Financial Meltdown:

1. Market Failure and the need for Government Regulation Financial Meltdown:

2. The Cost: • Bailout of Bear Stearns: $30 billion of government money at risk • Bailout of Fannie Mae and Freddie Mac: $200 billion of government money at risk • Government takeover of AIG: $85 million of government money invested • Government backing of Money Market Accounts: $50 billion (with over 2 trillion at risk) • Financial Bailout plan in fall of 2008: $700 billion • Impact on ‘real economy’ through reduced lending? We’ll let you know in a few years…

3. The History • Greenspan holds interest rates low in early 2000s to keep U.S. economy out of a deflationary spiral

4. The History • Extremely low interest rates translate into low borrowing costs throughout the economy and helps to fuel massive housing market appreciation

5. History – Traditional Lending • Along with low interest rates, a change in how mortgages are sold by banks helps to create the bubble • Traditionally, a bank would lend money to a borrower and keep the loan for the entire period…usually 30 years • Because they were depending on that person paying them back, they were very careful on who they lent too (“underwriting”)

6. The History - Securitization • Many banks “securitize” mortgages as Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDOs) to investors throughout the world – supposedly, risk is now so dispersed that essentially it is eliminated • The bulk of securitization is completed by Wall Street Investment Banks and the business is lucrative (hundreds of billions of dollars of profit) • Not having to deal with the mortgages for the long term, the banks become extremely aggressive in selling new products to the public

7. Side note on difference between MBS and CDOs: • The original mortgages were repacked in MBS according to “tranches” or levels or risk • The riskiest tranches could not be sold, so were kept on the books of the investment bank OR… • Repackaged AGAIN into CDOs and the re-sold to yet more investors • Estimated that up to 95% of risky mortgages could then be removed from the original investment bank’s balance sheet

8. The History – ‘Subprime’ • The lending banks now devise more and more ‘subprime’ lending tools to offer mortgages to buyers who would historically have been high risk and not qualified for such a loan • ARMs, Balloon loans, interest only loans… • For some loans, basic information like steady income is not collected • Remember, the bank will just turn around sell these mortgages so they don’t care…

9. The History – ‘Uh oh…’ • However, the rampant securitization of mortgages creates a systemic risk for the financial system only seen when subprime borrowers begin to default in 2006

10. The History – ‘Pop’ • House prices begin to drop slowly in 2006 and subprime borrowers who had planned on refinancing their mortgages on more favorable terms are unable to do so • Defaults begin to mount, the supply of homes grows larger and prices begin to fall sharply • Those banks who kept original mortgages on their “books” are hit first • By summer 2008, $440 billion lost at major banks due to mortgage defaults

11. The History – Impact on Banks The TED Spread • However, the trouble spreads to the banking system as a whole • Banks are unsure as to who has these “bad” assets on their books • Unwilling to lend to each other, interbank interest rates begin to spike • Money available for lending (liquidity) dries up and the Credit Crisis begins… • Bank failures begin to rise as they are unable to afford the new borrowing rates Spread between the yield of the 3 month Libor and the 3 month U.S. Treasury Bond. Viewed as best proxy for interbank lending rates. Normal range is shaded green area.

12. The History – End of ‘Wall Street’ • Investment banks who were able to get rid of their MBS and CDO “inventory” in time survive crisis… • Those who were unable to sell in time, have billions of dollars of bad assets and are unable to keep operating As of September 2008, only two of original ‘big five’ investment banks remain independent (Goldman/Morgan Stanley)

13. The History – Role the CDS • To complicate things, during the housing market run-up, financial institutions began selling increased amounts of “credit default swaps” • CDS’s are basically insurance policies, where the holder of a debt sells part of it’s return to a third party who accepts default risk for the debt • They were viewed as a low-risk way to boost overall profitability of a company Explosive growth of CDS market going into phase of the Credit Crisis

14. The History – Role of the CDS • Several big Investment Banks (Lehman Brothers) and Insurance Companies (AIG) enter the market as sellers of CDS for mortgage related securities (MBS/CDOs) • With the collapse of the market for these securities, the CDS obligations spiked, sending these companies out of business or into government takeover

15. The Punchline? • Last fall the government passed an emergency bill creating a $700 billion TARP fund • “Troubled Asset Relief Program” – has been used to inject money directly into banks (nationalization) and could be used for other purposes • This puts an estimated $700 billion of tax payer money at risk • This money has to be borrowed – the Chinese are the likely lenders

16. Debate in Washington: • Should we “nationalize” banks? • Should we use ownership stakes to have a voice in the running of the company? • Should companies that receive government assistance have limitations placed on executive compensation? • Should the government buy up ‘toxic’ assets from the banks to help them recover?

17. The Problem • All economists, even the strongest supporters of the free market system, agree there are times when markets fail to produce efficient outcomes • These market failures are categorized into three main groups: • Inadequate competition, Inadequate information and Externalities

18. Inadequate Information • A country’s financial system is designed to reduce the problems of inadequate information (assymetric information) • Banks are uniquely qualified (resources, experience, expertise) to examine the relative attractiveness of an investment for interested parties • They then pass this information on to clients and act as financial intermediaries (help to get money where it can be used most effectively)

19. Lifeblood of the economy • If money doesn’t flow to where it is most needed, economic activity dries up, growth and innovation cease and resources are misallocated

20. Need for Government Regulation • Market Failures necessitate government intervention • Inadequate competition = Anti-trust laws • Externalities = Taxes, Subsidies and direct restriction of the private market • Inadequate information = Regulatory bodies like the FDA, CPSC and the SEC

21. The Solution? • Both political parties are admitting that greater government regulation is needed to monitor the ever evolving financial markets • The problem is that as soon as rules and regulations are put in place, market participants create new techniques for sharing risk that escape the reach of the old rules • Ex. Development of unregulated CDS market

22. Proposed Solutions • Beef up self-regulatory bodies…the SEC enforces U.S. securities laws, but the financial industry is NOT directly regulated by the SEC • Instead, it is regulated by self-regulating organizations (SROs) • Ex. NYSE and NASD (national association of securities dealers) • The idea is that lower regulations and less government interference helps to the increase efficiency of industry

23. Proposed Solutions • Other approach is to expand the scope, funding and authority of government regulators • This approach is contrary to many politicians “free market” beliefs, but as evidenced by current crisis, some markets are especially prone to market failures such as those that stem from inadequate information