Financial Crisis- 2

1. Financial Crisis- 2

2. Great Depression & Financial Regulation • Stock Market Crash of 1929 • October 29, 1929 “Black Tuesday” • Financial collapse contributed to collapse of economy more generally • Despite Federal Reserve Act of 1913 • New financial regulations in 1930s: • Farm Credit Administration, • Federal Securities Act, Glass-Steagall Act (creates FDIC, lets Fed set max interest rates on S&L, splits commercial and investment banking), • Export-Import Bank created, • Exchange Stabilization Fund created, Federal Farm Mortgage Corporation, SEC created, etc.

3. Keynesian Era & financial Crises • Comprehensive financial regulation at home meant virtually no domestic financial crises • Bretton Woods agreement on fixed exchange rates with IMF as overseer and lender of last resort • UNTIL: accelerating inflation and growing gov. debt, trade deficits and speculative attacks on the dollar lead to abandonment of Bretton Woods, volitile flexible exchange rates and negative interest rates.

4. Deregulation • Formal Deregulation = removing rules that reduced or eliminated various activities • Some can be done by executive fiat • Some requires changes in the laws • E.g., Carter Airline Deregulation Act of 1978 • E.g., Clinton: Gramm-Leach-Bliley Act of 1999 • Defacto Deregulation = failure to enforce existing rules. • Can be the result of top-down executive policy changes • E.g., Nixon ending gold-dollar linkage and Bretton Woods • E.g., Reagan appointing James Watts head of Dept of Interior • Can involve reduced oversight • Can be engineered by defunding oversight institutions

5. Refusal to Regulate • Refusal to enforce existing law and/or rules • Presidential “Signing Statements” • James Watt, Reagan appointed Sec of Interior, failed to enforce environmental laws seen as burdensome /costly to business • Refusal to create new laws/rules to cover new situations. • Financial regulations had led to creative exploitation of loopholes in laws • Financial deregulation opened the door to all kinds of new speculative innovations • E.g., Collaterialized Debt Obligations (CDO’s) created in 1987 • E.g., Asset-backed Securities (ABS’s)

6. CDO = Collateralized debt obligationsABS = Asset-Backed SecuritiesCMBS = Commercial Mortgage-Backed SecuritiesRMBS = Residential Mortgage-Backed Securities

7. History of Financial Deregulation - 1 • Bought by financial lobbying over decades • Deregulation in Carter Administration • Financial Institutions Deregulation Bill of 1979 • Depository Institutions Deregulation and Monetary Control Bill of 1980 • Removed upper limits on interest rates in response to accelerating inflation (W > productivity ), negative real interest rates • Deregulation in the Reagan Administrations • Garn-St.Germain Depository Institutions Act of 1982 • Eliminated deposit interest rate ceilings • Permitted Savings & Loan Institutions to diversify their investments into commercial mortgages • In Aug. 1987 Reagan appoints Alan Greenspan head of FED • Ayn Rand disciple and pro-deregulation advocate

8. History of Financial Deregulation - 2 • Deregulation in the Reagan Administrations cont’d • Deregulation in general was attack on cost of labor • E.g., removal of OSHA protections • E.g., refusal to enforce protections (EPA) • E.g., union busting (PATCO, United Airlines, etc.) • Financial deregulation • Provided business an alternative to real investment • Reduced wages led to recourse to credit • Credit cards & mortgages: way to harness, profit from that recourse

9. History of Financial Deregulation - 3 • Deregulation in the Bush Sr. Administrations • 1990 J.P. Morgan given permission to underwrite securities • 1991 Fed approves expansion of Glass-Steagall loophole • 1996 Fed allows bank holding companies to own investment bank affiliates • 1998 Citicorp merges with Travelers that owned Smith-Barney (securities and insurance underwriting) • Deregulation in Clinton Administrations • Gramm-Leach-Bliley Act or Financial Services Modernization Act of 1999 repealed part of Glass-Steagall Act of 1933 that separated investment banking, deposit banking and insurance activities.

10. History of Financial Deregulation - 4 • Regulation in Bush Jr. Administration • Enron bankruptcy fiasco reveals accounting fraud in deregulated energy market • Sarbanes-Oxley Act of 2002: created Public Company Accounting Oversight Board to avoid Enron-style disasters • Failure to Regulate in Bush Jr. Administration • Mostly failure to regulate new methods of financial speculation, e.g., derivatives, keeps anti-regulation Alan Simpson at Fed. • First Treasury Secretary Paul O’Neill appalled at Bush lack of interest in ANYTHING he had to say about financial situation (see his book: The Price of Loyalty) • 2005 Chairman of SEC quits over White House resistance to regulating mutual and hedge funds

11. Shadow Banking System - 1 • Banking regulations since 1930s aimed at depository banks, e.g., commerical banks, S&L’s, credit unions. • “Shadow banking” has included • Investment banks • Hedge funds (hedge against downturns, speculate on upturns) • Money market funds (invests in short-term debt securities) • Shadow banks borrow short term credit markets and invest in longer term speculation • New Shadow banking methods, e.g., derivatives • remained unregulated even as financial deregulation allowed merger of depository and investment operations

12. Shadow Banking System - 2 • Shadow banking exploded with deregulation • Deregulation: regular banks diverted funds from usual regulated investments to unregulated ones • Shadow banking out grew regular banking • Shadow banking subject to panics • Like other banks, shadow banks can be subject to sudden loss of confidence in investors • When “asset bubble” speculation bursts – investors panic • Asset bubble = price of asset far exceeds real value •  inevitable collapse, bursting of the bubble • When participation in bubbles are widespread panic spreads, i.e., “financial contagion” (failure here = fear of failure there) • Sales of assets here = fall in value of assets there, or “vicious cycle of deleveraging”.

13. Recent Banking Crises • S&L Crisis of 1987 • Followed deregulation and bursting of commercial mortgage bubble • Swedish Banking Crisis of 1991 • Followed credit market deregulation and bursting of housing price bubble • Irish Banking Crisis of 2007 • Housing price bubble led to new regulatory efforts that discovered hidden financial deals • US Banking Crisis of 2007-2011 • Followed deregulation and bursting of housing price bubble in 2006.

14. US Financial Crisis - 1 • Deregulation facilitated widespread speculation, especially in housing bubble • Lax oversight of loan operations permitted widespread fraud • Rapid growth of sub-prime & adjustable rate mortgages • Bundling and securitization of mortgage bundles obscured risks • So money poured into housing boom inflating an asset bubble, housing prices jumped 60% • Housing price bubble burst in 2006 • Value of mortgage-based securities plummeted • Dramatically reducing value of assets of investors

15. US Financial Crisis – 2Timeline - 1 • Summer of 2007 • Jump in TED spread indicates jump in uncertainties • TED Spread = diff inter-bank interest rates from rates charged to the government • Fed reduces discount rate • Fall 2007 – Winter 2008 • Fed cuts Federal Funds Rate (down from 5.25% to 2.0%) • Bear Sterns investment bank nears bankruptcy as value of its MBS’s fall • Fed takes over Bear Sterns, loan to JP Morgan to take over • Citigroup & Morgan Stanly fire CEO’s after losses on MBS

16. US Financial Crisis – 3Timeline - 2 • September of 2008 (SHTF) • Lehman Brothers investment bank goes under, no Fed takeover or bailout • Fed loans AIG $85 billion (insurance conglomerate) • Massive flight from money market funds, Dow Jones plummets • Fed announces temporary insurance for money market funds • Fed establishes asset-backed loan facility • October of 2008 • Bush signs TARP legislation • Fed begins purchasing MBS’s, buys stock in banks • Federal Funds Rate near zero

17. US Financial Crisis – 4Timeline - 3 • November 2008 • Obama Elected, keeps same Fed Chairman • February 2009 • Obama signs fiscal stimulus package • October 2009 • Unemployment peaks at 10.1% • July 2010 • Obama signs Wall Street Reform and consumer Protection Act

18. US Financial Crisis – 5 • Obama signs Wall Street Reform and consumer Protection Act • New Financial Services Oversight Council to coordinate • New Consumer Protection Agency to force honest lending • New Office of Credit Ratings to examine rating agencies’ performance • Some derivatives to be bought and sold in open markets • Creates panel that can decide to regulate some shadow banks • FDIC gets new authority to seize some shadow banks • Issuers of MBS must retain min 5% of default risk • Financial holding companies prohibited from hedge funds

19. US Financial Crisis – 5 • New Regulations? • It remains to be seen whether these regulations will be enforced • Conservative opposition threatens to withhold funding needed for regulations to be enforced

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