[Winstonm]

The following was posted today on The Big Picture, the blog of Barry Ritholtz. It organizes a lot of information into a final test format. Even without answering, there is a lot of information here that most non-economist types do not know and never knew. I've added highlights to those areas which I believe are not commonly known.

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Final Examination


1. Following the dotcom implosion and 2000 market crash, the Federal Reserve lowered rates to 2% for 3 years, including a then unprecedented level of 1% for more than a year. Discuss the impact this has on various asset classes, including Real Estate, Fixed Income, Oil and Gold. What difference might a more traditional interest rate regime have made for these assets?

Bonus Question: Imagine you were FOMC Chair. Where would you have set rates in the 1990s? After the 2000 crash? Today?

2. The rating agencies (NRSROs) — Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings — business models was once funded by bond investors,who bought the NRSRO research. This changed in the 1990s to a Syndicators & Underwriter funded model. How did this change impact the performance of ratings agencies?

Bonus question: Does the financial world still require NRSROs? What potential alternatives might replace these entities in evaluating complex financial products.

3. The Commodity Futures Modernization Act of 2000 was an unusual piece of deregulatory legislation, creating a new world of uniquely self-regulated financial instruments — the derivative. What was the impact of this on risk management, leverage, and mortgage underwriting?

Bonus: What did the lack of reserve requirements for derivatives mean for firms such as AIG, Bear Stearns and Lehman Brothers?

4. More than 50% of subprime loans were made by nonbank mortgage underwriters not subject to comprehensive federal supervision; another 30% were made by banks or thrifts also not subject to routine supervision or examinations. What did this do to the supply/demand curve in the housing and mortgage markets?

Bonus: What is the role of changing credit standards in prior bubbles and financial crises?

5. In 2004, the SEC issued :”the Bear Stearns exemption” — they changed the Net Capitalization rule from 12 to 1 leverage to essentially unlimited for Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. None of these companies exist today in the same structure as prior to the rule change. Discuss the impact of this rule change on these companies.

Bonus: Changing broad legislation for only 5 companies is unusual. What does this say about regulatory capture, democracy and the impact of lobbying on American society?

6A. Mortgage underwriting standards changed rapidly in the 2000s. Many lenders stopped verifying income, payment history, credit scores.

6B. The loans themselves changed: Loan to value (LTV) went from 80% (20% down payment) to 100% (No Money Down) to even 120% (Piggyback mortgages).

6C. “Innovative” new mortgage products were developed and marketed in the 2000s: 2/28 ARMs, I/O s, Neg Ams

Discuss the correlation this had on a) home prices; b) new inventory build; and c) foreclosures.

7. Banks developed automated underwriting (AU) systems that emphasized speed rather than accuracy in order to process the greatest number of mortgage apps as quickly as possible. What was the impact of this on Housing prices, defaults and foreclosures?

Bonus: Real estate agents and mortgage brokers were known to repeatedly use the same corrupt appraisers to facilitate loans approval. Did this correlate with AU? Discuss how.

8. Collateralized debt obligation (CDO/CMOs) managers who created trillions of dollars in mortgage backed securities and the institutional investors (pensions, insurance firms, banks, etc.) who purchased these appear to have failed to engage in effective due diligence prior to the purchases of these products. Reconcile this in terms of the Efficient Market Hypothesis

Bonus: What does this mean for self regulation of the financial industry?

9. The Depression era Glass Steagall legislation was repealed in 1998. What impact did this have on the size of banking institutions? What did this do to the competitive landscape of financial services industry? Did this impact bank risk taking? Discuss.

10. Numerous states had anti-predatory lending laws which were in 2005 “Fedrally Pre-empted” by order of John Dugan, head of the Office of the Comptroller of the Currency (OCC). What impact did this have on states with anti-predatory lending laws default and foreclosure levels, pre and post pre-emption?

11. In 2006, more than 84% of subprime mortgages were issued by private lending institutions not covered by government regulations (McClatchy). Discuss what this means in terms of profit motive, government policy, and GSEs.

12. The Bank Bailouts “rescued” the system, but may have created additional issues in the future. Discuss the Moral Hazard of bailouts, what they mean in terms of competitive landscape and concentration of assets in the financial services industry.

Bonus: What impact might the Consumer Financial Protection Bureau on lending and future credit bubbles?

It seems fairly plain that self-regulating markets do not work because of excessive human greed.

[blackshoe]

Heh. How much greed is "excessive"? How much is not?

[mike777]

I do agree strongly with winston that there should be some govt. regulations concerning the American economy.

[kenberg]

 Winstonm, on 2011-July-20, 18:00, said:

It seems fairly plain that self-regulating markets do not work because of excessive human greed.

It's tough to draw a conclusion like that from a quiz.

Eg "Bonus Question: Imagine you were FOMC Chair. Where would you have set rates in the 1990s? After the 2000 crash? Today?"

My answers would be Don't know, don't know, and don't know. From this question, or my answer, you deduce something about greed?

PS, besides the three "don't know"s I had to look up FOMC on the internet.

Otoh, when I took my quals for my philosophy Ph.D minor I also didn't know anything but the chair of the department called me in to suggest I switch from mathematics to philosophy. I can sling it when I have to.

[luke warm]

 Winstonm, on 2011-July-20, 18:00, said:

It seems fairly plain that self-regulating markets do not work because of excessive human greed.

 kenberg, on 2011-July-20, 19:23, said:

It's tough to draw a conclusion like that from a quiz.

not really... you have to remember, you minored in philosophy... not everyone had that luxury... as much as you might want to distance yourself from it, you still use it admirably... a certain amount of logical thought (and recognition of fallacious argument) was necessary for that

[kenberg]

Both Mathematics and Philosophy have given me great respect for the limitations of logic.

[luke warm]

hence my use of "a certain amount"... still, it's helpful, though it often falls on deaf ears, to be able to easily spot illogical thought/speech

[jdeegan]

Self-regulating markets in financial claims can, imo, be compared to self-regulating markets in restaurant food. Having effective government regulation in the form of health inspectors helps everyone. It protects customers from disease. It makes it easier for new entrants, hence helps competition and innovation. Otherwise, only those restaurants with long-established reputations would be considered safe. So, there is a correct combination of both private and public efforts.

As a former government regulator, I can assure you that government regulation can only be based on past precedent. It is not too effective in the beginning when there has been recent innovation. This is precisely what happened in the 2005-2008 period with the securitization of mortgages. The private rating agencies, however, were outrageously culpable as well. They were sort of like the old empire British civil servants. If you listened closely enough, you could hear the truth, but hardly anyone did.

In the US there were also idiots like Christopher Cox running loose in the Federal bureaucracy which did not help at all.

[PassedOut]

 jdeegan, on 2011-August-04, 20:01, said:

Self-regulating markets in financial claims can, imo, be compared to self-regulating markets in restaurant food. Having effective government regulation in the form of health inspectors helps everyone. It protects customers from disease. It makes it easier for new entrants, hence helps competition and innovation. Otherwise, only those restaurants with long-established reputations would be considered safe. So, there is a correct combination of both private and public efforts.

I think it fair to say that honest business people welcome regulations that are sensible, clear, apply to everyone, and do not change abruptly or frequently.

[luke warm]

 PassedOut, on 2011-August-05, 05:37, said:

I think it fair to say that honest business people welcome regulations that are sensible, clear, apply to everyone, and do not change abruptly or frequently.

i'd guess dishonest business people wouldn't much mind those either...

[PassedOut]

 luke warm, on 2011-August-05, 15:50, said:

i'd guess dishonest business people wouldn't much mind those either...

Wrong. For example, business people who want to increase profits by selling mislabled or adulterated merchandise resist sensible, clear regulations and inspections. For many reasons, honest business people want that kind of business activity stopped.

[Winstonm]

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Winstonm, on 2011-July-20, 20:00, said:


It seems fairly plain that self-regulating markets do not work because of excessive human greed.

It's tough to draw a conclusion like that from a quiz

.

Connecting the dots seems fairly straightforward:

A. The Commodity Futures Modernization Act of 2000 was an unusual piece of deregulatory legislation, creating a new world of uniquely self-regulated financial instruments — the derivative.

Above all, the crisis was a derivative crisis as a worldwide web of interwoven risk and counterrisk accounted for trillions of dollars of unknown risk.

Why? Because of the CFMA it was impossible to know how widespread an event could be.

B. More than 50% of subprime loans were made by nonbank mortgage underwriters not subject to comprehensive federal supervision; another 30% were made by banks or thrifts also not subject to routine supervision or examinations

80% of the subprime loans were basically unregulated. Remember, this began as a subprime crisis.

C. In 2004, the SEC issued :”the Bear Stearns exemption” — they changed the Net Capitalization rule from 12 to 1 leverage to essentially unlimited for Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns

These banks then engaged in borrowing and trading derivatives (see item #1)

Change of regulations for banks leverage ratios plus a deregulated derivatives market trading in packages of loans of which 80% originated with little or zero oversight that led to a collapse of the banking industry isn't 100% guaranteed to be an ironclad example of human greed mixing negatively with deregulation; it is, however, a fairly useful conclusion to be drawn using inductive reasoning, especially as we replayed the scenario from the 1920s in the 2000s, including repealing or altering many of the safeguards created to prevent a recurrence.

[Winstonm]

Test answers from The Big Picture:

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1 Rates: After the dot-com implosion and 2000 market crash, the Federal Reserve lowered rates to 2 percent for three years, including a 1 percent rate for more than a year. That monetary policy was unprecedented. It had an enormous impact on various asset classes, including dollars, real estate, bonds, oil and gold. A more “traditional” interest rate between 4 and 6 percent would likely not have started the inflationary spiral we saw in commodities during the 2000s. Had rates been “normal,” it is doubtful we would have seen a 41 percent drop in the dollar from 2001 to 2008.

2 The rating agencies: Moody’s Investors Service, Standard & Poor’s and Fitch Ratings — all originally served bond investors, who paid for their research. But that model changed in the 1990s to one that was funded by the syndicators and underwriter of structured financial products such as mortgage-backed securities. Essentially, bankers “purchased” the rating they desired. As a result, the performance of the rating agencies decayed, as they were no longer judged on the quality of their analytical reviews. Second, the underwriting quality of syndicators fell, as they —not a neutral third party — were, in effect, picking their own credit ratings. The real question for the financial markets is why we even require rating agencies to evaluate complex financial products any more.

3 The radical deregulation of derivatives: The Commodity Futures Modernization Act of 2000 was a highly unusual piece of deregulatory legislation. It created a new world of uniquely self-regulated financial instruments — the credit derivative. Unlike traditional financial instruments — bonds, stocks, futures, options, mutual funds — it did not require anything from underwriters or traders. No reserve requirements against future obligations, no counter-party disclosure, no exchange trading needed, no capital minimums. This had an enormous impact on risk management, leverage and mortgage underwriting. AIG, for example, wrote $3 trillion of credit derivatives with a grand total loss reserves against any payout of zero dollars. Bear Stearns and Lehman Brothers were able to expand dramatically into the mortgage-backed security space using very little capital and lots and lots of leverage. You remember how that worked out.

4 Subprime loans: More than 50 percent of subprime loans were made by nonbank mortgage underwriters not subject to comprehensive federal supervision; another 30 percent were made by thrifts also not subject to routine supervision. With this, traditional lending standards disappeared. Millions of unqualified borrowers poured into the residential housing market as overleveraged buyers.

The irony is that dropping credit standards is a key factor in just about every bubble and financial crisis in history. Call it a lesson never learned.

5 Leverage rules: In 2004, the Securities and Exchange Commission issued the “Bear Stearns exemption,” replacing the existing Net Capitalization Rule — that is a 12 to 1 leverage limit — with essentially unlimited leverage for the five largest investment houses. Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns were given carte blanche to pile as much obligation onto their capital base as they saw fit. Following the rule exemption, they leveraged up 25, 35 even 45 to 1.

Less than five years after the exemption was granted, none of these companies existed in the same structure as before the rule change.

6 Mortgage underwriting standards: Beyond the subprime mortgages, lending standards dropped for home purchases in the 2000s. Many lenders stopped verifying income, payment history and credit scores. The 20 percent down standard disappeared. No money down loans rose up. “Piggyback mortgages” piled on a second mortgage. Not to mention “innovations” such as adjustable-rate mortgages. What followed? Rising home prices, housing overstock and booming defaults and foreclosures.

7 Automated underwriting: Loan demand became so great that bankers developed an automated underwriting system that emphasized speed and volume over accuracy and risk management. And the players all learned how to game the system. Real estate agents and mortgage brokers used corrupt appraisers to facilitate loan approval. Mortgage brokers learned how to tweak even the worst loan application to get it approved. Even bank loan officers circulated “unofficial” cheat memos on how to get lousy applications through the automated system.

8 Collateralized debt obligation (CDO): Here is an issue for those of you who believe markets are so efficient: CDO managers created trillions of dollars in mortgage-backed securities without really understanding what was going into these giant mortgage pools. The institutional investors — pensions, insurance firms, banks — who bought these appear to have failed to engage in effective due diligence. This teaches us just about everything we need to know about self-regulation of the financial industry. Indeed, given the outsize bonuses of bankers and the profit motive of banks themselves, financial self-regulation does not appear to be remotely possible.

9a. Glass Steagall: The Depression-era Glass Steagall legislation was effective in keeping Wall Street crises separate from Main Street. Think back to the 1987 crash — it had little impact on the broader banking industry. But the repeal of Glass Steagall in 1998 allowed FDIC-backed depository banks and Wall Street investment firms to become intertwined. It took less than 10 years for the entanglements to become extremely dangerous. By the time the 2008 credit crisis hit, the troubles on Wall Street were inseparable from Main Street. So banks and investment firms collapsed together.

9b State banking regulations: Many states had anti-predatory lending laws on their books. These prevented the making of loans or mortgages to borrowers who could not afford them. In 2005, these state laws were “federally preempted” by order of John Dugan, head of the Office of the Comptroller of the Currency. States with anti-predatory lending laws saw lower default and foreclosure levels than states that did not have them. Not surprisingly, after the preemption, default and foreclosure levels in those states rose.

10 Fannie and Freddie: In 2006, more than 84 percent of subprime mortgages were issued by private lending institutions not covered by government regulations, according to data from McClatchy. Indeed, before 2005, the government-backed private firms Fannie Mae and Freddie Mac were not allowed to buy nonconforming loans. But they were losing massive market share to Wall Street and, in response, petitioned their regulator for permission to buy alt A and subprime loans. Fannie and Freddie plunged headlong into the junk bond market just as the housing market peaked. But it was the profit motive and competition — not government policies — that led to this.

Where does this leave us? We have created an intensely concentrated financial industry, where a handful of banks control the majority of assets. Competition is less than it was before the crisis, and bank fees are creeping upwards.

While risk-taking remains rather subdued, history informs us it is likely to return as the crisis fades in the collective memory. The bailouts left us with a legacy of poor balance sheets and moral hazard. None of 10 factors discussed above have been, in any meaningful way, resolved.

[y66]

Bonus question:

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What should we have expected in terms of economic recovery?

Schularick and Taylor's answer:

Spoiler

The US and UK, 2007–12: actual versus predicted paths

Source: Fact-checking financial recessions: US-UK update via Krugman.

[mike777]

 y66, on 2012-October-24, 11:09, said:

Bonus question:


Schularick and Taylor's answer:

Spoiler

The US and UK, 2007–12: actual versus predicted paths

Source: Fact-checking financial recessions: US-UK update via Krugman.

from your same source came this:

"....Fact-checking financial recessions is a salient issue, especially in a US election year. On the one hand, the incumbent faces criticism that the recovery is slow. In August the Mitt Romney campaign invoked US history to argue that performance has been poor:

“The 2007-2009 financial crisis produced a severe recession ... But GDP growth has been anaemic since then, averaging just 2.2% per year since the trough. This pattern is unusual. The past ten recessions have been followed by faster recoveries,....."


What caught my eye was the claim that that the financial crisis produced a severe recession rather than the other way around. I dont know but I thought this question was still very much open to debate among economists?

[y66]

 mike777, on 2012-October-25, 13:39, said:

What caught my eye was the claim that that the financial crisis produced a severe recession rather than the other way around. I dont know but I thought this question was still very much open to debate among economists?

I'm not an economist. But I don't think the sequence part of the relationship between financial crises and recessions is open to debate. See this Wikipedia link for a chronology of U.S. recessions and their causes.

[mike777]

 y66, on 2012-October-26, 20:22, said:

I'm not an economist. But I don't think the sequence part of the relationship between financial crises and recessions is open to debate. See this Wikipedia link for a chronology of U.S. recessions and their causes.

I think it is open to debate

In fact I find your points for the most part worthless.

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In any point if you have proof...hard proof that is accepted ok what caused this recession ok....
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what gets me per many books...see silver for one..is how often proof real prev exp.... I mean real proof is not repeated in exper.......in fact it is not repeated....

[y66]

 mike777, on 2012-October-28, 03:59, said:

I think it is open to debate

In fact I find your points for the most part worthless.

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In any point if you have proof...hard proof that is accepted ok what caused this recession ok....
--


what gets me per many books...see silver for one..is how often proof real prev exp.... I mean real proof is not repeated in exper.......in fact it is not repeated....

You're right. Just because Wikipedia does not mention any instances of financial crises caused by recessions among the 14 U.S. recessions that have occurred since 1929 is not proof that it has not happened or that economists do not debate this. Sorry. I was not trying to sow confusion.

[Winstonm]

 mike777, on 2012-October-25, 13:39, said:

What caught my eye was the claim that that the financial crisis produced a severe recession rather than the other way around. I dont know but I thought this question was still very much open to debate among economists?

.
I don't think it is open to debate so much as closed to acknowledgement from idealogues who refuse to abandon beliefs.

[phil_20686]

 Winstonm, on 2012-October-28, 11:10, said:

.
I don't think it is open to debate so much as closed to acknowledgement from idealogues who refuse to abandon beliefs.

This is not fair. Its clear that long periods of below average NGDP growth will cause problems for any indebted player. Similarly, its hard to get into trouble regardless of the debt level if NGDP (=incomes) grow steadily. All financial crises are preceded by a sharp fall in NGDP, as an empirical fact. Then again, any financial crisis will result in a sharp fall in NGDP by elementary theoretical considerations. I don't think worrying about "causal" relation ships are that important. Since Fiscal/monetary policy can control NGDP, if you avoid falls in NGDP you can usually avoid financial crises.