Transcript The Financial Crisis

The Financial
Crisis
Thadford Jackson
Preface
 History

is not yet written
Ben Bernanke and the GD
 Those
who do not know the past….
 Better
still, those who know the past can profit in
the future



Biographies of business titans illustrate…
You will witness from 5 to 50 financial/economic
troughs
From households to global conglomerates!
Preface
 Blame
who you want, but the bottom line
is all that counts
 History
is a model that is only as good as it
is useful…to what end?
 History
is linear, though only by
construction

In fact, unfolding of events is simultaneous
and beyond the scope of comprehension
Preface
A
smart person learns from his own past; a
wise person learns from others’ past.
 History
is fascinating.
 History
repeats.

1907 versus 2007
Preface

Much of what we ‘know’ is wrong!

Expertise is the realization of ignorance.

Concentrate on the history of the doers,
instead of on the history of the pundits, critics,
or intellectuals

Those who study history live on different
planets from those who do not.

Probably no better preparation (besides
experience) than business history
A note on mass media
 Media
are intent on profit; sober
assessment of the facts does not sell as
well as finger-pointing and crucifixion
 As
noted, scholarly assessments are
incomplete at best
The Story
 Bankers,
or “Wall Street” types, are bad
people (think ‘Jews’ and anti-Semitism)
who:




Intentionally loaned money to people who
could not afford to repay
Reaped private gains, then leaving losses to
public
Lied to, cheated, and stole from Main
Street
Should be in jail!
The Story
 Republicans
are greedy and corrupt
people who are in bed with the bankers

W., an oil man, slashed all regulations on
banks which would have stopped the FC
from ever happening
 Democrats
are redistributionist fools who
forced banks to loan money to minorities
who could not afford the houses that they
acquired…and democrats are in the
pockets of the big banks, of course.
Definitions


Khan Academy on Credit Crisis
Financial crisis

Highly damaging, usually sudden, event
associated with large decline in asset values
Bubbles bursting
 Banking panics/runs
 Spillover to ‘real’ economy?


Bubble

Prolonged overvaluation of asset (class) from
fundamental value
Tulipmania, South Sea Bubble, Roaring Twenties,
Tokyo real estate, Housing bubble
 Greater fool, extrapolation, herding

Definitions

Subprime mortgage




Higher credit risk and higher returns
Prime purchased by Fannie and Freddie
Non-conforming
Derivative



Financial product that ‘derives’ value from
other financial asset
Option, future, forward, swap
Can be combined to produced synthetic
products


CDOs, CDSs, synthetic CDOs
Leverage

Example of 100% equity stake versus 10% stake;
i.e., leverage ratios of 0 versus 10 to 1
Definitions

Commercial banks


Funnels deposits to investors
Investment banks


Bank that does not take traditional deposits
From G-S to G-L-B, firewall between banks and
IBs



All major banks had IB functions after G-L-B
Goldman Sachs, Morgan Stanley, Merrill Lynch,
Bear Stearns, Lehmann Brothers, Blackstone,
Nomura Securities examples of long-time, pure
IBs
M&A, IPOs, advisory, wealth management,
proprietary trading, private equity
Definitions

Hedge Funds

Think mutual funds for sophisticated investors
Sophisticated equals high net worth and familiar
with complex financial products
 Pensions, endowments, high net worth
individuals


Can invest in wider variety of assets/asset
classes and use more sophisticated strategies



Vanilla hedge (130/30), global macro, event
driven, arbitrage, directional
2/20 compensation contract with high
watermark
Leverage
Definitions
 Originate-to-distribute


model
Used to be…bank loans money to
homebuyer and keeps loan on its books
(and services) for duration of loan
O-to-D:
 Lender
originates loan, sells loan to giant
bank who securitizes loan and allows SPE to
service loan
Definitions

ABS

Investment the cash flows of which are reliant
upon other assets


MBS



Represents a claim on the cash flows from
mortgage loans through a process known as
securitization
Heart of the crisis
RMBS v. CMBS
1.
2.
3.

Credit cards, student loans, real estate loans, etc.
SPV purchases/collects mortgages
Pools mortgages
Issues securities
GSEs major players in MBS market, but not only
ones
Definitions

More on MBS:
Why?







Liquidity thru standardization
Cash for originators
Diversification of finance sources
Regulatory arbitrage: meet capital
requirements easier
Profitable
About $15T outstanding
Definitions

CDOs




ABS with multiple tranches of varying risk
Water flows from senior to junior to equity
Created by hedge funds, investment
banks, banks
$1.4T total issuance
Definitions

CDS
Buyer makes regular payments to seller
who will indemnify buyer in the event of
credit event





Credit event is defined in contract
Failure to pay, repudiation, restructuring,
etc.
Swap that insures buyer against credit risk
OTC derivative; opaque market
Definitions

Synthetic CDO




CDO that references CDSs instead of assets
such as ABS (RMBS, CMBS, etc.)
Derivative of a derivative
Sliced into tranches of various risk appetites
much like a CDO
CRA



Moody’s, Standard & Poor's, Fitch Ratings
Many investors required to invest in “investment
grade” assets; no junk
Higher credit rating entails lower risk, lower
return
Definitions
 Too


Big to Fail
Some institutions are so large that their
failure would pose systemic risk
Systemic risk is just what it sounds like
 Tom
Brady (of Brady Bunch) is TBTF; Marsha is
expendable
 Predatory


lending
Fraudulent origination practices?
“Abusive” practices is more appropriate
definition
Definitions

Deregulation

‘Decreasing’ number, scope, and enforcement
of regulations


I am not aware of any examples; perhaps
regulatory consolidation led by VP Gore
Promoting freedom in the market place
Motor Carrier Act of 1980: deregulated assets
that could be carried, routes open to carriers,
price controls; result was more competition and
price declines
 Airline Deregulation Act of 1978: price and entry
controls relaxed; result in steady price declines
 Gramm-Leach-Bliley (Financial Services
Modernization Act of 1999):

Definitions

Promoting freedom in the market place
continued

Gramm-Leach-Bliley (Financial Services
Modernization Act of 1999):






Repealed part of Glass-Steagall of 1933
Permitted consolidation of insurance, commercial
banking, brokerages, and investment banking
Improved efficiency of scale and thus reduced
costs
Thought important for global competitiveness of U.S.
banks (bipartisan bill signed by WJC)
NOTE: disallowed merger if party failed to satisfy
CRA requirements
Lack of new regulation; most common charge
against republicans (during WJC presidency,
though)
Definitions
 GSE





Fannie Mae, Freddie Mac
Created by Congress to increase credit
availability in home loan market
Privately owned, but implicit guaranteed by
Uncle Sam
Bought up bulk of MBSs
Incentivized to purchase MBSs issued to
low-income borrowers
Definitions
 Shadow



banking system
Those institutions that perform banking
functions (liquidity and credit provision) but
lacking in heavy regulation and deposit
insurance
Hedge funds, money market funds, SPVs,
Repo market
In 2008, roughly twice size of banking
system; $20T versus $10T
Definitions

Maturity mismatch


Banks typically borrow over short-term and lend
over long-term
Bank run





Before deposit insurance, lost confidence in
banks led people to rush banks to demand
funds
Fractional-reserve banking means that bank
runs destroy banks
FDIC stopped bank runs in U.S.
Modern runs in repo market (which killed
Lehmann Brothers), money market funds
Country-wide runs (Greece)
Definitions
 Commercial




paper
Day-to-day financing of almost all major
firms reliant upon CP market
Unsecured notes, 1 day to 9 month maturity
Backbone of money market
Sold at discount and usually backed by
sponsoring bank
Definitions

Stimulus


TARP


Fiscal or monetary
Equity injections into major banks and car
companies
Liquidity trap

Zero percent interest rate environment
that precludes FRB from lowering rates to
stimulate economy