Causes of the Financial Causes of the Financial CrisisCrisis

(PREP: Open WSJ video clips “End of Wall Street” series)(PREP: Open WSJ video clips “End of Wall Street” series)

Main Causes of the Crisis:Main Causes of the Crisis: Risky Home MortgagesRisky Home Mortgages Consumer DebtConsumer Debt Financial Industry – Risky InvestmentsFinancial Industry – Risky Investments Failure of Ratings AgenciesFailure of Ratings Agencies DeregulationDeregulation Failure of RegulationFailure of Regulation

Risky Home MortgagesRisky Home Mortgages

What is a mortgage?What is a mortgage? DownpaymentsDownpayments

– 20% down vs. less down + 20% down vs. less down + mortgage insurancemortgage insurance

Types of MortgagesTypes of Mortgages– Fixed rate vs. Adjustable Fixed rate vs. Adjustable

raterate Subprime LoansSubprime Loans

– Given to people with poor credit Given to people with poor credit ratings or very low ratings or very low downpaymentsdownpayments

Subprime Subprime FrenzyFrenzy

Clinton and Bush Policies Encouraging HomeownershipClinton and Bush Policies Encouraging Homeownership Wall Street Derivatives fueled Subprime FrenzyWall Street Derivatives fueled Subprime Frenzy Fannie Mae and Freddie MacFannie Mae and Freddie Mac Countrywide and New CenturyCountrywide and New Century Predatory LendingPredatory Lending

Knowingly lending more than borrower could repayKnowingly lending more than borrower could repay Unreasonably high interest ratesUnreasonably high interest rates Falsifying loan applicationsFalsifying loan applications

Real Estate BubbleReal Estate Bubble Bubble Bursts Bubble Bursts Mortgage Default Crisis – 2007 & Mortgage Default Crisis – 2007 &

20082008 Question: Who is to Blame? (see article)Question: Who is to Blame? (see article)

Risky Investments by Financial Risky Investments by Financial IndustryIndustry

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

– – Frank Partnoy, Director of UC San Diego’s Center Frank Partnoy, Director of UC San Diego’s Center for Corporate and Securities Lawfor Corporate and Securities Law

Financial Industry: Derivatives as Financial Industry: Derivatives as “WOMDs”“WOMDs”

Collateralized Debt ObligationsCollateralized Debt Obligations– Subprime mortgages Subprime mortgages

bundled with other bundled with other investments & resoldinvestments & resold

– Hard to value the Hard to value the investment/risk because investment/risk because so complexso complex

– ““Toxic Assets”Toxic Assets”Commissions from banks for Commissions from banks for

selling CDOs was much selling CDOs was much higher than on other higher than on other investmentsinvestments

Mathematical ModelMathematical ModelDerivatives fueled the Derivatives fueled the

Subprime Mortgage FrenzySubprime Mortgage Frenzy

More Derivatives: Credit Default More Derivatives: Credit Default SwapsSwaps

Credit Default Swaps Credit Default Swaps – What is a credit default swap?What is a credit default swap?– UnregulatedUnregulated– Insurance or GamblingInsurance or Gambling– Don’t have to follow standard Don’t have to follow standard

Insurance regulations (AIG example)Insurance regulations (AIG example) Exported our debt Exported our debt global crisis global crisis Cyclical Effect: stock market plunges Cyclical Effect: stock market plunges

fewer loans made fewer loans made businesses go businesses go under under layoffs layoffs more people default more people default on mortgages on mortgages confidence plunges confidence plunges How end cycle? Taxpayers on the hookHow end cycle? Taxpayers on the hook

Why was this allowed? Why was this allowed? – Pressure for ever-more profits for Pressure for ever-more profits for

shareholdersshareholders– Short-term rewards for corporate Short-term rewards for corporate

executivesexecutives– Lobbying? Campaign Donations?Lobbying? Campaign Donations?

Question: Who is to Blame? (see Question: Who is to Blame? (see article)article)

Failure of Ratings AgenciesFailure of Ratings Agencies Gave highest ratings to risky derivatives “AAA”Gave highest ratings to risky derivatives “AAA”

– Despite giving much lower ratings to the underlying Despite giving much lower ratings to the underlying assetsassets

Why?Why?– Mathematical Model?Mathematical Model?– Conflict of Interest - Ratings agencies paid by the Conflict of Interest - Ratings agencies paid by the

companies they are rating (not by consumers)companies they are rating (not by consumers)– Banks paid them triple the usual feesBanks paid them triple the usual fees

Deregulation of Financial Industry Deregulation of Financial Industry (Lobbying intro…)(Lobbying intro…)

Reagan Reagan – Began financial deregulationBegan financial deregulation– End New Deal restrictions on End New Deal restrictions on

mortgage lendingmortgage lending– 1982 Garn-St. Germain Depository 1982 Garn-St. Germain Depository

Institutions Act - Deregulation of Institutions Act - Deregulation of Savings & LoansSavings & Loans

Early Warnings: Early Warnings: – S & L crisis of 1980s (Taxpayer S & L crisis of 1980s (Taxpayer

bail out of $124 billion)bail out of $124 billion)– 1998 failure of Long Term Capital 1998 failure of Long Term Capital

ManagementManagement

Deregulation continues in the Deregulation continues in the 90s90s

1999 Financial Services “Modernization” Act1999 Financial Services “Modernization” Act– Gramm-Leach-Bliley ActGramm-Leach-Bliley Act– Repeal part of 1933 Glass-Steagall ActRepeal part of 1933 Glass-Steagall Act– Tore down firewalls b/w banks, securities Tore down firewalls b/w banks, securities

companies, insurance companiescompanies, insurance companies

Result of 1999 Gramm-Leach-Bliley Act?Result of 1999 Gramm-Leach-Bliley Act?No coincidence that in 1 month we saw…No coincidence that in 1 month we saw…– Failure of largest insurance company in Failure of largest insurance company in

world (AIG insurance)world (AIG insurance)– Largest bank failure in US history Largest bank failure in US history

(Washington Mutual S &L)(Washington Mutual S &L)– Largest bankruptcy in US history (Lehman Largest bankruptcy in US history (Lehman

Brothers investment bank)Brothers investment bank)– Failure of Fannie Mae & Freddie Mac Failure of Fannie Mae & Freddie Mac

(owned/guaranteed over 40% of all (owned/guaranteed over 40% of all mortgages in U.S.) mortgages in U.S.)

– TOO BIG TO FAIL?TOO BIG TO FAIL?

Senator Phil Gramm (TX)

More Deregulation in 2000More Deregulation in 2000

2000 Commodity Futures 2000 Commodity Futures “Modernization” Act“Modernization” Act

– Lobbied for by Wendy & Phil GrammLobbied for by Wendy & Phil Gramm– Pushed for by Alan Greenspan, Sec. Pushed for by Alan Greenspan, Sec.

Treasury Robert RubinTreasury Robert Rubin– Slipped into bill at 11Slipped into bill at 11thth hour in hour in

December – never debatedDecember – never debated– Signed by President ClintonSigned by President Clinton– Exempted derivatives like credit default Exempted derivatives like credit default

swaps from regulationswaps from regulation

Failure of RegulationFailure of Regulation Another Warning:Another Warning:

– Enron CollapseEnron Collapse– Still no change to unregulated Still no change to unregulated

derivativesderivatives

Federal Reserve Federal Reserve – led efforts to deregulate led efforts to deregulate

derivativesderivatives– Resisted crackdown on subprime Resisted crackdown on subprime

lenders by Fedlenders by Fed– Could have raised interest rates Could have raised interest rates

more to slow housing bubblemore to slow housing bubble

Executive Branch:Executive Branch:– HUD PoliciesHUD Policies– Securities and Exchange Securities and Exchange

CommissionCommission Sec. Levitt and Sec. CoxSec. 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.

Who Benefitted?Who Benefitted?

Corporate ExecutivesCorporate Executives Companies repaid with taxpayer moneyCompanies repaid with taxpayer money Foreign Debtors who own U.S. debtForeign Debtors who own U.S. debt Subprime lenders who made fast buckSubprime lenders who made fast buck We ALL benefitted from lower interest We ALL benefitted from lower interest

rates for a whilerates for a while Much of wealth was imaginary (bubble)Much of wealth was imaginary (bubble)

Consumer DebtConsumer Debt Why has consumer debt increased so much?Why has consumer debt increased so much? Material cultureMaterial culture Wages not keeping pace with cost of livingWages not keeping pace with cost of living …….despite growing worker productivity.despite growing worker productivity Healthcare, College, Housing, Inflation, TaxesHealthcare, College, Housing, Inflation, Taxes What kept economy going?What kept economy going?

– Moving from 1 Moving from 1 2 earner families 2 earner families– Increasing consumer debt – credit cardsIncreasing consumer debt – credit cards– Housing and Stock BubblesHousing and Stock Bubbles– Home Equity loansHome Equity loans

INCREASING WEALTH & INCOME INEQUALITYINCREASING WEALTH & INCOME INEQUALITY– Income inequality at highest level since 1913 except one Income inequality at highest level since 1913 except one

other year (source: Economic Policy Institute) other year (source: Economic Policy Institute) CEO pay vs. Avg. workerCEO pay vs. Avg. worker (chart 3A p. 221) (chart 3A p. 221)

– From 1995 to 2004, 90% of gains in wealth occurred only in From 1995 to 2004, 90% of gains in wealth occurred only in top 25% of households. See top 25% of households. See Income and wealth DistributionIncome and wealth Distribution (source: Joint Center for Housing Studies at Harvard, see (source: Joint Center for Housing Studies at Harvard, see chart 2 p. 10 and chart 4 p. 13)chart 2 p. 10 and chart 4 p. 13)

– Top 1% own more than bottom 90% of workers (EPI)Top 1% own more than bottom 90% of workers (EPI)

Where Do We Go From Where Do We Go From Here?Here?

Wall Street & Mortgage ReformsWall Street & Mortgage Reforms Reforms in Lobbying, Revolving Door, Reforms in Lobbying, Revolving Door,

Campaign Finance?Campaign Finance? Global Competitiveness: Global Competitiveness:

– Americans have to save more, produce more, Americans have to save more, produce more, and carry less debt.and carry less debt.

– Invest in Technology, Infrastructure, Education, Invest in Technology, Infrastructure, Education, and Energy Conservation & Green and Energy Conservation & Green TechnologiesTechnologies

Lend each other a handLend each other a hand Creative ideas? Creative ideas?

DiscussionDiscussion

QUESTION:QUESTION: What policies would you put in place to What policies would you put in place to

prevent such a crisis from happening again?prevent such a crisis from happening again?

FUTURE DISCUSSIONS:FUTURE DISCUSSIONS: What role did the Media Play?What role did the Media Play? How Could Congress Allow this to Happen?How Could Congress Allow this to Happen? To Bail or not to Bail? How fix the Financial To Bail or not to Bail? How fix the Financial

Crisis?Crisis?