Financial Crisis- 2
Great Depression & Financial
Regulation
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Stock Market Crash of 1929
¢ October 29, 1929 “Black Tuesday”
¢ Financial collapse contributed to collapse of economy more
generally
¢ Despite Federal Reserve Act of 1913
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New financial regulations in 1930s:
¢ Farm Credit Administration,
¢ Federal Securities Act, Glass-Steagall Act (creates FDIC,
lets Fed set max interest rates on S&L, splits commercial
and investment banking),
¢ Export-Import Bank created,
¢ Exchange Stabilization Fund created, Federal Farm
Mortgage Corporation, SEC created, etc.
Keynesian Era & financial Crises
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Comprehensive financial regulation at home
meant virtually no domestic financial crises
Bretton Woods agreement on fixed exchange
rates with IMF as overseer and lender of last
resort
UNTIL: accelerating inflation and growing
gov. debt, trade deficits and speculative
attacks on the dollar lead to abandonment of
Bretton Woods, volitile flexible exchange
rates and negative interest rates.
Deregulation
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Formal Deregulation = removing rules that
reduced or eliminated various activities
¢ Some can be done by executive fiat
¢ Some requires changes in the laws
 E.g., Carter Airline Deregulation Act of 1978
 E.g., Clinton: Gramm-Leach-Bliley Act of 1999
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Defacto Deregulation = failure to enforce existing
rules.
¢ Can be the result of top-down executive policy changes
 E.g., Nixon ending gold-dollar linkage and Bretton Woods
 E.g., Reagan appointing James Watts head of Dept of Interior
¢ Can involve reduced oversight
¢ Can be engineered by defunding oversight institutions
Refusal to Regulate
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Refusal to enforce existing law and/or rules
¢ Presidential “Signing Statements”
¢ James Watt, Reagan appointed Sec of Interior, failed to
enforce environmental laws seen as burdensome /costly to
business
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Refusal to create new laws/rules to cover new
situations.
¢ Financial regulations had led to creative exploitation of
loopholes in laws
¢ Financial deregulation opened the door to all kinds of
new speculative innovations
 E.g., Collaterialized Debt Obligations (CDO’s) created in 1987
 E.g., Asset-backed Securities (ABS’s)
CDO = Collateralized debt obligations
ABS = Asset-Backed Securities
CMBS = Commercial Mortgage-Backed Securities
RMBS = Residential Mortgage-Backed Securities
History of Financial Deregulation - 1
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Bought by financial lobbying over decades
Deregulation in Carter Administration
¢ Financial Institutions Deregulation Bill of 1979
¢ Depository Institutions Deregulation and Monetary Control
Bill of 1980
 Removed upper limits on interest rates in response to accelerating
inflation (W > productivity ), negative real interest rates
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Deregulation in the Reagan Administrations
¢ Garn-St.Germain Depository Institutions Act of 1982
 Eliminated deposit interest rate ceilings
 Permitted Savings & Loan Institutions to diversify their investments into
commercial mortgages
¢ In Aug. 1987 Reagan appoints Alan Greenspan head of FED
 Ayn Rand disciple and pro-deregulation advocate
History of Financial Deregulation - 2
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Deregulation in the Reagan Administrations
cont’d
Deregulation in general was attack on cost of
labor
¢ E.g., removal of OSHA protections
¢ E.g., refusal to enforce protections (EPA)
¢ E.g., union busting (PATCO, United Airlines, etc.)
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Financial deregulation
¢ Provided business an alternative to real investment
¢ Reduced wages led to recourse to credit
¢ Credit cards & mortgages: way to harness, profit from
that recourse
History of Financial Deregulation - 3
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Deregulation in the Bush Sr. Administrations
¢ 1990 J.P. Morgan given permission to underwrite securities
¢ 1991 Fed approves expansion of Glass-Steagall loophole
¢ 1996 Fed allows bank holding companies to own investment
bank affiliates
¢ 1998 Citicorp merges with Travelers that owned SmithBarney (securities and insurance underwriting)
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Deregulation in Clinton Administrations
¢ Gramm-Leach-Bliley Act or Financial Services Modernization
Act of 1999 repealed part of Glass-Steagall Act of 1933 that
separated investment banking, deposit banking and
insurance activities.
History of Financial Deregulation - 4
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Regulation in Bush Jr. Administration
¢ Enron bankruptcy fiasco reveals accounting fraud in
deregulated energy market
¢ Sarbanes-Oxley Act of 2002: created Public Company
Accounting Oversight Board to avoid Enron-style disasters
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Failure to Regulate in Bush Jr. Administration
¢ Mostly failure to regulate new methods of financial
speculation, e.g., derivatives, keeps anti-regulation Alan
Simpson at Fed.
¢ First Treasury Secretary Paul O’Neill appalled at Bush lack
of interest in ANYTHING he had to say about financial
situation (see his book: The Price of Loyalty)
¢ 2005 Chairman of SEC quits over White House resistance to
regulating mutual and hedge funds
Shadow Banking System - 1
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Banking regulations since 1930s aimed at
depository banks, e.g., commerical banks, S&L’s,
credit unions.
“Shadow banking” has included
¢ Investment banks
¢ Hedge funds (hedge against downturns, speculate on
upturns)
¢ Money market funds (invests in short-term debt securities)
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Shadow banks borrow short term credit markets
and invest in longer term speculation
New Shadow banking methods, e.g., derivatives
¢ remained unregulated even as financial deregulation
allowed merger of depository and investment operations
Shadow Banking System - 2
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Shadow banking exploded with deregulation
¢ Deregulation: regular banks diverted funds from usual
regulated investments to unregulated ones
¢ Shadow banking out grew regular banking
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Shadow banking subject to panics
¢ Like other banks, shadow banks can be subject to sudden
loss of confidence in investors
¢ When “asset bubble” speculation bursts – investors panic
 Asset bubble = price of asset far exceeds real value
  inevitable collapse, bursting of the bubble
¢ When participation in bubbles are widespread panic
spreads, i.e., “financial contagion” (failure here = fear of
failure there)
¢ Sales of assets here = fall in value of assets there, or
“vicious cycle of deleveraging”.
Recent Banking Crises
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S&L Crisis of 1987
¢ Followed deregulation and bursting of commercial
mortgage bubble
Swedish Banking Crisis of 1991
¢ Followed credit market deregulation and bursting
of housing price bubble
Irish Banking Crisis of 2007
¢ Housing price bubble led to new regulatory efforts
that discovered hidden financial deals
US Banking Crisis of 2007-2011
¢ Followed deregulation and bursting of housing price bubble
in 2006.
US Financial Crisis - 1
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Deregulation facilitated widespread speculation,
especially in housing bubble
¢ Lax oversight of loan operations permitted widespread fraud
¢ Rapid growth of sub-prime & adjustable rate mortgages
¢ Bundling and securitization of mortgage bundles obscured
risks
¢ So money poured into housing boom inflating an asset
bubble, housing prices jumped 60%
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Housing price bubble burst in 2006
¢ Value of mortgage-based securities plummeted
¢ Dramatically reducing value of assets of investors
US Financial Crisis – 2
Timeline - 1
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Summer of 2007
¢ Jump in TED spread indicates jump in uncertainties
TED Spread = diff inter-bank interest rates from rates charged
to the government
¢ Fed reduces discount rate
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Fall 2007 – Winter 2008
¢ Fed cuts Federal Funds Rate (down from 5.25% to 2.0%)
¢ Bear Sterns investment bank nears bankruptcy as value of
its MBS’s fall
¢ Fed takes over Bear Sterns, loan to JP Morgan to take over
¢ Citigroup & Morgan Stanly fire CEO’s after losses on MBS
US Financial Crisis – 3
Timeline - 2
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September of 2008 (SHTF)
¢ Lehman Brothers investment bank goes under, no Fed
takeover or bailout
¢ Fed loans AIG $85 billion (insurance conglomerate)
¢ Massive flight from money market funds, Dow Jones
plummets
¢ Fed announces temporary insurance for money market
funds
¢ Fed establishes asset-backed loan facility
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October of 2008
¢ Bush signs TARP legislation
¢ Fed begins purchasing MBS’s, buys stock in banks
¢ Federal Funds Rate near zero
US Financial Crisis – 4
Timeline - 3
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November 2008
¢ Obama Elected, keeps same Fed Chairman
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February 2009
¢ Obama signs fiscal stimulus package
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October 2009
¢ Unemployment peaks at 10.1%
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July 2010
¢ Obama signs Wall Street Reform and consumer Protection
Act
US Financial Crisis – 5
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Obama signs Wall Street Reform and consumer
Protection Act
¢ New Financial Services Oversight Council to coordinate
¢ New Consumer Protection Agency to force honest lending
¢ New Office of Credit Ratings to examine rating agencies’
performance
¢ Some derivatives to be bought and sold in open markets
¢ Creates panel that can decide to regulate some shadow
banks
¢ FDIC gets new authority to seize some shadow banks
¢ Issuers of MBS must retain min 5% of default risk
¢ Financial holding companies prohibited from hedge funds
US Financial Crisis – 5
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New Regulations?
¢ It remains to be seen whether these regulations will be
enforced
¢ Conservative opposition threatens to withhold funding
needed for regulations to be enforced
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