Financial%20Crisis-%202

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Financial Crisis- 2

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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
  SL, splits commercial and investment banking),
• Export-Import Bank created,
• Exchange Stabilization Fund created, Federal
  Farm Mortgage Corporation, SEC created, etc.

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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.

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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

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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 (CDOs)
  created in 1987
• E.g., Asset-backed Securities (ABSs)

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

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History of Financial Deregulation - 2

• Deregulation in the Reagan Administrations contd
• 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

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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.

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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 ONeill 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

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Shadow Banking System - 1

• Banking regulations since 1930s aimed at
  depository banks, e.g., commerical banks, SLs,
  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

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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.

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Recent Banking Crises

• SL 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.

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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

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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 MBSs fall
• Fed takes over Bear Sterns, loan to JP Morgan to
  take over
• Citigroup Morgan Stanly fire CEOs after losses
  on MBS

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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 MBSs, buys stock in banks
• Federal Funds Rate near zero

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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

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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

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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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