We are in the midst of a Global Financial meltdown. These slides first presented to 2nd year MBA students at a major University, identifies the root causes of the problem explains why we are where we are today.

1. The Global Financial
Crisis
3/16/2009 1
Jay Prakash jay@strategicfocus.com
408-568-3993
www.strategicfocus.com

2. Table of Contents
• What is the crisis?
• Underpinnings of US Financial Crisis
– A history of deregulation
• Financial deregulation of S&L’s in the Regan era, 1980’s
• Bank deregulation of 1994
• Repeal of the Glass Stegal act in 1999, Clinton era
• SEC publishes Regulation ―B‖ in 2004
– Violation of Net Capital Rule
– Excessive leverage by Hedge Funds, Private Equity & Mortgage Companies
– Credit Default Swaps
– Failure to police sub-prime
– Packaging & selling of bonds backed by risky sub-prime loans
• Global Impact
• The changing nature of the Rescue Package
– Key Issues that need to be addressed
– Initial Package
– Current Package
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3. What is the crisis?
Foreign Investors
US Banks Federal Reserve
Consumer Positive Consequences
--Cars --Home --College
--Entrepreneurs --Small Businesses
Negative Consequences
Large Money Flow
Low Interest Rates
Easy Credit
Borrowing
Borrowing
Bank Failure
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4. What is the crisis?
Negative Consequences
• Over extended borrowers
• Home foreclosures
• Declining home values; home owners caught in a vicious
cycle
• Credit crunch for qualified borrowers including businesses
• Bank & other financial institutions failure due to non-
repayment of loans
• Loss of confidence
• Declining demand for goods & services in US markets
• Global Economies sliding into recession or reduced growth
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5. Underpinnings of the US Financial Crisis
History of Deregulation
• Financial de-regulation started with S&L’s in the Regan
era in 1980’s
• Many restrictions on the activities of S&L’s limiting to the
home loan market were removed.
• The result was an orgy of speculation, profiteering and
outright plundering of assets, culminating in collapse.
• This resulted in the biggest bailout in US history prior to
the current bailout costing the Federal government more
than $500 billion
• Clearly the lessons from these lax regulations had not been
learnt.
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6. Underpinnings of the US Financial Crisis
History of Deregulation
• Bank deregulation of 1994
• This allowed bank holding companies to operate in more
than one state.
• The result was a rash of merger & acquisitions of regional
banks and an appetite for new markets & new sources of
revenues.
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7. Underpinnings of the US Financial Crisis
History of Deregulation
• Repeal of the Glass Stegal act in 1999.
• Under the Glass Stegal act, banks, brokerage and insurance companies
were effectively barred from entering each other industries --
investment banking and commercial banking were separated.
• Act passed in 1933 in response to:
– 5000 bank failures,
– loss of $7 bil in depositors money,
– 600,000 foreclosures from 1930-1932 --all due to manipulation of the
market by giant banking houses.
• Single most damaging and most consequential act of the Clinton years.
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8. Underpinnings of the US Financial Crisis
History of Deregulation
• Repeal of the Glass Stegal act in 1999.
• Under the Glass Stegal act, banks, brokerage and insurance companies
were effectively barred from entering each other industries --
investment banking and commercial banking were separated.
• Act passed in 1933 in response to:
– 5000 bank failures,
– loss of $7 bil in depositors money,
– 600,000 foreclosures from 1930-1932 --all due to manipulation of the
market by giant banking houses.
• Single most damaging and most consequential act of the Clinton years.
3/16/2009 8

9. Underpinnings of the US Financial Crisis
History of Deregulation
• Clinton and the Republicans agreed to the deregulation of the US
Financial system in October 1999.
• Most sweeping banking deregulation bill in US history
• Lifted all restraints on the operation of giant monopolies which
dominate the financial system.
• No restrictions on the integration of banking, insurance and stock
trading imposed by the Glass Steagal act of 1933.
• Huge wave of mergers, ex. Citibank buying Travelers Insurance
creating one stop shop for Financial Services
• Law was passed due to pressure from the banks which sought more
profitable outlets for their capital especially in the stock market.
• In 1990 JP Morgan was allowed to engage in stock market operations
up to 10% of revenues. This was increased to 25% in 1994 and in 1999
it was abolished.
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10. Underpinnings of the US Financial Crisis
History of Deregulation
• SEC voted in June 2004 to publish
Regulation B.
• This allows banks to engage in certain
Securities activities without first registering
as brokers with the SEC.
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11. Underpinnings of the US Financial Crisis
Violation of Net Capital Rule
• SEC allows certain broker-dealer firms to legally violate existing net capital
rules that limits debt-to-net capital ratio to 12 to 1 by providing them with
exemptions.
• In 2004 the SEC granted an exemption to five firms—Goldman, Merrill,
Lehman, Bear Stearns, and Morgan Stanley.—which allowed them to leverage
up to 40 to1.
• Three of these firms have blown up. This reckless leverage has led to the
current crisis.
• The so called Net Capital Rule was created in 1975 to oversee broker dealers
that traded securities for customers as well as their own accounts.
• The rule requires that firms value all their tradeable assets at market prices,
and then it applies a hair-cut to account for market risk. The hair cut is 15% for
equities and 6% for Treasury securities because they are less risky. The net
capital rule requires that they limit their debt to capital ratio to 12 to 1 and are
forced to stop trading if they exceed it.
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12. Underpinnings of the US Financial Crisis
Excessive Leverage by Hedge Funds, etc.
• Failure to stop excess leverage. Excess
speculation with borrowed money.
• Typical leverage for a hedge fund and
private equity is 30:1.
• For sub-prime mortgage company the
leverage is infinite because there is no
capital.
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13. Underpinnings of the US Financial Crisis
Credit Default Swaps (CDS)
• CDS are credit derivatives of Mortgage backed securities.
• CDS is a fancy name for insurance. It is not called insurance because
regulatory laws require large capital reserves for losses.
• CDS was sold as an insurance for mortgaged backed securities and
were used to persuade investors to buy the securities in a declining
market.
• When the securities failed, the investors tried cash into the insurance
and this made a run on the bank’s inadequate reserves resulting in a
collapse of these investment firms.
• CDS is the key reason for failure of AIG, Bear Stearns, Merrill Lynch,
Lehman Brothers, etc.
• Regulation of CDS was opposed by Clinton Treasury Secretary Robert
Rubin & Greenspan in 1999
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14. Underpinnings of the US Financial Crisis
Failure to police Sub-Prime
• The core idea of bank regulation:
– Is to examine the banks books;
– Ensure that there are not too many loans behind in interest
payments; and
– Force the banks to raise more capital if needed to cover the losses.
• Regulators basically waived the rule of adequate capital
for the new wave of mortgage lenders who created sub-
prime.
• Many of the mortgage companies were not banks who
made the loans only to sell them off to Wall Street.
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15. Underpinnings of the US Financial Crisis
Packaging & Selling of Bonds backed by Sub-Prime Loans
• Unregulated agencies such as Moody’s and S&P
to rate these bonds.
• In return for a hefty fee, these agencies helped
manipulate the bond so it qualifies for a AAA
rating.
• Fannie Mae & Freddie Mac which purchased the
loans from the banks financed its operations by
selling such bonds.
• By selling the loans to FM & FM, it freed the
banks to issue even more sub-prime mortgages.
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16. Global Impact
• Loss of confidence in inter-bank lending.
• Severe credit crunch even for borrowers with good
credit history
• High interest rates.
• Increased number of home foreclosures, reduced
auto sales, reduced consumer spending
• Declining home values
• Emerging economies such as India & China hit
with lower growth rates because of declining
demand in the US markets
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17. Rescue Package
Key Issues
• Guaranteeing inter-bank lending
• Guaranteeing mortgage backed loans by
Fannie Mae & Freddie Mac
• Delay home foreclosures; allowing
refinance at lower fixed rates.
• Increasing money supply
• Increasing consumer & investor confidence
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18. Rescue Package
Initial Package
• $700 bil initial package from US Govt
• Bail out large institutions such as AIG
• Cleanup balance sheet of financial
institutions by buying up bad debt ie
mortgage based assets.
• Objective was to free up the companies to
make loans again.
• It is too early to tell if this is working!
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19. Rescue Package
Stimulus Package: $787 billion
• Infrastructure - Rebuilding our highways, bridges,
schools, etc. alongside creating more renewable energy
(39% of total)
• State Relief - Helping the states with unemployment
benefits, budget shortfalls, medicaid, and the like (13% of
total)
• Struggling Citizens - Increase food stamps,
unemployment insurance coverage, and provide insurance
for the jobless (12% of total)
• Tax Cuts - Tax cuts to individuals and business (36% of
total)
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20. Rescue Package
Stimulus Package: Detailed Breakdown
• Construction projects: $90 billion.
• Education: $142 billion.
• Renewable energy: $54 billion. Double production of
alternative energy in the next three years.
• Medicaid: $87 billion.
• Unemployment benefits: $43 billion.
• Middle-class tax cut: $145 billion.
• Tax cuts for companies suffering losses: $17 billion over
10 years.
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