Financial Institutions and Markets Market Failure, Crises, and Regulation

Financial Markets and Society Financial exclusion Household indebtedness Fraud and scandals Market bubbles, crashes, and financial crises

The Financial Crisis of 2008: What Happened? Financial institutions created instruments they did not fully understand Lenders made loans which borrowers could not pay Individuals bought houses they could not afford Insurance companies underestimated losses Rating agencies accepted unrealistic projections

The Role of Financial Institutions Securitization: a finance tool designed to increase liquidity and lower risk and cost in the debt markets Motivation? Additional revenue for the investment bank Accountability? Minimal; the investment bank does not have capital at risk

The Role of Lenders Traditional loan requirements Verified employment Good credit history Meaningful down payment New loan requirements No employment verification “Subprime” credit options No down payment required Interest rate structure – from fixed to variable

The Role of Individuals Lack of personal financial accountability Blind faith in the continued increase in real estate values Borrowing against real estate for personal expenditures

The Role of Insurance Companies Failure to realistically assess projected loan performance assumptions Conflict of interest; no insurance, no income

Rating Agencies Failure to realistically assess loan performance assumptions Conflict of interest; no rating, no revenue Overreliance on credit insurance without considering the insurers’ ability to pay

Why Did It All Come Crashing Down? Spending was based on debt, not the fundamental economic concept of growth Debt was based on increasing real estate values, not the fundamental economic concept of risk Increasing real estate values were the result of increased availability of debt, not the fundamental economic concept of value

Financial Markets and Government Regulation A free market economy Allows individuals to make choices in their best interest Provides opportunity for manipulation and excess Government regulation Limits individual choice Limits the potential for manipulation and excess