Financial Crisis, Leverage, and

the Government

Michael Connolly, Ph.D. University of Chicago

Prof. of Economics, University of Miami
Prof. of Finance, Hunan University, PRC

*Keynote lecture May 3, at the National Kaohsiung University of Applied Sciences,

Kaohsiung City, Taiwan. I offer my sincere acknowledgment of Pr. Dr. Chun-Ping Chang Ph.D.
(張存炳) Shih Chien University at Kaohsiung for his helpful comments, and to Dean Shenggang
Yang (杨胜刚), College of Finance, Hunan University for useful discussion.
Moral hazard, financial leverage and cheap money
Introduction: Many causes for the financial crisis
and near worldwide recession have been suggested:
1. Sub-prime mortgage loans securitized as
Mortgage Backed Assets (MBAs) or
Collateralized Debt Obligations (CDOs).
2. Moral hazard in the credit risk being passed on
to investors, including individuals, investment
banks, Fannie Mae and Freddie Mac.
3. High financial leverage in the origination of the
mortgages and packaging of MBAs and CDOs.
4. Low interest rates as a matter of policy.

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 Moral hazard and financial leverage
Yet, if the housing bubble had not burst, no
worries! Rising home prices yielded rising equity!

A. A simple mortgage loan

Loan origination (8-15-06, 6% fixed rate, 30 years)
Value of house Down payment Value of Mortgage Equity
100 0 100 0
100 10 90 10
100 20 80 20
100 30 70 30

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2. Moral hazard and financial leverage

At loan origination
Type of borrower Ninja* 10% Conventional (20%) 30%
Market value of house 100 100 100 100
Down payment (initial equity) 0 10 20 30
Amount of loan 100 90 80 70
Leverage ratios
Assets/Equity infinite 10 5 3.33
Debt/Equity infinite 9 4 2.33
* No income, no job, no assets.

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2. Rising housing prices 
Rising home prices beget rising equity!
B. One year later
1 year later (8-15-07, market rates remain at 6%) 10% rise
Value of house Down payment Value of Mortgage Equity
110 0 98.77 11.23
110 10 88.89 21.11
110 20 79.02 30.98
110 30 69.07 40.93
1 year later (8-15-07, market rates remain at 6%) 20% rise
Value of house Down payment Value of Mortgage Equity
120 0 98.77 21.23
120 10 88.89 31.11
120 20 79.02 40.98
120 30 69.07 50.93

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2. Rising housing prices 
Rising home prices beget rising equity!
B. One year later
1 year later (8-15-07, market rates remain at 6%) 30% rise
Value of house Down payment Value of Mortgage Equity
130 0 98.77 31.23
130 10 88.89 41.11
130 20 79.02 50.98
130 30 69.07 60.93
1 year later (8-15-07, market rates remain at 6%) 40% rise
Value of house Down payment Value of Mortgage Equity
140 0 98.77 41.23
140 10 88.89 51.11
140 20 79.02 60.98
140 30 69.07 70.93

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2. Falling housing prices 
Falling home prices beget falling equity!
B. One year later
1 year later (8-15-07, market rates remain at 6%) 10% fall
Value of house Down payment Value of Mortgage Equity
90 0 98.77 -8.77
90 10 88.89 1.11
90 20 79.02 10.98
90 30 69.07 20.93

1 year later (8-15-07, market rates remain at 6%)

20% fall
Value of house Down payment Value of Mortgage Equity
80 0 98.77 -18.77
80 10 88.89 -8.89
80 20 79.02 0.98
80 30 69.07 10.93

7
2. Falling housing prices 
Falling home prices beget falling equity!
B. One year later
1 year later (8-15-07, market rates remain at 6%) 30% fall
Value of house Down payment Value of Mortgage Equity
70 0 98.77 -28.77
70 10 88.89 -18.89
70 20 79.02 -9.02
70 30 69.07 0.93

1 year later (8-15-07, market rates remain at 6%) 40% fall

Value of house Down payment Value of Mortgage Equity
60 0 98.77 -38.77
60 10 88.89 -28.89
60 20 79.02 -19.02
60 30 69.07 -9.07

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2. Optimal strategic default
Positive and negative equity
Positive equity
Equity in home Equity in home
40
30
. .
20
10 . Value of home less mortgage payoff
-40 -30 -20 -10 10 20 30 40 (Equity in home)
Optimal strategic default -10
-20 “The value of mortgage prepayment and

writes a put option to

the borrower
.
Mortgage holder implicitly
-30
default options,” Yong Chen, Michael Connolly
Wenjin Tang, and Tie Su, The Journal of
Futures Markets, Vol. 29, No. 4, 1–22 (2009).
-40

Negative equity
9
 2. Optimal strategic default
THE VALUE OF MORTGAGE PREPAYMENT AND DEFAULT OPTIONS, by YONG CHEN, MICHAEL CONNOLLY, WENJIN TANG and TIE SU,
Journal of Futures Markets 29:840–861, 2009.

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2. The mortgage lender’s problem
This bank is solvent!
Balance sheet
Investment / Mortgage Bank
Assets Liabilities
Reserves 20 270 Deposits
Loans 280 30 Owner's equity
300 300

Leverage ratio (Assets/Equity) 10

Leverage ratio (Debt/Equity) 9

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2. The mortgage lender’s problem
This bank is insolvent, it’s loans have been marked
down 15% due to default and short sales!
Balance sheet
Investment / Mortgage Bank
Assets Liabilities
Reserves 20 270 Deposits
Loans 238 -12 Owner's equity
258 258
It may continue to operate as a zombie bank, but
eventually it will run out of cash flow from
operations.

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2. Leverage and the financial crisis
Leveraged mortgage borrowers and leveraged
mortgage lenders suffered massive losses due to
falling housing prices, triggering a financial crisis
characterized by:
1. Failing auctions and banks
2. Falling security prices
3. Foreclosures and short sales
4. Wealth losses (US household net wealth falls
falls $11 trillion in 2008 (77% of 2008 GDP)
5. Recession and high unemployment
6. Rising, state local and federal deficits

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2. The Case-Shiller US Home Price Indices

As of March 2010
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2. Foreclosures are accelerating in 2010
FORECLOSURE ACTIVITY INCREASES 7 PERCENT IN
FIRST QUARTER OF 2010 New Quarterly Records for
Scheduled Auctions and Bank Repossessions. All
Foreclosure Types Spike in March, Which Posts Highest
Monthly Total for Report RealtyTrac® (realtytrac.com),
the leading online marketplace for foreclosure properties,
today released its U.S. Foreclosure Market Report™ for
Q1 2010, which shows that foreclosure filings — default
notices, scheduled auctions and bank repossessions —
were reported on 932,234 properties in the first quarter,
a 7 percent increase from the previous quarter and a 16
percent increase from the first quarter of 2009. One in
every 138 U.S. housing units received a foreclosure filing
during the quarter.
By RealtyTrac Staff, April 15, 2010
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2. Foreclosures are accelerating
Foreclosure Activity by Type
During the quarter a total of 304,799 properties received :

•Default notices (Notices of Default and Lis Pendens), an increase of 1

percent from the previous quarter but down 1 percent from the first
quarter of 2009. Default notices were down nearly 11 percent from a peak
of more than 342,000 in the third quarter of 2009.
• Scheduled auctions Foreclosure auctions were scheduled for the
first time on a total of 369,491 properties during the quarter, the highest
quarterly total for scheduled auctions in the history of the report.
Scheduled auctions increased 12 percent from the previous quarter and
were up 21 percent from the first quarter of 2009.
• Bank repossessions (REOs) also hit a record high for the report in
the first quarter, with a total of 257,944 properties repossessed by the
lender during the quarter — an increase of 9 percent from the previous
quarter and an increase of 35 percent from the first quarter of 2009.

As of March 2010

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The FED is holding a trillion USD of MBAs

March 25, 2010

17
And loans to AIG, and Maiden Lane I,II, III

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A US Treasury Ponzi Game?
“Ponzi finance” is defined by Charles
Kindleberger “as a type of financial
activity engaged in when interest
charges of a business unit exceeds cash
flows from operations … with the
repayment of debt with the issuance of
new debt.”

Charles Kindleberger, (1989) Manias, Panics, and Crashes: a

History of Financial Crises, 2nd. ed. New York: Basic
Books: 86-87.

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A US Treasury Ponzi Game?
Table 1-2.
CBO’s Estimate of the President’s Budget
Actual
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
In Billions of Dollars
Revenues
On-budget 1,451 1,477 1,787 2,097 2,340 2,545 2,667 2,819 2,956 3,086 3,223 3,385
Off-budget 654
_____ 642
_____ 673
_____ 711
_____ 755
_____ 796
_____ 837
_____ 874
_____ 913
_____ 950
_____ 988
_____ 1,031
_____
Total 2,105 2,118 2,460 2,808 3,095 3,341 3,504 3,693 3,869 4,036 4,211 4,416

Outlays
Mandatory spending 2,094 2,034 2,156 2,091 2,176 2,322 2,454 2,636 2,752 2,871 3,084 3,267
Discretionary spending 1,237 1,375 1,401 1,334 1,301 1,303 1,323 1,355 1,381 1,407 1,446 1,487
Net interest 187
_____ 209
_____ 244
_____ 298
_____ 365
_____ 440
_____ 520
_____ 596
_____ 675
_____ 755
_____ 834
_____ 916
_____
Total 3,518 3,618 3,802 3,722 3,842 4,065 4,297 4,587 4,808 5,032 5,364 5,670
On-budget 3,001 3,061 3,223 3,117 3,205 3,398 3,598 3,852 4,032 4,212 4,496 4,750
Off-budget 517 557 579 606 637 667 699 736 776 820 867 920

Deficit (-) or Surplus -1,413 -1,500 -1,342 -914 -747 -724 -793 -894 -940 -996 -1,152 -1,254
On-budget -1,550 -1,585 -1,435 -1,019 -865 -853 -931 -1,033 -1,076 -1,126 -1,273 -1,365
Off-budget 137 85 93 105 118 130 138 139 136 130 121 112

Debt Held by the Public 7,545 9,221 10,512 11,579 12,467 13,329 14,256 15,297 16,396 17,553 18,870 20,294

Memorandum:
Gross Domestic Product 14,236 14,595 14,992 15,730 16,676 17,606 18,421 19,223 20,036 20,823 21,667 22,544
Mandatory spending and interest 108% 106% 98% 85% 82% 83% 85% 88% 89% 90% 93% 95%
divided by total revenues
Fannie Mae & Freddie Mac 91.3 20.5 13.1 10.4 8.3 6.4 6.4 5.3 4.2 3.3 3.4 3.4
(USD billions)

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A US Treasury Ponzi Game?
CBO’s Estimate of the
President's Budget As a Percentage of Gross Domestic Product
Revenues 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
On-budget 10.2 10.1 11.9 13.3 14.0 14.5 14.5 14.7 14.8 14.8 14.9 15.0
Off-budget 4.6 4.4 4.5 4.5 4.5 4.5 4.5 4.5 4.6 4.6 4.6 4.6
Total 14.8 14.5 16.4 17.9 18.6 19.0 19.0 19.2 19.3 19.4 19.4 19.6

Outlays 14.7 13.9 14.4 13.3 13.0 13.2 13.3 13.7 13.7 13.8 14.2 14.5
Mandatory spending 8.7 9.4 9.3 8.5 7.8 7.4 7.2 7.0 6.9 6.8 6.7 6.6
Discretionary spending 1.3 1.4 1.6 1.9 2.2 2.5 2.8 3.1 3.4 3.6 3.9 4.1
Net interest 1.3
____ 1.4
____ 1.6
____ 1.9
____ 2.2
____ 2.5
____ 2.8
____ 3.1
____ 3.4
____ 3.6
____ 3.8
____ 4.1
____
Total 24.7 24.8 25.4 23.7 23.0 23.1 23.3 23.9 24.0 24.2 24.8 25.2
On-budget 21.1 21.0 21.5 19.8 19.2 19.3 19.5 20.0 20.1 20.2 20.8 21.1
Off-budget 3.6 3.8 3.9 3.9 3.8 3.8 3.8 3.8 3.9 3.9 4.0 4.1

Deficit (-) or Surplus -9.9 -10.3 -8.9 -5.8 -4.5 -4.1 -4.3 -4.7 -4.7 -4.8 -5.3 -5.6
On-budget -10.9 -10.9 -9.6 -6.5 -5.2 -4.8 -5.1 -5.4 -5.4 -5.4 -5.9 -6.1
Off-budget 1.0 0.6 0.6 0.7 0.7 0.7 0.8 0.7 0.7 0.6 0.6 0.5

Debt Held by the Public 53.0 63.2 70.1 73.6 74.8 75.7 77.4 79.6 81.8 84.3 87.1 90.0
Source: Congressional Budget Office.

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Prolonging the housing crisis
● Wealth losses suffered by the fall in net equity
of homeowners have not recovered:
●Fannie Mae and Freddie Mac are still making sub-
prime loans. Congress has removed the limits to
Federal subsidies to these two GSAs and
guarantees their debt. Plans to privatize these
nationalized institutions have been put off.

●Tax credits and subsidies to “first time home

buyers” have been extended in 2010, pumping
purchases and prices.

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Prolonging the housing crisis
●New building and home sales are stalled.

●Foreclosure rates are increasing.

●Unsold inventories are not dwindling.

●Shadow inventories will come on the market.

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Conclusion
●The US recovery will be slow and anemic.
Housing is still in financial distress.
● Fannie Mae and Freddie Mac are still making
sub-prime loans guaranteed by the US Treasury.
● The US Treasury is running a Ponzi Game,
Congress will not cut entitlements and interst and
tax revenues will not cover these expenditures.
● Treasuries will eventually default explicitly or
implicitly by a burst of unexpected inflation caused
by seigniorage issue (see Thomas Sargent and Neil Wallace
(1981).

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Conclusion
Have we learned anything?
● A little, but this is not the last housing bubble
we will see in our lifetimes. World economic
history is one of periodic bubbles and financial
crises.
● Financial leverage and securitization will return,
despite regulation.
● Life goes on, but it is better to invest in US
Treasury TIPS (Treasury Inflation Protected
Securities) rather than US Treasuries.

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Thank you! 

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References
Kindleberger, Charles, (1989) Manias, Panics, and Crashes:
a History of Financial Crises, 2nd. ed. New York: Basic
Books: 86-87.

Thomas Sargent and Neil Wallace,(1981) Quarterly

Review,”Some Unpleasant Monetarist Arithmetic,” Federal
Reserve Bank of Minneapolis, Fall.

Yong Chen, Michael Connolly, Wenjin Tang, and Tie Su,

(2009). “The Value of Mortgage Prepayment and Default
Options,” The Journal of Futures Markets, Vol. 29, No. 4,
1–22.

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