1 Chapter 12 The Financial Collapse of 2007 - 2009 These slides supplement the textbook, but should not replace reading the textbook
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1
Chapter 12 The Financial Collapse of
2007 - 2009
These slides supplement the textbook, but should not replace reading the textbook
2
Where do we begin?
The role of government – free markets vs. a planned economy
3
Why is Growth important?
If we do not grow there is less goods and services
4
What is the upshot to the story of our
financial collapse? Government intervention
distorted markets
5
When was Fannie Mae founded?
It was founded in 1938 as a government sponsored enterprise (GSE), privately owned but publicly chartered, which went public in 1968
6
What is the purpose of Fannie Mae?
Its purpose is to expand the secondary mortgage market by securitizing mortgages in the form of mortgage backed securities (MBS)
7
What is a Security? A financial instrument
representing financial value such as mortgages, bonds, banknotes, stocks, future contracts, and derivatives
8
What does Securitizing securities mean?
The financial practice of pooling debts, like mortgages, and selling the consolidated debts as bonds (securities) which pay the investors principle and interest regularly
9
What is the purpose of Securitizing securities?
Its purpose is to allow lenders to reinvest their assets into more lending and in affect increase the number of lenders in the mortgage market
10
What are some problems with
securitizing debt? The complexity can limit
investors ability to monitor risk, and make it more difficult to standardize the market
11
What are some other problems with
securitizing debt? Off-balance sheet
arrangements and excessive leverage
12
What is an off-balance sheet arrangement?
Financial institutions can have responsibility for assets (often securities) for clients without actually owning the securities
13
What is leverage? Leverage is the practice of
investing with borrowed money. For example, in 2004 the SEC authorized investment banks to leverage with ratios as high as 40 to 1
14
What is Freddie Mac?
Authorized by Congress in 1972 to purchase private mortgages on the secondary market to compete with Fannie Mae
15
Why did Fan and Fred defraud investors?
To increase market share in the subprime loan market and to meet the demands of the Housing and Community Development Act of 1977
16
What is the Housing and Community Development
Act of 1977? Banks were required to make
substantial loans to low income persons even with bad credit ratings
17
Who is Angelo Mozilo and what is Country
Wide Mortgage? Angelo Mozilo founded
Country Wide, a mortgage company that specialized in subprime mortgages
18
What role did Country Wide Home Loans play?
Country Wide, partnered with Fannie and formed a reduced documentation loan program, Country Wide found the customers and Fan provided the money
19
What is an Alt-A Loan?
Sometimes called “Liar Loans” they required less documentation than traditional subprime loans
20
What is the Private Securities Litigation
Act of 1995? This act protected Wall Street
firms from legal suits and restricted investors from suing banks for fraud
21
What was the result of the secondary
mortgage market and the Private Securities Litigation Act of 1995?
They gave banks and mortgage related companies a free hand to engage in high levels of speculation and fraud
22
What is the Financial Crises Inquiry Commission?
A Congressional commission that spent 18 months investigating the subprime mortgage problem and in 2011 found Fan and Fred innocent of any fault and blamed the crises on private bankers
23
What is the lawsuit that the SEC brought
against Fannie and Freddie in 2012?
The SEC claims that six Fan and Fred executives defrauded investors because they knew and approved misleading statements about their subprime loan exposure
24
What is an example of hedging?
A farmer agrees to sell his corn to someone at a set price on a set date in the future
25
What is a hedge fund? A private investment fund
which may invest in a diverse range of assets and may employ a variety of investment strategies to protect from downturns and maximize the market upswings
26
What is a derivative?
A contract whose payoff depends on the behavior of some tradeable asset like a stock or a commodity
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What is a derivatives market?
A financial market for future contracts, these financial instruments in a futures market are called options
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What is a futures market?
A specific type of derivative involving a bet between two parties on the future price, called the strike price, of some specified standardized product, like the price of corn six months from the agreement
29
How is future value determined?
Derivatives often rely on some complicated mathematical model to determine future value, like the Black - Scholes model
30
What is an over-the-counter
derivatives market? A market that is an agreement
between two parties and no one else, the contract is personal between the two parties, there is no exchange where information is shared
31
Is it possible that even the purchaser of the derivative is not privy to the facts?
Yes, investment companies like Bear Stearns often sold contracts to others, like pension funds, without divulging all the facts
32
How large is the derivatives market today?
The notional value, the hypothetical value existing only in theory, is about $600 trillion!!!
33
What is the Commodity Futures Trading
Commission (CFTC)? Authorized to regulate agricultural futures and the derivatives market
34
Who is Brooksley Born? She was the head of the Commodity Futures Trading Commission from August 1996 to June 1999
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What did Brooksley Born do as head of the CFTC? She lobbied Congress and the President to give the CFTC oversight of the over-the-counter derivatives market
36
Why was Brooksley Born concerned ?
Dangerous things were happening in the market like fraud and excessive speculation leading to major failures
37
What was the event that brought these excesses to light?
In 1996 Proctor and Gamble ended up owing $200 billion in the derivatives market and it sued their derivatives dealer, Bankers Trust, for fraud claiming it was not given proper explanation
38
What was the outcome between
Proctor and Gamble and Bankers Trust?
In 1996 Bankers Trust settled with Proctor and Gamble forgiving most of the debt
39
What happened after Brooksley Born
alerted the Treasury, the Fed, and the SEC about her concern? She was relieved of her
jurisdiction over the derivatives market
40
Who is Alan Greenspan?
He was Chairman of the Fed from 1987 to 2006
41
Who was Ayn Rand (1905-1982)?
She was a playwright, screenwriter, and author who wrote The Fountainhead (1943) and Atlas Shrugged (1957)
42
What was Ayn Rand’s philosophy?
She believed in a strict laissez faire capitalistic economic system with minimal government and where rational self-interest plays a key role
43
Who was Atlas in Greek mythology?
He was a god who held the world on his shoulders
44
Who was Atlas in her book Atlas Shrugged? The entrepreneur, when he
shrugs the whole world comes tumbling down
45
How did Ayn Rand influence Alan Greenspan?
He was her protégé and close friend
46
What was Alan Greenspan’s response
to Brooksley Born? He believed that the free
market would take care of all problems and that any interference in the market would be harmful
47
What is leverage?
The act of using borrowed money to make bets on some future event
48
What happened to Long Term Capital in
1998? Long Term Capital, a hedge
fund, was highly leveraged in the derivatives market with $1.25 trillion notional value with only $4 billion capital to back it up
49
What happened to Long Term Capital?
In 1998 big banks stepped in and took over Long Term Capital and incurred large losses on its leveraged investments
50
What is the Commodity Futures Modernization
Act of 2000? This act stripped the
Commodity Futures Trading Commission of all responsibility over the derivatives market
51
What did the Modernization Act do ? It forbid state regulators to
interfere with the over-the-counter derivatives market
52
What did rent seeking have to do with the
situation between 2000 and 2010?
Wall Street firms plied over $1.7 billion in campaign contributions and $3.4 billion on lobbyists
53
What was the Glass-Steagall Act of 1932 ?
This act separated commercial banking from investment banking, commercial banks were regulated and investment banks were not
54
What happened to the Glass-Steagall Act?
The Commodity Futures Modernization Act of 2000 obliterated the difference between commercial banks and investment banks
55
What else did the Modernization Act of
2000 do? The FDIC granted the
same protection to investment banks as they did to commercial banks
56
What is a Credit Default Swap?
A CDS is a bet on a future event involving a hedge against a possible default, for a price it transfers liability on an investment from party A to party B
57
When did CDSs emerge?
In 1994 when young executives from JP Morgan bank had a weekend meeting in Boca Raton Florida
58
What is the American International Group (AIG)?
AIG is an American insurance corporation who in 2008 was the 18th largest public company in the world
59
What is an example of a CDS?
Bank A lends one million dollars to the XYZ company and then pays AIG to take the risk of a possible default
60
What effect did a bank’s CDS have on its
excess reserves? The Fed agreed to lower its
reserve requirement because of the lower risk incurred by banks
61
Who is Joe Cassano?
Between 2001 and 2008 he was the head of the Financial Products Division of AIG
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What did Joe Cassano do?
He sold billions of dollars worth of CDSs to banks without the assets to back up the insurance
63
What is a Naked CDS? In a naked CDS neither party
actually holds the underlying loan, in essence two non-involved parties make a bet on some future event
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How did Joe Cassano use Naked CDSs?
He sold CDSs protection to numerous non-involved banks on the same loan
65
What is a Subprime Mortgage?
A type of mortgage which involved a high level of risk to the lender and in some cases actual deceit and fraud
66
What is the Securities and Exchange
Commission (SEC)? This commission is responsible
for enforcing the federal securities law and regulating the securities industry
67
What did the SEC do in 2004 that effected the
securities market? It allowed banks to set their
own “debt-to-net-capital rule” which changed the industry standard from a 12 to 1 debt capital ratio to 40 to 1 ratio
68
Which firms benefited the most from this
change in legal ratios? • Goldman Sachs • Bear Stearns • Morgan Stanley • Merrill Lynch • Lehman Brothers
69
What happened in 2008 to these investment banks? They all collapsed and either
disappeared or were converted to bank holding companies so they could be bailed out by the Fed
70
What precipitated the Financial Bubble in 2000?
• Fed policies • Deregulation mania • Excessive leverage
71
What is an Adjustable Rate Mortgage Loan?
The interest rate would increase over time according to a pre-determined schedule
72
What does it mean to be upside down on a
mortgage? You owe more on a house
than what the house is worth on the market
73
What mandates were put on Fannie Mae and Freddie Mac in 2004?
They were required to purchase subprime loans from banks to the tune of about $1 billion per week
74
What is a Collaterized Debt Obligation (CDO)? A type of structured asset
whose value and payments are derived from a portfolio of fixed income assets, it is a collection of streams of income under one roof
75
How are CDOs structured?
Hundreds of loans are put into a pool and then divided into different tranches according to risk level
76
What gives CDOs value? The money that flows into and
out of the CDO as people pay their monthly installment loans or retire the loans
77
What is Standard and Poor’s and Moody’s? Two credit rating agencies
78
How did Standard and Poor’s and Moody’s
rate these CDOs? They looked at the senior
tranches with the highest value loans and rated the whole CDO according to this top tranche, the senior tranche
79
What are the 12 Deregulatory Steps to Financial Meltdown?
The 12 slides will discuss the 12 events which resulted in the financial collapse of 2007 to 2008 as explained in Sold Out of March 2009 http://www.wallstreetwatch.org
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#1 Repeal of the Glass-Steagal Act
The Financial Services Modernization Act of 1999 formally repealed the Glass-Steagal Act of 1932
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#2 Hiding Liabilities: Off Balance Sheet Accounting The Financial Accounting
Standards Board allowed securitized mortgages to be held as an off-balance sheet entity so that banks did not have to have capital reserves to secure the pool of loans
82
#3 The Executive Branch Rejects Financial
Derivative Regulation Brooksley Born was relieved of
her duties and the Commodity Futures Trading Commission was instructed to cease any activities over the derivatives market, as well as states
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#4 Congress Blocks Financial Derivative
Regulation The Commodities Futures
Modernization Act of 2000 exempted financial derivatives from regulation
84
#5 The SECs allowed Banks to set their own reserve requirements
In 2004 the SEC authorized investment banks to develop their own net capital requirements, this resulted in excessive leverage with ratios as high as 40 to 1
85
#6 Bank Self-Regulation Goes Global: Preparing Repeat of the Meltdown
The complicated financial maneuvering made it hard for international banks to agree and enforce any strict capital reserve requirements
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#7 Failure to Protect Predatory Lending
Regulators sat on their hands when it came to protecting abusive behavior in the sub-prime mortgage market
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#8 Federal Preemption of State Consumer
Protection Laws The Office of the Comptroller of
the Currency issued formal opinions preempting all state predatory lending laws, thereby rendering them inoperative
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#9 Escaping Accountability
Under existing federal law only the original mortgage lender is liable for any predatory and illegal features of a mortgage – even if the mortgage is transferred to another party
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#10 Fannie Mae and Freddie Mac Enter the
Subprime Market The purchase of subprime
assets was a break from prior practice but was forced on these agencies by Congress in their attempt to make every American a home owner
90
#11 Merger Mania The abandonment of antitrust
related principles over the past has enabled a concentration in the banking sector resulting in megabanks with to-big-to-fail status with government guarantees against failure
91
#12 Rampant Conflicts of Interest: Credit
Rating Firm’s Failure The credit ratings given by the
credit rating agencies were influenced by the fact that they got paid from the firms they rate resulting in the highest rating for CDOs based on the best mortgages in the pool
92
What is the Dodd-Frank Wall Street Reform and Protection Act of 2010?
An Act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes
93
How long is the Dodd-Frank bill and what are
some highlights? 2100 pages • New Consumer Protection Agency
tucked under the Federal Reserve • Establishes rigorous standards &
supervision for financial firms • Establishes council to identify
systemic risks
94
• Eliminates loopholes that allow risky and abusive practices
• Provides rules for transparency and accountability for credit rating agencies
• Strengthens oversight and empowers regulators to pursue financial fraud, conflict of interests, and any manipulation of the market
95
What is the Consumer Financial Protection Bureau as part of the
Dodd-Frank Bill? • Receives 10% of Fed’s assets but
is not under its jurisdiction • Led by an independent director • Able to autonomously write rules
for financial institutions • Authority to examine and enforce
regulations of banks with assets over $10 billion and all mortgage related businesses
96
• Consolidates numerous federal agencies
• Establishes a Financial Oversight Council made up of 10 voting members and 5 nonvoting to be chaired by the Treasury Secretary
• Establishes strict rules for capital, leverage, liquidity, risk management
• Establishes a new office of Financial Research
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• Provides the SEC and CFTC with authority to regulate over-the-counter derivatives
• Establishes a clearing house for derivatives
• Establishes a code of all swap dealers • Establishes a new Office of Minority
and Women Inclusion • Establishes standard for all home
loans
98
• Ends the “shadow” financial system by requiring hedge funds and private equity advisors to register with the SEC and provide information about their trades
• Establishes a new Office of Credit Ratings at the SEC
• Gives the SEC the authority to deregister an agency for providing band ratings over time
• Encourages people to report securities violations giving 30% of funds recovered by information
99
What is the Volcker Rule?
Implements regulations for banks, affiliates, and holding companies that prohibit proprietary trading, investments in hedge funds, and private equity funds
100
Tell me more
• YouTube "Fear the Boom and Bust" a Hayek vs. Keynes Rap Anthem
• YouTube "Hayek's 'Road to Serfdom' in Five Minutes“
• YouTube "Senator Paul Ryan on the Rule of Man vs. the Rule of Law"
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END
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