Karl Smith

1
Credit Crisis and Recession

• Karl Smith
• School of Government
• Jan 2008

2
Crisis Overview

• The Origins of the Crisis
• Housing
• Credit
• Current State of Financial Markets
• General Crisis
• Municipal Bond Markets
• Real Economy
• Job Losses
• Unemployment
• Revenue Outlook

3
Problem

• Economy is in a unprecedented condition
• Financial Crisis Reminiscent of Great Depression
  or Japanese Depression
• Extremely Responsive Government Action
• Resilient Real Economy Until Recently
• Rapidly Deteriorating Real Economy Now
• Take a Brief Look at the Fundamentals of the
  Crisis

4
Housing Bubble

• Usual Chart
• Steady Climb
• Sharp Fall
• Housing Bubble!
• However, all Cities did not experience the same
  phenomenon

5
Housing Bubble

• North Carolina did not have the same run-up
• Will not have the same crash
• Will suffer the effects of the financial collapse
  nonetheless

6
Credit vs. Housing

• General Credit Bubble
• There will be weakness across all credit products
• Consumer Credit
• Auto Loans
• Commercial Real Estate
• Corporate Bonds
• Banks will be forced to cut lending
• Consumers and Business will find it harder to get
  loans and lines of credit

7
Financial Innovation

• Fed Policy and Foreign Reserve Building played a
  role
• Even more important is the role of financial
  innovation
• Traditionally mortgages were funded by banks and
  held as assets
• GSEs Fannie Mae, Freddie Mac
• Started 1930s
• Exploded late 1980
• However not everyone could qualify for a GSE
• LTV, Credit, Amortizing

8
Financial Innovation

• In the early part of this decade investment banks
  expanded more heavily into securitization using
  structured debt (CDOs)
• Structured debt involves breaking an obligation
  into tranches
• Tranches allowed banks to create safe debt out of
  risky mortgages (or so they thought)
• This allowed the investment banks to fund
  mortgages from risky borrowers

9
Housing Boom

• This combination of
• Low Fed Funds Rate
• Easy credit because of financial innovation
• Created an environment where anyone could buy a
  home
• NINJA loans became common place (No Income No Job
  or Assets)
• With so many buyers out there housing prices in
  tight markets skyrocketed

10
Ted Spread Stress on Banks

• One measure of the panic is known as the TED
  spread
• The difference between what the government pays
  to borrow money and what banks pay other banks to
  borrow money

11
Commercial Paper Spread Stress on Business

• A second measure is the difference between
  commercial paper from highly secure companies and
  riskier entities

12
Municipal Bond Stress on Government

• Municipal bonds spreads are still rising
• More and more expensive to issue debt
• Fed is acting to open market Goal mid 2009

13
The Real Economy

• The current economic situation may seem bad but
  many economists feared that it would be much
  worse than it currently is
• The same forces that are at work today, large
  scale credit contractions, are the same that
  caused the Great Depression
• Our hope is that we have learned from previous
  mistakes
• So how is the real economy doing?

14
Unemployment

• Definitive Marker
• Characteristic Pattern

15
Job Creation

• Also year over year job creation is consistent
  with recession

16
The Future

• The level of uncertainty is high and there are at
  least four possible scenarios each with a
  different likely result for government revenue
• Weak growth through 2009
• Hard Recession late in 2008 with recovery late
  2009 early 2010
• Japanese style depression

17
Hard Landing

• Worldwide slowdown means US exports will fall
• Credit Crisis means sharp slowdown in lending as
  financial institutions reduce their debt to
  capital ratios
• Recession larger than 2001 or 1990
• On par with early 1980s

18
Japanese Style Depression

• We cannot rule this out
• Sept 18th was close Commercial Paper market was
  frozen
• Corporations and Banks depend on short term loans
  (CP)
• Many loans ultimately come from MMMF
• MMMF accounts were drawn down
• Revenue Effects large and unpredictable

19
Statewide Taxes
20
Statewide Trends Sales Tax
21

• Unprecedented Collapse in Spending on Goods

22
Property Tax in Previous Recession

• Declines in the property tax base are
  unprecedented
• Conceivable if foreclosures rise to record levels

23
Caveats

• Much depends on how well the Federal Government
  can respond
• Stimulus Package to States
• Efforts to get Muni, Mortgage and Corporate Bonds
  rates down
• Keep Financial System Intact