Capitalism in Crisis Midterm

Solvency

"Solvency is the ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business as it asserts a company's ability to continue operations into the foreseeable future. While a company also needs liquidity (Links to an external site.)Links to an external site. (the ability to meet short term financial obligations) to thrive, liquidity should not be confused with solvency. A company that is insolvent must often enter bankruptcy (Links to an external site.)Links to an external site.. Solvency directly relates to the ability of an individual or business to pay their long-term debts including any associated interest. To be considered solvent, the value of an entity's assets, whether in reference to a company or an individual, must be greater than the sum of its debt obligations." Solvency comes up numerous times throughout the assigned readings. In the crisis, the banking sector became insolvent amid declining asset prices and increasing haircuts (Gorton & Metric, 427-428 from reading section 2). Investment banks that funded themselves with short term money in the repo markets and held toxic MBS on their balance sheets were especially susceptible to becoming insolvent, and quickly. Neil Irwin discusses how Bear Stearns in March 2008 "had $398 billion in total assets on its books, but also owed $387 billion in debts. That meant it wouldn't take much of a dip in the value of mortgage securities for Bear Stearns to become insolvent" (87, from reading section 5, "The Alchemists").

Automatic Stabilizers

"economic policies and programs designed to offset fluctuations in a nation's economic activity without intervention by the government or policymakers on an individual basis" (Investopedia). programs already written into law that "kick in" to inject more money into the economy during periods of low aggregate demand and less money during periods of high aggregate demand. in an economic downturn, people apply for and receive more unemployment benefits than usual. This stimulates the economy without Congress having to pass a stimulus bill. Other examples of automatic stabilizers include taxes and other transfer programs such as SNAP. The Congressional Budget Office estimated that automatic stabilizers provided economic stimulus that amounted to more than $300 billion annually in 2009 through 2012.

Balance Sheet Recession

A balance sheet recession occurs when private sector actors with large debts focus on paying down their debts and saving money after an asset bubble bursts. This is different from an ordinary recession, since the private sector is not maximizing profits as they normally would in this situation. The deleveraging leads to a deflationary spiral, since aggregate demand stays low and investing stops, even when interest rates are at a minimum. The way to fix a balance sheet recession is consistent fiscal policy that does not pull back at the first signs of recovery.

Basel Committee and Basel III

A committee of banking supervisory authorities established in 1974 by the G-10 based in Basel, Switzerland. Now made of Central Bankers, Treasury officials and bank regulators from 27 major financial centers. The Committee meets on a regular basis to agree on guidelines and frameworks that are used by sovereign central banks in regulating their respective wholesale and retail banks. Under the Basel III agreement, first published in late fall 2009, Banks were required to make the several large changes in response to the crisis of 2007-08 particularly with regards to their capital requirements. Some of the key changes include, an increase in the capital requirements (more invested capital to absorb losses). Higher capital requirements in order to partake in counter party derivative trading and stress testing of their capital and liquidity in case money markets seize up. Banks were required to use simple leverage ratios of equity to assets without risk adjustment to ensure that any losses can be absorbed.

Haircut

A haircut is a premium that a lender deducts from the value of collateral in order to account for the risk of a fall in the collateral's value. Often used for banks' short-term funding. A bank lends out an asset in exchange for cash funding, promising to repurchase the asset at a later date. Asset serves as collateral in case the bank does not repay the counterparts who deducts a haircut from the amount of cash it extends to the bank. Provides the counterparty a financial cushion to protect against the risk that the collateral's value will decline. During the financial crisis, investment banks relied heavily on repo markets for short-term funding. Banks such as Lehman used short-term funds to purchase longer-term investments, profiting off of the spread between assets of shorter and longer-term maturity. With mortgage-backed securities (MBS) and other securitized products frequently used as collateral in such repo markets, investors began to demand larger haircuts as stress in MBS became increasingly evident. The result is that average repo haircut rates for securitized products skyrocketed from nearly 0% to about 45% between July 2007 and November 2008. By raising borrowing costs sufficiently banks had difficulty servicing their liabilities, the spike in haircuts was integral to bringing investments banks to (or over) the edge of bankruptcy during the crisis.

Repurchase agreement

A repurchase agreement, or Repo, has been in capital markets since the 1960's. It is a contract consisting of a two-part transaction intended to give access to short-term liquidity with minimal risk. In the first part, there is a transfer of securities and cash between two parties. The bank (one market participant) obtains the cash and the lender (the other market participant) obtains the bond. As for the second part, it is agreed upon that the bank can purchase the bond back at the original price, plus an additional interest. This purchase can literally be overnight. The agreement is arraigned in such a way as to avoid bankruptcy courts. The significance is that repos became an integrated and dependable part of the capital markets, booming to trillion of dollars under management.

Collateralised Debt Obligation (CDO)

A structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors. Example: In 2006, Paulson and Co selected 123 MBS they expected to fall and hired Goldman Sachs to create CDO for them. Goldman Sachs packages MBS into Abacus CDO, allowing Paulson to short them. Goldman Sachs then sold the CDO to its investors touting its stability, not revealing the fact that Paulson & Co was betting against it. In the 2008 crisis, packaging of CDOs made it possible for banks to recycle risky debt in bonds with AAA ratings. This process encourages the issuance of subprime mortgages. Because there are a large number of mortgage bonds packaged into these CDOs, the overall bond is considered a safer asset because cumulatively there is a reduced rate of default. As people starting defaulting on their mortgages at an unprecedented rate, the health of the mortgage bonds was shocked and the CDOs started to fail.

Subprime mortgage

A subprime mortgage is a type of mortgage that is normally issued by a lending institution to borrowers with low credit ratings. As a result of the borrower's lower credit rating, a conventional mortgage is not offered because the lender views the borrower as having a larger-than-average risk of defaulting on the loan. Lending institutions often charge interest on subprime mortgages at a rate that is higher than a conventional mortgage in order to compensate themselves for carrying more risk. However, during the United States housing bubble, loans like NINJA (no income, no job, no assets) were created. Large waves of foreclosures and defaults on subprime loans on housing occurred during the subprime mortgage crisis undermined the funding and the whole credibility system of the banking industry. Banks' greed towards capital draw a clear contrast with the market's and the society's truly incapable ability in governing the banking industry.

Balance of Financial Terror

A term coined by Larry Summers to describe the precarious stability of the US dollar. The US government can continue to not finance their own current account (trade) deficit due to China's highly concentrated proportion of external savings in US dollar-denominated bonds. As the US provides a stable store of value for China's savings, China must continue to ensure the US's current account deficit continues to be financed. Professor Tooze uses a cartoon of the US and China holding a gun at each others heads to describe the situation, particularly in Lectures 1 and 2 where we describe the panic on the dollar. Further reading on the subject may be found in the Section 1 reading packet, particularly the blog post by Brad Setzer, where he argues that the costs for maintaining the status quo balance are rising for China.

Twin Deficit

A twin deficit is a negative balance of trade with another country (importing more than we're exporting; sending capital out rather than goods) combined with an internal budget deficit. In the case of the United States in the lead-up to 2008, the twin deficit was created by a negative trade balance with China, and a growing internal budget deficit due to the Bush 43 tax cuts and the wars in Iraq and Afghanistan. Tax cuts would not create such a problem if spending was also reduced, however the wars meant spending was drastically increased.

AIG - American International Group

AIG is an insurance corporation that got caught up in the financial crisis and had to be bailed out. Before the crisis AIG realized that it could make a lot of money by insuring the CDOs through a CDS (Credit Default Swap). They believed that a CDO was never going to default and so they would not have to cover the losses. They essentially were taking the risk that the housing market was only going to go up. Therefore when other companies - like Goldman Sachs- were buying CDOs, they also got CDSs in order to maintain a certain level of balance, AIG was only being the one's to insure. They never had a way to counteract their losses. But, they were making so much money so they kept doing this. When the financial crisis hit, AIG suffered huge losses and were at risk of insolvency. Therefore, the government bailed them out. Why? Because AIG was considered too big to fail. They were invested in and insured by too many pension funds, hedge funds and banks to be allowed to fail. So many banks had their CDOs insured by AIG that those banks would lose millions causing even more problems.

Bretton-Woods System

After the 1944 Bretton-Woods agreement, US, Canada, Western Europe, Australia, and Japan comes together to agree to attach their currency to the gold-standard. US dollar is attached to the gold, while the rest of the world is attached to the dollar. They also agree to set up the IMF to bridge the temporary imbalance of payments between countries. Nixon took US off the gold-standard and Bretton-Woods in 1971 facing the Great Depression. It means that the global currency system which uses the dollar as the reserve currency suddenly becomes free-floating, creating problems of power balance in the Europe which eventually will lead to the establishment of EU. The strength of German currency, the instability of the exchange rate and the need to contain Germany led to the monetary unification in Europe and the birth of E.U.

SPVs

An SPV (Special Purpose Vehicle) or SIV (Structured Investment Vehicle)is a legal entity that allows a large institution, such as a commercial or investment bank, to hold some of its asset-backed securities (like mortgage-backed securities) off of its balance sheet. This is done by selling the asset-backed securities to the SPV. This entity is significant because it was widely used during the crisis by investment banks that held lots of loans off of their balance sheet, so they would not have to necessarily comply with the requirement of a certain amount of capital for a certain amount of ABS that they had. An SIV specifically is funded by issuing commercial paper, or short term debt, to pay for the long term debt that it purchased from the bank. This is done through repo or ABCP.

Ben Bernanke

Ben Bernanke Chairman of the Federal Reserve from 2006 to 2014. Oversaw fed response to crisis. Unorthodox measures: Fed lowered interest rate from 5.25% to 0% within a year, initiated Quantitative Easing (created 1.3 billion USD which was used to buy financial assets from banks and from the government) Criticized for bailing out Wall Street and injecting an additional $600 billion into the banking system to give slow recovery a boost. Controversy in regards to his and Paulson's involvement with the merger between Merrill Lynch and Bank of America as well as his bailout of AIG. Broadly - role in crisis relates to the moral hazard of bailing and extent of government involvement.

Liquidity crisis

Central to the financial crisis of 2007-2008, a liquidity crisis occurs when there is a lack of available cash on the market with which firms can service their debts. This became particularly important with the essentially industry-wide switch to short-term funding models, which financial institutions used to increase their leverage and thus their profits. Crucially, commercial banks began to adopt this strategy, which was previously used only by investment banks. By borrowing large amounts of the money needed to purchase, e.g., MBS, firms could show great returns from very little initial capital. The increasing sophistication of global finance made this possible, as banks no longer needed to rely on brick-and-mortar deposits and could instead borrow through repo agreements and the wholesale money market. This model only worked if the borrower could roll over the short-term loans to new ones once they were due. As long as there was adequate credit to be had, this model worked; however, starting with BNP's announcement in August 2007 that it did not know how much its MBS were worth (an unprecedented wave of defaults began in 2006, as homeowners who had taken out adjustable-rate mortgages found themselves unable to pay their new, higher rates, thus throwing the assumption of independent risk crucial to the subprime MBS experiment into serious doubt), the wholesale money market began to dry up. As more financial institutions engaging in this kind of short-term borrowing for long-term assets (maturity mismatch) in the MBS market began to show large losses (e.g., Bear Stearns, March 2008; Lehman Brothers, Sept. 2008), lenders were increasingly unwilling to extend them the short-term loans needed to continue operating, thus rendering them illiquid and exposed as not having the capital they needed to cover even minor losses. As the exposure to MBS losses was increasingly revealed to be nearly system-wide, short-term lending ground to a halt. This helps explain the severity and the systemic nature of the crisis, as it affected even those banks such as dear Northern Rock (Sept. 2007) which were not involved in the MBS business, but were using short-term funding. Additionally, the liquidity crisis extended to households, which could no longer finance consumption by borrowing (and were largely dedicated to deleveraging); thus, aggregate demand decreased and the US economy (and many of those abroad whose financial institutions were similarly exposed) entered a deflationary spiral (see Prof. Tooze's favorite visual in e.g., Lecture 7), in which decreased access to credit (and increased deleveraging) led to decreased spending, which led to decreased production, which led to increased unemployment, which leads to decreased spending, etc. The liquidity crisis required a massive Fed response -- it bought bad bank assets (TARP) to provide them with capital to absorb losses (and take the toxic assets off their books -- or out of their SPVs) and acted as lender of last resort -- providing liquidity banks needed for day-to-day operations, esp. payment of short-term loans -- to both US banks and foreign banks (the latter by reactivating currency swap lines to grant foreign banks with large dollar-denominated debt access to the dollars they so badly needed). As suggested by Koo (2011), monetary policy (money creation) was not enough in an environment where lending conditions were prohibitive; the government had to engage in expansionary fiscal policy to combat the crisis and the concomitant recession.

Christina Romer

Christina Romer is the former Chairwoman of the Council of Economic Advisors early in the administration of Barack Obama, and is currently a professor of economics at the University of California, Berkeley. A great deal of Romer's early academic work focused on the Great Depression, including macroeconomic volatility before and after World War II, the causes of the Depression, and the recovery process in the U.S. Romer has found that President Roosevelt's New Deal fiscal policy in the 1930s was not the key engine of recovery in the Depression, despite popular opinion. Since Roosevelt's fiscal expansion was small, it had only small effects on the state of the economy. Instead, monetary expansion in the form of quantitative easing conducted by the Treasury Department was crucial to the recovery. After Roosevelt devalued the dollar in terms of gold and Europe continued to destabilize on the path toward war, large quantities of gold flowed into the U.S. Treasury from abroad, allowing the Treasury to issue more notes, increasing the monetary supply. This broke the spiral of deflation, ushered in expectations of price stability, and brought down interests rates, benefiting consumer and firm behavior. Romer's deep body of work on the Great Depression prompted the Obama transition team to offer her the position of CEA Chair in November 2008. In late 2008, Romer, National Economic Council Chair Larry Summers, and Office of Management and Budget Director Peter Orszag presented President-elect Obama with a stimulus package that would address financial institutions, major automakers, and the foreclosure crisis. Ultimately, in mid-December 2008, Obama and his economic team settled on a proposed stimulus package of around $800 billion. What initially went undocumented however, was Romer's frustration at her inability to include an even larger stimulus option of $1.7 - to - $1.8 trillion in the final memo that the team presented to Obama. Though Summers agreed with Romer's conclusion that a larger stimulus package would only be beneficial in filling the output gap, he also knew that Congress would never pass a stimulus package north of $1 trillion and that such a proposal would only make the economists appear out of touch in the eyes of Obama and his top political advisors. In a purely political move, Summers blocked the inclusion of any proposal above $1 trillion, leading Obama to believe he was choosing the "larger" package of $800 billion (compared to the other basic choice of $600 billion), despite Romer's calculation that the final package should have been at least $1 trillion larger.

International Monetary Fund (IMF)

Created during the Bretton Woods conference in 1944, the IMF is an international organization dedicated to monitoring the global financial system, providing assistance to governments through loans, and developing new infrastructure for banking and governing. During the subprime mortgage crisis, Eastern European countries were subject to IMF assistance because of their inability to secure further lending. For whatever reason, no swap lines were extended to the Eastern European countries and they received no help from the EU nor the ECB. The IMF also provided over 110 billion euros in bailout money for Greece in 2010.

US Treasury Bills/Bonds

Debt obligations issued by the US treasury. US government uses the money raised from the sale of these to fund their spending. Safe asset as highly unlikely that the US government will default on their payment. In times of financial uncertainty investors flock to the US treasury as a safe harbor. China holds massive amounts of US treasuries. A major fear during the financial crisis was that they would sell off their dollars - instead they continued to buy them. The Federal Reserve is one of the main players in the US treasury market as they buy and sell bonds to control the money supply and interest rates of the US. This is a fundamental difference from the ECB, which cannot buy sovereign debt in the primary markets.

Larry Summers

Director of National Economic Council under Obama 09-10. Censored Romer's initial stimulus package recommendation of $1.8trillion

Marginal Propensity to Consume (MPC)

From Keynesian economics: predicts how much of disposable income will saved vs used for consumption. Can use to calculate money multiplier - explains effectiveness of stimulus on economic growth. Romer, the lone "liberal" on Obama's economic advisory team utilized MPC multipliers to argue that the Obama Administration's proposed stimulus package should be upwards of $1.7 trillion. Romer further argued that the most effective projects in the stimulus (the projects which had the larger MPC multipliers) were social programs and infrastructure spending. Romer's plea for a larger stimulus dismissed by Larry Summers, the head of the advisory team, because he believed that such a large stimulus would be 'dead on arrival' in Congress. For "bipartisan support", Summers decided to reduce the proposed stimulus to $825 billion, and proposed making the largest part of the stimulus tax cuts (despite their much lower multiplier) to attract Republican votes in the Senate. The second, is Sufi's argument that bailing out homeowners would have produced a much larger MPC than Obama's Treasury Secretary, Tim Geithner, had estimated in assessing the crisis. Sufi's calculations reveal that Geithner purposefully lowballed the economic effects of MPC, and that the bailing out homeowners would have been a much more significant boost to the economy than Geithner believed.

G20

G20, or literally, Group of Twenty, is a forum of leaders (usually finance ministers) from the world's most industrial and emerging economies. The first G20 meeting took place in the late 1990s in effort to manage the complex and emerging financial and social world. This G20 meeting followed the framework of the G8, a similar style forum that ended after the dissolution of the Soviet Union. The G20, as a response to WWII and Cold War politics, aimed to better manage and communicate the current global financial affairs while including the world's foremost economies. In the fall of 2008, following the September collapse of Lehman and the election of President-elect Obama, the G20 summit was redesigned and reinstated. By the spring of 2009, the first annual G20 took place in Washington, D.C. This meeting marketed itself as the new Bretton Woods given it provided a space for the world's Western leaders to communicate and argue for political and financial solutions. The 2009 G20 meeting focused on highlighting the emergence of Eastern economies, most notably China, and discussing how the economic growth in China would shift and influence the Western world. Since this inaugural G20 meeting, the forum has become annual. The presence of the G20 currently allows for economic/financial leaders to be in constant communication and discuss world issues before they become crises. The G20 website refers to its conferences as "shaping an interconnected world."

Government Sponsored Enterprises (GSEs)

GSE's were created during the New Deal as a form of Government housing subsidy meant to offer stable mortgage finance to a wider group. They are privately owned but backed by the US treasury: this allowed GSEs to buy risky mortgages but continue to sell safe debt. In order to spread out risk, GSEs pioneered securitization in the early 2000s, selling tranched and repackaged mortgages. This arguably opened the door to the housing crisis as private financial institutions not backed by the US government began mimicking these strategies. Key examples of GSEs are Fannie Mae and Freddie Mac.

Timothy Geithner

He served as the Secretary of the Treasury under President Barack Obama, and he was instrumental in the Bear Sterns/ AIG bailouts. In week 5 reading, Irwin notes that Geithner was one of a few men who decided to invoke the 13 (3) provision of the Federal Reserve Act to resolve the Bear Stearns crisis and to save it from bankruptcy (p.87). He further describes the choices that Geithner, Bernanke, and a few others had to make regarding saving other failing institutions and the political/ legal limits in each case. Although Geithner worked with Paulson to formulate a deal with AIG that saved it from bankruptcy, they could not realistically save Lehman. In terms of Lehman, we read that Geithner and Paulson were unable to save it from bankruptcy although they presented the institution's bankruptcy as a deliberate choice on their part. The way that crisis management was marketed to Americans (and the world) is crucial in understanding the political, social, and economic pressures and limitations that factored into the decisions of a few actors. Later on, Geithner presented policy recommendations to President-elect Obama to further stabilize the markets, which included "Decisively [stabilizing] core financial institutions to help create the conditions for recovery and growth" (Memo, pg. 35) as well as "[reinforcing] the stability of banks and systemically-significant through capital injections and decisively expand support for lending and credit markets..."(Memo, pg.36)

Fire Sale

Illiquid banks experiencing a credit crunch need to get new cash somehow--if all else fails, by selling their current assets. Money needed on a time-sensitive basis, so they sell assets quickly at lower prices. As a result, the market prices of similar assets are devalued, so banks have to sell more at lower prices to match the same capital needs. Situation snowballs from there. (Fire sales also happen when an insolvent bank goes down and its assets are split up and sold, like Lehman.) Happened in the housing securities market, leading to a fall in housing prices (the foreclosure externality), homeowner equity, and the underwater mortgages. to limit financial pandemic during the 2008 crisis, the Fed set up the Primary Dealer Credit Facility and the Term Securities Lending Facility, in order to provide firms with short term dollar funding during the credit crunch, allowing them to roll over that debt until market settled

Robert Rubin

Important to understand the old democratic party's view of fiscal responsibility. Rubin was President Clinton's "economic guru" who promoted fiscal discipline, trade liberalization, open markets and most importantly, a surplus in the government balance sheet. Young Obama gave a speech at the Brookings institute that touched upon the ideals of investing in people, and to keep deficits out of foreign markets, hitting Rubin's top priorities for approval. Rubin's view of economics would have led to the crisis the U.S. was anticipating -- the decline of the dollar and a bond sell off from the Chinese. He enumerated the "panic of debt" crisis, which never actually happened. But this line of thinking is influential in both the U.S. and Europe. The Germans adopt the same view of "fiscal responsibility' in dealing with the Euro Crisis (Lecture 15). Despite the debt crisis being the wrong crisis, it's important to know Rubin's influence in the democratic party and its economic thinking and why there was concern over a dollar crisis. As the actual financial crisis unfolded, Rubin was integrally tied to Citigroup which both received bail outs, and was the source of a lot of President Obama's economic advisers.

TARP (Plan B)

Initially, Hank Paulson's strategy to use the TARP funds was hugely ineffective from a leverage standpoint. Paulson wanted to buy a bank's troubled assets--but the more impactful move was to inject capital directly into a bank's balance sheet. Reducing the leverage of a bank is a ratio game; if a bank has $200bn in bad loans, and you want to reduce leverage from 20:1 to 10:1, you can buy $100bn in bad loans (making the leverage ratio 100:10) or inject $10bn in capital (making the ratio 200:20). The US government eventually opted for the more efficient plan of injecting capital into banks. This was seen as a controversial move because it gave the government a massive stake of ownership in the purportedly private banks; this issue was skirted by the government promising not to exercise their rights as shareholders.

Transfer Purchases

It is a form of governmental stimulus that provides wealth redistribution. This takes in the form of food stamps, social security, medicare, unemployment insurance, and medicaid. These programs target low income individuals because they have more propensity to spend. Also, some of these programs such as the unemployment insurance were to help individuals secure better jobs. Transfer payments are known as automatic stimulators, which were used to force an economic recovery by increasing consumption. The Obama administration desired to employ these methods because they would have stopped the decrease in consumption and help boost the economy. This is one form of fiscal stimulus, which governments employ.

Jean-Claude Trichet

Jean-Claude Trichet was a president of European Central Bank( ECB) from 2003-2011. During 2007/8 crisis he is known for working closely with Mervyn King of Bank of England and Ben Bernanke. He was a leading participants in the Dec 2007 was "Bank of Canada, Bank of England and European Central Bank, the FED and Swiss National Bank" swap currencies between each other. Therefore, ECB would take dollars in exchange for euros, and ECB would eventually lend dollars out to the banks in the Eurozone that were of a shortage of dollars. Then, two central banks would return each other money "He was determined to keep the ECB;s attempts to prop up the European banking system separate from monetary policies." ( page 88, reading 5 ) He saw rising inflation as a danger and greatest risk on the horizon, which he announced at the public press conference on June 8, where he said that there is "heightening alertness" of high-interest rates, which didn't commit to that decision but gave high after that that was likely to happen.

LIBOR

LIBOR stands for London InterBank Offered Rate, and is the benchmark rate for the exchange of currencies between Leading banks. 18 Banks release their rates daily, and from this a figure is generated. It acts as a global marker of the exchange rate, operating in five different currencies in seven maturities. Within the relevance of the course, the most important rate is the 3 month USD rate, since it allows for Cross Currency Basis Spread swaps, which shields against fluctuations in the Exchange rate since it is a guaranteed rate. This allows banks and governments to borrow in USD against their own currency to offset their dollar liabilities. LIBOR is also used as the rate for future contracts, mortgages, student loans, and even corporate funding since it is less fixed than the USD official rate. Essentially the rate shows the level of liquidity in the market, and reflects risk and tension in the international banking system. It's important in our studies because it was the benchmark for the European Banks, like Deutsche and UBS, for attaining Dollars to lever up and acquire dollar assets, since it is far easier for them to fund their dollar liability in Euro liability and therefore can, even when US entities are less willing to lend dollars, acquire the currency they need. Its unregulated nature is very much a product of the race to the bottom between New York and London following the end of the Bretton Woods system. They then use this LIBOR exchange to swap for ABCPs and Financial securities. The problem here is that most of the ARMs were indexed to LIBOR, and so when the market began to show stress, banks became far less willing to lend, and liquidity of dollars in the market crashed. In addition, since it was unregulated, there was no way to directly influence it. The US solution was to use swap lines to weaken the dollar, thus keeping LIBOR down, and therefore improving liquidity.

Macroprudential Regulation

Macroprudential Regulation is an approach to financial regulation which mitigates risk to the financial system as a whole. This is done by looking at the health of individual financial institutions and performing stress tests and other scenario analyses to determine the financial system's sensitivity to economic shocks. The phrase is significant because it blurs the distinction between macroeconomics, microeconomics of markets and regulation of individual businesses. An example of recent implementation of Macroprudential regulation can be seen with the Basel III Accords in response to deficiencies in financial regulation.

Swap Line

Two central banks agree to exchange currencies at a relatively low interest rate. Enables a central bank to obtain more liquidity from foreign currency. Necessary in helping financial markets stay stable during crises, allows central banks to remain liquid and gives them the capacity to lend to their private banks. Dec 2007-Fall of 2008 the US Federal Reserve opened swap lines with 14 foreign central banks. Hoped to successfully tackle global dollar scarcity/liquidity crisis. For US this is the largest example of sovereign last resort lending to the international financial system in history. Swap lines have recently been used in order to stop tension in the market from affecting the stability of the economy.

Interest on Reserves and Interest on Excessive Reserves

Prior to October 2008, the Fed did not pay interest on reserves. Congress authorized the payment of interest on reserves starting in October, 2011, but this was moved up due to the financial crisis. The purpose in October 2008 was to put a floor on the fed funds rate We see a porous floor in practice Initially, interest was just paid on excess reserves (IOER) - i.e., those reserves on deposit at the Fed in excess of what is required. Currently, interest is paid on all reserve holdings (IOR) Interest on reserves was 25 basis points when Fed Funds target range was 0 to 25 basis points. Interest on reserves is currently 50 basis points and the Fed Funds target range is 25 to 50 basis points. The bill was passed earlier than expected in order to begin the tightening process earlier Political issues

Stress Test

Proposed by Geithner, the stress test is a mechanism to evaluate the risks of banks in a simulated financial crisis. The Fed uses stress testing as a guideline for the injection of TARP fund into these banks. Most significantly, only 19 banks with assets totaling more than $100 billion are selected for the test and become target for TARP funds, implying that the Fed would take action to relieve these specific 19 banks. As a result, stress testing boosted the market's confidence in these banks as they received help from the American government. In its essence, the stress test runs a simulated crisis scenario less severe than the actual one, thereby injecting less capital for the banks. The banks would need to search for private funds to fill in the gaps.

Round Tripping

Round tripping describes the flow of funds between Europe and the United States in the lead up to the crisis. European banks would borrow from the wholesale money markets in the US to get dollar liquidity and then reinvest the money in the United States dollar-denominated assets, which often took the form of MBS and other real estate assets. Importantly, this exemplifies maturity transformation by banks and the consequent liquidity mismatch: short term funding from liabilities is used to purchase long term assets. As Tooze explains in the second reading packet, the largest inflow of funds in the United States came not from the Chinese trade surplus but rather the reinvestment by European borrowing. This comes back to haunt the Europeans as dollar scarcity erupts and home prices fall. Unable to pay back their short term funding, many banks nearly become insolvent. A major consequence is that the private debt is transformed into public debt as European governments are forced to provide guarantees to their toxic banks in order to quell the panic.

SRM - shared responsibility mortgage

SRM is a proposed solution (by Mian & Sufi) for the negative externalities of foreclosures and fire sales in housing crises. Since fire sales bring down the neighborhood's real estate value, homeowners are essentially losing money on their housing investment, thus by decreasing their asset values, more people in the neighborhood will be pushed into foreclosure. As a result, there will be more saving, less spending, and a decrease in aggregate demand, which will bring down the economy in a vicious cycle of market contraction. With SRM, the burden of foreclosure as a result of housing crashes like in 2007-2008 is not fully placed on the vulnerable homeowner, but also on the lender. Middle to lower class home owners' are less able to bear these losses since their wealth is heavily dependent on their house's value, especially when compared to financial investors, creating even greater financial inequality in society. The govt should push for these types of mortgages by securitizing them through Fannie Mae and Freddie Mac, because our mortgage model, especially in recessions, is bad for homeowners and the overall economy. Summers criticizes this argument by claiming that this policy could actually end up taking more money out of economy, since people who don't actually need relief could take advantage of this.

Securitization

Securitization is the process of taking a group illiquid assets and forming a security out of them. By placing non-AAA mortgages into SPVs (defined by Ruth above) and subsequently tranching them into slices of debt and pooling the high risk bonds, investment banks created AAA by minimizing the ability of all of them defaulting (or increasing the potential for one or more of them to pay out). A key reasoning is the independence of events when calculating these probabilities of defaulting, which ultimately did not end up being independent (refer to Fire Sale). This process of securitization was originally pioneered by the government, specifically through the GSEs Fannie Mae and Freddie Mac as a way to take the risk of lenders but keep it off the balance sheets. However, GSEs didn't cause the crisis but rather a more private form of securitization through Investment and Commercial banks.

FDIC

Stands for Federal Deposit Insurance Corporation. Provides deposit insurance to prevent bank runs by reassuring people that they'll always be able to get their money back. But FDIC support comes with premiums and restrictions, so investment banks and mortgage lenders didn't have it. (Because FDIC support lessens the risks they can take, and so lessens their potential profit.) In the crisis of 2008, the head of the FDIC, Sheila Bair, clashed with Geithner over the best way to deal with the crisis. Her priority was protecting taxpayer money, while his was ensuring that the banks didn't fail.

TARP- Troubled Asset Relief Program

Tarp is a collection of programs run and initiated by the US Treasury,under the Emergency Economic Stabilization Act, on 3rd October 2008. It's main aim was to prevent further foreclosure of important (financial) companies, resuscitate economic growth and help to fix the financial system by increasing liquidity in the secondary mortgage markets and buying illiquid assets (MBS) of companies in danger of failing. Initially it was authorised $700 billion to purchase these assets however this amount was reduced to $475 billion by the Dodd-Frank act. Companies who received help from TARP had to place some measure i.e. has to lose certain tax benefits,place limits of excessive compensations and cancel bonuses to their top 25 executives.Companies such as AIG, Chrysler, and GM Motors were heavily supported by this program.TARP was proposed to the congress by Paulson. At the first try, the Republicans opposed TARP, 2:1. This can be seen as a breaking point from which a division emerges in the Republican party as they more or less divided on the issue of TARP. In a way, TARP forces american banks to recapitalise (even the ones that did not need to be). The program reaffirms the importance of capital (by buying bad assets) and the US banks start rapidly raising equity. The European banks on the other hand, do not initiate in such a vigorous central bank induced liquidity solution and hence limp behind the American banks. (which adds to European crisis later)

Bucharest Summit

The 20th NATO summit was held in Bucharest from 2-4 April 2008. Among other issues discussed, such as commitment of NATO troops to Afghanistan and a NATO backing of a US Anti-Missile shield in Eastern Europe, was a proposal from the Bush administration to offer NATO membership to the state of Georgia. The summit was attended by Russian president Putin, who opposed this move and stated at the summit's conclusion that NATO membership for Ukraine would be a political affront to Russia. Ultimately, membership was not directly extended due to the influence of France and Germany who feared unnecessarily antagonizing the Russians, but pressure from the Bush administration extended the idea that Georgia could "earn" NATO membership by pursuing several criteria and going down a prescribed path of self-improvement. This dangling invitation is seen as one of the major reasons for the invasion of Georgia by Russia in August 2008, a war that was started under the pretense of disputed territory but was a political powerplay by the Russians. The dispute was ultimately mediated with the help of the French, but marked a significant increase in tension between the US and Russia which had economic ramifications, such as the Russian dumping of dollar-monetized assets in 2008-2009 and the lack of extension of any US swap line to the Russian economy (which would have been unthinkable by this point).

Basel Accords

The Basel accords were international global "rules" put into place in the 1980's. They come from the Basel Committee on Banking Supervision and are not in any way actually binding or backed up by regulatory force. Rather, they were guidelines to encourage the world's most advanced economies to have a more common standard by which to approach banking supervision. Basel II superseded Basel I and was the protocol in place at the time of the 2008 financial crisis. The guidelines of the Basel Accords were primarily concerned with what banks had to do to mitigate the risk of insolvency. This is where the guidance that banks should have 8% capital on a risk-weighted balance sheet, with high-risk assets disincentivized, in order to be in compliance with these standards. These standards played a big role in motivating banks to move things off of balance sheets in order to seem better leveraged than they actually were, and in motivating banks to purchase and retain more and more high-rated securities that would hardly count against them on their balance sheets such as the toxic mortgage backed securities, even though the ratings of these securities turned out to be inaccurate.

Dodd-Frank

The Dodd-Frank Wall Street Reform and Consumer Protection Act is a legislation passed by the Obama Administration in 2010 in response to the Financial Crisis of 2008. The aim of the legislation is to promote financial stability and protect American taxpayers and consumers by providing more rigorous supervisions on the US financial sector to improve its accountability and transparency. For example, the Act provides rigorous standards for regulating derivatives such as credit default swap. A key component of Dodd-Frank is the Volker Rule which prevents commercial banks from engaging in reckless speculative investments that are widely blamed for the financial crisis of 2008.

New Deal Federal Housing Administration

The Federal Housing Administration (FHA) is a US government agency "that offers mortgage insurance to lenders that are FHA-approved and meet specified qualifications," "established with the primary goal of stimulating the housing industry" (Investopedia). The FHA was created during the New Deal after the collapse of housing prices in 1929 and the epidemic of foreclosures. Various forms of New Deal innovation (Home Owners' Loan Corporation, FDIC) changed mortgages to become long term (20+ years), fully amortized, at fixed interest rates, low deposit, and easy to refinance. If interest rates went down, borrowers could refinance, while if interest rates increased, the fixed interest mortgages were worth less, hurting lenders; as a result, the FHA insurance was a way of safeguarding lenders. Fannie Mae was also created in this time to provide a secondary market for FHA-insured loans. The result was a drastic increase in housing ownership rates. The long-term implications of this New Deal legislation included the savings & loan crisis. This is because this legislation required economic conditions to be predictable to function effectively. Between 1945 and 1966, fixed-rate mortgages were typically between 5 and 6 percent, higher than yields on 3 month treasury bills; however, after the end of Bretton Woods, interest rates increased drastically, upending the American housing market.

The Great Moderation

The Great Moderation is the period of time from the mid-1980's to the crisis in 2007. During this period, the Fed was under the chairmanships of Volcker, Greenspan, and Bernanke. The era is characterized by macroeconomic stability. The stability was a result of changes in the structure of the economy, good luck, and good policy. The structure of the economy was changed first through the shift from a manufacturing based economy to a service based one, and also through deregulation, which allowed for smoother adjustments to shocks and improvements in technology also allowed for more accuracy in production thus reducing volatility in production. More open international trade has also contributed to the stabilization of the economy during they period. Although the period's stability was partially attributed to good luck, the shocks during the period were mostly minor in scale, it was much more significantly impacted by good monetary policy. After the very high (~12%) inflation rates in the 1970's, Volcker brought it down and refocused on price stability, beginning the Great Moderation. Some argue that the Great Recession ended the Great Moderation, but the stability now is comparable to that of the Great Moderation, leading others to believe that the Great Recession was an interruption in the Great Moderation.

Shadow Banking

The financial intermediaries involved in facilitating the creation of credit across the global financial system but whose members are not subject to regulatory oversight. Shadow banking can refer to not only institutional agents, like hedge funds, but also to any practices and products that allow investment banks to expand their leverage. Since the late 1990s an increasingly important part of this side of shadow banking has been the 'over-the-counter' credit derivatives market, notably collateralized debt obligations (CDOs) and credit default swaps (CDSs). Enabled banks to expand leverage beyond regulation standards. Subsequent to the financial crisis in 2008, the activities of the shadow banking system came under increasing scrutiny and regulations.

BERNANKE INFLUENCE

The significance of Bernanke's comments on Milton Friedman's birthday in 2002, rest on the iteration of Friedman and Schwartz's work on the Great Depression insomuch that they used history to address the causes and effects of the crisis. It was history that presented a means to identify the cause of such drastic economic symptoms. Bernanke states that "what I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful." He emphasizes the importance of avoiding crisis altogether. He ends his statement by saying "Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again." Bernanke was referring to deflation here. Friedman showed that a smaller money supply could action cause deflation and that deflation is ruinous to an economy. The extent of Bernanke's response to the 2008 crisis mirrors his response to Friedman, enforcing the position that there will be no deflation and that he will do whatever was required to prevent it. Bernanke turned to the banks' balance sheets and the currency swap lines to control the money supply. Two core policies resulted: i) forced recapitalization and ii) uncapped swap lines

Freshwater vs. Saltwater Economists

The term freshwater economists is associated with an approach of thinking about economics that was centered in the faculties of US universities such as the University of Chicago, Carnegie Mellon, Cornell, or Rochester. Its name stems from the fact that these universities are located near to the North American Great Lakes. Economists that belong to the freshwater school usually believe that the economy is always in equilibrium, which implies that there is no involuntary unemployment. They also believe that government spending to stabilize the economy over the business cycle is not effective. In fact, they argue that it has even detrimental effects because it crowds-out private investments and because people are rational and change their consumption plans as a reaction to a change in government spending, because they foresee that the debt the government has issued in order to pay for its additional spending has to be paid back in the future (an effect known as the Ricardian equivalence). Therefore, the multiplier of public spending is negative. Saltwater economists, on the other hand, are associated with an economic approach centered in the faculties of institutions near the east and west coast, namely Columbia, Yale, Harvard, Penn, Brown, and UC Berkeley. Freshwater economists reject the theory of rational expectations and do not believe that the economy is always in equilibrium. In their opinion, the economy is sometimes operating significantly below (and sometimes above) potential output. In their view, the government should actively intervene in the economy through changes in public spending in order to close the output gap. The multiplier of government spending is positive and thus, in their view, the government is able to successfully stabilize the economy over the business cycle.

Tri-party Repo

Tri-party repo is related to Lehman's illiquidity crisis, which was the fatal part of Lehman's financial vicious cycle. Repo is an effective short-term financing vehicles with securities as collateral. A tri-party repo consists security dealer, cash investor, and a clearing bank. Lehman's illiquidity issue was largely due to its possession of huge amount of repos, which were proven to be unreliable and enticed the cash investors to cut off the funding. Losses of repos were disastrous for Lehman and Bear Stearns. Lehman's loss of repos caused its loss of short-term funding and illiquidity issues. Lehman's illiquidity exacerbates during July and August of 2008; on September 12, Lehman had almost no cash and would go on default without question on Monday, September 15. And we know the rest part of the story.

Illiquidity

When the assets can't be sold or exchanged for cash without incurring a significant amount of loss. A fundamental problem during the financial crisis - banks held illiquid assets and securities with their mortgage bonds. As the assets underlying the securitized mortgage bonds were difficult to value, firms couldn't sell them at the rate that they were priced. Firms holding securitized mortgage bonds faced illiquidity problems as it made it difficult to raise cash to meet its debt obligations, which is called illiquidity.

Credit Default Swap

a financial swap agreement that the seller of the CDS will compensate the buyer (usually the creditor of the reference loan) in the event of a loan default (by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against some reference loan defaulting. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults. In the years leading up to the crisis insurance issuers such as AIG began selling credit default swaps on many of the mortgage backed securities that would ultimately play such a large role in the crisis. In September of 2008, as the MBS market continued to decline, investors recognized that as the MBSs failed, AIG would fail as well since it was insuring them, and began making collateral calls. In the wake of these events, AIG would ultimately need to be one of the institutions bailed out by the federal government.

Postponeable

a purchase or investment that isn't necessarily time-imperative for a private individual or entity to make. Usually this takes the form of various consumer goods (automobiles, furniture, technology upgrades) or investment opportunities unneeded for subsistence. In the wake of the economic crisis, consumers, firms, and investors across the globe held off on postponable finances until they felt that the markets had stabilized. This 'holding back' on purchases during the banking crisis created to a trade crisis. Suddenly, demand for many goods and services across the world dropped (as did the demand for all of the intermediate parts, components, and raw materials needed to create these goods). In addition to the global manufacturing/trade network being disrupted - so did the global tourism industry. People were postponing their vacations and leisure travel until they had a better idea where their finances would be in the next year. This is an example of how globalization of trade can contribute the synchronization of economic crisis across different locations. The abstain from Postponeables also is an example of the global "fear factor" that affected financial institutions and private individuals - leading them to act irrationally and further entrench the world in crisis.

The American Recovery and Reinvestment Act

a stimulus bill passed by Congress in the aftermath of the Great Recession by the Obama Administration in 2009. While it was part of a bipartisan effort on behalf of the Obama Administration, it only earned the votes of three Republicans in the Senate. It was the first priority of the Obama Administration and promised approximately 787$ billion in stimulus (Romer 2009) amidst a contentious debate among Obama's economic team (comprised of Larry Summers who led the National Economic Council, Peter Orstag who was the Budget Director, and Timothy Geithner of Treasury). While Romer had advocated for a larger package, Summers warned that it would come at too much of a political cost (Lecture #12 10/16/17). The package included tax relief, aid for states, investment for infrastructure and green science (Plotz 2012), healthcare expansion, unemployment protections, and education. It is a classic example of Keynesian economics fiscal expansion. As government spending increases, consumption increases, which has an underlying multiplier effect on the growth of the economy. While many on the left of the political spectrum wanted it to be bigger (Romer wanted it to be 1.8 trillion), the stimulus has the effect of mobilizing the right wing of the Republican Party (so called Tea Party) in reaction to "big government." The stimulus is largely considered a reason for the subsequent tempering of the recession.

Underwater/ Upside down mortgage

amount owed on a property is more than the property is worth. If the owner cannot wait to sell the property when the market improves, this can result on a decision to default on the loan. During the financial crisis, many homeowners' mortgage(s) went underwater. Thus, some who could afford their payments chose to instead default (as this is the better economic decision), as they owed more than what the home was worth.

ASSET-BACKED COMMERCIAL PAPER (ABCP)

debt issued by banks used to finance further off-balance sheet lending for mortgage and MBS purposes. The issuance of ABCP allows banks to further lever themselves while remaining compliant with pre-Dodd-Frank capital requirements as they are issued technically off balance sheets by a SIV. ABCP was then bought by many of the same institutions that invested in risky MBS's further compounding the severity of the mortgage crisis in the financial sector in the United States. In addition, the ABCP proved to be integral to evading capital requirements for banks to be legally allowed to lever themselves to amounts where if they only incurred 1-2% losses they would not have enough capital to absorb said losses. Thus, ABCP was a product of financial engineering used to increase returns via leverage but also resulted in greater losses when mortgages began to default as the ABCP was used to create untenable leverage responsible for taking down many banking institutions.

Moral Hazard

occurs when there is a lack of motivation to guard against risk because one is protected from future consequences. It is essentially a "subsidy for risky behavior" or, as The Wall Street Journal once put it, "the distortions introduced by the prospect of not having to pay for your sins." Insurance is often cited as the most common instance of moral hazard because someone might engage in a dangerous activity knowing that their costs will be covered. This is an argument often used to counter proposals of a stimulus or bailout. Most prominently, "Moral Hazard" has come up twice in our readings, once in relation to Lehman Brothers and once in relation to the Eurozone crisis. Certain economists, particularly Reinhart, believed that bailing out Lehman would discourage other financial institutions from restructuring, since they expected to be bailed out as well. In this manner, the bailout would encourage risky behavior rather than stabilize the markets. Similarly, Germany was hesitant to bailout PIIG nations for fear that it would send a signal that the EU condoned fiscal irresponsibility.

Senior-subordinate structure

refers to tranched debt structures after they have been divided, with certain slices of debt holding claims to the underlying cash flows that legally come prior to other slices. Because different cash flows on the same debt asset have differing likelihoods of being paid (the first $100 is more likely than the last $100), the practice of dividing debt into senior and subordinate claims to these cash flows allows for the construction of AAA assets from what otherwise would have been considered a junk loan. To create good assets by tranching you also necessarily create bad assets from what's left over--people buy those worse assets for the promise of a higher interest rate to compensate them for their risk. In the financial crisis large institutions held lots of these assets in SPVs because they were deemed to be relatively safe. Mortgage foreclosures made the assets with weak claims to the mortgage cash flows close to worthless, driving down the collateral value institutions could use in overnight repo markets to obtain funding, and creating risk of default because of maturity mismatch.

European Monetary Fund

this concept, never undertaken seriously during the Eurozone crisis, refers to the institution of a collective European bank for the management of financial crises and balance of payments issues. Wolfgang Schäuble, the German finance minister from 2009 through October 24, 2017 (yesterday), was a devout supporter of the idea, which he saw as a means of building European institutions and paving the way for future European federalization. Schäuble remains a proponent of the EMF through the present day, seeking to confer the fund with powers to superintend European national budgets, a power currently residing with the European Commission per the European Fiscal Compact's controls on allowable budget deficits. However, his approach was rejected in 2009 by Angela Merkel, who preferred to globalize the European problem and use the IMF itself as a means of instituting fiscal discipline in the Greek economy. While the Obama administration would have supported the EMF idea during the crisis as a constructive solution in the interests of the Greek population, Merkel's intransigence and insistence on the IMF permanently eroded American trust in the European capacity to deal with the crisis. In the long-term, the European Monetary Fund idea is symbolic of the divides between northern and southern plus peripheral Europe which we have explored in the course. To the extent that northern European countries are interested in the EMF, it is because it could prove a valuable tool for sustaining fiscal discipline in neighbors they view as habitually profligate borrowers. Southern European states like Spain and Italy, with French support, would prefer to cooperate on funding an EMF which could supply more lenient crisis support than the IMF. Additionally, an EMF would have the advantage of circumventing the damaging stigma of IMF loans. As Professor Tooze referenced in lecture, Sarkozy said that the IMF was for African states like Burkina Faso, and this sort of perception made it all the more difficult for the Greeks to acquire the record 250 billion euro IMF loan they ultimately were granted.