Recap
Lecture 1 – Origins of the current crisis
Wages disconnected from productivity; debt
increased; inequality reached pre-Great Depression
levels
“Mixed economy” economics replaced by free
market ideology (Keynes vs. Hayek); government is
the problem; deregulation spreads
Financialization of the economy; securitization of
mortgages; “originate to distribute banking”
Recap
Lecture 2 – Money and the FED
Money supply consists of coin, currency and
checking account deposits
FED controls the money supply by:
Changing the reserve requirement
Through the “discount” window
Buying or selling treasury bonds in open markets
FED is dominated by banking interests
Housing Bubble and
Credit Crunch
The Economy Hits the Fan
“Financial Instability
Hypothesis”
Hyman Minsky
Future is Unknowable
Economic expansion depends on willingness
of people and banks “to speculate on future
cash flows and financial market conditions”
Banks primary allocator of capital
Like all businesses banks compete to supply
capital by expanding existing forms of credit
innovate new financial “products”
What Causes Financial Instability?
Shifts occur in investors’ psychology moving
out of a recession into an economic expansion
At first very cautious (hold large cash reserves)
As recovery continues, expectations rise (more
risky loans made)
Finally “Ponzi Finance”
Where future payments depend on new or additional
sources of revenue
What’s to stop this boom-bust cycle?
“Thwarting institutions”
Regulations designed to limit speculation
Government bailouts to prevent a major economic
depression
But overtime the effectiveness of bailouts will
diminish
Double-edged: prevent depressions, but limit the
costs to spectulators
Score card last twenty years
Stock market crash in 1987
S&L crisis in 1989-90
“Emerging markets” crisis of 1997-98
Brought down Long-Term Capital Management
Dot-com market bubble in 2001
Each could have produced a 1930s-style
collapse in absence of govt bailout operations
Upshot: Stability is Destabilizing
Any given period of calm is a “transitory state
because speculation upon and experimentation
with liability structures and novel financial
assets will lead the economy to an investment
boom.” [Minsky]
Banks are “merchants of debt”
Informal timeline
1. The Spark (2003)
2. Lure of Real Estate (Boom, 2003-2006)
3. Sub-prime Chain (Euphoria/Peak, 2006-07)
4. The Unraveling (Bust, 2007-08)
1. THE SPARK (2003)
What was the spark that caused the
underlying forces of the developing “Perfect
Storm” to combine into a “bubble”?
The FED lowered the Federal Funds Rate from
6.5% in May, 2000 to 1.00% in June, 2003
May, 2000 = 6.5%
June, 2003 = 1.0%
Source: Federal Reserve Board. Link: http://www.moneycafe.com/library/fedfundsratehistory.htm
Cheap Credit
Borrowing binge, esp. financial sector and
households
Banks increased leverage and risk
Borrow cheap to lend more
Greater use of shifting liabilities to “off balance sheets”
The shadow banking system
Merrill Lynch’s liabilities:
End of 2002 = $422B
End of 2006 = $800B
Lax regulatory oversight provided the
dry brush for the spark
Greenspan played in key role during the
1990s in the dismantling of the Glass-Steagall
Act of 1933
Had kept depositary institutions (e.g. Citibank)
from taking part in investment banking activities
(selling stocks, bonds, mortgage securities)
Traditional banking vs. casino-like gambling
Replaced by Gramm-Leach-Bliley Act of
1999
2. THE LURE OF REAL ESTATE
(Boom 2003-2006)
Total value of real estate owned by American
families ballooned between 1997 and 2006
1997 = $8.8T
2002 = $14.5T (a 65% increase)
2006 = $21.9T (a 150% increase in 9 years)
Speculative element in real estate
Higher prices can generate higher demand
It’s different than airplane travel, steaks,
entertainment, etc.
Also different from past bubbles (dot.com)
Family home building block of community, social
life, the economy
Downturns can cause ripple effects almost
everywhere
Additional housing demand:
“Ownership Society”
Clinton’s National Homeownership Strategy
Increase minority homeownership
Bush 2’s agenda
American Dream Act (2002): $10,000 for low-income
households struggling to make a down payment on a new
home
Both President’s pressed Fannie Mae/Freddie Mac to
increase funding of home loans to middle-class and
low-income lenders
2004: Homeownership rate at all time high of 69%
Overconfidence
“Tulipmania” – crowd psychology, copycat
behavior
People assuming that recent trends are typical
and extrapolating from them
People who don’t share the consensus view of
the market start to feel left out
Eventually it appears the really crazy people are
those NOT in the market.
3. THE SUB-PRIME CHAIN
(Euphoria/peak, 2006-07)
From “hard money lending” until the early
1990s …..
B&C lending: Where loan applications were
carefully scrutinized
Remember Beneficial Finance?
…. to “Ponzi mortgages”
Credit to people with poor credit histories
Where applications were screened by computers
based on self-reported information
The Subprime Machine
Sample deal: CMLTI 2006-NC2
4,499 mortgages made by New Century
$940M for these mortgages came from borrowing from 8
banks [secured by the mortgages themselves]
The banks borrowed short term thru repurchase
(“repo”) agreements
Two months later, New Century sold the RMBS to
Citigroup for $979M (including interest)
After paying the repo lenders, New Century pocketed
$24M in fees (2.5%)
LIBOR+
(5.32%)
The CDO Machine
Recall …. Combining many RMBS into a sort
of mutual fund to create a “collateralized debt
obligation”
Key players
Securities firms [Merrill Lynch, Goldman Sachs,
Citigroup]
Rating agencies [S&P, Moody’s]
Investors in tranches [public, banks, other CDOs]
Financial guarantors [AIG]
CMLTI 2006-NC2, the story continued
After Citigroup purchased this mortgage-
backed security …..
It sold them to a separate legal entity that
Citigroup owned (off balance sheet)
The “SIV” purchased it with cash raised by
selling securities these loans would back
That “SIV” issued tranches to be sold to investors
Trillions of dollars in securities rested
on:
The ability of millions of homeowners to
make payments on their subprime mortgages
Stability of the market value of their homes
Even expecting rising home prices
Lending Standards Fall
Minsky’s financial instability hypothesis at
work
Types of mortgages near peak of cycle
Alt-A, subprime, interest only, low-doc, no-doc,
ninja (no income, no job, no assets), 2-28s, 3-27s,
liar loans, pick-a-pay adjustable rate mortgage
Mortgages packaged into securities and sold
off: IBGYBG
“I’ll be gone, you’ll be gone”
Where were the “thwarting agencies”?
As long as housing prices continued to rise,
the “Ponzi” process would continue
The only checks
Government oversight and regulation
Which we know adhered to the Efficient Market
Hypothesis
Rating agencies
Role of the Credit Rating Agencies
“Essential cogs” in the meltdown [FCIC]
Problem: “issuer pays” model of credit ratings
Moody’s, S&P, Fitch received generous fees
For “CMLTI” sample Moody’s was paid $208,000 &
S&P was paid $135,000
Example:
2006 Moody’s issued 30 AAA ratings on mortgage-
related securities every working day
83% of those were later downgraded
Note: in 2010 only 6 US corporations carried this rating
Related problem: laxer home appraisal standards
Final link in the chain: Credit Default
Swaps [CDS]
These should be called “credit insurance contracts”
Basically it’s buying insurance against default
A bank (say Citigroup) holding CDOs pays a premium to
an insurer (like AIG).
If a default occurs, then AIG covers the losses
1998 – 2004: they increased exponentially
This insurance market was entirely unregulated
“Financial weapons of mass destruction” [W. Buffet]
Total Credit Default Swaps
Outstanding [$B]
2001 918.87
2002 2,191.57
2003 3,779.40
2004 8,422.26
2005 17,096.14
2006 34,422.80
2007 62,173.20
2008 38,563.82
2009 30,428.11
Composition of US Dollar CDS
Years to
maturity
Total $15.5T
2008 2Q
FED Chair Greenspan
“Recent regulatory reform coupled with innovative
technologies has spawned rapidly growing markets
for, among many other products, asset-backed
securities, collateral loan obligations, and credit
derivative default swaps.”
“These increasingly complex financial instruments
have contributed ...to the development of a far more
flexible, efficient, and hence resilient financial
system than existed just a quarter-century ago.”
It’s even worse ….
So far my focus has been on subprime lending
Bernanke: “Prospective subprime losses were
clearly not large enough on their own to account
for the magnitude of the crisis.”
Shadow Banking System
Comprised of investment banks, hedge funds,
money market mutual funds, insurance
companies
These were never regulated by the FED
US Banking System Ultimate Creditors
Traditional Banking System
Ultimate
Borrowers
“Cash” Shadow Banking System
“Synthetic” Shadow Banking System
As the securitization boom continued
into 2006 and early 2007
Some of the biggest holders of subprime
RMBS and CDOs ended up being the very
banks and investment banks that created them
Citigroup
Set up off-balance-sheet “vehicles”
Issued short term debt to investors
Used cash to buy long term assets for their parent
company (including CDOs)
Running out of investors
As supply of subprime paper increased, the
interest-rate premiums [“spread”] decreased
Yet Wall Street firms continued issuing subprime
securitizations for their hefty underwriting fees
and bonuses
Buyers balked, especially at investing in the
senior tranches
Thus Wall street firms ended up holding them
“They ate their own cooking, and got poisoned.”
What could go
wrong?
What could go
wrong?
4.THE UNRAVELING
(Bust, 2007-08)
“When the music stops, in terms of liquidity,
things will be complicated. But as long as the
music is playing, you’ve got to get up and
dance. We’re still dancing.”
Citigroup CEO Charles Prince
Subprime
adjustable
Prime
fixed
London Bridge is Falling Down
Millennium Bridge
The footbridge opened on June 10, 2000
Closed on June 12
“Synchronous lateral excitation”
Reopened February 2002
Relationship to financial markets?
Pedestrians on the bridge are like banks adjusting
their stance
Movements of the bridge are like price changes
The “first step”
BNP Paribas – August 9, 2007
Great credit crunch of 2007-2009 had begun
Rush to government bonds (yields down sharply)
Interbank lending largely dried up
Information lacking about other banks’
holdings [that long sub-prime mortgage chain]
Hayek’s telecommunications system no longer
emitted reliable price signals, if any at all
Initially, FED policymakers
underestimated the unfolding calamity
Thought it was a temporary liquidity crisis
Discount window opened
The illusion of stability
Thought the sub-prime market was small
Besides, losses would be concentrated outside of
the banking system
Final months of 2007, first part of
2008
Clearly the shadow banking system had helped
concentrate the risks associated with subprime
lending at the heart of the financial world
“Synchronous lateral excitation”
Market prices played a key role coordinating self-
defeating behavior: “mark to market”
The loss spiral: leveraging down (total assets/equity
capital, spreadsheet example)
All banks trying to shrink their balance sheets
simultaneously asset prices continue to fall
Add to this the slumping housing
market
As we’ve seen delinquencies rose
By February 2008, roughly one in four
subprime borrowers was at least one month
behind on mortgage payments
The slump in residential investment did
serious damage to the construction industry
The recession had begun: Officially,
December 2007
Fall 2007: mortgage-related losses
Biggest losers
Citigroup $23.8B; Merrill Lynch $24.7B
More losers
Bank of America $9.7B; Morgan Stanley $10.3B;
JP Morgan $5.3B; Bear Sterns $2.6B
AIG, other insurance companies, hedge funds,
other financial institutions $100B
FED enlarges its role
It arranged a takeover of Bear Sterns by JPMorgan
Chase (March 2008)
It agreed to shoulder the risk of losses of Bear’s toxic
mortgages
Bear was small, but “too interconnected to fail”
It opened discount window to other Wall Street
firms needing cash
Collateral included “toxic” mortgage securities
The FED thus acknowledged that some of the losses
would be socialized
Fannie and Freddie put under
conservatorship
September 7, 2008: The Treasury took an
80% ownership in each of the companies
Appointed new managements
Agreed to provide up to $100B each in fresh
capital
They remained nominally independent, but
the Treasury Department effectively
controlled them
“Free Market Day”
September 15, 2008 Lehman Brothers was allowed
to fail
Leverage ratio: 30/1
4% drop in value of firm’s assets can wipe out its
entire capital base
At the time the largest bankruptcy filing at $600B in
assets
Beginning of the worst market disruption in postwar
American history ...and the FED blinked
Within 24 hours: AIG was bailed out
It had $400B in credit protection provided to
banks (CDS)
The FED promised to lend AIG up to $85B
As collateral demanded AIG’s entire assets,
including its profitable life and property
insurance divisions
Obtained warrants entitling the FED to an 80%
equity state in AIG
Contrast with Scandinavia
Finland
The government combined 40+ savings banks
into one state-owned bank
It nationalized the country’s three largest banks
(wiping out their shareholders)
Sweden
The government seized control of the two largest
banks and shunted their toxic assets into a state-
owned company
(Hidden) Socialism in our time
FED was running out of resources (and legitimacy)
Bernanke and Treasury Sec’y Paulson asked
President Bush and Congress for authority to spend
$700B (5% of GDP) to strengthen the financial
sector
The now much-despised Troubled Asset Relief Program
[TARP]
Recapitalizing the banks directly through the purchase of
preference shares and toxic assets
Elements of the financial stabilization
program
A pledge not to let systemically important
institutions collapse
A commitment to use taxpayers’ money to
socialize some losses
An endorsement of unorthodox central bank
policies aimed at kick-starting the credit
markets
It also discredited “laissez faire” economics
Worth the price?
IMF’s price tag for western governments to shore up
their financial systems: $10 T
Half from direct commitments; half in insurance schemes
and guarantees.
It did not stop the global recession
It did prevent a wholesale collapse of the financial system
In the US, homeowners had little or no relief
“Tea Partiers” and “Occupiers” clearly don’t think it
was worth the price.
So how do we deal with
the “Great Recession”?
Next: do we have a debt crisis or a jobs crisis?