Bubbles and Bailouts Guest Lecture: 2010/02/22 Political Science 301: Comparative Political Economy Jonathan Alevy: Department of Economics afja@uaa.alaska.edu

Lecture Outline How do economists think about pricing in financial markets Contrast with goods markets Housing market lending Lending quality declines Bailouts Impacts

Housing prices 1:

Housing Prices: Bubble and Crash Two lines of prices note real and nominal. The last years… a housing bubble? Bubble is a divergence from fundamental values….what is a fundamental value? Need a model http://mysite.verizon.net/vodkajim/housingbubble/

Stock Prices

Carbon Permits: European Union Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Are financial (& housing) markets efficient? In an efficient market, a security’s price fully reflects all available information Implication 1: Prices are “the right prices” good signals for making investments, hiring decisions Implication 2: There are no unexploited profit opportunities. (hard to make money) Note: #2 may be correct even if #1 is wrong.

What makes markets efficient? A person’s behavior reflects their private information Assumption: people want to profit Profit seeking behavior spreads information to the market Therefore: Market price reflects all available information or aggregates private information

Arguments for and against EMT People need not be rational If rational…it works If not rational and trade at random No important effect on prices (on average they cancel each other out) If deviate from rationality in same way (e.g. follow charts, sentiment etc.) Creates a “risk-free” profit opportunity for rational traders (arbitrageurs) Systematic irrationality: Sentiment - Belief in rising prices Must be strong enough to overwhelm rational traders. Does seem to happen from time-to-time Conclusion: Markets “pretty efficient, most of the time”

Bubbles in the laboratory.

Bubbles reduce over time

Laboratory Asset Markets Fundamental value known with certainty. Not true in the real world Coordinating Expectations through experience Not always possible in the real world.

Back to the crisis Causes Responses What’s next

Lending Statistics 8.5% 18.5% Increase in low quality loans in 2004 Mortgage Originations (Billions) Subprime Originations (Billions) Subprime Share in Total Subprime Mortgage Backed Securities Percent Subprime Securitized 2001 $2 ,215 $190 8.6% $95 50.4% 2002 $2,885 $231 8.0% $121 52.7% 2003 $3,945 $335 8.5% $202 60.5% 2004 $2,920 $540 18.5% $401 74.3% 2005 $3,120 $625 20.0% $507 81.2% 2006 $2,980 $600 20.1% $483 80.5% Mortgage Originations (Billions) Subprime Originations (Billions) Subprime Share in Total Subprime Mortgage Backed Securities Percent Subprime Securitized 2001 $2 ,215 $190 8.6% $95 50.4% 2002 $2,885 $231 8.0% $121 52.7% 2003 $3,945 $335 8.5% $202 60.5% 2004 $2,920 $540 18.5% $401 74.3% 2005 $3,120 $625 20.0% $507 81.2% 2006 $2,980 $600 20.1% $483 80.5% Increase in low quality loans in 2004 Increase in securitization – reduces incentive to make quality loans

Empirical Evidence Dramatic increase in subprime lending (2004) SEC allows more leveraged investment banks Federal preemption of state “predatory lending” laws. Housing prices Had been trending higher Disconnect from economic fundamentals at this time Low quality loans are securitized Holders want ‘insurance’ against default Credit default swaps AIG is the biggest player, but sells their insurance too cheaply.

Potential Causes of Subprime Lending Surge Regulatory changes SEC allows more leveraged investment banks http://www.nytimes.com/2008/10/03/business/03sec.html Federal preemption of state “predatory lending” laws. http://www.ritholtz.com/blog/2009/10/pre-emption-of-state-anti-predatory-lending-laws-led-to-more-foreclosures/

Bailout of financial system Biggest beneficiary: AIG $185 Billion Who benefits? Recipients of bonuses (relatively small amount) Counterparties Owners of AIG issued CDS Primarily domestic and foreign “risk-taking” banks Financial System defaults pose systemic risk, one firm’s default causing others to be insolvent Purpose is to support real economy

Real GDP

Unemployment claims

Sources of Bailout Monies Direct aid to financial institutions TARP funds Fed Lending Total about 4 trillion Stimulus Spending Total about 800 billion Bernanke Fed Chair: Scholar of the Great Depression

Moral Hazard Too Big To Fail Why were banks willing to take risks that proved so damaging both to themselves and the rest of the economy? One of the key reasons…is that the incentives to manage risk and to increase leverage were distorted by the implicit support or guarantee provided by government to creditors of banks that were seen as “too important to fail”. Mervyn King Governor of the Bank of England Oct. 20,2009

Dealing with “bigness” Alternative paths Regulation: restrict activities Current White House policy See also Canada: BBB Big boring banks Break up the banks “If they’re too big to fail, they’re too big. In 1911 we broke up Standard Oil — so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.” Alan Greenspan former Fed Reserve Chairman http://www.npr.org/templates/story/story.php?storyId=113650178

Lessons from other countries Simon Johnson Former Chief Economist at IMF Has overseen crises in many developing countries. http://www.theatlantic.com/doc/200905/imf-advice “…the economic solution is seldom very hard to work out. The real concern…is almost invariably the politics of countries in crisis. Typically, these countries are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks.”

Resources Rajan & Zingales Feel free to contact me: Saving Capitalism from the Capitalists Well researched discussion of the importance of finance for creating wealth Capture in historical perspective Goes beyond typical ideological disputes (left/right) Feel free to contact me: afja@uaa.alaska.edu