The Financial Crisis 2007 1 Dorian Ford Prince, May 2010.

The Financial Crisis 2007The Financial Crisis 2007

1Dorian Ford Prince, May 2010Dorian Ford Prince, May 2010

Capitalism = ‘boom’ and ‘bust’some recent crises:

Tulip mania - Netherlands 1637South Seas Bubble, UK 1720The Mississippi Bubble, France 1720, John Law, first paper moneyPanic of 1819 – USAThe Long Depression 1876 – 1896 UK, USA, EuropePanic of 1907Wall Street Crash – 1929, Great Depression 1930-45Oil crisis 1973 (UK – IMF in 1976)Savings and Loan Scandal, USA, 1986-96, US$ 125 bn bailoutJapanese asset bubble – 1986 - ?Mexico 1994 Asian financial crisis (“IMF crisis”) – Thailand, Indonesia,

South Korea,Philippines, 1997-8Russian financial crisis 1998Dot-com bubble 1995-2001Argentina defaults – largest debt default in history - 2002

2Dorian Ford Prince, May 2010

First paper banknote issued by John Law 1714

Dorian Ford Prince, May 2010 3

Financial Crisis 2007

Or The End of Economic Theory?

Economists cannot agree on :

• what caused the crisis

•What are the short, medium and long term effects

•Who is to blame

•How long it will last

•Solutions

•When the next crisis will happen

Possible causes

1. Loose monetary policy – low interest rates2. Financial deregulation3. New, complex, innovative financial products4. US housing boom, sub-prime mortgages5. Globalisation and the new US-Asia economic

model6. Ratings Agencies


1. Loose monetary policy and low interest rates

• After ‘Dot-com bubble’ and 9/11, FED reduces interest rates from 6.5% in 2000 to 1% in 2003

• Printed too many dollars – banks had too much cash

• Foreigners increased holdings of US Treasury bonds, increasing liquidity. Proceeds mainly went into housing market.

• FED increased interest rates to 6% in 2006, many householders not could not reimburse their mortgages


Alan Greenspan, Chairman,US Federal Reserve, 1987-2006

2. Financial Deregulation• In 1999, President Clinton abolishes Glass-Steagall Act of 1933, separating

commercial banking from investment banking• In 2004, Securities and Exchange Commission relaxes restrictions on

amount of debt which investment banks are allowed to hold• US regulators allow major deposit banks to move assets and liabilities off

their balance sheets into “structured investment vehicles”• Growth of ‘shadow banking system’ unchecked and unregulated. By end

2006, unregulated banks are bigger than traditional, regulated banks• In 1997 FED Chairman Greenspan blocks attempts to regulate

“derivatives”• In 2000, President and Congress allow ‘credit default swaps’ to be self-

regulated


3. New Financial Products• Structured investment vehicle – accounting trick by

banks to get around capital and risk requirements• Derivative – insurance policy guaranteeing future value

of a commodity, equity or loan• Mortgage backed securities - bundle together disparate

loans (such as sub prime mortgages, car loans), and/or risky investments, create packaged securities and sell off the shares

• Credit default swaps – A contracts a risky loan with B then asks C for an insurance policy whereby if B cannot pay (defaults), C will pay A an amount. In return C charges a premium. In order to spread the risk, C bundles together all sorts of risks into derivatives which it sells to other institutional lenders. In 2007, CDS worldwide were worth US$ 58 trillion while world GDP was only US$ 54.3 trillion


“Financial weapons of mass destruction” Warren Buffett

4. US housing boom

Average US Home prices Growth in subprime loans


US Housing Crash• Not enough mortgages to satisfy Wall Street’s demands for

derivatives, so riskier loans, second mortgages to finance consumers

• Interest rates increase suddenly from 1% to 6% so by August 2008, 15% of all mortgages had defaulted

• Mortgages as % US GDP increased from 45% in 1990 to 73% in 2008. US private household debt represented 127% of personal disposable income by end 2007. By end 2008, US private debt equals 290% GDP

• 6 million Americans lost their homes• House prices fell by 30-40% in 2008, MBS and CDS shown to be

worthless pieces of paper


5.(a) Globalisation


5(b) New US-Asia Economic Model


US trade deficit (2008):China $270 bnJapan $70 bn

Stocks of US Treasury Bonds:China $ 810 bn Japan $1106 bn

6. Ratings agencies

• Only 3 Ratings Agencies (Moody’s, Fitch, S&P) = world cartel

• All the derivatives, CDS, MBS etc, plus all the investment banks (including Bear Stearns and Lehman) had been given AAA ratings as “safe investments”

• Since 2000, ratings agencies paid by the companies they rated rather than by potential investors


EFFECTS

• Unemployment reaches 10% in USA, 15% in UK, 21% in Spain, 30% Greece

• Iceland collapses. Ireland collapses.• Greece, Portugal, Spain? Break-up of EURO?• Bank runs lead to US bailout costing over $ 2 trillion,

UK bailout 2 trillion pounds (UK debt now equals 120% GDP)

• World trade falls by 40% in 2008 – so far no real recovery


Solutions?

• Reduce interest to 0 • Print money (extra $3trillion in US)• Increase budget deficit (record $ 15 trillion

expected in US by 2015 = 100% GDP)• Stimulus package (infrastructure, health

education programmes, US$ 1 trillion)• Re-regulate the financial services industry

(Obama legislation, IMF proposed tax on financial services, SEC investigation into Goldman Sachs, G20 programme)


But haven’t these solutions been tried before?

• Weimar Republic 1919-33• Japan 1990 –• Zimbabwe 2000 -


50 Million Mark noteIssued in 1924Worth only US$1

How long will the Financial Crisis last?


Ben BernankeUS Fed Chairman

“Technically, the recession is over but the economic recovery will appear very weak in 2010”, Bernanke, September 2009

Stock markets reach historic highs in April 2010

Domestic growth high in some Asian markets

BUT problems loom.....

• US and EU consumers (70% of world economy), affected by unemployment and debt, reluctant to resume buying

• Income tax will rise in US and EU to repay extravagant fiscal deficits, further depressing consumption

• World trade will only recover slowly, especially if US imposes trade restrictions

• Sovereign debt crisis will affect many other countries (and many states of the US)

• New asset bubbles. Next Asian crisis? Bust in China? Default in Vietnam?

• Longer term – inflation? Currency devaluations?


Two views on financial institutionsAlan Greenspan, Chairman of the US Federal Reserve, 1987 - 2006

• “Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country … With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. … Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s “ 2004.

Sir Isaac NewtonCommenting on his personal financial loss during the South Seas

Bubble, 1720

• “I can measure the movement• of the stars, but I cannot• measure the madness of men”


The Financial Crisis 2007 1 Dorian Ford Prince, May 2010.

Documents

mortgages dorian ford

us gdp

us bailout

worth us

bn slide

us private debt

us housing crash

us trade deficit