 News:  Followup on pay restrictions  Too big to fail.  Review of capture  Rajan & Zingales  More on securitization and credit ratings  How do banks work?  Chapter 10

 Executive pay at bailed out firms  Followup at Marginal Revolution :  What to do about big financial institutions ▪ ING (Dutch) financial firm forced to “downsize” today ▪ ▪ Contrast (probable) US approach ▪ Watch closely, failure controlled, don’t restrict size

 Rajan & Zingales  Saving Capitalism from the Capitalists ▪ Well researched discussion of the importance of finance for creating wealth ▪ Focuses on importance of capture as ever-present danger.  Simon Johnson  Adam Smith  “to widen the market and narrow the competition is always the interest of the dealers”

Mortgage Originations (Billions) Subprime Originations (Billions) Subprime Share in Total Subprime Mortgage Backed Securities Percent Subprime Securitized 2001$2,215$1908.6%$9550.4% 2002$2,885$2318.0%$ % 2003$3,945$3358.5%$ % 2004$2,920$ %$ % 2005$3,120$ %$ % 2006$2,980$ %$ % Increase in low quality loans in 2004 Increase in securitization – reduces incentive to make quality loans Mortgage Originations (Billions) Subprime Originations (Billions) Subprime Share in Total Subprime Mortgage Backed Securities Percent Subprime Securitized 2001$2,215$1908.6%$9550.4% 2002$2,885$2318.0%$ % 2003$3,945$ % $ % 2004$2,920$ % $ % 2005$3,120$ %$ % 2006$2,980$ %$ %

 Dramatic increase in subprime lending (2004)  SEC allows more leveraged investment banks ▪ New research from the FED  Federal preemption of state “predatory lending” laws.  Housing prices (Academic Research) ▪ Had been trending higher ▪ Disconnect from economic fundamentals at this time 1-5

 SEC allows more leveraged investment banks  Rapid increase in subprime loans  New evidence: Disproportionate focus on ▪ Low quality loans in high price appreciation areas  Why? ▪ Credit rating agencies give higher ratings (ceteris paribus) where price appreciation has taken place. ▪ Cheapest way to AAA rating is to package low quality high price appreciation  Credit agency default models are critical component  Potential conflict of interest ▪ Those bundling the securities pay the agencies for the ratings. 1-6

The Bank Balance Sheet  Liabilities : Sources of funds  Checkable deposits  Nontransaction deposits  Borrowings  Bank capital

The Bank Balance Sheet  Assets: Uses of funds  Reserves  Cash items in process of collection  Deposits at other banks  Securities  Loans  Other assets