1、The Financial Crisis:,Causes and Possible Cures,2,Basic Background,Government policies primary cause of crisisMixed EconomyFinancial industry more government than privateLiquidity issues in capital markets have been created by deflation in residential real estate marketsOther factors are significant
2、 and created “perfect storm”, however, are less fundamental,3,Residential Real Estate,$800+ billion overinvestment in residential real estate,Too many houses, too big of houses, houses in wrong place.Should have invested in technology, manufacturing capacity, agriculture, education, etc.,4,How Did O
3、verinvestment of this Scale Occur,Only government can make a mistake of this magnitude possiblePrimary Sources of ProblemsFederal ReserveFDICHousing PolicyFreddie Mac / Fannie MaeSECGovernment policy makers (Treasury, Federal Reserve, President, Congress) turned a natural market correction into a pa
4、nicMost government action since “crisis” began will reduce standard of living in the long run,5,Government Policy As Causation Federal Reserve,Government owns monetary systemUnlimited federal debt / print money / inflationReduced capital requirementsPerception of “no” riskLow savings rateSignificant
5、 mismanagement of monetary policyInverted yield curve,Problems with Federal Reserve are systems design: many outstanding people at Fed.,6,Government Policy As Causation FDIC Insurance,Lack of market disciplineStart-up banks: AtlantaIndy Mac, WaMu, Countrywide: as examples,7,Government Policy As Caus
6、ation Housing Policy,Increase home ownership above natural market rateTax policyAffordable Housing / Subprime: NY Times 9/30/99 Freddie Mac / Fannie Mae: Government sponsored enterprisesWould not exist in free marketLeverage 1000 to 1$5 TrillionGovernment did have to “bailout” implied guarantee: Pol
7、iticsFreddie / Fannie primary current cause of housing/financial problemsBelief that housing prices never fall: based on government policies,8,How Did Residential Real Estate Markets Create Financial Crisis,Ultimately residential real estate values are driven by the cost of reproduction, affordabili
8、ty and the cost to rent.,From peak residential real estate prices need to fall 30% to become affordable.,(All numbers are rough approximate and national in scope markets vary materially),9,Bad News,Residential real estate values have fallen 20% (U.S.)The fall has destroyed $500+ billion in capital i
9、n financial services industryFinancial intermediaries leveraged 10 to 1Investment banks 30 to 1$500 billion x 10 = $5 trillion in liquidity lostSome capital replaced = actual loss of liquidity “guesstimate”$3.0 trillion,10,Bad News,Fear of additional decline in real estate values of $100 billion or
10、moreWould destroy $1 trillion or more in liquidityNo more capital for financial intermediaries because of unknown “bottom” in real estate may go past affordability:,11,Bad News,Treasury, Federal Reserve, FDIC destroy capital markets for banks when they completely “wipe out” WaMu debt holders. These
11、federal agencies created “need” for financial institutions “bail out” programHousing overbuilt in other countries and foreign banks heavily invested in U.S. housing international liquidity problem,12,Another Failure of Government Policy: Fair Value Accounting,New accounting rule: mark-to-marketDoes
12、not work when there is no market:Inconsistent with law of supply and demand: must be willing buyer and willing sellerViolates “going concern” conceptMajor Cause of systematic liquidity problem: Public companies not purchase economically valuable assets because of accounting riskFails to consider gai
13、ns. Example: bank retail deposits,13,Fair Value Accounting,Asset values should be based on projected cash flows, not “fire sale” valueIf Fair Value Accounting applied in 1990 U.S. financial system / economy would have failedIf applied to all business in U.S. as applied to financial intermediaries: 9
14、0% of U.S. businesses would be insolvent given lack of liquidity in marketsSEC (government agency) makes accounting rules: i.e., laws: primary supporters of Fair Value: State Government and union pension plans,14,FDIC Insurance Makes “Pick-A-Payment” Mortgages Possible,Owe $1,000 interest per month;
15、 only pay $500Each month you owe more on your houseTargeted at high growth markets: CA, FL, etcGolden West (Wachovia) / WaMu / CountrywideOnly possible with FDIC InsuranceWhy BB&T did not offer productMission“Trader Principle”,15,How Government Policy Created “Originate and Sell” Model,Federal Reser
16、ve / FSLIC systematically destroyed thrift industry“Originate and sell model” replaces “originate and hold”Freddie/Fannie drive many financial intermediaries out of mortgage markets due to government guarantees on debt: leverage 1000 to 1 lower cost of capitalEncourages banks to hold riskier mortgag
17、es Freddie/Fannie make “mortgage broker” origination model viable Brokers feed Countrywide/Washington Mutual who feed Freddie/Fannie to meet “affordable housing” goals to keep support in congress,16,Perverse incentives for originations: sloppiness/fraudS&P, Moodys, Fitch (government sanctioned) make
18、 huge rating mistakesInvestment bankers create financial “innovations” under belief that Federal Reserve will keep risk in financial markets lowInvestment bankers make irresponsible decisions based on pragmatic thinking: i.e., short term: irrational/lacks integrity/evasion/arrogance,Originate and Se
19、ll,17,Misregulation: Not Deregulation,Regulatory cost at all time high at peak of bubble (2005-2007) Sarbanes Oxley Patriot Act Irrational belief in “models” Wachovia as “Best Practices” BASEL/European banks Huge misdirection of management energyBank Regulators have tightened lending standards! Talk
20、 one game / play another: unequal incentives for regulators,18,Failure of Government Policy SEC,Sanctioning Rating AgenciesBASEL rules for investment banksSignificantly increased leverage MisregulationSarbanes OxleyMeaningless, confusing, detailed disclosureShort sale rules: not enforcedOwnership of
21、 accounting systemReliance on rules instead of principlesFair ValueLoan loss reservesArtificially created fluctuations in accounting results,19,Market Corrections Are Not All Bad,World is a better place to live with Countrywide and WaMu out of business: misallocations of capital.Credit standards wer
22、e far too loose at peak of bubble: standards need to be tightened Excessive leverageSaving rate needs to be increasedOverinvestment in housing needs to be corrected: less capital to housing: more to productive investmentWe needed a correction: natural market process: creative destructionWe did not n
23、eed a panic: never would have had excesses and misallocations of this magnitude without government policyWe would have experienced minor corrections all along,20,“Panics” Are All Bad,Unnecessary and inappropriate actions of Federal Reserve, Treasury, President and Congress have created “panic” $700
24、billion: scary amountInconsistency (Citi vs. Wachovia / Goldman vs. Lehman)Unpredictability“Panics” negatively affect even the best run financial companies and the overall economyEven best run financial institutions had to compete against risky institutionsRemember: Financial institutions borrow sho
25、rt and lend long: “Panic” creates liquidity risk for all Too tight of lending standards are destructive Self fulfilling spiral down Deflation is extraordinarily destructive,21,TARP #2,Capital injection in banks: investment must be repaid with interestCreates lending capacityIncreases willingness of
26、banks to lend to each otherFDIC Debt GuaranteeFDIC insurance$250,000 (TARP #1)Unlimited non-interest depositsPrimarily helps small / weak banksFED Buys Rated Commercial Paper“Saves” GEDid help liquidity problem: unknown is whether it will make people want to borrow,22,Effect of Government Financial
27、“Rescue” Plan (TARP),All large banks have chosen to participate in TARP #2 because:Intense regulatory “encouragement”Failure to participate would be a major competitive disadvantageWhile positioned as providing capital to encourage healthy banks to lend, a significant purpose of TARP is to save weak
28、 financial institutions and, thereby, theoretically reduce system riskLong term effect: huge moral hazardReward excessive risk takingA zebra does not change its stripesCitigroup saved 3 times: each time bigger and worse,23,Effect of Government Financial “Rescue” Plan (TARP),Oligopoly created in fina
29、ncial industry: not by market forces, but by extremely arbitrary government actions (Lehman vs. Goldman)4 financial institutions “too big to fail”(maybe 9: why 9 first TARP)Tremendous competitive advantage in funding long-termNot selected by markets (Citigroup)If “too big to fail” should be broken-u
30、p: anti-trust policy of Fed completely irrational,24,Effect of Government Financial “Rescue” Plan (TARP),Healthy financial institutions (BB&T) hurt by “bailout”End of flight to quality Continued irrational competitionCost of FDIC insuranceImpractical not to participate: nature of government programs
31、Lost opportunities to make acquisitionsMessage to take more risk in future?Competing with “too big to fail” / government created oligopolies,25,What Are Possible Cures Immediate Real Estate Tax Credit,Create a credible program that deals with deflation in residential real estate which is cause of pr
32、oblems in capital markets 10% tax credit (true tax credit: available only to tax payers) $150 billion Will help all homeownersNothing is as important as stabilizing residential real estate marketAny program not focused on residential real estate will not be most effective way to solve problem,26,To
33、become affordable, residential real estate prices (cost to purchase) needs to fall an additional 10% Approximately $100-$150 billion.However, if prices fall $100-$150 billion financial institutions will leverage down (10 to 1) $1-$1.5 trillion probably more because prices may fall below affordabilit
34、y due to capital constraints.,What Are Possible Cures Immediate Real Estate Tax Credit,27,10% tax credit on residential real estate purchasesReduces cost to buyers without reducing price to sellersAvailable to all / also receive interest deductionGoal: to entice individuals to purchase real estate w
35、ho would not otherwise invest at this timeClear housing marketGovernment sponsored once in a lifetime “fire sale”,10% Real Estate Tax Credit,28,Only available for new houses under construction (or completed) and pre-owned homes for sale as of January 1, 2009Do not want to incent additional house con
36、structionIncent to act nowonly available to August 30, 2009limited to $150 billion: first come / first serve(use part of $700 billion)Must have carry forward tax feature for everyone, and must be available to high income individuals pay taxes and have capital,10% Real Estate Tax Credit,29,House pric
37、es stabilizeEvery home owner in America wins:greater sense of securitywilling to invest / spendHome equity lines have availability: More Retail SalesCapital markets can properly estimate losses / establish value for mortgage bondsLiquidity starts to return to markets,10% Real Estate Tax Credit,30,Wh
38、at Are Possible Cures Long Term,Deflation is potentially worse than inflation: However, risk of inflation after correction is extremely significant: Riskiest asset long term treasuries?Most fundamental issue is the attack on capitalism / free markets We do not have a free market in U.S.: mixed econo
39、myFinancial system is primarily government owned: Federal ReserveBy far primary causes of current financial crisis is government policy, not market failure: Federal Reserve, FDIC, Housing Policy, Freddie / Fannie, SEC, HUDLess regulation, not moreAttack on “wealthy” is an attack on the productive pr
40、oductive will go “on strike” in many different ways,31,What Are Possible Cures Long Term,Privatize / Liquidate Freddie/Fannie After crisis: 2011 Political risk / affordable housingReturn to originate / hold for residential mortgages:Do not attempt to salvage originate / sell model: CanadaReintermedi
41、ate to banking systemDo not “save” irrational competitors: mutual money fundsFederal Reserve stripped of powers: one basic goal to grow monetary supply at fixed rate (Milton Friedman 3%) Do not manage in short runConsider market based monetary standard (gold)Federal Government owns monetary system:
42、unlimited federal debt,32,What Are Possible Cures Long Term,If do not privatize banking system then raise capital requirements for bank (especially “start ups”) Reduce FDIC insurance back to $100,000 Make it explicitly clear that Federal Reserve can not/will not “save” non-banks If you buy GEs comme
43、rcial paper that is your risk Stop subsidies to housing (tax policy)Encourage productive investment low/neutral tax rates: tax consumption, not savings increase productivityFree trade,33,What Are Possible Cures Long Term,Carefully and systematically privatize Medicare, and Social SecuritySignificant
44、ly cut cost of defense: By defending U.S. not “saving” worldEncourage immigration of the productive and hardworking; especially well educatedRestore discipline to system Save more Spend less,34,Deepest Causes are Philosophical Different Than You May Think,Altruism Affordable Housing Redistribute fro
45、m productive to non-productive No one has a right to their own life Pragmatism Short term: What works: Negative amortization mortgages worked for a number of years Irrationality Lack of integrity “Free Lunch” Mentality Social Security Medicare Lack of Personal Responsibility Death of Democracies: Ty
46、ranny of Majority,35,Deepest Cure is Philosophical,Life, Liberty, and the Pursuit of Happiness Right to your life and your happiness Personal responsibility No “free” lunches Demands and rewards rationality / self-disciplinePursuit of each individuals long term rational self-interest in the context
47、of the “Trader Principle” creating win/win relationships Atlas Shrugged (1957),36,What Happens Now? Short Term,We are in a serious recession: how deep and how long?Real economic issuesLack of confidenceGlobal Financial Crisis will probably be contained: Fed / International Governments are not likely
48、 to make mistakes of 1930s Most likely: modest economic recovery in 2010 followed by period of slow real growth growth rate below economic potential recent government “incentive” programs reduce long term productivity stagflation?,37,What Happens In The Long Term,Depends on us Continuation of Altrui
49、sm / Free Lunch mentality will ultimately result in economic disaster: forces in motion to make disaster possible: Social Security deficit, Medicare deficits, government operating deficits, irrational foreign policy: demographics: failed K-12 education systemA return to individual rights, limited go
50、vernment, free markets which lead to personal responsibility and self-discipline can restore long term positive economic trends We need less regulation, not more Every time government makes big mistake the answer is more governmentAmerican Sense of Life: Good News!Principled individuals / principled leadership,
