The Financial Crisis of and the Great Recession A Massive Failure of the Financial and Political Elites in the United States

Securitization and The Shadow Banking System (The Road to Hell is Paved With Good Intentions)

Types of Securitization Collateralized Debt Obligations (CDO) Asset Back Securities (ABS) Commercial Mortgage Backed Securities (CMBS) Residential Mortgage Backed Securities (RMBS)

The Three Pillars of the financial crisis (THE DOOMSDAY MACHINE) a. First, bad paper was widely written in the form of sub-prime mortgages. b. Second, these mortgages were securitized; the securities, endorsed by egregious evaluations by ratings agencies and marketing by financial institutions, were pushed to investors around the world (Lots of Extra Money Floating Around due to World Economic Development in the 1990s).

c. Third, the securities – mainly RMBS’s -- insured by credit default swaps. AIG was the dominant insurer. SECURITIZATION – These securities were used [ALONG WITH MANY OTHER SECURITIES] as collateral in the shadow banking system. d. The three pillars promoted a housing market bubble.

1. Securitization, plus … 2. Huge World Capital Surplus produced … The Shadow Banking System

Securitization and the Shadow Banking System These securities (along with many other securities – private & Fannie Mae and Freddie Mac) were used as collateral in the Shadow Banking System. Sale and Repurchase Market (“REPO”) – The essence of “Shadow” Banking. Shadow Banks (1) do not take deposits; (2) provide credit and liquidity; (3) no access to central bank funding or the FDIC.

“REPO” Market This Market only works if you have access to Collateral that is seen as “Good as Gold.” The Collateral must be SAFE – so safe that you do not have to worry about it or make much of an effort to investigate it.

1978Supreme Court deregulates consumer interest rates on credit cards; Maine allows entry of out- of-state banks. Similar laws passed in all states except Hawaii by Depository Institutions Deregulatory and Monetary Control Act. Eliminates regulation of interest rates. 1982Garn–St. Germain Act. Allows for adjustable rate mortgages and interstate acquisitions of troubled banks Federal Reserve, bank holding companies can acquire discount securities brokers. 1984Secondary Mortgage Market Enhancement Act. Facilitates private issuance of mortgage- backed securities. Preemption of state regulation. 1987, 1989, 1996Fed expands securities underwriting capacity of banks. 1989FIRREA passed to resolve savings and loan crisis, weak regulatory structure implemented. Timeline of Deregulation of Financial Markets

1994Riegle-Neal Interstate Banking and Branching Efficiency Act of Interstate acquisitions and branching permitted. 1999Gramm-Leach-Bliley Financial Services Modernization Act. Repeals Glass-Steagall separation of investment and commercial banking. 2000Commodity Futures Modernization Act. Deregulates derivatives markets. American Homeownership and Economic Opportunity Act. 2003American Dream Down payment Assistance Act. 2004SEC allows investment banks to expand leverage. 2005Congressional impasse on predatory lending. Republicans seek to eliminate state regulation, Democrats seek stronger regulation.

1977Community Reinvestment Act. Bans redlining. Used to increase -low-income loans of banks seeking merger approval. 1990Cranston-Gonzalez National Affordable Housing Act (the HOME Investment Partnerships Act) Housing and Community Development Act—Section VIII: Federal Housing Enterprises Financial Safety and Soundness Act. Lowered down-payment requirements. 1996Housing Opportunity Program Extension Act of American Homeownership and Economic Opportunity Act American Dream Down Payment Assistance Act. Timeline of Minority and Low-income Housing Legislation

Bubbles: Economic and Political

When the Housing Bubble Popped it triggered a classic Bank Run. Only it was a Run on the Shadow Banking System. This Brought the Economy Down.

What is a Bubble?? “This Dance Can go on Forever” Basically – “If it is too good to be true…..it ain’t”

Asset Bubbles and Political Bubbles are shaped by: Ideologies (Beliefs); Institutions; and Interests

Economic Bubbles Stock Market c – – “Irrational Exuberance” Dot Com Bubble in the late 1990s. – New Information Economy was emerging. “Bricks and Mortar” will be a thing of the past. Housing Bubble late 1990s – – Globalization and a Savings Glut from Developing countries could drive interest rates to permanently low levels.

Political Bubbles Stock Market c – – Not the Government’s Business. Dot Com Bubble late 1990s – If the information economy is the wave of the future it would be Luddism to tighten standards for public offerings or pricing of stock options. Housing Bubble late 1990s – – Markets self-correct (rational expectations). If savings glut reduces interest rates it would be folly for monetary policy to interfere.

Bubble Expectations 1) Investors appear to be only boundedly rational. 2) When you are riding the Bubble up the trick is to jump off before the peak. 3) When the policy makers share the bubble beliefs, they must also believe there is no rationale for intervention.

Almost Everyone Believes…… THIS TIME IS DIFFERENT!

The Ideologies at Work in the latest Crisis – 1990s to 2008 Free Market Conservatism Fundamentalist Free Market Conservatism Egalitarianism

THREE COMMON FEATURES OF TWO TYPES OF BUBBLES 1) shared ideology of market actors and politicians; 2) both are influenced by institutions – political rules determine economic rules; 3) Self Interest and Greed Hard to disentangle Greed and Ideology