Y376 International Political EconomyY376 International Political Economy

March 10, 2011March 10, 2011

Global Financial Crisis 2007-8

Led by bursting of the housing bubble in the US Led by bursting of the housing bubble in the US in 2007in 2007

Made worse by near collapse of US financial Made worse by near collapse of US financial markets connected with mortgage-backed markets connected with mortgage-backed securities, synthetic collateralized debt securities, synthetic collateralized debt obligations (CDOs), and credit default swapsobligations (CDOs), and credit default swaps

Response to the crisis revived the debate over Response to the crisis revived the debate over regulation of financial markets and Keynesian regulation of financial markets and Keynesian approaches to preventing deep recessionsapproaches to preventing deep recessions

Bursting of the Housing Price Bursting of the Housing Price BubbleBubble

1890-2005

1963-2008

The Bubble Bursts

Contributing FactorsContributing Factors

Subprime mortgagesSubprime mortgages Unethical mortgage brokersUnethical mortgage brokers Low interest rates set by the Federal Low interest rates set by the Federal

ReserveReserve Credit Rating Agencies (conflicts of Credit Rating Agencies (conflicts of

interest)interest) Insufficient regulation of financial marketsInsufficient regulation of financial markets

Mortgages and related marketsMortgages and related markets Derivatives, including credit default swapsDerivatives, including credit default swaps

Subprime MortgagesSubprime Mortgages Definition: a type of mortgage granted to Definition: a type of mortgage granted to

individuals with low credit ratings (FICO less individuals with low credit ratings (FICO less than 600)than 600)

Subprime mortgages feature higher interest Subprime mortgages feature higher interest rates than conventional mortgages because of rates than conventional mortgages because of the higher risk of defaultthe higher risk of default

Subprime borrowers were offered adjustable Subprime borrowers were offered adjustable rate mortgages (ARMs)rate mortgages (ARMs)

US policy from the 1990s on was to encourage US policy from the 1990s on was to encourage the growth of this market to make home the growth of this market to make home ownership available to a wider spectrum of the ownership available to a wider spectrum of the populationpopulation

Expansion of Subprime MarketExpansion of Subprime Market

Unethical Mortgage BrokersUnethical Mortgage Brokers

Exaggerated expected Exaggerated expected earnings of borrowersearnings of borrowers

Sold more expensive loans Sold more expensive loans when less expensive loans when less expensive loans were availablewere available

Conspired with real estate Conspired with real estate brokers to raise the sale brokers to raise the sale price of properties above price of properties above market valuemarket value

As a result, subprime As a result, subprime delinquency rates began to delinquency rates began to increase rapidly after 2007increase rapidly after 2007

The Role of Low Interest RatesThe Role of Low Interest Rates

Investors were looking for ways to obtain Investors were looking for ways to obtain higher rates of return for low-risk higher rates of return for low-risk investmentsinvestments

Treasury Bonds became less attractive for Treasury Bonds became less attractive for this purposethis purpose

Mortgage Backed Securities (MBSs) and Mortgage Backed Securities (MBSs) and Collaterized Debt Obligations (CDOs) Collaterized Debt Obligations (CDOs) expanded rapidly to fill the voidexpanded rapidly to fill the void

Credit Rating AgenciesCredit Rating Agencies

These firms (e.g. Fitch Group, Moody’s, These firms (e.g. Fitch Group, Moody’s, Standard and Poor’s) establish credit Standard and Poor’s) establish credit ratings for issuers of certain types of debt ratings for issuers of certain types of debt obligations.obligations.

The highest rating is AAA which denotes The highest rating is AAA which denotes low risk and high liquidity.low risk and high liquidity.

They sometimes compete for business by They sometimes compete for business by offering better ratings (a clear conflict of offering better ratings (a clear conflict of interest).interest).

Fun with Credit Rating AgenciesFun with Credit Rating Agencies

Insufficient RegulationInsufficient Regulation

Securities and Exchange Commission (SEC) Securities and Exchange Commission (SEC) was supposed to regulate the mortgage market was supposed to regulate the mortgage market and apparently failed to do soand apparently failed to do so

The Federal Reserve (especially when headed The Federal Reserve (especially when headed by Alan Greenspan) chose not to regulate by Alan Greenspan) chose not to regulate derivatives marketsderivatives markets

Government financial regulators relied too much Government financial regulators relied too much on the private credit rating agencies and on the private credit rating agencies and business journalist to expose malfeasance and business journalist to expose malfeasance and overly risky investmentsoverly risky investments

Short-Term US Government Short-Term US Government ResponsesResponses

““Rescue” of Bear StearnsRescue” of Bear Stearns Decision not to rescue Lehman BrothersDecision not to rescue Lehman Brothers Takeover of Fannie Mae and Freddie MacTakeover of Fannie Mae and Freddie Mac Troubled Asset Relief Program (TARP)Troubled Asset Relief Program (TARP)

Bailouts of AIG and GMBailouts of AIG and GM $245 billion invested in US banks$245 billion invested in US banks

Obama’s economic stimulus packageObama’s economic stimulus package

Medium and Long-Term MeasuresMedium and Long-Term Measures

Capital Adequacy Requirements and Capital Adequacy Requirements and DeleveragingDeleveraging

Regulation of previously unregulated Regulation of previously unregulated markets (derivatives, but especially credit markets (derivatives, but especially credit default swaps)default swaps)

Improved protection for consumersImproved protection for consumers Mortgage renegotiation incentivesMortgage renegotiation incentives

Global ResponsesGlobal Responses

Reworking of international capital Reworking of international capital adequacy requirements (Basel Accords)adequacy requirements (Basel Accords)

Structural adjustment programs for Structural adjustment programs for Iceland, Ireland, Greece, Spain, and other Iceland, Ireland, Greece, Spain, and other countries – often involving austerity countries – often involving austerity measuresmeasures

Debates in each country about what to do Debates in each country about what to do to return the domestic economy to healthto return the domestic economy to health

A Quick and Dirty Guide to Books A Quick and Dirty Guide to Books on the Crisison the Crisis

The Financial Crisis Inquiry ReportThe Financial Crisis Inquiry Report Andrew Ross Sorkin, Andrew Ross Sorkin, Too Big to FailToo Big to Fail Carmen Reinhart and Kenneth Rogoff, Carmen Reinhart and Kenneth Rogoff,

This Time is DifferentThis Time is Different Michael Lewis, Michael Lewis, The Big ShortThe Big Short William Cohan, William Cohan, House of CardsHouse of Cards Lawrence McDonald & Patrick Robinson, Lawrence McDonald & Patrick Robinson,

A Colossal Failure of Common SenseA Colossal Failure of Common Sense