Financial Crisis 2 Great Depression Financial Regulation Stock

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 1930 s: ¢ Farm Credit Administration, ¢ Federal Securities Act, Glass-Steagall Act (creates FDIC, lets Fed set max interest rates on S&L, 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.

Deregulation $ Formal Deregulation = removing rules that reduced or eliminated various activities ¢ Some can be done by executive fiat ¢ Some requires changes in the laws u E. g. , Carter Airline Deregulation Act of 1978 u 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 changes u E. g. , Nixon ending gold-dollar linkage and Bretton Woods u E. g. , Reagan appointing James Watts head of Dept of Interior ¢ Can involve reduced oversight ¢ Can be engineered by defunding oversight institutions

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 situations. ¢ Financial regulations had led to creative exploitation of loopholes in laws ¢ Financial deregulation opened the door to all kinds of new speculative innovations u E. g. , Collaterialized Debt Obligations (CDO’s) created in 1987 u E. g. , Asset-backed Securities (ABS’s)

CDO = Collateralized debt obligations ABS = Asset-Backed Securities CMBS = Commercial Mortgage-Backed Securities RMBS = 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 u Removed upper limits on interest rates in response to accelerating inflation (W > productivity ), negative real interest rates $ Deregulation in the Reagan Administrations ¢ Garn-St. Germain Depository Institutions Act of 1982 u Eliminated deposit interest rate ceilings u Permitted Savings & Loan Institutions to diversify their investments into commercial mortgages ¢ In Aug. 1987 Reagan appoints Alan Greenspan head of FED u Ayn Rand disciple and pro-deregulation advocate

History of Financial Deregulation - 2 $ $ Deregulation in the Reagan Administrations cont’d Deregulation in general was attack on cost of labor ¢ E. g. , removal of OSHA protections ¢ E. g. , refusal to enforce protections (EPA) ¢ E. g. , union busting (PATCO, United Airlines, etc. ) $ Financial deregulation ¢ Provided business an alternative to real investment ¢ 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 securities ¢ 1991 Fed approves expansion of Glass-Steagall loophole ¢ 1996 Fed allows bank holding companies to own investment bank affiliates ¢ 1998 Citicorp merges with Travelers that owned Smith. Barney (securities and insurance underwriting) $ 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 activities.

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 O’Neill 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 1930 s aimed at depository banks, e. g. , commerical banks, S&L’s, credit unions. “Shadow banking” has included ¢ Investment banks ¢ Hedge funds (hedge against downturns, speculate on upturns) ¢ Money market funds (invests in short-term debt securities) $ $ 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 u Asset bubble = price of asset far exceeds real value u 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 $ $ S&L 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 mortgages ¢ 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 investors

US Financial Crisis – 2 Timeline - 1 $ Summer of 2007 ¢ Jump in TED spread indicates jump in uncertainties u. 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 2. 0%) ¢ Bear Sterns investment bank nears bankruptcy as value of its MBS’s fall ¢ Fed takes over Bear Sterns, loan to JP Morgan to take over ¢ Citigroup & Morgan Stanly fire CEO’s after losses on MBS

US Financial Crisis – 3 Timeline - 2 $ September of 2008 (SHTF) ¢ Lehman Brothers investment bank goes under, no Fed takeover or bailout ¢ Fed loans AIG $85 billion (insurance conglomerate) ¢ Massive flight from money market funds, Dow Jones plummets ¢ Fed announces temporary insurance for money market funds ¢ Fed establishes asset-backed loan facility $ October of 2008 ¢ Bush signs TARP legislation ¢ Fed begins purchasing MBS’s, buys stock in banks ¢ Federal Funds Rate near zero

US Financial Crisis – 4 Timeline - 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 coordinate ¢ New Consumer Protection Agency to force honest lending ¢ New Office of Credit Ratings to examine rating agencies’ performance ¢ Some derivatives to be bought and sold in open markets ¢ Creates panel that can decide to regulate some shadow banks ¢ FDIC gets new authority to seize some shadow banks ¢ Issuers of MBS must retain min 5% of default risk ¢ Financial holding companies prohibited from hedge funds

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

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