1. Bubbles and Bailouts Guest Lecture: 2010/02/22
Political Science 301: Comparative Political Economy
Jonathan Alevy: Department of Economics

2. Lecture Outline
How do economists think about pricing in financial markets
Contrast with goods markets
Housing market lending
Lending quality declines
Bailouts
Impacts

3. Housing prices 1:

4. Housing Prices: Bubble and Crash
Two lines of prices note real and nominal. The last years… a housing bubble? Bubble is a divergence from fundamental values….what is a fundamental value? Need a model

5. Stock Prices

6. Carbon Permits: European Union
Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

7. Are financial (& housing) markets efficient?
In an efficient market, a security’s price fully reflects all available information
Implication 1: Prices are “the right prices”
good signals for making investments, hiring decisions
Implication 2: There are no unexploited profit opportunities. (hard to make money)
Note: #2 may be correct even if #1 is wrong.

8. What makes markets efficient?
A person’s behavior reflects their private information
Assumption: people want to profit
Profit seeking behavior spreads information to the market
Therefore:
Market price reflects all available information or aggregates private information

9. Arguments for and against EMT
People need not be rational
If rational…it works
If not rational and trade at random
No important effect on prices (on average they cancel each other out)
If deviate from rationality in same way (e.g. follow charts, sentiment etc.)
Creates a “risk-free” profit opportunity for rational traders (arbitrageurs)
Systematic irrationality: Sentiment - Belief in rising prices
Must be strong enough to overwhelm rational traders.
Does seem to happen from time-to-time
Conclusion: Markets “pretty efficient, most of the time”

10. Bubbles in the laboratory.

11. Bubbles reduce over time

12. Laboratory Asset Markets
Fundamental value known with certainty.
Not true in the real world
Coordinating Expectations through experience
Not always possible in the real world.

13. Back to the crisis
Causes
Responses
What’s next

14. Lending Statistics 8.5% 18.5% Increase in low quality loans in 2004
Mortgage Originations (Billions)
Subprime Originations (Billions)
Subprime Share in Total
Subprime Mortgage Backed Securities
Percent Subprime Securitized
2001
$2 ,215
$190
8.6%
$95
50.4%
2002
$2,885
$231
8.0%
$121
52.7%
2003
$3,945
$335
8.5%
$202
60.5%
2004
$2,920
$540
18.5%
$401
74.3%
2005
$3,120
$625
20.0%
$507
81.2%
2006
$2,980
$600
20.1%
$483
80.5%
Mortgage Originations (Billions)
Subprime Originations (Billions)
Subprime Share in Total
Subprime Mortgage Backed Securities
Percent Subprime Securitized
2001
$2 ,215
$190
8.6%
$95
50.4%
2002
$2,885
$231
8.0%
$121
52.7%
2003
$3,945
$335
8.5%
$202
60.5%
2004
$2,920
$540
18.5%
$401
74.3%
2005
$3,120
$625
20.0%
$507
81.2%
2006
$2,980
$600
20.1%
$483
80.5%
Increase in low quality loans in 2004
Increase in securitization – reduces incentive to make quality loans

15. Empirical Evidence 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.

16. Potential Causes of Subprime Lending Surge
Regulatory changes
SEC allows more leveraged investment banks
Federal preemption of state “predatory lending” laws.

17. Bailout of financial system
Biggest beneficiary: AIG $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

19. Real GDP

20. Unemployment claims

21. Sources of Bailout Monies
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

22. Moral Hazard 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

23. Dealing with “bigness”
Alternative paths
Regulation: restrict activities
Current White House policy
See also Canada: BBB
Big boring banks
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

24. Lessons from other countries
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.”

25. Resources Rajan & Zingales Feel free to contact me:
Saving Capitalism from the Capitalists
Well researched discussion of the importance of finance for creating wealth
Capture in historical perspective
Goes beyond typical ideological disputes (left/right)
Feel free to contact me: