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U.S. housing policies are the root cause of the current financial crisis.

Other players-- greedy investment bankers; foolish investors; imprudent

bankers; incompetent rating agencies; irresponsible housing speculators;

short sighted homeowners; and predatory mortgage brokers, lenders, and borrowers--all played a part, but they were only following the economic incentives that government policy laid out for them.

- Peter J. Wallison

Note: Financial services and insurance accounted for 7.8% of U.S. GDP in 2006.

Originate-andDistribute Model Excess Global Liquidity Scant Regulatory Oversight Mortgage Securitization Mispricing of Risk Credit Default Swaps Deterioration of Underwriting Standards

Rising Real Estate Prices

Low Interest Rates

Excessive Financial Leverage


Drive to Increase Investment Returns

Mauro F. Guilln, The Wharton Schoo

Housing prices were relatively stable during the 1990s, but they began to rise

toward the end of the decade. Between January 2002 and mid-year 2006, housing prices increased by a whopping 87 percent. The boom had turned to a bust, and the housing price declines continued throughout 2007 and 2008. By the third quarter of 2008, housing prices were approximately 25 percent below their 2006 peak.
Annual Existing House Price Change
20.0% 15.0% 10.0% 5.0% 0.0% -5.0% -10.0% -15.0% -20.0%

Source:, S and P Case-Schiller Housing Price Index.

19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08

The default rate fluctuated, within a narrow range, around 2

percent prior to 2006. It increased only slightly during the recessions of 1982, 1990, and 2001. The rate began increasing sharply during the second half of 2006 It reached 5.2 percent during the third quarter of 2008.
Default Rate
6% 5% 4% 3% 2% 1% 0%

19 79 19 80 19 81 19 82 19 84 19 85 19 86 19 87 19 89 19 90 19 91 19 92 19 94 19 95 19 96 19 97 19 99 20 00 20 01 20 02 20 04 20 05 20 06 20 07
Source:, National Delinquency Survey.

The global story : macro imbalances meet financial

innovations. UK story : specific developments. Global finance without global government: faultiness in regulatory approach. Fundamental theoretical issues: market efficiency and rationality.

2007: crisis in markets for mortgage related

Large losses at hedge funds for credit default swaps.

Credit rating downgrades of subprime products

Prices of mortgage-backed securities fell and demand dried

up. Banks began to write down mortgage related assets. Some institutions were unable to raise needed funds.

Two key crisis events were outside the

August 2007,French Bank BNP Paribas froze

redemptions saying couldnt value underlying securities. UK bank Northern Rock bailed out in sep,2007.

Fed and other Central Banks began

aggressive response.

2008:credit conditions continued to

March : bear sterns Sep

: Fannie Mae and Freddie Mac Sep 15 : Lehman Brothers Sep 16 : AIG Sep 25 : WAMU

Credit markets froze up.

U.S. and the world entered the most severe

recession since 1930s.

Why did a crisis in a relatively limited

part of the market turn into a full blown crisis? 1.Borrower s balance sheet effects
Loss spiral : asset prices fall->must sell assets to

correct BS -> asset sales cause further price decline. Margin/haircut spiral: with increases assessment of risk, large margins are required-> must reduce leverage -> asset sales -> as in loss spiral. 2. L ending channel
Precautionary hoarding by banks and non banks.

3. Runs on non bank financial institutions.

Eg. Hedge funds pulling money out of Bear sterns , AIG

forced to post more collaterals.

4. Networking effects
Counterparty risk : the argument for saving AIG The gridlock risk.

What we need and what we do not need

The crisis was foreseen so the problem is not lack of information but lack of instruments.

What do we need?
Countercyclical instruments:
interest rates?

Revise definition Not enough to flatten a strong bubble.

liquidity support.?

Stigma issue Moral hazard.

Capital and liquidity requirements ,time varying loan to value ratios?

Raises cost of borrowing. Can drive business off-shore Increase information burden Off-load assets onto associated off-balance sheet entities.

Banks should disclose all associated off balance

sheet business Central banks to lend almost invariably in case of real crisis. so commit to vary lending rate Special resolution scheme(carrot and stick policy) Devise time varying liquidity scheme. construct proper tools to make financial system potent.

CP1 : price stability

CP2 : financial stability

Short term interest rate as the only instrument:CP1

and CP2 in conflict. To maintain gold standard and avoid liquidity panic: two instruments namely LOLR lending keep interest rates high.

Lead role of central banks in financial regulation(Financial Service Authority

The aim of financial regulators are: confidence stability 3.consumer protection protection for consumers. 4.reduction of financial crime suggestion: follow Twin peaks approach ~The twin peaks is

)and not banking supervision.

characterized by separate prudential and market conduct regulators. Since equal weight is given to prudential and market conduct regulation, it is regarded as the optimal way to ensure that consumer protection and market integrity receive sufficient priority and are not routinely presumed to be subservient to prudential concerns. CP1 settled but exaggerated financial turmoil of 2007.

Overall conclusion: look for instruments to settle CP2 along with CP1.