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Financial Crisis- 2


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Title: Financial Crisis- 2

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
    SL, 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.

  • 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
  • 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

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
  • 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)

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? gt
    productivity ?), negative real interest rates
  • Deregulation in the Reagan Administrations
  • Garn-St.Germain Depository Institutions Act of
  • Eliminated deposit interest rate ceilings
  • Permitted Savings Loan Institutions to
    diversify their investments into commercial
  • 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 contd
  • Deregulation in general was attack on cost of
  • E.g., removal of OSHA protections
  • E.g., refusal to enforce protections (EPA)
  • E.g., union busting (PATCO, United Airlines,
  • Financial deregulation
  • Provided business an alternative to real
  • 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
  • 1991 Fed approves expansion of Glass-Steagall
  • 1996 Fed allows bank holding companies to own
    investment bank affiliates
  • 1998 Citicorp merges with Travelers that owned
    Smith-Barney (securities and insurance
  • 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

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

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
  • 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
  • ? 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
  • 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.

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
  • 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

US Financial Crisis 2Timeline - 1
  • Summer of 2007
  • Jump in TED spread indicates jump in
  • 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
  • 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

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
  • Massive flight from money market funds, Dow Jones
  • 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

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
  • New Consumer Protection Agency to force honest
  • New Office of Credit Ratings to examine rating
    agencies performance
  • Some derivatives to be bought and sold in open
  • Creates panel that can decide to regulate some
    shadow banks
  • FDIC gets new authority to seize some shadow
  • Issuers of MBS must retain min 5 of default risk
  • Financial holding companies prohibited from hedge

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