Y376 International Political Economy

1. Y376 International Political Economy March 10, 2011

2. Global Financial Crisis 2007-8 Led by bursting of the housing bubble in the US in 2007 Made worse by near collapse of US financial markets connected with mortgage-backed securities, synthetic collateralized debt obligations (CDOs), and credit default swaps Response to the crisis revived the debate over regulation of financial markets and Keynesian approaches to preventing deep recessions

3. Bursting of the Housing Price Bubble 1963-2008 The Bubble Bursts 1890-2005

4. 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

5. 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

6. Expansion of Subprime Market

7. 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

8. 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

9. 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).

10. Fun with Credit Rating Agencies

11. 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

12. 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

13. 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

14. 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

15. 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