Financial Crises: Chapter 9

Regulation and Capture Calomiris and Johnson

At worst CRA no worse than other lenders…probably better

Retail presence is important “… one of the more interesting findings of our research is

the evidence that some aspect of “local” presence seems to matter in predicting the sustainability of a loan.▪ Once a lender is removed from the community…or from

the origination decision (wholesale loan)…foreclosure increase significantly.”

CRA & asymmetric information Low-income neighborhoods contain people who are

good credit risks. Local bankers are gathering information on who

these people are ▪ Therefore make better loans.

Asset Markets Effects on Balance Sheets Stock market decline▪ Decreases net worth of corporations.

Unanticipated decline in the price level ▪ Liabilities increase in real terms and net worth

decreases.

Asset write-downs.▪ E.g due to mortgage foreclosures

Deterioration in Financial Institutions’ Balance Sheets Decline in lending.

Banking Crisis Loss of information production and

disintermediation. Bank runs in all crises up through 1933.

http://mysite.verizon.net/vodkajim/housingbubble/ 1-6

Mortgage Originations

(Billions)

Subprime Originations

(Billions)

Subprime Share in Total

Subprime Mortgage

Backed Securities

Percent Subprime

Securitized

2001 $2 ,215 $190 8.6% $95 50.4%

2002 $2,885 $231 8.0% $121 52.7%

2003 $3,945 $335 8.5% $202 60.5%

2004 $2,920 $540 18.5% $401 74.3%

2005 $3,120 $625 20.0% $507 81.2%

2006 $2,980 $600 20.1% $483 80.5%

Increase in low quality loans in 2004Increase in securitization – reduces incentive to make quality loans

Mortgage Originations

(Billions)

Subprime Originations

(Billions)

Subprime Share in Total

Subprime Mortgage

Backed Securities

Percent Subprime

Securitized

2001 $2 ,215 $190 8.6% $95 50.4%

2002 $2,885 $231 8.0% $121 52.7%

2003 $3,945 $335 8.5% $202 60.5%

2004 $2,920 $540 18.5% $401 74.3%

2005 $3,120 $625 20.0% $507 81.2%

2006 $2,980 $600 20.1% $483 80.5%

Dramatic increase in subprime lending (2004) SEC allows more leveraged investment banks Federal preemption of state “predatory lending”

laws. Housing prices ▪ Had been trending higher▪ Disconnect from economic fundamentals at this time

Low quality loans are securitized Holders want ‘insurance’ against default ▪ Credit default swaps▪ AIG is the biggest player, but sells their insurance too

cheaply.

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Regulatory changes SEC allows more leveraged investment

banks▪ http://www.nytimes.com/2008/10/03/business/03sec.html

Federal preemption of state “predatory lending” laws.▪ http://www.ritholtz.com/blog/2009/10/pre-emption-of-state-anti-predatory-

lending-laws-led-to-more-foreclosures/

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AIG bailouts, $185 Billion: Who benefits? Recipients of bonuses (relatively small

amount) Counterparties▪ Owners of AIG issued CDS▪ Primarily domestic and foreign “risk-taking” banks

Financial System▪ defaults pose systemic risk, one firm’s default

causing others to be insolventPurpose is to support real economy

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Direct aid to financial institutions TARP funds Fed Lending Total about 4 trillion

Stimulus Spending Total about 800 billion

Bernanke Fed Chair: Scholar of the Great

Depression

Too Big To FailWhy were banks willing to take risks that proved sodamaging both to themselves and the rest of the economy?

One of the key reasons…is that the incentives to manage risk and to increase leverage were distorted by the implicit support or guarantee provided by government to creditors of banks that were seen as “too important to fail”.

Mervyn KingGovernor of the Bank of England Oct. 20,2009

Alternative paths Regulation: restrict activities▪ Current White House policy

Break up the banks▪ “If they’re too big to fail, they’re too big. In 1911 we

broke up Standard Oil — so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.”▪ Alan Greenspan former Fed Reserve Chairman

http://www.npr.org/templates/story/story.php?storyId=113650178

Simon Johnson Former Chief Economist at IMF Has overseen crises in many developing countries. http://www.theatlantic.com/doc/200905/imf-advice

“…the economic solution is seldom very hard to work out.

The real concern…is almost invariably the politics of countries in crisis.

Typically, these countries are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks.”

Rajan & Zingales Saving Capitalism from the Capitalists▪ Well researched discussion of the importance

of finance for creating wealth▪ Capture in historical perspective

Feel free to contact me: afja@uaa.alaska.edu