Presentation is loading. Please wait.

Presentation is loading. Please wait.

We have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. …Planet Finance was beginning.

Similar presentations


Presentation on theme: "We have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. …Planet Finance was beginning."— Presentation transcript:

1

2 We have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. …Planet Finance was beginning to dwarf Planet Earth. …The total annual issuance of mortgage-backed securities, including fancy new “collateralized debt obligations” (C.D.O.’s), rose to more than $1 trillion. The volume of “derivatives”—contracts such as options and swaps—grew even faster, so that by the end of 2006 their notional value was just over $400 trillion. … Then, beginning in the summer of 2007, Planet Finance began to self-destruct in what the International Monetary Fund soon acknowledged to be “the largest financial shock since the Great Depression.” ---Niall Ferguson, “Wall Street Lays Another Egg,” Vanity Fair, December 2008.

3

4 We have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. …Planet Finance was beginning to dwarf Planet Earth. …The total annual issuance of mortgage-backed securities, including fancy new “collateralized debt obligations” (C.D.O.’s), rose to more than $1 trillion. The volume of “derivatives”—contracts such as options and swaps—grew even faster, so that by the end of 2006 their notional value was just over $400 trillion. … Then, beginning in the summer of 2007, Planet Finance began to self-destruct in what the International Monetary Fund soon acknowledged to be “the largest financial shock since the Great Depression.” ---Niall Ferguson, “Wall Street Lays Another Egg,” Vanity Fair, December 2008.

5

6 We have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. …Planet Finance was beginning to dwarf Planet Earth. …The total annual issuance of mortgage-backed securities, including fancy new “collateralized debt obligations” (C.D.O.’s), rose to more than $1 trillion. The volume of “derivatives”—contracts such as options and swaps—grew even faster, so that by the end of 2006 their notional value was just over $400 trillion. … Then, beginning in the summer of 2007, Planet Finance began to self-destruct in what the International Monetary Fund soon acknowledged to be “the largest financial shock since the Great Depression.” ---Niall Ferguson, “Wall Street Lays Another Egg,” Vanity Fair, December 2008.

7

8 Beyond Fear and Greed: The Moral Roots of Financial Crises by Daniel Friedman Professor of Economics UCSC Faculty Research Lecture February 1, 2010 Thanks to: Ralph Abraham and Luba Petersen

9 Tonight we’ll take a 1-hour tour of Planet Finance. We’ll meet many bizarre creatures living in tangled webs. It is complicated at first …

10 …but things will get simpler as we dig deeper. To keep the tour on schedule, I’ll defer most questions until the end. I’m happy to revisit anything in more detail after we reach our destination.

11 The Crust… For most of the 20 th century, financing a home was simple. $ $ $

12 Early in 21 st Century, CDOs and other derivatives began to thrive $ $ $ C.D.O.

13

14

15 $ $ $

16

17

18

19 Crisis on Planet Finance

20

21

22

23 Crisis Response

24 Mantle A volcano eruption is sudden manifestation of deep slow underlying forces or trends. The big three…

25 1. Globalization of Financial Markets

26

27 2. Financial Engineering Heat Equation: Black-Scholes Equation:

28 JDs and MBAs listened to Quants when they felt like it.

29 3. Keynes-Minsky-Kindleberger Financial markets tend to cycle irregularly Phase 0: Normalcy. Consensus beliefs, prudent behavior. Phase 1: An unusual opportunity arises – 1720 London: SSC to purchase national debt – 1980 Japan: new manufacturing system – 1998 Silicon Valley: e-commerce – 2004 US: Securitized mortgage assets go global Divergent beliefs regarding its value

30 KMK Phase 2: Euphoria The early optimists rack up impressive profits. – Trend followers pile in – help drive up prices further – Greed grows Peer pressure on prudent investors – Sir Isaac Newton; Charles Prince – Keynes’ higher levels. Financial innovations help to accommodate – subprime mortgages, CDOs, CDSs, … Asset price inflates, as does leverage and exposure to risk

31 KMK Phase 3: Revulsion Eventually the supply of dazzled investors (and financial innovation) runs dry. – 1/90 in Japan, 2/00 in Silicon Valley, 6/07 in US home sales Then asset prices pause. – The most leveraged investors have to sell Asset prices and perceived quality fall. – “financial distress” – Borrowers default, and lenders suffer losses – Fear prevails; pessimists regain their voice – Contagion: even fundamentally sound investments take a hit – Can have a soft or hard landing Crash phase usually moves faster than the bubble phase

32 KMK Phase 4: Recovery Lower asset prices eventually attract bargain hunters – Asset prices begin to stabilize – “Stimulus” and bailouts of key participants can reduce contagion – Bankruptcies re-allocate resources: transfers from the overoptimistic to the prudent. Consensus beliefs gradually return – Immunization against future bubbles may last a generation or more.

33 Simulation

34 Down to the Core The basic function of finance is to provide for the future by an exchange of promises. Providing for the future usually requires widespread cooperation, e.g., – planting crops in the spring – building irrigation systems or city walls in ancient Mesopotamia – building high-speed rail link to LA – launching a Digital Arts/New Media major.. Cooperation is sustained by promises of a fair share, e.g., – if you help plant and cultivate, then you get a share of harvest – If you contribute to building rail link, then you get a return

35 Traditional Finance: Eranos In Athens 2500 years ago, say that you want to ship 100 amphorae of olive oil to Alexandria and bring back a boatload of wheat  the opportunity. Eranos loan: You call on your friends and relatives to help buy the oil and shipping: – you promise to return their money when you are paid – 0% interest but you will return the favor. Your promise is backed by – your personal code of honor, plus – moral sanctions of your social network.

36 Limits to Eranos Vulnerable to (and can help cause) discord in the personal network. Draws only on your own personal network. – Only a few dozen individuals. – Huge gains from broadening and diversifying the lenders and borrowers. Urban societies have always also had less personal lending. – see Morals and Markets Ch 7 on: – moneylenders, daneizein, medieval Florence’s banking networks, etc.

37 Financial Markets Briefly appeared in Roman republic, launched again in Amsterdam 400 years ago.

38 Financial markets Briefly appeared in Roman republic, launched again in Amsterdam 400 years ago. What are they? – Where promises are bought and sold, by strangers. – Promises must be depersonalized and standardized. – Eg., mortgages, stocks, bonds, derivatives are all standardized promises to make specified payments. Why have they come to dominate finance? – Last major alternative---state capitalism---collapsed 20 years ago. – Something lost in depersonalization, but much is gained in tradability.

39 Financial Market Magic, I Markets scale up beautifully. – Draw on resources of all participants Not just dozens as in eranos, – or hundreds as in Florence banking network, – But rather thousands, eventually millions and billions of individuals. Can routinely raise vast sums of money for good-looking projects, – Chunnel, or DANM building, or a new software company.

40 Financial Market Magic, II Asset price can reflect any piece of information held by any participant (EMH) – Thus greedy investors can deliver results similar to mind-reading angels. E.g., Netflix raised about $100M in 2 weeks when it went public in 2002, financed expansion etc. – Greedy investors steered resources towards Netflix and away from Blockbuster. They aggregate information. – Draw on diverse minds (Hayek)

41 Financial Market Risks, I Financial markets fail unless they have adequate moral infrastructure – To channel greed and fear productively. Participants must compete to find value, not to fleece or steal from other participants. Financial markets require eternal vigilance against expropriation and fraud. – Main reason for failure in ancient Rome, in 1990s Russia, in Zimbabwe, etc. Hence the need for regulators and guarantors.

42 Financial Market Risks, II Regulators’ and Guarantors’ safety nets can encourage riskier behavior – Clever entrepreneurs offer one way bets: heads I win, tails the taxpayers lose. – Called “moral hazard.” KMK instability – Regulators become less vigilant after decades of stability. – The more confident are investors, the stronger the push towards the risky edge. – Can get positive feedback bubbles and crashes, where info fails to aggregate properly.

43 Highlights of the Tour Crust: – 7 ring circus spins toxic assets – Homebuyers, lenders, brokers, investment bankers, raters, regulators, investors Mantle: – Globalization – Innovation (derivative securities) – KMK ratchet Core: – Promises of cooperation, market for promises – Market usually harnesses greed and fear

44 Lessons for Not a sudden outbreak of greed and fear—they are never in short supply. Rather: Decades of good performance lulled investors and regulators into overconfidence – awareness of inherent market instability faded Globalization and innovation overstretched the markets’ moral sinews. – Responsibility (for liar loans, CDSs, etc) unclear for raters, regulators, dealers, brokers, originators,... – Top managers and shareholders didn’t really understand the innovations. E.g., that CDO-sq distill systemic risk, not accounted for in Moody’s AAA.

45 Finance in the 21 st Century More personalized finance? Roscas and microfinance grow rapidly in emerging countries, now over 150 million borrowers

46 Web-enabled microlending also is growing in developed countries: Kiva, MicroPlace, Prosper, DonorsChoose Tradeoff remains between direct personal connections and scalability (or efficiency). Available data confirms that success is modest. I expect growth to continue, especially in charitable giving, but that financial markets will continue to dominate.

47 Reforming Financial Markets After the meltdown, our natural moral instinct is to: – find the bad guys, punish them severely, and – clamp down so it can’t happen again. Natural, but perhaps misguided. – Should prosecute the lawbreakers (Madoff, …), but witch hunts are counterproductive – We risk losing huge advantages of financial markets if we try to return to the 1950s. – Need smarter reforms.

48 Rebuilding the Moral Infrastructure 2. Increase transparency. – Investors and rivals should see aggregate positions and prices. – Should encourage competition and info aggregation but discourage rent-seeking. 1. Restore clear lines of responsibility among participants and regulators – Cheaters must not prosper (e.g. Madoff) – Legal one-way bets must be spotted quickly and the profits drained (e.g. AIG’s CDS traders)

49 More Steps 3. Encourage true innovation, discourage evasive innovation – E.g., weather derivatives are good – SIVs for evading capital requirements, or – Avoiding a CDS exchange are bad 4. Measure systemic risk, and tax it – A Pigouvian tax, as for alcohol. – Hire “rocket scientists” with a conscience to help measure and monitor impact of new innovation. – Laboratory test beds and behavioral finance can help.

50 The Next Year is Critical 1930s legislation shaped financial markets until recently. – as 100 year floods shape rivers, the major crises shape financial markets. Here at UCSC we will do our part – SCIIE – Sury Initiative – Bruce Initiative

51 To Learn More Morals and Markets, – Preface and Ch 7 cover previous bubbles and crashes, Ponzi schemes, origins of banking and financial markets, information aggregation, lab experiments, etc. Other sources – The Big Short, Michael Lewis, Mar 2010 – Malmendier, JEL Dec 2009 Friedman & Abraham, J Econ Dynamics and Control. April markets/ markets Bureau of Economic Analysis (Flow of Funds data)

52 Supplementary material

53 Comments Basically KMK describe a learning process – following novelty – distorted by financial market imperfections. Bubbles and crashes are spectacular but not necessarily disastrous. – They quickly channel vast resources to the novel opportunity. – Recovery from the crash can be fairly rapid But when bankruptcy laws are weak or abrogated – The political process determines who gets stuck with the losses. – This can be very slow, delaying recovery for many years, as in Japan , and previously in Latin America.

54 Collateralized Debt Obligation (CDO) A security that is backed by a pool of assets (bonds, loans, mortgage-backed securities, etc.) Cash flows from the pool are divided into “tranches” that differ by seniority and promised rate of return. – The least risky (“senior”) tranches are paid first; the most risky (“junior”) are paid last. – The promised returns increase with risk. Total volume of CDOs outstanding from U.S.-based issuers was approximately $900 billion in Other asset backed securities include asset backed securities, mortgage backed securities, credit derivatives and collateralized fund obligations.

55 Fannie, Freddy and Ginny The Federal National Mortgage Association (FNMA) is commonly known as Fannie Mae. – Founded in 1938 as a federal agency, its mission was to widen home ownership by guaranteeing conventional mortgages. – Congress spun it off in 1968 as a shareholder owned government- sponsored enterprise (GSE). – Implicit federal backing gave it a competitive advantage that allowed rapid growth until recently. – Assets, mainly conforming loans, reached $882.5 billion by – Rocked by scandal in 2004, it became insolvent when the housing bubble collapsed and was put into conservatorship (temporary renationalization) by the US Treasury Dept in Sept Freddy Mac (FHLMC, the Federal Home Loan Mortgage Corporation) has a similar history. Fannie Mae and Freddie Mac owned or guaranteed about half of the U.S.’s $12 trillion mortgage market as of Ginny Mae (GNMA) is still operating as a GSE.

56 Credit Default Swap (CDS) A contingent contract. The buyer makes a series of payments to the seller. The seller promises a large payment to the buyer if some specified bond or loan goes into default. A form of default insurance, but… Buyer does not need to own the bond or loan, and can sell the CDS to a third party. No clearinghouse for secondary market – Hence Lehman, AIG distress led to unprecedented counterparty risk – Like HIV danger; paralyzed financial markets. Volume of CDS outstanding in 2008 was $47 trillion

57 American Insurance Group (AIG) Until 2008, the largest underwriter of commercial and industrial insurance in the U.S. Most profitable product from mid 00s was CDSs on AAA securities, especially those constructed from subprime loans. AIG’s stock price plummeted over 95% in 2008 when those securities became toxic. Crisis precipitated when Moody’s and S&P downgraded AIG’s own credit rating, requiring AIG to post additional $10B collateral with counterparties. – Got $85 bil bailout, the largest ever. – Full repayment is doubtful.

58 Moody’s Provides credit ratings, research and risk analysis. Along with S&P (and Fitch). Since 2000, a public corporation, most of whose revenues come from the companies it rates! Earned consulting income by advising CDO issuers how they could structure things to get AAA rating as cheaply as possible.

59 Lehman Brothers Global financial services and investment firm Until 2008, issued and held large positions in subprime and other risky mortgage-backed assets. Suffered massive losses during the subprime mortgage crisis. In the first half of 2008, Lehman Brothers lost 73% of its value. Credit ratings fell. Largest bankruptcy in U.S. history on September 15, 2008.

60 Systemic Risk Risk arising from events affecting the financial system as a whole, – as opposed to idiosyncratic risk arising from events affecting only the issuer of the security. – Systemic risk does not disappear with diversification. – Due to the interlinkages and interdependencies in a system, failure in one market spills over into other markets. AAA ratings don’t separate systemic risk from idiosyncratic risk. – Senior CDOs (and CDO-sq’s) distill systematic risk, a fact understood by some Quants but few top managers or regulators.

61 Roscas Rotating Savings and Credit Associations a group of individuals who agree to meet for a defined period of time in order to save and borrow together. "ROSCAs are the poor man's bank, where money is not idle for long but changes hands rapidly, satisfying both consumption and production needs.“--F.J.A. Bouman, 1983 Rosca participation ranges from 50-95% in many rural areas in Libiya, Ivory Coast, Togo, and Nigeria (Bouman, 1995), 45-50% in Kenya (Kimuyu, 1999), and as many as 80% in Taiwan (Levenson and Besley, 1996).


Download ppt "We have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. …Planet Finance was beginning."

Similar presentations


Ads by Google