The Financial Crisis 2007
Dorian Ford Prince, May 2010
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First paper banknote issued by John Law 1714
Capitalism = ‘boom’ and ‘bust’
some recent crises:
Tulip mania - Netherlands 1637
South Seas Bubble, UK 1720
The Mississippi Bubble, France 1720, John Law, first paper money
Panic of 1819 – USA
The Long Depression 1876 – 1896 UK, USA, Europe
Panic of 1907
Wall Street Crash – 1929, Great Depression 1930-45
Oil crisis 1973 (UK – IMF in 1976)
Savings and Loan Scandal, USA, 1986-96, US$ 125 bn bailout
Japanese asset bubble – 1986 - ?
Mexico 1994
Asian financial crisis (“IMF crisis”) – Thailand, Indonesia,
South Korea,Philippines, 1997-8
Russian financial crisis 1998
Dot-com bubble 1995-2001
Argentina defaults – largest debt default in history - 2002
Dorian Ford Prince, May 2010
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Financial Crisis 2007
Or The End of Economic Theory?
Economists cannot agree on :
• what caused the crisis
•What are the short, medium and long term effects
•Who is to blame
•How long it will last
•Solutions
•When the next crisis will happen
Dorian Ford Prince, May 2010
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Possible causes
1.
2.
3.
4.
5.
Loose monetary policy – low interest rates
Financial deregulation
New, complex, innovative financial products
US housing boom, sub-prime mortgages
Globalisation and the new US-Asia economic
model
6. Ratings Agencies
Dorian Ford Prince, May 2010
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1. Loose monetary policy and low
interest rates
• After ‘Dot-com bubble’ and 9/11, FED
reduces interest rates from 6.5% in
2000 to 1% in 2003
• Printed too many dollars – banks had
too much cash
• Foreigners increased holdings of US
Treasury bonds, increasing liquidity.
Proceeds mainly went into housing
market.
• FED increased interest rates to 6% in
2006, many householders not could
not reimburse their mortgages
Dorian Ford Prince, May 2010
Alan Greenspan, Chairman,US
Federal Reserve, 1987-2006
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2. Financial Deregulation
• In 1999, President Clinton abolishes Glass-Steagall Act of 1933, separating
commercial banking from investment banking
• In 2004, Securities and Exchange Commission relaxes restrictions on
amount of debt which investment banks are allowed to hold
• US regulators allow major deposit banks to move assets and liabilities off
their balance sheets into “structured investment vehicles”
• Growth of ‘shadow banking system’ unchecked and unregulated. By end
2006, unregulated banks are bigger than traditional, regulated banks
• In 1997 FED Chairman Greenspan blocks attempts to regulate
“derivatives”
• In 2000, President and Congress allow ‘credit default swaps’ to be selfregulated
Dorian Ford Prince, May 2010
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3. New Financial Products
• Structured investment vehicle – accounting trick by banks
to get around capital and risk requirements
• Derivative – insurance policy guaranteeing future value of
a commodity, equity or loan
• Mortgage backed securities - bundle together disparate
loans (such as sub prime mortgages, car loans), and/or
risky investments, create packaged securities and sell off
the shares
• Credit default swaps – A contracts a risky loan with B
then asks C for an insurance policy whereby if B cannot
pay (defaults), C will pay A an amount. In return C
charges a premium. In order to spread the risk, C bundles
together all sorts of risks into derivatives which it sells to
other institutional lenders. In 2007, CDS worldwide were
worth US$ 58 trillion while world GDP was only US$ 54.3
trillion
Dorian Ford Prince, May 2010
“Financial
weapons of mass
destruction”
Warren Buffett
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4. US housing boom
Average US Home prices
Growth in subprime loans
Dorian Ford Prince, May 2010
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US Housing Crash
• Not enough mortgages to satisfy Wall Street’s demands for
derivatives, so riskier loans, second mortgages to finance
consumers
• Interest rates increase suddenly from 1% to 6% so by August
2008, 15% of all mortgages had defaulted
• Mortgages as % US GDP increased from 45% in 1990 to 73% in
2008. US private household debt represented 127% of
personal disposable income by end 2007. By end 2008, US
private debt equals 290% GDP
• 6 million Americans lost their homes
• House prices fell by 30-40% in 2008, MBS and CDS shown to
be worthless pieces of paper
Dorian Ford Prince, May 2010
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5.(a) Globalisation
Dorian Ford Prince, May 2010
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5(b) New US-Asia Economic Model
US trade deficit (2008):
China $270 bn
Japan
$70 bn
Stocks of US Treasury Bonds:
China $ 810 bn
Japan $1106 bn
Dorian Ford Prince, May 2010
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6. Ratings agencies
• Only 3 Ratings Agencies (Moody’s, Fitch, S&P)
= world cartel
• All the derivatives, CDS, MBS etc, plus all the
investment banks (including Bear Stearns and
Lehman) had been given AAA ratings as “safe
investments”
• Since 2000, ratings agencies paid by the
companies they rated rather than by potential
investors
Dorian Ford Prince, May 2010
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EFFECTS
• Unemployment reaches 10% in USA, 15% in UK, 21%
in Spain, 30% Greece
• Iceland collapses. Ireland collapses.
• Greece, Portugal, Spain? Break-up of EURO?
• Bank runs lead to US bailout costing over $ 2 trillion,
UK bailout 2 trillion pounds (UK debt now equals
120% GDP)
• World trade falls by 40% in 2008 – so far no real
recovery
Dorian Ford Prince, May 2010
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Solutions?
• Reduce interest to 0
• Print money (extra $3trillion in US)
• Increase budget deficit (record $ 15 trillion
expected in US by 2015 = 100% GDP)
• Stimulus package (infrastructure, health
education programmes, US$ 1 trillion)
• Re-regulate the financial services industry
(Obama legislation, IMF proposed tax on financial services, SEC
investigation into Goldman Sachs, G20 programme)
Dorian Ford Prince, May 2010
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But haven’t these solutions been tried before?
• Weimar Republic 1919-33
• Japan 1990 –
• Zimbabwe 2000 50 Million Mark note
Issued in 1924
Worth only US$1
Dorian Ford Prince, May 2010
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How long will the Financial Crisis last?
“Technically, the recession is
over but the economic recovery
will appear very weak in 2010”,
Bernanke, September 2009
Stock markets reach historic
highs in April 2010
Domestic growth high in some
Asian markets
Ben Bernanke
US Fed Chairman
Dorian Ford Prince, May 2010
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BUT problems loom.....
• US and EU consumers (70% of world economy), affected by
unemployment and debt, reluctant to resume buying
• Income tax will rise in US and EU to repay extravagant fiscal
deficits, further depressing consumption
• World trade will only recover slowly, especially if US imposes
trade restrictions
• Sovereign debt crisis will affect many other countries (and
many states of the US)
• New asset bubbles. Next Asian crisis? Bust in China? Default in
Vietnam?
• Longer term – inflation? Currency devaluations?
Dorian Ford Prince, May 2010
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Two views on financial institutions
Sir Isaac Newton
Alan Greenspan, Chairman of the US
Federal Reserve, 1987 - 2006
Commenting on his personal financial
loss during the South Seas Bubble, 1720
• “Innovation has brought about a multitude of new
products, such as subprime loans and niche credit
programs for immigrants. Such developments are
representative of the market responses that have
driven the financial services industry throughout the
history of our country … With these advances in
technology, lenders have taken advantage of creditscoring models and other techniques for efficiently
extending credit to a broader spectrum of consumers.
… Where once more-marginal applicants would simply
have been denied credit, lenders are now able to quite
efficiently judge the risk posed by individual applicants
and to price that risk appropriately. These
improvements have led to rapid growth in subprime
mortgage lending; indeed, today subprime mortgages
account for roughly 10 percent of the number of all
mortgages outstanding, up from just 1 or 2 percent in
the early 1990s “ 2004.
•
•
•
“I can measure the movement
of the stars, but I cannot
measure the madness of men”
Dorian Ford Prince, May 2010
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