 Financial Crises:  Chapter 9  Regulation and Capture  Calomiris and Johnson

 At worst CRA no worse than other lenders…probably better  Retail presence is important  “… one of the more interesting findings of our research is the evidence that some aspect of “local” presence seems to matter in predicting the sustainability of a loan. ▪ Once a lender is removed from the community…or from the origination decision (wholesale loan)…foreclosure increase significantly.”  CRA & asymmetric information  Low-income neighborhoods contain people who are good credit risks.  Local bankers are gathering information on who these people are ▪ Therefore make better loans.

Factors Causing Financial Crises  Asset Markets Effects on Balance Sheets  Stock market decline ▪ Decreases net worth of corporations.  Unanticipated decline in the price level ▪ Liabilities increase in real terms and net worth decreases.  Asset write-downs. ▪ E.g due to mortgage foreclosures

Path of Financial Crises  Deterioration in Financial Institutions’ Balance Sheets  Decline in lending.  Banking Crisis  Loss of information production and disintermediation.  Bank runs in all crises up through 1933.

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  Federal preemption of state “predatory lending” laws.  Housing prices ▪ Had been trending higher ▪ Disconnect from economic fundamentals at this time  Low quality loans are securitized  Holders want ‘insurance’ against default ▪ Credit default swaps ▪ AIG is the biggest player, but sells their insurance too cheaply. 1-8

 Regulatory changes  SEC allows more leveraged investment banks ▪  Federal preemption of state “predatory lending” laws. ▪ led-to-more-foreclosures/ led-to-more-foreclosures/ 1-9

 AIG bailouts, $185 Billion: Who benefits?  Recipients of bonuses (relatively small amount)  Counterparties ▪ Owners of AIG issued CDS ▪ Primarily domestic and foreign “risk-taking” banks  Financial System ▪ defaults pose systemic risk, one firm’s default causing others to be insolvent  Purpose is to support real economy 1-10

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 Direct aid to financial institutions  TARP funds  Fed Lending  Total about 4 trillion  Stimulus Spending  Total about 800 billion  Bernanke  Fed Chair: Scholar of the Great Depression

 Too Big To Fail Why were banks willing to take risks that proved so damaging both to themselves and the rest of the economy? One of the key reasons…is that the incentives to manage risk and to increase leverage were distorted by the implicit support or guarantee provided by government to creditors of banks that were seen as “too important to fail”. Mervyn King Governor of the Bank of England Oct. 20,2009

 Alternative paths  Regulation: restrict activities ▪ Current White House policy  Break up the banks ▪ “If they’re too big to fail, they’re too big. In 1911 we broke up Standard Oil — so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.” ▪ Alan Greenspan former Fed Reserve Chairman 

 Simon Johnson  Former Chief Economist at IMF  Has overseen crises in many developing countries.  “…the economic solution is seldom very hard to work out. The real concern…is almost invariably the politics of countries in crisis. Typically, these countries are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks.”

 Rajan & Zingales  Saving Capitalism from the Capitalists ▪ Well researched discussion of the importance of finance for creating wealth ▪ Capture in historical perspective  Feel free to contact me: 