The Financial CrisisThadford Jackson

Preface History is not yet written

Ben Bernanke and the GD

Those who do not know the past….

Better still, those who know the past can profit in the future Biographies of business titans illustrate… You will witness from 5 to 50 financial/economic

troughs From households to global conglomerates!

Preface Blame who you want, but the bottom

line is all that counts

History is a model that is only as good as it is useful…to what end?

History is linear, though only by construction In fact, unfolding of events is

simultaneous and beyond the scope of comprehension

Preface A smart person learns from his own

past; a wise person learns from others’ past.

History is fascinating.

History repeats. 1907 versus 2007

Preface Much of what we ‘know’ is wrong!

Expertise is the realization of ignorance.

Concentrate on the history of the doers, instead of on the history of the pundits, critics, or intellectuals

Those who study history live on different planets from those who do not.

Probably no better preparation (besides experience) than business history

A note on mass media

Media are intent on profit; sober assessment of the facts does not sell as well as finger-pointing and crucifixion

As noted, scholarly assessments are incomplete at best

The Story Bankers, or “Wall Street” types, are bad

people (think ‘Jews’ and anti-Semitism) who: Intentionally loaned money to people who

could not afford to repay Reaped private gains, then leaving losses

to public Lied to, cheated, and stole from Main

Street Should be in jail!

The Story Republicans are greedy and corrupt

people who are in bed with the bankers W., an oil man, slashed all regulations on

banks which would have stopped the FC from ever happening

Democrats are redistributionist fools who forced banks to loan money to minorities who could not afford the houses that they acquired…and democrats are in the pockets of the big banks, of course.

Definitions Khan Academy on Credit Crisis Financial crisis

Highly damaging, usually sudden, event associated with large decline in asset values Bubbles bursting Banking panics/runs Spillover to ‘real’ economy?

Bubble Prolonged overvaluation of asset (class) from

fundamental value Tulipmania, South Sea Bubble, Roaring Twenties,

Tokyo real estate, Housing bubble Greater fool, extrapolation, herding

Definitions Subprime mortgage

Higher credit risk and higher returns Prime purchased by Fannie and Freddie Non-conforming

Derivative Financial product that ‘derives’ value from other

financial asset Option, future, forward, swap Can be combined to produced synthetic products

CDOs, CDSs, synthetic CDOs Leverage

Example of 100% equity stake versus 10% stake; i.e., leverage ratios of 0 versus 10 to 1

Definitions Commercial banks

Funnels deposits to investors Investment banks

Bank that does not take traditional deposits From G-S to G-L-B, firewall between banks and

IBs All major banks had IB functions after G-L-B

Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns, Lehmann Brothers, Blackstone, Nomura Securities examples of long-time, pure IBs

M&A, IPOs, advisory, wealth management, proprietary trading, private equity

Definitions Hedge Funds

Think mutual funds for sophisticated investors Sophisticated equals high net worth and

familiar with complex financial products Pensions, endowments, high net worth

individuals Can invest in wider variety of assets/asset

classes and use more sophisticated strategies Vanilla hedge (130/30), global macro, event

driven, arbitrage, directional 2/20 compensation contract with high

watermark Leverage

Definitions Originate-to-distribute model

Used to be…bank loans money to homebuyer and keeps loan on its books (and services) for duration of loan

O-to-D: Lender originates loan, sells loan to giant

bank who securitizes loan and allows SPE to service loan

Definitions ABS

Investment the cash flows of which are reliant upon other assets Credit cards, student loans, real estate loans, etc.

MBS Represents a claim on the cash flows from mortgage

loans through a process known as securitization Heart of the crisis RMBS v. CMBS

1. SPV purchases/collects mortgages2. Pools mortgages3. Issues securities

GSEs major players in MBS market, but not only ones

Definitions More on MBS:

Why? Liquidity thru standardization Cash for originators Diversification of finance sources Regulatory arbitrage: meet capital

requirements easier Profitable

About $15T outstanding

Definitions CDOs

ABS with multiple tranches of varying risk

Water flows from senior to junior to equity

Created by hedge funds, investment banks, banks

$1.4T total issuance

Definitions CDS

Buyer makes regular payments to seller who will indemnify buyer in the event of credit event

Credit event is defined in contract Failure to pay, repudiation, restructuring,

etc. Swap that insures buyer against credit

risk OTC derivative; opaque market

Definitions Synthetic CDO

CDO that references CDSs instead of assets such as ABS (RMBS, CMBS, etc.)

Derivative of a derivative Sliced into tranches of various risk

appetites much like a CDO CRA

Moody’s, Standard & Poor's, Fitch Ratings Many investors required to invest in

“investment grade” assets; no junk Higher credit rating entails lower risk, lower

return

Definitions Too Big to Fail

Some institutions are so large that their failure would pose systemic risk

Systemic risk is just what it sounds like Tom Brady (of Brady Bunch) is TBTF; Marsha

is expendable Predatory lending

Fraudulent origination practices? “Abusive” practices is more appropriate

definition

Definitions Deregulation

‘Decreasing’ number, scope, and enforcement of regulations I am not aware of any examples; perhaps regulatory

consolidation led by VP Gore Promoting freedom in the market place

Motor Carrier Act of 1980: deregulated assets that could be carried, routes open to carriers, price controls; result was more competition and price declines

Airline Deregulation Act of 1978: price and entry controls relaxed; result in steady price declines

Gramm-Leach-Bliley (Financial Services Modernization Act of 1999):

Definitions Promoting freedom in the market place

continued Gramm-Leach-Bliley (Financial Services

Modernization Act of 1999): Repealed part of Glass-Steagall of 1933 Permitted consolidation of insurance, commercial

banking, brokerages, and investment banking Improved efficiency of scale and thus reduced costs Thought important for global competitiveness of U.S.

banks (bipartisan bill signed by WJC) NOTE: disallowed merger if party failed to satisfy CRA

requirements Lack of new regulation; most common charge

against republicans (during WJC presidency, though)

Definitions GSE

Fannie Mae, Freddie Mac Created by Congress to increase credit

availability in home loan market Privately owned, but implicit guaranteed

by Uncle Sam Bought up bulk of MBSs Incentivized to purchase MBSs issued to

low-income borrowers

Definitions Shadow banking system

Those institutions that perform banking functions (liquidity and credit provision) but lacking in heavy regulation and deposit insurance

Hedge funds, money market funds, SPVs, Repo market

In 2008, roughly twice size of banking system; $20T versus $10T

Definitions Maturity mismatch

Banks typically borrow over short-term and lend over long-term

Bank run Before deposit insurance, lost confidence in

banks led people to rush banks to demand funds

Fractional-reserve banking means that bank runs destroy banks

FDIC stopped bank runs in U.S. Modern runs in repo market (which killed

Lehmann Brothers), money market funds Country-wide runs (Greece)

Definitions Commercial paper

Day-to-day financing of almost all major firms reliant upon CP market

Unsecured notes, 1 day to 9 month maturity

Backbone of money market Sold at discount and usually backed by

sponsoring bank

Definitions Stimulus

Fiscal or monetary TARP

Equity injections into major banks and car companies

Liquidity trap Zero percent interest rate environment

that precludes FRB from lowering rates to stimulate economy