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Y376 International Political Economy


... Bubble 1890-2005 1963-2008 The Bubble Bursts Contributing Factors Subprime mortgages Unethical mortgage brokers Low interest ... risk investments ... Fannie Mae ... – PowerPoint PPT presentation

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Title: Y376 International Political Economy

Y376 International Political Economy
  • March 10, 2011

Global Financial Crisis 2007-8
  • Led by bursting of the housing bubble in the US
    in 2007
  • Made worse by near collapse of US financial
    markets connected with mortgage-backed
    securities, synthetic collateralized debt
    obligations (CDOs), and credit default swaps
  • Response to the crisis revived the debate over
    regulation of financial markets and Keynesian
    approaches to preventing deep recessions

Bursting of the Housing Price Bubble
The Bubble Bursts
Contributing Factors
  • Subprime mortgages
  • Unethical mortgage brokers
  • Low interest rates set by the Federal Reserve
  • Credit Rating Agencies (conflicts of interest)
  • Insufficient regulation of financial markets
  • Mortgages and related markets
  • Derivatives, including credit default swaps

Subprime Mortgages
  • Definition a type of mortgage granted to
    individuals with low credit ratings (FICO less
    than 600)
  • Subprime mortgages feature higher interest rates
    than conventional mortgages because of the higher
    risk of default
  • Subprime borrowers were offered adjustable rate
    mortgages (ARMs)
  • US policy from the 1990s on was to encourage the
    growth of this market to make home ownership
    available to a wider spectrum of the population

Expansion of Subprime Market
Unethical Mortgage Brokers
  • Exaggerated expected earnings of borrowers
  • Sold more expensive loans when less expensive
    loans were available
  • Conspired with real estate brokers to raise the
    sale price of properties above market value
  • As a result, subprime delinquency rates began to
    increase rapidly after 2007

The Role of Low Interest Rates
  • Investors were looking for ways to obtain higher
    rates of return for low-risk investments
  • Treasury Bonds became less attractive for this
  • Mortgage Backed Securities (MBSs) and
    Collaterized Debt Obligations (CDOs) expanded
    rapidly to fill the void

Credit Rating Agencies
  • These firms (e.g. Fitch Group, Moodys, Standard
    and Poors) establish credit ratings for issuers
    of certain types of debt obligations.
  • The highest rating is AAA which denotes low risk
    and high liquidity.
  • They sometimes compete for business by offering
    better ratings (a clear conflict of interest).

Fun with Credit Rating Agencies
Insufficient Regulation
  • Securities and Exchange Commission (SEC) was
    supposed to regulate the mortgage market and
    apparently failed to do so
  • The Federal Reserve (especially when headed by
    Alan Greenspan) chose not to regulate derivatives
  • Government financial regulators relied too much
    on the private credit rating agencies and
    business journalist to expose malfeasance and
    overly risky investments

Short-Term US Government Responses
  • Rescue of Bear Stearns
  • Decision not to rescue Lehman Brothers
  • Takeover of Fannie Mae and Freddie Mac
  • Troubled Asset Relief Program (TARP)
  • Bailouts of AIG and GM
  • 245 billion invested in US banks
  • Obamas economic stimulus package

Medium and Long-Term Measures
  • Capital Adequacy Requirements and Deleveraging
  • Regulation of previously unregulated markets
    (derivatives, but especially credit default
  • Improved protection for consumers
  • Mortgage renegotiation incentives

Global Responses
  • Reworking of international capital adequacy
    requirements (Basel Accords)
  • Structural adjustment programs for Iceland,
    Ireland, Greece, Spain, and other countries
    often involving austerity measures
  • Debates in each country about what to do to
    return the domestic economy to health

A Quick and Dirty Guide to Books on the Crisis
  • The Financial Crisis Inquiry Report
  • Andrew Ross Sorkin, Too Big to Fail
  • Carmen Reinhart and Kenneth Rogoff, This Time is
  • Michael Lewis, The Big Short
  • William Cohan, House of Cards
  • Lawrence McDonald Patrick Robinson, A Colossal
    Failure of Common Sense
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