Financial Crisis Activity * Thanks to Curt Anderson, University of Minnesota, Duluth.

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Presentation transcript:

Financial Crisis Activity * Thanks to Curt Anderson, University of Minnesota, Duluth

Slippery Economics Casino You have 3 options: Option 1: Don’t Play Option 2: Flip a coin; if heads you get $5 and if tails you lose $5 Option 3: Flip a coin; if heads, you get $100 and if tails you lose $100

Case 1 You may choose Option 1 (Don’t Play) or Option 2 ($5), but NOT Option 3. Hands: How many for Option 1? Hands: How many for Option 2?

Case 2 You may choose any option. Hands: How many for Option 3? Hands: How many for Option 2? Rest for Option 1.

Case 3 You may choose any option, but you receive (or pay) 20% of the amount stated. Hands for Option 3 (Win/Lose $20)? Hands for Option 2 (Win/Lose $1)? Rest for Option 1.

Case 4 You may choose any option, but you receive (or pay) 5% of the amount stated. Hands for Option 3 (Win/Lose $5)? Hands for Option 2 (Win/Lose $0.25)? Rest for Option 1.

Case 5 You may choose any option, but you receive 5% of the amount stated or pay $0. Hands for Option 3 (Win $5/Lose $0)? Hands for Option 2 (Win $0.25/Lose $0)? Rest for Option 1.

What does it mean? Normal economics behavior (responding to incentives) means people will move from no-risk Option 1 and low-risk Option 2 to high-risk Option 3 as we move from Case 1 to Case 5. The reasons are: Regulation Leverage Moral Hazard.

Regulation The changes from Case 1 to Case 2 indicate the effect of regulation (not allowing certain risky behaviors). Risk lovers will select Option 3 when they are allowed to do so, but the risk-averse will stay with lower-risk Option 2 or no-risk Option 1.

Leverage The changes from Case 2 through Case 4 show the effects of higher degrees of leverage (your money at risk is only part of the whole risk). Higher leverage means less of your money at risk, so your potential loss is lower. Higher leverage means people are willing to play the riskier options (Options 2 and 3).

Moral Hazard Movement from Case 4 to Case 5 indicates the effects of moral hazard (perverse or incorrect incentives). If there is no way to lose because someone will cover your losses (or bail you out) then any real risk is gone. Most people will select Option 3.

Leverage: Playing with Other People’s Money 1.0 Regulated Insurance Company Assets:$1,000 m (quality/type regulated) Debt (Liabilities):$ 750 m Equity/Capital:$ 250 m Debt/Equity Ratio:3:1 Company could withstand a 25% decline in the value of its assets.

Leverage: Playing with Other People’s Money 2.0 FDIC-Insured Bank Assets:$1,000 m (quality/type regulated) Debt (Liabilities):$ 900 m Equity/Capital:$ 100 m Debt/Equity Ratio:9:1 Company could withstand a 10% decline in the value of its assets.

Leverage: Playing with Other People’s Money 3.0 Unregulated Investment Bank or Insurance Company Assets:$1,000 m Debt (Liabilities):$ 970 m Equity/Capital:$ 30 m Debt/Equity Ratio:32:1 Company could withstand a 3% decline in the value of its assets.

Timeline: 1980s 1982: Savings and Loans were deregulated—allowed to lend outside home mortgages 1989: S&L collapse due to risky and fraudulent real estate deals. Federal government provides bailout.

Timeline: 1990s 1994: Hedge funds (unregulated) including Long-Term Capital Management (LTCM) start. 1998: Russian default on debt causes massive losses for LCTM leading to ~$3.6 billion bailout by federal government. 1999: Freddie and Fannie relax mortgage requirements to encourage home ownership.

Timeline: : Fed lowers federal funds rate to1% due to 9/11 and recessionary economy 2002: Housing market booms with EZ terms and low-cost credit 2004: Investment banks (ML,GS, LB, BS, MS) get SEC to allow leverage increase from 12:1 to 40:1 without any oversight. Mortgage bundling rises.

Timeline: : Mortgage brokers offer riskier loans (0% down, “teaser” rates, sub-prime) to feed banks’ demand for mortgages. All share assumption: house prices will rise; mortgages are safe so shaky mortgages are easy to refinance. 2006: Investment banks create securities (CMOs) and buy bond insurance based on mortgage bundles, all unregulated and very difficult to value.

Timeline: : Housing market troubles (Oversupply? Lagging personal income growth?) lead to defaults on mortgages as they cannot refinance lower housing prices 2008: Investment banks’ high leverage (>30:1) mean they don’t have cash to pay interest on mortgage-backed securities. Insurance companies’ high leverage (AIG) means they can’t cover losses on these bonds.

Backup Plan (Moral Hazard) $700 billion bailout

The World’s Banks Could Prove Too Big to Fail—or to Rescue rldbusiness/11charts.html?partner=permalink&e xprod=permalinkhttp:// rldbusiness/11charts.html?partner=permalink&e xprod=permalink New York Times Off the Charts By FLOYD NORRIS Published: October 11, 2008 As the banking system quaked this week in many countries, one question was asked quietly: Can the governments afford it?

Banks versus Bank Holding Companies US: Bank short-term liabilities are 15% of GDP US: Bank holding companies