Lecture notes on the financial crisis

The lecture took place on October 1 and Sanders auditorium was jam packed with students, as threats to the job market are evidently a fantastic way to pique the curiosity of undergraduates. But I am probably being unfair, the crisis in general is fascinating, and Ms Johnson-Lans, Ms Pearlman, Mr Flynn, and Mr Johnson did an excellent job. Here are my notes:

Relevant History: 

• Banks have been regulated heavily ever since 1929
• The Glass-Steagall act of 1933 created a firewall between investment and commercial banks
• The Community Reinvestment Act passed in 1977, required banks to do a certain amount of housing loans in poor and minority neighborhoods
• In 1999 the Glass-Steagall act was repealed, leading to mergers and more complicated financial instruments, and ultimately contributed to our crisis (note that Alex Tabarokk at MR sees it differently, arguing than national banks with security affiliates are actually less likely to fail)
• Lending mortgages were offered with low interested rates, "suprime," because mortgage-backed secturities (commonly referred to as MBS) were able to make so much money

Financial system failure--what caused it:

• The process of securitization is a story of risk, as financial entities took on too much risk in order to maximize profit 
• Bank failures thus far this year are historically speaking low, only 13 this year compared to 100+ in the Savings and Loans crisis, however WaMu was much larger in scale (see here)
• Fannie Mae and Freddie Mac (as well as a few others) buy mortgages from banks, which are then bought by investment banks and packed into crazy MBSs
• Fannie Mae and Freddie Mac buy mortgages from banks. The point was not to make money but to create more homeowners (as Arnold Kling explains from his personal experience here)
• Pros of Freddie and Fannie: great for banks, can lend out cash once they sell the mortgage. Cons: No longer have to worry about default, because it transfers over to whoever bought the mortgage
• IBs bought secturies and combined them into complex MBSs. Due to "quick pricing methods" that caught on around 2000, more and more cash was channeled to these, and there was more and more incentives for banks to issue mortgages
• CDOs are a separate entity which allowed people to buy rights to the cash flow from mortgages. These states are called traunches, and there is an order of preference for the right to buy them. The lowest preference ones are what people talk about when they say "toxic waste"
• Lots of people bought tench positions in CDOs, many of which were incorrectly rated AAA by S&P and Moody's (rating agencies) -- they were wrong. They undervalued the level of risk, and have taken lots of heat (Barry Ritholtz appears to agree here)
• There was also protection of "credit default swaps"--you can buy insurance in case the mortgages fail to pay. this is what brought down AIG--they didn't have enough liquidity to back this insurance once they started to fail, even though it was only 10% of their business
• The point is that splitting up risk does not make it go away. People undervalue risk for two reasons: 1) Due diligence was passed off to many times, nobody was making sure that the people can actually pay back the loans, and 2) A rapid decline in house prices which nobody expected

Mortgate loans:

• Main problem is that banks are giving loans to people who can't pay them off
• If home prices keep rising, it doesn't matter if you can't pay back because they could always sell the house for a profit
• The government forced people to buy houses they couldn't afford
• Ratio of house prices to rent is a goodmeasure of whether house prices are off--it started getting huge in the 2000s.
• Price bubbles feed on themselves, everybody thinks that they may be stupid to buy into it, but that there will always be a stupider guy out there--until there isn't
• The tulip bubble is a fascinating example of this, Issac Newton lost his life savings in the South Sea Bubble. They have happened throughout history and will happen again, the housing bubble is another example, but why did it cause so much damage this time (mainly those crazy leverages, says Tyler Cowen)
• Community Law of 1977 updated very badly in 1995, after a racism study was reported by the Boston Fed, which was somewhat of a scandal
• The mortgage laws forcing banks to make loans to poor people is a bad thing, we should just let the market do it's thing instead (although Tyler Cowen thinks that this "minority lending" wasn't the main cause of our current problems)
• The problem is not that Wall Street is greedy (Wall Street is always greedy!), the problem is that generally there is fear to counterbalance the greed, but that vanished because IBs thought that they had eliminated risk with their complex instruments. They were wrong

Moving forward:

• State of financial institutions is not good, Wall Street as we know it is pretty much already gone
• State of credit markets is a problem: borrowing is very, very difficult. This makes it hard to determine what the value of assets are
• Banks can't lend money between each other, which is an essential part of the banking system (and why the FDIC needs to step in)
• The financial system produces "working capital," which is key to lots of business, without it businesses won't be able to operate, and unemployment will jump
• Recessions are very costly, it is estimated that the worst one since WWII caused a decline in real GDP of 30-40%, which is almost $4 trillion
• Paulson plan is to give $700 billion to banks and see what happens, or in other words buy $700 billion of assets from them. The problem is that we don't know what they're worth. The FED will probably pay too much for bad assests. It also may not work--reminiscent of what happened in Japan in the 1980s (The blogosphere has destroyed this plan, but the main problem is its tremendous capabilities to lose large amounts of money, see Arnold Kling here. It is the distribution of possibilities that we need to look at, not the probability of it making versus losing money.)
• The other extreme is to do nothing, and use $700 billion for fiscal policy in an attempt to mitigate the recession (if it comes) to build roads and other infrastructure which we need 
• Middle plan (in his view) is the Swedish plan, nationalization. It's guaranteed bank deposits. Use $700 to buy out shareholders and seize the banks, use to some money to run the bank, then walk away in 5-10 years. The problems in his view is merely scaling (Megan McCardle thinks the scaling issue is too great)
• Under the Swedish plans, we would need regulatory changes as well. One caveat for the US is that Sweden has higher quality governance, which got a chortle from the crowd.

I think it is a huge analytic mistake to spend too much time worrying about the bailout. In all likelihood your personal understanding of the current financial crisis means next to nothing, unless you are discussing your personal ability to profit from it in some way. However, if you are interested in a purely intellectual and quasi-entertainment sense, then this is fascinating stuff. It is remarkable to see such smart people disagree so intensely about such diverse topics, and what is incredible is how time sensitive all of the information is. If this lecture had been one week ago, it may have been completely different in structure.