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The Global Financial Crisis V3

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Jay Prakash
Jay Prakash

We are in the midst of a Global Financial meltdown. These slides first presented to 2nd year MBA students at a major University, identifies the root causes of the problem explains why we are where we are today.

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The Global Financial Crisis 3/16/2009 1 Jay Prakash jay@strategicfocus.com 408-568-3993 www.strategicfocus.com
Table of Contents • What is the crisis? • Underpinnings of US Financial Crisis – A history of deregulation • Financial deregulation of S&L’s in the Regan era, 1980’s • Bank deregulation of 1994 • Repeal of the Glass Stegal act in 1999, Clinton era • SEC publishes Regulation ―B‖ in 2004 – Violation of Net Capital Rule – Excessive leverage by Hedge Funds, Private Equity & Mortgage Companies – Credit Default Swaps – Failure to police sub-prime – Packaging & selling of bonds backed by risky sub-prime loans • Global Impact • The changing nature of the Rescue Package – Key Issues that need to be addressed – Initial Package – Current Package 3/16/2009 2
What is the crisis? Foreign Investors US Banks Federal Reserve Consumer Positive Consequences --Cars --Home --College --Entrepreneurs --Small Businesses Negative Consequences Large Money Flow Low Interest Rates Easy Credit Borrowing Borrowing Bank Failure 3/16/2009 3
What is the crisis? Negative Consequences • Over extended borrowers • Home foreclosures • Declining home values; home owners caught in a vicious cycle • Credit crunch for qualified borrowers including businesses • Bank & other financial institutions failure due to non- repayment of loans • Loss of confidence • Declining demand for goods & services in US markets • Global Economies sliding into recession or reduced growth 3/16/2009 4
Underpinnings of the US Financial Crisis History of Deregulation • Financial de-regulation started with S&L’s in the Regan era in 1980’s • Many restrictions on the activities of S&L’s limiting to the home loan market were removed. • The result was an orgy of speculation, profiteering and outright plundering of assets, culminating in collapse. • This resulted in the biggest bailout in US history prior to the current bailout costing the Federal government more than $500 billion • Clearly the lessons from these lax regulations had not been learnt. 3/16/2009 5
Underpinnings of the US Financial Crisis History of Deregulation • Bank deregulation of 1994 • This allowed bank holding companies to operate in more than one state. • The result was a rash of merger & acquisitions of regional banks and an appetite for new markets & new sources of revenues. 3/16/2009 6
Underpinnings of the US Financial Crisis History of Deregulation • Repeal of the Glass Stegal act in 1999. • Under the Glass Stegal act, banks, brokerage and insurance companies were effectively barred from entering each other industries -- investment banking and commercial banking were separated. • Act passed in 1933 in response to: – 5000 bank failures, – loss of $7 bil in depositors money, – 600,000 foreclosures from 1930-1932 --all due to manipulation of the market by giant banking houses. • Single most damaging and most consequential act of the Clinton years. 3/16/2009 7
Underpinnings of the US Financial Crisis History of Deregulation • Repeal of the Glass Stegal act in 1999. • Under the Glass Stegal act, banks, brokerage and insurance companies were effectively barred from entering each other industries -- investment banking and commercial banking were separated. • Act passed in 1933 in response to: – 5000 bank failures, – loss of $7 bil in depositors money, – 600,000 foreclosures from 1930-1932 --all due to manipulation of the market by giant banking houses. • Single most damaging and most consequential act of the Clinton years. 3/16/2009 8
Underpinnings of the US Financial Crisis History of Deregulation • Clinton and the Republicans agreed to the deregulation of the US Financial system in October 1999. • Most sweeping banking deregulation bill in US history • Lifted all restraints on the operation of giant monopolies which dominate the financial system. • No restrictions on the integration of banking, insurance and stock trading imposed by the Glass Steagal act of 1933. • Huge wave of mergers, ex. Citibank buying Travelers Insurance creating one stop shop for Financial Services • Law was passed due to pressure from the banks which sought more profitable outlets for their capital especially in the stock market. • In 1990 JP Morgan was allowed to engage in stock market operations up to 10% of revenues. This was increased to 25% in 1994 and in 1999 it was abolished. 3/16/2009 9
Underpinnings of the US Financial Crisis History of Deregulation • SEC voted in June 2004 to publish Regulation B. • This allows banks to engage in certain Securities activities without first registering as brokers with the SEC. 3/16/2009 10
Underpinnings of the US Financial Crisis Violation of Net Capital Rule • SEC allows certain broker-dealer firms to legally violate existing net capital rules that limits debt-to-net capital ratio to 12 to 1 by providing them with exemptions. • In 2004 the SEC granted an exemption to five firms—Goldman, Merrill, Lehman, Bear Stearns, and Morgan Stanley.—which allowed them to leverage up to 40 to1. • Three of these firms have blown up. This reckless leverage has led to the current crisis. • The so called Net Capital Rule was created in 1975 to oversee broker dealers that traded securities for customers as well as their own accounts. • The rule requires that firms value all their tradeable assets at market prices, and then it applies a hair-cut to account for market risk. The hair cut is 15% for equities and 6% for Treasury securities because they are less risky. The net capital rule requires that they limit their debt to capital ratio to 12 to 1 and are forced to stop trading if they exceed it. 3/16/2009 11
Underpinnings of the US Financial Crisis Excessive Leverage by Hedge Funds, etc. • Failure to stop excess leverage. Excess speculation with borrowed money. • Typical leverage for a hedge fund and private equity is 30:1. • For sub-prime mortgage company the leverage is infinite because there is no capital. 3/16/2009 12
Underpinnings of the US Financial Crisis Credit Default Swaps (CDS) • CDS are credit derivatives of Mortgage backed securities. • CDS is a fancy name for insurance. It is not called insurance because regulatory laws require large capital reserves for losses. • CDS was sold as an insurance for mortgaged backed securities and were used to persuade investors to buy the securities in a declining market. • When the securities failed, the investors tried cash into the insurance and this made a run on the bank’s inadequate reserves resulting in a collapse of these investment firms. • CDS is the key reason for failure of AIG, Bear Stearns, Merrill Lynch, Lehman Brothers, etc. • Regulation of CDS was opposed by Clinton Treasury Secretary Robert Rubin & Greenspan in 1999 3/16/2009 13
Underpinnings of the US Financial Crisis Failure to police Sub-Prime • The core idea of bank regulation: – Is to examine the banks books; – Ensure that there are not too many loans behind in interest payments; and – Force the banks to raise more capital if needed to cover the losses. • Regulators basically waived the rule of adequate capital for the new wave of mortgage lenders who created sub- prime. • Many of the mortgage companies were not banks who made the loans only to sell them off to Wall Street. 3/16/2009 14
Underpinnings of the US Financial Crisis Packaging & Selling of Bonds backed by Sub-Prime Loans • Unregulated agencies such as Moody’s and S&P to rate these bonds. • In return for a hefty fee, these agencies helped manipulate the bond so it qualifies for a AAA rating. • Fannie Mae & Freddie Mac which purchased the loans from the banks financed its operations by selling such bonds. • By selling the loans to FM & FM, it freed the banks to issue even more sub-prime mortgages. 3/16/2009 15
Global Impact • Loss of confidence in inter-bank lending. • Severe credit crunch even for borrowers with good credit history • High interest rates. • Increased number of home foreclosures, reduced auto sales, reduced consumer spending • Declining home values • Emerging economies such as India & China hit with lower growth rates because of declining demand in the US markets 3/16/2009 16
Rescue Package Key Issues • Guaranteeing inter-bank lending • Guaranteeing mortgage backed loans by Fannie Mae & Freddie Mac • Delay home foreclosures; allowing refinance at lower fixed rates. • Increasing money supply • Increasing consumer & investor confidence 3/16/2009 17
Rescue Package Initial Package • $700 bil initial package from US Govt • Bail out large institutions such as AIG • Cleanup balance sheet of financial institutions by buying up bad debt ie mortgage based assets. • Objective was to free up the companies to make loans again. • It is too early to tell if this is working! 3/16/2009 18
Rescue Package Stimulus Package: $787 billion • Infrastructure - Rebuilding our highways, bridges, schools, etc. alongside creating more renewable energy (39% of total) • State Relief - Helping the states with unemployment benefits, budget shortfalls, medicaid, and the like (13% of total) • Struggling Citizens - Increase food stamps, unemployment insurance coverage, and provide insurance for the jobless (12% of total) • Tax Cuts - Tax cuts to individuals and business (36% of total) 3/16/2009 19
Rescue Package Stimulus Package: Detailed Breakdown • Construction projects: $90 billion. • Education: $142 billion. • Renewable energy: $54 billion. Double production of alternative energy in the next three years. • Medicaid: $87 billion. • Unemployment benefits: $43 billion. • Middle-class tax cut: $145 billion. • Tax cuts for companies suffering losses: $17 billion over 10 years. 3/16/2009 20

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The Global Financial Crisis V3

  • 1. The Global Financial Crisis 3/16/2009 1 Jay Prakash jay@strategicfocus.com 408-568-3993 www.strategicfocus.com
  • 2. Table of Contents • What is the crisis? • Underpinnings of US Financial Crisis – A history of deregulation • Financial deregulation of S&L’s in the Regan era, 1980’s • Bank deregulation of 1994 • Repeal of the Glass Stegal act in 1999, Clinton era • SEC publishes Regulation ―B‖ in 2004 – Violation of Net Capital Rule – Excessive leverage by Hedge Funds, Private Equity & Mortgage Companies – Credit Default Swaps – Failure to police sub-prime – Packaging & selling of bonds backed by risky sub-prime loans • Global Impact • The changing nature of the Rescue Package – Key Issues that need to be addressed – Initial Package – Current Package 3/16/2009 2
  • 3. What is the crisis? Foreign Investors US Banks Federal Reserve Consumer Positive Consequences --Cars --Home --College --Entrepreneurs --Small Businesses Negative Consequences Large Money Flow Low Interest Rates Easy Credit Borrowing Borrowing Bank Failure 3/16/2009 3
  • 4. What is the crisis? Negative Consequences • Over extended borrowers • Home foreclosures • Declining home values; home owners caught in a vicious cycle • Credit crunch for qualified borrowers including businesses • Bank & other financial institutions failure due to non- repayment of loans • Loss of confidence • Declining demand for goods & services in US markets • Global Economies sliding into recession or reduced growth 3/16/2009 4
  • 5. Underpinnings of the US Financial Crisis History of Deregulation • Financial de-regulation started with S&L’s in the Regan era in 1980’s • Many restrictions on the activities of S&L’s limiting to the home loan market were removed. • The result was an orgy of speculation, profiteering and outright plundering of assets, culminating in collapse. • This resulted in the biggest bailout in US history prior to the current bailout costing the Federal government more than $500 billion • Clearly the lessons from these lax regulations had not been learnt. 3/16/2009 5
  • 6. Underpinnings of the US Financial Crisis History of Deregulation • Bank deregulation of 1994 • This allowed bank holding companies to operate in more than one state. • The result was a rash of merger & acquisitions of regional banks and an appetite for new markets & new sources of revenues. 3/16/2009 6
  • 7. Underpinnings of the US Financial Crisis History of Deregulation • Repeal of the Glass Stegal act in 1999. • Under the Glass Stegal act, banks, brokerage and insurance companies were effectively barred from entering each other industries -- investment banking and commercial banking were separated. • Act passed in 1933 in response to: – 5000 bank failures, – loss of $7 bil in depositors money, – 600,000 foreclosures from 1930-1932 --all due to manipulation of the market by giant banking houses. • Single most damaging and most consequential act of the Clinton years. 3/16/2009 7
  • 8. Underpinnings of the US Financial Crisis History of Deregulation • Repeal of the Glass Stegal act in 1999. • Under the Glass Stegal act, banks, brokerage and insurance companies were effectively barred from entering each other industries -- investment banking and commercial banking were separated. • Act passed in 1933 in response to: – 5000 bank failures, – loss of $7 bil in depositors money, – 600,000 foreclosures from 1930-1932 --all due to manipulation of the market by giant banking houses. • Single most damaging and most consequential act of the Clinton years. 3/16/2009 8
  • 9. Underpinnings of the US Financial Crisis History of Deregulation • Clinton and the Republicans agreed to the deregulation of the US Financial system in October 1999. • Most sweeping banking deregulation bill in US history • Lifted all restraints on the operation of giant monopolies which dominate the financial system. • No restrictions on the integration of banking, insurance and stock trading imposed by the Glass Steagal act of 1933. • Huge wave of mergers, ex. Citibank buying Travelers Insurance creating one stop shop for Financial Services • Law was passed due to pressure from the banks which sought more profitable outlets for their capital especially in the stock market. • In 1990 JP Morgan was allowed to engage in stock market operations up to 10% of revenues. This was increased to 25% in 1994 and in 1999 it was abolished. 3/16/2009 9
  • 10. Underpinnings of the US Financial Crisis History of Deregulation • SEC voted in June 2004 to publish Regulation B. • This allows banks to engage in certain Securities activities without first registering as brokers with the SEC. 3/16/2009 10
  • 11. Underpinnings of the US Financial Crisis Violation of Net Capital Rule • SEC allows certain broker-dealer firms to legally violate existing net capital rules that limits debt-to-net capital ratio to 12 to 1 by providing them with exemptions. • In 2004 the SEC granted an exemption to five firms—Goldman, Merrill, Lehman, Bear Stearns, and Morgan Stanley.—which allowed them to leverage up to 40 to1. • Three of these firms have blown up. This reckless leverage has led to the current crisis. • The so called Net Capital Rule was created in 1975 to oversee broker dealers that traded securities for customers as well as their own accounts. • The rule requires that firms value all their tradeable assets at market prices, and then it applies a hair-cut to account for market risk. The hair cut is 15% for equities and 6% for Treasury securities because they are less risky. The net capital rule requires that they limit their debt to capital ratio to 12 to 1 and are forced to stop trading if they exceed it. 3/16/2009 11
  • 12. Underpinnings of the US Financial Crisis Excessive Leverage by Hedge Funds, etc. • Failure to stop excess leverage. Excess speculation with borrowed money. • Typical leverage for a hedge fund and private equity is 30:1. • For sub-prime mortgage company the leverage is infinite because there is no capital. 3/16/2009 12
  • 13. Underpinnings of the US Financial Crisis Credit Default Swaps (CDS) • CDS are credit derivatives of Mortgage backed securities. • CDS is a fancy name for insurance. It is not called insurance because regulatory laws require large capital reserves for losses. • CDS was sold as an insurance for mortgaged backed securities and were used to persuade investors to buy the securities in a declining market. • When the securities failed, the investors tried cash into the insurance and this made a run on the bank’s inadequate reserves resulting in a collapse of these investment firms. • CDS is the key reason for failure of AIG, Bear Stearns, Merrill Lynch, Lehman Brothers, etc. • Regulation of CDS was opposed by Clinton Treasury Secretary Robert Rubin & Greenspan in 1999 3/16/2009 13
  • 14. Underpinnings of the US Financial Crisis Failure to police Sub-Prime • The core idea of bank regulation: – Is to examine the banks books; – Ensure that there are not too many loans behind in interest payments; and – Force the banks to raise more capital if needed to cover the losses. • Regulators basically waived the rule of adequate capital for the new wave of mortgage lenders who created sub- prime. • Many of the mortgage companies were not banks who made the loans only to sell them off to Wall Street. 3/16/2009 14
  • 15. Underpinnings of the US Financial Crisis Packaging & Selling of Bonds backed by Sub-Prime Loans • Unregulated agencies such as Moody’s and S&P to rate these bonds. • In return for a hefty fee, these agencies helped manipulate the bond so it qualifies for a AAA rating. • Fannie Mae & Freddie Mac which purchased the loans from the banks financed its operations by selling such bonds. • By selling the loans to FM & FM, it freed the banks to issue even more sub-prime mortgages. 3/16/2009 15
  • 16. Global Impact • Loss of confidence in inter-bank lending. • Severe credit crunch even for borrowers with good credit history • High interest rates. • Increased number of home foreclosures, reduced auto sales, reduced consumer spending • Declining home values • Emerging economies such as India & China hit with lower growth rates because of declining demand in the US markets 3/16/2009 16
  • 17. Rescue Package Key Issues • Guaranteeing inter-bank lending • Guaranteeing mortgage backed loans by Fannie Mae & Freddie Mac • Delay home foreclosures; allowing refinance at lower fixed rates. • Increasing money supply • Increasing consumer & investor confidence 3/16/2009 17
  • 18. Rescue Package Initial Package • $700 bil initial package from US Govt • Bail out large institutions such as AIG • Cleanup balance sheet of financial institutions by buying up bad debt ie mortgage based assets. • Objective was to free up the companies to make loans again. • It is too early to tell if this is working! 3/16/2009 18
  • 19. Rescue Package Stimulus Package: $787 billion • Infrastructure - Rebuilding our highways, bridges, schools, etc. alongside creating more renewable energy (39% of total) • State Relief - Helping the states with unemployment benefits, budget shortfalls, medicaid, and the like (13% of total) • Struggling Citizens - Increase food stamps, unemployment insurance coverage, and provide insurance for the jobless (12% of total) • Tax Cuts - Tax cuts to individuals and business (36% of total) 3/16/2009 19
  • 20. Rescue Package Stimulus Package: Detailed Breakdown • Construction projects: $90 billion. • Education: $142 billion. • Renewable energy: $54 billion. Double production of alternative energy in the next three years. • Medicaid: $87 billion. • Unemployment benefits: $43 billion. • Middle-class tax cut: $145 billion. • Tax cuts for companies suffering losses: $17 billion over 10 years. 3/16/2009 20