On Financial panics

Maniacs, crashes and panics

The Crash of 2008.
Kubik 11.2008; updated 11.2009

Recent history has witnessed unprecedented events in the housing and securities markets. Prices of homes and a
wide range of financial assets have declined dramatically and traditional policy tools have limited application to this
unusual environment, witness the reduced effect of discount rate changes amidst the general pessimism prevailing in
the business sector. Standard models are, of consequence, of limited use in explaining the character of these times.
We turn to two frameworks, game theory and the Minsky model of panics to help organize a discussion of these
events.

1. Game Theory.
Explaining movements in market values is typically undertaken by mainstream economic theory by relying on
traditional supply and demand analysis. The stock market, though, as with a number of similar institutions, is not
well suited to this pattern of presentation.

Why? First, the equilibrium approach of traditional supply and demand analysis implies that there will always be
but one solution to a given economic situation, e.g. one price, one quantity. Often times though there may be more
than one solution to a given situation. The stock market is famous for reacting in different ways at different points
in time to essentially the same piece of information.

Second, one of the implicit assumptions underlying supply and demand analysis is that individual preferences, and
hence individual consumer decisions, are independent of one another. But again, it may well be the case that in
some situations the actions of one party may shape the actions of another, e.g. if JetBlue prices its flight from
Chicago to NY at $99, it can expect a reaction from United, American and other relevant airlines. Decision-making
in equity markets would seem, to parallel this type of situation.

It may be, then, that explaining stock market activity is better expressed using the tools of a body of mathematics
known as game theory. Game theory will also allow us to shed some light on a difficult to conceptualize facet of
stock market history: the tendency of this market to overreact to individual pieces of information.

Game theory is a body of mathematics parallel to calculus, geometry or algebra.

Relatively new: derives initially from the work of two Princeton academics = Oskar Morgenstern and John von
Neumann and their work entitled The Theory of Games and Economic Behavior (1945).

Basic unit of analysis: the individual game.

A game can be said to exist when: (1) there are at least two participants to an activity; (2) no player can dominate the
outcome of the game; and (3) each of the players is assumed to act in their own best interests.

Applications to politics, e.g. Obama-McCain, military situations, e.g. U.S. and al Qaeda, and economics, e.g. Boeing
and Airbus, AA, UAL, Southwest, et.al.

In any game situation one must know at least the following:

1) the number of players;
2) their feasible strategies;
3) the possible combinations;
4) the results or payoffs;
and 5) the sequence of play, i.e. either simultaneous or sequential.
A stock market game with three players and two strategies. N.b. many ways to construct.

Assume that we know the following pieces of information: 1) if there are more buyers than sellers of a given stock,
its price rises. If there are more sellers than buyers, its price falls. 2) the income and reputations of stock market
advisors is positively related to the quality of the advice they give. [Construct matrix].

Note: (a) more than one outcome possible and (b) the actions of the parties involved are interrelated.

2. The Crash and the Minsky Model.

While the game theory presentation is useful in highlighting some aspects of stock market activity, the
panics that have developed throughout market history, including those of 1837, 1857, 1873, 1893, 1907, 1929 and
2008 are not normal events that are fully explained even by the preceding model. One model that seeks to explain
the course of events that develop in financial panics was developed by the Post-Keynesian economist Hyman
Minsky at Washington University in St. Louis. The Minsky model starts from the position that financial markets are
inherently unstable. It suggests that all panics are similar in that they follow a series of clearly identifiable stages.

Stage one: displacement.

A displacement is any exogenous shock or development outside the normal cause and effect of business
cycle movements. It is a development that is large enough to alter the economic outlook by changing profit
opportunities in at least one significant sector or industry. For example, an invention or innovation of a given
technology, the discovery of a new source of raw materials, e.g. California Gold Rush (1849) which ultimately led
to the Panic of 1857, or a political event such as regime change.

In 1929 one might argue that the following displacements occurred:

1. the technological changes of the 2d Industrial Revolution, which included the automobile and its
related industries, consumer durables (describe the electrification of the household, the radio) and talking pictures
(see The Jazz Singer with Al Jolson, released 1927).
2. the re-establishment of the gold standard in Britain (1925) and the settlement of the reparations
issue with the Dawes Plan (1924).

In 2008 one can identify at least the following displacements:

1. technological changes of the last decade in so-called brainpower

industries, e.g. computer hardware and software, telecommunications (cellular technology), biotechnology (GMOs)
and robotics (non-American significance).

2. We have been living through a period of significant deregulation of

economic activity, including financial activity. Many examples could be cited to evidence this situation, but one
prominent example came in 1999 with the Gramm-Leach-Bliley Financial Services Modernization Act. GLB
Financial Modernization Act formally repealed the Glass-Steagall Act of 1933 & 1935 which had been put in place
to address the causes of the Great Crash and Great Depression. It allowed insurance companies and securities firms
to buy banks and allowed banks to underwrite insurance and securities and to engage in real estate activities.

Stage two: boom

After the initial displacement an economic boom develops, i.e. a boom in the real economy. The demand for goods
and services and financial assets increases.

Over the years 1920-29, two short-lived contractions developed in 1923-24 and 1926-27. The second downturn
was driven to a considerable extent by a 6 month shutdown at Ford Motor as the corporation retooled its plants from
producing the Model T to the Model A so that Ford could compete more effectively against Chevrolet.

Historically, increases in demand eventually bring about price increases as existing capacity begins to be reached.
Price increases tend to brighten the profit outlook creating a positive feedback loop to the economic boom and
expectations.
Over the course of 1920-29 stock market values more than quadrupled and real GNP increased from $40.7 billion in
1921 to $60.7 billion in 1929 (1913 prices).

The recent boom developed primarily in securities and housing markets. In January 2000, for example, the median
price of new homes sold in the U.S. equaled $163,500. By April 2006 the same measure had risen to $257,000.
This was part of a longer boom in home prices. According to the index number tracked by the Office of Federal
Housing Enterprise Oversight, home prices rose every quarter between 1991 and 2007.3 (in comparison with the
same quarter a year before).

This boom, one can note, was not confined to the U.S. Home prices in the UK increased nearly 70 percent between
1998 and 2007.

While we are primarily concerned here with financial market activity one can note that a parallel boom in the real
economy was underway beginning in the fourth quarter of 2001. While an anemic expansion initially, the economy
continued to grow until the third quarter of 2008. A relatively long expansion, this was not a record, which had been
set by the previous expansion of the 1990s, which lasted roughly ten years and represents the longest sustained
peacetime expansion in U.S. history. The boom, one can note, was fueled in part by the relatively low interest rate
policy of the FRS. The Fed kept its target for the federal funds rate at a relatively low level for a sustained period of
time after the level of income began to expand at the end of 2001. The continuing high level of unemployment in
the U.S justified this policy position. In September 2001, at the conclusion of the period of contracting GDP the rate
of unemployment stood at 5.0 percent. By June of 2003 that rate had climbed to 6.3%.

Stage three: euphoria

After a period of time a period of euphoria may develop (n.b. will not develop in all business expansions).
By the term euphoria, Minsky is suggesting that an overestimation of profit opportunities develops, what used to be
called overtrading. Different assets can be the focus of speculation. In the 1630s, for example, tulip speculation in
Holland reached a fever pitch before the market collapsed. Land, stocks and other assets have been the target in
different asset bubbles.

The bubble or mania that develops typically brings in large segments of the population that are normally
aloof or not able to participate in such ventures. In a sense, euphoria can be supported by the herd mentality
described in the game-theoretic discussion above. Individuals increasingly came to rely, in other words, on the
judgment of others that home prices were only going to continue their climb.

It has been estimated that by 1929 more than one million new investors were participating in the stock
market in comparison with 1926. In this environment corporations find it easier to raise money capital through the
issue of stock (rather than borrowing from banks or the issue of bonds). In January 1925 the total number of shares
listed on the NYSE equaled 443.4 million. By October 1929 their absolute number had risen above one billion. It
should be pointed out that this process was also driven by the practice of splitting individual shares, e.g. a share of
Ford Motor Company stock valued by the market at $100 would be split into two shares worth $50 each. This
tended to give the appearance that individual stocks were more affordable and hence also served to bring new
entrants into the market.

Overestimation of returns in the housing industry during the period from the 1990s to 2006, which were driven in
part by relatively low interest rates in the first part of the economic expansion and the longer history of relatively
long periods of economic prosperity, e.g. expansion that began in 1983.1 lasted nearly eight years, setting a record
for peacetime expansions, then after a relatively brief downturn lasting about nine months, an even longer expansion
began in 1991 and lasted for roughly ten years.

Housing demand depends primarily on three factors: household income (which was rising from 2001.4 to
2008.2); interest rates (which were relatively low at the start of this period); and the expectation of future price
movements (the expectation of increasing home prices by itself tended to support further demand for homes and
upward pressure on price).
A new component in the housing market developed during this period: the extension of loans to less creditworthy
borrowers. Prior to 2004, most of the mortgage loans in the U.S were still provided to highly creditworthy ‘prime’
borrowers. They possessed relatively high credit scores and histories of repaying debt. Beginning in 2004 though,
loans came to be provided on an ever-increasing scale to subprime borrowers, formally, those with a FICO score (a
credit score named after the Fair Isaac Corporation that had developed it) of less than 620. Loans also came to be
provided to ALT-A borrowers, those with less than prime quality credit scores and with little or no documentation of
their income. From 2001-2003, 85 percent of “conforming” mortgage loans continued to be provided to prime
borrowers. In 2004, however, this percentage fell to 64 percent; in 2005 to 56 percent; and in 2006 to 52 percent.
The balance of loans—astoundingly nearly half—were being provided to subprime and Alt-A borrowers and in the
form of equity loans, i.e. loans against the equity/ownership share individuals had established in their homes. These
home equity loans helped fuel the increase in consumption spending and decline in the savings rate that was a
hallmark of the first decade of the 20th century.

The extension of lending to subprime borrowers was supported by the development of a new group of financial
innovations.

An aside on the process of financial innovation.

Financial innovation is the development and diffusion of new financial instruments and institutions,
including markets. It occurs as economic agents attempt to exploit profit opportunities in the financial sector. Profit
opportunities are created, or are revealed, for one of three reasons.

1. In response to a change in the underlying economic environment, e.g. late 1970s and early 1980s were
witness to a period of relatively high and volatile interest rates. Take the interest rate on 3-month Treasury bills to
illustrate this pattern. In the decade of the 1950s (1950-59) the interest rate of 3-month Tbills moved between 1 and
3 and one-half percent. In the 1970s in contrast the rate moved between 4 and 11 and a half percent. In the period
1980-89, the same rate fluctuated between 5 and 15 percent. These were relatively high rates in absolute terms.
One could also illustrate the increased volatility of the time. This development led to an increase in the uncertainty
financial institutions faced in predicting interest rate movements. This is particularly worrisome for depository
institutions like commercial banks that accept deposits and make loans. An increase in interest rates/the cost of
borrowing with an existing block of fixed interest rate loans would reduce commercial banks profits. This led to a
series of financial innovations, e.g. futures and option markets for financial instruments, variable rate loans and
interest swaps.

Note the role played by Federal Reserve System targeting procedures in the creation of this period of
relatively volatile interest rates [money supply and money demand framework].

The share of loans originating as adjustable-rate mortgages (ARMs) rose substantially during the 2000s. In
1999, 51% of sub prime loans and just 6% of Alt-A loans originated as ARMS. By 2006 these values had risen to
81 and 70 percent respectively, in a substantially enlarged market.

2. Financial innovation can also occur due to the development of a new technology. For example, advances
in computer and telecommunication technology helped bank create bank credit cards.

3. Financial innovation develops in response to government regulation, in both a negative and positive
sense.

In a negative sense, financial innovation occurs as economic agents attempt to circumvent restrictive
government regulation. Commercial banks in the United States, to take one example as illustration, are subject to
Federal Reserve (central bank) reserve requirements. These req’ts obligate banks to set aside a block of funds
against deposits. For example, if a bank with $100 million in deposits (a small mom and pop operation in a town of
perhaps 25,000 people) and the RRR is 4% against deposits, then $4 million must be held in the form of reserves.
Since these funds cannot be lent out, or used to generate an interest return, they serve to limit profits. In response
commercial banks developed the Eurodollar market.
 In a positive way, the development of new laws, e.g. the creation of private banking laws in formerly
planned economies, allow for the creation of new institutions and markets. Changes in government regulation can
also enable financial institutions to engage in profit making activities they previously had been restricted from
engaging in, e.g. Garn-St. Germain Act (1982) allowed savings and loan institutions to engage in non-mortgage
lending.

The process of financial innovation that helped fuel the asset bubble of the 2000s was focused primarily on
the process of securitization. Securitization involved transforming an illiquid asset into a liquid security. A bit of
history is in order here.

Home ownership in the United States has long been encouraged by a pair of government-sponsored
enterprises (GSEs): Fannie Mae and Freddie Mac. Fannie Mae was created in 1938, Freddie Mac in 1970. This
goal was accomplished effectively for decades through the buying of mortgage loans from depository institutions.
Initially confined to ‘prime’ borrowers who took out conforming loans, i.e. loans with a principal below a certain
level. These transaction served to increase the amount of funds available for lending—and to potentially lower
mortgage rates.

The system was conservatively run and worked effectively for more than four decades. The GSEs initially
raised capital by issuing their own bonds.

In June 1983, officials at Freddie Mac created a new instrument for raising capital: the mortgage-backed
security (MBS). This device bundles together a group of geographically-dispersed mortgages, selling them as a
package to private investors. Since their had never been a nation-wide collapse in home prices, geographic
dispersion seemed to guarantee the soundness of the enterprise.

Each mortgage-backed security is then divided into slices or tranches.

1. The highest quality or senior level (typically including 75 percent of the underlying
loans). The holders of this slice were paid first out of the proceeds of the underlying
mortgage payments, but also received the lowest yields.
2. The next level, the mezzanine or junior level paid next, with a higher return.
Included 22.5 percent of the total package; slightly lower quality, riskier mortgages.
3. The equity level comprised the remaining 2.5 percent. It was the last to be paid and
so defaults could occur within the block of mortgages bundled into the MBS, but as
long as these did not exceed 2.5 percent of the total the senior and mezzanine level
slices would not be affected. But any surplus funds would be paid to the holders of
the equity slice.

The creation of the MBS allowed Fannie Mae and Freddie Mac to greatly expand their operations. By 2008 these
GSEs held or guaranteed $5.4 trillion in mortgage debt. With the falling home values and rising default rates, these
institutions were nationalized in September 2008.

In the year 2000, MBS issued by FMae and FMac made up 78 percent of the total market. By 2006, however, their
share of an expanded market had fallen to just 44 percent. With the movement of private firms into the MBS market
came a relaxation of the standards that governed the types of loans included in an MBS. Private firms, led by an ill-
fated group, which included Bear Stearns, Lehmann Bros., Countrywide, Washington Mutual and Merrill Lynch,
began to bundle riskier mortgage loans into the MBS they offered.

These poorer quality loans, subprime loans and Alt-A loans, made up the geographically-dispersed underpinnings of
the MBS. Division into three slices: senior; mezzanine; and equity, along similar percentages as traditional MBSs.
While the market for housing boomed these securities offered attractive returns to all parties involved.

To this layer of instruments, another was added in the form of the collateralized debt obligation. These instruments
bundled together slices from disparate MBS, e.g. senior level slices of different MBS (some of which were
subprime) in conjunction with automobile loans, student loans and business loans. Again, these would be divided
into senior, mezzanine and equity level slices.
A parallel but separate financial innovation was developing at the same time: the credit default swap.
The idea of the credit default swap (CDS) came at a weekend junket held for a group of JPMorgan bankers in Boca
Raton, Florida in 1994. Assume that a financial institution, e.g. a commercial bank makes a mortgage loan to a
home buyer. The financial institution faces a number of risks, e.g. market risk due to a change in exchange rates or
rising interest rates which will drive up costs, and derivative markets exist to address these concerns, e.g. interest
rate swaps, but significant among them: default risk.

CDSs were created to address this problem. The CDS is a contractual agreement in which a third party to the loan
arrangement agrees to compensate the bank in the event of the reference entity, e.g. mortgage borrower, default, in
exchange for a stream of regular premium payments. [Diagram: boxes of three parties] As such, the CDS is similar
to an insurance policy for commercial banks—insurance market regulated, CDS totally unregulated. The reference
party, it can be noted, is not a party to the contract and the buyer or seller of protection need not obtain in consent of
the reference party to enter into a CDS.

Note: this is not a new problem. Default risk has existed as long as lending has existed.
Theoretically, four potential outcomes are possible given these arrangements: (1) no default; (2) CDS seller unable
to meet obligation, but no default by reference entity, therefore operationally equivalent to case #1; (3) default of
reference party and CDS seller meets obligation to cover default; finally, (4) double default—the damning
contemporary case.

After a few years CDS began to be used to shift the risk associated with mortgage loans off the balance sheets of
banks and other lenders. The timing of this innovation was associated with the relatively buoyant character of the
housing market in recent years and was made possible by advanced computer technology, which was able to handle
the calculation of risk and return associated with instruments. The market grew rapidly. CDSs came to be sold by
commercial banks, investment banks and hedge funds and were applied to loans to both firms and households and
bonds. From its effective start in 1997, the market grew to approximately $62 trillion by the end of 2007.

Insurers like AIG were soon not just issuing homeowners insurance, but insuring the mortgages on those same
houses. When it was bailed AIG held $440 billion in CDSs.

All financial instruments are bought and sold in either an over the counter market or at an organized exchange.
Exchange rules, e.g. NYSE, help regulate the character of securities traded in these markets. OTC transactions in
CDS are privately negotiated contracts between two parties are not regulated. CDS agreements do abide by standard
payment dates, i.e. March 20, June 20, September 20 and December 20. There is a commonly used agreement: the
International Swaps and Derivatives Association (ISDA) Master Agreement, but parties are free to deviate from this
standard contract. But no standard or required capital requirements for institutions issuing these instruments and no
standard way of placing a value on these contracts.

There is a reason that Warren Buffett called these instruments “financial weapons of mass destruction.” While a
complete evaluation of the role these instruments played in the collapse has yet to be finished, there are concerns
that CDS have reduced the incentive for lenders to analyze the creditworthiness of borrowers. It might also be the
case that lenders used CDS to move risk associated with highly risky assets, lemons, off their books and on to the
balance sheets of default insurance, e.g. to investment pools known as hedge funds. The role of the latter in the CDS
market grew from just 5 percent of the market in 2000 to 32 percent in 2006. Finally, it appears clear in retrospect
that the issuers of CDSs did not set aside the necessary capital needed to make good on these obligations. Part of the
explanation for why relates to the fact that it become typical to think of CDSs as similar to traditional insurance,
traditional insurance issued to cover events, e.g. automobile accident or home fire. If your neighbor gets into an
accident that does not mean you will. In the mortgage loan industry, in contrast, defaults can rise not because on
borrower is thrown out of work, but because a general slowdown develops which puts substantial numbers of
individual home buyers in the unemployment line.

Later anxiety in the markets driven in part by the uncertainty regarding CDSs and the novelty and complexity of
these instruments.
Stage four: peak 1929.
At some point, a point not seen by all, the market peaks. The peak period is created in part because a few
insiders decide to sell off their holdings and take their profits. This often goes unnoticed for the individuals/firms
withdrawing from the market are balanced/replaced by new “outside” recruits. Values tend to flatten out, however,
often times seen only in retrospect. A period of financial distress can follow in which investors more broadly begin
to contemplate the possibility that they will not be able to meet their obligations/liabilities. An external event, e.g.
the discovery of a fraud, or Presidential appeal for reason and calm, is uncovered.

During the Great Crash of 1929 the stock market peak was reached in September 1929. The daily peak was reached
September 19, 1929. After moving sideways for about two weeks, the downward slide began on October 3. The
sell-off began driving stock prices downward. Panic selling occurred on October 24 (Black Thursday), and after a
brief shoring up, then Black Tuesday October 29. Trading on the latter day set a record at 16.4 million shares
traded: a record that was to stand for 40 years.

The trigger for the 1929 Crash may have been the fraud and closure of the Hatry Empire in London. Clarence Hatry
was a British entrepreneur owned a series of companies which produced, among other things, cameras and
photographic equipment, slot machines and a set of small loan companies. Hatry had been attempting to use these
assets as a base for borrowing 8 million pounds in a bid to buy United Steel. When it was discovered that he had
used fraudulent collateral he was forced into bankruptcy. The Bank of England, which had been looking for an
excuse to do so, raised its rediscount rate from 5.5 to 6.5 percent. British funds began to leave New York and the
sell-off was on. The rush to liquidity became a stampede and prices tumbled as investors become willing to sell
their securities at any price.

The slide continues as banks cease to lend on the collateral of assets whose value is uncertain. The slide post-
October 1929 continued for nearly three years, into July 1932. Generally, the downward slide in prices continues
until the market is closed by officials or investors are induced to hold less liquid assets, e.g. through actions
undertaken by the central bank.

The Crash served, at a minimum, to turn business and household expectations about the future highly pessimistic,
which led to a reining in of spending, in conjunction with the wealth effect. So, while it did not initiate the Great
Depression, it helped to increase the severity of the downturn.

4. Peak 2008
It is difficult to date the peak of the market this close to the event itself. Insiders take the money and run.
Home prices had already started moving downwards in some parts of the country as early as 2006. A number of
significant institutions were closed in 2007. For the stock market, the date will likely be fixed at some point in the
late summer (July/August), beginning of September 2008. Let us focus on the events of the fall of 2008; these are
among the most dramatic.

5. Panic/rush to liquidity 2008.

At the end of August, 2008/beginning of September it became apparent that AIG was facing difficulty in
meeting its credit default swap obligations. It was not alone in this regard. Lehman Bros. held $700 billion in CDSs
prior to its closure. Since AIG is listed on the Dow Jones, the erosion in the value of its stock helped push down the
Dow directly, this served to add fuel to the panic. On September 14, 2008, AIG attempted to arrange a $40 billion
loan from the FRS. When the failure of that effort was announced the following day, the market went into freefall.
September 15th decline 504 points = the worst day since the instability surrounding 9/11.

One measure of stock market volatility is the number of days in which an index closes up or down at least 4
percent. There were none such days in the period 2003-2007. There were just three such days during the entire
decade of the 1950s and just two in the entire decade of the 1960s. In October 2008, there were nine days of excess
volatility. On two days that month the market moved more than 9 percent—once up and once down. That had
never been done before.

Volatility was not limited to the U.S. and not just the stock market. Equity markets in Russia, Britain, Japan, India
and Brazil exhibited even more volatility than the U.S. Russia led the way with 17 days of greater than 4 percent
movement.
Markets in the real economy also showed considerable instability. The price of petroleum per barrel, for example,
fell 33 percent from a July peak of $145 to just $54 per barrel (November 10, 2008).

Understanding these events will not be complete at the present point in time. There are pieces of the story
that we simply do not know yet. The role and extent of fraudulent activity in the crash has yet to be determined.
The consequences of government policy will take time to assess, e.g. bailing out AIG, but not Lehman Bros. and
increasing government ownership of commercial banks.

Timeline of the crash of 2008.

September 7 U.S. government bails out Fannie Mae and Freddie Mac, the nation’s two largest mortgage
finance companies. Each buys billions in mortgages from commercial lenders, then sells
a portion of them to investors as mortgage-backed securities, keeping the rest in their
own portfolio.

September 14 Lehman Brothers declares bankruptcy

Merrill Lynch is sold to Bank of America

September 15 DJIA plunges 504 = worst one day loss since 9/11.
AIG shares fell 60 percent as $40 billion loan request refused by FRS.

September 16 FRS loan rescues AIG ($85 billion)

September 17 DJIA falls 449. Largest one day gain in gold prices in ten years.

September 18 Treasury/FRS Bailout plan announced. Market rises 410.

September 21 Morgan Stanley and Goldman Sachs, the last big investment banks on Wall Street, would be
transformed into bank holding companies which are subject to far greater regulation

September 25 Washington Mutual (the nation’s largest S&L) seized, merger with JPMorgan Chase.

September 29 Bailout package fails to pass the House (228-205). Stock market panic ensues: DJIA plunges
778 points.

October 1 Senate approves bailout plan

October 3 House passes bailout package.

October 6 Dow finishes below 10,000 for the first time since 2004

October 7 FRS rate cut announced. Dow falls 508. Following day central banks coordinate actual rate
cut. FRS, ECB, Canada, Sweden and Switzerland involved.

October 10 Dow ends worst week on record. U.S. government to buy bank shares. Planned injection
$250 billion. Purchase of preferred stock (BoAM, Citigroup, JPMorgan Chase and Wells
Fargo $25 billion each; Goldman Sachs and Morgan Stanley $10 billion each).
Unlimited FDIC insurance to all accounts. Executive compensation limited at banks
receiving investments.
Stocks soar 11 percent.

October 15 Dow plunges 773 amidst fears re. economy,

October 28 Dow rises 889 (11%) after days of volatility.

October 29 FRS cuts fed funds target to 1 percent.

November 4 Barack Obama elected 44th President of the United States.

November 23 Treasury provides $20 billion to Citigroup in exchange for preferred stock. Partial guarantee
of $306 billion of mortgage-backed assets.

December 16 Federal funds rate slashed to 0-0.25 percent by FRS, the lowest in Fed history. Years closes
with 12 percent of Americans behind on their mortgage of in foreclosure.

February 17, 2009 $787 billion stimulus plan signed by President.

March 2 AIG announces losses of $61.7 billion = the highest quarterly losses of any company in U.S.
history.

March 16 AIG blocked from spending $165 million on executive bonuses—company received $165
billion in federal support.

April 30 Chrysler files for bankruptcy.

June 1 GM files for bankruptcy.

August 24 Cash for Clunkers

Present Bureau of Economic Analysis of the Department of Commerce announces positive 3.4
percent rate of GDP growth for third quarter 2009. Unemployment rate continues to
rise.

The response.

There are a number of pressing problems that require a response. One involves addressing the balance sheet
problems of the banking sector. Basic accounting identity: Assets = liabilities plus net worth. With loan defaults
and declining asset values, bank assets have fallen in value. Bankruptcy exists when liabilities exceed the value of
assets. This is a widespread condition throughout the banking sector. There were three primary alternatives
proposed to deal with this situation.

Alternatives:
1. creation of a “bad bank”;
2. nationalize all or part of the banking sector;
3. federal guarantee of toxic assets.

We can consider each of these in turn.

1. Bad Bank.
Under this option the federal government would create a “bad bank” that would take on the bad, or non-performing
assets of the banking system. Funding for such a bank would likely have to come from the federal government
itself. The bad bank would then hold these assets until they reach maturity. A sizable percentage of these assets
would be made up of the mortgage-backed securities we mentioned earlier. The problem with this solution lies in
part in valuing those bad assets. They have been sold at fire sale prices in the midst of the recent panic, which banks
claim under represent their actual value. Getting the prices wrong will tend to shift the burden onto the shoulders, or
into the pocketbooks of taxpayers or shareholders of the bank. Care must be taken in this instance since having the
bank itself share the burden of costs associated with this process reduces the problem of uncertainty for the
institution.

The implicit assumption of this approach is that the underlying financial institution can be a viable business in the
long-run, but are hampered by some short-run problem. Moving the bad assets off of the books of this institution
would allow them to begin operating normally again. Some question about systemic problems, i.e. would banks
suddenly start to lend in the midst of this downturn? It remains unlikely.

In the U.S. the first notable application of the good bank/bad bank model came with the New York Mellon Bank in
1988. Faced with a set of bad real estate loans, the bank split into two component parts: Mellon and Grant Street
Banks. The bad assets were moved to the
Grant Street institution. A similar set of actions was taken in the insurance industry by the U.S. firm CIGNA. A
successful application of the good bank/bad bank model developed in Sweden in the early 1990s amidst a similar
collapse in asset values. Two of the largest Swedish banks were taken over by the state and divided into good and
bad components. Some other Swedish banks stayed out of government hands but used the same good bank/bad
bank model. This effort, it can be noted, is much larger than could currently be handled by an existing institution.
Problems of hiring staff, allowing them to become familiar with the portfolio of the institution and the tendency for
mission creep arise.

2. Nationalization
A second option can be labeled nationalization. This label actually involves a number of different
strategies. At one extreme, the state could nationalize the entire banking system. The national government would
confiscate or purchase banks from their shareholders, compensating them accordingly. Although payments would
be made in market economies, not all nationalizations involve a payment to the owners of the institution, e.g. in
Cuba following the Communist take-over in 1959, the Communist regime took control of the American-owned oil
refineries, dispossessing Standard Oil and other companies of their ownership rights. This would appear to be an
unlikely scenario at the present point in time, in part, because although the current situation is serious, such an
extreme measure does not appear to be called for at this point.

Before this extreme is reached, the government can proceed to take-over any percentage of the banking industry.
Nationalization, in a technical sense, could mean the take-over of 50.1 percent of the industry, thereby becoming the
dominant owner in the industry.

Among the more widely discussed options available to the federal government would be to nationalize the weakest
banking firms in the country. This has been done in the past in the U.S. and elsewhere.

This approach would address the problems of banks taking on high-risk assets as they are waiting to be rescued; it
would potentially give the government more of a return on the upside and losses on the downside; and given the
government the ability to punish shareholders and managers of weak banks and allow the state to set compensation
levels for the near future. This may, however, lead more competent managers to move to other private sector jobs.
Fear of manipulation of lending to serve political ends. Finally there are portfolio effects to be considered, i.e. will
nationalization of some banks lead to a sell-off of bank stocks more generally and thereby reduce the value of well-
run bank stocks?

3. Federal guarantee.
The final option would be to create a federal guarantee for toxic, or bad assets within the banking industry.
This solution is distinct from the first alternative because the bank shareholders retain ownership of the bank and
bank managers continue to operate the institution, rather than the state. Part of the attractiveness of this alternative
lies in the familiarity of the bank’s staff with its existing assets and liabilities. It would take some amount of
calendar time for an outside authority to familiarize itself with the balance sheet of the bank.

While each of these different responses has been considered and a number of individual rescue attempts
have been mounted the significant economy-wide response to the problems of the financial sector came during the
Bush Administration. In October 2008 President Bush signed the Troubled Asset Relief Program into law. More
commonly known by its acronym, TARP, this program began as a $700 billion federal effort to directly buy bad
loans and debt from banks. A year later it has evolved into a dozen different programs, e.g. the Mortgage
Modification Program which is using $50 billion of the original TARP money to help struggling homeowners. It is
too early to assess the effectiveness of these efforts but an overall collapse of the banking system has to this point in
time been avoided. The initial claim that taxpayers would not lose any money on this arrangement was overly
optimistic.
 It should be made clear that there are no good solutions here. One is attempting instead to make the least
bad decision.

There are several competing explanations for the asset bubble and following crash. The foregoing discussion
attempts to suggest that the crash was a multi-faceted phenomenon, with multiple causes and multiple culprits.
While this debate will go on for a considerable period of time—economic historians continue to debate the cause of
the Great Depression—we should note that another prominent explanation suggests that the crash was due to a
failure of government policy (see Anna J. Schwartz).

It should be noted that fraud played a role in the events of the last decade.
It was not, however, a primary role. As one indicator, mortgage fraud cases rose from 3,500 in 2000 to 53,000 in
2007. This signal, however, was missed to a large extent by federal and state regulators.

Similarities and differences between 1929 and 2008.

Similarities:
1. 1929 Crash preceded by two mild downturns (1923-24 and 1926-27). 2008 Crash preceded by mild downturn
(just three quarters in length, 2001.1-2001.3). Longest sustained expansion in U.S. history in the 1990s.

2. Relatively unequal distribution of income. Explanation of Gini coefficient.

3. Absence of political leadership.

1929: Hoover, laissez-faire; balanced federal budget.
2008: Bush approval ratings/lame duck; Presidential election; lack of Congressional leadership = initial
failure of bailout package.

4. Period of financial innovation preceded both.

1929: Installment consumer credit and non-bank financing for stock market activity.
2008: mortgage-backed securities; collateralized debt obligations; and credit default swaps.

5. Stock ownership was not widespread. In 2004, for example, stock holdings of more than $5,000 were held
directly by just 13.5 percent of the population; indirectly (pension) by 31 percent, for a total of 34.9 percent of the
population. Wealth is even more unevenly distributed than income in the United States. Households with incomes
in excess of $250,000 include 2.5 percent of the population, but of these 94.6 percent own stock in some form and
hold 44 percent of all stock. The top one percent of income recipients received 16.9 percent of total income, but
own 42.2 percent of all non-financial assets.

Differences:
1. Size of government relative to GDP. Stabilizing force in 2008.
2. Knowledge of 1929/Japanese collapse possessed in 2008.
3. FDIC. Panic has not led to bank runs.
4. Active FRS and Treasury intervention. Early and often.

Conclusions.
1. Will financial panics be eliminated?
No, I do not think they will. Why? Because financial activity in the U.S. will and should still be largely
privately done. Financial innovation will continue its attempt to evade regulation in an effort to generate profits.
Regulation, regardless of how well improved, will always lag behind innovation. As a result, private decision-
making, despite its clear, numerous advantages, will give way to future panics.

2. Can policy be effective in influencing the course of events?

Yes, I would argue it can. New Deal experience led to the creation of the FDIC, which has served the
country well in this panic. 9,000 bank failures in Great Depression = substantially greater loss of assets for average
American than in 2008.
 Knowledge of the costs of not aggressive action visible in the Japanese collapse post-1989. In December 1989
the Nikkei Index (similar to the Dow Jones Industrial Average in the U.S.) stood at 38,916. By August 1992 the
Nikkei had fallen to 14,309—a larger fall that the 1929 Crash. In the decade that followed Japanese households lost
$14 trillion in asset holdings. In the 1990s Japan managed only a measly one percent annual growth rate in GDP.
At the same time, the U.S. was growing at over 3% per year.

There will certainly be an increase in government regulation of a number of markets—most pointedly given its role
in the panic: credit default swaps. In their absence, lenders will be more cautious about making loans, which will
impact even sound well-run institutions.

3. The period of difficulty is not yet complete.

Problems continue to mount in the commercial real estate market. Additional pressures may be placed on
the FDIC. Federal Deposit Insurance Corporation was created in 1933 in the wake of the Great Crash Depression.
It insures deposits at depository institutions, including both banks and saving and loan institutions up to $250,000.