INTRODUCTION TO BUSINESS FINANCE

REPORT ON:

THE FINANCIAL
CRISIS

Submitted by:
 MARIA SHAFFAQ MALIK

OVERVIEW
OF
FINANCIAL CRISES

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 THE FINANCIAL CRISIS

Introduction:

The Global Financial Crisis has been called by leading economists, the worst financial
crisis since the one related to the Great Depression of the 1930s. It contributed to the
failure of key businesses, declines in consumer wealth estimated in the trillions of U.S.
dollars, substantial financial commitments incurred by governments, and a significant
decline in economic activity. Many causes have been proposed, with varying weight
assigned by experts. Both market-based and regulatory solutions have been implemented
or are under consideration, while significant risks remain for the world economy.
The collapse of a global housing bubble, which peaked in the U.S. in 2006, caused the
values of securities tied to housing prices to plummet thereafter, damaging financial
institutions globally. Questions regarding bank solvency, declines in credit availability,
and damaged investor confidence had an impact on global stock markets, which suffered
large losses during late 2008 and early 2009. Economies worldwide slowed during this
period as credit tightened and international trade declined. Critics argued that credit rating
agencies and investors failed to accurately price the risk involved with mortgage-related
financial products, and that governments did not adjust their regulatory practices to
address 21st century financial markets. Governments and central banks responded with
unprecedented fiscal stimulus, monetary policy expansion, and institutional bailouts.

The recent upheaval in the financial sector has some people in a panic, most people
bewildered, and others busy aiming their pointer fingers at whomever they think is guilty
of doing something that contributed to this problem. The presidential candidates are in
the latter category. They aren’t quite sure what to do or what to say, but that doesn’t stop
them from saying something, anyway.

John McCain made a decisive statement, attempting to show leadership, but his statement
was not a very smart one. Barack Obama, by contrast, simply blamed Republicans.

Few things are as simple as politicians make them seem in an election year. Political
candidates succeed by issuing pointed statements that are easy to understand and that
connect with voters; truth and accuracy are not the primary concerns.

The important thing right now is to figure out what actually happened in the financial
sector, and fix things so it can’t happen again. We must ignore the tremendous amount of
speculation about what “might” happen, and the doom and gloom soothsayers who tell us
that the sky is falling or that the end of the world draweth nye.

Because of its complexity the current financial situation invites simple political messages
that connect with voters; it does not lend itself to full explanations that illuminate. So,
when Sen. Obama says, “it’s the Republicans’ fault,” he is expressing a simple idea that a
lot of people buy into, but doesn’t explain anything. It is a silly oversimplification
unworthy of a man who would be President. It appeals to emotional prejudices and
ignores inconvenient realities, and most important of all, it is just plain wrong.

When Sen. McCain suggested that Securities and Exchange Commission head
Christopher Cox didn’t do his job, and if he were president he would fire Mr. Cox, the
Senator didn’t offer specifics. We’ll know more about Mr. Cox’s role as time passes and
we learn more of the details, and can then judge if Mr. McCain’s simple message to
voters about firing Chris Cox was a proper evaluation of the situation.

Sen. Obama described the current agony as "the most serious financial crisis since the
Great Depression,” ignoring all the recessions since then, even the ones in the 80s and the
one following the 9-11 attacks, both arguably more serious crises. Of course, it remains
to be seen just how serious this problem will ultimately be, but given Mr. Obama’s
abysmal understanding of things economic, we would do well to take his
prognostications with a grain of salt.

The root of this problem is the housing market’s sub-prime loan crisis. A sub-prime loan
is a loan made to someone who under normal circumstances would not qualify for a loan,
based upon their income and their ability to make payments. That begs the question: Why
would a bank make a loan to someone it believes is unable to make the payments?

The Community Reinvestment Act (CRA) was given life during the Carter
administration, and empowers four federal financial supervisory agencies to oversee the
performance of financial institutions in meeting the credit needs of their entire
community, including low- and moderate-income neighborhoods. Whenever an
institution wants to make virtually any change in its business operation, such as merging,
opening up a new branch, or getting into a new line of business, it must first prove to
regulators that it has made ample loans to the government's preferred borrowers, those in
low- and middle-income neighborhoods who normally would not qualify for a loan. The
government can fine lenders with low ratings.

The Carter administration used tax dollars to fund numerous "community groups" that
helped the government enforce the CRA by filing petitions against banks whose
“cooperativeness” didn’t measure up, and sometimes stopping their efforts to expand
their operations. Banks responded by giving money to the community groups and by
making more loans. One of those organizations was the Association of Community
Organizations for Reform Now (ACORN). An active associate of ACORN in the 90s was
a young public-interest attorney named Barack Obama.

So, starting in 1977 the federal government began “encouraging”—perhaps “strong-

arming” is a more accurate term—banks to make loans to people to whom they normally
would not make a loan, and in 1995 the Clinton administration pushed through revisions
to the CRA that substantially increased the number and amount of these loans.

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All of the bad loans weren’t caused by the CRA, of course, but billions of dollars in CRA
loans did go bad, as should have been expected. When Fannie Mae and Freddie Mac
came along and made it possible for banks to escape the risk associated with these ill-
advised loans, conditions were just right for a large portion of the banking industry, even
institutions that did not fall under the CRA, to become involved in making loans to
unqualified borrowers, and banks participated in big numbers.

The federal government’s fingerprints are all over this crisis, and the Democrats who are
today so righteously indignant and blaming the administration are at least as guilty as the
Republicans.

Borrow more than pay back:

This is a rather obvious cause of the financial crisis we are in. We do it both individually
and as a nation. Our government sets a bad example by spending more each year than it
receives. Our money then flows overseas to foreign nations in the form of interest on
loans. US consumers borrow more than they can pay back, and banks let them do it.

This is simple enough and hard to disagree with. Now there are probably several reasons
why we borrow more than we can responsibly pay back, but let's just consider one good
one.

Produce less than we consume:

This is rather strait forward. We don't make things anymore. It has been said that
America is a paper economy. Some people seem to be able to ignore basic laws of
physics. You can't go along producing nothing and consuming everything for long until
things start to get out of whack. But that's exactly what America has been doing. We have
been running a trade deficit for years and it only seems to get worse not better. As a result
nations like China have all our money. We send it to them in the form of the trade deficit.
Producing less than we consume explains why we borrow more than we can responsibly
pay back. Now why do we produce less than we consume?

Unprofitable to hire people:

Again that's sort of by definition true and I have so far avoided getting political. We don't
manufacture things in America because it's not profitable to do so. I think there are many
ingenious Americans that could probably invent some really good manufacturing
processes. In fact they did, but unfortunately the processes were exported overseas and
other countries get to enjoy the business advantages of using the technologies. Anyway
since it's not profitable to hire people to manufacture things we produce less than we
consume. So why is it not profitable to hire people to make things in America?

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Excessive taxes and regulations on businesses:

Simply put our government makes it difficult or usually foolish to hire workers to make
things. It's better to do it overseas. Ironically the government usually does this to 'protect'
workers, but the media never considers the result of the 'protection' is that the jobs no
longer exist. Our government imposing excessive taxes and regulations explains why it's
not profitable to hire people to manufacture things. Continuing back up the chain we
arrive at the final result: Financial Crisis.

Most people look at things like this so they don't understand the reasons for our current
situation, and they have no idea what the solution is. When it comes to our current crises
they just 'react' they get upset about giving money to bankers, or maybe they get scared
enough that they are willing to give money to the bankers. Both way most people are
simply reactive in nature and that solves nothing. We need as a culture to reward
substantive dialogue. Instead, substantive thinking has come unfortunately to be often
punished in our culture. Pure symbolism and social talk is a waste of time but it's the
level most people find themselves on most of the time, deviating from it is breaking the
collective rules of behavior we seem to have either decided on or arrived at.

Socialism is a form of collectivism where the government controls what would otherwise
be private property ostensibly for the good of society and usually for the purpose of
promoting equality.

All nations that went the socialist route and to the extent they did suffer financial
crisis.There are also other observations. For example, inequality is not eliminated in
socialist systems but always dramatically increased. The reason, of course, is when you're
in financial crisis every penny really counts and for the have-nots socialism is a real
tough situation. I have traveled a few socialist societies. In Laos, for example, the hotel
clerks at a relatively nice hotel make about $45 a month. I think there is a bit of arrogance
almost bordering on racism in America when we assume we can go the same socialist
route without the same thing happening to us. We can't.

Most voters don't recognize America as socialist. They don't want to admit we are a
socialist nation and members of the left usually say something like: 'The best theory is a
mix of capitalism and socialism.' When you consider that the endpoint is less than $45 a
month I don't think anyone wants to experience pure socialism. Even the Lao people
enjoy some free market reforms or they wouldn't make nearly such a high wage.

Imagine a continuum where on one side you have freedom and on the other pure
socialism. When one considers the sheer magnitude of US government spending we are a
good way towards socialism in the continuum. I would argue regulations also have to be
factored in, and due to our relative prosperity the left has managed to impose more
regulations on business than occurs in many more purely socialist societies. In fact we
may have more burdensome regulations than has ever occurred in any society for all

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history. In a way it's quite an astounding liberal achievement. But when you factor in
regulations and place us in the continuum we are nowhere near the freedom side and
getting closer and closer to the socialist side. So following the empirical argument we
should be suffering and we are. I suppose you could call it experimental verification the
hard way.

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 REASONS
OF
FINANCIAL CRISES

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The immediate cause or trigger of the crisis was the bursting of the United States housing
bubble, which peaked in approximately 2005–2006. High default rates on "sub prime
lending" and adjustable rate mortgages (ARM), began to increase quickly thereafter. An
increase in loan incentives such as easy initial terms and a long-term trend of rising
housing prices had encouraged borrowers to assume difficult mortgages in the belief they
would be able to quickly refinance at more favorable terms. However, once interest rates
began to rise and housing prices started to drop moderately in 2006&2007 in many parts
of the U.S., refinancing became more difficult. Finance and foreclosure activity increased
dramatically as easy initial terms expired, home prices failed to go up as anticipated, and
ARM rates reset higher. In the years leading up to the start of the crisis in 2007,
significant amounts of foreign money flowed into the U.S. from fast-growing economies
in Asia and oil-producing countries. This inflow of funds made it easier for the Federal
Reserve to keep interest rates in the United States too low (by the Taylor rule) from
2002&2006, which contributed to easy credit conditions, leading to the United States
housing bubble. Loans of various types (e.g., mortgage, credit card, and auto) were easy
to obtain and consumers assumed an unprecedented debt load. As part of the housing and
credit booms, the amount of financial agreements called mortgage-backed securities
(MBS) and collateralized debt obligations (CDO), which derived their value from
mortgage payments and housing prices, greatly increased. Such financial innovation
enabled institutions and investors around the world to invest in the U.S. housing market.
As housing prices declined, major global financial institutions that had borrowed and
invested heavily in sub prime MBS reported significant losses. Falling prices also
resulted in homes worth less than the mortgage loan, providing a financial incentive to
enter foreclosure. The ongoing foreclosure epidemic that began in late 2006 in the U.S.
continues to drain wealth from consumers and erodes the financial strength of banking
institutions. Defaults and losses on other loan types also increased significantly as the
crisis expanded from the housing market to other parts of the economy. Total losses are
estimated in the trillions of U.S. dollars globally. While the housing and credit bubbles
built, a series of factors caused the financial system to both expand and become
increasingly fragile. Policymakers did not recognize the increasingly important role
played by financial institutions such as investment banks and hedge funds, also known as
the shadow banking system. Some experts believe these institutions had become as
important as commercial (depository) banks in providing credit to the U.S. economy, but
they were not subject to the same regulations. These institutions as well as certain
regulated banks had also assumed significant debt burdens while providing the loans
described above and did not have a financial cushion sufficient to absorb large loan
defaults or MBS losses. These losses impacted the ability of financial institutions to lend,
slowing economic activity. Concerns regarding the stability of key financial institutions
drove central banks to provide funds to encourage lending and restore faith in the
commercial paper markets, which are integral to funding business operations.
Governments also bailed out key financial institutions and implemented economic
stimulus programs, assuming significant additional financial commitments.

Growth of housing bubble:

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Between 1997 and 2006, the price of the typical American house increased by 124%.
During the two decades ending in 2001, the national median home price ranged from 2.9
to 3.1 times median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006.
This housing bubble resulted in quite a few homeowners refinancing their homes at lower
interest rates, or financing consumer spending by taking out second mortgages secured by
the price appreciation. In a Peabody Award winning program, National Public Radio
(NPR) correspondents argued that a "Giant Pool of Money" (represented by $70 trillion
in worldwide fixed income investments) sought higher yields than those offered by U.S.
Treasury bonds early in the decade. Further, this pool of money had roughly doubled in
size from 2000 to 2007, yet the supply of relatively safe, income generating investments
had not grown as fast. Investment banks on Wall Street answered this demand with the
MBS and CDO, which were assigned safe Credit ratings by the credit rating agencies and
the sub prime crisis. In effect, Wall Street connected this pool of money to the mortgage
market in the U.S., with enormous fees accruing to those throughout the mortgage supply
chain, from the mortgage broker selling the loans, to small banks that funded the brokers,
to the giant investment banks behind them. By approximately 2003, the supply of
mortgages originated at traditional lending standards had been exhausted. However,
continued strong demand for MBS and CDO began to drive down lending standards, as
long as mortgages could still be sold along the supply chain. Eventually, this speculative
bubble proved unsustainable. The CDO in particular enabled financial institutions to
obtain investor funds to finance sub prime and other lending, extending or increasing the
housing bubble and generating large fees. A CDO essentially places cash payments from
multiple mortgages or other debt obligations into a single pool, from which the cash is
allocated to specific securities in a priority sequence. Those securities obtaining cash first
received investment-grade ratings from rating agencies. Lower priority securities
received cash thereafter, with lower credit ratings but theoretically a higher rate of return
on the amount invested. By September 2008, average U.S. housing prices had declined
by over 20% from their mid-2006 peak. As prices declined, borrowers with adjustable-
rate mortgages could not refinance to avoid the higher payments associated with rising
interest rates and began to default. During 2007, lenders began foreclosure proceedings
on nearly 1.3 million properties, a 79% increase over 2006. This increased to 2.3 million
in 2008, an 81% increase vs. 2007. By August 2008, 9.2% of all U.S. mortgages
outstanding were either delinquent or in foreclosure. By September 2009, this had risen
to 14.4%.

Easy credit conditions:

Lower interest rates encourage borrowing. From 2000 to 2003, the Federal Reserve
lowered the federal funds rate target from 6.5% to 1.0%. This was done to soften the
effects of the collapse of the [[dot-com bubble]] and of the September 2001 terrorist
attacks, and to combat the perceived risk of deflation. Additional downward pressure on
interest rates was created by the USA's high and rising current account (trade) deficit,
which peaked along with the housing bubble in 2006. Ben Bernanke explained how trade
deficits required the U.S. to borrow money from abroad, which bid up bond prices and
lowered interest rates. Bernanke explained that between 1996 and 2004, the USA current
account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these

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deficits required the USA to borrow large sums from abroad, much of it from countries
running trade surpluses, mainly the emerging economies in Asia and oil-exporting
nations. The balance of payments requires that a country (such as the USA) running a
current account deficit also have a capital account (investment) surplus of the same
amount. Hence large and growing amounts of foreign funds (capital) flowed into the
USA to finance its imports. This created demand for various types of financial assets,
raising the prices of those assets while lowering interest rates. Foreign investors had these
funds to lend, either because they had very high personal savings rates (as high as 40% in
China), or because of high oil prices. Bernanke referred to this as a saving glut. A "flood"
of funds (Financial capital or liquidity) reached the USA financial markets. Foreign
governments supplied funds by purchasing USA Treasury bonds and thus avoided much
of the direct impact of the crisis. USA households, on the other hand, used funds
borrowed from foreigners to finance consumption or to bid up the prices of housing and
financial assets. Financial institutions invested foreign funds in mortgage-backed
securities. The Fed then raised the Fed funds rate significantly between July 2004 and
July 2006. This contributed to an increase in 1-year and 5-year adjustable-rate mortgage
(ARM) rates, making ARM interest rate resets more expensive for homeowners. This
may have also contributed to the deflating of the housing bubble, as asset prices generally
move inversely to interest rates and it became riskier to speculate in housing. USA
housing and financial assets dramatically declined in value after the housing bubble burst.

Sub-prime lending:
The term sub rime refers to the credit quality of particular borrowers, who have
weakened credit histories and a greater risk of loan default than prime borrowers. The
value of U.S. sub rime mortgages was estimated at $1.3 trillion as of March 2007, In
addition to easy credit conditions, there is evidence that both government and competitive
pressures contributed to an increase in the amount of sub prime lending during the years
preceding the crisis. Major U.S. investment banks and government sponsored enterprises
like Fannie Mae played an important role in the expansion of higher-risk lending. Sub
prime mortgages remained below 10% of all mortgage originations until 2004, when they
spiked to nearly 20% and remained there through the 2005-2006 peak of the United
States housing bubble. A proximate event to this increase was the April 2004 decision by
the U.S. Securities and Exchange Commission (SEC) to relax the net capital rule, which
encouraged the largest five investment banks to dramatically increase their financial
leverage and aggressively expand their issuance of mortgage-backed securities. This
applied additional competitive pressure to Fannie Mae and Freddie Mac, which further
expanded their riskier lending. Sub prime mortgage payment delinquency rates remained
in the 10-15% range from 1998 to 2006, and then began to increase rapidly, rising to 25%
by early 2008. Some, like American Enterprise Institute fellow believe the roots of the
crisis can be traced directly to sub-prime lending by Fannie Mae and Freddie Mac, which
are government sponsored entities. On 30 September 1999, ''The New York Times''
reported that the Clinton Administration pushed for sub-prime lending: "Fannie Mae, the
nation's biggest underwriter of home mortgages, has been under increasing pressure from
the Clinton Administration to expand mortgage loans among low and moderate income

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people...In moving, even tentatively, into this new area of lending, Fannie Mae is taking
on significantly more risk, which may not pose any difficulties during flush economic
times. But the government-subsidized corporation may run into trouble in an economic
downturn, prompting a government rescue similar to that of the savings and loan industry
in the 1980s. In 1995, the administration also tinkered with President Jimmy Carter's
Community Reinvestment Act of 1977 by regulating and strengthening the anti-redlining
procedures. The result was a push by the administration for greater investment, by
financial institutions, into riskier loans. A 2000 United States Department of the Treasury
study of lending trends for 305 cities from 1993 to 1998 showed that $467 billion of
mortgage credit poured out of CRA-covered lenders into low and mid level income
borrowers and neighborhoods. Nevertheless, only 25% of all sub-prime lending occurred
at CRA-covered institutions, and a full 50% of sub-prime loans originated at institutions
exempt from CRA. Others have pointed out that there were not enough of these loans
made to cause a crisis of this magnitude. In an article in Portfolio Magazine, Michael
Lewis (author) spoke with one trader who noted "There weren’t enough Americans with
bad credit taking out bad loans to satisfy investors’ appetite for the end product."
Essentially, investment banks and hedge funds used financial innovation to synthesize
more loans using derivative (finance). "They were creating loans out of whole cloth. One
hundred times over! That’s why the losses are so much greater than the loans.

Predatory lending:
Predatory lending refers to the practice of unscrupulous lenders, to enter into "unsafe" or
"unsound" secured loans for inappropriate purposes. A classic bait-and-switch method
was used by Countrywide, advertising low interest rates for home refinancing. Such loans
were written into extensively detailed contracts, and swapped for more expensive loan
products on the day of closing. Whereas the advertisement might state that 1% or 1.5%
interest would be charged, the consumer would be put into an adjustable rate mortgage
(ARM) in which the interest charged would be greater than the amount of interest paid.
This created negative amortization, which the credit consumer might not notice until long
after the loan transaction had been consummated. Countrywide, sued by California
Attorney General Jerry Brown for "Unfair Business Practices" and "False Advertising"
was making high cost mortgages "to homeowners with weak credit, adjustable rate
mortgages (ARMs) that allowed homeowners to make interest-only payments. When
housing prices decreased, homeowners in ARMs then had little incentive to pay their
monthly payments, since their home equity had disappeared. This caused Countryside’s
financial condition to deteriorate, ultimately resulting in a decision by the Office of Thrift
Supervision to seize the lender. Former employees from Ameriquest, which was United
State’s leading wholesale lender, described a system in which they were pushed to falsify
mortgage documents and then sell the mortgages to Wall Street banks eager to make fast
profits. There is growing evidence that such mortgage frauds may be a cause of the crisis.

Deregulation:
Critics have argued that the regulatory framework did not keep pace with financial
innovation, such as the increasing importance of the shadow banking system, derivative

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(finance) and off-balance sheet financing. In other cases, laws were changed or
enforcement weakened in parts of the financial system. Key examples include:
• In October 1982, President Ronald Reagan signed into Law the Garn-St. Germain
Depository Institutions Act, which began the process of banking deregulation that
helped contribute to the savings and loan crises of the late 80's/early 90's, and the
financial crises of 2007-2009. President Reagan stated at the signing, "all in all, I
think we hit the jackpot".
• In November 1999, President Bill Clinton signed into Law the [[Gramm-Leach-
Bliley Act]], which repealed part of the Glass-Steagall Act of 1933. This repeal
has been criticized for reducing the separation between commercial banks (which
traditionally had a conservative culture) and investment banks (which had a more
risk-taking culture).
• In 2004, the Securities and Exchange Commission relaxed the net capital rule,
which enabled investment banks to substantially increase the level of debt they
were taking on, fueling the growth in mortgage-backed securities supporting sub
prime mortgages. The SEC has conceded that self-regulation of investment banks
contributed to the crisis.
• Financial institutions in the shadow banking system are not subject to the same
regulation as depository banks, allowing them to assume additional debt
obligations relative to their financial cushion or capital base. This was the case
despite the Long-Term Capital Management debacle in 1998, where a highly
leveraged shadow institution failed with systemic implications.
• Regulators and accounting standard-setters allowed depository banks such as Citi-
group to move significant amounts of assets and liabilities off-balance sheet into
complex legal entities called structured investment vehicles, masking the
weakness of the capital base of the firm or degree of financial leverage or risk
taken. One news agency estimated that the top four U.S. banks would have to
return between $500 billion and $1 trillion to their balance sheets during 2009.
This increased uncertainty during the crisis regarding the financial position of the
major banks. Off-balance sheet entities were also used by Enron scandal as part of
the scandal that brought down that company in 2001.
• As early as 1997, Fed Chairman Alan Greenspan fought to keep the derivatives
market unregulated. With the advice of the Working Group on Financial Markets,
the U.S. Congress and President allowed the self-regulation of the [[over-the-
counter]] derivatives market when they enacted the Commodity Futures
Modernization Act of 2000. Derivatives such as credit default swaps (CDS) can
be used to hedge or speculate against particular credit risks. The volume of CDS
outstanding increased 100-fold from 1998 to 2008, with estimates of the debt
covered by CDS contracts, as of November 2008, ranging from US$33 to $47
trillion. Total over-the-counter (OTC) derivative notional value rose to $683
trillion by June 2008. Warren Buffett famously referred to derivatives as
"financial weapons of mass destruction" in early 2003.

Increased debt burden or over-leveraging:

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U.S. households and financial institutions became increasingly indebted or financial
leverage during the years preceding the crisis. This increased their vulnerability to the
collapse of the housing bubble and worsened the ensuing economic downturn. Key
statistics include:
• Free cash used by consumers from home equity extraction doubled from $627
billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of
nearly $5 trillion dollars over the period, contributing to economic growth
worldwide. U.S. home mortgage debt relative to GDP increased from an average
of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.
• USA household debt as a percentage of annual disposable personal income was
127% at the end of 2007, versus 77% in 1990.
• In 1981, U.S. private debt was 123% of GDP; by the third quarter of 2008, it was
290%
• From 2004-07, the top five U.S. investment banks each significantly increased
their financial leverage, which increased their vulnerability to a financial shock.
These five institutions reported over $4.1 trillion in debt for fiscal year 2007,
about 30% of USA nominal GDP for 2007. Lehman Brothers was liquidated, Bear
Stearns and Merrill Lynch were sold at fire-sale prices, and Goldman Sachs and
Morgan Stanley became commercial banks, subjecting themselves to more
stringent regulation. With the exception of Lehman, these companies required or
received government support.
• Fannie Mae and Freddie Mac, two U.S Government sponsored enterprises, owned
or guaranteed nearly $5 trillion in mortgage obligations at the time they were
placed into conservator-ship by the U.S. government in September 2008.
These seven entities were highly leveraged and had $9 trillion in debt or guarantee
obligations, an enormous concentration of risk; yet they were not subject to the same
regulation as depository banks.

Financial innovation and complexity:

The term financial innovation refers to the ongoing development of financial products
designed to achieve particular client objectives, such as offsetting a particular risk
exposure (such as the default of a borrower) or to assist with obtaining financing.
Examples pertinent to this crisis included:
• The adjustable-rate mortgage
• The bundling of sub prime mortgages into mortgage-backed securities (MBS) or
collateralized debt obligations (CDO) for sale to investors, a type of
securitization.
• A form of credit insurance called credit default swaps (CDS).
The usage of these products expanded dramatically in the years leading up to the crisis.
These products vary in complexity and the ease with which they can be valued on the
books of financial institutions.
Certain financial innovation may also have the effect of circumventing regulations, such
as off-balance sheet financing that affects the leverage or capital cushion reported by

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major banks. For example, Martin Wolf wrote in June 2009: "...an enormous part of what
banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives
and the 'shadow banking system' itself – was to find a way round regulation.

Incorrect pricing of risk:

The pricing of risk refers to the incremental compensation required by investors for
taking on additional risk, which may be measured by interest rates or fees. For a variety
of reasons, market participants did not accurately measure the risk inherent with financial
innovation such as MBS and CDO's or understand its impact on the overall stability of
the financial system. For example, the pricing model for CDO’s clearly did not reflect the
level of risk they introduced into the system. The average recovery rate for "high quality"
CDO’s has been approximately 32 cents on the dollar, while the recovery rate for
mezzanine capital CDO's has been approximately five cents for every dollar. These
massive, practically unthinkable, losses have dramatically impacted the balance sheets of
banks across the globe, leaving them with very little capital to continue operations.
Another example relates to AIG, which insured obligations of various financial
institutions through the usage of credit default swaps. The basic CDS transaction
involved AIG receiving a premium in exchange for a promise to pay money to party A in
the event party B defaulted. However, AIG did not have the financial strength to support
its many CDS commitments as the crisis progressed and was taken over by the
government in September 2008. U.S. taxpayers provided over $180 billion in government
support to AIG during 2008 and early 2009, through which the money flowed to various
counter-parties to CDS transactions, including many large global financial institutions.
The limitations of a widely used financial model also were not properly understood. This
formula assumed that the price of CDS was correlated with and could predict the correct
price of mortgage-backed securities. Because it was highly tractable, it rapidly came to be
used by a huge percentage of CDO and CDS investors, issuers, and rating agencies.
According to one wired.com article:
"Then the model fell apart. Cracks started appearing early on, when financial markets
began behaving in ways that users of Li's formula hadn't expected. The cracks became
full-fledged canyons in 2008—when ruptures in the financial system's foundation
swallowed up trillions of dollars and put the survival of the global banking system in
serious peril... Li's Gaussian copula formula will go down in history as instrumental in
causing the unfathomable losses that brought the world financial system to its knees."
As financial assets became more and more complex, and harder and harder to value,
investors were reassured by the fact that both the international bond rating agencies and
bank regulators, who came to rely on them, accepted as valid some complex
mathematical models which theoretically showed the risks were much smaller than they
actually proved to be in practice. George Soros commented that
"The super-boom got out of hand when the new products became so complicated that the
authorities could no longer calculate the risks and started relying on the risk
management methods of the banks themselves. Similarly, the rating agencies relied on

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 the information provided by the originators of synthetic products. It was a shocking
abdication of responsibility."

Boom and collapse of the shadow banking system:

In a June 2008 speech, President and CEO of the NY Federal Reserve Bank Timothy
Geithner, who in 2009 became Secretary of the United States Treasury, placed significant
blame for the freezing of credit markets on a "run" on the entities in the "parallel"
banking system, also called the shadow banking system. These entities became critical to
the credit markets underpinning the financial system, but were not subject to the same
regulatory controls. Further, these entities were vulnerable because they borrowed short-
term in liquid markets to purchase long-term, illiquid and risky assets. This meant that
disruptions in credit markets would make them subject to rapid deleveraging, selling their
long-term assets at depressed prices. He described the significance of these entities: "In
early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in
auction-rate preferred securities, tender option bonds and variable rate demand notes, had
a combined asset size of roughly $2.2 trillion. Assets financed overnight in tri-party repo
grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The
combined balance sheets of the then five major investment banks totaled $4 trillion. In
comparison, the total assets of the top five bank holding companies in the United States at
that point were just over $6 trillion, and total assets of the entire banking system were
about $10 trillion." He stated that the "combined effect of these factors was a financial
system vulnerable to self-reinforcing asset price and credit cycles.
Paul Krugman, laureate of the Nobel Memorial Prize in Economic Sciences, described
the run on the shadow banking system as the "core of what happened" to cause the crisis.
"As the shadow banking system expanded to rival or even surpass conventional banking
in importance, politicians and government officials should have realized that they were
re-creating the kind of financial vulnerability that made the Great Depression possible—
and they should have responded by extending regulations and the financial safety net to
cover these new institutions. Influential figures should have proclaimed a simple rule:
anything that does what a bank does, anything that has to be rescued in crises the way
banks are, should be regulated like a bank." He referred to this lack of controls as
"malign neglect."

Commodity bubble:
A commodity price bubble was created following the collapse in the housing bubble. The
price of oil nearly tripled from $50 to $140 from early 2007 to 2008, before plunging as
the financial crisis began to take hold in late 2008. Experts debate the causes, which
include the flow of money from housing and other investments into commodities to
speculation and monetary policy or the increasing feeling of raw materials scarcity in a
fast growing world economy and thus positions taken on those markets, such as Chinese
increasing presence in Africa. An increase in oil prices tends to divert a larger share of
consumer spending into gasoline, which creates downward pressure on economic growth
in oil importing countries, as wealth flows to oil-producing states.

Systemic crisis:

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Another analysis, different from the mainstream explanation, is that the financial crisis is
merely a symptom of another, deeper crisis, which is a systemic crisis of capitalism itself.
According to Samir Amin, an Egyptian economist, the constant decrease in gross
domestic product, economic growth rates in Western world since the early 1970s created
a growing surplus of capital, which did not have sufficient profitable investment outlets
in the real economy. The alternative was to place this surplus into the financial market,
which became more profitable than capital (economics), productive capital, investment,
especially with subsequent deregulation. According to Samir Amin, this phenomenon has
led to recurrent economic bubble/financial bubbles (such as the internet bubble) and is
the deep cause of the financial crisis of 2007-2009. John Bellamy Foster, a political
economy analyst and editor of the Monthly Review, believes that the decrease in GDP
rates since the early 1970s is due to increasing market saturation. John C. Bogle wrote
during 2005 that a series of unresolved challenges face capitalism that have contributed
to past financial crises and have not been sufficiently addressed:
"Corporate America went astray largely because the power of managers went virtually
unchecked by our gatekeepers for far too long...They failed to 'keep an eye on these
geniuses' to whom they had entrusted the responsibility of the management of America's
great corporations."
He cites particular issues, including:
• "Manager's capitalism" which he argues has replaced "owner's capitalism,"
meaning management runs the firm for its benefit rather than for the shareholders,
a variation on the principal-agent problem
• Burgeoning executive compensation
• Managed earnings, mainly a focus on share price rather than the creation of
genuine value; and
• The failure of gatekeepers, including auditors, boards of directors, Wall Street
analysts, and career politicians.

Role of economic forecasting:

Dirk Bezemer in his research credits 12 economists with predicting (with supporting
argument and estimates of timing) the crisis: Dean Baker (US), Wynne Godley (US),
Fred Harrison (UK), Michael Hudson (US), Eric Janszen (US), Stephen Keen (Australia),
Jakob Brøchner Madsen & Jens Kjaer Sørensen (Denmark), Kurt Richebächer (US),
Nouriel Roubini (US), Peter Schiff (US), Robert Shiller (US). A cover story in Business
Week Magazine claims that economists mostly failed to predict the worst international
economic crisis since the Great Depression of 1930s. The Wharton School of the
University of Pennsylvania online business journal examines why economists failed to
predict a major global financial crisis. An article in the New York Times informs that
economist Nouriel Roubini warned of such crisis as early as September 2006, and the
article goes on to state that the profession of economics is bad at predicting recessions.
According to The Guardian, Roubini was ridiculed for predicting a collapse of the

15
housing market and worldwide recession, while The New York Times labeled him "Dr.
Doom". However, there are examples of other experts who gave indications of a financial
crisis.

IMPACT
OF
FINANCIAL CRISES

16
 FINANCIAL MARKETS IMPACTS

The International Monetary Fund estimated that large U.S. and European banks lost more
than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009.
These losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were
forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The IMF
estimated that U.S. banks were about 60 percent through their losses, but British and
Euro zone banks only 40 percent. One of the first victims was Northern Rock, a medium-
sized British bank. The highly leveraged nature of its business led the bank to request
security from the Bank of England. This in turn led to investor panic and a bank run in
mid-September 2007. Calls by Liberal Democrat Shadow Chancellor
Vince to nationalize the institution were initially ignored; in February 2008, however,
the British government (having failed to find a private sector buyer) relented, and the
bank was taken into public hands. Northern Rock's problems proved to be an early
indication of the troubles that would soon befall other banks and financial institutions.

Initially the companies affected were those directly involved in home construction and
mortgage lending such as Northern Rock and Countrywide, as they could no longer
obtain financing through the credit markets. Over 100 mortgage lenders went bankrupt
during 2007 and 2008. Concerns that investment bank Bear Stearns would collapse in
March 2008 resulted in its fire sale to JP Morgan Chase. The crisis hit its peak in
September and October 2008. Several major institutions failed, were acquired under
duress, or were subject to government takeover.

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 RECOMMENDATIONS

Recommendations:

1. Stabilize the financial system.

2. Stabilize the economy.
3. Arrange long-term financing for steps #1 and #2 with our foreign creditors.

Click on the above links for details. A conclusion follows below, explaining why we will
not implement such measures and the possible consequences. The above links go to
posts explaining each recommendation in greater detail.

I. Stabilize the financial system

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No modern economy can survive the meltdown of its financial system. There are many
ways to avoid this, illustrated by the following.

(a) Re-capitalize the financial sector by a transfer of wealth from the taxpayers to banks
and brokers – This is probably the key element of the Paulson Plan, done by the
government buying assets at above market prices.

(b) Close defunct or weakening financial institutions under new bankruptcy legislation,
under which the courts could act with extraordinary speed and authority. This should
involve replace managements. New managements could be selected by a bi-partisan
committee of business leaders that should have only a minority of members from the
financial industry.

(c) Outright nationalization — As done the defunct Savings and Loans during the early
1990’s, and today with the GSE’s and AIG. Large-scale nationalizations might be
required. If so, our political regime’s survival might depend on how this is done. Not
just their acquisition, but their operation and eventual privatization (if any).

Creation of an agency like the Depression era Home Owners Loan Corporation,
as recommended by Nouriel Roubini, can play a role in any of these policy choices.

II. Stabilize the economy.

(a) Why wait? Set up the job training and education programs now, rather than throw
them together in haste when they are needed yesterday. There will be many unemployed,
and this is an opportunity to upgrade their skills for the next cycle.

(b) Many local governments will go bankrupt, as so many are vulnerable (e.g., NYC).
Work with the States now to prepare the necessary legal and financial apparatus to handle
these.

(c) Implement a massive monetary stimulus, such as taken by Japan at the start of their
dark decade after the 1989 crash. That means near-zero interest rates (far below the level
of inflation) and a rapid increase in the balance sheet of the Federal Reserve. The
government has not taken these steps because they might lead to currency flight from the
US Dollar, and the government does not want to take the necessary measures to prevent
this (see III).

III. Arrange long-term financing for steps #1 and #2 with our foreign
creditors

This means a negotiated agreement with the foreign central banks who are our primary
creditors, with the appropriate support from Congress.

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We will need to reschedule our debt and obtain new financing. Our government will
have to rollover roughly $500 billion/year, plus the trillion or so in additional borrowing
(as tax revenue declines and expenses skyrocket) for the next two years (perhaps
longer). Plus measures will be needed to stabilize the value of the US dollar, allowing a
orderly decline.

These extraordinary negotiations will be inherently destabilizing, putting in question both

the US Dollar’s role as reserve currency and America’s role as global hegemon. This is
the price paid by our past folly, getting us into this crisis.

Obtaining and executing this agreement must be concluded successfully. It is a jump

across a chasm to a new world. But the chasm lies ahead of us, and must be crossed
eventually. Let’s strike a deal while we can negotiate from a position of strength. Rather
than waiting until we are desperate.

The cost will be high. An agreement will be in the best interest of all, but that does not
mean that we will not have to make concessions. To give just one example, China might
ask that the US break our relations (esp military) with Taiwan.

20
 CONCLUSION

Conclusion

I believe that the downturn can be mitigated by immediate and decisive action. Building
public support for these measures and avoiding panic will require the highest level of
statesmanship by our leaders — and responsible citizenship by us.

Of course we will not take such actions in a timely fashion. Our leaders’ happy talk was
intended to maintain spending and investment during a brief slowdown. The unintended
consequence is that the American people are psychologically unprepared for this crisis.

Worse, our Observation-Orientation-Decision-Action loop is broken. Despite years of

warnings (see this list) we have not seen the danger ahead. Now that it is upon us, our

21
fixed optimism prevents us from orienting ourselves to changed conditions. I doubt that
our leaders can either formulate adequate plans or execute them.

As so often in American history, we must fall back on the resourcefulness of the

American people. Our ability to act together, to force our leaders onto the right path, to
have the resilience to weather difficult times.

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