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The Financial CrisisThadford Jackson
Preface History is not yet written
Ben Bernanke and the GD
Those who do not know the past….
Better still, those who know the past can profit in the future Biographies of business titans illustrate… You will witness from 5 to 50 financial/economic
troughs From households to global conglomerates!
Preface Blame who you want, but the bottom
line is all that counts
History is a model that is only as good as it is useful…to what end?
History is linear, though only by construction In fact, unfolding of events is
simultaneous and beyond the scope of comprehension
Preface A smart person learns from his own
past; a wise person learns from others’ past.
History is fascinating.
History repeats. 1907 versus 2007
Preface Much of what we ‘know’ is wrong!
Expertise is the realization of ignorance.
Concentrate on the history of the doers, instead of on the history of the pundits, critics, or intellectuals
Those who study history live on different planets from those who do not.
Probably no better preparation (besides experience) than business history
A note on mass media
Media are intent on profit; sober assessment of the facts does not sell as well as finger-pointing and crucifixion
As noted, scholarly assessments are incomplete at best
The Story Bankers, or “Wall Street” types, are bad
people (think ‘Jews’ and anti-Semitism) who: Intentionally loaned money to people who
could not afford to repay Reaped private gains, then leaving losses
to public Lied to, cheated, and stole from Main
Street Should be in jail!
The Story Republicans are greedy and corrupt
people who are in bed with the bankers W., an oil man, slashed all regulations on
banks which would have stopped the FC from ever happening
Democrats are redistributionist fools who forced banks to loan money to minorities who could not afford the houses that they acquired…and democrats are in the pockets of the big banks, of course.
Definitions Khan Academy on Credit Crisis Financial crisis
Highly damaging, usually sudden, event associated with large decline in asset values Bubbles bursting Banking panics/runs Spillover to ‘real’ economy?
Bubble Prolonged overvaluation of asset (class) from
fundamental value Tulipmania, South Sea Bubble, Roaring Twenties,
Tokyo real estate, Housing bubble Greater fool, extrapolation, herding
Definitions Subprime mortgage
Higher credit risk and higher returns Prime purchased by Fannie and Freddie Non-conforming
Derivative Financial product that ‘derives’ value from other
financial asset Option, future, forward, swap Can be combined to produced synthetic products
CDOs, CDSs, synthetic CDOs Leverage
Example of 100% equity stake versus 10% stake; i.e., leverage ratios of 0 versus 10 to 1
Definitions Commercial banks
Funnels deposits to investors Investment banks
Bank that does not take traditional deposits From G-S to G-L-B, firewall between banks and
IBs All major banks had IB functions after G-L-B
Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns, Lehmann Brothers, Blackstone, Nomura Securities examples of long-time, pure IBs
M&A, IPOs, advisory, wealth management, proprietary trading, private equity
Definitions Hedge Funds
Think mutual funds for sophisticated investors Sophisticated equals high net worth and
familiar with complex financial products Pensions, endowments, high net worth
individuals Can invest in wider variety of assets/asset
classes and use more sophisticated strategies Vanilla hedge (130/30), global macro, event
driven, arbitrage, directional 2/20 compensation contract with high
watermark Leverage
Definitions Originate-to-distribute model
Used to be…bank loans money to homebuyer and keeps loan on its books (and services) for duration of loan
O-to-D: Lender originates loan, sells loan to giant
bank who securitizes loan and allows SPE to service loan
Definitions ABS
Investment the cash flows of which are reliant upon other assets Credit cards, student loans, real estate loans, etc.
MBS Represents a claim on the cash flows from mortgage
loans through a process known as securitization Heart of the crisis RMBS v. CMBS
1. SPV purchases/collects mortgages2. Pools mortgages3. Issues securities
GSEs major players in MBS market, but not only ones
Definitions More on MBS:
Why? Liquidity thru standardization Cash for originators Diversification of finance sources Regulatory arbitrage: meet capital
requirements easier Profitable
About $15T outstanding
Definitions CDOs
ABS with multiple tranches of varying risk
Water flows from senior to junior to equity
Created by hedge funds, investment banks, banks
$1.4T total issuance
Definitions CDS
Buyer makes regular payments to seller who will indemnify buyer in the event of credit event
Credit event is defined in contract Failure to pay, repudiation, restructuring,
etc. Swap that insures buyer against credit
risk OTC derivative; opaque market
Definitions Synthetic CDO
CDO that references CDSs instead of assets such as ABS (RMBS, CMBS, etc.)
Derivative of a derivative Sliced into tranches of various risk
appetites much like a CDO CRA
Moody’s, Standard & Poor's, Fitch Ratings Many investors required to invest in
“investment grade” assets; no junk Higher credit rating entails lower risk, lower
return
Definitions Too Big to Fail
Some institutions are so large that their failure would pose systemic risk
Systemic risk is just what it sounds like Tom Brady (of Brady Bunch) is TBTF; Marsha
is expendable Predatory lending
Fraudulent origination practices? “Abusive” practices is more appropriate
definition
Definitions Deregulation
‘Decreasing’ number, scope, and enforcement of regulations I am not aware of any examples; perhaps regulatory
consolidation led by VP Gore Promoting freedom in the market place
Motor Carrier Act of 1980: deregulated assets that could be carried, routes open to carriers, price controls; result was more competition and price declines
Airline Deregulation Act of 1978: price and entry controls relaxed; result in steady price declines
Gramm-Leach-Bliley (Financial Services Modernization Act of 1999):
Definitions Promoting freedom in the market place
continued Gramm-Leach-Bliley (Financial Services
Modernization Act of 1999): Repealed part of Glass-Steagall of 1933 Permitted consolidation of insurance, commercial
banking, brokerages, and investment banking Improved efficiency of scale and thus reduced costs Thought important for global competitiveness of U.S.
banks (bipartisan bill signed by WJC) NOTE: disallowed merger if party failed to satisfy CRA
requirements Lack of new regulation; most common charge
against republicans (during WJC presidency, though)
Definitions GSE
Fannie Mae, Freddie Mac Created by Congress to increase credit
availability in home loan market Privately owned, but implicit guaranteed
by Uncle Sam Bought up bulk of MBSs Incentivized to purchase MBSs issued to
low-income borrowers
Definitions Shadow banking system
Those institutions that perform banking functions (liquidity and credit provision) but lacking in heavy regulation and deposit insurance
Hedge funds, money market funds, SPVs, Repo market
In 2008, roughly twice size of banking system; $20T versus $10T
Definitions Maturity mismatch
Banks typically borrow over short-term and lend over long-term
Bank run Before deposit insurance, lost confidence in
banks led people to rush banks to demand funds
Fractional-reserve banking means that bank runs destroy banks
FDIC stopped bank runs in U.S. Modern runs in repo market (which killed
Lehmann Brothers), money market funds Country-wide runs (Greece)
Definitions Commercial paper
Day-to-day financing of almost all major firms reliant upon CP market
Unsecured notes, 1 day to 9 month maturity
Backbone of money market Sold at discount and usually backed by
sponsoring bank
Definitions Stimulus
Fiscal or monetary TARP
Equity injections into major banks and car companies
Liquidity trap Zero percent interest rate environment
that precludes FRB from lowering rates to stimulate economy