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Derivatives

  • Most derivatives are created to reduce risk
  • Although face value might be $1 billion, actual risk is probably $10 million
  • They are a zero sum game - for every loser there is a winner
  • Large houses mismanaged risk
  • Real problem was misrating

Shadow Banking

Fractional Reserve Banking?

  • Name is a pejorative for the unregulated nondepositary sector
  • Money had been forced into unregulated sector by overregulation
  • This includes large public pension funds like CALPERS
  • Ditto Fannie and Freddie
  • So large amounts not backed by deposits
  • Big debate in libertarian circles (Rothbard v Mises)
  • Murray Rothbard claims FRB is fraudulent and an abuse of property rights
  • Mises - cannot enforce 100% reserve banking
  • Posner - a deposit at a bank is a loan
  • Contract rights apply, not property rights
  • All banks do offer 100% guaranteed deposits

FSOC and SIFIs

"Too Big to Fail"

Misconceptions

ZIRP

Mark-to-Market

  • FSOC is a super-regulator
  • Has power to designate SIFIs - "Systemically Important Financial Institutions"
  • Entrenches "too big to fail"
  • Large banks want SIFI status
  • Insurance companies caught up as "cash cows" to pay for bailouts

CFPB

Risk of Contagion?

  • Concept based on contagion argument
  • Also applied to GM and Chrysler (why?)
  • Result was Dodd-Frank Act
  • All sorts of extraneous measures added
  • TARP was not used for troubled assets but for bailouts
  • Neal Barofsky SIGTARP
  • Accounting standards issue
  • How do you account for the value of an asset that changes over time?
  • Mark-to-market says you value according to the current market value
  • This does reveal real losses but...
  • Creates accounting bubbles and crashes
  • Continued lack of real recovery has led to sustained ZIRP
  • Companies are not borrowing to expand but to buy back shares
  • Consumers - evidence mixed
  • Main beneficiary has been government borrowers
  • So how can ZIRP ever end?
  • Idea of Elizabeth Warren
  • Financial equivalent of CPSC
  • "Loans are not toasters"
  • Immense power
  • Immune from checks and balances
  • Cracking down on any form of lending
  • But fines finance firms for not lending to the right people
  • AIG bailout was mainly about protecting counterparties
  • Goldman Sachs was largest counterparty
  • Goldman claims it had hedged the risk
  • Why "save" Goldman from a non-problem?
  • Why "save" Goldman and not Lehmann?
  • Hank Paulson and DC connections
  • Cronyism not contagion?

Monetary Policy

  • Fractional Reserve Banking
  • Were derivatives to blame?
  • Shadow Banking?
  • Contagion?
  • What about deregulation?
  • US Federal Reserve used monetary policy to "stimulate" economy after 2001
  • Fed has "dual mandate"
  • Interest rates reduced to near zero to encourage spending
  • Saving became uneconomical so savers looked to other investments
  • Real estate became source of speculation

The Response (US)

Moral Hazard

Deposit Insurance

Preconditions

  • Deposit insurance introduced in US 1933
  • Only 12 countries in 1974
  • 113 in 2014
  • Deposit insurance discourages savers from paying attention to actions of banks
  • Encourages banks to take risks

Deregulation?

  • Deposit insurance raised to $250,000
  • So obvious increase in moral hazard - vicious circle with other regulations
  • Has also prompted regulators to exercise their powers more
  • "Operation Choke Point"
  • "Too Big To Fail"
  • Bailouts
  • Dodd-Frank
  • FSOC
  • CFPB
  • Deposit insurance rise
  • ZIRP
  • Financial deregulation is an extraordinary myth
  • SarbOx had vastly increased US regulation
  • Only real deregulation was government housing policy
  • UK - "deregulation" of 1980s in fact introduced government regulation
  • Alphabet soup of regulators

Financial Technology

  • Monetary policy
  • Moral hazard
  • Modern financial technology
  • International regulatory environment
  • Accounting standards
  • New technologies led to "quant" phenomenon
  • Value at Risk models were a pretense of knowledge
  • VaR a Gaussian model so ignored "tail risk"
  • VaR encouraged use of very risky instruments
  • If you don't know what you're doing and play with fire, you will get burnt

International Regulation

Basel III

  • 1973 - Herstatt Bank collapse led to calls for international regulation
  • 1988 - Basel I
  • 2004 - Basel II
  • "Risk-weighting" of assets
  • OECD - Basel accords led to unconventional banking practices designed to skirt regulations
  • Even more complicated version of Basel II
  • Same problems apply
  • Forcing consolidation of medium-sized banks
  • Those banks then become large banks...
  • Bank of England (Andy Haldane) - regulatory discretion is necessary

Housing Policy

Rating Agencies

The FSB

The 2008 Crisis

The Response (Int'l)

  • Legacy of Jim Crow had led to discrimination in housing lending
  • Community Reinvestment Act of 1977
  • Banks encouraged to lend to minority communities
  • Meanwhile, Fannie and Freddie drive banks out of "prime market"
  • Banks developed products to make "subprime" lending profitable

Precipitants

  • International super-super regulator
  • Coordinates international regulatory cooperation
  • Two degrees removed from accountability
  • Is driving harmonization of regulation
  • Rohac/Sinclair - result could be next crisis will be deeper and wider
  • In US, regulators demanded CDOs have risk ratings set by one of three agencies
  • Banks employed the agencies, not the purchasers of CDOs
  • Systemic overrating of CDOs
  • Buyers routinely failed in due diligence (others didn't)

Stress Tests

  • Basel III
  • Financial Stability Board
  • International regulatory cooperation
  • Stress Tests
  • The Eurocrisis
  • Government Housing Policy
  • Zoning
  • Rating Agencies
  • SEC Actions

Causes?

  • Preconditions
  • Precipitants
  • Triggers

Misconceptions

The Response

How should we regulate the system?

SEC Regulations

  • Stress Tests are being used all over the world
  • Iceland 2008 - passed
  • Ireland 2010 - passed
  • Cyprus 2013 - passed
  • December 2014 - UK banks pass...
  • Problem: lower risk-weighted asset scores do not mean lower risk
  • Problem: single, weak scenario
  • Kevin Dowd

Zoning

  • Sarbanes-Oxley (box checking)
  • Financial disclosures meaningless
  • With Eliot Spitzer, destroyed investment research model
  • Banks started trading their own capital instead of clients'
  • So encourage higher leveraging
  • Randal O'Toole: American Nightmare
  • States with strict urban planning controls suffered worse in housing crisis
  • California - prices doubled then collapsed
  • Georgia - Prices up 25%, no decline
  • Zoning creates artificial scarcity, constraining supply

The Eurocrisis

  • Not the place to go into detail
  • Important to note that banks purchased huge amounts of sovereign debt after 2008 using Basel II guidelines
  • Sovereign debt proved to be very risky
  • Banks passed stress tests

Fannie and Freddie

The SubPrime Bubble

  • January 2006 - "eye-popping 43% of first-time home buyers purchased their homes with no-money-down loans" (Nat Assn Realtors)
  • Bellwether Index of construction, mortgage and investment firms shows bubble popped about then
  • White House - "soft landing" Ha!

A Liberal Response?

  • Purpose is to expand mortgage market by securitizing morgtages
  • "Government-sponsored"
  • Had line of credit but never used
  • Underwrote half of all mortgage market
  • $15 billion losses by July 2008
  • Congress passed act to create FHFA and bail FF out in July 2008
  • Bailout total up to $360 billion

Triggers

Lehman Bros

  • Reduce perverse incentives
  • "Skin in the game" (prudential, not mandated)
  • Competition - more banks
  • Abolish deposit insurance
  • Government out of housing policy
  • "Bundesbank" monetary policy
  • Repeal death taxes
  • The subprime bubble
  • Bear Stearns
  • Fannie & Freddie
  • Lehman Brothers
  • AIG
  • Competitor of Bear Stearns
  • Posted big losses July 2008
  • Share price cratered
  • In September, filed for bankruptcy
  • Expected bailout so did not plan for bankruptcy risk
  • No bailout - why?
  • Fed felt this was a solvency issue not a liquidity issue as with BS
  • But...

Common Features of Financial Crises

Bear Stearns

  • BS actually increased its exposure in 2006-7
  • Leverage ration went from 5:1 to 36:1 after the bubble had already burst
  • Two subprime funds lost all value July 2007
  • March 2008 - Fed Bailout (Cox: "lack of confidence")
  • Volcker: Fed actions "extend to the very edge of its lawful and implied powers"

AIG

Dowd and Hutchinson 2010

From 1720 to 2008

  • Rampant speculation*
  • Government involvement
  • Monetary policy
  • Bad regulation
  • Financial innovation
  • Major insurance firm
  • London office had diversified (Man Utd)
  • $58 billion "AAA" subprime assets
  • Credit rating downgraded
  • Losses magnified by mark-to-market
  • Liquidity crisis
  • Sept 2008 Fed bailout of $85bn with stock as collateral

Note: speculation not a bad thing

Too Big to Fail?

Regulating the Financial System

Iain Murray

July 2015

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