Reasons for the global financial crisis of 2009

1. THE GLOBAL FINANCIAL
CRISIS

2. OUTLINE
 PRELUDE TO A CRISIS
 ECONOMIC IMPACTS OF THE CRISIS
 UNDERLYING CAUSES OF THE FINANCIAL CRISIS
 REMEDIES AND IDEAS FOR AVERTING FUTURE CRISES

3. PRELUDE TO A CRISIS

4.  INCREASE IN DEMAND FOR REAL ESTATE
 INCREASE IN REAL ESTATE PRICES
 INCREASE IN HOME PRICES FED A SPECULATIVE FRENZY
 MILLIONS RUSHED TO BUY, BELIEVING THAT PRICES COULD ONLY GO
UP
 SPECULATIVE FLURRY WAS FED BY:
 THE “DOT-COM BUBBLE”
 THE UNPRECEDENTED ACCESS TO CREDIT IN THE FORM OF
MORTGAGES
 VERY LOW MORTGAGE RATES AMONG OTHER FACTORS
THE HOUSING BUBBLE IN THE U.S

5. HISTORICAL HOUSING PRICES IN THE U.S.
0
50
100
150
200
250
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
SHILLER
HOUSING
PRICE
INDEX

6. 0
1
2
3
4
5
6
7
100
110
120
130
140
150
160
170
180
190
200
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
EFFECTIVE
FEDERAL
FUNDS
RATE
SHILLER
HOUSING
PRICE
INDEX
Housing Price Fed Interest Rate
HOUSING BUBBLE AND CREDIT ACCESS

7. PEOPLE TAKE OUT
MORTGAGES
INVESTMENT BANKS
GROUP MORTGAGES
INTO MORTGAGE-
BACKED SECURITIES
(MBS)
CDO
MBS MBS
MBS
MBS
MBS
POOLS
Mortgage default
AAA
AA
BBB
BB unrated
A
lower yield first paid
higher yield last paid
AAA
AA
BBB
unrated
A
CDO
TRANCHES
EACH MBS IS DIVIDED
INTO TRANCHES; THE
FIRST IS TO BE PAID IN
THE EVENT OF
MORTGAGE DEFAULT
AND HENCE
THE SAFEST
FINANCIAL INSTITUTIONS DEVELOPED COLLATERALIZED
DEBT OBLIGATIONS (CDOS): MAKING A “BUNDLE OF
BUNDLES” OF MORTGAGES.
A HIERARCHY OF TRANCHES IS AVAILABLE, EACH CARRYING
A CALCULATED RISK-RETURN BALANCE
MORTGAGE-BACKED SECURITY (MBS)

8. 8
INVESTMENT
BANK
OR INSURANCE
COMPANY INVESTMENT
BANK
CREDIT DEFAULT SWAP
SELLER
CREDIT DEFAULT SWAP BUYER
A BUYER OF THE CDS PAYS A FEE TO THE
SELLER
THE SELLER AGREES TO COVER LOSSES IN CASE OF
DEFAULT
CREDIT DEFAULT SWAP: A SECURITY THAT IS EFFECTIVELY AN INSURANCE
POLICY AGAINST DEFAULTS RELATED TO MBS AND CDOS
CREDIT DEFAULT SWAP

9.  RISING DEMAND FOR BUNDLED SECURITIES
 BANKS RELAXED LENDING CRITERIA
 SUBPRIME MORTGAGE: A MORTGAGE THAT DOES NOT
MEET THE QUALITY STANDARDS OF TRADITIONAL
MORTGAGES
 2006: WAVE OF SUBPRIME FORECLOSURES HASTENED
DOWNWARD SPIRAL OF PRICES (GLUT IN HOUSE
SUPPLY)
THE SUBPRIME CRISIS

10.  FALLING HOUSE PRICES
 LIMITED EQUITY OF HOMEOWNERS
 MANY MORTGAGES BECAME WORTHLESS
 LOSSES IN THE VALUE OF MBSS AND CDOS
 BANKS PUT PART OF THEIR FUNDS IN CDOS
 PRESUMPTION: EVERY BANK IS A HIGH-RISK BORROWER
 BANKS STOPPED LENDING TO EACH OTHER AND TO
CUSTOMERS
 OUTPUT CONTRACTED SHARPLY
FROM HOUSING CRASH TO BANKING CRISIS

11.  HOUSE PRICES INCREASED TREMENDOUSLY IN IRELAND, SPAIN
AND BRITAIN
 MBSS AND CDOS PLAYED NO ROLE IN EUROPEAN COUNTRIES
 WITH THE END OF THE U.S. HOUSING BUBBLE, REAL ESTATE
BUBBLES IN EUROPE ALSO BURST
 BANKS IN EUROPE BECAME MORE CAREFUL IN LENDING
 WITH FALLING HOUSE PRICES, HOUSEHOLDS STARTED TO
DEFAULT ON THEIR MORTGAGES AND PROPERTY DEVELOPERS
ON THEIR LOANS
 NATIONAL BANKING CRISES IN EUROPEAN COUNTRIES
HOUSING BUBBLES IN EUROPE

12. ECONOMIC IMPACTS OF THE CRISIS

13.  IN THE INDUSTRIALIZED WORLD, 14 MILLION JOBS WERE LOST
 HOUSEHOLDS SAW THEIR WEALTH DIMINISHED
 VICIOUS CIRCLE:
INCOME
FALLS
BANKS
INCREASE
LENDING
STANDARDS
LESS CREDIT
LESS
AGGREGATE
DEMAND
EMPLOYMENT
FALLS
UNEMPLOYMENT AND THE VICIOUS RECESSIONARY SPIRAL

14.  BOTH DOWNTURNS WERE PRECEDED BY A PERIOD OF ECONOMIC
STRENGTH
 BUT: CONSEQUENCES ARE DIFFERENT DUE TO
 SOCIAL SAFETY NET
 GOVERNMENT REGULATIONS TO PROTECT ORDINARY CITIZENS
 ACTIVIST MACROECONOMIC POLICY
 GOVERNMENT PROGRAMS KEPT CURRENT DOWNTURN FROM
BECOMING FAR WORSE
THE GREAT DEPRESSION AND THE GREAT RECESSION COMPARED

15. INDICATOR GREAT DEPRESSION
1932 VS. 1929
GREAT RECESSION
2009 VS. PEAK 2007/8
GDP, REAL, CHANGE IN PERCENT -10.0 -4.0
MANUFACTURING PRODUCTION, CHANGE IN PERCENT -23.2 -20.2
EXPORTS, CHANGE IN PERCENT -58.5 -20.9
STOCK MARKET INDEX, CHANGE IN PERCENT -55.4 -53.4
EMPLOYMENT, CHANGE IN PERCENT -17.3 -2.5
UNEMPLOYMENT RATE (1932 AND 2010) 19.6 9.2
UNEMPLOYMENT RATE, CHANGE IN PERCENTAGE POINTS 13.2 3.1
INFLATION, IN PERCENT -12.8 1.0
Source: Karl Aiginger (2010). The Great Recession versus the Great Depression: Stylized Facts on Siblings That
Were Given Different Foster Parents. Economics: The Open-Access, Open-Assessment E-Journal, 4 (2010-18): 1—41.
* Austria, Germany, Belgium, Spain, France, Finland, Sweden, United Kingdom, the United States and Japan.
Numbers are unweighted averages for these ten countries.
SELECTED ECONOMIC INDICATORS FOR TEN INDUSTRIALIZED ECONOMIES* IN THE
GREAT DEPRESSION AND THE GREAT RECESSION

16. CAUSES OF THE FINANCIAL CRISIS

17.  U.S.:
 SINCE 1999, LOW AND MIDDLE INCOMES STARTED TO DECLINE
 MAJORITY OF FAMILIES FACED DIFFICULTIES TO MAINTAIN LEVEL OF
CONSUMPTION
 DEBT-FINANCED CONSUMPTION
 GERMANY:
 WAGES OF THE POORER HALF OF THE POPULATION DECLINED
 CONSUMPTION STAGNATED
 RICH HOUSEHOLDS AND CORPORATIONS EARNED MORE MONEY THAN THEY
COULD (OR WOULD) SPEND
 NET SAVINGS INCREASED
INEQUALITY

18.  SINCE THE 1980S, BANK MERGERS LED TO A GROWING NUMBER
OF LARGE BANKS
 FINANCIAL SECTOR BECAME DEREGULATED
 “TOO BIG TO FAIL”: WHEN A COMPANY GROWS SO LARGE THAT
ITS FAILURE WOULD CAUSE WIDESPREAD ECONOMIC HARM IN
TERMS OF LOST JOBS AND DIMINISHED ASSET VALUES
 “TOO BIG TO FAIL” MENTALITY OF BANKS ENCOURAGED MORE
RISK TAKING
 GOVERNMENTS HAD TO BAIL OUT BANKS
BANK SIZE AND DEREGULATION

19. 0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
84:1 87:1 90:1 93:1 96:1 99:1 02:1 05:1 08:1 11:1
YEAR: QUARTER
Assets > $10 Billion Assets $1 Billion - $10 Billion
Assets $100 Million - $1 Billion Assets < $100 Million
PERCENT
OF
TOTAL
BANK
SECTOR
ASSETS
Source: Federal Deposit Insurance Corporation (www2.fdic.gov/qbp/);
www.fdic.gov/bank/statistical/stats/2012dec/industry.html.
Chapter 15
INCREASING BANK SIZE IN THE U.S.

20.  CEO PAY IN THE FORM OF STOCK OPTIONS
 PERFORMANCE RELATED PAY SCHEME ENCOURAGED SHORT-
TERM ORIENTATION
FOCUS ON SHORT-TERM GAINS
IGNORING LONG-TERM RISKS
MISGUIDED CORPORATE INCENTIVE STRUCTURE

21.  DISTRIBUTION OF GAINS AND LOSSES FROM GLOBALIZATION
REINFORCE GROWING PATTERNS OF INEQUALITY
 IN THE U.S.: DEBT FINANCED CONSUMPTION
 IN GERMANY: INCREASE IN SAVINGS
 SAVINGS FROM OTHER PARTS OF THE WORLD CONTRIBUTED
TO U.S. HOUSING BOOM AND ASSET PRICE INFLATION
 INVESTMENT BANKS AND HEDGE FUNDS POSSESSED LARGE
AMOUNTS OF CAPITAL, TOOK ON MORE RISK AND DEBT TO
MULTIPLY RETURNS
GLOBAL AND LONG TERM ECONOMIC TRENDS