Financial Crisis- 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.

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.

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

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)

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

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

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

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.

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

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

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”.

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.

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

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

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

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

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

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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