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Y376 International Political Economy, Lecture #15...

Y376 International Political Economy, Lecture #15
March 10, 2011

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  • 1. Y376 International Political Economy March 10, 2011
  • 2. Global Financial Crisis 2007-8
    • Led by bursting of the housing bubble in the US in 2007
    • Made worse by near collapse of US financial markets connected with mortgage-backed securities , synthetic collateralized debt obligations (CDOs), and credit default swaps
    • Response to the crisis revived the debate over regulation of financial markets and Keynesian approaches to preventing deep recessions
  • 3. Bursting of the Housing Price Bubble 1890-2005 1963-2008 The Bubble Bursts
  • 4. Contributing Factors
    • Subprime mortgages
    • Unethical mortgage brokers
    • Low interest rates set by the Federal Reserve
    • Credit Rating Agencies (conflicts of interest)
    • Insufficient regulation of financial markets
      • Mortgages and related markets
      • Derivatives, including credit default swaps
  • 5. Subprime Mortgages
    • Definition: a type of mortgage granted to individuals with low credit ratings (FICO less than 600)
    • Subprime mortgages feature higher interest rates than conventional mortgages because of the higher risk of default
    • Subprime borrowers were offered adjustable rate mortgages (ARMs)
    • 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
  • 6. Expansion of Subprime Market
  • 7. Unethical Mortgage Brokers
    • Exaggerated expected earnings of borrowers
    • Sold more expensive loans when less expensive loans were available
    • Conspired with real estate brokers to raise the sale price of properties above market value
    • As a result, subprime delinquency rates began to increase rapidly after 2007
  • 8. The Role of Low Interest Rates
    • Investors were looking for ways to obtain higher rates of return for low-risk investments
    • Treasury Bonds became less attractive for this purpose
    • Mortgage Backed Securities (MBSs) and Collaterized Debt Obligations (CDOs) expanded rapidly to fill the void
  • 9. Credit Rating Agencies
    • These firms (e.g. Fitch Group, Moody’s, Standard and Poor’s) establish credit ratings for issuers of certain types of debt obligations.
    • The highest rating is AAA which denotes low risk and high liquidity.
    • They sometimes compete for business by offering better ratings (a clear conflict of interest).
  • 10. Fun with Credit Rating Agencies
  • 11. Insufficient Regulation
    • Securities and Exchange Commission (SEC) was supposed to regulate the mortgage market and apparently failed to do so
    • The Federal Reserve (especially when headed by Alan Greenspan) chose not to regulate derivatives markets
    • Government financial regulators relied too much on the private credit rating agencies and business journalist to expose malfeasance and overly risky investments
  • 12. Short-Term US Government Responses
    • “ Rescue” of Bear Stearns
    • Decision not to rescue Lehman Brothers
    • Takeover of Fannie Mae and Freddie Mac
    • Troubled Asset Relief Program (TARP)
      • Bailouts of AIG and GM
      • $245 billion invested in US banks
    • Obama’s economic stimulus package
  • 13. Medium and Long-Term Measures
    • Capital Adequacy Requirements and Deleveraging
    • Regulation of previously unregulated markets (derivatives, but especially credit default swaps)
    • Improved protection for consumers
    • Mortgage renegotiation incentives
  • 14. Global Responses
    • Reworking of international capital adequacy requirements (Basel Accords)
    • Structural adjustment programs for Iceland, Ireland, Greece, Spain, and other countries – often involving austerity measures
    • Debates in each country about what to do to return the domestic economy to health
  • 15. A Quick and Dirty Guide to Books on the Crisis
    • The Financial Crisis Inquiry Report
    • Andrew Ross Sorkin, Too Big to Fail
    • Carmen Reinhart and Kenneth Rogoff, This Time is Different
    • Michael Lewis, The Big Short
    • William Cohan, House of Cards
    • Lawrence McDonald & Patrick Robinson, A Colossal Failure of Common Sense