Causes of the Financial Crisis

1
Causes of the Financial Crisis

• (PREP Open WSJ video clips End of Wall Street
  series)
• Main Causes of the Crisis
• Risky Home Mortgages
• Consumer Debt
• Financial Industry Risky Investments
• Failure of Ratings Agencies
• Deregulation
• Failure of Regulation

2
Risky Home Mortgages

• What is a mortgage?
• Downpayments
• 20 down vs. less down mortgage insurance
• Types of Mortgages
• Fixed rate vs. Adjustable rate
• Subprime Loans
• Given to people with poor credit ratings or very
  low downpayments

3
Subprime Frenzy

• Clinton and Bush Policies Encouraging
  Homeownership
• Wall Street Derivatives fueled Subprime Frenzy
• Fannie Mae and Freddie Mac
• Countrywide and New Century
• Predatory Lending
• Knowingly lending more than borrower could repay
• Unreasonably high interest rates
• Falsifying loan applications
• Real Estate Bubble
• Bubble Bursts ? Mortgage Default Crisis 2007
  2008
• Question Who is to Blame? (see article)

4
Risky Investments by Financial Industry

• Today when I am asked if anyone saw this crisis
  coming.my answer is yes. We invented the
  products that ultimately blew up the banks. We
  created the instruments at the center of the
  subprime mortgage meltdown. We fostered a
  culture of epic greed, which nearly destroyed the
  financial system.if you are looking for a single
  word to use in laying blame.Derivatives.
  Without derivatives, leveraged bets on subprime
  mortgages could not have spread so far or so
  fast.
• Frank Partnoy, Director of UC San Diegos
  Center for Corporate and Securities Law

5
Financial Industry Derivatives as WOMDs

• Collateralized Debt Obligations
• Subprime mortgages bundled with other investments
  resold
• Hard to value the investment/risk because so
  complex
• Toxic Assets
• Commissions from banks for selling CDOs was much
  higher than on other investments
• Mathematical Model
• Derivatives fueled the Subprime Mortgage Frenzy

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More Derivatives Credit Default Swaps

• Credit Default Swaps
• What is a credit default swap?
• Unregulated
• Insurance or Gambling
• Dont have to follow standard Insurance
  regulations (AIG example)
• Exported our debt ? global crisis
• Cyclical Effect stock market plunges ? fewer
  loans made ? businesses go under ? layoffs ? more
  people default on mortgages ? confidence plunges
  ? How end cycle? Taxpayers on the hook
• Why was this allowed?
• Pressure for ever-more profits for shareholders
• Short-term rewards for corporate executives
• Lobbying? Campaign Donations?
• Question Who is to Blame? (see article)

7
Failure of Ratings Agencies

• Gave highest ratings to risky derivatives AAA
• Despite giving much lower ratings to the
  underlying assets
• Why?
• Mathematical Model?
• Conflict of Interest - Ratings agencies paid by
  the companies they are rating (not by consumers)
• Banks paid them triple the usual fees

8
Deregulation of Financial Industry (Lobbying
intro)

• Reagan
• Began financial deregulation
• End New Deal restrictions on mortgage lending
• 1982 Garn-St. Germain Depository Institutions Act
  - Deregulation of Savings Loans
• Early Warnings
• S L crisis of 1980s (Taxpayer bail out of 124
  billion)
• 1998 failure of Long Term Capital Management

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Deregulation continues in the 90s

• 1999 Financial Services Modernization Act
• Gramm-Leach-Bliley Act
• Repeal part of 1933 Glass-Steagall Act
• Tore down firewalls b/w banks, securities
  companies, insurance companies
• Result of 1999 Gramm-Leach-Bliley Act?
• No coincidence that in 1 month we saw
• Failure of largest insurance company in world
  (AIG insurance)
• Largest bank failure in US history (Washington
  Mutual S L)
• Largest bankruptcy in US history (Lehman Brothers
  investment bank)
• Failure of Fannie Mae Freddie Mac
  (owned/guaranteed over 40 of all mortgages in
  U.S.)
• TOO BIG TO FAIL?

Senator Phil Gramm (TX)
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More Deregulation in 2000

• 2000 Commodity Futures Modernization Act
• Lobbied for by Wendy Phil Gramm
• Pushed for by Alan Greenspan, Sec. Treasury
  Robert Rubin
• Slipped into bill at 11th hour in December
  never debated
• Signed by President Clinton
• Exempted derivatives like credit default swaps
  from regulation

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Failure of Regulation

• Another Warning
• Enron Collapse
• Still no change to unregulated derivatives
• Federal Reserve
• led efforts to deregulate derivatives
• Resisted crackdown on subprime lenders by Fed
• Could have raised interest rates more to slow
  housing bubble
• Executive Branch
• HUD Policies
• Securities and Exchange Commission
• Sec. Levitt and Sec. Cox

Alan Greenspan, former Chair of Federal Reserve,
acknowledged he made a mistake in presuming that
the banks self-interest would cause them to
regulate themselves.
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Who Benefitted?

• Corporate Executives
• Companies repaid with taxpayer money
• Foreign Debtors who own U.S. debt
• Subprime lenders who made fast buck
• We ALL benefitted from lower interest rates for a
  while
• Much of wealth was imaginary (bubble)

13
Consumer Debt

• Why has consumer debt increased so much?
• Material culture
• Wages not keeping pace with cost of living
• .despite growing worker productivity
• Healthcare, College, Housing, Inflation, Taxes
• What kept economy going?
• Moving from 1 ? 2 earner families
• Increasing consumer debt credit cards
• Housing and Stock Bubbles
• Home Equity loans
• INCREASING WEALTH INCOME INEQUALITY
• Income inequality at highest level since 1913
  except one other year (source Economic Policy
  Institute) CEO pay vs. Avg. worker (chart 3A p.
  221)
• From 1995 to 2004, 90 of gains in wealth
  occurred only in top 25 of households. See
  Income and wealth Distribution (source Joint
  Center for Housing Studies at Harvard, see chart
  2 p. 10 and chart 4 p. 13)
• Top 1 own more than bottom 90 of workers (EPI)

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Where Do We Go From Here?

• Wall Street Mortgage Reforms
• Reforms in Lobbying, Revolving Door, Campaign
  Finance?
• Global Competitiveness
• Americans have to save more, produce more, and
  carry less debt.
• Invest in Technology, Infrastructure, Education,
  and Energy Conservation Green Technologies
• Lend each other a hand
• Creative ideas?

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Discussion

• QUESTION
• What policies would you put in place to prevent
  such a crisis from happening again?
• FUTURE DISCUSSIONS
• What role did the Media Play?
• How Could Congress Allow this to Happen?
• To Bail or not to Bail? How fix the Financial
  Crisis?