Causes of the Financial Crisis (PREP: Open WSJ video clips “End of Wall Street” series) (PREP: Open WSJ video clips “End of Wall Street” series) Main Causes of the Crisis: Main Causes of the Crisis: Risky Home Mortgages Risky Home Mortgages Consumer Debt Consumer Debt Financial Industry – Risky Investments Financial Industry – Risky Investments Failure of Ratings Agencies Failure of Ratings Agencies Deregulation Deregulation Failure of Regulation Failure of Regulation

Risky Home Mortgages What is a mortgage? What is a mortgage? Downpayments Downpayments –20% down vs. less down + mortgage insurance Types of Mortgages Types of Mortgages –Fixed rate vs. Adjustable rate Subprime Loans Subprime Loans –Given to people with poor credit ratings or very low downpayments

Subprime Frenzy Clinton and Bush Policies Encouraging Homeownership Clinton and Bush Policies Encouraging Homeownership Wall Street Derivatives fueled Subprime Frenzy Wall Street Derivatives fueled Subprime Frenzy Fannie Mae and Freddie Mac Fannie Mae and Freddie Mac Countrywide and New Century Countrywide and New Century Predatory Lending Predatory Lending  Knowingly lending more than borrower could repay  Unreasonably high interest rates  Falsifying loan applications Real Estate Bubble Real Estate Bubble Bubble Bursts  Mortgage Default Crisis – 2007 & 2008 Bubble Bursts  Mortgage Default Crisis – 2007 & 2008 Question: Who is to Blame? (see article) Question: Who is to Blame? (see article)

Risky Investments by Financial Industry “Today when I am asked if anyone saw this crisis coming….my answer is yes. We invented the products that ultimately blew up the banks. We created the instruments at the center of the subprime mortgage meltdown. We fostered a culture of epic greed, which nearly destroyed the financial system….if you are looking for a single word to use in laying blame….Derivatives. Without derivatives, leveraged bets on subprime mortgages could not have spread so far or so fast.” “Today when I am asked if anyone saw this crisis coming….my answer is yes. We invented the products that ultimately blew up the banks. We created the instruments at the center of the subprime mortgage meltdown. We fostered a culture of epic greed, which nearly destroyed the financial system….if you are looking for a single word to use in laying blame….Derivatives. Without derivatives, leveraged bets on subprime mortgages could not have spread so far or so fast.” – Frank Partnoy, Director of UC San Diego’s Center for Corporate and Securities Law – Frank Partnoy, Director of UC San Diego’s Center for Corporate and Securities Law

Financial Industry: Derivatives as “WOMDs” Collateralized Debt Obligations –Subprime mortgages bundled with other investments & resold –Hard to value the investment/risk because so complex –“Toxic Assets” Commissions from banks for selling CDOs was much higher than on other investments Mathematical Model Derivatives fueled the Subprime Mortgage Frenzy

More Derivatives: Credit Default Swaps Credit Default Swaps Credit Default Swaps –What is a credit default swap? –Unregulated –Insurance or Gambling –Don’t have to follow standard Insurance regulations (AIG example) Exported our debt  global crisis Exported our debt  global crisis Cyclical Effect: stock market plunges  fewer loans made  businesses go under  layoffs  more people default on mortgages  confidence plunges  How end cycle? Taxpayers on the hook Cyclical Effect: stock market plunges  fewer loans made  businesses go under  layoffs  more people default on mortgages  confidence plunges  How end cycle? Taxpayers on the hook Why was this allowed? Why was this allowed? –Pressure for ever-more profits for shareholders –Short-term rewards for corporate executives –Lobbying? Campaign Donations? Question: Who is to Blame? (see article) Question: Who is to Blame? (see article)

Failure of Ratings Agencies Gave highest ratings to risky derivatives “AAA” Gave highest ratings to risky derivatives “AAA” –Despite giving much lower ratings to the underlying assets Why? Why? –Mathematical Model? –Conflict of Interest - Ratings agencies paid by the companies they are rating (not by consumers) –Banks paid them triple the usual fees

Deregulation of Financial Industry (Lobbying intro…) Reagan –Began financial deregulation –End New Deal restrictions on mortgage lending –1982 Garn-St. Germain Depository Institutions Act - Deregulation of Savings & Loans Early Warnings: Early Warnings: –S & L crisis of 1980s (Taxpayer bail out of $124 billion) –1998 failure of Long Term Capital Management

Deregulation continues in the 90s 1999 Financial Services “Modernization” Act 1999 Financial Services “Modernization” Act –Gramm-Leach-Bliley Act –Repeal part of 1933 Glass-Steagall Act –Tore down firewalls b/w banks, securities companies, insurance companies Result of 1999 Gramm-Leach-Bliley Act? Result of 1999 Gramm-Leach-Bliley Act? No coincidence that in 1 month we saw… –Failure of largest insurance company in world (AIG insurance) –Largest bank failure in US history (Washington Mutual S &L) –Largest bankruptcy in US history (Lehman Brothers investment bank) –Failure of Fannie Mae & Freddie Mac (owned/guaranteed over 40% of all mortgages in U.S.) –TOO BIG TO FAIL? Senator Phil Gramm (TX)

More Deregulation in Commodity Futures “Modernization” Act –Lobbied for by Wendy & Phil Gramm –Pushed for by Alan Greenspan, Sec. Treasury Robert Rubin –Slipped into bill at 11 th hour in December – never debated –Signed by President Clinton –Exempted derivatives like credit default swaps from regulation

Failure of Regulation Another Warning: Another Warning: –Enron Collapse –Still no change to unregulated derivatives Federal Reserve Federal Reserve –led efforts to deregulate derivatives –Resisted crackdown on subprime lenders by Fed –Could have raised interest rates more to slow housing bubble Executive Branch: Executive Branch: –HUD Policies –Securities and Exchange Commission  Sec. Levitt and Sec. Cox Alan Greenspan, former Chair of Federal Reserve, acknowledged he made a mistake in presuming that the banks’ self-interest would cause them to regulate themselves.

Who Benefitted? Corporate Executives Corporate Executives Companies repaid with taxpayer money Companies repaid with taxpayer money Foreign Debtors who own U.S. debt Foreign Debtors who own U.S. debt Subprime lenders who made fast buck Subprime lenders who made fast buck We ALL benefitted from lower interest rates for a while We ALL benefitted from lower interest rates for a while Much of wealth was imaginary (bubble) Much of wealth was imaginary (bubble)

Consumer Debt Consumer Debt Why has consumer debt increased so much? Why has consumer debt increased so much? Material culture Material culture Wages not keeping pace with cost of living Wages not keeping pace with cost of living ….despite growing worker productivity ….despite growing worker productivity Healthcare, College, Housing, Inflation, Taxes Healthcare, College, Housing, Inflation, Taxes What kept economy going? What kept economy going? –Moving from 1  2 earner families –Increasing consumer debt – credit cards –Housing and Stock Bubbles –Home Equity loans INCREASING WEALTH & INCOME INEQUALITY INCREASING WEALTH & INCOME INEQUALITY –Income inequality at highest level since 1913 except one other year (source: Economic Policy Institute) CEO pay vs. Avg. worker (chart 3A p. 221) CEO pay vs. Avg. workerCEO pay vs. Avg. worker –From 1995 to 2004, 90% of gains in wealth occurred only in top 25% of households. See Income and wealth Distribution (source: Joint Center for Housing Studies at Harvard, see chart 2 p. 10 and chart 4 p. 13) Income and wealth DistributionIncome and wealth Distribution –Top 1% own more than bottom 90% of workers (EPI)

Where Do We Go From Here? Wall Street & Mortgage Reforms Wall Street & Mortgage Reforms Reforms in Lobbying, Revolving Door, Campaign Finance? Reforms in Lobbying, Revolving Door, Campaign Finance? Global Competitiveness: Global Competitiveness: –Americans have to save more, produce more, and carry less debt. –Invest in Technology, Infrastructure, Education, and Energy Conservation & Green Technologies Lend each other a hand Lend each other a hand Creative ideas? Creative ideas?

Discussion QUESTION: QUESTION: What policies would you put in place to prevent such a crisis from happening again? What policies would you put in place to prevent such a crisis from happening again? FUTURE DISCUSSIONS: FUTURE DISCUSSIONS: What role did the Media Play? What role did the Media Play? How Could Congress Allow this to Happen? How Could Congress Allow this to Happen? To Bail or not to Bail? How fix the Financial Crisis? To Bail or not to Bail? How fix the Financial Crisis?