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A lecture on the origins and consequences of the Financial Crisis of 2007-8

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  1. 1. Causes and Consequences of the Global Financial Crisis of 2007-8 Jeffrey A. Hart Indiana University March 10, 2011
  2. 2. Global Financial Crisis 2007-8 <ul><li>Led by bursting of the housing bubble in the US in 2007 </li></ul><ul><li>Made worse by near collapse of US financial markets connected with mortgage-backed securities , synthetic collateralized debt obligations (CDOs), and credit default swaps </li></ul><ul><li>Response to the crisis revived the debate over regulation of financial markets and Keynesian approaches to preventing deep recessions </li></ul>
  3. 3. Bursting of the Housing Price Bubble 1890-2005 1963-2008 The Bubble Bursts
  4. 4. How the Bubble Occurred
  5. 5. Contributing Factors <ul><li>Subprime mortgages </li></ul><ul><li>Unethical mortgage brokers </li></ul><ul><li>Low interest rates set by the Federal Reserve </li></ul><ul><li>Credit Rating Agencies (conflicts of interest) </li></ul><ul><li>Insufficient regulation of financial markets </li></ul><ul><ul><li>Mortgages and related markets </li></ul></ul><ul><ul><li>Derivatives, including credit default swaps </li></ul></ul>
  6. 6. Subprime Mortgages <ul><li>Definition: a type of mortgage granted to individuals with low credit ratings (FICO less than 600) </li></ul><ul><li>Subprime mortgages feature higher interest rates than conventional mortgages because of the higher risk of default </li></ul><ul><li>Subprime borrowers were offered adjustable rate mortgages (ARMs) </li></ul><ul><li>US policy from the 1990s on was to encourage the growth of this market to make home ownership available to a wider spectrum of the population </li></ul>
  7. 7. Expansion of Subprime Market
  8. 8. Unethical Mortgage Brokers <ul><li>Exaggerated expected earnings of borrowers </li></ul><ul><li>Sold more expensive loans when less expensive loans were available </li></ul><ul><li>Conspired with real estate brokers to raise the sale price of properties above market value </li></ul><ul><li>As a result, subprime delinquency rates began to increase rapidly after 2007 </li></ul>
  9. 9. The Role of Low Interest Rates <ul><li>Investors were looking for ways to obtain higher rates of return for low-risk investments </li></ul><ul><li>Treasury Bonds became less attractive for this purpose </li></ul><ul><li>Mortgage Backed Securities (MBSs) and Collaterized Debt Obligations (CDOs) expanded rapidly to fill the void </li></ul>
  10. 10. Credit Rating Agencies <ul><li>These firms (e.g. Fitch Group, Moody’s, Standard and Poor’s) establish credit ratings for issuers of certain types of debt obligations. </li></ul><ul><li>The highest rating is AAA which denotes low risk and high liquidity. </li></ul><ul><li>They sometimes compete for business by offering better ratings (a clear conflict of interest). </li></ul>
  11. 11. Fun with Credit Rating Agencies
  12. 12. Insufficient Regulation <ul><li>Securities and Exchange Commission (SEC) was supposed to regulate the mortgage market and apparently failed to do so </li></ul><ul><li>The Federal Reserve (especially when headed by Alan Greenspan) chose not to regulate derivatives markets </li></ul><ul><li>Government financial regulators relied too much on the private credit rating agencies and business journalist to expose malfeasance and overly risky investments </li></ul>
  13. 13. Short-Term US Government Responses <ul><li>“ Rescue” of Bear Stearns </li></ul><ul><li>Decision not to rescue Lehman Brothers </li></ul><ul><li>Takeover of Fannie Mae and Freddie Mac </li></ul><ul><li>Troubled Asset Relief Program (TARP) </li></ul><ul><ul><li>Bailouts of AIG and GM </li></ul></ul><ul><ul><li>$245 billion invested in US banks </li></ul></ul><ul><li>Obama’s economic stimulus package </li></ul>
  14. 14. Medium and Long-Term Measures <ul><li>Capital Adequacy Requirements and Deleveraging </li></ul><ul><li>Regulation of previously unregulated markets (derivatives, but especially credit default swaps) </li></ul><ul><li>Improved protection for consumers </li></ul><ul><li>Mortgage renegotiation incentives </li></ul>
  15. 15. Global Responses <ul><li>Reworking of international capital adequacy requirements (Basel Accords) </li></ul><ul><li>Structural adjustment programs for Iceland, Ireland, Greece, Spain, and other countries – often involving austerity measures </li></ul><ul><li>Debates in each country about what to do to return the domestic economy to health </li></ul>
  16. 16. A Quick and Dirty Guide to Books on the Crisis <ul><li>The Financial Crisis Inquiry Report </li></ul><ul><li>Andrew Ross Sorkin, Too Big to Fail </li></ul><ul><li>Carmen Reinhart and Kenneth Rogoff, This Time is Different </li></ul><ul><li>Michael Lewis, The Big Short </li></ul><ul><li>William Cohan, House of Cards </li></ul><ul><li>Lawrence McDonald & Patrick Robinson, A Colossal Failure of Common Sense </li></ul>