Brewing Up a Crash Financial crashes are like airline crashes Some happen because of a single cause Example: birds sucked into engine Example: the Twin Towers attacks Most happen because multiple systems fail Example: “fly by wire” backups fail Example: the crash we just saw

Preconditions for the Crash Many things went wrong at once There were warning signs They were ignored by most investors The crash was caused by multiple failures among multiple systems Can the G-20 fix things? Will limiting bonuses make any difference?

Fancy New Products “Mortgage backed securities” Mortgages are pooled, sold like bonds First done by FNMA, FreddieMac Both created by U.S. government Banks and other companies got into act Pools expanded to include credit-card receivables, college loans, car loans, etc. See site for the many forms of this stuff: CLOs, CDOs, ARSs—on and on

Easy Money U.S. Fed, other central banks kept interest rates low after 9/11 Easy to get a loan, easy to buy a house Real estate, other assets rocketed up Foreign economies began to get into act U.K. in particular followed the pattern

High Leverage Banks, institutions, individuals borrowed lots of money to reinvest—leverage Lehman invested more than $30 in borrowed money for every $1 it had Leverage magnifies losses as well as profits Only works if prices go up forever

Lack of Regulation In U.S., two laws made all this stuff unregulated Repeal of Glass-Steagall, 1999 Commodities Futures Modernization Act, 2000 Assumption was that “hand of God” made markets self-regulating Lessons of Great Depression forgotten

No Actual Market Sales of this stuff were peer-to-peer No exchange as in stock market Difficult to get bid/ask prices No sense of how values change day to day Makes it easy for fear to stop sales “I’m not buying any of this stuff!” Markets vulnerable to catastrophic seizure

Fake Insurance Credit-default swaps If CLOs, MBSs failed, the swaps would cover the losses Sellers of swaps couldn’t pay up when the instruments seized up AIG, Lehman among biggest issuers of CDSs Gave everyone false sense of security

Inept Evaluation Credit-rating agencies gave a lot of this stuff triple-A ratings Moody’s, Standard & Poors, Fitch were main culprits Ratings meant not likely to fail False sense of confidence Issuers pay the agencies—conflict? Yes! Outright fraud a possibility.

Mark to Model With no exchange, buyers and sellers used computer models to value stuff Models put together by Nobel prize winners, other geniuses Ended up being completely wrong New law required “mark to market” It has been suspended in U.S.! Lets banks, others inflate value of junk they still hold

Poltical Pressures In U.S., Democrats pressured FNMA, FreddieMac to lower lending standards Republicans pressured regulators to keep hands off private financial sector Loans became shakier and shakier More “subprime” loans than ever

Crooked Salespeople Mortgage brokers didn’t ensure that people could afford what they bought Ratings agencies relied on mortgage brokers for information Brokers sold the mortgages to banks, others who made them into bonds Huge commissions for brokers No lasting liabilities for brokers

Terminal Hubris Pervasive sense that things had changed No more crashes ever Market takes care of itself Suddenly, no more buyers Prices rose as far as they could Things began to fall apart Market began to seize up Even short-term loans impossible to get

Government Steps In With market frozen, central banks began covering losses, pumping in money Now they’re buying their own bonds! That’s printing money Many reforms being proposed Issues eclipsed by health care, climate Commercial loans still out there—same problem if they go bad?