Chapter 12. The Financial Collapse of These slides supplement the textbook, but should not replace reading the textbook

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1 Chapter 12 The Financial Collapse of These slides supplement the textbook, but should not replace reading the textbook 1

2 Why is Growth important? If we do not grow there is less goods and services as things deteriorate over time 2

3 Where do we begin? The role of government free markets vs. a planned economy 3

4 Does the Keynesian policy of increasing government spending lead to more growth or less growth? Keynesians believe that it increases growth by shifting the aggregate demand curve to a full employment equilibrium 4

5 Does the Keynesian policy of increasing government spending lead to more growth or less growth? The Austrian viewpoint is that in the short run it could lead to more growth, but in the long run it will lead to less growth 5

6 Why does an increase in government spending lead to less growth? Higher taxes More debt More regulations Diminishes private investments Choices made because of politics rather than economics 6

7 What is the upshot to the story of our financial collapse of ? Policies of the government and the Federal Reserve distorted markets 7

8 What was the policy of Alan Greenspan, chair of the Fed from ? The easy-money policies of the Fed during Greenspan's tenure has been suggested to be a leading cause of the subprime mortgage crisis 8

9 Why were the easy money policies of the Fed a factor in the mortgage crises? People borrowed money to buy homes, the price of homes increased, equity increased, and many people borrowed against the home s equity 9

10 Why is excessive debt a problem in an economic downturn? People cannot meet their debt obligations and a dominoes affect sets in 10

11 When was Fannie Mae founded? It was founded in 1938 as a government sponsored enterprise (GSE), privately owned but publicly chartered, which went public in

12 What is the purpose of Fannie Mae? Its purpose is to expand the secondary mortgage market by securitizing mortgages in the form of mortgage backed securities (MBS) 12

13 What is a Security? A financial instrument representing financial value such as mortgages, bonds, banknotes, stocks, future contracts, and derivatives 13

14 What does Securitizing securities mean? The financial practice of pooling debts, like mortgages, and selling the consolidated debts as bonds (securities) which pay the investors principle and interest regularly 14

15 What is the purpose of Securitizing securities? Its purpose is to allow lenders to reinvest their assets into more lending and in affect increase the number of lenders in the mortgage market 15

16 What are some problems with securitizing debt? The complexity can limit investors ability to monitor risk, and make it more difficult to standardize the market 16

17 What are some other problems with securitizing debt? Off-balance sheet arrangements and excessive leverage 17

18 What is an off-balance sheet arrangement? Financial institutions can have responsibility for assets (often securities) for clients without actually owning the securities 18

19 What is leverage? Leverage is the practice of investing with borrowed money. For example, in 2004 the SEC authorized investment banks to leverage with ratios as high as 40 to 1 19

20 What is Freddie Mac? Authorized by Congress in 1972 to purchase private mortgages on the secondary market to compete with Fannie Mae 20

21 Why did Fan and Fred defraud investors? To increase market share in the subprime loan market and to meet the demands of the Housing and Community Development Act of

22 What is the Housing and Community Development Act of 1977? Banks were required to make substantial loans to low income persons even with bad credit ratings 22

23 What is the Housing and Community Development Act of 1992? Fannie Mae and Freddie Mac were required to meet a goal of 30% mortgages bought should be from low and moderate income families, raised to 55% in

24 What pressure was put on Fannie Mae in 1999? The Clinton Administration encouraged an increase in loan purchases stemming from inner city areas and pressed for an easing of standards in the primary mortgage market 24

25 Who is Angelo Mozilo and what is Country Wide Mortgage? Angelo Mozilo founded Country Wide, a mortgage company that specialized in subprime mortgages 25

26 What role did Country Wide Home Loans play? Country Wide, partnered with Fannie and formed a reduced documentation loan program, Country Wide found the customers and Fan provided the money 26

27 What is an Alt-A Loan? Sometimes called Liar Loans they required less documentation than traditional subprime loans 27

28 What is the Private Securities Litigation Act of 1995? This act protected Wall Street firms from legal suits and restricted investors from suing banks for fraud 28

29 What was the result of the secondary mortgage market and the Private Securities Litigation Act of 1995? They gave banks and mortgage related companies a free hand to engage in high levels of speculation and fraud 29

30 What is the Financial Crises Inquiry Commission? A Congressional commission that spent 18 months investigating the subprime mortgage problem and in 2011 found Fan and Fred innocent of any fault and blamed the crises on private bankers 30

31 What is the lawsuit that the SEC brought against Fannie and Freddie in 2012? The SEC claims that six Fan and Fred executives defrauded investors because they knew and approved misleading statements about their subprime loan exposure 31

32 What is an example of hedging? A farmer agrees to sell his corn to someone at a set price on a set date in the future 32

33 What is an option? A derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price (the strike price) 33

34 What are the two types of options? An option to buy something at a specific price in the future is named a call ; an option to sell something at a specific price is named a put 34

35 What does it mean to short the stock market? You borrow shares from a brokerage house in order to sell them in the hope that you can buy them later at a lower price, you gain when the price declines and lose when the price increases 35

36 What is a hedge fund? A private investment fund which may invest in a diverse range of assets and may employ a variety of investment strategies to protect from downturns and maximize the market upswings 36

37 What is a derivative instrument? A contract between two parties that specifies conditions under which payments are to be made between the two parties 37

38 What is a derivatives market? A financial market for future contracts, these financial instruments in a futures market are called options 38

39 What is a futures market? A specific type of derivative involving a bet between two parties on the future price, called the strike price, of some specified standardized product, like the price of corn six months from the agreement 39

40 How is future value determined? Derivatives often rely on some complicated mathematical model to determine future value, like the Black - Scholes model 40

41 What is an example of speculative trading in the derivatives market? In 1995 Nick Leeson, a trader for Barings Bank, the oldest investment bank in London, made poor and unauthorized investments in futures contracts bankrupting the bank 41

42 What is an over-the-counter derivatives market? A market that is an agreement between two parties and no one else, the contract is personal between the two parties, there is no exchange where information is shared 42

43 Is it possible that even the purchaser of the derivative is not privy to the facts? Yes, investment companies like Bear Stearns often sold contracts to others, like pension funds, without divulging all the facts 43

44 How large is the derivatives market today? The notional value, the hypothetical value existing only in theory, is about $600 trillion!!! 44

45 What is the Commodity Futures Trading Commission (CFTC)? Authorized to regulate agricultural futures and the derivatives market 45

46 Who is Brooksley Born? She was the head of the Commodity Futures Trading Commission from August 1996 to June

47 What did Brooksley Born do as head of the CFTC? She lobbied Congress and the President to give the CFTC oversight of the over-the-counter derivatives market 47

48 Why was Brooksley Born concerned? Dangerous things were happening in the market like fraud and excessive speculation leading to major failures 48

49 What was the event that brought these excesses to light? In 1996 Proctor and Gamble ended up owing $200 billion in the derivatives market and it sued their derivatives dealer, Bankers Trust, for fraud claiming it was not given proper explanation 49

50 What was the outcome between Proctor and Gamble and Bankers Trust? In 1996 Bankers Trust settled with Proctor and Gamble forgiving most of the debt 50

51 What happened after Brooksley Born alerted the Treasury, the Fed, and the SEC about her concern? She was relieved of her jurisdiction over the derivatives market 51

52 Who is Alan Greenspan? He was Chairman of the Fed from 1987 to

53 Who was Ayn Rand ( )? She was a playwright, screenwriter, and author who wrote The Fountainhead (1943) and Atlas Shrugged (1957) 53

54 What was Ayn Rand s philosophy? She believed in a strict laissez faire capitalistic economic system with minimal government and where rational self-interest plays a key role 54

55 Who was Atlas in Greek mythology? He was a god who held the world on his shoulders 55

56 Who was Atlas in her book Atlas Shrugged? The entrepreneur, when he shrugs the whole world comes tumbling down 56

57 How did Ayn Rand influence Alan Greenspan? He was her protégé and close friend 57

58 What was Alan Greenspan s response to Brooksley Born? He believed that the free market would take care of all problems and that any interference in the market would be harmful 58

59 What is leverage? The act of using borrowed money to make bets on some future event 59

60 What happened to Long Term Capital in 1998? Long Term Capital, a hedge fund, was highly leveraged in the derivatives market with $1.25 trillion notional value with only $4 billion capital to back it up 60

61 What happened to Long Term Capital? In 1998 big banks stepped in and took over Long Term Capital and incurred large losses on its leveraged investments 61

62 What is the Commodity Futures Modernization Act of 2000? This act stripped the Commodity Futures Trading Commission of all responsibility over the derivatives market 62

63 What did the Modernization Act do? It forbid state regulators to interfere with the over-thecounter derivatives market 63

64 What did rent seeking have to do with the situation between 2000 and 2010? Wall Street firms plied over $1.7 billion in campaign contributions and $3.4 billion on lobbyists 64

65 What was the Glass- Steagall Act of 1932? This act separated commercial banking from investment banking, commercial banks were regulated and investment banks were not 65

66 What happened to the Glass-Steagall Act? The Commodity Futures Modernization Act of 2000 obliterated the difference between commercial banks and investment banks 66

67 What else did the Modernization Act of 2000 do? The FDIC granted the same protection to investment banks as they did to commercial banks 67

68 What is a Credit Default Swap? A CDS is a bet on a future event involving a hedge against a possible default, for a price it transfers liability on an investment from party A to party B 68

69 When did CDSs emerge? In 1994 when young executives from JP Morgan bank had a weekend meeting in Boca Raton Florida 69

70 What is the American International Group (AIG)? AIG is an American insurance corporation who in 2008 was the 18 th largest public company in the world 70

71 What is an example of a CDS? Bank A lends one million dollars to the XYZ company and then pays AIG to take the risk of a possible default 71

72 What effect did a bank s CDS have on its excess reserves? The Fed agreed to lower its reserve requirement because of the lower risk incurred by banks 72

73 Who is Joe Cassano? Between 2001 and 2008 he was the head of the Financial Products Division of AIG 73

74 What did Joe Cassano do? He sold billions of dollars worth of CDSs to banks without the assets to back up the insurance 74

75 What is a Naked CDS? In a naked CDS neither party actually holds the underlying loan, in essence two noninvolved parties make a bet on some future event 75

76 How did Joe Cassano use Naked CDSs? He sold CDSs protection to numerous non-involved banks on the same loan 76

77 What is a Subprime Mortgage? A type of mortgage which involved a high level of risk to the lender and in some cases actual deceit and fraud 77

78 What is the Securities and Exchange Commission (SEC)? This commission is responsible for enforcing the federal securities law and regulating the securities industry 78

79 What did the SEC do in 2004 that effected the securities market? It allowed banks to set their own debt-to-net-capital rule which changed the industry standard from a 12 to 1 debt capital ratio to 40 to 1 ratio 79

80 Which firms benefited the most from this change in legal ratios? Goldman Sachs Bear Stearns Morgan Stanley Merrill Lynch Lehman Brothers 80

81 What happened in 2008 to these investment banks? They all collapsed and either disappeared or were converted to bank holding companies so they could be bailed out by the Fed 81

82 What precipitated the Financial Bubble in 2000? Fed policies Deregulation mania Excessive leverage 82

83 What is an Adjustable Rate Mortgage Loan? The interest rate would increase over time according to a pre-determined schedule 83

84 What does it mean to be upside down on a mortgage? You owe more on a house than what the house is worth on the market 84

85 What mandates were put on Fannie Mae and Freddie Mac in 2004? They were required to purchase subprime loans from banks to the tune of about $1 billion per week 85

86 What is a Collaterized Debt Obligation (CDO)? A type of structured asset whose value and payments are derived from a portfolio of fixed income assets, it is a collection of streams of income under one roof 86

87 How are CDOs structured? Hundreds of loans are put into a pool and then divided into different tranches according to risk level 87

88 What gives CDOs value? The money that flows into and out of the CDO as people pay their monthly installment loans or retire the loans 88

89 What is Standard and Poor s and Moody s? Two credit rating agencies 89

90 How did Standard and Poor s and Moody s rate these CDOs? They looked at the senior tranches with the highest value loans and rated the whole CDO according to this top tranche, the senior tranche 90

91 What are the 12 Deregulatory Steps to Financial Meltdown? The 12 slides will discuss the 12 events which resulted in the financial collapse of 2007 to 2008 as explained in Sold Out of March

92 #1 Repeal of the Glass-Steagal Act The Financial Services Modernization Act of 1999 formally repealed the Glass- Steagal Act of

93 #2 Hiding Liabilities: Off Balance Sheet Accounting The Financial Accounting Standards Board allowed securitized mortgages to be held as an off-balance sheet entity so that banks did not have to have capital reserves to secure the pool of loans 93

94 #3 The Executive Branch Rejects Financial Derivative Regulation Brooksley Born was relieved of her duties and the Commodity Futures Trading Commission was instructed to cease any activities over the derivatives market, as well as states 94

95 #4 Congress Blocks Financial Derivative Regulation The Commodities Futures Modernization Act of 2000 exempted financial derivatives from regulation 95

96 #5 The SECs allowed Banks to set their own reserve requirements In 2004 the SEC authorized investment banks to develop their own net capital requirements, this resulted in excessive leverage with ratios as high as 40 to 1 96

97 #6 Bank Self-Regulation Goes Global: Preparing Repeat of the Meltdown The complicated financial maneuvering made it hard for international banks to agree and enforce any strict capital reserve requirements 97

98 #7 Failure to Protect Predatory Lending Regulators sat on their hands when it came to protecting abusive behavior in the subprime mortgage market 98

99 #8 Federal Preemption of State Consumer Protection Laws The Office of the Comptroller of the Currency issued formal opinions preempting all state predatory lending laws, thereby rendering them inoperative 99

100 #9 Escaping Accountability Under existing federal law only the original mortgage lender is liable for any predatory and illegal features of a mortgage even if the mortgage is transferred to another party 100

101 #10 Fannie Mae and Freddie Mac Enter the Subprime Market The purchase of subprime assets was a break from prior practice but was forced on these agencies by Congress in their attempt to make every American a home owner 101

102 #11 Merger Mania The abandonment of antitrust related principles over the past has enabled a concentration in the banking sector resulting in megabanks with to-big-to-fail status with government guarantees against failure 102

103 #12 Rampant Conflicts of Interest: Credit Rating Firm s Failure The credit ratings given by the credit rating agencies were influenced by the fact that they got paid from the firms they rate resulting in the highest rating for CDOs based on the best mortgages in the pool 103

104 What is the Dodd-Frank Wall Street Reform and Protection Act of 2010? An Act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes 104

105 How long is the Dodd- Frank bill and what are some highlights? 2100 pages New Consumer Protection Agency tucked under the Federal Reserve Establishes rigorous standards & supervision for financial firms Establishes council to identify systemic risks 105

106 What is the Consumer Financial Protection Bureau as part of the Dodd-Frank Bill? Receives 10% of Fed s assets but is not under its jurisdiction Led by an independent director Able to autonomously write rules for financial institutions Ends the shadow financial system by requiring hedge funds to register with the SEC and provide information about their trades 106

107 What is the Volcker Rule? Implements regulations for banks, affiliates, and holding companies that prohibit proprietary trading, investments in hedge funds, and private equity funds 107

108 What is the Shadow Banking System? The financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight 108

109 What are some examples of Shadow Banking System? Hedge funds Unlisted derivatives Credit default swaps hypothecation 109

110 What is Hypothecation? When a person pledges a mortgage or other assets as collateral for a loan, it refers to the right that a banker has to liquidate goods if you fail to service a loan. You are said to "hypothecate" the mortgage when you pledge it as collateral for a loan 110

111 What is Rehypothecation? The practice by banks and brokers of using, for their own purposes, assets that have been posted as collateral by their clients. Clients who permit rehypothecation of their collateral may be compensated either through a lower cost of borrowing or a rebate on fees 111

112 What is an example of Rehypothecation? In a typical example of rehypothecation, securities that have been posted with a prime brokerage as collateral by a hedge fund are used by the brokerage to back its own transactions and trades 112

113 What is the status of Rehypothecation in America? In the United States, rehypothecation of collateral by broker-dealers is limited to 140% of the loan amount to a client 113

114 What is the status of Rehypothecation in the UK? Unlimited rehypothecation is legal, this is called churning, 30 to1 leverage is common 114

115 What is Re-hypothecation in the UK an example of? Unlimited leverage 115

116 What is the latest casualty of re-hypothecation? John Corsign and MF Global collapse, 8 th largest bankruptcy in America s history The following video is not required 116

117 Who could be the next casualty? JP Morgan has $500 billion in the hypothecation market and an off balance sheet $90 trillion in derivatives. Every large financial institution has large sums of money in this market with liquidity backed by no assets The following video is not required 117

118 What do low interest rates have to do with hypothecation? Financial firms can borrow money at close to zero interest rates and use the money to use in the hypothecation market using the same collateral over and over resulting in the world s largest credit bubble 118

119 What is Moral Hazard? In economic theory, a moral hazard is a situation where there is a tendency to take undue risks because the costs are not borne by the party taking the risk 119

120 Tell me more YouTube "Fear the Boom and Bust" a Hayek vs. Keynes Rap Anthem YouTube "Hayek's 'Road to Serfdom' in Five Minutes YouTube "Senator Paul Ryan on the Rule of Man vs. the Rule of Law" 120

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