THE FINANCIAL CRISIS

$$$$ went so wrong what the

When you start thinking that you can create something out of nothing, it is very hard to resist.
Lee Hsien Loong Prime Minister, Singapore

HISTORICAL CONTEXT
1930s: Great Depression

Thursday, October 24, 1929

HISTORICAL CONTEXT
1930s: Great Depression 23% Crash in Dow Jones in 2 days in October 1929

46%

Decline in USs industrial production (1929-32)

>54%

Foreign trade decline - US, UK, Fra, Ger (1929-32)

607%

Increase in US unemployment (1929-32)

HISTORICAL CONTEXT
1932-33 a) b) c) d) Banking Act & Glass-Steagall Act passed

1930s: Great Depression led to strict financial regulation

Commercial & Investment banks separated (eg JPMorgan) Fed empowered to regulate savings account interest rates Federal Deposit Insurance Corporation (FDIC) established Expanded range of assets rediscounted by the Fed

CAUSES OF THE CRISIS

Deregulation: ended largely crisis-free period
1982

Reagan signed into Act providing for adjustable-rate mortgage loans, marking onset of financial deregulation
Glass Steagall repeal sought by bankers culminated in Gramm-Bliley Act repealing separation of ownership Legislation passed to thwart regulation of derivatives backed by key Government officials SEC relaxed net capital rule, effectively allowing overleveraging

1990s

2000

2004

HISTORICAL CAUSES
Deregulation: laying the foundations of the crisis
1980s onwards End-1980s1990s 1990s 2001 1996-2006 Expanded credit availability created unstable bubbles in several markets in the US economy

Savings & loan crisis cost taxpayers c.$124bn

Financial sector consolidated into a handful of XL (a.k.a. too big to fail) firms Dot-com bubble burst, leading to $5tn investor losses (nearly 3x Indias current GDP) Housing prices increased c.194%

THE FINANCIAL BUBBLE

Deregulation & technology led to growth of derivatives
Late 1990s Unregulated derivatives market already worth $50tn

2000

Commodity Futures Modernisation Act banned regulation of derivatives Under Bush administration, large FIs created a securitisation food-chain

2001

THE FINANCIAL BUBBLE

Derivatives utilised to engender a financial bubble
Securitisation Change in risk profile Predatory lending Loans combined with other loans into Collateralised Debt Obligations Since risk of default no longer with lender, loans got riskier, and hence more profitable Big banks now mandated mortgage brokers to sell primarily sub-prime loans to get higher interest rates

Overleveraging

Banks borrowed to purchase risky & profitable loans, leading to leverage ratios up to 33:1

OVER-LEVERAGING
All major investment banks severely over-leveraged 35x 30x 25x 20x
LB BS ML GS MS

15x
10x

2003

2004

2005

2006

2007

Source: Company Annual Reports (SEC Form 10K)

THE HOUSING BUBBLE

Large increase in sub-prime lending led to housing bubble
Ability to package risky loans into CDOs led to predatory lending Credit rating of AAA (as safe as US Government bonds) generated sufficient demand for these CDOs

AAA rating maintained despite most sub-prime lending being equivalent to 99.3% of house price on average
As a result, sub-prime lending as a % of total mortgage lending skyrocketed between 2004-06 In absolute value, sub-prime lending increased from c.$30bn p.s. to more than $600bn p.a. in 10 years

THE HOUSING BUBBLE

Wall Street excesses rewarded short-term profits
Conflicts of interest existed as most Fed regulators were drawn from the largest financial institutions Countrywide made $11bn profits by lending $97bn worth of subprime mortgages Wall Street bonuses grew 3x between 2002-06

Lehman (biggest underwriter) CEO took home $485m

All along, the Fed under Greenspan avoided intervening even though existing regulation allowed it to

THE HOUSING BUBBLE

Increased subprime lending made mortgages riskier 25% 20% 15% 10% 5% 0%
Subprime % of mortgage origination Home ownership rates

70% 69%

68%
67% 66%

65%
64%
Source: US Census Bureau, Harvard State of the Nations Housing Report 2008

INSURING THE BUBBLE

Insurance of derivatives spread risk even further
Credit Default Swaps
Speculation

AIG began issuing CDSs to insure against CDOs

Speculators allowed to purchase CDSs led to big banks betting against their own CDOs in downturn

Unregulated
Lop-sided incentives Amount

CDS market unregulated so no cover maintained for potential losses

Contract signing led to bonuses, but no penalty imposed if CDO were defaulted on

AIGs London division issued $500bn worth of CDSs, many for CDOs backed by sub-prime mortgages

THE BUBBLE BURST

Collapse of the housing market led to financial epidemic
Defaults
Conflicts of interest

1/3 of all mortgages defaulted by 2007, most others headed down the same route
Leading to several big banks betting against their own CDOs, worsening the situation

Foreclosures
Meltdown Meltdown

Increased from c.300k in 1Q07 to c.900k by 3Q09

Lenders couldnt sell their sub-prime loans anymore, hence they failed

Investment banks were also left with CDOs, real estate that they couldnt finance or sell

ONSET OF THE CRISIS

Collapse of housing market sparked financial collapse
Bear Sterns declares bankruptcy; acquired by JPMorgan Fed Governor Mishkin retires leaving 3 (of 7) seats vacant Federal takeover of Freddie Mac & Fannie May Lehman Brothers reported record $3.2bn losses Lehman Brothers ran out of cash Fed officers met top bankers to consider Lehman bailout Mar08 Aug08 7 Sep08 9 Sep08 12 Sep08 13 Sep08

15 Sep08

Lehman Brothers filed for Chapter 11 bankruptcy in US

ONSET OF THE CRISIS

Crisis spreads like wild fire in globalised world
16 Sep08 AIG too didnt have money to pay CDS holders

17 Sep08
18 Sep08

AIG taken over by the Federal Government Paulson & Bernanke ask Congress for $700bn bailout to prevent catastrophic collapse of the system

End-Sep08 Dow crashed 777 points among largest single drops ever 4 Oct08 After After After Bush signs bailout bill, but stock markets continue to fall Raise US & EU unemployment to 10% Recession soon spread to globalised developing nations And the rest, as they say, is history

The crisis was not a natural disaster, but the result of high-risk, complex financial products, undisclosed conflicts of interest, and the failure of regulators, credit rating agencies and the market itself to rein in the excesses of Wall Street.
United States Senates Levin-Coburn Report

The crisis was avoidable and caused by widespread failures in financial regulation, including the Feds failure to stem the tide of toxic mortgages and systemic breaches in accountability and ethics at all levels
US Financial Crisis Inquiry Commission January 2011 Report