On the causes of the financial crisisMichael Brandl, PhD Distinguished Visiting Professor LectureThe University of Texas at Austin Johnson & Wales University Xavier Auditorium McCombs School of Business Providence, RI

April 22, 2010

Overview The causes of the crisis – not merely

the symptoms. Understanding how we got here. Understanding this isn’t a “recent” problem”

What we can learn from the crisis What economists should do

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The Popular Press 7 seconds view The Federal Reserve lowered interest rates

too low in 2003 and kept them too low through 2004.

Homebuyers were

duped by mortgage

lenders.

Unregulated financial markets lent money too freely.

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Post War Era Pent up demand from war years

Full employment, but nothing to buy.

Homeownership: The American Dream Post War Baby Boom 30 yr fixed rate

Mortgages with 20%

down. Federal income tax

deduction for interest Savings & Loans Interstate highways

Result: Post War economic boom! But…it’s not 1947 anymore…

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The importance of “banks” In the post war era it was believed:

Bank were “special” Subject to bank runs Needed to keep interest rates low Needed to help fund government

spending (infrastructure, war debt, etc)

Banks should not compete with each other. Regulation Q: interest rate ceiling from 1930s Bank chartering

Commercial banks were boring. Investment banks where “white shoe”

firms – conservative, reserved, steady.

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Problems develop… 1970s: stagflation

Disintermediation – deposits leave depository institutions. Savings & Loan is big trouble. Bad idea 1: DIDMCA 1980– loosen Reg Q Bad idea 2: G-St.G 1982 – let S&Ls lend more Bad idea 3: Capital forbearance – look the other way.

1980s: bank failures Banks face competition from non-bank banks.

Bad idea 4: Allow easier regulation on lending Result: “Third World Debt Crisis” Bad idea 5: Establishing Too Big To Fail… Result: Heads I win, tails the government looses. Bad idea 6: Banks focus on “fee income” Result: originate to hold to originate to securitize

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Banks caused problems before US banks have continuously “mispriced

risk” and had the US taxpayer bail them out. “Third World” Debt Crisis in 1980s. Peso Crisis in 1995. Asian Financial Crisis 1997-99. Russian Ruble Crisis 1999-2000. Telecom asset bubble 2000-01. Argentine Financial Crisis 2001-03. Next…

Each time: systemic risk!!! But…what about moral hazard of these bailouts?

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The push for mortgages After dot.com bust Fed pushes interest rates

to new lows. Leads to a search

for returns: mortgages

Banks collateralize or

package mortgages into

bundles. Fee income

is key.

As demand for mortgage backed assets increases, banks

and other lenders weaken underwriting standards. Adjustable rate mortgages, zero down mortgages, zero

documentation mortgages, etc. “subprime” market expands…

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Our current little mess…2000

2007

Timeline of the Crisis I June 7, 2007: Bear Stearns announces two of its hedge

funds are suspending redemptions July 19, 2007: Bear Stearns liquidates hedge funds Dec 12, 2007: Fed announces creation of TAF December 2007: recession begins according to the NBER Feb. 17, 2008: Northern Rock taken over by UK Treasury. March 11, 2008: Fed announces creation of Term Securities

Lending Facility March 17, 2008: Bear Stearns bought by JP Morgan Chase. Sept. 7, 2008: Fannie Mae & Freddie Mac taken over by the

US Treasury Sept. 14, 2008: Merrill Lynch purchased by BA. Sept. 15, 2008: Lehman Bros files bankruptcy. Sept. 16, 2008: AIG gets $85b loan from Treasury & Federal

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Timeline of the Crisis II Sept. 21. 2008: Goldman Sachs & Morgan Stanley

become commercial banks. Sept. 25, 2008: Washington Mutual fails Oct. 3, 2008: Wachovia bought by Wells Fargo Oct. 3, 2008: Congress passes and President Bush signs

the $700bn TARP. Nov. 12, 2008: Paulson announces TARP will not buy assets. Jan 9, 2009: The Congressional Oversight Panel blasts

TARP Jan 16, 2009: Fed, Treasury & FDIC announce rescue plan

for Bank of America Feb 6, 2009: Fed announces TALF will be extended to include

auto loans, credit card loans, student loans & SBA loans Feb 10, 2009: Geithner announces public-private plan to buy

bank toxic assets

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Timeline of the Crisis III Feb 25, 2009: Government announces stress test plan April 1, 2009: Fed and Treasury fail to answer questions

posed by Congressional Oversight Panel Aug 28, 2009: Fed announces reduction in auction of TAF Nov. 9, 2009: Fed announces 9 of 10 bank holding

companies required to raise capital have – GMAC not. Dec. 11, 2009: House creates Fin Stability Council Dec. 14, 2009: Citigroup & Wells Fargo repay TARP Feb. 1, 2010: Four quantitative easing facilities expire Feb. 18, 2010: Fed raises discount rate from ½% to ¾% March 11, 2010: Court appointed examiner report on Lehman

Bros failure is released…accounting fraud? March 15, 2010: Sen. Dodd releases his bank reform bill April 16, 2010: SEC sues Goldman Sachs for fraud

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What we can learn from the crisis

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1) History matters We need to understand where we have been

to understand where we are. The danger of reliving mistakes of the past. Q: Is this crisis really a surprise?

Of course, there can be different interpretations of the past. Danger of Whig History.

Understanding history helps to separate symptoms from causes

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2) The long run matters… Be careful of only worrying about the current

problem. For every action there are many reactions.

Sometimes the cure can be worse than the disease.

If you don’t address the cause of the problem, the problem will arise again and again… Problems of the early 1980s… Continually bailing out banks…

The markets do punish short term thinking. The constant concern for only short term profits, led to

long term disasters. What may be beneficial in the short run, may kill you in the

long run.16

3) Finance is not just numbers Markets and societies change over time.

As they change financial markets change. This change may not show up in Excel spreadsheets. Example: the assumption that 2% of mortgages fail.

Rules and regulations overseeing the markets need to change. But often they don’t… Misalignment of incentives can develop.

Financial markets are based on trust. Contracts are used when markets fail. Ethical behavior – often determined by institutions – is key

to financial market success.

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4) The regulators can’t save us… Financial markets were not unregulated.

FDIC deposit insurance, Federal Reserve, insurance market regulation, etc.

Should this be streamlined? Maybe/maybe not.

Regulators can not mandate ethical behavior. It’s up to the financial market participants to do that. And…customers need to punish the unethical.

Customers need to demand better run financial institutions. A better educated public would help. Business leaders need to take the lead…

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What economists should do July 18, 2009 edition

of The Economist Macroeconomics often

ignores the importance of finance & financial markets.

Finance often argues markets will regulate themselves & financial innovation is always beneficial.

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The Economist July 18, 2009“Economists need to reach out from their

specialized silos: macroeconomists must understand finance, and finance professors need to think harder about the context within which markets work.

And everybody needs to work harder on understanding asset bubbles and what happens when they burst. For in the end economists are social scientists, trying to understand the real world. And the financial crisis has changed that world.”

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Q & A

ask about anything…

Michael.brandl@mccombs.utexas.edu

http://blogs.mccombs.utexas.edu/brandl

Twitter: MichaelBrandlFacebook: Michael.Brandl

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