The Financial Crisis: 2 + years and counting

Michael Brandl, PhD Northeastern Business & Economics AssocThe University of Texas at Austin 36th Annual ConferenceMcCombs School of Business Worchester, MA

November 7, 2009

Overview Press view of the crisis How we got here Where we are headed What our students should learn

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The Popular Press 7 seconds view The Federal Reserve lowered interest rates

too low in 2003 and kept them too low through 2004.

Homebuyers were

duped by mortgage

lenders.

Unregulated financial markets lent money too freely.

Government bailout & stimulus spending kept us from the Great Depression II.

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The true start of the crisis Homeownership: The American Dream

Post War Baby Boom Interstate highways Federal income tax

deduction for interest 30 yr fixed rate

Mortgages with 20%

down. Result: Post War economic boom! But…Savings & Loan crisis of 1980s tells us

something

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Banks caused problems before US banks have continuously “mispriced

risk” and had the US taxpayer bail them out. “Third World” Debt Crisis in 1980s. Peso Crisis in 1995. Asian Financial Crisis 1997-99. Russian Ruble Crisis 1999-2000. Telecom asset bubble 2000-01. Argentine Financial Crisis 2001-03. Next…

Each time: systemic risk!!! But…what about moral hazard of these bailouts?

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The push for mortgages After dot.com bust Fed pushes interest rates

to new lows. Leads to a search

for returns: mortgages

Banks collateralize or package

mortgages into bundles.

Fee income is key.

As demand for mortgage backed assets increases, banks

and other lenders weaken underwriting standards. Adjustable rate mortgages, zero down mortgages, zero

documentation mortgages, etc. “subprime” market expands…

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Our current little mess…2000

2007

The holy trilogy

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Timeline of the Crisis I June 7, 2007: Bear Stearns announces two of its hedge

funds are suspending redemptions August 9, 2007: BNP Paribas stop redemptions on three

funds. July 19, 2007: Bear Stearns liquidates hedge funds Dec 12, 2007: Fed announces creation of TAF December 2007: recession begins according to the NBER Feb. 17, 2008: Northern Rock taken over by UK Treasury. March 11, 2008: Fed announces creation of Term Securities

Lending Facility March 17, 2008: Bear Stearns bought by JP Morgan Chase. Sept. 7, 2008: Fannie Mae & Freddie Mac taken over by the

US Treasury Sept. 14, 2008: Merrill Lynch purchased by BA. Sept. 15, 2008: Lehman Bros files bankruptcy.

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Timeline of the Crisis II Sept. 16, 2008: AIG gets $85b loan from Treasury & Federal

Reserve Sept. 19, 2008: Fed creates Asset-Backed Commercial

Paper Money Market Mutual Fund Liquidity Facility (AMLF) Sept. 21. 2008: Goldman Sachs & Morgan Stanley

become commercial banks. Sept. 25, 2008: Washington Mutual fails Oct. 3, 2008: Wachovia bought by Wells Fargo Oct. 3, 2008: Congress passes and President Bush signs

the $700bn TARP. Oct. 7, 2008: Fed creates Commercial Paper Funding Facility

(CPFF) Nov. 12, 2008: Paulson announces TARP will not buy assets. Nov 25, 2008: Fed creates Term Asset-Backed Securities

Lending Facility (TALF)

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Timeline of the Crisis III Dec 22, 2008 Treasury injects capital into CIT Group Dec 30, 2008: SEC calls for end of marking to market Jan 9, 2009: The Congressional Oversight Panel blasts

TARP Jan 16, 2009: Fed, Treasury & FDIC announce rescue plan

for Bank of America Feb 6, 2009: Fed announces TALF will be extended to include

auto loans, credit card loans, student loans & SBA loans Feb 10, 2009: Geithner announces public-private plan to buy

bank toxic assets Feb 25, 2009: Government announces stress test plan April 1, 2009: Fed and Treasury fail to answer questions

posed by Congressional Oversight Panel Aug 28, 2009: Fed announces reduction in auction of TAF Nov. 1, 2009 CIT Group files for bankruptcy

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Where we are headed…

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What is being done Trouble Asset Relief Program (TARP)

$700 billion to…well…give banks money to lend. They haven’t.

Fed’s “quantitative easing” Various programs by the Fed to pump money into

financial markets. Fed lends money to a variety of financial market players. Fed buys up a variety of financial assets.

Expansionary fiscal policy Federal government spending to “prime the pump.”

Takes awhile to spend the money….

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What should we do? Rethink the mortgage market

Restructure mortgage for those who need help. Punish those who speculated.

Q: Do we really need the home mortgage interest deduction any more? Is there a better use for that capital? Is there a better use for those resources?

Rethink “too big to fail” No more “heads I win, tails the government loses.” Make the bankers pay for the bailouts.

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What our students can learn…

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Understanding markets matter Far too many think finance is “just” numbers

Finance is so much more than excel spreadsheets. Math tools without market knowledge led to mispricing

CDO risk.

Far too few understand how markets tie together Bankers thought they had gotten rid of mortgage market

risk…but off balance sheet transactions brought it all back.

Understanding incentives is key Loan to hold…to…originate to distribute Bond rating agencies incentives

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Macroeconomics & Finance July 18, 2009 edition

of The Economist Macroeconomics often

ignores the importance of finance & financial markets.

Finance often argues markets will regulate themselves & financial innovation is always beneficial.

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The Economist July 18, 2009“Economists need to reach out from their

specialized silos: macroeconomists must understand finance, and finance professors need to think harder about the context within which markets work.

And everybody needs to work harder on understanding asset bubbles and what happens when they burst. For in the end economists are social scientists, trying to understand the real world. And the financial crisis has changed that world.”

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Q & A

ask about anything…

Michael.brandl@mccombs.utexas.edu

http://blogs.mccombs.utexas.edu/brandl

Twitter: MichaelBrandl

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