2007/2008 financial crisis

Prior to 1933 financial markets and institutions were largely unregulated. They
were treated like any other private business.

After 1933 crisis a new environment has emerged. Commercial banks became
heavily regulated. Remember things like Glass Steagall Act.

Also, after 1933, we had a highly specialized financial system. We had

commercial banks investment banks, insurance, brokerages, mutual funds.
Particular institutions did particular things. Glass Stea said there must be
separation between commercial and investment banking. So thus, diff
specialities in the diff institutions. (however no financial supermarket)
There was regulation in controlling the size of banks. However, banks etc.
didn’t like that because they would not get the benefits of economies of scale.
FINALS US Banking panic of 1933…..

Now, in mid 1990s, pressure arises to relax glass Steagall: Less regulation and
also less specialization.
Economies of scale and economies of scope. Read reading on retail financial
services in 1998. Whats the underlying issue in this reading? Whats happening
in the financial system at this time? -> Question 4 tutorial question. Here
commercial banks want to get into selling insurance because e.g. when one
gets a car loan they need car insurance, but have to go elsewhere to get that
insurance because they can’t provide it. But they want to provide insurance to
get that business.

So there were complaints that the Glass Stea is too restrictive. Can’t reap
benefits of economies of scale and scope.
Economies of scale – As you increase in size, cost per unit falls because costs
spread over more units.
Economies of scope – Using the same asset base to service different
customers.

Glass Stea was soon repealed (By Bill Clinton). So now we have a less
regulated, less specialized financial system. ( we have financial supermarket)

Subprime meltdown reading and two powerpoint..

2007/2008 Financial crisis:
outbreak of financial crisis power point (global financial crisis powerpoint):
June 15 2007 – Bear Stearns etc…
Impacts to date…
US subprime mortgage crisis – On July 2007, chairman Ben said potential losses
from subprime loans would not be more than $100 billion.
So value of mortgages is 1.3 trillion. If you have a default of 7.69% you get 100
billion. And the default rate was around 8.5%. So in a sense, Ben was actually
correct.
Now, how could subprime mortgages of 1.3 trillion result in 20 or 30 trillion?
This is important to understand.
So traditional vs. subprime mortgage.
What is traditional mortgage?: It is typically a 30 year mortgage. Has a fixed
interest rate. It is an adjustable rate mortgage (an ARM). Loan to value ratio is
80% or less. That means people have to come up with 20% deposit and the
bank will give the rest. Why does bank require this? Because they want client
to have a commitment and equity in the loan.
When there is an economic crisis, how do you respond?: So what was done to
make banking system safer after 1933 panic? Deposit insurance, glass Steagall.
People thought that moving towards a European like system would be more
effective. In US there are many small banks. Some single bank that serves a
single community.

But with Eurpoean, banks are spread and you have diversification. But small
states in the US were worried that the bigger banks of bigger states e.g NY and
California would take their small banks out of business. Also, small states have
as many senators as bigger states, so legislation would not support…?

So why did they go to glass stea and deposit insurance. Because it worked
given their culture, history and politics.. How you respond to a crisis depends
on this, they want to preserve their banking system rather than adopt
European approach where they have few big banks.
Politics – Because of structure of US government, going to a European system
would be difficult because you need to get people to vote for that legislation.

Securitization – Packaging it into something else.

– Fannie and Freddie Mac securitized mortgages. So, this means that they
would buy mortgages from mortgage originators and then sell mortgage back
securities.
So, someone goes to bank and gets a mortgage. Bank is mortgage originator.
Banks sells the mortgage to Mac (Packagers). So now what does Mac do with
the mortgage. They create new financial instruments by sell bonds on the
market e.g. to pensions, insurances and endowments, that are backed by these
mortgages. Full potential in the financial system is brought out. This means
that there is more money available for mortgage lending. Interest rates on
mortgages are thus lowered.
Now, why would the bank want to sell the mortgage?: Because they have to
wait 30 years to get back their money. But think of time value of money. So if
packager wants to buy it NOW, better for them to get that money NOW.

How packager makes money? –

How can people defaulting on their loan have such a dramatic effect on the
financial system. Because now, with these mortgages, the risk is so much more
divided in the economy with the packagers buying it then selling it to insurance
companies pensions etc. ALL these people will be affected. (look at diagram in
slide)

NINJA loans – No income, no job banks still give a mortgage. Banks so this
cause if they default, that effect will not be on them, it will be further down
the chain…? Packagers..? idk

Why would people by bonds backed by subprime mortgages?: The notion of

diversification. While the risk of subprime person defaulting is high, if you have
a portfolio of these subprime mortgages, the risk is diversified.
Investors look at credit ratings