Crisis Economics Part 16

63 Financial innovation changed that: The account that follows draws heavily on Gillian Tett, Fool's Gold: How the Bold Dream of a Small Tribe at J. P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe (New York: Free Press, 2009), 51-56; Mark Zandi, Financial Shock: A 360 Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis (Upper Saddle River, N.J.: Financial Times Press, 2008), 111-19.

63 the Government National Mortgage a.s.sociation: Cameron L. Cowan, American Securitization Forum, statement before the both the Subcommittee on Housing and Community Opportunity and the Subcommittee on Financial Inst.i.tutions and Consumer Credit, Committee on Financial Services, U.S. House of Representatives, November 5, 2003.

65 pa.s.sed down the line like a hot potato: On the erosion of due diligence, see Amiyatosh K. Purnanandam, "Originate-to-Distribute Model and the Sub-Prime Mortgage Crisis," paper presented at the American Finance a.s.sociation Annual Meeting, September 18, 2009, Atlanta, Ga.

65 As securitization became increasingly commonplace: See, for example, Vinod Kothari, Securitization: The Financial Instrument of the Future (Hoboken, N.J.: John Wiley and Sons, 2006).

66 new, exotic, and complicated: Douglas J. Lucas, Laurie S. Goodman, and Frank J. Fabozzi, "Collateralized Debt Obligations and Credit Risk Transfer," Journal of Financial Transformation 20 (2007): 47-59.

66 an elegant solution: the CDO: Zandi, Financial Shock, 117-19. See also Janet Tavakoli, Collateralized Debt Obligations and Structured Finance: New Developments in Cash and Synthetic Securitization (Hoboken, N.J.: John Wiley and Sons, 2003).

68 Moral hazard played a significant role: See, for example, Kevin Dowd, "Moral Hazard and the Financial Crisis." Cato Journal 29 (2009): 141-66.

68 the way these firms provided compensation: Much of the discussion in this section is drawn from Gian Luca Clementi, Thomas F. Cooley, Matthew Richardson, and Ingo Walter, "Rethinking Compensation in Financial Firms," and Viral V. Acharya et al., "Corporate Governance in the Modern Financial Sector," both in Viral V. Archaya and Matthew Richardson, eds., Restoring Financial Stability: How to Repair a Failed System (Hoboken, N.J.: John Wiley and Sons, 2009).

68 a system of annual bonuses: Raghuram Rajan, "Bankers' Pay Is Deeply Flawed," Financial Times, January 8, 2008; Gian Luca Clementi and Thomas Cooley, "Executive Compensation: Facts," New York University, Stern School of Business, Working Paper, November 10, 2009, online at http://pages.stern.nyu.edu/~gclement/Papers/facts.pdf.

69 paid ever more staggering sums: Christine Harper, "Bonuses at Wall Street Big-Five Surge to $36 Billion," Bloomberg.com, November 6, 2006, online at http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=atEk12XYMerk.

72 as the career of Alan Greenspan amply suggests: Alan Greenspan, The Age of Turbulence: Adventures in a New World (New York: Penguin Press, 2007).

72 "In a crisis environment . . . we shouldn't . . .": Greenspan quoted in John M. Berry, "Black Monday for Greenspan: A Race to Forestall a Liquidity Crisis," Was.h.i.+ngton Post, October 19, 1997.

73 "take away the punch bowl . . .": Martin quoted in Kenneth T. Jackson, Karen Markoe, and Arnie Markoe, eds., The Scribner Encyclopedia of American Lives, vol. 5 (New York: Charles Scribner's Sons, 2002), 73 "irrational exuberance": Alan Greenspan, "The Challenge of Central Banking in a Democratic Society," Francis Boyer Lecture of the American Enterprise Inst.i.tute, December 5, 1996, online at http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm.

73 it created a Greenspan put: Miller, Weller, and Zhang, "Moral Hazard and the US Stock Market."

73 "For us to go in and audit . . .": Greenspan quoted in Greg Ip, "Did Greenspan Add to Subprime Woes?" Wall Street Journal, June 9, 2007; Edmund L. Andrews, "Fed Shrugged as Subprime Crisis Spread," New York Times, December 18, 2007.

74 "led to rapid growth in subprime . . .": Alan Greenspan, remarks to the Federal Reserve System's Fourth Annual Community Affairs Research Conference, Was.h.i.+ngton, D.C., April 8, 2005, online at http://www.federalreserve.gov/boarddocs/speeches/2005/20050408/default.htm.

74 The most notable casualty: James R. Barth, R. Dan Brumbaugh, Jr., and James A. Wilc.o.x. "Policy Watch: The Repeal of Gla.s.s-Steagall and the Advent of Broad Banking," Journal of Economic Perspectives 14, no. 2 (Spring 2000): 191-204; and Jill M. Hendrickson. "The Long and b.u.mpy Road to Gla.s.s-Steagall Reform: A Historical and Evolutionary a.n.a.lysis of Banking Legislation," American Journal of Economics and Sociology 60 (2001): 849-79.

75 "We've said these are the big guys": Quoted in Stephen Labaton, "Agency's '04 Rule Let Banks Pile Up New Debt," New York Times, October 2, 2008.

75 Community Reinvestment Act of 1977: See, for example, Peter J. Wallison, "Cause and Effect: Government Policies and the Financial Crisis," Critical Review 21 (2009): 365-76.

76 legislation pa.s.sed in the 1990s: Carol D. Leonnig, "How HUD Mortgage Policy Fed the Crisis," Was.h.i.+ngton Post, June 10, 2008.

77 "shadow banking system": Having coined the term at the Fed conference at Jackson Hole in 2007, McCulley elaborated on it in a newsletter for PIMCO. See Paul McCulley, "The Shadow Banking System and Hyman Minsky's Economic Journey," Global Central Bank Focus, PIMCO, May 2009. See also James Crotty, "Structural Causes of the Global Financial Crisis: A Critical a.s.sessment of the 'New Financial Architecture,' "Cambridge Journal of Economics 33 (2009): 563-80.

77 "You're thinking of this place . . .": It's a Wonderful Life, complete film script, online at http://www.imdb.com/scripts/It%27s-a-Wonderful-Life.html.

78 Federal Deposit Insurance Corporation: Federal Deposit Insurance Corporation, A Brief History of Deposit Insurance in the United States (Was.h.i.+ngton, D.C.: FDIC, 1998), 20-44.

79 3-6-3 rule: John R. Walter, "The 3-6-3 Rule: An Urban Myth?" Federal Reserve Bank of Richmond Economic Quarterly 92 (2006): 51-78.

79 Basel Committee: Basel Committee on Banking Supervision, "History of the Basel Committee and Its Members.h.i.+p," Bank for International Settlements, August 2009, online at http://www.bis.org/bcbs/history.pdf?noframes=1.

79 "Weaknesses in the banking system . . .": Basel Committee on Banking Supervision, "Core Principles for Effective Banking Supervision," September 1997, online at http://www.bis.org/publ/bcbs30a.pdf.

80 "whole alphabet soup . . .": Paul McCulley, "Teton Reflections," Global Central Bank Focus, PIMCO, August-September 2007.

81 "bond market conundrum": Alan Greenspan, testimony before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, February 16, 2005, online at http://www.federalreserve.gov/boarddocs/hh/2005/february/testimony.htm.

81 determined in global markets: See, for example, Tao Wu, "Globalization's Effects on Interest Rates and the Yield Curve," Economic Letter, Federal Reserve Bank of Dallas, September 2006, 1-8; online at http://www.dallasfed.org/research/eclett/2006/el0609.pdf.

82 Leverage has been on the increase: Minsky, Stabilizing an Unstable Economy, 265; Martin Wolf, "Seeds of Its Own Destruction," Financial Times, March 8, 2009; Susan Webber, "No Leverage," Conference Board Review, May-June 2009, 61-65.

83 Leverage comes in many flavors: See, for example, Charles R. Morris, The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash (New York: Public Affairs, 2008), 147-49; Katia D'Hulster, "The Leverage Ratio," World Bank Crisis Response Note no. 11, December 2009, online at http://rru.worldbank.org/doc.u.ments/CrisisResponse/Note11.pdf.

Chapter 4: Things Fall Apart.

86 "are imprudent in so carefully . . .": Bagehot, Lombard Street, 249-50.

87 "We are in a minefield . . .": Quoted in Ralph Atkins, Michael Mackenzie, and Paul J. Davies, "ECB Chief Fails to Rea.s.sure Markets," Financial Times, August 14, 2007.

87 "advance it most freely . . .": Bagehot, Lombard Street, 51-52.

88 "Ca.s.sandra-like warnings . . .": Minsky, Stabilizing an Unstable Economy, 237.

88 "fas.h.i.+onable printouts": Ibid.

88 "stock prices have reached . . .": Fisher quoted in "Fisher Sees Stocks Permanently High," New York Times, October 16, 1929; "Realtors Group Says Home Sales Will Slip in 2006," Wall Street Journal, December 13, 2005.

89 cracks appeared in the facade: This chapter draws heavily from Nouriel Roubini's blog postings, which are now available to subscribers at http://www.roubini.com. Also helpful in retelling this story have been Zandi, Financial Shock, and Tett, Fool's Gold.

90 Bernanke fell into this trap: Ben S. Bernanke, testimony before the Joint Economic Committee, U.S. Congress, March 28, 2007, online at http://www.federalreserve.gov/newsevents/testimony/bernanke20070328a.htm.

90 "visibility and transparency": Quoted in Grace Wong, "Behind Wall Street Subprime Fear Index," online at http://money.cnn.com/galleries/2007/news/0711/gallery.abx_index/index.html.

91 A sudden aversion to risk: Kindleberger, Manias, Panics, and Crashes,19-20; Justin Lahart, "In Time of Tumult, Obscure Economist Gains Currency," Wall Street Journal, August 18, 2007.

94 Frank H. Knight's now famous distinction: Frank H. Knight, Risk, Uncertainty, and Profit (Boston: Houghton Mifflin, 1921); Nouriel Roubini, "Current Market Turmoil: Non-Priceable Knightian 'Uncertainty' Rather Than Priceable Market 'Risk,' " August 15, 2007, available to subscribers at http://www.roubini.com.

95 "twenty-five standard deviation events": Peter Thal La.r.s.en, "Goldman Pays the Price for Being Big," Financial Times, August 13, 2007.

95 "every day, as a panic grows . . .": Bagehot, Lombard Street, 49.

96 On August 9 the European Central Bank: Jeremy W. Peters and Wayne Arnold, "U.S. Stocks Recover Some Ground after Global Sell-off," New York Times, August 10, 2007.

97 "We are certainly not going to protect . . .": Quoted in Tett, Fool's Gold, 187.

98 "Any aid to a present . . .": Bagehot, Lombard Street, 100-101.

99 "I'm at the age where . . .": E. Scott Reckard and Annette Haddad, "A Rush to Pull Out Cash," Los Angeles Times, August 17, 2007.

99 "I don't think the bank . . .": Julia Werdigier, "Official a.s.surances Fail to Stem Rush of Withdrawals at British Bank," New York Times, September 18, 2007.

100 "we have been pa.s.sing through. . .": Herbert Hoover, address to the Chamber of Commerce of the United States, May 1, 1930, online at http://www.presidency.ucsb.edu/ws/?pid=22185.

101 "The worst is likely to be . . .": Henry M. Paulson, Jr., remarks to the Was.h.i.+ngton Post 200 Lunch, Was.h.i.+ngton, D.C., May 16, 2008, online at http://www.ustreas.gov/press/releases/hp981.htm.

101 Many crises follow this pattern: H. M. Boot, The Commercial Crisis of 1847, Occasional Papers in Economic and Social History, no. 11 (Hull, U.K.: Hull University Press, 1984); R. Ray McCartney, The Crisis of 1873 (Minneapolis: Burgess, 1935); Kindleberger, World in Depression.

102 the LIBOR-OIS spread: Liz Capo McCormick, "Interest-Rate Contracts May Be Best Gauge of Fed Plan," Bloomberg.com, December 17, 2007, online at http://www.bloomberg.com/apps/news?pid=20601083&sid=aP.BgxqgrJjE.

102 "I'm optimistic . . .": George W. Bush, press conference, January 8, 2008, online at http://georgewbush-whitehouse.archives.gov/news/releases/2008/01/20080108-5.html.

104 banks found themselves stuck: Greg Morcroft, "Banks Have Sold Off About Half of Hung Loans," Market.w.a.tch.com, May 7, 2008, online at http://www.market.w.a.tch.com/story/correctbanks-have-sold-off-about-half-of-hung-loans.

109 a hero, the banker J. P. Morgan: Bruner and Carr, Panic of 1907.

110 Morgan had locked: Ibid., 121-25.

110 "Everybody is exposed": Paulson quoted in Deborah Solomon, Dennis K. Berman, Susanne Craig, and Carrick Mollenkamp, "Ultimatum by Paulson Sparked Frantic End," Wall Street Journal, September 15, 2008.

Chapter 5: Global Pandemics.

116 "The financial crisis is above all . . .": Noah Barkin, "U.S. Will Lose Financial Superpower Status," Reuters, September 25, 2008, online at http://www.reuters.com/article/idUSTRE48O2L020080925; "We Were All Staring into the Abyss," Der Spiegel, September 29, 2008, online at http://www.spiegel.de/international/business/0,1518,581201,00.html.

117 catch the proverbial cold: The academic literature on contagion has expanded to address the recent crisis. See, for example, Thijs Markwat, Erik Kole, and d.i.c.k van Dijk, "Contagion as a Domino Effect in Global Stock Markets," Journal of Banking and Finance 33 (2009): 1996-2012; and Philippe Jorion and Gaiyan Zhang, "Credit Contagion from Counterparty Risk," Journal of Finance 64 (2009): 2053-87. For historical parallels, see Graciela L. Kaminsky, Carmen M. Reinhart, and Carlos A. Vegh, "The Unholy Trinity of Financial Contagion," Journal of Economic Perspectives 17(2003): 51-74.

117 "It must be a very long time . . .": Times (London), June 3, 1837, quoted in Jessica Lepler, "The Pressure of 1836: Interpreting Atlantic Bank Wars," unpublished ms. in authors' possession.

118 collapse of some venerable firm: Robert Sobel, Panic on Wall Street: A History of America's Financial Disasters (New York: Collier, 1968), 154-96; Kindleberger, World in Depression, 144-47; Aurel Schubert, The Credit-Anstalt Crisis of 1931 (Cambridge, U.K.: Cambridge University Press, 1991).

118 "Lehman Shock": Daniel Gross, "The Lehman Shock," Newsweek, September 14, 2009.

120 "The whole world has become . . .": Quoted in Kindleberger, Manias, Panics, and Crashes, 133.

121 "There's all kinds of stuff . . .": John Greenwood, "Grain Piles up in Ports," Financial Post, October 8, 2008.

122 The collapse of global trade: Richard Baldwin and Daria Taglioni, "The Great Trade Collapse and Trade Imbalances," VoxEu.org, November 27, 2009, online at http://www.voxeu.com/index.php?q=node/4301; Li Yanping, "China Trade Surplus Plunges as Exports Fall by Record," Bloomberg.com, March 10, 2009, online at http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=a9Ih4pDxaIK4 ; Roslan Rahman, "East Asia: Exports in Decline," March 3, 2009, available to subscribers at http://www.stratfor.com.

122 "The Great Synchronization": Sonia Araujo and Joaquim Oliveira Martins, "The Great Synchronisation," online at http://www.voxeu.org/index.php?q=node/3751.

122 In some Central American countries: Dovelyn Agunias, "Remittance Trends in Central America," Migration Policy Inst.i.tute, April 2006, online at http://www.migrationinformation.org/USfocus/display.cfm?ID=393.

123 a range of commodity prices: Kindleberger, World in Depression, 71-87, 136-41.

123 commodity exporters: Clifford Krauss, "Commodity Prices Tumble," New York Times, October 13, 2008; "Fall Copper Prices Hurt Chile," December 10, 2008, online at http://www.forbes.com/2008/12/09/chile-copper-budget-cx_1210oxford.html.

124 seek safe havens: Robert N. McCauley and Patrick McGuire, "Dollar Appreciation in 2008: Safe Haven, Carry Trades, Dollar Shortage and Overhedging," BIS Quarterly Review, December 2009, 85-93, online at http://www.bis.org/publ/qtrpdf/r_qt0912i.pdf.

124 a pattern established by crises past: Much of this discussion derives from Kindleberger, Manias, Panics, and Crashes, 116-37.

125 "two nations . . . the most commercial . . .": Martin Van Buren, address to Special Session of Congress, September 4, 1837, online at http://www.presidency.ucsb.edu/ws/index.php?pid=67234.

125 "reckless extension . . .": John Crosby Brown, A Hundred Years of Merchant Banking: A History of Brown Brothers and Company (New York: n.p., 1909), 79.

126 "It looks like the biggest bubble . . .": "In Come the Waves," Economist, June 16, 2005.

127 leverage ratios: Daniel Gross and Stefano Micossi, "The Beginning of the End Game," VoxEu.org, September 20, 2008, online at http://www.voxeu.org/index.php?q=node/1669.

128 the European Central Bank raised estimates: Ralph Atkins, "ECB Raises Estimate on Bank Writedowns," Financial Times, December 18, 2009, online at http://www.ft.com/cms/s/0/31f38b8c-ebdd-11de-930c-00144feab49a.html.

128 In 2007 alone, 496.7 billion worth: European Securitisation Forum Data Report, Winter 2008, online at http://www.europeansecuritisation.com/Market_Standard/ESF%20Data%20Report%20Winter%202008.pdf.

128 "the markets have decided that . . .": Marc Champion, Joanna Slater, and Carrick Mollenkamp, "Banks Reel On Eastern Europe's Bad News," Wall Street Journal, February 18, 2009, online at http://online.wsj.com/article/SB123489966805902405.html.

129 similar crises emerge in different places: For work that complicates the usual contagion model, see Andrew K. Rose and Mark Spiegel, "Cross-Country Causes and Consequences of the 2008 Crisis: International Linkages and American Exposure," Centre for Economic Policy Research Discussion Paper no. 7466, online at http://www.cepr.org/pubs/dps/DP7466.asp.

129 India kept a tight lid: See, for example, Vikas Bajaj, "In India, Central Banker Played It Safe," New York Times, June 25, 2009.

130 In the crisis of 1825, British investors flooded: Carlos Marichal, A Century of Debt Crises in Latin America: From Independence to the Great Depression, 1820-1930 (Princeton, N.J.: Princeton University Press, 1989), 12-67.

130 "considerable panic": Frank Griffith Dawson, The First Latin American Debt Crisis: The City of London and the 1822-1825 Loan Bubble (New Haven, Conn.: Yale University Press, 1990), 125.

130 In the wake of the panic of 1837: Jessica Lepler, "The Pressure of 1836: Interpreting Atlantic Bank Wars." On the panic generally, see Peter Temin, The Jacksonian Economy (New York: W.W. Norton, 1969).

130 a similar flight took place in 1857: Mira Wilkins, The History of Foreign Investment in the United States to 1914 (Cambridge, Ma.s.s.: Harvard University Press, 1989), 90-140.

131 In the 1990s a new generation: Roubini and Setser, Bailouts or Bail-Ins?

133 the global economy contracted: Barry Eichengreen and Kevin H. O'Rourke, "A Tale of Two Depressions," VoxEU.org, September 1, 2009, and original column of April 6, 2009, both online at http://www.voxeu.org/index.php?q=node/3421.

133 "recoupled" with a vengeance: Michael P. Dooley and Michael M. Hutchison, "Transmission of the U.S. Subprime Crisis to Emerging Markets: Evidence on the Decoupling-Recoupling Hypothesis," National Bureau of Economic Research Working Paper no. 15120, June 2009.