econ101crisis

econ101crisis - Mark Siegler Economics 101 UC Davis J l...

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7/27/2009 1 Mark Siegler Economics 101 UC Davis July 27-28, 2009 1 The Financial System y Financial markets and financial institutions perform Financial markets and financial institutions perform two critical tasks for the economy: y Allocating savings y Managing risk In retrospect, they have failed miserably at both tasks. Trillions of dollars were allocated to home loans well beyond Americans’ ability to pay, and financial innovations have created more risk, not less. 2
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7/27/2009 2 Top 10 Background Ingredients For the Current Crisi For the Current Crisis 3 Background Ingredient #1 y Global Savings Glut y Series of financial crises in the 1990s (Mexico 1994, Asia 1997-98, Russia 1998, Brazil 1998, and Argentina 2002) caused these countries to increase their savings substantially and to curtail foreign borrowing. They lent vast sums to the rest of the world, particularly the U.S. since the U.S. was perceived to be a “safe haven” in a world of global financial insecurity. y Savings glut in China 4
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7/27/2009 3 Background Ingredient #2 y Mistaken belief by those in power that deregulation always leads to better outcomes. y Period of deregulation, which began in the 1970s, and persisted through Republican and Democratic administrations (trucking, airlines, long-distance telephones, etc.), but also (unfortunately) in banking and finance. 5 Christopher Cox, Chairman of the Securities and Exchange Commission, recently said that the oversight program was “fundamentally flawed from the beginning because investment banks could opt in or out of supervision voluntarily. . . . The last six months have made it abundantly clear that voluntary [emphasis added] regulation does not work.” New York Times , September 27, 2008 6
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7/27/2009 4 Background Ingredient #3 y Ri d f i i l it i Rapid financial innovation y Large increase in number of adjustable-rate mortgages y Negative amortization loans y “Liars” loans y Loans in excess of the value of your home and more! y Mortgage-backed securities (CMOs, CDOs) y Credit default swaps (CDSs) and other derivatives 7 Over the past generation — ever since the banking deregulation of the Reagan years — the U.S. economy has been “financialized.” The business of moving money around, of slicing, dicing and repackaging financial claims, has soared in importance compared with the actual production of useful stuff. . . . Such growth would be fine if financialization really delivered on its promises — if financial firms made money by directing capital to its most productive uses, by developing innovative ways to spread and reduce risk. But can anyone, at this point, make those claims with a straight face? Paul Krugman, New York Times , July 16, 2009 8
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7/27/2009 5 9 “Credit default swaps are not traded on an Credit default swaps are not traded on an exchange. They aren’t traded through a central counterparty, which means if one of those firms fails, among the consequences would be that the banks and others who had purchased credit insurance would be forced to write down tens of billions of dollars of value.” Ben Bernanke, October 15, 2008 10
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econ101crisis - Mark Siegler Economics 101 UC Davis J l...

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