The Financial Crisis of 2007-2008

and the Great Recession

A Massive Failure of the Financial and
Political Elites in the United States
Who is to Blame for the Financial
Meltdown and the Great
Recession?
1. Congress – Slowly deregulated the financial
system.
2. Presidents Carter to Obama – Their choices for
cabinet officers, regulatory agencies,
and their advisors.
3. Banks and Financial Companies – “Infectious
Greed” and “Irrational Exuberance.”
4. The Rating Agencies – Moody’s, Standard &
Poor’s, Fitch.
5. The American Elite who served on various boards
of directors and directly benefited from the
Housing Bubble.
Securitization and The Shadow Banking
System (The Road to Hell is Paved With
Good Intentions)
 What is Securitization?
• 1. Suppose you are a business with a steady (and predictable)
cash flow (car rental agency).
• 2. You can transfer the cash flow to a Special Purpose Vehicle
(a tax-exempt company or Trust) that can issue bonds. The
interest on the bonds is paid by the cash flow (accounts
receivable).
• 3. Wikipedia: Securitization is the financial practice of
pooling various types of contractual debt such as residential
mortgages, commercial mortgages, auto loans or credit card
debt obligations (or other non-debt assets which generate
receivables) and selling their related cash flows to third party
investors as securities, which may be described as bonds,
pass-through securities, or collateralized debt obligations
(CDOs).
 Types of Securitization

Collateralized Debt Obligations (CDO)

Asset Back Securities (ABS)

Commercial Mortgage Backed Securities (CMBS)

Residential Mortgage Backed Securities (RMBS)

 The Three Pillars of the financial crisis (THE

DOOMSDAY MACHINE)

a. First, bad paper was widely written in the form of

sub-prime mortgages.

b. Second, these mortgages were securitized; the

securities, endorsed by egregious evaluations by ratings

agencies and marketing by financial institutions, were

pushed to investors around the world (Lots of Extra Money

Floating Around due to World Economic Development in the

1990s).
 c. Third, the securities – mainly RMBS’s -- insured by

credit default swaps. AIG was the dominant insurer.

SECURITIZATION – These securities were used [ALONG WITH

MANY OTHER SECURITIES] as collateral in the shadow banking

system.

d. The three pillars promoted a housing market bubble.

1. Securitization, plus …
2. Huge World Capital Surplus
produced …

The Shadow Banking System

Securitization and the Shadow Banking
System
• These securities (along with many other
securities – private & Fannie Mae and Freddie
Mac) were used as collateral in the Shadow
Banking System.
• Sale and Repurchase Market (“REPO”) – The
essence of “Shadow” Banking. Shadow Banks
(1) do not take deposits; (2) provide credit
and liquidity; (3) no access to central bank
funding or the FDIC.
 “REPO” Market
• This Market only works if you have access to
Collateral that is seen as “Good as Gold.”
• The Collateral must be SAFE – so safe that you
do not have to worry about it or make much
of an effort to investigate it.
Federal National Mortgage
Association (Fannie Mae)
Federal Home Loan Mortgage Corporation
(FHLMC, called Freddie Mac)
Timeline of Deregulation of Financial Markets
1978 Supreme Court deregulates
consumer interest rates on credit
cards; Maine allows entry of out-
of-state banks. Similar laws passed
in all states except Hawaii by 1992.
1980 Depository Institutions
Deregulatory and Monetary
Control Act. Eliminates regulation
of interest rates.
1982 Garn–St. Germain Act. Allows for
adjustable rate mortgages and
interstate acquisitions of troubled
banks.
1983 Federal Reserve, bank holding
companies can acquire discount
securities brokers.
1984 Secondary Mortgage Market
Enhancement Act. Facilitates
private issuance of mortgage-
backed securities. Preemption of
state regulation.
1987, 1989, 1996 Fed expands securities
underwriting capacity of banks.
1989 FIRREA passed to resolve savings
and loan crisis, weak regulatory
structure implemented.
1994 Riegle-Neal Interstate Banking
and Branching Efficiency Act of
1994. Interstate acquisitions and
branching permitted.
1999 Gramm-Leach-Bliley Financial
Services Modernization Act.
Repeals Glass-Steagall separation
of investment and commercial
banking.

2000 Commodity Futures

Modernization Act. Deregulates
derivatives markets. American
Homeownership and Economic
Opportunity Act.
2003 American Dream Down payment
Assistance Act.
2004 SEC allows investment banks to
expand leverage.

2005 Congressional impasse on

predatory lending. Republicans
seek to eliminate state regulation,
Democrats seek stronger
regulation.
Timeline of Minority and Low-income Housing Legislation

1977 Community Reinvestment Act.

Bans redlining. Used to increase
-low-income loans of banks
seeking merger approval.
1990 Cranston-Gonzalez National
Affordable Housing Act (the
HOME Investment
Partnerships Act).
1992 Housing and Community
Development Act—Section VIII:
Federal Housing Enterprises
Financial Safety and Soundness
Act. Lowered down-payment
requirements.
1996 Housing Opportunity Program
Extension Act of 1996.
2000 American Homeownership and
Economic Opportunity Act.

2003 American Dream Down

Payment Assistance Act.
Bubbles: Economic and Political
When the Housing Bubble Popped
it triggered a classic Bank Run.

Only it was a Run on the Shadow

Banking System.

This Brought the Economy Down.

• What is a Bubble??
• “This Dance Can go on Forever”

• Basically – “If it is too good to be true…..it

ain’t”
• Asset Bubbles and Political Bubbles are
shaped by: Ideologies (Beliefs); Institutions;
and Interests
 Economic Bubbles
• Stock Market c. 1927 – 1929.
– “Irrational Exuberance”
• Dot Com Bubble in the late 1990s.
– New Information Economy was emerging. “Bricks
and Mortar” will be a thing of the past.
• Housing Bubble late 1990s – 2006.
– Globalization and a Savings Glut from Developing
countries could drive interest rates to
permanently low levels.
 Political Bubbles
• Stock Market c. 1927 – 1929.
– Not the Government’s Business.
• Dot Com Bubble late 1990s
– If the information economy is the wave of the future it
would be Luddism to tighten standards for public
offerings or pricing of stock options.
• Housing Bubble late 1990s – 2006.
– Markets self-correct (rational expectations). If savings
glut reduces interest rates it would be folly for
monetary policy to interfere.
 Bubble Expectations

1) Investors appear to be only boundedly

rational.

2) When you are riding the Bubble up the

trick is to jump off before the peak.

3) When the policy makers share the bubble

beliefs, they must also believe there is no

rationale for intervention.

 Almost Everyone Believes……

• THIS TIME IS DIFFERENT!

 The Ideologies at Work in the latest
Crisis – 1990s to 2008
• Free Market Conservatism
• Fundamentalist Free Market Conservatism
• Egalitarianism
 THREE COMMON FEATURES OF TWO TYPES OF BUBBLES

1) shared ideology of market actors and

politicians;

2) both are influenced by institutions –

political rules determine economic rules;

3) Self Interest and Greed

Hard to disentangle Greed and Ideology