Y376 International Political Economy March 10, 2011

Global Financial Crisis Global Financial Crisis  Led by bursting of the housing bubble in the US in 2007 housing bubblehousing bubble  Made worse by near collapse of US financial markets connected with mortgage-backed securities, synthetic collateralized debt obligations (CDOs), and credit default swaps mortgage-backed securitiescredit default swapsmortgage-backed securitiescredit default swaps  Response to the crisis revived the debate over regulation of financial markets and Keynesian approaches to preventing deep recessions

Bursting of the Housing Price Bubble The Bubble Bursts

Contributing Factors  Subprime mortgages  Unethical mortgage brokers  Low interest rates set by the Federal Reserve  Credit Rating Agencies (conflicts of interest)  Insufficient regulation of financial markets  Mortgages and related markets  Derivatives, including credit default swaps

Subprime Mortgages  Definition: a type of mortgage granted to individuals with low credit ratings (FICO less than 600)  Subprime mortgages feature higher interest rates than conventional mortgages because of the higher risk of default  Subprime borrowers were offered adjustable rate mortgages (ARMs)  US policy from the 1990s on was to encourage the growth of this market to make home ownership available to a wider spectrum of the population

Expansion of Subprime Market

Unethical Mortgage Brokers  Exaggerated expected earnings of borrowers  Sold more expensive loans when less expensive loans were available  Conspired with real estate brokers to raise the sale price of properties above market value  As a result, subprime delinquency rates began to increase rapidly after 2007

The Role of Low Interest Rates  Investors were looking for ways to obtain higher rates of return for low-risk investments  Treasury Bonds became less attractive for this purpose  Mortgage Backed Securities (MBSs) and Collaterized Debt Obligations (CDOs) expanded rapidly to fill the void

Credit Rating Agencies  These firms (e.g. Fitch Group, Moody’s, Standard and Poor’s) establish credit ratings for issuers of certain types of debt obligations.  The highest rating is AAA which denotes low risk and high liquidity.  They sometimes compete for business by offering better ratings (a clear conflict of interest).

Fun with Credit Rating Agencies

Insufficient Regulation  Securities and Exchange Commission (SEC) was supposed to regulate the mortgage market and apparently failed to do so  The Federal Reserve (especially when headed by Alan Greenspan) chose not to regulate derivatives markets  Government financial regulators relied too much on the private credit rating agencies and business journalist to expose malfeasance and overly risky investments

Short-Term US Government Responses  “Rescue” of Bear Stearns  Decision not to rescue Lehman Brothers  Takeover of Fannie Mae and Freddie Mac  Troubled Asset Relief Program (TARP)  Bailouts of AIG and GM  $245 billion invested in US banks  Obama’s economic stimulus package

Medium and Long-Term Measures  Capital Adequacy Requirements and Deleveraging  Regulation of previously unregulated markets (derivatives, but especially credit default swaps)  Improved protection for consumers  Mortgage renegotiation incentives

Global Responses  Reworking of international capital adequacy requirements (Basel Accords)  Structural adjustment programs for Iceland, Ireland, Greece, Spain, and other countries – often involving austerity measures  Debates in each country about what to do to return the domestic economy to health

A Quick and Dirty Guide to Books on the Crisis  The Financial Crisis Inquiry Report  Andrew Ross Sorkin, Too Big to Fail  Carmen Reinhart and Kenneth Rogoff, This Time is Different  Michael Lewis, The Big Short  William Cohan, House of Cards  Lawrence McDonald & Patrick Robinson, A Colossal Failure of Common Sense