Chapter 12
The Financial Collapse of
2007 - 2008
These slides supplement the
textbook, but should not
replace reading the textbook
1
What is the main point of
Frederick Hayek’s 1944 book
The Road to Serfdom?
The loss of personal freedom
comes when planners realize
that the only way for the plan
to work is to mandate that
everyone adhere to the plan
2
What is the main point of
Philip Howard’s 2014 book
The Rule of Nobody?
Rules are replacing basic
principles and with the
proliferation of arcane rules
and lengthy and complex
regulations, individual
freedom is destroyed
3
Why is Growth
important?
If we do not grow there is less
goods and services as
things deteriorate over time
4
Where do we begin?
The role of government
free markets / planned economy
5
Does the Keynesian
policy of increasing
government spending
lead to more growth or
less growth?
Keynesians believe that it
increases growth by
shifting the aggregate
demand curve to a full
employment equilibrium
6
According to Keynesians why
does an increase in
borrowing and government
spending lead to growth?
The Keynesian multiplier
supports the idea that when
people have a dollar they
will save some of it, but if
the government has the
dollar it will spend all of it
7
What is the main objection
that Austrian Economists
have against Keynesians?
The Keynesian emphasis on
government borrowing and
spending impede growth
because it works at cross
purposes to saving,
investing and supply
8
According to Austrians
why does an increase in
government spending lead
to less growth?
• Higher taxes
• More debt
• More regulations
• Diminishes private investments
• Choices made because of
politics rather than economics
9
What is the upshot to
the story of our
financial collapse of
2007-2008?
Policies of the federal
government and the Federal
Reserve distorted markets
10
Why is excessive debt a
problem in an economic
downturn?
People cannot meet their
debt obligations and a
dominoes affect sets in
11
What is a Security?
A financial instrument
representing financial value
such as mortgages, bonds,
banknotes, stocks, future
contracts, and derivatives
12
What does Securitizing
Debts Mean?
The financial practice of
pooling debts, like
mortgages, and selling the
consolidated debts as
bonds (securities) which
pay the investors principle
and interest regularly
13
What is the Purpose of
Securitizing Debts?
Its purpose is to allow
lenders to reinvest their
assets into more lending
and in affect increase
the number of lenders in
the mortgage market
14
What is a Collaterized
Debt Obligation (CDO)?
A type of structured asset
whose value and payments
are derived from a portfolio
of fixed income assets, it is
a collection of streams of
income under one roof
15
How are CDOs structured?
Hundreds of loans are put
into a pool and then divided
into different tranches
according to risk level
16
What gives CDOs value?
The money that flows into and
out of the CDO as people pay
their monthly installment
loans or retire the loans
17
Show me how
collateralized debt
obligations work
http://www.khanacademy.
org/financeeconomics/corefinance/v/collateralizeddebt-obligation-overview
18
What is the purpose of
Fannie Mae?
Its purpose is to expand the
secondary mortgage market
by securitizing mortgages in
the form of mortgage
backed securities (MBS)
19
What is Freddie Mac?
Authorized by Congress in
1972 to purchase private
mortgages on the
secondary market to
compete with Fannie Mae
20
What are some
problems with
securitizing debt?
The complexity can limit
investors ability to
monitor risk, and make it
more difficult to
standardize the market
21
What is leverage?
The act of using borrowed
money to make bets on
some future event
22
What is a
Subprime Mortgage?
A type of mortgage which
involved a high level of risk to
the lender and in some cases
actual deceit and fraud
23
What is an Alt-A Loan?
Sometimes called “Liar
Loans” they required less
documentation than
traditional subprime loans
24
What was the policy of
Alan Greenspan, chair of
the Fed from 1987-2006?
The easy-money policies of
the Fed during
Greenspan's tenure has
been suggested to be a
leading cause of the
subprime mortgage crisis
25
Why were the easy
money policies of the
Fed a factor in the
mortgage crises?
People borrowed money to
buy homes, the price of
homes increased, equity
increased, and many
people borrowed against
the home’s equity
26
What is the Housing and
Community Development
Act of 1977?
Banks were required to make
substantial loans to low
income persons even with
bad credit ratings
27
Why did Fan and Fred
defraud investors?
To increase market share
in the subprime loan
market and to meet the
demands of the Housing
and Community
Development Act of 1977
28
What is the Housing and
Community Development
Act of 1992?
Fannie Mae and Freddie Mac
were required to meet a goal
of 30% mortgages bought
should be from low and
moderate income families,
raised to 55% in 2007
29
What pressure was put
on Fannie Mae in 1999?
The Clinton Administration
encouraged an increase in
loan purchases stemming
from inner city areas and
pressed for an easing of
standards in the primary
mortgage market
30
What mandates were
put on Fannie Mae and
Freddie Mac in 2004?
They were required to
purchase subprime loans
from banks to the tune of
about $1 billion per week
31
What is the Securities
and Exchange
Commission (SEC)?
This commission is responsible
for enforcing the federal
securities law and regulating
the securities industry
32
What did the SEC do in
2004 that effected the
securities market?
It allowed banks to set their
own “debt-to-net-capital rule”
which changed the industry
standard from a 12 to 1 debt
capital ratio to 40 to 1 ratio
33
Which firms benefited
the most from this
change in legal ratios?
• Goldman Sachs
• Bear Stearns
• Morgan Stanley
• Merrill Lynch
• Lehman Brothers
34
What happened in 2008 to
these investment banks?
They all collapsed and either
disappeared or were
converted to bank holding
companies so they could be
bailed out by the Fed
35
What is the Private
Securities Litigation
Act of 1995?
This act protected Wall Street
firms from legal suits and
restricted investors from
suing banks for fraud
36
What was the result of
the secondary
mortgage market and
the Private Securities
Litigation Act of 1995?
They gave banks and mortgage
related companies a free hand
to engage in high levels of
speculation and fraud
37
Who is Angelo Mozilo
and what is Country
Wide Mortgage?
Angelo Mozilo founded
Country Wide, a mortgage
company that specialized
in subprime mortgages
38
What role did Country
Wide Home Loans play?
Country Wide, partnered with
Fannie and formed a
reduced documentation
loan program, Country Wide
found the customers and
Fan provided the money
39
What is the Financial
Crises Inquiry
Commission?
A Congressional commission
that spent 18 months
investigating the subprime
mortgage problem and in 2011
found Fan and Fred innocent
of any fault and blamed the
crises on private bankers
40
What is the lawsuit that
the SEC brought
against Fannie and
Freddie in 2012?
The SEC claims that six Fan
and Fred executives
defrauded investors because
they knew and approved
misleading statements about
their subprime loan exposure
41
What is an example of
Hedging?
A farmer agrees to sell his corn
to someone at a set price on
a set date in the future
42
What is an Option?
A derivative financial
instrument that specifies a
contract between two parties
for a future transaction on
an asset at a reference price
(the strike price)
43
What are the two types
of Options?
An option to buy something
at a specific price in the
future is named a “call”;
an option to sell
something at a specific
price is named a “put”
44
What does it mean to
Short the Stock Market?
You borrow shares from a
brokerage house in order
to sell them in the hope
that you can buy them
later at a lower price, you
gain when the price
declines and lose when
the price increases
45
What is a Hedge Fund?
A private investment fund
which may invest in a diverse
range of assets and may
employ a variety of investment
strategies to protect from
downturns and maximize the
market upswings
46
What is a
Derivative Instrument?
A contract between two
parties that specifies
conditions under which
payments are to be made
between the two parties
47
What is a
Derivatives Market?
A financial market for future
contracts, these financial
instruments in a futures
market are called options
48
What is a
Futures Market?
A specific type of derivative
involving a bet between two
parties on the future price,
called the strike price, of some
specified standardized
product, like the price of corn
six months from the agreement
49
How is Future
Value Determined?
Derivatives often rely on
some complicated
mathematical model to
determine future value, like
the Black - Scholes model
50
What is an example of
Speculative Trading in
the Derivatives Market?
In 1995 Nick Leeson, a
trader for Barings Bank, the
oldest investment bank in
London, made poor and
unauthorized investments
in futures contracts
bankrupting the bank
51
What is an
Over-the-Counter
Derivatives Market?
A market that is an agreement
between two parties and no
one else, the contract is
personal between the two
parties, there is no exchange
where information is shared
52
Is it possible that
even the purchaser of
the derivative is not
privy to the facts?
Yes, investment companies
like Bear Stearns often
sold contracts to others,
like pension funds, without
divulging all the facts
53
How large is the
Derivatives Market today?
The notional value, the
hypothetical value existing
only in theory, is about
$600 trillion!!!
54
What is the Commodity
Futures Trading
Commission (CFTC)?
Authorized to regulate
agricultural futures and
the derivatives market
55
Who is Brooksley Born?
She was the head of the
Commodity Futures
Trading Commission from
August 1996 to June 1999
56
What did Brooksley Born
do as head of the CFTC?
She lobbied Congress
and the President to
give the CFTC oversight
of the over-the-counter
derivatives market
57
Why was Brooksley
Born concerned ?
Dangerous things were
happening in the market
like fraud and excessive
speculation leading to
major failures
58
What was the event
that brought these
excesses to light?
In 1996 Proctor and Gamble
ended up owing $200 billion in
the derivatives market and it
sued their derivatives dealer,
Bankers Trust, for fraud
claiming it was not given
proper explanation
59
What was the
outcome between
Proctor and Gamble
and Bankers Trust?
In 1996 Bankers Trust settled
with Proctor and Gamble
forgiving most of the debt
60
What happened after
Brooksley Born
alerted the Treasury,
the Fed, and the SEC
about her concern?
She was relieved of her
jurisdiction over the
derivatives market
61
Who is Alan Greenspan?
He was Chairman of the
Fed from 1987 to 2006
62
Who was Ayn Rand
(1905-1982)?
She was a playwright,
screenwriter, and author who
wrote The Fountainhead (1943)
and Atlas Shrugged (1957)
63
What was Ayn Rand’s
philosophy?
She believed in a strict laissez
faire capitalistic economic
system with minimal
government and where rational
self-interest plays a key role
64
Who was Atlas in
Greek mythology?
He was a god who held the
world on his shoulders
65
Who was Atlas in her
book Atlas Shrugged?
The entrepreneur, when he
shrugs the whole world
comes tumbling down
66
How did Ayn Rand
influence Alan Greenspan?
He was her protégé
and close friend
67
What was Alan
Greenspan’s response
to Brooksley Born?
He believed that the free
market would take care of all
problems and that any
interference in the market
would be harmful
68
What happened to
Long Term Capital in
1998?
Long Term Capital, a hedge
fund, was highly leveraged
in the derivatives market
with $1.25 trillion notional
value with only $4 billion
capital to back it up
69
What happened to
Long Term Capital?
In 1998 big banks stepped
in and took over Long
Term Capital and incurred
large losses on its
leveraged investments
70
What is the Commodity
Futures Modernization
Act of 2000?
This act stripped the
Commodity Futures Trading
Commission of all
responsibility over the
derivatives market
71
What did the
Modernization Act do ?
It forbid state regulators to
interfere with the over-thecounter derivatives market
72
What did rent seeking
have to do with the
situation between 2000
and 2010?
Wall Street firms plied over
$1.7 billion in campaign
contributions and $3.4
billion on lobbyists
73
What was the GlassSteagall Act of 1932 ?
This act separated commercial
banking from investment
banking, commercial banks
were regulated and
investment banks were not
74
What happened to the
Glass-Steagall Act?
The Commodity Futures
Modernization Act of 2000
obliterated the difference
between commercial banks
and investment banks
75
What else did the
Modernization Act of
2000 do?
The FDIC granted the
same protection to
investment banks as they
did to commercial banks
76
What is a Credit
Default Swap?
A CDS is a bet on a future
event involving a hedge
against a possible default,
for a price it transfers
liability on an investment
from party A to party B
77
When did CDSs
emerge?
In 1994 when young
executives from JP
Morgan bank had a
weekend meeting in Boca
Raton Florida
78
What is the American
International Group (AIG)?
AIG is an American
insurance corporation who
th
in 2008 was the 18 largest
public company in the world
79
What is an example
of a CDS?
Bank A lends one million
dollars to the XYZ company
and then pays AIG to take the
risk of a possible default
80
What effect did a
bank’s CDS have on its
excess reserves?
The Fed agreed to lower its
reserve requirement
because of the lower risk
incurred by banks
81
What is Standard and
Poor’s and Moody’s?
How do they get paid?
Two credit rating agencies
– They are paid by the
companies they rate
82
What role did these
agencies play in the
financial collapse of
2007-2008?
Because AIG sold CDSs to
CDOs and AIG had a
triple A credit rating, the
whole CDO was given a
triple A rating
83
Who is Joe Cassano?
Between 2001 and 2008 he
was the head of the Financial
Products Division of AIG
84
What did Joe Cassano do?
He sold billions of dollars
worth of CDSs to banks
without the assets to back
up the insurance
85
What is a Naked CDS?
In a naked CDS neither party
actually holds the underlying
loan, in essence two noninvolved parties make a bet
on some future event
86
How did Joe Cassano
use Naked CDSs?
He sold CDSs protection to
numerous non-involved
banks on the same loan
87
What precipitated the
Financial Bubble in 2000?
• Fed policies
• Deregulation mania
• Excessive leverage
88
What is an Adjustable
Rate Mortgage Loan?
The interest rate would
increase over time according
to a pre-determined schedule
89
What does it mean to
be Upside Down on a
Mortgage?
You owe more on a house
than what the house is
worth on the market
90
END
91
What are the 12
Deregulatory Steps to
Financial Meltdown?
The 12 slides will discuss the
12 events which resulted in
the financial collapse of 2007
to 2008 as explained in Sold
Out of March 2009
http://www.wallstreetwatch.org
92
#1 Repeal of the
Glass-Steagal Act
The Financial Services
Modernization Act of 1999
formally repealed the GlassSteagal Act of 1932
93
#2 Hiding Liabilities: Off
Balance Sheet Accounting
The Financial Accounting
Standards Board allowed
securitized mortgages to be
held as an off-balance sheet
entity so that banks did not
have to have capital reserves
to secure the pool of loans
94
#3 The Executive Branch
Rejects Financial
Derivative Regulation
Brooksley Born was relieved of
her duties and the Commodity
Futures Trading Commission
was instructed to cease any
activities over the derivatives
market, as well as states
95
#4 Congress Blocks
Financial Derivative
Regulation
The Commodities Futures
Modernization Act of 2000
exempted financial
derivatives from regulation
96
#5 The SECs allowed
Banks to set their own
reserve requirements
In 2004 the SEC authorized
investment banks to develop
their own net capital
requirements, this resulted in
excessive leverage with ratios
as high as 40 to 1
97
#6 Bank Self-Regulation
Goes Global: Preparing
Repeat of the Meltdown
The complicated financial
maneuvering made it hard for
international banks to agree
and enforce any strict capital
reserve requirements
98
#7 Failure to Protect
Predatory Lending
Regulators sat on their hands
when it came to protecting
abusive behavior in the subprime mortgage market
99
#8 Federal Preemption
of State Consumer
Protection Laws
The Office of the Comptroller of
the Currency issued formal
opinions preempting all state
predatory lending laws, thereby
rendering them inoperative
100
#9 Escaping
Accountability
Under existing federal law only
the original mortgage lender is
liable for any predatory and
illegal features of a mortgage
– even if the mortgage is
transferred to another party
101
#10 Fannie Mae and
Freddie Mac Enter the
Subprime Market
The purchase of subprime
assets was a break from prior
practice but was forced on
these agencies by Congress
in their attempt to make every
American a home owner
102
#11 Merger Mania
The abandonment of antitrust
related principles over the past
has enabled a concentration in
the banking sector resulting in
megabanks with to-big-to-fail
status with government
guarantees against failure
103
#12 Rampant Conflicts
of Interest: Credit
Rating Firm’s Failure
The credit ratings given by the
credit rating agencies were
influenced by the fact that they
got paid from the firms they
rate resulting in the highest
rating for CDOs based on the
best mortgages in the pool
104
What is the Dodd-Frank
Wall Street Reform and
Protection Act of 2010?
An Act to promote the financial
stability of the United States by
improving accountability and
transparency in the financial system,
to end "too big to fail", to protect the
American taxpayer by ending
bailouts, to protect consumers from
abusive financial services practices,
and for other purposes
105
How long is the DoddFrank bill and what are
some highlights?
2100 pages
• New Consumer Protection Agency
tucked under the Federal Reserve
• Establishes rigorous standards &
supervision for financial firms
• Establishes council to identify
systemic risks
106
What is the Consumer Financial
Protection Bureau as part of the
Dodd-Frank Bill?
• Receives 10% of Fed’s assets but is
not under its jurisdiction
• Led by an independent director
• Able to autonomously write rules for
financial institutions
• Ends the “shadow” financial system
by requiring hedge funds to register
with the SEC and provide
information about their trades
107
What is the Volcker Rule?
Implements regulations for banks,
affiliates, and holding companies
that prohibit proprietary trading,
investments in hedge funds, and
private equity funds
108
What is the
Shadow Banking System?
The financial intermediaries
involved in facilitating the creation
of credit across the global financial
system, but whose members are
not subject to regulatory oversight
109
What are some examples of
Shadow Banking System?
 Hedge funds
 Unlisted derivatives
 Credit default swaps
 hypothecation
110
What is Hypothecation?
When a person pledges a mortgage
or other assets as collateral for a
loan, it refers to the right that a
banker has to liquidate goods if you
fail to service a loan. You are said to
"hypothecate" the mortgage when
you pledge it as collateral for a loan
111
What is Rehypothecation?
The practice by banks and brokers
of using, for their own purposes,
assets that have been posted as
collateral by their clients. Clients
who permit rehypothecation of their
collateral may be compensated
either through a lower cost of
borrowing or a rebate on fees
112
What is an example of
Rehypothecation?
In a typical example of
rehypothecation, securities that have
been posted with a prime brokerage
as collateral by a hedge fund are
used by the brokerage to back its
own transactions and trades
113
What is the status of
Rehypothecation in America?
In the United States,
rehypothecation of collateral by
broker-dealers is limited to 140%
of the loan amount to a client
114
What is the status of Rehypothecation in the UK?
Unlimited rehypothecation is legal,
this is called churning, 30 to1
leverage is common
115
What is Re-hypothecation in
the UK an example of?
Unlimited leverage
116
What is the latest casualty of
re-hypothecation?
John Corsign and MF Global
collapse, 8th largest bankruptcy in
America’s history
The following video is not required
http://rt.com/programs/capitalaccount/mf-global-banking-mafia/
117
Who could be the next casualty?
JP Morgan has $500 billion in the
hypothecation market and an off –
balance sheet $90 trillion in
derivatives. Every large financial
institution has large sums of
money in this market with liquidity
backed by no assets
The following video is not required
http://rt.com/programs/keiserreport/episode-223-max-keiser/
118
What do low interest rates have
to do with hypothecation?
Financial firms can borrow money
at close to zero interest rates and
use the money to use in the
hypothecation market using the
same collateral over and over
resulting in the world’s largest
credit bubble
119
What is Moral Hazard?
In economic theory, a moral hazard
is a situation where there is a
tendency to take undue risks
because the costs are not borne by
the party taking the risk
120
Tell me more
• YouTube "Fear the Boom and Bust" a
Hayek vs. Keynes Rap Anthem
• YouTube "Hayek's 'Road to Serfdom' in
Five Minutes“
• YouTube "Senator Paul Ryan on the
Rule of Man vs. the Rule of Law"
121