US Financial Crisis 2008

Submitted by:

Arushi Jindal
Preetam Ray
Shubham Ambani
Annushree

Starting with:

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1907-1913: -
Creation of Federal Reserve Bank.

In 1907, there was a drop of 50% in stock prices due to the banking panic that was believed
to be created by the large banks in order to have a central authority to decide reserve ratios
for every bank rather than individual banks deciding for themselves. Thus, eliminating
competition. The panic started with falling stocks of companies in 1906 which was
supported by other events such as earthquake in san Francisco bursting gas and water lines
costing millions of dollars to the city and secondly, there a new legislation called Hepburn
Act was passed in 1906 that allowed controlled pricing on rail rates causing rail stocks to
tank. These events brought companies like united copper company under pressure from
short sellers and the company stocks fell to 10$ leading to further fall of knickerbocker trust
company, one of the largest trusts of USA causing bankruptcies, bank run and mass panic.
Also, gold was drawn out of the world’s major money centres. This caused liquidity crunch
and recession in 1907.So, JP Morgan stepped in to inject money in the banking sector after
which there felt a need to have central bank that would be common to all and would help in
such situations. This led to the creation of Federal Reserve under Federal Reserve Act, 1913
signed by President Woodrow Wilson into law. Federal reserve was set up to provide
security and stability to the banks with more flexible and safer monetary and financial
system. First chairman of Federal reserve bank was Charles Sumner Hamlin in 1914.

1920’s: -
ROARING 20’s

During this time the economy was growing at its peak. It grew at 42% with mass production
of consumer goods and with coming up of new airlines and auto industries. New
technologies were developed. Returning soldiers from wars in brought skills and perspective
with them.US was producing nearly half of world’s output. The unemployment was never
above the natural rate of 4%. The inflation rate was around 1-2% during this time. Average
income rose from $6460 to $8016 per person which was not distributed evenly. In 1922, the
top 1 percent of the population received 13.4 percent of total income. The United States
transformed from a traditional to free market economy. Farming declined from 18 percent
to 12.4 percent of the economy. Taxes per acre rose 40 percent, while farm income fell 21
percent. By 1929, average annual income was only $273 for farmers, but $750 per person.
GDP was rising consistently as shown below: -
1924: $827.4 billion
1925: $846.8 billion
1926: $902.1 billion
1927: $910.8 billion
1928: $921.3 billion
1929: $977.0 billion
STOCK MARKET was in a boom. It started rising in 1920 when shares traded nearly doubled
to 5mn per day. Investors were allowed to buy on margins where brokers would lend 80-
90% of the value. Stock market was rising by about 20%. This was due to the financial
innovations.

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1929 onwards: -
CAUSES OF GREAT DEPRESSION:

In 1929, as market was flourishing, US economy was growing there was a boom situation.
Great depression started with ‘Black Thursday’ on 24th October 1929. That's when traders
sold 12.9 million shares of stock in one day, triple the usual amount. At the same time, years
of over-cultivation and drought created the “Dust Bowl” in the Midwest. It ended
agriculture in a previously fertile region. When winds blew, clouds of dirt got accumulated
over everything suffocating livestock and people. Prices for crops fell below subsistence
levels. This affected entire economy worsening the effects of the depression.
When the stock market crashed, investors turned to the currency markets. At that time, the
gold standard supported the value of the dollars held by the U.S. government. Speculators
began trading in their dollars for gold in September 1931. That created a run on the dollar.
And also, to increase the value of dollar fed reserve increased the rate from 5% to 6%
leading to further recession.
Prices fell 10 percent each year. Panicked government leaders passed the Smoot-Hawley
tariff to protect domestic industries and jobs. As a result, world trade plummeted 65
percent as measured in U.S. dollars.
Book profits shown by the investors were overvalued as the brokers invested in the junk
stocks to earn commissions without bringing this in the notice of the investor. This led to
inflated profits in the books than the real profits in hand.
Margin selling also became one of the reasons of stock markets falling. By its height in 1933,
unemployment had risen from 3 percent to 25 percent of the nation’s workforce. Wages for
those who still had jobs fell 42 percent. U.S. gross domestic product was cut in half, from
$103 billion to $55 billion.

STEPS TAKEN BY GOVT: -

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In 1932, the country elected Franklin D. Roosevelt as president. He promised to create
federal government programs to end the Great Depression. Within 100 days, he signed the
New Deal into law. It created 42 new agencies. They were designed to create jobs, allow
unionization, and provide unemployment insurance. Many of these programs still exist.
They include Social Security, the Securities and Exchange Commission, and the Federal
Deposit Insurance Corporation. These programs help safeguard the economy and prevent
another depression.
On March 12, 1933, Roosevelt delivered the first of his live-radio “fireside chats.” In the first
chat he spoke about the banking crisis and explained the actions he and Congress had taken
to address it. During his presidency he delivered thirty “fireside chats,” explaining to the
public in reassuring tones and plain-spoken language his New Deal policies and the Second
World War through the medium of radio.
SOME OF THE IMPORTANT ACTS UNDER NEW DEAL PROGRAM: -
Emergency Banking Act - March 9: FDR closed all banks as soon as he was inaugurated to
stop bank runs. It was enacted at great speed. A special session of Congress passed the bill
in seven-and-a-half hours. This Act allowed banks to reopen once examiners found them to
be financially secure. Five thousand banks reopened in the next three days.
Abandonment of Gold Standard - April 19: FDR stopped a run on the precious metal. He
ordered everyone to exchange all gold for dollars.
Federal Emergency Relief Act - May 12: Funded a wide variety of jobs in agriculture, the arts,
construction, and education.
Abrogation of Gold Payment Clause - June 5: The government no longer had to repay dollars
with gold.
Glass-Steagall Banking Act - June 16: Separated investment banking from retail banking,
which prevented banks from using depositors' funds for risky investments. It gave regulation
of retail banks to the Federal Reserve, prohibited bank sales of securities, and created the
Federal Deposit Insurance Corporation. Repealed in 1999 by the Gramm-Leach-Bliley Act.
After the names of two congressmen carter glass and Henry Steagall. Also known as banking
act of 1933.
OTHER REFORMS: -
Gold Reserve Act - January 30: FDR prohibited private gold ownership. He increased the
price of gold to $35 per ounce, up from $20.67 per ounce where it had been for 100 years.
That nearly doubled the value of the gold held in Fort Knox from $4.033 billion to $7.348
billion, making the U.S. the world's largest owner of gold.
Works Progress Administration with $5 million. It employed 8.5 million people to build
bridges, roads, public buildings, public parks, and airports. It paid artists to create 2,566
murals and 17,744 pieces of sculpture to decorate the public works.
Social Security Act - August: Created the Social Security Trust Fund and Administration to
provide income to the elderly, the blind, the disabled and children in low-income families.

INSTITUITIONS THAT CAME UP: -

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1.FEDERAL DEPOSIT INSURANCE CORPORATION: -
In order to build and retain the trust of depositors in banking again, FDIC came up. It was
setup in 1933 under Glass Steagall Act. The FDIC insures savings, checking and other deposit
accounts. It does not insure stocks, bonds, or mutual funds. During the 2008 financial crisis,
the FDIC temporarily raised the upper limit to $250,000 per account ($500,000 per joint
account). In 2010, the Dodd-Frank Wall Street Reform Act made the new limit permanent.
When a bank fails, FDIC sells the bank to another one and transfers the depositors to the
purchasing bank. The chairman at this time was Walter J. Cummings (1933). Currently,
Jelena Mc Williams is its chairman.
2.SECURITIES EXCHANGE COMMISSION: -
It was setup in 1934 to regulate the commerce in stocks, bonds and other securities. It
ensures the orderly functioning of securities markets, to protect the interests of the
investors by providing them the necessary information to make decisions. The first chairman
was Joseph Kennedy, President John F. Kennedy's father. Currently, Jay Clayton is its
chairman.
3.FEDERAL OPEN MARKET COMMITTEE: -
The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve Board
that determines the direction of monetary policy. The FOMC meets several times a year to
discuss whether to maintain or change current policy. A vote to change policy would result
in either buying or selling U.S. government securities on the open market to promote the
growth of the economy.

ROLE OF US IN WORLD WAR II : -

It started on Sept 1, 1939 with German invasion of Poland. With war already raging in Asia,
the invasion sparked a global conflict that lasted until 1945. The Axis Powers fought
relentlessly against the Allied Powers for dominance around the world.

The United States remained neutral in the war until Japan, a member of the Axis Powers,
attacked an American naval base at Pearl Harbor, Hawaii, on December 7, 1941. In response
to the attack and a dramatic speech by President Franklin Delano Roosevelt, the U.S.
Congress declared war on Japan on December 8, 1941. Three days later, the United States
declared war on Germany and Italy.
World war II had a positive impact on US employment levels. American factories were
retooled to produce goods to support the war effort and almost overnight unemployment
rate dropped to around 10%. US provided arms to other countries during this time.
Women were forced into the workplace due to lack of men who would usually do the jobs
as men were called upon to serve the army. During the war, women who worked in war
industry jobs were referred to as "Rosies." There was more production of war supplies and
military vehicles instead of consumer goods, guns, planes, tanks, & other military equipment
at an unbelievable rate. As a result, there were more jobs available, and more Americans
went back to work.

BRETTONWOODS AGREEMENT: -

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In an effort to free international trade and fund post war reconstruction , the member
states agreed to fix their exchange rates by tying their currencies to the US Dollar as the
global currency, taking the world off of the gold standard. US dollar was chosen because US
held 3/4th of world’s supply of gold. No other currency had enough gold to back it as a
replacement. Dollar’s value was 1/35 ounce of gold.
Brettonwoods agreement was created in 1944 conference of all the world war 2 allied
nations. It took place in Bretton woods, New Hampshire (state in north eastern US).
Delegates from 44 countries met and in total 730 delegates attended to prevent competitive
devaluations, promote economic growth and ensure foreign exchange rate system.
Until world war I, most countries were on the gold standard. But they went off so they could
print the currency needed to pay for their war costs. It caused hyperinflation, as the supply
of money overwhelmed the demand. Also, after the stock market crash of 1929, investors
switched to forex trading and commodities that raised the prices of gold and people were
redeeming their dollars for gold. Fed reserve raised interest rates and to make dollar more
valuable which made the situation worse. So, Brettonwoods gave nations more flexibility
than a strict adherence to the gold standard.
It led to the creation of IMF and World Bank Group. IMF was created to monitor exchange
rates and lend reserve currencies to nations. World Bank Group was set up to provide
financial assistance for countries during the reconstruction post world war I phase.
In 1971, the United States was suffering from massive stagflation. That's a deadly
combination of inflation and recession. It was partly a result of the dollar's role as a global
currency. In response, President Nixon started to deflate the dollar's value in gold. Nixon
revalued the dollar to 1/38 of an ounce of gold, then 1/42 of an ounce. But the plan
backfired. It created a run on the U.S. gold reserves at Fort Knox as people redeemed their
quickly devaluing dollars for gold. In 1973, Nixon unhooked the value of the dollar from gold
altogether. Without price controls, gold quickly shot up to $120 per ounce in the free
market. The Bretton Woods system was over.

FANNIE MAE, FREDDIE MAC AND GINNIE MAE: -

Fannie Mae comes from an acronym Federal National Mortgage Association (FNMA). Fannie
Mae was a Government Sponsored Enterprise (GSE), established in 1938 in order to boost
housing market. This was done by then president Franklin D. Roosevelt. Its function was to
buy Federal Housing Administration (FHA) insured mortgages from banks and sold them as
securities in secondary market to the investors. As this would provide more liquidity to the
lenders to make more loans in turn making housing easy and affordable. Roosevelt wanted
Fannie Mae to help realize the American dream of home ownership. Fannie Mae
transformed into company in 1968 through IPO’s and started operating as independent
entity. The mortgages issued by Fannie Mae were implicitly backed by government which
had its own implications.
Freddie Mac comes from Federal Home Loan Mortgage Corporation (FHLMC). It was setup
in 1970 by Nixon administration for same purpose as Fannie Mae. But it could buy any type
of mortgages and not just FHA ones. It wanted to transfer the risk of default. It took
mortgages from other small banks and general public also.
So, these developed secondary market for selling mortgages to free their funds in order to
make additional mortgages. These were given government sponsored monopoly on a large

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part of US secondary mortgage market. This monopoly and government implicit guaranty
that no matter what government will come to rescue them to keep these firms afloat, had
serious implications that would later contribute to the mortgage market’s collapse.
Ginnie Mae comes from Government National Mortgage Association (GNMA), set up in
1968 to promote home ownership. Unlike Fannie and Freddie, Ginnie is wholly owned by
the U.S. government as a public entity, and all mortgage-backed securities that it sells to
investors are explicitly backed by the U.S. government. In contrast, the securities bought
from Fannie and Freddie are implicitly — i.e., implied to be — backed. Historically, investing
in Ginnie Mae's bonds is safer than investing in those bought from Fannie Mae and Freddie
Mac. Ginnie Mae is part of the Department of Housing and Urban Development (HUD) and
mainly guarantees Veterans Affairs / VA loans and Federal Housing Administration / FHA
loans. Ginnie Mae allows mortgage lenders to obtain a better price for their loans in the
capital markets, which allows lenders to use the proceeds to make new mortgage loans
available to consumers.
By offering guarantees on securitized loans, Ginnie Mae is instrumental in keeping the
nation's housing market moving: the investments in these funds help create new lending
opportunities. Even in uncertain times, investors are guaranteed payment of interest and
payment, in full and on time. Because they know they'll always receive payments, lenders
can create more mortgages at more affordable rates.

SAVINGS AND LOAN CRISIS: -

Savings and Loans are specialized banks created to promote affordable homeownership.
They used savings that were insured by the Federal Savings and Loans Insurance
Corporation (FSLIC) to fund mortgages. Depositors were willing to accept lower interest
rates on their savings because they were insured. This allowed the banks to charge lower
interest rates on the mortgages, and still be profitable. S&Ls make homeownership more
affordable by extending the term of the loan to 30 years.
As there were volatile interest rates during the 1970’s to curb inflation and recession i.e.
stagflation (Inflation tripled in 1973 from 3.4% to 9.6% and unemployment peaked at 9% in
1975), Nixon govt took steps to end Bretton woods international monetary system causing
the value of dollar to fall and increased the price of gold so that people don’t redeem dollars
for gold. This made him revalue the gold to 38$ per ounce of gold and then to 42$ per
ounce which created inflation. This further prevented Saving and Loan institutions from
raising interest rates as these were regulated by government that time and this eroded their
capital from deposits and they could no longer make low cost mortgages. Depositors
withdrew their money from S&L’s and deposited them in money market funds offering them
higher interests. S&L banks asked Congress to remove the low interest rate restrictions. The
Carter Administration allowed S&Ls to raise interest rates on savings deposits. It also
increased the insurance level from $40,000 to $100,000 per depositor. In 1982, President
Reagan signed the Garn-St. Germain Depository Institutions Act. It solidified the elimination
of the interest rate cap. It permitted the S&Ls to use federally-insured deposits to make
risky loans. Between 1982 and 1985, S&L assets increased by 56 percent.
Despite these laws, 35 percent of the country's S&Ls still weren't profitable by 1983. 9
percent were technically bankrupt. As banks went under, the FSLIC started running out of

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funds. For that reason, the government allowed bad S&Ls to remain open. They continued
to make bad loans, and the losses kept mounting.

In 1987, the FSLIC fund declared itself insolvent by $3.8 billion. By 1989, more than 1,000 of
the nation's savings and loans had failed. Between 1986-1995, more than half of the
nation's S&Ls had failed. In all cost to S&L Industry was $29bn and taxpayers $124bn. The
Federal Savings and Loan Insurance Corporation paid $20 billion to depositors of failed S&Ls
before it went bankrupt.

‘Keating five’ scandal: -

Charles Keating, real estate millionaire and head of Lincoln Savings and Loan Association
began putting depositor’s savings into real estate ventures, stocks, junk bonds and other
high yield instruments.
This brought the attention of Federal Home Loan Banking Board, the regulatory authority to
look into the suspicious activities of the company. So, Charles Keating in order to avoid this,
paid campaign contributions of $1.5mn to the 5 US Senators and in return wanted them to
put pressure on the board to overlook the activities of his company. He hired Alan
Greenspan, soon to be chairman of Federal Reserve Bank, who compiled a report saying
Lincoln’s depositors faced ‘no foreseeable risk’ and praising a ‘seasoned and expert’
management. Assets at Lincoln ballooned to $5.46bn and billions were in speculative
investments. Lincoln went bankrupt in 1987 and was seized by government. Some 23000
customers were left holding $250mn in worthless bonds, life savings of many and taxpayers
paid $3.4bn to cover Lincoln’s losses.

In 1989, the newly-elected President George H.W. Bush unveiled his bailout plan. The
Financial Institutions Reform, Recovery and Enforcement Act provided $50 billion to close
failed banks and stop further losses. It set up a new government agency called the
Resolution Trust Corporation to resell bank assets. The proceeds were used to pay back
depositors. FIRREA also changed S&L regulations to help prevent further poor investments
and fraud. The crisis pushed the state into recession. When the banks' bad land investments
were auctioned off, real estate prices collapsed. That increased office vacancies to 30
percent, while crude oil prices fell 50 percent.

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Stock Market Crash 1987

The biggest crash in stock market in happened on 19th October 1987,termed as Black
Monday. On this day Dow Jones Industrial Average fall by 22.68% and recorded the biggest
decline. DJIA is calculated by price weighted average taking the top 30 stocks. The impact of
this was huge and created a panic among people. The major reason for the crash was Forced
Selling, Short selling, Portfolio insurance ,Mergers and Takeover Bill.

1.Forced Selling:- Forced selling is the involuntary sale of assets or securities to create
liquidity in the event of an uncontrollable situation. In case of security market, forced selling
can occur within an investor’s margin account if the investor fails to bring his account
above the minimum requirements after being issued a margin call. Forced liquidations
generally occur after warnings have been issued by the broker, regarding the under-margin
situation of an account. If the account holder choose not to meet the margin requirements,
the broker has the right to sell off the current positions.
Margin Account-A margin account lets an investor borrow money from a broker to purchase
securities up to certain limits.
Margin Call- When an investor is not able to keep a minimum balance in the margin account
then he gets a call from the broker to refill his margin account
Example of Forced Selling:- If Broker Atul changes its minimum margin requirement from Rs
1,000 to Rs 2,000, Rohit’s margin account with a stock value of Rs 1,500 now falls below the
new requirement. Broker Atul would issue a margin call to Rohit to either deposit additional
funds or sell some of her open positions to bring her account value up to the required
amount. If Rohit fails to respond to the margin call, Broker Atul has the right to sell Rs 500
worth of her current investments.

2.Short Selling:- A normal trader usually buys the shares first and when the market grows it
sells.The difference is between the buying and selling is the profit. In short selling people
expect the market to fall ,and here they sell first and then buy. Here the profit is the
difference of sell and buy.
Example:- Jack expects that a company B is going to fall in next 2 hours due to some
management dispute. So he calls his broker and asks him to short 1 share of B. The broker
then sells 1 share of B in the market at the market price ie Rs 100 and credit this balance to
Jacks account. Now after 2 hours the market falls and share of B comes down to Rs 70.Now
Jack buys B’s 1 share at 70. He makes a profit of 100-70=30 and end of the day he returns
that share to his broker. So he earned a profit from declining market. But in short selling the
profit can be limited in this case he can max earn upto Rs 100 but on the other hand he may
can have unlimited loss. But in long selling a person can have unlimited profit and limited
loss.
Portfolio insurance is a hedging technique frequently used by institutional investors
when market is volatile. Short selling index futures can offset any downturns, but it also
blocks any gains. Thus this type of Short selling was done in the futures of S&P500 during
that time which led to the falling of the index. The problem came when investors from
several other different areas "had to sell" at the same time, with each obligation further
aggravating the situation. Thus this type of Short selling was done in the future of S&P500
during that time.

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3. TakeOver- During this time every company wanted to grow big so they started acquiring
the small companies. The takeovers can be of different types like leverage
buyout,tenderoffer and proxy fight.csacasc A leveraged buyout is the acquisition of another
company using a significant amount of borrowed money to meet the cost of acquisition. The
assets of the company being acquired are often used as collateral for the loans, along with
the assets of the acquiring company. The purpose of leveraged buyouts is to allow
companies to make large acquisitions without having to commit a lot of capital. A proxy
fight is when a group of shareholders join forces and gather enough shareholder proxies to
win a corporate vote.Tender offer- When a company goes directly to target companies
share holders and offer them a premium share price so that the share holder sell his share
to the acquiring company.Example-KKR took over RJR Nabisco at $24.88bn or $109 share by
tender offer method of takeover.
Risk Arbitrage:- This strategy, risk arbitrage, is the effort to simultaneously buy the stock of a
company that is being acquired, and shorting the stock of the acquiring company. The
speculative method tries to take advantage of the spread between the time the deal is
announced, until the deal closes.
For eg- Company A is acquiring company B. So the stock price will go up eventually in future
so people will buy the stocks of B. But the stock price of A will fall for a small time.as A is
acquiring its going to take huge loans which will lead to fall in share price for a very small
time and in that instance people will buy the stock of A. And gaining from the time
difference.
Take Over Bill:- This bill was proposed in the House and Ways means committee which led
to further cras of stock market.This bill was introduced to reduce takeover. This bill will limit
on the amount of loan a company can take from bank.As the company wont be able to take
much loan ,so the expansion will go down .Due to which the share price wont be that high
which led to the felling among people to sell its share now to gain maximum profit.
Regulations after Crash: To prevent such type of crash in future a concept of circuit breaker
was introduced by the SEC.The circuit breakers temporarily halt trading on an exchange or
in individual securities when prices hit pre-defined tripwires.It has different levels, if the
index falls to 7% below its previous close, this is known as Level 1; Level 2 is a 13% drop;
Level 3 a 20% drop. Level 1 or 2 will halt trading on all exchanges for 15 minutes, unless it
occurs at or after 3:25 pm, in which case trading is allowed to continue. Level 3, whenever it
occurs, will halt trading for the remainder of the trading day (9:30 am to 4:00 pm).

In India we have, BSE Circuit breakers:-

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 Trigger Market halt Pre-open call auction
limit Trigger time duration session post market halt
Before 1:00 pm. 45 Minutes 15 Minutes
At or after 1:00
pm upto 2.30 pm 15 Minutes 15 Minutes
At or after 2.30
10% pm No halt Not applicable
1 hour 45
Before 1 pm minutes 15 Minutes
At or after 1:00
pm before 2:00
pm 45 Minutes 15 Minutes
On or after 2:00 Remainder of
15% pm the day Not applicable
Any time during Remainder of
20% market hours the day Not applicable

In India this type of incident occurred on May 18,2009 when UPA won its Lok Sabha
elections.

DOTCOM Bubble:- ARPANET(Advanced Research Projects Agency Network) was born in the
1960’s at USA. It used the method of packet switching in which the information is broken
down into packets and sent.Then in 1983 came the idea of TCP( transmission control
protocol) and IP ( internet protocol) in which each packet of information came with an
unique IP. Then in 1990 a proper internet( International Network) or .com was formed. The
Dot Com bubble started in 1995, with the introduction of new technology and an entire new
industry, the Internet market. The ‘overrating of everything what is new’, resulted in the
boom burst, especially in this market. Many companies never made any money but where
highly valued though, especially when Dot Com (.com) or e-dash (e-) was added to the
company name. Low interest rate boosts startup capital amounts, so it was relatively easy to
start up a company. Another reason for the boom is ‘do not miss the boat’. People who had
no prior knowledge of trading are buying the stocks, based on expected future high returns.
People had more opportunities to buy shares, lease them and were lured in by the high past
profits. There was a wide belief of “get big fast”, this alongside with an increase of private
equity.
The bubble started with the IPO of Netscape in 1995. Investment bank Morgan Stanley,
which collaborated in Netscape’s IPO, set an initial stock price for Netscape between $12
and $14. Netscape managers argued this price was too low. The price then was set at $28,
resulting in a Market Capitalization of $1 billion. During the first trading day the price even
skyrocketed to $71, before closing at a 108 percent gain on day 1.

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Role of Investment Bankers:

The research analysts saw their role grow as the SEC loosened its enforcement of the
GlassSteagall Act. As firms like J.P. Morgan and Chase Manhattan and Morgan Stanley and
Dean Witter merged, the traditional line between retail brokerages and investment banks
became blurred. Analysts, who were previously only responsible for recommending stocks
at retail brokerages, took on the role of helping companies go public and marketing their
stocks to the public — something previously reserved for investment bankers. The division
between the analysts and the firm’s big money-makers — the traders and the bankers —
soon disappeared. Analysts now routinely interacted with traders and bankers, and
increased responsibilities led them to be labelled the firm’s “rainmakers.” Since they needed
to secure underwriting business for their investment banking colleagues and market stocks
to the public, investment analysts exposed themselves to a major conflict of interest. In
order to attract underwriting business and take companies public,analysts rated companies
positively and encouraged investors to purchase shares in the corporation. Since rating a
company poorly would discourage it from working with the analyst’s firm in the future and
scare off other potential partnerships, analysts were extremely reluctant to downgrade
companies. Instead, analysts competed amongst each other to see who could make the
highest predictions as to what price a company’s stock would reach.
The Internet bubble was a case study in how the market became divorced from underlying
values in the face of new technology. Awed by the promises of the Internet, investors
flocked to Internet stocks, driving up demand for Internet company stock offerings. As
demand for Internet companies’ stocks rose, investment banks began to compete for the
companies’ underwriting businesses. To secure stock offerings, investment banks pressured
their research analysts to issue positive ratings and market the companies they took public
to investors. Knowing that their pay and job security was contingent on how well their firm’s
investment banking business did, research analysts involved themselves in less analysis and
more salesmanship than ever before. Most investors, with little stock picking knowledge but
a desire to get rich, adopted the “objective” ratings analysts provided. As investors gobbled
up shares, demand for new stock offerings stayed constant. Investment banks continued to
issue IPOs, and stock analysts found themselves forced to come up with creative ways to
justify purchasing companies with large losses and little market share

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Henry Blodget –

One of the biggest culprits of outlandish price targets was Internet stock analyst Henry
Blodget. Although most technology analysts on Wall Street had attended business school,
Blodget only carried a history degree from Yale. After his ambition to be a journalist went no
further than a job as a fact checker for Harper’s Magazine, Blodget became a Wall Street
trainee, worked as an analyst, and bet his career on the rise of the Internet. On December
16, 1998, Blodget made the call that would earn him celebrity status in the financial world.
While most analysts — such as Merrill Lynch’s Jonathan Cohen — predicted Amazon’s $242
stock price would fall, Blodget boldly predicted that the Internet-based retailer’s shares
would hit $400 a piece. Three weeks after Blodget’s prediction, Amazon's shares hit $400.
Several weeks later, Blodget was hired to take Cohen’s position.
Financial pundits and the media alike proclaimed Blodget’s superstar status, and the
influential magazine Institutional Investor named Blodget its top-ranked Internet analyst in
2000.Riding on his newfound fame, Blodget maintained his fair-weather predictions and
marketed them in the media. Through 1999 and well-into 2000, all of Blodget’s stock ratings
were “buy” (20% or more growth expected) or “accumulate” (10% or more growth
expected) — the two highest ratings an analyst could give. Initially, as the speculation mania
raged, Blodget seemed to meet his predictions. When the bubble burst on March 11, 2000,
however, Blodget ran out of luck. By the summer of 2000, it was clear that the public could
not trust Blodget for investment advice. Blodget’s recommended portfolio for the year 2000
had an average return of -54.2 percent, with only one stock gaining value.CMGI, a company
Blodget had advised investors to “accumulate,” fell from a high of $100 in early 2000 to
below $3 by the summer of 2001.Internet Capital Group, a company Merrill Lynch took
public, fell from a high of $225 to $3.25 within a year.Pets.com and eToys, two startups in
Blodget’s portfolio, failed before every turning a profit.Blodget had misled millions of
investors, and in the process, ruined what was supposed to be savings for these people.
Blodget’s poor ratings, however, were not accidental; rather, they were the result of
pressure from Merrill Lynch to rate stocks highly in order to market them and recruit more
underwriting business. Although not explicitly written out, it was well-understood that all
analysts were not permitted to issue negative opinions about investment banking
clients.Analysts were paid largely on the profitability of their investment banking unit, and
investment bankers at Merrill often had a say in analysts’ bonuses.Contrary to the image of
objectivity they projected, Merrill Lynch analysts “knowingly compromised their honestly
held beliefs and [...] often initiated, continued, and/or manipulated research coverage for
the purpose of attracting and keeping investment banking clients,” stated the Spitzer
Report, a brief produced by New Attorney General Eliot Spitzer as he investigated the
conduct of investment analysts during the late 1990s. As a result of internal policy, analysts
did not issue “reduce” (10% percent to 20% price drop expected) or “sell” (20% or more
price drop expected) ratings. The list of covered Internet stocks for the second quarter of
2000, for instance, lists 24 stocks, none of which were rated less favorably than
“accumulate.”
When Blodget’s colleague Kirsten Campbell concluded that GoTo.com, an Internet
advertising company that was accruing heavy losses, deserved a negative rating, Blodget
responded by suggesting Campbell revise her recommendation to a “2-2” rating — a short-

13
term and long-term “accumulate.” In other words, Blodget wanted Campbell to rate a
company whose price she expected to fall as having a 10 to 20 percent growth opportunity.
Campbell’s effort to secure independence from the investment banking division was futile,
however. Blodget’s team had helped produce a hundred million dollars in investment
banking revenue from December 1999 to September 2000, and Blodget would not stop
because of his Campbell’s moral quandary.From the spring of 1999 to the fall of 2001 —
more than a year after the bubble burst — Merrill Lynch never published a single “reduce”
rating, despite believing otherwise. In email threads, Blodget and his team referred to 24/7
Media, which was rated a long-term “buy,” as a “piece of shit.” Despite recommending
Internet Capital Group as a long-term “buy,” Merrill Lynch analysts believed — and correctly
predicted — that the stock would “go to 5 [dollars].”

Role of Media:

Part of the reason these analyst recommendations were so harmful was that they were
amplified by the media. Publications created indexes that tracked the performance of the
best performing technology stocks of the late 1990s.Reporter after reporter wrote favorably
about IPOs on the assumption that new offerings would continue to proliferate. Stock
predictions by analysts were reported on as fact rather than as opinion.
The media organizations that fanned the flames of the speculation bubble most were CNBC
and, ironically, the non-profit Public Broadcasting Station (PBS). Noticing that their
viewership increased when they promoted stocks, CNBC consistently featured bullish
analysts on its shows. Flip-flopping analysts — or those who alternated between negative
and positive recommendations of particular stocks — were pilloried and labeled penguins
on-air.
Egged on by publications and the television media, small investors rushed to join the
Internet frenzy. Even if these investors could not lead the revolution, they wanted a stake in
the revolution.
As investors rushed to engage in speculation, Internet entrepreneurs became more eager to
IPO as soon as possible. Having seen companies such as Amazon, Netscape, and
Priceline.com succeed tremendously on the stock market without turning profits, many
Silicon Valley creators came to believe their company was “the next big thing.”
These entrepreneurs prodded Wall Street to take their firm public, and Wall Street, sensing
financial opportunity, gladly accepted. Along the way, Wall Street and the companies going
public ensured that analysts would give them positive ratings and retain these
recommendations. This, in turn, encouraged more companies to seek IPOs, more media
coverage, and more market speculation.
Bubble Burst:- Microsoft Corporation was accused of holding a monopoly and engaging
in anti competitive practices. In this Microsoft used to bundle and sell its browser along with
the operating system. As any company which wanted to buy the operating system had to
also buy the browser. Due to losing of the case Microsoft share prices fall and similarly the
index. During the peak of the market Dell and Cisco pulled out majority of its shares and
investment which led to panic selling as people thought that the market may fall in future so
they took out their shares. Another reason was Y2K(year 2000 Millenium Bug) during this
time many programs only allowed two digit change. As the year after 1999 to 2000, will lead
to a four digit change people anticipated that change is not possible.So they started pulling
out their investment which led to the fall of the market and led to bubble burst.

14
Companies which survived were amazon, adobe , priceline etc. They survived because they
had diversified their business and tried to kept focus properly. As amazon shifted from
books to selling of CD’s,DVD’s.Adobe started making more and useful softwares.

Twin Tower Attack:-

On 9/11/2001,Four planes were hijacked by 19 terrorist. The targets were World Trade
Centre,Pentagon and White House. Tower 1 was hit by 8:46 am, Tower 2- 9:03 am and
pentagon at 9:37am. White house was saved as its passengers were brave enough to crash
the plane before hand .Total deaths of this attack was 2966 including the hijacker. It had a
adverse effect on the economy as:- Anticipating market chaos, panic selling and a disastrous
loss of value in the wake of the attacks, the NYSE and the Nasdaq remained closed until
September 17. On the first day of NYSE trading after 9/11, the market fell 684 points, a 7.1%
decline, setting a record for the biggest loss in exchange history for one trading day. At the
close of trading that Friday, ending a week that saw the biggest losses in NYSE history,
the Dow Jones was down almost 1,370 points, representing a loss of over 14%. The S&P ‘s
index lost 11.6%. An estimated $1.4 trillion in value was lost. American Airlines, Inc. stock
dropped from a $29.70 per share close of September 11 to $18.00 per share close on
September 17, a 39% decline. United Airlines, Inc. stock dropped from $30.82 per share
close to $17.50 per share on the close on September 17, a 42% decline. Similar steep
declines hit the travel, tourism, hospitality, entertainment and financial service sectors as a
wave of temporary fear and uncertainty swept through the nation. Among the financial
services giants with the steepest drops —Merrill Lynch lost 11.5%, and Morgan Stanley lost
13%
Insurance firms reportedly eventually paid out some $40.2 billion in 9/11 related claims.
Among the biggest losers was Warren Buffet's BerkshireHathway
After this US government started war on terror to prevent such mishap happening in
future.The major target countries were Afghanistan and Iraq. Till now war on terror
program by USA is going on costing them $2Trillion dollars.This total process of recession
from dotcom bubble,high fed fund rate and twin tower attack led to decline in GDP.But to
help the people it reduced its interest rate to 1.75% and also decreased the corporate rates.

15
Gram Leach Bliley Act

The Gramm-Leach-Bliley Act of 1999 (GLBA) was a bi-partisan regulation under President Bill
Clinton, passed by Congress on November 12, 1999. The GLBA was an attempt to update
and modernize the financial industry. Due to the remarkable losses incurred as a result of
1929's Black Tuesday and Thursday, the Glass-Steagall Act was originally created to protect
bank depositors from additional exposure to risk, associated with stock market volatility. As
a result, for many years, commercial banks were not legally allowed to act as brokers. Since
many regulations have been instituted since the 1930s to protect bank depositors, GLBA
was created to allow these financial industry participants to offer more services.

GLBA was passed on the heels of commercial bank Citicorp’s merger with the insurance firm
Travelers Group. This led to the formation of the conglomerate Citigroup, which offered not
only commercial banking and insurance services, but also lines of business related
to securities. Its brands at this stage included Citibank, Smith Barney, Primerica, and
Travelers. Citicorp’s merger was a violation of the then-existing Glass–Steagall Act, as well as
the Bank Holding Company Act of 1956.

The history of the GLBA has its roots in the separation of banks, brokerage companies, and
insurance companies. As a result of the financial failures of the Great Depression, Congress
in 1933 passed the Glass-Steagall Act prohibiting national and state banks from affiliating
with securities companies. In 1956, Congress passed the Bank Holding Company Act that
prohibited a bank from controlling a non-bank company. In 1982 Congress amended the
Bank Holding Act to further forbid banks from conducting general insurance underwriting or
agency activities. This changed, however, in 1999, when the GLBA repealed sections of these
acts and allowed banks to engage in a wide range of financial services.

Privacy Protections Under the GLBA

The GLBA's privacy protections only regulate financial institutions--businesses that are
engaged in banking, insuring, stocks and bonds, financial advice, and investing.

1) These financial institutions, whether they wish to disclose your personal information
or not, must develop precautions to ensure the security and confidentiality of
customer records and information, to protect against any anticipated threats or
hazards to the security or integrity of such records, and to protect against
unauthorized access to or use of such records or information which could result in
substantial harm or inconvenience to any customer.

1) Financial institutions are required to provide you with a notice of their information
sharing policies when you first become a customer, and annually thereafter. That
notice must inform the consumer of the financial institutions' policies on: disclosing
non-public personal information (NPI) to affiliates and non-affiliated third parties,

16
 disclosing NPI after the customer relationship is terminated, and protecting NPI.
"Non-public personal information" means all information on applications to obtain
financial services (credit card or loan applications), account histories (bank or credit
card) and the fact that an individual is or was a customer. This interpretation of NPI
makes names, addresses, telephone numbers, Social Security Numbers and other
data subject to the GLBA's data sharing restrictions.

2) The GLBA gives consumers the right to opt-out from a limited amount of NPI sharing.
Specifically, a consumer can direct the financial institution to not share information
with unaffiliated companies.

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After the Dot com bubble where in the U.S. stock market came crashing down, U.S.
citizens lost their confidence in the stock market and they abandoned the stock market.
Now people started investing in real estate as a result the prices of real estate started to
rise. Over the next 6 years, the mania over homeownership grew increasingly as interest
rates went down.

The Government’s homeownership encouragement increased housing prices by 50% to

100%. This buying frenzy drew the attention of the speculators who started to earn tens of
thousands of dollars in profits in as little as two weeks.

Original Lending System/Prime Lending:

In US when a citizen wants to take a home loan, he/she cannot directly approach a bank.
They have to approach a broker who will act as a mediator between the commercial banks
(lenders) and the borrowers. In return, the brokers will receive commission from the
borrowers. After background checking, the lenders would provide loans to borrowers and in
return borrowers gave mortgage papers as securities.

This gave rise to prime lending, wherein people who were provided with loans were having
job security, good credit worthiness and very minimal chances of defaulting.

Securitization:

Securitization is the process of converting illiquid assets into liquid assets.

The loans from the lenders were purchased by the Special Purpose Vehicles (SPV). These
SPVs packaged all kinds of loans i.e. student loan, car loan, credit card loan, home loan into
a single liquid security known as Collateralized Debt Obligations (CDO). The CDOs were
divided into 3 tranches (i) Safe Tranche (AAA) (ii) Ok Tranche (BBB) (iii) Risky Tranche (B).
Depending upon the risk taking capability of the investors, Pension Funds purchased Safe
Tranche, Retail investors purchased Ok Tranche and Hedge Companies purchased Risky
Tranche. The CDOs were further sold off to the investors.

Now, the risk of collecting the payments shifted from the lenders to the SPVs. So the citizens
directly started making payments to the SPVs. With the mortgage payments, the SPVs would
firstly pay off the safe tranche, then the ok tranche and finally the risky tranche. The
investors were finding it profitable and started demanding more from the SPVs. Since SPVs
also had some financial crunch it took the help of Leverage technique to raise more money.

18
The SPVs would demand more from the lenders and lenders in return would demand more
from the brokers.

Now the broker, bought anyone and everyone who wanted a house, the brokers even
bought people who had 1 house but wanted to buy another house. This situation gave rise
to subprime lending. Ninja Loans is a type of loan given to people who had no income, no
job security and poor credit worthiness. Since the risk of collecting the payment shifted from
the lenders to the SPVs, lenders were not background checking the citizens and were
providing loans in return of mortgage papers as a security. Predatory Lending is a type of
lending in which initially the rate of interest is as low as zero and increases with passage of
time. Predatory lending attracted those customers also who already had one house to buy
homes. The amount of subprime lending increased from $30 billion to $600 billion.

The process continued and created a bubble in housing estate and it final burst in
September 2008, when the subprime lenders started to default. As a result, SPVs couldn’t
get any liquidity and hence they couldn’t pay back to the investors and hence investors
stopped demanding from the SPVs, and the SPVs stopped demanding from the lenders and
lenders stopped demanding from the brokers. As a result brokers went jobless. The SPVs
were left only with mortgage properties and it couldn’t sell it off as well because there was
no demand for the houses.

Foreclosures:

A foreclosure is a home that belongs to the bank which once belonged to homeowner. The
homeowner either abandoned the home or voluntarily deeded the home to the bank.
During the market crash from 2005 through 2011, many homeowners simply walked away
from their homes because the values had fallen and they owed more than their homes were
worth. U.S foreclosure filings spiked by 81% in 2008. A total of 8,61,664 families lost their
home to foreclosure in 2008.

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Asset-Backed Securities

Asset-backed securities, also called ABS, are pools of loans that are packaged and sold as
securities – a process known as “securitization”. The type of loans that are typically
securitized includes home mortgages, credit card receivables, auto loans, home equity
loans, student loans, and even loans for boats or recreational vehicles.

Working:

When a consumer takes out a loan, their debt becomes an asset on the balance sheet of the
lender. The lender, in turn, can sell these assets to a trust or “special purpose vehicle,”
which packages them into an asset-backed security that can be sold in the public market.
The interest and principal payments made by consumers “pass through” to the investors
that own the asset-backed securities. Typically, individual securities are gathered in
"Tranches" or groups of other loans with similar ranges of maturities and delinquency risks.

The benefit for the issuer of an ABS is that the issuer removes these items from its balance
sheet, thereby gaining both a source of new funds as well as greater flexibility to pursue
new business. The benefit to the buyer – usually institutional investors – is that they can
pick up additional yield relative to government bonds and augment their
portfolio diversification.

ABS Risks

ABS carry some prepayment risk, which is the chance that investors will experience reduced
cash flows caused by borrowers paying off their loans early, particularly in a declining
interest rate environment when borrowers can refinance existing loans with new, lower
interest-rate loans.

The mixed history of ABS securities suggests that some caution needs to be exercised even
when buying AAA or AA rated ABS, since in the past the credit ratings attached to some of
these by Moody's and others has not always been reliable.

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 Mortgage Backed Securities
MBS is a type of bond representing an investment in a pool of real estate loans. Mortgage-
backed securities (MBS) are groups of home mortgages that are sold by the issuing banks
and then packaged together into “pools” and sold as a single security.

Eg. Tony wants to buy a house worth $500,000, so usually Tony would go to his bank and
apply for a mortgage for $500,000 and in return for loaning this money, the bank would
make Tony pay interest on the loan at say 8%. Before the world of MBS, the bank would
simply keep this loan on its book and receive principal and interest for the duration of the
loan say 30 years. One downside of this arrangement was that the bank had to keep this
loan for 30 years, tying up the capital and resources. One day the bank had an idea that it
could sell the stream of interest the 8% and principal payments from Tony’s loan to
investors to get it off the bank’s book and free up capital at the same time. The bank could
make money simply from originating and servicing the mortgages and from other associated
fees in order to sell the interest streams to investors. The bank bundles Tony’s loan together
with 100s maybe even 1000s of other mortgages, then the bundle of mortgages is sold to an
investment bank in the form of a single bond. The investment bank partitions the pool of
loans according to quality and sells to other investors. So although Tony makes payment to
his bank alone is in the hands of the investment banks. MBS are essentially a way for banks
to free up capital and provide a way for investors to buy into mortgages.

Credit Default Swaps

A credit default swap is a particular type of swap designed to transfer the credit
exposure of fixed income products between two or more parties.

Under the terms of a CDS contract, a protection buyer must make periodic payments to the
protection seller, and will typically do so on a quarterly basis for a period of five years. The
protection buyer will generally pay a fee proportionate to the credit risk of the debt
obligation referenced by the CDS. In return, the protection seller must pay the protection
buyer if a credit event takes place. What is credit event? A credit event is a negative
development relating to the specified reference debt obligation, such as a failure to pay
under the obligation or the bankruptcy of the entity that issued the reference obligation. If a
credit event occurs, a CDS requires the protection seller to pay the protection buyer the
diminished value of the reference debt obligation.

A credit default swap is a contract that guarantees against bond defaults. Most CDS protect
against default of high-risk municipal bonds, sovereign debt and corporate debt. Investors

21
also use them to protect against the credit risk of mortgage-backed securities, junk
bonds, and collateralized debt obligations.

Swaps work like an insurance policy. They allow purchasers to buy protection against an
unlikely but devastating event. They are also like an insurance policy in that the buyer
makes periodic payments to the seller.

Credit default swaps came into existence in 1994 when they were invented by Blythe
Masters from JP Morgan. They became popular in the early 2000s, and by 2007, the
outstanding credit default swaps value stood at $62.2 trillion. During the financial crisis of
2008, the value of CDS was hit hard, and it dropped to $26.3 trillion by 2010 and $25.5
trillion in 2012. There was no legal framework to regulate swaps, and the lack of
transparency in the market became a concern among regulators.

Example:

A company issues a bond. Several companies purchase the bond, thereby lending the
company money. They want to make sure they don't get burned if the borrower defaults.
They buy a credit default swap from a third party, who agrees to pay the outstanding
amount of the bond. Most often, the third party is an insurance company, banks, or hedge
fund. The swap seller collects premiums for providing the swap.

Credit default swaps on Lehman Brothers debt helped cause the 2008 financial crisis. The
investment bank owed $600 billion in debt. Of that, $400 billion was "covered" by credit
default swaps. The companies that sold the swaps were American International Group,
Pacific Investment Management Company, and hedge fund, Citadel.

22
 Collateralized Debt Obligations

Collateralized debt obligations were created in 1987 by bankers at Drexel Burnham Lambert
Inc. Within 10 years, the CDOs had become a major force in the so-called derivatives
market, in which the value of a derivative is "derived" from the value of other assets. In a
CDO, an investment bank collected a series of assets -- often high-yield junk
bonds, mortgage-backed securities, credit-default swaps and other high-risk, high-yield
products from the fixed-income market. The investment bank then created a corporate
structure -- the CDO -- that would distribute the cash flows from those assets to investors in
the CDO.

CDOs were marketed as investments with a defined risk and reward. In other words, if you
bought one you would know how much of a return you could expect in exchange for risking
your capital. The investment banks that were creating the CDOs presented them as
investments in which the key factors were not the underlying assets. Rather, the key to
CDOs was the use of mathematical calculations to create and distribute the cash flows. In
other words, the basis of a CDO wasn't a mortgage, a bond or even a derivative -- it was the
metrics and algorithms of quants and traders. The CDO market skyrocketed in 2001 with the
invention of a formula called the Gaussian Copula, which made it easier to price CDOs
quickly.

The Fallout:

By early 2008, the CDO crisis had morphed into what we now call the credit crisis. As the
CDO market collapsed, much of the derivatives market tumbled along with it. Hedge funds
folded. Credit-ratings agencies, which had failed to warn Wall Street of the dangers, saw
their reputations severely damaged. Banks and brokerage houses were left scrambling to
increase their capital.

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Leverage

Leverage results from using borrowed capital as a funding source when investing to expand
the firm's asset base and generate returns on risk capital. It is a technique to amplify profits
or losses. Leverage was increased to 33:1 ratio for the SPVs.

Working of Leverage:

Say you have $20,000 to invest in property. You buy land worth $20,000. Over a period of
time its market value increases by 10%. You make $2,000.
If you have $20,000 you should be able to persuade a financial institution to lend you a lot
more. Let's say you are loaned 19 times your original amount, making the total sum
$400,000. So you invest $400,000 in property. The value increases by 10%. You sell the
property and find that you have made $40,000. Instead of the 10% profit you would have
made with the old-fashioned technique, you have made 200%. You have to pay interest on
the money you borrowed, and that might cut your profits in half, but 100% profit ($20,000)
is still way, way better than 10% ($2,000).
When times are good there is no doubting the attractions of leverage, but when the bubble
bursts things can get very, very nasty.
In the old days, if you bought property worth $20,000 with your own money and land values
dropped by 10%, you could hold onto the property, shed a few tears about losing $2,000
and wait for the good times to come back again.
What happens to the leveraged investment? Well, after the 10% drop in land values your
$400,000 investment is now worth $360,000. The market looks bad and the people who
loaned you the money want it back. They loaned you $380,000 (19 times 20,000). You can
get $360,000 by selling the property, but you still owe another $20,000. You started with
$20,000 not so long ago, and now you owe $20,000. You haven't lost 10%, you've lost
200%!! Actually, it's even worse than that because you also owe interest on the loan, which
could be another $20,000, so you lose all your money and owe $40,000 (meaning you made
a loss of 300%). You start tearing your hair out. And it's not only you who is tearing out hair.
The financial institution is, too, because it isn't an old fashioned bank. It is also leveraged up
to the hilt. It has made lots and lots of other loans like yours, all leveraged. In this way, a
relatively small downturn in the market can send a tidal wave through the investment and
finance business, leaving lots of companies bankrupt.

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 Special Purpose Vehicle

A special purpose vehicle/entity is a subsidiary company with an asset/liability structure and

legal status that makes its obligations secure, even if the parent company goes bankrupt. An
SPV/SPE is also a subsidiary corporation designed to serve as a counterparty for swaps and
other credit-sensitive derivative instruments.

Special Purpose Vehicle (SPV) sometimes referred to as a Special Purpose Entity (SPE) is an
off-balance sheet vehicle (OBSV) comprised of a legal entity created by the sponsor or
originator, typically a major investment bank or insurance company, to fulfil a temporary
objective of the sponsoring firm. SPV relies of the principle of ‘bankruptcy remoteness’
whereby the SPV operates as a distinct legal entity with no connection to the sponsor firm.
The investment banks have used SPV to hide debt and thus make company’s financial
statements look better.
The investment banks create SPVs, now these SPVs are entitled to receive the mortgage
payments. The banks issue shares to their SPVs, and these shares are Mortgage backed
securities. SPVs do not have any assets or liabilities, they are just a company shown on
papers. They will show only the mortgage loans as their assets and the payment they have
to make to the investors as their liability. As the banks would give more and more loans, the
debt to equity ratio (indicates how much debt a company is using to finance its assets) of
banks would increase, which is not a good indication.

25
 American International Group

The AIG story begins in China in 1919, when American Cornelius Vander Starr started an

insurance agency in Shanghai. The enterprise grew first across China, then across the globe.

AIG companies serve customers in more than 130 countries around the world. AIG’s
corporate headquarters are in New York City, its British headquarters are in London,
continental Europe operations are based in La Défense, Paris, and its Asian headquarters are
in Hong Kong.

The AIG Financial Products division, headed by Joseph Cassano, in London, had entered into
credit default swaps to insure $441billion worth of securities originally rated AAA. Of those
securities, $57.8 billion were structured debt securities backed by subprime loans. As a
result, AIG’s credit rating was downgraded and it was required to post additional collateral
with its trading counter-parties, leading to an AIG liquidity crisis that began on September
16, 2008.

The bond issuers almost never go bankrupt. So, many banks and hedge funds figured they
could make a fortune by selling CDSs, keeping the premium, and almost never having to pay
out anything. Most banks and hedge funds would buy CDS protection on the one hand and
then sell CDS protection to someone else at the same time. When a bond defaulted, the
banks might have to pay some money out, but they’d also be getting money back in. They
netted out. CDS are largely over-the-counter instruments. That means they’re not traded on
an exchange. One bank just agrees with another bank to do a CDS deal. There’s no reliable
central repository of information. There’s no way to know how exposed a bank is. Banks
would have no way of knowing how badly other banks have been affected.

Reasons for AIG Fallout:

A. AIG’s collapse came as a result of the following sequence of events:

1. In the wake of the decline in real estate prices, the market value of mortgage-backed
securities declined.
2. Under accounting rules that were established after the downfall of Enron — implemented
to require rapid disclosure of investment losses — AIG marked down the value of its
mortgage-backed securities portfolio.
3. These investment losses resulted in a reduction of AIG’s capital reserves — the core

26
measure of its financial strength.
4. As a result of the decline in AIG’s capital reserves, Standard & Poor’s and Moody’s
Investors Service downgraded AIG from triple-A to the single-A level.
5. These rating downgrades to the single-A level triggered collateralization requirements
under AIG’s CDS contracts.
6. The amount of the collateral that AIG had to produce under its estimated $450 billion of
CDS contracts approximated $100 billion.

And AIG did not have $100 billion in available funds.

This was the explosive event that destroyed AIG. It was not the market losses on its
investments in mortgage-backed securities. It was not payouts on CDS contracts where
default events had actually occurred. It was a collateral call.

B. The swaps expose AIG to three types of financial pain. If the debt securities default,
AIG has to pay up. But there are two other financial risks as well. The buyers of the
swaps -- AIG's "counterparties" or trading partners on the deals -- typically have the
right to demand collateral from AIG if the securities being insured by the swaps
decline in value, or if AIG's own corporate-debt rating is cut. In addition, AIG is
obliged to account for the contracts on its own books based on their market values.
If those values fall, AIG has to take write-downs.

C. Goldman Sachs held swaps from AIG that insured about $20 billion of securities. In
August 2007, Goldman demanded $1.5 billion in collateral, arguing that the assets
backing the securities were falling in value. AIG argued that the demand was
excessive, and the two firms eventually agreed that AIG would post $450 million to
Goldman. Goldman hedged its exposure by making a bearish bet on AIG, buying
credit-default swaps on AIG's own debt.

Facts and Figures:

 AIG had about $1 trillion in assets prior to the crisis, lost $99.2 billion in 2008.
 On 16/09/2008, the Federal Reserve Bank of New York stepped in with an $85 billion
two year loan to keep the failing company from going under. Fed took ownership of
79.9% of AIG’s equity.
 Blackstone acted as an adviser for AIG during 2007-08 financial crisis.
 CEO during crisis – Martin Sullivan
CEO after crisis – Robert Bob Willumstad
CEO current – Brian Duperreault
 The $3.6 trillion money market fund industry invested in AIG debt & securities.
 In October 2008, the Fed hired Edward Liddy as CEO & Chairman. His job was to
break up AIG & sell of the pieces to repay the loan.

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  On 8/11/2008, Fed’s $85 billion bailout of AIG was revised. The Treasury Department
(Secretary – Henry Merritt Paulson) purchased $40 billion in AIG preferred shares
using TARP Funds. The Fed purchased $52.5 billion in mortgage backed securities.
 AIG reported the largest loss in corporate history, a record $61.7 billion in Q4
2008. As a result of AIG's loss, the Dow fell almost 300 points to close at 6,763.29.

Lehman Brothers

Many believe the beginning of the end for Lehman Brothers was when Washington repealed
the Glass-Steagall Act. This landmark legislation from the Great Depression separated the
interests of commercial and investment banks, preventing them from competing against
each other and protecting their balance sheets by allowing each sector to focus on the
business and transactions that it did best. For investment banks, that typically meant highly
liquid, asset-light portfolios, leaving commercial banks to handle capital-intensive portfolios,
including real estate or corporate investments. Additionally, the act insulated the economy
from mass collapse in the event of one sector’s failure by preventing the other from being
dragged down in tow. But in 1999, President Clinton signed the Gramm-Leach-Bliley Act into
law, allowing commercial and investment banks to compete head-to-head for the first time
in 60 years. The arms race that ensued would prove disastrous for Lehman Brothers, the
financial community, and the global economy at large.

With the repeal of Glass-Steagall, Lehman Brothers became a key player in the United States
housing boom. From 2004 to 2006, Lehman Brothers experienced a 56 percent surge in
revenues from real estate businesses alone. The firm recognized profits from 2005 to 2006,
and in 2007 it reported a record net income of $4.2 billion on revenues of $19.3 billion. In
the same year, Lehman Brothers’ stock reached an all-time high of $86.18 per share, giving
it a market capitalization close to $60 billion. This proved exceptional to the surrounding
climate, however, and the housing market began to show signs of a pending bubble burst.

In March 2007, the stock market experienced its biggest single-day plunge in five years,
while the number of mortgage defaults simultaneously rose to the highest percentage in
almost a decade. Bear Stearns, Lehman Brothers’ most comparable Wall Street rival,
experienced the total failure of two hedge funds in August. Despite rapidly deteriorating
marketing conditions, Lehman Brothers continued writing mortgage-backed securities and
touting its financial strength to the press and shareholders while decrying the notion that
domestic and global economies were in danger. Meanwhile, its operations were reckless, as
illustrated by its $11.9 billion in tangible equity and $308.5 billion in tangible assets on
balance sheets in 2003 that yielded a leverage ratio of 26 to 1. Four years later, its $20
billion in tangible equity and $782 billion in tangible assets sent its leverage ratio
skyrocketing to 39 to 1. Even with storms brewing in every direction, Lehman Brothers failed
to trim its portfolio of high-risk, illiquid assets, and when crisis erupted in 2007, Lehman

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Brothers had missed its chance. Instead of acknowledging this misstep, executives took
internal action to preserve a rosy façade.

By means of deliberate accounting sleight-of-hand, concealment, and communication of

misleading information, until 2008 Lehman Brothers maintained the appearance of
underdog success to the investment community. The primary means by which Lehman
Brothers disguised its distress was through implementation of what was known to insiders
as “Repo 105.” This legal but shady accounting device helped create favorable net leverage
and liquidity measures on the balance sheet, which was key for credit rating agencies and
consumer confidence. By utilizing Repo 105, Lehman Brothers raised cash by selling assets
to a behind-the-scenes phantom company called Hudson Castle, which appeared to be an
independently run organization but was actually controlled by Lehman Brothers executives.
In accordance with Repo 105 terms, assets were sold to Hudson Castle and repurchased
between one and three days later . Because the assets were valued at 105 percent of the
cash received, GAPP accounting rules allowed the transactions to be treated as sales, thus
removing the assets from Lehman Brothers’ balance sheet altogether.

Under the direction of Chief Financial Officer Erin Callan and the certification of Chief
Executive Officer Richard S. Fuld, Jr., Lehman Brothers applied this technique at the end of
the first and second fiscal quarters of 2008 to transfer a combined total of $100 billion,
amending its leverage ratio from 13.9 to a far more favorable 12.1. Thanks to creative
accounting and clever public relations, Lehman Brothers was able to report a positive view
of its net leverage, including a $60 billion reduction in net assets on the balance sheets and
a deep liquidity pool. Each of these quarterly balance sheet spins was intended to offset the
effect of announcing — for the first time in years — a loss of $2.8 billion from write-downs
on assets, decreased revenues, and losses on hedges. Application of Repo 105 allowed
Lehman Brothers to avoid having to report selling assets at a loss.

During the bankruptcy investigation, the company’s global finance controller admitted that,
“there was no substance to [Repo 105] transactions.” Fuld, Callan, and their respective
teams concealed the use of this tactic from ratings agencies, investors, and the board of
directors. The one party in on the scheme was Ernst & Young, Lehman Brothers’ audit firm,
which failed to alert either internal or external parties to the manipulation that was taking
place, even when explicitly questioned. They could not maintain the illusion for long,
however, and in September 2008, Lehman Brothers’ situation finally came to a head.

On September 10, 2008, just three months after reporting second-quarter successes,
Lehman Brothers announced that its supposedly robust liquidity amounted to
approximately $40 billion, but only $2 billion constituted assets that could be readily
monetized. The remainder was tied up on so-called “comfort deposits” with various clearing
banks, and though the firm technically had the right to recall said deposits, the validity of
Lehnman Brothers’ work with these institutions was questionable at best (2). By August, the
deposits had been converted into actual pledges.

A few months prior, Fuld began coming to terms with Lehman Brothers’ negative outlook. In
a last-ditch effort, he made a public offering that yielded $6 billion in new capital for the
firm. However, by the by the time third fiscal quarter financial statements were due,
Lehman Brothers was projecting additional losses of $3.9 billion. Its stock price had

29
plummeted to $3.65 per share, a 94 percent decrease from January 2008. Fuld announced a
plan to spin off the majority of the company’s real estate holdings into a new public
company, but there were no prospective buyers (Holdings, Inc.). On Sept. 13, the United
States Treasury made it clear that Lehman Brothers would not be the recipient of bailout
money. Instead, a number of financial institutions, including Barclays and Bank of America,
were being encouraged to acquire the faltering company, invigorate it with much-needed
capital, and bring it back from the edge of collapse (3). Each potential acquiror declined. On
Sept. 15, 2008, Fuld admitted defeat and finally heeded private advice from Treasury
Secretary Henry Paulson, Jr. At 1:45 a.m., he filed for Chapter 11 bankruptcy protection, just
before the opening of Asian markets.

In the days following the largest bankruptcy filing in United States history, the American
market experienced a shock unlike any it had felt since the Great Depression. When the
domestic stock market opened on Sept. 15, the Dow Jones dropped 504 points. The
following day, Barclays agreed to buy Lehman Brothers’ United States capital markets
division for the bargain price of $1.75 billion. Meanwhile, insurance giant AIG was on the
verge of total collapse, forcing the federal government to step in with a financial bailout
package that ultimately cost $182 billion. On Sept. 16, the Primary Fund announced that due
to its Lehman Brothers exposure, its price had plummeted to less than $1 per share. The
ripple effect of Lehman Brothers’ failure was widespread, giving rise to a confidence crisis in
global banks and hedge funds. Credit markets froze, forcing international governments to
step in and attempt to ease concerns. Domestically, this resulted in the controversial
passage of the Trouble Asset Relief Program, a $700 billion federal rescue aid package, on
Oct. 3, 2008.

Facts and Figures:

 The debt to equity ratio provides an indication as to how the company
utilizes debt in financing its operations, further providing insight on how the
company can meet current and future financial obligations. In Lehman’s
situation, it was defined by net assets divided by equity. The net assets
eradicated certain types of assets from total assets, with intangibles and
assets seized as collateral. This reduced the debt to equity ratio and boosted
the company’s superficial health.
 At the time of Lehman’s bankruptcy, between 900,000 to 1,000,000 derivative contracts
across 8,000 different counter parties beyond belief, held the Lehman name.
 Repo 105 was a type of loophole in accounting wherein a company could
classify a short-term loan as a sale and subsequently use the cash proceeds
from the sale to reduce its liabilities.

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 As the stock market fell drastically, to help the economy grow both the Treasury and Fed
Reserve started working towards it.
Following are the responses of the U.S. government to the Financial crisis.

Congress
Emergency Economic Stabilization Act of 2008 (EESA)
 Enacted October 3, 2008.
 Directs the Treasury Secretary to establish the Troubled Asset Relief Program (TARP),
which authorizes the purchase of up to $700 billion of “troubled assets” from “financial
institutions.”
 Provides tax relief to banking organizations that have suffered losses on certain holdings of
Fannie Mae and Freddie Mac preferred stock by changing the character of these losses
from capital to ordinary for federal income tax purposes.
 Authorizes SEC to suspend mark-to-market accounting for any issuer or with respect to
any class or category of transaction. Requires SEC to study mark-to-market accounting
applicable to financial institutions, including depository institutions, and report its findings
and recommendations to Congress.
(The report was delivered to Congress on December 30, 2008 and is available
at http://www.sec.gov/news/studies/2008/marktomarket123008.pdf).
 Temporarily increases insurance limits on FDIC and credit union accounts to $250,000 per
account through December 31, 2009.

The American Recovery and Reinvestment Act of 2009 (Recovery Act or ARRA)
 Enacted February 17, 2009.
 Economic stimulus package totaling $787 billion. Package includes spending initiatives in a
variety of areas (e.g., education, health care, infrastructure, energy) and almost $300
billion in tax relief for both individuals and businesses.

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 Title VII of the Act requires the Treasury Secretary to establish standards for executive
compensation and corporate governance applicable to any entity that has received or will
receive assistance under the TARP. Among other things, these standards must: (1) limit the
payment of incentive compensation to senior executives and other highly compensated
employees; (2) provide for the entity to “claw back” any bonus or incentive compensation
payment that is based on statements of earnings or similar criteria that are later found to
be materially inaccurate; (3) require the entity’s CEO and CFO to certify compliance with
the standards; (4) require the entity’s board to adopt a policy on “excessive or luxury
expenditures”; and (5) for public entities, give shareholders an annual, non-binding “say-
on-pay” vote. TARP recipients are generally permitted to withdraw from the program at
any time by repaying the government assistance.

Federal Reserve
AIG—Federal Assistance Package
 September 2008: AIG is permitted to draw up to $85 billion under loan facility with a two-
year term. Interest to accrue on the outstanding balance at a rate of three-month Libor
plus 850 basis points.
 November 10, 2008: Federal Reserve and Treasury announce a restructuring of the federal
assistance to AIG:
o Treasury to purchase $40 billion of newly issued AIG preferred shares under the TARP.
o AIG loan facility to be modified as follows: (1) amount available reduced from $85 billion
to $60 billion; (2) length of facility extended from two to five years; and (3) interest rate
reduced to three-month Libor plus 300 basis points.
o Residential Mortgage-Backed Securities Facility to be established: Newly formed limited
liability company will borrow up to $22.5 billion to purchase residential mortgage-
backed securities from AIG’s U.S. securities lending collateral portfolio. Proceeds from
the facility, together with other AIG resources, will be used to return all cash collateral
posted for loans outstanding under AIG’s U.S. securities lending program. Prior $37.8
billion lending facility established on October 8, 2008, by the New York Federal Reserve
Bank will be repaid and terminated.
o Collateralized Debt Obligations Facility to be established: Newly formed limited liability
company will borrow up to $30 billion to purchase multi-sector collateralized debt
obligations on which AIG has written credit default swap (CDS) contracts. CDS
counterparties will concurrently unwind the related CDS transactions.
 March 2, 2009: Federal Reserve and Treasury announce a further restructuring of the
federal assistance to AIG:
o Treasury to exchange its existing $40 billion in cumulative perpetual preferred shares for
new preferred shares with revised terms more closely resembling common equity.
o Treasury to create a new equity capital facility that will allow AIG to draw down up to
$30 billion in exchange for non-cumulative preferred stock issued to Treasury.

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 Additional changes to the AIG loan facility noted above (for details,
see http://www.federalreserve.gov/newsevents/press/other/20090302a.htm).

Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF)
 Non-recourse loans at the primary credit rate to U.S. depository institutions and bank
holding companies to finance purchases of high-quality asset-backed commercial paper
from money market mutual funds. AMLF was initiated on September 19, 2008, and
subsequently extended twice; it is now authorized until October 30, 2009.

Responses to frequently asked questions are available

at http://www.frbdiscountwindow.org/mmmf.cfm?hdrID=14#f4.

Commercial Paper Funding Facility (CPFF)

 A liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle
that will purchase three-month unsecured and asset-backed commercial paper directly
from eligible issuers. CPFF became operational on October 27, 2008, and was extended
once; it is now authorized until October 30, 2009.

Responses to frequently asked questions are available

at http://www.newyorkfed.org/markets/cpff_faq.html.
Interest on Required Reserve Balances and Excess Reserves
 Under an interim final rule effective October 9, 2008, the Federal Reserve Banks will pay
interest on depository institutions’ required and excess reserve balances. The payment of
interest on required reserve balances effectively eliminates the implicit tax that reserve
requirements imposed on depository institutions. The payment of interest on excess
balances reduces the incentive for institutions to lend federal funds at rates much below
the targeted federal funds rate.

Responses to frequently asked questions are available

at http://reportingandreserves.org/IOR_FAQ.pdf.

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 Money Market Investor Funding Facility (MMIFF)
 October 21, 2008: Federal Reserve creates a funding facility to support a private-sector
initiative intended to provide liquidity to U.S. money markets. Under the MMIFF, the
Federal Reserve Bank of New York will provide senior secured funding to a series of special
purpose vehicles (SPVs) that will purchase high-quality money market instruments
maturing in 90 days or less from U.S. money market funds. The SPVs became operational
in late November 2008 and were initially authorized to purchase assets until April 30,
2009; this date was later extended until October 30, 2009.

Information about the MMIFF and responses to frequently asked questions are available
at http://www.newyorkfed.org/markets/mmiff_faq.html.
 January 7, 2009: Participation in MMIFF expanded to include other money market
investors, such as U.S.-based securities lending cash-collateral reinvestment funds,
portfolios, and accounts, as well as U.S.-based investment funds that operate in a manner
similar to money market funds (e.g., certain local government investment pools, common
trust funds, collective investment funds).

Primary Dealer Credit Facility (PDCF)

 Overnight loan facility that provides discount window loans to primary dealers. Program
was initiated in March 2008 and expanded in September to broaden allowable collateral to
match closely the types of collateral that can be pledged in the tri-party repo systems of
the two major clearing banks. The PDCF, which has been extended twice, is now set to
expire on October 30, 2009.

Responses to frequently asked questions are available

at http://www.newyorkfed.org/markets/pdcf_faq.html.

Term Asset-Backed Securities Loan Facility (TALF)

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 November 25, 2008: Federal Reserve announces a loan facility designed to increase credit
availability and support economic activity by facilitating renewed issuance of consumer
and small business asset-backed securities. Federal Reserve Bank of New York (FRBNY) will
lend up to $200 billion on a non-recourse basis to holders of certain AAA-rated asset-
backed securities (ABS) that are backed by newly and recently originated auto loans, credit
card loans, student loans, and small business loans guaranteed by the Small Business
Administration. Treasury, through the TARP, will provide $20 billion of credit protection to
the FRBNY in connection with this facility.
 February 10, 2009: Federal Reserve announces that it “is prepared to undertake a
substantial expansion” of the TALF, which could increase in size to as much as $1 trillion;
the classes of ABS eligible for financing also could be broadened. Expansion of the TALF
would be supported by additional funds from Treasury under the TARP.
 March 3, 2009: Federal Reserve and Treasury announce the launch of the TALF, which will
hold monthly fundings beginning March 25 and ending in December 2009. Responses to
frequently asked questions about the TALF are available
at http://www.newyorkfed.org/markets/talf_faq.html.
Term Auction Facility (TAF)
 Biweekly auctions of term funds to depository institutions against collateral that can be
used to secure loans at the discount window. Program initiated in December 2007.
 Current status: Size of program has been expanded many times since its inception.
Biweekly alternating auctions of 28-day and 84-day term paper now at $150 billion each.
Program to continue until the Fed deems it is no longer necessary. Information about the
TAF is available at http://www.federalreserve.gov/monetarypolicy/taffaq.htm.
Term Securities Lending Facility (TSLF)
 Weekly loan facility that promotes liquidity in Treasury securities and other collateral
markets, and thus fosters the functioning of financial markets more generally. The
program offers Treasury securities for loan over a one-month term against other program-
eligible general collateral. Securities loans are awarded to primary dealers based on a
competitive single-price auction. Program was initiated in March 2008.
 Current status: The amount of Treasury securities offered for auction and the types of
eligible collateral have been increased several times since the program’s inception.
Program is currently in effect until October 30, 2009. Responses to frequently asked
questions about the TSLF are available
at http://www.newyorkfed.org/markets/tslf_faq.html.

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 Treasury Department
Bank of America—Federal Assistance Package
 January 16, 2009: Treasury, Federal Reserve, and FDIC announce an agreement with Bank
of America to provide a package of guarantees, liquidity access, and capital. Composition
of the assistance package is similar to that granted to Citigroup (described below), except
that protected asset pool in this case totals approximately $118 billion.
Citigroup—Federal Assistance Package
 November 23, 2008: Treasury, Federal Reserve, and FDIC announce an agreement with
Citigroup to provide a package of guarantees, liquidity access, and capital:
o Treasury (pursuant to the Asset Guarantee Program under the TARP, which is described
below) and FDIC to provide protection against “possibility of unusually large losses” on
approximately $306 billion of loans and asset-backed securities that will remain on
Citigroup’s balance sheet. Citigroup to issue preferred shares to each agency.
o If necessary, Federal Reserve will backstop residual risk in the asset pool through a non-
recourse loan.
o Treasury (pursuant to the Targeted Investment Program under the TARP, which is
described below) to invest $20 billion in Citigroup, in exchange for preferred stock
paying an 8 percent dividend.
 February 27, 2009: Treasury agrees to restructure its interest in Citigroup, the details of
which are described at http://treas.gov/press/releases/tg41.htm.

Fannie Mae/Freddie Mac Guarantee

 Treasury guarantees outstanding debt of Fannie Mae and Freddie Mac on September 7,
2008, when both agencies were placed in conservatorship by the Federal Housing Finance
Agency.

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 Reserve Fund—Assistance with Liquidation of its U.S. Government Money Market Fund
 November 20, 2008: Treasury announces that it will serve as a buyer of last resort for the
fund’s securities to ensure that the fund is liquidated in an orderly and timely fashion. The
agreement requires the fund to use best efforts to sell its assets within a 45-day period,
after which Treasury’s Exchange Stabilization Fund will purchase any remaining securities
at amortized cost, up to an amount required to ensure that each shareholder receives $1
per share. Information about the agreement is available
at http://www.treas.gov/press/releases/hp1286.htm.

Temporary Guarantee Program for Money Market Funds

 September 19, 2008: Treasury announces temporary guarantee program for publicly
offered Rule 2a-7 money market funds that elect to participate in the program. Guarantee
applies only to shares held by any shareholder of record on September 19 and would be
triggered if a fund’s NAV falls below a certain level. Upon the fund’s liquidation, program
would make up the difference between the value per share and $1. Information about the
program and responses to frequently asked questions are available
at http://www.treasury.gov/offices/domestic-finance/key-initiatives/money-market-
fund.shtml. Program originally set to expire on December 18, 2008.
 November 24, 2008: Treasury extends the program until April 30, 2009, for money market
funds that are current participants and meet certain requirements. Funds must make an
extension payment and submit an extension notice by December 5, 2008. Information
about the extension is available at http://www.treas.gov/press/releases/hp1290.htm.

Securities and Exchange Commission

Ban on Short Selling of Financial Stocks
 September 18, 2008: SEC issues an order temporarily banning the short sale of 799
financial stocks. Ban later modified to (1) include additional financial stocks and (2) exclude
bona fide market making activity.
 Current status: Short sale ban expired on October 8, 2008, following EESA enactment.
Disclosure of Short Sale Activity
 September 18, 2008: SEC issues an order temporarily requiring institutional investment
managers to make weekly disclosures of daily short sale activity. Order later extended and
modified to provide that disclosure is made only to SEC and not publicly.
 Current status: Disclosure requirement extended, with certain modifications, as interim
final temporary Rule 10a-3T under the Securities Exchange Act until August 1, 2009.

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 Prohibition Against “Naked” Short Sales
 September 17, 2008: SEC issues temporary Rule 204T under the Securities Exchange Act to
address “naked” short selling. Rule requires that short sellers and their broker-dealers
deliver securities by the close of business on the settlement date (three days after the sale
transaction date, or T+3). Broker-dealers in violation of this requirement are prohibited
from further short sales in the same security unless the shares are located and pre-
borrowed.
 Current status: Close-out requirement and pre-borrow penalty in temporary Rule 204T
extended as interim final rule until July 31, 2009. Interim final rule specifies that securities
lending will not be treated as a short sale under the temporary rule if a bona fide recall of
the security is initiated within two business days after trade date.
Shadow Pricing Relief for Money Market Funds
 No-action letter to the Institute dated October 10, 2008: Temporarily allowed money
market funds to value certain securities at amortized cost for shadow pricing under Rule
2a-7. Relief limited to First Tier Securities with maturities of 60 days or less that the fund
reasonably expects to hold to maturity. Relief expired on January 12, 2009.
Temporary Exemption for Certain Money Market Fund Liquidations
 November 20, 2008: SEC issues Rule 22e-3T under the Investment Company Act of 1940 as
an interim final temporary rule. Rule applies to certain money market funds that have
elected to participate in the Treasury Department’s Temporary Guarantee Program for
Money Market Funds (see Treasury section above for program summary). Rule is intended
to facilitate orderly liquidations and help prevent the sale of fund assets at “fire sale”
prices. The rule will expire on October 18, 2009, unless the SEC announces an earlier
expiration date.
Easing Restrictions on Issuer Repurchases
 September 18, 2008: SEC issues order to temporarily alter the timing and volume
restrictions that typically apply when issuers repurchase their shares. Intent was to provide
additional flexibility and certainty to issuers that could be executing repurchases during
the current market conditions.
 Current status: Order extended once and then allowed to expire on October 17, 2008.

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TARP:
The Troubled Asset Relief Program (TARP) was a group of programs created and run by the
U.S. Treasury to stabilize the country’s financial system, restore economic growth, and
mitigate foreclosures in the wake of the 2008 financial crisis. TARP sought to achieve these
targets by purchasing troubled companies’ assets and equity.

Global credit markets came to a near standstill in September 2008, as several major financial
institutions, such as Fannie Mae, Freddie mac, and American International Group (AIG),
experienced severe financial problems, and as Lehman brothers went bankrupt. Goldman
Sachs and Morgan Stanley changed their Charters to become commercial banks, in an
attempt to stabilize their capital situations. To prevent further fail in the economy, the
Troubled Asset Relief Program (TARP) was initiated.

TARP was signed into law by President George W. Bush on October 3, 2008 with the passage
of the Emergency Economic Stabilization Act. The program was pioneered by Treasury
Secretary Henry Paulson in a bid to address the subprime mortgage crisis which was
spiraling out of control. It was initially created to increase the liquidity of the secondary
mortgage markets by purchasing the illiquid MBS, and through that, reducing the potential
losses of the institutions that owned them. Later, it was modified slightly to allow the
government to buy equity stakes in banks and other financial institutions. TARP initially gave
the Treasury purchasing power of $700 billion to buy illiquid MBS and other assets from key
institutions in an attempt to restore liquidity to the money markets The Dodd-Frank Wall
Street Reform and Consumer Protection Act later reduced the $700 billion authorization to
$475 billion.

The rules of TARP demanded that companies involved lose certain tax benefits and, in many
cases, placed limits on executive compensation and forbade fund recipients from awarding
bonuses to their top 25 highest-paid executives.

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 The U.S. government bought preferred stock in eight banks: Bank of America/Merrill Lynch,
Bank of New York Mellon, Citigroup, Goldman Sachs, J.P. Morgan, Morgan Stanley, State
Street, and Wells Fargo. The banks were required to give the government a 5 percent
dividend that would increase to 9 percent in 2013, encouraging banks to buy back the stock
within five years. From the program’s inception until the final date when funds could be
extended on October 3, 2010, $245 billion went to stabilize banks, $27 billion went to
programs to increase credit availability, $80 billion went to the U.S. auto industry
(specifically, to GM and Chrysler), $68 billion went to stabilize AIG, and $46 billion went to
foreclosure prevention programs, such as Making Home Affordable.

As of December 2013, the Treasury wrapped up TARP and the government concluded that
its investments had earned more than $11 billion for taxpayers. To be more specific, TARP
recovered funds totaling $441.7 billion from $426.4 billion invested. The government also
claimed that TARP prevented the American auto industry from failing and saved more than
1 million jobs, helped stabilize banks, and restore credit availability for individuals and
businesses.

TARP
 Capital Purchase Program
o October 14, 2008: Treasury announces that it will purchase up to $250 billion of senior
preferred shares from certain U.S. controlled banks and thrifts, as well as certain bank
and savings and loan holding companies. In addition to the non-voting preferred shares,
Treasury will receive warrants to purchase common stock from each participating
institution. Intent of the program is to encourage financial institutions to build capital so
as to increase the flow of financing to U.S. businesses and consumers.
o Application documents and responses to frequently asked questions for three categories
of applicants—public institutions, privately-held institutions, and S corporations—are
available at http://www.treas.gov/initiatives/eesa/application-documents.shtml.
 Systemically Significant Failing Institutions
o Program objective is to provide stability and prevent disruption to financial markets in
order to limit the impact from the failure of a systemically significant institution.
Program guidelines are available at http://www.treas.gov/initiatives/eesa/program-
descriptions/ssfip.shtml.
o November 10, 2008: Treasury announces that it will purchase $40 billion of newly issued
AIG preferred shares as part of a restructuring of federal aid to the company (see
Federal Reserve section above for details).

 Targeted Investment Program

o Program objective is to strengthen financial market stability through targeted
investments. Treasury will determine the form, terms, and conditions of any such
investment on a case-by-case basis in accordance with the considerations mandated in
EESA. Program guidelines are available
at http://www.treas.gov/press/releases/hp1338.htm.
o Investments in Bank of America and Citigroup made pursuant to this program (see
entries for each at the beginning of this section).

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DODD-FRANK ACT:
The Dodd-Frank Wall Street Reform and Consumer Protection Act is a massive piece of
financial reform legislation passed by the Obama administration in 2010 as a response to
the financial crisis 2008. Named after sponsors U.S. Senator Christopher J. Dodd and U.S.
Representative Barney Frank, the act's numerous provisions, spelled out over roughly 2,300
pages, are being implemented over a period of several years and intended to decrease
various risks in the U.S. financial system. The act established a number of new government
agencies tasked with overseeing various components of the act and by extension various
aspects of the banking system. President Donald Trump has pledged to repeal Dodd-Frank,
and on May 22, 2018, the House of Representatives voted to roll back significant pieces of
Dodd-Frank.

The Orderly Liquidation Authority monitors the financial stability of major firms whose
failure could have a major negative impact on the economy (companies deemed "too big to
fail"). It also provides for liquidations or restructurings via the Orderly Liquidation Fund,
which provides money to assist with the dismantling of financial companies that have been
placed in receivership, and prevents tax dollars from being used to prop up such firms. The
council has the authority to break up banks that are considered to be so large as to pose a
systemic risk; it can also force them to increase their reserve requirements. Similarly, the
new Federal Insurance office is supposed to identify and monitor insurance companies
considered "too big to fail."

The CFPB is supposed to prevent predatory mortgage lending (reflecting the widespread
sentiment that the subprime mortgage market was the underlying cause of the 2008
catastrophe) and make it easier for consumers to understand the terms of a mortgage
before finalizing the paperwork. It prevents mortgage brokers from earning higher
commissions for closing loans with higher fees and/or higher interest rates, and says that
mortgage originators cannot steer potential borrowers to the loan that will result in the
highest payment for the originator.

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The CFPB also governs other types of consumer lending, including credit and debit cards,
and addresses consumer complaints. It requires lenders, excluding automobile lenders, to
disclose information in a form that is easy for consumers to read and understand; an
example is the simplified terms you'll find on credit card applications.

Components of the Dodd-Frank Wall Street Reform and Consumer

Protection Act

A key component of Dodd-Frank, the Volcker Rule (Title VI of the Act), restricts the
ways banks can invest, limiting speculative trading and eliminating trading. Effectively
separating the investment and commercial functions of a bank, the Volcker Rule strongly
curtails an institution’s ability to employ risk-on trading techniques and strategies when also
servicing clients as a depository. Banks are not allowed to be involved with hedge funds or
private equity firms, as these kinds of businesses are considered too risky. In an effort to
minimize possible conflict of interests, financial firms are not allowed to trade proprietarily
without sufficient "skin in the game." The Volcker Rule is clearly a push back in the direction
of the Glass Steagall act of 1933 – a law that first recognized the inherent dangers of
financial entities extending commercial and investment banking services at the same time.

The act also contains a provision for regulating derivatives such as the CDS that were widely
blamed for contributing to the 2008 financial crisis. Because these exotic financial
derivatives were traded over the counter, as opposed to centralized exchanges as stocks
and commodities are, many were unaware of the size of their market and the risk they
posed to the greater economy.

Dodd-Frank set up centralized exchanges for swaps trading to reduce the possibility of
counterparty default and also required greater disclosure of swaps trading information to
the public to increase transparency in those markets. The Volcker Rule also regulates
financial firms' use of derivatives in an attempt to prevent "too-big-to-fail" institutions from
taking large risks that might wreak havoc on the broader economy.

Dodd-Frank also established the SEC Office of Credit Ratings, since credit rating agencies
agencies were accused of giving misleadingly favorable investment ratings that contributed
to the financial crisis. The office is tasked with ensuring that agencies improve their accuracy

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and provide meaningful and reliable credit ratings of the businesses, municipalities and
other entities they evaluate.

Aiding Whistleblowers
Dodd-Frank strengthened and expanded the existing whistleblower program promulgated
by the Sarbanes Oxley Act. Specifically, the Act:

 Established a mandatory bounty program under which whistleblowers can receive

from 10 to 30% of the proceeds from a litigation settlement
 Broadened the scope of a covered employee by including employees of the company
as well as its subsidiaries.
 Extended the limitations under which a whistleblower can bring forward a claim
against his employer from 90 to 180 days after a violation is discovered

Criticisms of Dodd-Frank
Proponents of Dodd-Frank believe the act will prevent our economy from experiencing a
crisis like that of 2008 and protect consumers from many of the abuses that contributed to
that crisis. Unfortunately, limiting the risks that a financial firm is able to take
simultaneously decreases its profit-making ability. Detractors believe the bill could harm the
competitiveness of U.S. firms relative to their foreign counterparts. In particular, the need to
maintain regulatory compliance, they feel, unduly burdens community banks and smaller
financial institutions — despite the fact that they played no part in the recession.

Such financial-world notables as former Treasury Secretary Larry Summers, Blackstone

Group L.P. (BX) CEO Stephen Schwarzman, activist Carl Icahn and JPMorgan Chase & Co.
(JPM) CEO Jamie Dimon also argue that, while each institution is undoubtedly safer due to
capital constraints imposed by Dodd-Frank, these constraints make for a more illiquid
market overall. The lack of liquidity can be especially potent in the bond market, where all
securities are not mark to market and many bonds lack a constant supply of buyers and
sellers.

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The higher reverse requirements under Dodd-Frank mean banks must hold a higher
percentage of their assets in cash, which decreases the amount they are able to hold in
marketable securities. In effect, this limits the bond market-making role that banks have
traditionally undertaken. With banks unable to play the part of a market maker, prospective
buyers will have a harder time finding counteracting sellers, but, more importantly,
prospective sellers will find it more difficult to find counteracting buyers.

Critics believe the act will ultimately hurt economic growth. If this criticism proves true, the
act could affect Americans in the form of higher unemployment, lower wages and slower
increases in wealth and living standards. Meanwhile, it will cost money to operate all these
new agencies and enforce all these new rules — over 225 new rules across a total of 11
federal agencies, to be exact — and that money will come from taxpayers.

Rollback of Dodd-Frank Provisions

On May 22, 2018 U.S. House of Representatives voted 258-159 in favor of a bill that will
significantly rollback provisions of the Dodd-Frank Act. the bipartisan legislation called
the Economic Growth, Regulatory Relief, and Consumer Protection Act will now be sent to
the President for his signature. Here are some of the provisions of this bill that reverse the
stance of existing financial regulations-

 Small and Regional Banks: The new bill eases Dodd-Frank regulations for small and
regional banks by increasing the asset threshold for application of prudential standards,
stress test requirements and mandatory risk committees.
 Large Custodial Banks: For institutions that had have custody of clients' assets but do
not function as lenders or traditional bankers, the new bill proposes lower capital
requirements and leverage ratios.
 Mortgage Credit: The new bill exempts escrow requirements for residential mortgage
loans held by a depository or credit union under certain conditions. The bill also directs
the Federal Housing Finance Agency to set up standards for Freddie Mac and Fannie
Mae to consider alternate credit scoring methods.
 Small Lenders: The bill exempts lenders with assets less than $10 billion from
requirements of the Volcker rule and proposes less stringent reporting and capital
norms for small lenders.
 Credit Bureaus: The bill proposes free credit security freezes for customers of credit
bureaus like Equifax.

Future of the Volcker Rule

In February 2017, U.S. President Donald Trump signed an executive order directing then-
Treasury Secretary Steven Mnuchin to review existing financial system regulations. Since the
executive order, Treasury officials have released multiple reports proposing changes to

44
Dodd-Frank, including a recommended proposal to allow banks greater exemptions under
the Volcker Rule.

In one of the reports, released in June 2017, the Treasury said it recommends significant
changes to the Volcker Rule while adding that it does not support its repeal and "supports in
principle" the rule's limitations on proprietary trading. The report notably
recommends exempting banks with less than $10 billion in assets from the Volcker Rule. The
Treasury also cited regulatory compliance burdens created by the rule and suggested
simplifying and refining the definitions of proprietary trading and covered funds on top of
softening the regulation to allow banks to more easily hedge their risks.

Since the June 2017 assessment, Bloomberg reported in January 2018 that the
Treasury's Office of the Comptroller of the Currency has led efforts to revise the Volcker
Rule in accordance with some of the Treasury's recommendations. A timeline for any
proposed revisions to take effect remains unclear, though it would certainly take months or
years. The vote by the Federal Reserve Board in late May of 2018 sets the stage for a
broader unwinding of the Rule as it stands.

Quantitative easing
Quantitative easing is a massive expansion of the open market operations of a central bank.
It’s used to stimulate the economy by making it easier for businesses to borrow money. The
bank buys securities from its member banks to add liquidity to capital markets. This has the
same effect as increasing the money supply. In return, the central bank issues credit to the
banks' reserves to buy the securities.

Where do central banks get the credit to purchase these assets? They simply create it out of
thin air. Only central banks have this unique power. This is what people are referring to
when they talk about the Federal Reserve “printing money.”
The purpose of this type of expansionary monetary policy is to lower interest rates and spur
economic growth. Lower interest rates allow banks to make more loans. Bank
loans stimulate demand by giving businesses money to expand. They give shoppers credit to
purchase more goods and services.
By increasing the money supply, QE keeps the value of the country's currency low. This
makes the country's stocks more attractive to foreign investors. It also makes exports
cheaper.

Japan was the first to use QE, from 2001 to 2006. It restarted in 2012, with the election of
Shinzo Abe as Prime Minister. He promised reforms for Japan's economy with his three-
arrow program, “Abenomics.”

The U.S. Federal Reserve undertook the most successful QE effort. It added almost $2 trillion
to the money supply. That’s the largest expansion from any economic stimulus program in
history. As a result, the debt on the Fed’s balance sheet doubled from $2.106 trillion in
November 2008 to $4.486 trillion in October 2014.

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The European Central Bank adopted QE in January 2015, after seven years of austerity
measures. It agreed to purchase 60 billion in euro-denominated bonds, lowering the value
of the euro and increasing exports. It increased those purchases to 80 billion euros a month.
In December 2016, it announced it would taper its purchases to 60 billion euros a month in
April 2017. The euro to dollar conversion shows how the euro is faring against the U.S.
dollar.

Quantitative Easing Explained

How does quantitative easing work? The Fed adds credit to the banks' reserve accounts in
exchange for mortgage-backed securities and Treasury. The asset purchases are done by the
trading desk at the New York Federal Reserve Bank.

The reserve requirement is the amount that banks must have on hand each night when they
close their books. The Fed requires that banks hold around 10 percent of deposits either in
cash in the banks' vaults or at the local Federal Reserve bank.
When the Fed adds credit, it gives the banks more than they need in reserves. Banks then
seek to make a profit by lending the excess to other banks. The Fed also lowered the
interest rate banks charge. This is known as the fed funds rate. It is the basis for all other
interest rates.

Quantitative easing also stimulates the economy in another way. The federal government
auctions off large quantities of Treasury to pay for expansionary fiscal policy. As the Fed
buys Treasury, it increases demand, keeping Treasury yields low. Since Treasury are the
basis for all long-term interest rates, it also keeps auto, furniture and other consumer debt
rates affordable. The same is true for corporate bonds, making it cheaper for businesses to
expand. Most important, it keeps long-term, fixed-interest mortgage rates low.

Process of QE

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Phases explained:

QE1: December 2008 - June 2010

At the November 25, 2008, Federal Open Market Committee meeting, the Fed announced it
would purchase $800 billion in bank debt, U.S. Treasury notes, and mortgage-backed
securities from member banks. The Fed started quantitative easing to combat the financial
crisis of 2008. It had already dramatically lowered the fed funds rate to effectively zero.
The current fed interest rates are always an important indicator of the nation’s economic
direction.

Its other monetary policy tools were also maxed out. The discount rate was near zero. The
Fed even paid interest on banks' reserves.

By 2010, the Fed bought $175 million in MBS that had been originated by Fannie
Mae, Freddie Mac, or the Federal Home Loan Banks. It also bought $1.25 trillion in MBS that
had been guaranteed by the mortgage giants. Initially, the purpose was to help banks by
taking these subprime MBS off of their balance sheets. In less than six months, this
aggressive purchasing program had more than doubled the central bank's holdings.
Between March and October 2009, the Fed also bought $300 billion of longer-term
Treasury, such as 10-year notes.

The Fed halted purchases in June 2010 because the economy was growing again. Just two
months later, the economy started to falter, so the Fed renewed the program. It bought $30
billion a month in longer-term Treasury to keep its holdings at around $2 trillion. Although
there were some shortcomings, QE1 was successful enough in helping prop up the fallen
housing market with low interest rates.

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QE2: November 2010 - June 2011

On November 3, 2010, the Fed announced it would increase quantitative easing, buying
$600 billion of Treasury securities by the end of the second quarter of 2011. The Federal
Reserve's quantitative easing 2 shifted its focus to inducing mild inflation, gradual enough to
spur demand.

Operation Twist: September 2011 - December 2012

In September 2011, the Fed launched Operation Twist. This was similar to QE2, with two
exceptions.
First, as the Fed's short-term Treasury bills expired, it bought long-term notes.
Second, the Fed stepped up its purchases of MBS. Both "twists" were designed to support
the sluggish housing market.

QE3: September 2012 - October 2014

On September 13, 2012, the Fed announced QE3. It agreed to buy $40 billion in MBS and
continue Operation Twist, adding a total $85 billion of liquidity a month. The Fed did three
other things it had never done before:

1 Announced it would keep the fed funds rate at zero until 2015.
2 Said it would keep purchasing securities until jobs improved "substantially."
3 Acted to boost the economy, not just avoid a contraction.

QE4: January 2013 - October 2014

In December 2012, the Fed announced it would buy a total of $85 billion in long-term
Treasury and MBS. It ended Operation Twist, instead just rolling over the short-term bills. It
clarified its direction by promising to keep purchasing securities until one of two conditions
were met. Either unemployment would fall below 6.5 percent or inflation would rise above
2.5 percent. Since QE4 is really just an extension of QE3, some people still refer to it as QE3.
Others call it "QE Infinity" because it didn't have a definite end date.

QE4 allowed for cheaper loans, lower housing rates, and a devalued dollar, all of which
spurred demand and as a consequence, employment.

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The End of QE

On December 18, 2013, the FOMC announced it would begin tapering its purchases, as
its three economic targets were being met.

1 The unemployment rate was at 7 percent.

2 GDP growth was between 2 and 3 percent.
3 The core inflation rate hadn't exceeded 2 percent.

The FOMC would keep the fed funds rate and the discount rate between zero and one-
quarter points until 2015, and below 2 percent through 2016.

Sure enough, on October 29, 2014, the FOMC announced it had made its final purchase. Its
holdings of securities had doubled from $2.1 trillion to $4.5 trillion. It would continue to
replace these securities as they came due to maintain its holdings at those levels.

On June 14, 2017, the FOMC announced how it will begin reducing its QE holdings. It will
allow $6 billion of Treasury to mature each month without replacing them. Each following
month it will allow another $6 billion to mature until it has retired $30 billion a month. The
Fed will follow a similar process with its holdings of mortgage-backed securities. It will retire
an additional $4 billion a month until it reaches a plateau of $20 billion a month being
retired. This change won't occur until the fed funds rate reaches 2 percent.

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Basic difference between QE and Helicopter
Money

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Taper Tantrum:
Taper tantrum is the term used for the 2013 surge the U.S. treasury yields, which resulted
from the Fed’s use of tapering to gradually reduce the amount of money it was feeding into
the economy. The taper tantrum ensued when investors panicked in reaction to news of this
tapering and drew their money rapidly out of the bond market, which drastically increased
bond yields.

When the economy needs a boost or is on the verge of crashing, the Federal Reserve feeds
money into the system through QE which gives everyone extra money. This allows people to
spend more money, which boosts businesses, which in turn boosts manufacturers, and the
economy as a whole experiences a boost. This is commonly known as stimulus package

QE is only intended to be a short-term solution. The danger comes when the Federal
Reserve either feeds the economy for too long, which lessens the value of the dollar, or cuts
it off abruptly, which causes mass panic. Tapering is a system of slowly reducing the amount
of money the Fed puts into the economy, which, in theory, gradually reduces the economy's
reliance on that money. However, if the public hears that the Fed is planning to engage in
tapering, panic can still ensue; that panic is called a taper tantrum.

What Caused the 2013 Taper Tantrum?

Tapering can backfire and causes a taper tantrum when investors hear about the Federal
Reserve's reduction of money into the economy and view it as an indication that the market

51
will be unstable without these extra funds. In 2013, Federal Reserve Chairman Ben Bernanke
announced that the Fed would no longer be purchasing bonds, and mass global panic
ensued. Bond yields drastically increased. However, once investors realized that there was
no reason to panic, the market leveled out again.

But Why Didn’t the Stock Market Fall During the Taper Tantrum?

Many pundits believed that the stock market would plummet when the Fed announced it
would scale down its bond-buying program in 2013. Instead Dow Jones made gains
following the first signs of the the QE program, even though previous warnings resulted in
declines in mid-2013. Some of the reasons the stock market didn’t necessarily follow the
warnings include that there was overall mood in the Fed’s faith in recovery. Secondly, there
was a sense that the tapering would reduce uncertainty in the economy, eliminating shock
while tightening the conditions slowly. Furthermore, much of the sell off already happened,
and more people were buying into the news of the tapering by the government.

Indications of Taper Tantrums in the Future

As the economy recovers from the Great recession there has been talk of another potential
taper tantrum. The Federal Reserve has started to raise interest rates, which means people
will spend more money on loans and investors will speculate on whether the economy is
moving toward another recession. There is controversy over whether a taper tantrum is
expected, as experts are divided on the issue. Regardless, the market is expected to react
negatively, and bond yields are expected to increase, even if a full-blown taper tantrum
doesn't occur.

Quantitative Easing Worked

QE achieved some of its goals, missed others completely and created several asset bubbles.
First, it removed toxic subprime mortgages from banks' balance sheets, restoring trust and
therefore banking operations. Second, it helped to stabilize the U.S. economy, providing the
funds and the confidence to pull out of the recession. Third, it kept interest rates low
enough to revive the housing market.

Fourth, it stimulated economic growth, although probably not as much as the Fed would
have liked. That's because it didn't achieve the Fed's goal of making more credit available. It
gave the money to banks, but they sat on the funds instead of lending them out. Banks used
the funds to triple their stock prices through dividends and stock buybacks. In 2009, they
had their most profitable year ever.

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The large banks also consolidated their holdings. Now, the largest 0.2 percent of banks
control more than 70 percent of bank assets.

That's why QE didn't cause widespread inflation, as many had feared. If banks had lent out
the money, businesses would have increased operations and hired more workers. This
would have fueled demand, driving up prices. Since that didn't happen, the Fed's
measurement of inflation, the core CPI, stayed below the Fed's 2 percent target.

Instead of inflation, QE created a series of asset bubbles. In 2011, commodities traders

turned to gold, driving its price per ounce from $869.75 in 2008 to $1,895.

In 2012, investors turned to U.S. Treasury, driving the yield on the 10-year note to a 200-
year low.

In 2013, investors fled out of Treasury and into the stock market, driving the Dow up 24
percent. This followed Ben Bernanke's announcement on June 19 that the Fed was
considering tapering. That threw bond investors into a panicked selling spree. As demand
for bonds fell, interest rates spiked 75 percent in three months. As a result, the Fed held off
the actual taper until December, giving the markets a chance to calm down.

In 2014 and 2015, the value of the dollar rose 25 percent, as investors created an asset
bubble in U.S. dollars. This is the opposite of what's supposed to happen with QE. But the
U.S. dollar is a global currency and a safe haven. Investors flock to it despite high supply,
making this one area that turned okay despite the QE not working as intended.

The Fed did what it was supposed to do. It created credit for the financial markets when
liquidity was severely constrained. But it couldn't overcome contractionary fiscal policy.
Between 2010 and 2014, Tea Party Republicans gained control of the House of
Representatives. They insisted on budget cuts when the economy was not yet on its feet.
They threatened to default on the national debt in 2011. They also initiated a 10 percent
spending sequester. They created a government shutdown in 2013.

The Fed also could not force banks to lend. Its strategy of adding money to the system was
like pushing a string. It created bubbles in other asset classes without getting needed funds
to households and businesses.

Quantitative Tightening
Before getting into the policy known as quantitative tightening, it’s crucial to understand its
counterpart: quantitative easing. And since the onset of the global financial crisis in 2007,
the major international central banks—the U.S. Federal Reserve, the Bank of Japan and the
European Central Bank, and to a lesser degree the Bank of England—have embarked on this
monetary policy called “Quantitative tightening” Also known as QE, the policy sets out to
spur economic growth and lower interest rates in their respective domains.

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Put simply, the central banks have created money by purchasing financial assets, generally
bonds issued by their respective sovereign governments. They also purchase bonds and
sometimes, in the case of the BOJ, equity issued by private corporations, in order to make
money more widely available to borrowers.

According to a report dated 7 February 2018, entitled “Global Economic Briefing: Central
Bank Balance Sheets,” the collective balance sheets of the Fed, the ECB and the BOJ have
more than quadrupled over the past 10 years, from a little more than US$3 trillion in early
2007 to US$14.6 trillion in January 2018. The following reflect the banks’ respective balance
sheet growth:

1. The Fed’s balance sheet has jumped from about US$800 billion before the crisis to
more than US$4.4 trillion as of February 2018.
2. The ECB’s has grown to more than US$5.5 trillion from about US$1.5 trillion.
3. The BOJ’s has increased to US$4.8 trillion from about US$1 trillion.

WHY QUANTITATIVE TIGHTENING?

As memories of the financial crisis and the resulting Great Recession have faded and the
world economy has begun to expand again, pressure has been growing on the central banks
to start unwinding those massive portfolios and normalizing monetary policy for fear of
igniting runaway inflation. That process, which would essentially reverse quantitative easing,
has come to be known as quantitative tightening. Much as the initial QE policy was
unprecedented, “QT” will also be untried and untested. However, it may have more
negative repercussions on the world economy and financial markets than QE.

That’s because the net effect of massive central bank asset purchases drove up the price of
those assets, both bonds and stocks, which benefited most investors. It stands to reason,
then, that doing the reverse—either by selling off assets or, in the case of bonds, allowing
them to mature—may have the opposite effect. Namely, it would drive down the price of
stocks and bonds, which would unnerve investors and have a negative impact on economic
growth just as the world economy is starting to rebound.
Driving down the price of bonds should raise interest rates, other things being equal. As an
example, the Fed is the largest holder of U.S. government debt, so if it reduces its
purchases, more buyers will be needed to pick up the slack. This is especially the case as U.S.
Treasury borrowing is expected to rise sharply over the next several years as government
deficits increase. If enough new buyers don’t materialize, interest rates will have to rise in
order to make them more attractive for investors.
That’s why the process is called “tightening,” because the central bank is essentially draining
money out of the financial system. This creates a scarcity, which then makes it more
expensive to borrow money. Interest rates, after all, are the price of money.

HOW QUANTITATIVE EASING AND QUANTITATIVE TIGHTENING WORK?

While the common belief is that QE involves central banks “printing money,” that’s not
exactly what happens. Rather, central banks essentially create money by depositing money

54
at private banks and other financial institutions and then buy the government securities it
wants from them, with the money remaining in those institutions. The intention, the central
banks hope, is that this money will be loaned out to corporations and consumers in order to
spur business activity.6)
In reversing the process, the central bank sells assets back to the financial institutions, thus
draining the money the bank keep on deposit. That reduces the amount of money they have
to lend, which, again, other things being equal, should raise the cost of money to borrowers,
i.e., interest rates.

THE MOVE FROM QUANTITATIVE EASING INTO QUANTITATIVE TIGHTENING:

In the U.S., the Fed ended its asset purchases in 2014 but continued to reinvest interest
payments and the proceeds of matured bonds into new securities, leaving the size of its
portfolio mostly unchanged. On 14 June 2017, the Fed announced it will begin reducing its
portfolio holdings as the U.S. economy has finally shown sustained growth. It will allow US$6
billion of Treasury securities to mature each month without replacing them, increasing the
total by another US$6 billion a month until US$30 billion a month is being retired. The Fed
will follow a similar process with its holdings of mortgage-backed securities, retiring an
additional US$4 billion a month until it reaches a total of US$20 billion a month.

The Fed began the process in November 2017 and allowed several billion dollars of
government bonds to mature without reinvesting the proceeds. The Fed reported that its
portfolio holdings of Treasury securities declined by US$6 billion in its holdings, the first
indication that QT had begun. The institution has not indicated that it has any intention of
actually selling securities out of its portfolio, and that appears unlikely. So far, there are only
plans to allow the portfolio to run off gradually, over a period of several years, in order to
minimize the impact on financial markets.

QT has yet to begin at the other major central banks. In October 2017, the ECB announced
that it would reduce its monthly asset purchases by half, to €30 billion, beginning in January
2018, with the purchases scheduled to end in September. However, ECB officials have said
the program may be extended beyond that date depending on economic data. The BOJ
continues its QE program and has given no indication when it may end.

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Jackson Hole:

The Jackson Hole Economic Symposium is one of the longest-standing central banking
conferences in the world. The mission of the event is to foster an open discussion.
Attendees are selected based on each year’s topic with additional consideration given to
create regional diversity among attendees. In a typical year, about 120 people attend,
representing a variety of backgrounds and industries. In order to foster the open discussion
that has been so critical to the symposium’s success, attendance at the event is limited. In
addition, while the Federal Reserve Bank of Kansas City receives numerous requests from
media outlets worldwide, press attendance is also limited to a select group to
provide transparency to the symposium, while not overwhelming or influence the
proceedings. All symposium participants, including members of the press, pay a fee to
attend. The fees are then used to recover event expenses.

Jerome Powell’s speech was the main focus of the event this year.
It is decided that there will be fed rate hike from 2% to 2.25% in September then to 2.5% in
December and mostly to 3% in June next year.
Also there were discussions of new bond purchasing programs but not disclosed.

Explanation of graphs:

1. Total assets held by the Federal Reserve

QE process helped to add $2 trillion to the economy hence, the Federal Reserve’s balance

56
sheet rose from $2.106 trillion in the year 2009 to $4.486 in the year 2014.
Hence, proving the benefits of the implementation of QE.

2. Emerging Market Currencies

The Federal Reserve continued its tapering process, slowing monthly purchases of
Treasuries and mortgage-backed securities another $10 billion to a total of $65 billion per
month. Why has the taper, in combination with some weaker data coming out of China, led
to a selloff in some emerging markets such as Brazil, Turkey, Indonesia and South Africa?
Figure 1 depicts the recent slide in the Brazilian Real, Turkish Lira, Indonesian Rupiah and
South African Rand against the U.S. Dollar since Bernanke started discussing tapering on
May 22nd 2013 (a higher number indicates a weaker currency).

57
Ultra-low interest rates led to a search for yield with investors flocking into higher yielding
and riskier emerging market assets. These flows aren’t necessarily bad as diversification into
faster growing economies is beneficial to both investors and the recipient countries. The risk
is that the recipient countries don’t have economic structures and financial markets which
are equipped to handle what can be massive flows relative to the size of these economies.

3. Inflation Rate

Following the Financial Crisis of 2008, the United States Government implemented a
stimulus package of historical proportions, and the Federal Reserve carried out a monetary
policy known as QE. The large increase in government spending coupled with tax cuts,
completely goes against the intuition behind the government budget constraint. In my eyes,
the immense amount of money creation necessary to balance the aforementioned policies,
and then put into the economy, is being deemphasized and concealed from plain view.

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 4. GDP

Economic activity increased 1.9% in last year's fourth quarter, the Bureau of Economic
Analysis reports, slightly below expectations. Compared with the strong 3.5% rise in Q3,
today's update looks worrisome. But closer inspection, using year-over-year comparisons,
shows that nothing much has changed - moderate growth endures. In fact, the trend picked
up a bit.

Matching the quarterly rate, real GDP also increased 1.9% in Q4 vs. the year-earlier level,
the best gain in 2016 for annual changes. Compared with results since the Great Recession

59
ended in 2009, today's numbers reflect a year-over-year change that's just below the
average increase (2.0%).

5. Unemployment Rate

Unemployment rate is an economic indicator of any economy. The unemployment was at

it’s peak in the year 2008-2009 when the QE started but eventually started to fall because of
the positive effects of the process. With the creation of money supply in the economy, there
was more cash in hand with the people and there was more production thus creating
employment opportunities.

6. S&P Performance

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The QE process had positive impacts on the stock market of US also because of the
generation of more money in the economy and gradually by creating trust within the
people.

7. US House Prices and Mortgages

The US housing finance bubble was the underlying cause of the ‘sub-prime’ crisis that
triggered the deepest US and global recession since the depression of the 1930s. It is also
central to US economic recovery. House prices across the US more than doubled during the
2000s boom but then crashed by more than one third on average in the bust, with many
cities suffering declines of 60% or more. Prices have been recovering steadily since early

61
2012. The key has been mortgage interest rates, which have come down from 8.5% in 2000
to below 4% since 2012.

8. Dividend Yield

Since market price and dividend share an inverse relationship, it can be seen here in the
graph that whenever the market price goes up the dividend yield lessens and vice versa.

9. Gold and Dollar correlation

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The performance of gold obviously depends on the U.S. economic condition and the Fed’s
future actions. In the short run, the end of QE3 will most likely not change anything and gold
will most likely decline on a dollar rally. It is likely to last as long the U.S. central bank
credibility is at all-time heights. This is because gold can be seen as the reciprocal of central
bank credibility. Thus, when central bank credibility is at a peak, gold is in the dumps

10. Consumer and Business Borrowings

The price and yield share an inverse relationship and thus, after the QE process people
started investing more in bonds rather than in the stock market hence, raising the demand
and price for the bond thus decreasing the return of the same.

11.Emerging currencies after QT

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Reasons of declining currencies:
 US China trade war
 Turkey Lira crisis
 Emerging countries did not realize the emergence of QT in US after 31st
January,2018.

12. Current FED holdings

QT is set to rise from a current potential $30B per month to $50B in Q4 this year.

All else equal, QT is likely to be a headwind for both stocks and bonds.

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 Globally, the ECB and BOJ are providing some offset, but will each be heading for the exits at
some point too.
As the Fed is steadily progressing through its balance sheet normalization plan, it's worth
checking in on a few charts that highlight the path to normalcy, and some of the potential
stumbling blocks along the way. The beginning of large scale asset purchases (or QE -
Quantitative Easing) in the wake of the financial crisis was a grand monetary policy
experiment, and we are now entering into another grand monetary policy experiment.

The key takeaways on quantitative tightening (or QT) are:

 QT is set to rise from a current potential $30B per month to $50B in Q4 this year.
 All else equal, QT is likely to be a headwind for both stocks and bonds.
 Globally, the ECB and BOJ are providing some offset, but will each be heading for the exits at
some point too.

Impact on India- It majorly affected the banks. The mosted affected was the ICICI Bank
as its share price went down from Rs 230 to Rs 58.24. As ICICI bank had a UK branch ICICI
UKplc which had invested around $80 million in Lehman Brother s Bond. When the Lehman
Brothers collapsed this branch also had a hit. This information when came to India people
panicked and started selling their shares and the prices fall.But RBI came into rescue and
offered a statement in which it stated ICICI bank has good amount of liquidity ratio and no
need to worry, after which the share price started increasing. Moreover India’ s export
import were not much affected because of the foreign trade policy which came in 2009.

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China- A large no of exports from China were sent to USA. As the economy of America
fall,the purchasing power decreased, so exports of China decreased. Due to less export
production declined and unemployment rose. But due to strong fiscal policy of China it
again stabilized after certain time.

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 Japan- In Japan’s stock exchange,60% is invested by foreign investors .As the market in USA
fall it had a domino effect in Japan. People started pulling out their money leading to fall.But
Japan government started stimulus programs and also did quantitative easing to help the
economy. Similarly the exports got affected as the purchasing power of USA decreased.

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