2008 Financial Crisis Part 2 (WCM 2009)

Financial Crisis – Part IIEducational Seminar 3

Tuesday, November 10, 2009

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Disclaimer

This presentation was prepared exclusively for the benefit and use of the members of Western Capital Markets (“WCM”) for the purpose of teaching and discussing financial and investment matters. This presentation is proprietary to WCM .

The information and any analyses contained in this presentation are taken from, or based upon, information obtained from the WCM Executive Team or from publicly available sources. Any information taken from external literature is appropriately referenced. The completeness and accuracy of this presentation cannot be assured by WCM.

To the extent projections and financial analyses are set forth herein, they may be based on estimated financial performance prepared by WCM and are intended only to suggest reasonable ranges of results. Any calculations or value ranges indicated herein are preliminary and should not be construed as opinions of WCM or their individual members as to value, fair market value, or target prices at which a transaction would be considered fair from a financial point of view and must not be relied upon or disclosed as constituting such a document or opinion.

WCM does not take liability for any inaccurate information, and is not liable for any investment advice. Before acting on any information, from WCM or external sources, you should contact a Certified Financial Advisor.

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Agenda

I. History Leading Up to The Crisis

II. “CDOs, MBSs, Sub-Prime, Oh My!”

III. Credit Default Swaps (CDSs)

IV. Recommended Readings & Questions – Part I

V. New York Trip Information

VI. Introduction to Career Management

VII. Changes in the Housing Market & Housing Financial Instruments

VIII. Failure of Financial Institutions

IX. Bailouts

X. Where We Are Now

XI. Recommended Readings & Questions – Part II

Part I – Tuesday, October 27, 2009

Part II – Tuesday, November 10, 2009

Changes in the Housing Market & Housing Financial Instruments

SECTION VII

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A House For Everyone – Even If You Can’t Afford It!

U.S. Home Ownership Rates

Since 1997, everyone started

viewing the housing market as a

“sure thing” where prices will

always trend upwards

Houses no longer served as

a comfortable way to live –

they served as a

“guaranteed” investment

Home ownership began to

skyrocket, partially fuelled by

loosened lending practices for

mortgages (low interest rates and

securitization of subprime loans -

see Financial Crisis Presentation

Part I) up until 2006-2007

Source: Calculated Risk Files (www.calculatedrisk.com)

Historically speaking, personal house ownership (excludes condos and apartments that are rented) has “bounced around”

the 64-65% mark

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Buy vs. Rent – U.S. Market Said: “BUY, BUY, BUY!”

Price-to-Rent Ratio (“Case-Schiller Index”)

Case-Schiller Index is a method for studying home pricing trends - calculated from data on repeat sales of single family

homes

Ultimately compares prices per unit area (such as sq. ft.) to rent per unit area

Indicates how expensive it is to own a unit area of housing vs. rent it (good benchmark for changes in relative

prices)


Index was on a steady increase up until late

2006 / early 2007, and has since declined

dramatically (roughly to 2001 levels)

Signals that the properties have been

largely devalued since early 2007

likely because their value was

overstated at that point in the first

place

With the drop in house prices, several

individuals who invested in housing

because it was a “sure thing” have

since seen their investment dollars go

to waste

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The Rise & Fall of Housing Prices

A clear way of visualizing the magnitude of the housing bubble


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Back to Econ. Basics: Supply vs. Demand

Housing Market Becomes Oversupplied (By a Lot) --> “Crap hits the fan”

With low unemployment, a booming economy, low interest rates, easy access to credit, and a broad infatuation with the

housing market, all indicators pointed towards large investment in houses

Both the Case-Schiller and Real Freddie Mac Purchase Indices point towards a rapid appreciation in house prices

(but remember a high price does not necessarily imply a high value – things are often overvalued!)

Owning a house for a few years and later selling it for a large profit is too good to be true – that trend can never

last forever

As the market over-heated, companies began to develop more houses than there was demand for (supply >

demand, therefore prices dropped (recall Presentation 1 which introduced concepts of supply and demand])

Individuals who financed their houses through sub-prime / “NINJA” loans realized that they could not pay

their deferred payments and thus turned over their keys to the banks (which further inflated the supply of

houses on the market)

Finding the individual responsible for insuring the cash-flow on securitized mortgages (owners of

Credit Default Swaps (CDSs)) became difficult (could have been anyone; from a financial institution

to a Price in a Middle-Eastern country!)

This scared investors, who then further devalued the Mortgage-Backed Securities (MBSs) and

the houses that secured them

Over night, the supply of houses massively exceeded demand causing a large devaluation in: houses, Sub-Prime MBSs, and CDOs

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Oversupply of Houses? Prove It!

A Close Look at Housing Starts

Housing starts refers to the

number of privately owned

new homes (technically

housing units) on which

construction has been

started in a given period

Housing starts were

on the rise until the

peak of the housing

market in early 2007

Subsequently,

housing starts

dropped at a dramatic

rate (businesses won’t

build houses if there

are already too many

on the market!)


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Too Many Houses For Too Few People = Vacancy

Homeowner Vacancy Rate Just as one would expect, as the oversupply of houses grew, housing vacancy rates began grow


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History Building Up to Financial Crisis

Interest Rates & Housing As An Investment

The number of delinquencies / defaults on mortgage payments began to rise as the number of sub-prime mortgages rose

More risky investments (individuals on “NINJA” loans (no income, no job, no assets)), meaning that when deferred

mortgage / interest payments came due, these individuals defaulted on their payments and subsequently turned

over their house keys to the banks (“foreclosures”)


This caused an oversupply of

houses and a resulting

contraction of the broad

market

As market conditions

continued to tighten, more

and more individuals on sub-

prime loans became unable

to make payments, causing

even further defaults – in this

regard, the defaulting of

loans acted in a self-

perpetuated cycle

Failure of Financial Institutions

SECTION VIII

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House Prices Dropped…So What?!

The housing crisis quickly turned into a financial

crisis given that investments in the housing

industry were bundled (“securitized”) and turned

into exotic financial assets – buyers, sellers, and

insurers of these assets were therefore all

interconnected and impacted when the housing

market collapsed

The Financial Crisis is a testament to the

magnitude of interconnectedness of firms /

industries resulting from today’s heavily innovative

and global economy

Several firms have since either ceased to exist

(i.e. Lehman Brothers), been acquired by other

firms (i.e. Merrill Lynch), have received massive

government relief funding in exchange for

ownership (i.e. General Motors (GM)), or a

combination of these

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Firms Impacted by Housing Crisis (to Name a Few…)

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Nice Timeline of Corporate Write-Downs in 2007

Source: Summit Financial Advisors (http://www.summit-advisors.com/)

Bailouts

SECTION IX

Bailouts – Why/How Much?

To maintain some stability in the economy and

push for a recovery in the market, governing

bodies of many countries / regions (particularly the

U.S.) have signed agreements for monetary and

fiscal stimuli

The governments do this to offer a sense of

stability (namely, maintain the operations of major

local companies such as GM, in order to maintain

employment levels, and therefore output (GDP)

levels and steady / reasonable average income for

its citizens)

Without these stimuli, it is no question that the

economy which we see today would look a lot

different (auto companies and banks may have

merged / collapsed, and the average quality of life

(income, employment rates, purchasing power,

etc.) would have dramatically dropped for us a

citizens)

Government Response to Financial Crisis ($ Billions), through March 2009Federal Reserve Committed ProvidedTerm auction credit 900 469Other loans Unlimited 135

Primary credit Unlimited 64Secondary credit Unlimited 0Seasonal credit Unlimited 0Primary Dealer Credit Facility Unlimited 20AB Commercial Paper Money Mkt. Mutual Fund Unlimited 8AIG 43 43AIG (for SVPs) 9 0AIG (for ALICO, AIA) 26 0

Rescue of Bear Stearns 27 26AIG - RMBS purchase program 23 18AIG - CDO purchase program 30 28Term Securities Lending Facility 200 18Commercial Paper Funding Faciluty 1800 241TALF 1000 0Money Market Investor Funding Facility 540 0Currency swap lines Unlimited 329Purchase of GSE debt and MBS 1250 285

Guarantee of Citigroup assets 286 0Guarantee of BoA assets 108 0

Purchase of long-term Treasuries 300 0TreasuryTARP 700 547Fed supplementary financing account 479 479Back stop of Fannie Mae and Freddie Mac 400 0Federal Deposit Insurance Corporation (FDIC)Guarantee of U.S. Banks' debt 1400 201

Guarantee of Citigroup assets n/a 10Guarantee of BoA assets n/a 2.5

Transaction deposit accounts 500 0Federal Housing AdministrationRefinancing of mortgages 100 0CongressEconomic Stimulus Act of 2008 170 170American Recovery & Reinvestment Act of 2009 787 787Joint Fed, FDIC, and TreasuryPublic-Private Investment Fund 1000 0Total 12,077 3,746

Where We Are Now

SECTION X

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Where Are We Now?

Upward Momentum in Stock Market in 2009 The stock market has risen 64% since the March trough, with risky assets roaring ahead in anticipation of rapid, “V-

shaped” recovery

But is a rapid recovery underway? Not

quite.

Unemployment continues to climb

(recently hit 10.2%, only 60 basis

points below post WWII highs)

Average weekly working hours

and labour participation rates are

still falling precipitously

Economy can’t usually recover without

creating jobs. The job situation doesn’t

appear to be getting better in a hurry

Despite stabilizing GDP figures and a

buoyant stock market, for “Joe the

Plummer” (the average person), today’s

market certainly feels like a recession!


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Unemployment Still at Near All-Time Highs...


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…But Consumer Confidence Is Trending Upwards


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Going Forward… Will the recovery be U or V shaped? That's the question

Policy responses:

Federal Reserve is committed to zero interest policy to stimulate demand until conditions improve

Governments around the world are pledging to offer larger stimulus, as G20 finance ministers announced recently

These measures often immediately benefit the price of risky assets, but its uncertain whether they will trigger an improvement

in the economy

Economy will not recover unless consumers return to their over-consuming way of life, but evidence of that is scarce:

Consumer credit declining at 6.6% Y-o-Y

Consumer sentiment is rebounding, but really slowly

Thus, expect a protracted U-shaped recovery as consumer demand – a key driver of growth – remain sluggish

Future risk: Should economy recover, the Fed will need to mop up excess liquidity in a timely manner or else they will face a

set of massive inflationary consequences

Food for thought :

Financial system – preventing firms from becoming too big to fail? Unpopular idea in Washington, but benefits clear

Taming the beast: Derivatives regulation – a move towards standardized, exchange traded instruments is currently

taking place, and will make derivatives safer investments

Often, recruiting conditions can act as a good proxy for firms’ confidence in the direction of the market (in tough times, they need less people and recruit less and good times, the need more people and recruit rigorously). From our knowledge of the recruitment market, many

firms are currently growing their employee-base (potential opportunities for you!)

SECTION XI

Recommended Readings & Questions – Part I

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Suggested Reading Materials (Same as Part I Pres.)

Financial Crisis Topics

http://search.barnesandnoble.com/booksearch/imageviewer.asp?ean=9780137016631






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2008 Financial Crisis Part 2 (WCM 2009)

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Transcript of 2008 Financial Crisis Part 2 (WCM 2009)