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Slide 1: The Global Financial Crisis www.strategicfocus.com 3/16/2009 Jay Prakash jay@strategicfocus.com 408-568-3993 1
Slide 2: Table of Contents • • What is the crisis? Underpinnings of US Financial Crisis – A history of deregulation • • • • Financial deregulation of S&L’s in the Regan era, 1980’s Bank deregulation of 1994 Repeal of the Glass Stegal act in 1999, Clinton era SEC publishes Regulation ―B‖ in 2004 – – – – – Violation of Net Capital Rule Excessive leverage by Hedge Funds, Private Equity & Mortgage Companies Credit Default Swaps Failure to police sub-prime Packaging & selling of bonds backed by risky sub-prime loans • • Global Impact The changing nature of the Rescue Package – Key Issues that need to be addressed – Initial Package 3/16/2009 Current Package – 2
Slide 3: What is the crisis? Foreign Investors Large Money Flow Bank Failure US Banks Easy Credit Federal Reserve Low Interest Rates Consumer Borrowing Borrowing 3/16/2009 Negative Positive Consequences --Cars --Home --College --Small Businesses 3 --Entrepreneurs Consequences
Slide 4: What is the crisis? Negative Consequences • Over extended borrowers • Home foreclosures • Declining home values; home owners caught in a vicious cycle • Credit crunch for qualified borrowers including businesses • Bank & other financial institutions failure due to nonrepayment of loans • Loss of confidence • Declining demand for goods & services in US markets • Global Economies sliding into recession or reduced growth 3/16/2009 4
Slide 5: Underpinnings of the US Financial Crisis History of Deregulation • Financial de-regulation started with S&L’s in the Regan era in 1980’s • Many restrictions on the activities of S&L’s limiting to the home loan market were removed. • The result was an orgy of speculation, profiteering and outright plundering of assets, culminating in collapse. • This resulted in the biggest bailout in US history prior to the current bailout costing the Federal government more than $500 billion • Clearly the lessons from these lax regulations had not been learnt. 3/16/2009 5
Slide 6: Underpinnings of the US Financial Crisis History of Deregulation • Bank deregulation of 1994 • This allowed bank holding companies to operate in more than one state. • The result was a rash of merger & acquisitions of regional banks and an appetite for new markets & new sources of revenues. 3/16/2009 6
Slide 7: Underpinnings of the US Financial Crisis History of Deregulation • Repeal of the Glass Stegal act in 1999. • Under the Glass Stegal act, banks, brokerage and insurance companies were effectively barred from entering each other industries -investment banking and commercial banking were separated. • Act passed in 1933 in response to: – 5000 bank failures, – loss of $7 bil in depositors money, – 600,000 foreclosures from 1930-1932 --all due to manipulation of the market by giant banking houses. • Single most damaging and most consequential act of the Clinton years. 3/16/2009 7
Slide 8: Underpinnings of the US Financial Crisis History of Deregulation • Repeal of the Glass Stegal act in 1999. • Under the Glass Stegal act, banks, brokerage and insurance companies were effectively barred from entering each other industries -investment banking and commercial banking were separated. • Act passed in 1933 in response to: – 5000 bank failures, – loss of $7 bil in depositors money, – 600,000 foreclosures from 1930-1932 --all due to manipulation of the market by giant banking houses. • Single most damaging and most consequential act of the Clinton years. 3/16/2009 8
Slide 9: Underpinnings of the US Financial Crisis History of Deregulation • Clinton and the Republicans agreed to the deregulation of the US Financial system in October 1999. • Most sweeping banking deregulation bill in US history • Lifted all restraints on the operation of giant monopolies which dominate the financial system. • No restrictions on the integration of banking, insurance and stock trading imposed by the Glass Steagal act of 1933. • Huge wave of mergers, ex. Citibank buying Travelers Insurance creating one stop shop for Financial Services • Law was passed due to pressure from the banks which sought more profitable outlets for their capital especially in the stock market. • In 1990 JP Morgan was allowed to engage in stock market operations up to 10% of revenues. This was increased to 25% in 1994 and in 1999 it was abolished. 3/16/2009 9
Slide 10: Underpinnings of the US Financial Crisis History of Deregulation • SEC voted in June 2004 to publish Regulation B. • This allows banks to engage in certain Securities activities without first registering as brokers with the SEC. 3/16/2009 10
Slide 11: Underpinnings of the US Financial Crisis Violation of Net Capital Rule • • • • • SEC allows certain broker-dealer firms to legally violate existing net capital rules that limits debt-to-net capital ratio to 12 to 1 by providing them with exemptions. In 2004 the SEC granted an exemption to five firms—Goldman, Merrill, Lehman, Bear Stearns, and Morgan Stanley.—which allowed them to leverage up to 40 to1. Three of these firms have blown up. This reckless leverage has led to the current crisis. The so called Net Capital Rule was created in 1975 to oversee broker dealers that traded securities for customers as well as their own accounts. The rule requires that firms value all their tradeable assets at market prices, and then it applies a hair-cut to account for market risk. The hair cut is 15% for equities and 6% for Treasury securities because they are less risky. The net capital rule requires that they limit their debt to capital ratio to 12 to 1 and are forced to stop trading if they exceed it. 11 3/16/2009
Slide 12: Underpinnings of the US Financial Crisis Excessive Leverage by Hedge Funds, etc. • Failure to stop excess leverage. Excess speculation with borrowed money. • Typical leverage for a hedge fund and private equity is 30:1. • For sub-prime mortgage company the leverage is infinite because there is no capital. 3/16/2009 12
Slide 13: Underpinnings of the US Financial Crisis Credit Default Swaps (CDS) • CDS are credit derivatives of Mortgage backed securities. • CDS is a fancy name for insurance. It is not called insurance because regulatory laws require large capital reserves for losses. • CDS was sold as an insurance for mortgaged backed securities and were used to persuade investors to buy the securities in a declining market. • When the securities failed, the investors tried cash into the insurance and this made a run on the bank’s inadequate reserves resulting in a collapse of these investment firms. • CDS is the key reason for failure of AIG, Bear Stearns, Merrill Lynch, Lehman Brothers, etc. • Regulation of CDS was opposed by Clinton Treasury Secretary Robert Rubin & Greenspan in 1999 3/16/2009 13
Slide 14: Underpinnings of the US Financial Crisis Failure to police Sub-Prime • The core idea of bank regulation: – Is to examine the banks books; – Ensure that there are not too many loans behind in interest payments; and – Force the banks to raise more capital if needed to cover the losses. • Regulators basically waived the rule of adequate capital for the new wave of mortgage lenders who created subprime. • Many of the mortgage companies were not banks who made the loans only to sell them off to Wall Street. 3/16/2009 14
Slide 15: Underpinnings of the US Financial Crisis Packaging & Selling of Bonds backed by Sub-Prime Loans • Unregulated agencies such as Moody’s and S&P to rate these bonds. • In return for a hefty fee, these agencies helped manipulate the bond so it qualifies for a AAA rating. • Fannie Mae & Freddie Mac which purchased the loans from the banks financed its operations by selling such bonds. • By selling the loans to FM & FM, it freed the banks to issue even more sub-prime mortgages. 3/16/2009 15
Slide 16: Global Impact • Loss of confidence in inter-bank lending. • Severe credit crunch even for borrowers with good credit history • High interest rates. • Increased number of home foreclosures, reduced auto sales, reduced consumer spending • Declining home values • Emerging economies such as India & China hit with lower growth rates because of declining demand in the US markets 3/16/2009 16
Slide 17: Rescue Package Key Issues • Guaranteeing inter-bank lending • Guaranteeing mortgage backed loans by Fannie Mae & Freddie Mac • Delay home foreclosures; allowing refinance at lower fixed rates. • Increasing money supply • Increasing consumer & investor confidence 3/16/2009 17
Slide 18: Rescue Package Initial Package • $700 bil initial package from US Govt • Bail out large institutions such as AIG • Cleanup balance sheet of financial institutions by buying up bad debt ie mortgage based assets. • Objective was to free up the companies to make loans again. • It is too early to tell if this is working! 3/16/2009 18
Slide 19: Rescue Package Stimulus Package: $787 billion • Infrastructure - Rebuilding our highways, bridges, schools, etc. alongside creating more renewable energy (39% of total) • State Relief - Helping the states with unemployment benefits, budget shortfalls, medicaid, and the like (13% of total) • Struggling Citizens - Increase food stamps, unemployment insurance coverage, and provide insurance for the jobless (12% of total) • Tax Cuts - Tax cuts to individuals and business (36% of total) 3/16/2009 19
Slide 20: Rescue Package Stimulus Package: Detailed Breakdown • Construction projects: $90 billion. • Education: $142 billion. • Renewable energy: $54 billion. Double production of alternative energy in the next three years. • Medicaid: $87 billion. • Unemployment benefits: $43 billion. • Middle-class tax cut: $145 billion. • Tax cuts for companies suffering losses: $17 billion over 10 years. 3/16/2009 20