Greater Price Uncertainty
50
Big Banks Begin To Collapse In March, 2008…
Financial Institution Failures
Mar
Failed
Savior
Bear Stearns
JPMorganChase
 Major Securitizer
 CP Issuer
 Loan Guarantees
 Reputational Puts
July FNMA/FHLMC
 Major Securitizers
 MSB Issuer
 $2 Per Share
 FED Guarantee
($29B)
U.S. Government
 UST Buys Preferred Shares
 FED Loan Facility
Private Sector
 Buys Preferred Shares
Sep FNMA/FHLMC
Major Securitizers
 MSB Issuer
U.S. Government
 FHFA Takes Over
 Mortgage GSEs
Re-Nationalized
Lehman Brothers
 Major CDS Seller
 Heavy Reliance on CP
American Int’l Group
 Major CDS Seller
 Lehman is “Credit Event”
Triggering CDS Claims
U.S. Government
 UST Buys 80% of Shares
 UST Extends Credit at
LIBOR+8.5%
 FED Backs Credit Line
51
And Failures Continued Through October …
October Failures
Failed
Savior
WAMU
JP Morgan Chase
 Major S&L
 CP Issuer
 $15 Per Share
 Wins Over CitiGroup
Offer of $2
Wachovia
Wells Fargo Bank
 Major Bank
 $15 Per Share
 Wins Over CitiGroup
Offer of $2
Morgan Stanley
 Major Investment Bank
Mitsubishi Bank
 $9B Of Preferred
(20% of Equity)
 UST Guarantees
Investment
52
And Into November
Failed
CitiGroup
 News Of TARP I-A
Disrupts Citi Sales
Of Mortgages To UST
 Citi Stock Tanks
Savior
UST, Fed, FDIC
 Gives Citi A Put Option
 Citi Losses Capped
At $29B Plus 10%
Of Additional Losses
53
Who’s To Blame?
54
Human Greed
¶ Gullible (At Best) And Mendacious (At Worst)
Home Buyers
¶ Mendacious (At Best) And Criminal (At Worst)
Mortgage Brokers And Lenders
¶ Nothing New Here
55
International Trade Policies
(The China Syndrome)
¶ Export-Led Development Models In Asia
 Support Of The Dollar By China And Japan Led to
Overvaluation of U.S. Dollar
 Overvaluation Created A Large U.S. Trade Deficit vs.
Asian Countries (= Large Asian Trade Surplus)
 The Resulting Foreign Saving Glut Created Demand For
Investments In U.S.
¶ Foreign Saving Inflows Went Into Home Mortgages
 U.S. Businesses And U.S. Treasury Borrowing Was
Unusually Low
 Prime Mortgage Market Was Saturated
 A Market For Subprime and Alt-A Mortgages Arose
56
Macroeconomic Policy: Easy Monetary Policy
In The Greenspan Years
57
A Dysfunctional Mortgage Market Structure
¶ A Disconnect Between Borrowers And Lenders
 The Use Of Mortgage Brokers With Short-Term
Income Goals To Provide Loans To Lenders With
Long-term Goals
¶ Declining Credit Standards With Excessive Reliance
On External Ratings And Insurance
 Moody’s And S&P Ratings Of Security Pools
 Private Mortgage Insurance (MBIA, ANBAC, FSA)
 Credit Default Swaps Sold By Investment Banks
58
A Dysfunctional Mortgage Market Structure
¶ Subprimes Were Especially Sensitive To Housing Prices
 Credit-Worthy Loans Had Low LTV Ratio So Equity Was
Secure
 Subprimes Were Predicated On Equity Buildup From Price
Increases
59
Complex And Opaque Financial Instruments
¶ The CDO – CDS Structure Hid Important Information
 Poor “Price Discovery”
• CDOs Extremely Difficult To Value
• Layering Of CDOs (CDO2, Synthetic CDOs, Synthetic
CDO2) Compounded Pricing Problems
 Unclear Locus Of Ultimate Risks
• Insurance via CDSs Laid The Risks Off Onto
Unknown Risk-Buyers
 No Firm Knew The Positions Of Other Firms
• CDOs And CTSs OTC-Products—No Clearing House
60
Obtuse Risk Management
¶ The Myth Of Systemic Safety Through Portfolio
Diversification
 Defective Risk-Management-By-Bell-Curve (“Black Swans”)
 Reliance On Unregulated Credit Derivatives (CDSs) And
Private Mortgage Insurance Companies
 Failure To Appreciate That What Is Good For One Can Be
Bad For All
¶ The “Investment Banking Model”
 Holding An Unbalanced Book (Duration Exposure)
 High Leverage To Hold Inventory Of Assets
61
Ideology
¶ Financial De-Regulation
 The Reagan-Greenspan Model Of Self-Regulation
 Implementation Of Opaque Proprietary Risk-Management
Models At Major Banks (Basel II)
 Relaxation Of Net Capital Rule For Investment Bank
Brokerage Divisions (SEC, 2004)
 Low Capital Requirements For GSEs (30:1 Debt/Equity)
 In 2000 The CFTC Excluded OTC Swap Agreements
From Regulation
62
Politics
¶ Political Pressures For “Affordable” Homeownership
 The CRA of 1977 And GLB of 1999
 HUD’s “Special Affordable Loan” Quotas For GSEs:
(12% in 1996, 22% in 2005, 28% in 2008)
 Strong Bipartisan Support
• President Bush Advocated Broadened Home
Ownership
• Congressional Leaders Pushed GSE Lending To
“Needy” Homebuyers Starting with The Federal Housing
Enterprises Financial Safety and Soundness Act (1992)
¶ Tax Policy
 1997 Shift In Capital Gains Taxes on Housing Profits
to $500K Exclusion ($125K Single Taxpayer)
63
Poorly-Timed Improvements In Transparency
¶ FASB 157 “Mark-To-Market” Requirement For Level 3
(“Toxic”) Assets, Effective Nov. 2007
¶ Introduction In 2006 Of The ABX Index Of CDO Prices
Ended The “Assymetric Information”
64
Policy Responses:
Bailing Out Wall Street
65
66
U.S. Treasury
The Troubled Asset Relief Plan (TARP)
¶ TARP I (October 3, 2008)
 $350 Authorized To Provide Capital To Banks And Encourage
Bank Lending; Additional $350B Available In Second Tranche
• Initial Goal: Buy Toxic Assets At “Hold-To-Maturity” Prices
• Modified Goal: Buy Preferred Stocks of Banks
 Uses Of TARP I Funds:
Purchase Of Bank Preferred Stock
$ 290 B
Purchase Of AIG Preferred Stock
$ 40 B
Loan To GM And Chrysler
$ 25 B
Guarantee Of Bank And AIG Assets
$ 13 B
UST Guarantee Of Fed Loan Facility
$ 20 B
Total
$388 B
67
U.S. Treasury
The Troubled Asset Relief Plan (TARP)
¶ TARP II (February 11, 2009)
 $312B Available After TARP I
• $100B UST Guarantee for Fed Levered PublicPrivate Toxic Asset Purchases
• $ 75B Mortgage Modification Program
• $ 30B Purchase Of Additional AIG Equity
 $107B Still Available
68
U.S. Treasury
Government Sponsored Enterprise Support Program
¶ $600B Asset Purchase And Loan Facility For Fannie Mae
And Freddie Mac


$500B Purchase Of Mortgage Assets From GSEs
$100B Loans to GSEs
69
Federal Reserve System Programs
¶ $1,600B Purchase Of Commercial Paper
¶ $ 540B Credit Facility For Money Market Funds
¶ $ 200B Troubled Asset-Backed Loan Facility (TALF)
To Make Loans To Buy Commercial Mortgage,
Student Loan, And Consumer Loan Paper
¶ Made Commercial Paper and Mortgage AssetBacked Securities Eligible For Bank Borrowing At
Discount Window
¶ Unprecedented Expansion of Bank Reserves And
Money Supply
70
Joint Treasury-Fed-FDIC Programs
¶ Public Private Investment Program (PPIP)
 Designed To Create Market For Toxic Assets
• Final Implementation Of Original TARP Mission
• Announced March 23, 2009
 The PPIP Plan
• Private Sector Bids For Assets
• For Each Dollar Of Assets Purchased
- Private Party Pays 8 cents (Equity)
- U.S. Treasury Pays 8 cents (Equity)
- Fed Lends Private Party 84 cents in Non-Recourse
Loan
- FDIC Insures 84 cents of Non-Recourse Loans
71
Joint Treasury-Fed-FDIC Programs
¶ Results Of PPIP
 The Payoffs
• Private Party Gets 50% Of Asset Price Increases, Loses
Maximum Of 8% Of Investment
• Public Sector Gets 50% Of Price Increases, Loses
Maximum Of 92% (8% Equity + 92% Fed Loan)
 PPIP Implies High Public-Sector Leverage
• 8 cents Equity And 84 cents Debt Gives 12.5:1
Debt/Equity Ratio
• $100B Treasury Investment Generates $1,250B Toxic
Assets Purchased
72
Government Financial Market Programs
U. S. Treasury
Troubled Asset Relief Program
(TARP — October 3)
 $700 Billion To Buy Troubled
Mortgages At “Available For Sale”
Prices
Federal Reserve
Assisted Mergers
 Bear Stearns/JPMorgan
 Merrill/Bank of America
 Passed October 3
Monetary And Credit Policy
TARP I
Buy Senior Preferred Stock Of
Financial Institutions
(October 14)
 $350 Billion Used
 Never Implemented
TARP Goal Modification
Expanded Bank Reserves And
Reduced Fed Funds Rate
Made Mortgage Asset-Backed
Securities And Commercial Paper
Eligible As Collateral
$540B Credit Facility For
Money Market Mutual Funds
(October 14)
Rejects TARP I Approach; All
TARP To Go To Preferred Stock
(November 12)
73
Government Financial Market Support Programs
U. S. Treasury
GSE Mortgage Support
Provides $500 Billion To Buy
Mortgages From GSEs
Buy $100B Of GSE Obligations
Federal Reserve
Troubled Asset-Backed Lending Facility
(TALF)
Provides $200 Billion For Purchases Of AssetBacked Consumer Credit And Commercial
Mortgages
(November 26, 2008)
(November 26,2008)
TARP II
Congress Approves Second $350B
Of TARP For Additional Assistance
To Financial Institutions
(January 15, 2009)
74
The Federal Financial Bailout Budget
75
76
Treasury And Fed Financial Bailout Budget
Authorized
As Investor
$2,350.0 B
Committed
$ 576.0 B
Fed – Commercial Paper Purchase Facility
$ 1,600.0 B
$ 257.0 B
UST – Levered Fed TALF
$
100.0 B
$
UST TARP I – Bank/AIG Capital Purchase
$
290.0 B
$ 290.0 B
UST TARP I – GM/Chrysler Preferred Stock
$
24.8 B
$ 18.4 B
UST TARP I – Purchases from GSEs
$
500.0 B
$
0.0 B
UST TARP II – Bank Capital Purchase
$
100.0 B
$
0.0 B
UST TARP II – Toxic Asset-Backed Paper
$
200.0 B
$
0.0 B
As Lender
$1,502.0 B
0.0 B
$ 229.0 B
UST Loans to GSEs
$
100.0 B
$ 212.0 B
Fed Loans to Money Market Funds
$
540.0 B
$ 17.0 B
UST TARP II – Homeowner Assistance
$
75.0 B
As Insurer
$ 397.5 B
Total
$3,877.0 B
$
0.0 B
$ 75.0 B
$ 983.0 B
77
Policy Responses:
Bailing Out Main Street
78
The American Recovery And Reinvestment Act of 2009
Federal Fiscal Outlays And Revenue Reduction
79
The American Recovery And Reinvestment Act of 2009
The Allocation Of Increased Federal Fiscal Outlays
80
81
Timing Of Outlays and Revenue Reductions
Under The ARRA Of 2009
82
How Have The Rescue Plans Played In Peoria?
83
What’s Next ?
84
85
…For Credit Markets?
More Shoes To Fall
¶ Credit Card ABSs
¶ Auto Loan ABSs
¶ Student Loan ABSs
¶ Commercial Mortgage ABSs
86
…For The Stock Market
¶ The Risk Premium On Stocks Has Risen Sharply
(See Previous VIX Chart)
¶ Once The Market Bottoms It Will Appreciate At An
Historically High Rate (Above the 8-9 % Annual Average)
¶ If The Risk Premium Falls The Remaining Slide Will Be Less
And The Subsequent Rate Of Appreciation Will Be Even
Greater
¶ But…Where IS The Bottom?
87
…For Main Street?
The U.S. Had Unprecedented Macroeconomic Stability
From 1985 through 2007…
88
But Now The Sources Of Aggregate Demand Are Weak
¶ Weak Spending On Consumer Durable Goods
 Automobiles
 Appliances And Household Furnishings
 Not Simply A Matter Of Credit Cost And Availability
¶ Weak Private Domestic Investment
 A Chronic Problem Since The Dot Com / Tech Bust In 2000
 Exacerbated By Weak Consumer Demand
89
But Now The Sources Of Aggregate Demand Are Weak
¶ Slow Recovery In Residential And Commercial Construction
 Large Excess Inventory
 Tightening Credit Standards
¶ Uncertain Net Exports
 Decline In International Trade As All Economes Weaken
 Strong Dollar Works Aginst U.S. Trade (Weakens Exports and
Encourages Imports)
90
Leaving A Prognosis Of A Weak Economy Well Into 2010
EVEN IF Federal Spending And Federal Deficit Increase
¶ Proposed Energy And Infrastructure Projects Take
Significant Time To Ramp Up Even If Spending Is
Approved Quickly
 Could Be Too Much Too Late
 Will Divert Resources From Private Sector Long After
Needed
¶ Fiscal Policy Is Less Powerful Than Was RThught
 Temporary Tax Cuts Have Little Effect On Spending
 The Spending Multipler Is About 1.0
91
Leaving A Prognosis Of A Weak Economy Well Into 2010
EVEN IF Federal Spending And Federal Deficit Increase
¶ Little Hope For Effective Federal Reserve Monetary
Policy
 Short-Term Interest Rates Near Floor (Zero)
 Medium-To-Long Term Interest Rates Quite Low
 The Fed Has Shifted To “Quantitative Easing,” But The
Japanese Experience Was Not Encouraging
92
The Case For A Slow U-Shaped Recovery
¶ Worst Macroeconomic Shock Since The 43-Mont
Decline In 1930-1933
¶ No Clear Sector To Lead Recovery
¶ The Problems Are On An International Scale
¶ Massive Deleveraging With Tighter Credit Standards Will
Create Little Room For Spending Increases
93
The Future
94
New Financial Regulation
¶ New Regulatory Framework And Market Mechanisms
 Consolidation Of Supervisors—A “Super Regulator”
 Extension Of Clearing Houses To Credit Derivatives
And Related Insurance Products
• Makes Positions Open To Public
• Mitigates Counterparty Risk
 Improved Alignment Of Financial System Compensation
With Public Interest In Financial Stability
¶ Development Of Uniform International Accounting And
Regulatory Standards
 GAAP Now Being Replaced By IASB Standards
 Nascent Cooperation On Regulation (Basel II, Treasury Plan)
95
A New National Psyche
¶ Post-Depression Era Psychology
 Saving Over Consumption
 Increased Risk Aversion In Investing
 An Anti-Business Environment
 A Shift Of New Capital Investment From Corporations To
Government
• Direct Government Investments (e.g., Infrastructure)
• Government Subsidies And Guarantees
(e.g., Energy, Environment)
96
A New International Financial Order
¶ International Skepticism About Cross-Border Investing
 Growth In European Financial Markets
 Potential Reduction In Role Of U.S. Dollar As Reserve Currency
• Loss Of U.S. Seignorage Rents
• Dollar Depreciation And Consequent Inflation
 An Anti-Business Environment
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Some Common-Sense
Investment Lessons
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Some Common Sense Investment Lessons
¶ Understand Your Investments
 COMPLEXITY Is Good For The Seller, Not The Buyer
 Price Transparency Is Good—Know How Assets Are
Priced
 Liquidity Is Good—Allows an Exit Plan
¶ Very Bad Outcomes, Though Rare, Are More Common Than
Experts Say
¶ No Free Lunch: If It Has High Returns, It Has High Risks
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And More Common Sense Investment Lessons
¶ Market Timing Doesn’t Work
 For Each Who Buys Low And Sells High, There Is
Someone Who Sells Low And Buys High—Which are you?
 Evidence Is Strongly Against It
¶ Indexed Investments Are Good
 Provide Broad Diversification
 Generally Have Low Operating Costs
 Much Expensive Active Management Is Really Closet
Indexing
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And Even More Common Sense Investment Lessons
¶ Avoid Well-Known Psychological Pitfalls
 Excessive Loss Aversion—Realized vs. Unrealized Losses
 Over Confidence In Investment Skills—Excessive Trading
 Over-Reaction At Peaks And Troughs
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Finis
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