IT Can Happen Again: A Global Financial Crisis This time a Gringo Pathology?

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2 IT Can Happen Again: A Global Financial Crisis This time a Gringo Pathology?

3 Why is the financial system important? "Financial systems are crucial to the alloca2on of resources in a modern economy. They channel household savings to the corporate sector and allocate investment funds among firms; they allow intertemporal smoothing of consump2on by households and expenditures by firms; and they enable households and firms to share risks. These func2ons are common to the financial systems of most developed economies. - Comparing Financial Systems by Franklin Allen and Douglas Gale March 2001

4 Banks are inherently fragile ins7tu7ons Banks liabili>es are predominantly demand deposits. Banks assets are predominantly illiquid loans. This combina>on is important for banks to perform their func>ons (provide liquidity to depositors and monitoring services/credit to corpora>ons), but leaves them exposed to a risk of runs. If depositors panic or learn there is a poten>al problem with their bank, their have an incen>ve to run and withdraw their deposits. Since banks will not have enough liquidity (because their loans are illiquid) to meet the needs of their depositors, a run can force a bank into bankruptcy.

5 Bank runs are not just an academic concept

6 Bank runs are s7ll possible

7 Bank runs can be costly They can lead to the failure of banks that are otherwise solvent ins>tu>ons Worse, they can trigger failures in other banks, which could propagate in a domino fashion and culminate with the collapse of the financial system. Financial crises are costly: Early studies find that output losses during a banking crisis are, on average, 6%- - 8% of annual GDP. More recent studies find that cumula>ve output losses during a banking crisis are, on average, 15%- - 20%, of annual GDP.

8 Why did it Happen Capitalist Fools?

9 Nobel Laureate Joe Stiglitz Policy Mistakes by US Administrations at every fork in the road: 1. Firing the Chairman Reagan sacks Volker for Greenspan appointing an antiregulator as your enforcer at the Fed. 2. Tearing Down the Walls Nov Glass Steagall Provisions Repealed ending firewall between investment and commercial banking 3. Applying the Leeches Bush Tax Cuts 4. Faking the Numbers 5. Let It Bleed Former Treasury Secretary Paulsen and the $700 Bailout George Soros The crisis was generated by the financial system itself.

10 Rogues Gallery or a Model for Financial Disaster? Bad People, Bad Incentives, Bad Regulation?

11 A Theory of Financial Crisis: Debt Deflation and the Financial Instability Hypothesis Keynes is Dead. Long Live Keynes? Need to Revisit the theme of Enterprise vs Speculation Minsky, Kindleberger, and Irving Fisher on the FIH Displacement, Boom Monetary Expansion Euphoria Overtrading Revulsion, Financial Distress, Torschplusspanik

12 A Crisis in the Making: Easy Monetary Policy

13 Fueling the Crisis Easy Monetary Policy Post 9/11 & Dot.com rate cuts to avoid Japanese style Debt deflation crisis Sustained 1% Asian Savings Glut Undervalued currency pegs, support huge CA surpluses, accumulating dollar savings which are pumped back into US with securities purchases Low interest rates, encourage financial innovation and use of leverage to pump returns. Asset allocation shift to real estate, hedge funds and private equity. Global economy lulled into a false sense of security

14 Securitization Grows Mortgage lending business model changes from Originate to Own to Originate and Distribute. Banks earn fees for underwriting mortgages. No longer hold loans on balance sheets (which would constrain lending behavior) Securitization becomes a new path to growth producing a systemic increase in leverage Commercial banks no longer limited to slow and costlier business of attracting retail deposits. The Reckoning April 2004 SEC meeting to Self Regulate five largest investment banks. Leverage will increase from 12 to 30.

15 Gradual Monetary Tightening promotes loose lending standards and growth of subprime mortgages Gradual Fed rate increases slow home sales & reduce underwriting volume. Response Lower credit standards. In 2006 Investment banks collected 60% more from underwriting mortgages than in 2003 Traditional LT mortgages 84% in 2001; down to 55% by 2006 Subprime mortgages up 5% in 2001 to 20% by 2006 Why did investment houses with such highly paid talent permit such a degradation in risk composition? Assumed it impossible for home prices to fall 30% Assumed subprime mortgages could be continually refinanced The Market delivers the Hybrid ARM

16 Defaults and Delinquencies Rise: mid Aug 2007 Volatility Spikes and Liquidity Dries up Run from commercial paper to government securities Inter bank lending breaks down with lack of transparency in Asset Backed Commercial Paper (ABCP) structures Fed Response: Term Auction Facility Financial Turmoil Intensifies January September 2008 January basis FFR cut to 3.5% March 7 TAF increased 100 billion to $200 billion March 11 Fed decides to lend to Primary Dealers in bond market Fed extends $29 billion to facilitate sale of Bear Stearns to JP Morgan Sept 6: Treasury takes over Fannie Mae and Freddie Mac Sept 13: Bank of America acquires Merrill Lynch $50 billion Lehman Brothers files for bankruptcy Sept 16: Fed lends AIG $85 billion in return for 80% control Cash for Trash

17 The Developed Countries are in Recession Globally

18 2. Commodity Price Booms are now Bust

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21 Hudson: Junk Bonding Industry Fic7on: Banks and stock markets finance capital forma>on to help companies Reality: The stock market has become a vehicle for leveraged buyouts and corporate takeovers to load companies down with debt. This diverts profits away from being used for new investment while raising breakeven costs, making financialized companies (and economies) less compe>>ve.

22 Corporate Takeovers Replace Equity with Debt Fic7on: Bank loans and bond issues finance produc>ve capital investment, crea>ng profits that borrowers use to pay off their loans. Reality: Banks extend most credit against property already in place. Most corporate bond issues since the 1980s have been to finance takeovers. This inflates asset prices, but does not finance tangible capital forma>on. Interest must be paid out of income streams already in place- or by cu\ng back capital spending and squeezing more out of employees or their pension funds.

23 Some Almost- Successful Takeover A3empts of 2005 Fic7on: Corporate takeovers streamline inefficient management by cu\ng the fat. Reality: Financial predators cut bone and muscle as they reduce investment programs with long lead- >mes. They increase returns by paying bills more slowly and running companies deeper into debt- to raise stock prices, not produc>on.

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