"And then the Roof Caved In" Notes

Chapter 3:

• massive rise in subprime industry between 2002 and 2006
• southern california, nevada, arizona, florida
• caused by push for greater home ownership rate - especially among people lacking the 3 C’s
  • character
  • credit history
  • collateral
  • also: lower interest rates, loose regulations
• piggyback loans - risky for the second bank (the piggyback) who didn’t get priority on the collateral
• alt-A loans - between subprime and prime, often used to refinance houses - lower down payment, less background checks
  • interest Alt-A loans - regular
  • hybrid ARM - fixed interest period, then variable - ie. 2/28
  • negative amortization - borrower pays less than interest value - principal goes up
  • option ARM - buyer can choose how much they pay - often ends up with neg. amort.

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Chapter 4:

• Dr. Edward Gramlich and Sheila Bair noticed fragility of bubble, but Greenspan didn’t listen
  • gramlich wanted to apply rules, but greenspan refused because weren’t enforceable
• independent loan companies: Quick Loan, Ameriquest - no regulation
• many lenders couldn’t afford to make safer policies - would simply lose out on business
• “eyes wide shut” - wilfull ignorance - people refused to believe what was right in front of them
• in 2005, more than half of subprime loans were originated by unincorporated businesses - UNREGULATED!

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Chapter 5:

• 1938 - Fannie Mae founded as part of New Deal to purchase mortgages from lenders to free up capital
  • didn’t start with much money but sold bonds to raise capital
  • 1970 - Freddie Mac founded, introduced MBS (mortgage backed securities). used payments collected from mortgages to pay off MBS, and used MBS payments to buy more mortgages
  • MBS’s cut into tranches - different groups with different risk levels - more risk → higher interest rate from Freddie
  • many international investors got involved in US mortgage market thru this
  • Fannie + Freddie had a ton of power - CONFORMING mortgages
• 2003 - Freddie Mac caught understating … Fannie caught overstating. reputation destroyed, Wall Street took over, less regulation.

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Chapter 6:

• rating agencies: Moody’s, Standard & Poor’s, Fitch
  • Lou Ranieri → Congress in 1970s, passed ERISA to allow MBS’s to be rated
• corruption of rating agencies - tried to market themselves to banks by offering inflated ratings - ISSUER PAYS model
  • “rating shopping” became a thing
• no historical standards for rating MBS’s - rating agencies could basically do whatever
  • analysts encouraged to ignore accuracy of unregulated mortgage applications, so they could give higher ratings
• Moody’s went public - more profit focused, less controlled by parent Dun & Bradstreet

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Chapter 8:

• globalization of US housing + financial markets - willingness of banks to peddle securities across the world to fund more mortgages
• investors were willing to invest in US assets because of large trade deficits
  • complexity
  • ignorance
  • trust
• rise of unconscious buyer
• narvik needed money to fund public services
• bought into synthetic CDO triple A tranche (actually shit)
  • group of diversified loans gathered together, even though they were bad, were given higher rating bc unlikely to all default at once
• even Terra (broker) didn’t understand what they were saying

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Chapter 9:

• investment banks behaved very riskily in the lead up to 2008 - Merrill Lynch’s implostion (in part due to Stan O’Neal)
  • O’Neal raised profit margins by reducing costs through risky business practices
  • merrill originated, bought, and pacakged more mortgages into CDOs
  • very dependent on mortgage securitizations because they were profitable while the market was going up
  • eventually, Merrill assets equaled more than 27 times their equity - not stable - a decline in assets would erase all their capital
• private partnerships → public around time of structured products - thus, shareholders responsible for losses, so corporations were riskier - higher leverage ratio
  • business’s assets/equity given

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Chapter 10:

• short selling: borrow stock from a lender, sell right away, expecting price will go down and you can repurchase and give stock back at a lower price, making money in the process
  • possibility of infinite loss, unlike regular speculation (where loss is maximum amount purchased)
  • ie. shorting Bre-X stock and shorting CDOs - US housing market
  • Cui Bono?
• Bass figured out housing market instability by:
  • disparate housing price and income ratio to history
  • large number unsold homes
  • lack of regulation
  • bass went to Bear Stearns, who didn’t agree. found they were leveraged 38 times - 38:1 asset:equity ratio
• a lot of people borrowing beyond their means ex: Arturo Trevilla

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Chapter 11:

• Feb 25, 2007: first major warning sign - remittance data to owners of mortgage securities (how many ppl late on payments/in default)
  • many subprime lenders forced to close, as Wall Street stopped buying - tightened standards for everyone
• less home mortgages given → less home buyers, home prices began to drop
  • too many houses, not enough buyers
  • many people had believed that home prices would never go down - kept refinancing (to their peril in 2008)
• july 10, 2007 - Standard & Poor’s announced downgrades on MBSs and CDOs
  • foreign investors quickly sold off assets
  • triple A’s never defaulted - would be downgraded first!

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Epilogue:

• 2006: more than 25% mortgages considered subprime - UNDERESTIMATE because people who refinanced subprimes were no longer subprime!
• 2008 crash: banks lost 1.2 trillion globally, millions of ppl forcolsed on
• 700 billion bailout by US government - on the TAXPAYER DOLLAR
  • “Too big to fail” - AIG (treasury stepped in + bought about 80% of shares) , Fannie, Freddie
  • merrill lynch sold self to bank of america
  • without bailout, liquidity crisis most likely prolonged, banks insolvent
• more regulations imposed - however, greed, major cause, left unaddressed
• boom and bust cycle continues
  • FTX DISASTER!
• many ppl left below poverty lines for rest of their lives
  • spectacular gains for a select few

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Aftermath:

• 2009: Obama’s Financial Crisis Inquiry Commission
  • Feb 2011 published report - 9 major reasons they believed crisis occured - 3 of them were:
  • crisis was avoidable
  • gov was unprepared
  • over-the-counter derivatives contributed greatly
• CDOs and CLOs have returned in recent years
• most likely currently in growth or deregulation phase
• issuer pays model for rating agencies still in existence at many agencies
• high national unemployment of almost 10%
• modest spending by consumers → slower recovery
• JP Morgan Chase considered one of the few “winners” - generally stayed away from CDOs, and was able to buy up a lot of investment firms at a low price

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