[MUSIC] So we're now at the end of our course on the global financial crisis. What have we learned? First, Secretary Geithner talked to us about the lessons from history. The only reliable predictor of financial crises is an increase in leverage in the overall economy. Lots of other things seem to by signals, but one thing we know for sure is that in advance of every financial crisis, there is a large increase in leverage. When such leverage occurs, we are particularly vulnerable to a panic when this debt is short-term, called runnable. People can run very fast to try to get it out. It has been a long time since the last crisis. So there's some complacency. This time is different thinking. It is accompanied by a housing boom, which has been present in every major financial crisis in large industrialized economies since World War II. We turn next to understanding the demand side and supply side. The supply side coming from housing. That's where we supplied the raw material that could make up safe assets that were being demanded all around the world. From 2003 to 2007 there was a large increase in the demand for safe assets coming from many parts of the world. At the same time, the easy supply of safe assets from the debt of rich countries was shrinking or flat. In the United States, we were actually running some budget surpluses. And just supply of US government debt is actually shrinking at the same time that many many investors want to hold US government debt, or some substitute to it. To meet this increased demand, the financial sector responded by manufacturing safe assets through securitization and other financial innovations of the shadow banking sector. On the supply side for housing, what we've known for a long time, and banks have been doing it since we've had banks, is that the best way to manufacture safe assets is by using simple, easy to understand collateral. The housing boom and its role in the build-up to the crisis was strongly influenced by the belief on the part of many market participants that housing prices would continue to rise, which brings us to complacency. Financial panics are a bit like disease epidemics. They happen at surprisingly regular intervals, as shown in the graphic displayed by Secretary Giger. We need a new population of victims that have not previously been exposed to disease, in order to have an epidemic to happen. And we need a new population of investors, and savers, and consumers, who have not previously been exposed to a very deep financial panic, for them to believe that it could not happen again. To stretch another analogy, panics are also like forest fires. The longer it has been since we have had one, the bigger the fire will be when it actually comes. You've got a very long period of time, 75 years between the Great Depression and the global financial crisis. That was enough time for a fair amount of complacency to build up in a lot of quarters, thinking this was not the type of thing that would happen in a developed country, and for when it finally did happen, for the fire to burn very very hot. To understand global financial crisis, we really need to get inside the mechanics of what would happen when we have a panic happen in the shadow banking system or the parallel banking system, unlike the traditional bank runs of yesteryear. In the first anxiety phase of the crisis, there were problems in the subprime housing market that were known to market participants as early as 2005, but became apparent in market prices. Specifically an index that we've talked about. That was an index of credit default swabs in the subprime housing market in early 2007. These problems in the subprime market spread to interbank markets in August 2007. Beginning with events at the large French bank BNP Paribas on August 9th, when they admitted an inability to price some of the securities that were in the portfolios of funds that they manage. If BNP Paribas can't price them, then what hope does the rest of the market have? The first major bank run of the global financial crisis occurred in the United Kingdom at the large lender Northern Rock in September of 2007. Coincidentally, beginning just slightly earlier in August, the asset backed commercial paper market dried up worldwide, draining between 300 and 400 billion of unsecured funding from financial institutions. The anxiety phase continued through early 2008 with interbank markets remaining stressed through the first nine months including several notable events. The collapse of the somewhat obscure, but it turns out central, auction rates securities market in February. Evidence that market stress could affect securities such as student loans and municipal debt that had no direct relationship to subprime. The large investment bank Bear Stearns was rescued in March of 2008, leading to the first use of the Federal Reserve's emergency powers, which are also known as their 13(3), for the section of the Federal Reserve Act that they're listed emergency lending powers. In the United States, new regulatory powers over the government sponsored enterprises of Fannie Mae and Freddie Mac were given in July by Congress. And then the use of the new powers that were given, specifically conservatorship, bringing these two large agencies formally under the umbrella of the United States government, was announced on September 6th. The panic phase of the crisis can be dated to the famous weekend known sometimes as Lehman Weekend, which begins on Friday, September 12th. Over that weekend, several very large milestones happen. Bank of America buys Merrill Lynch, so there was some discussion over that weekend that Bank of America would buy Lehman Brothers. But instead they chose to buy Merrill Lynch, leaving Lehman Brothers without an obvious buyer. One potential buyer, which was Barclay's Bank, a very large United Kingdom lender, falls through over that weekend for a variety of reasons and then Lehman Brothers files for bankruptcy on September 15th. Following Lehman's filing for bankruptcy, a very large money market mutual fund that had invested in some of Lehman's debt, the Reserve Fund, breaks the buck. Meaning, they're no longer able to guarantee that they can pay 100 cents on the dollar back to their investors. That happens on September 16th. That same day, a large bailout, the first large bailout is announced for American International Group, an enormous insurer based in the United States with operations all over the world. From these different pieces, from these different events, it became clear that the markets were in full blown panic. And at this point, government agencies, which perhaps had been waiting, not sure if what they were seeing was something that was containable just with the tools they had available, clearly realized in the United States, in the United Kingdom, in the Euro Zone, in the Asian markets, that this was going to require a much more forceful response. Secretary Geithner took you through this response and explained some of the motivations that officials had in the United States for the actions that they took. These actions were unprecedented. Globally, countries used a combination of emergency lending programs, usually by their central banks, and then guarantees and capital injections by their fiscal authorities to fight the panic. By Columbus Day weekend, just shortly thereafter, the worst of the panic phase was over. But it would still be six more months until the release of stress tests on banks in the United States, before we could really look at interbank markets and say that the panic phase was finally over. On the lending side, in The United States the Federal Reserve took the lead on emergency lending programs, using its authority under section 13.3 of the Federal Reserve Act, that we have spoken about earlier in the course. TAF, TALF, CPFF, TSLF, many of which that use special purpose vehicles created so that the federal reserve could do lending to institutions expanded the Feds lending to cover virtually all of the shadow banking lending sector. On the guarantee side, in the United States, it was led by the FDIC, which has the authority to guarantee the liabilities of banks when there is systemic risk in the financial sector. The programs helped banks to borrow in debt markets, and provided unlimited insurance for non interest bearing transaction accounts. But countries need to be careful about guarantees. Ireland tried to guarantee a large portion of their banking system. And it lead ultimately to a sovereign debt crisis, because the banking system was simply too large for the government to be able to promise that they could actually bail out. This case we see attention. We need to have a forceful response. But in some cases, the government simply lacks the ultimate fire power to make that response credible. For capital, when banks are either insolvent, or where their depositors feel that they may be insolvent, ultimately you need to inject some capital into the banks. The government needs to make formal investments in order to restore solvency and the confidence of that solvency to the system. The United States passed a law authorizing TARP, the Troubled Asset Relief Program on September 30, 2008. But did not figure out exactly how to use it for another 11 days, eventually following the lead of the United Kingdom, and using direct capital injections into the banks, instead of buying troubled assets off of their balance sheets. At the same time in Europe, the global financial crisis really can be thought of as not being finished. The crisis exposed underlying economic problems in the Eurozone, exacerbated by policy mistakes and structural rigidity. Bailouts have been required in Greece, Ireland, Portugal, and Cyprus, and Spain and Italy still remain precarious. In the aftermath of the global financial crisis throughout the world, policy makers have created new authorities, and been given new responsibilities for the management of something called systemic risk, the risk of another catastrophic failure for the entire financial system. This authority did not exist, except in very few countries, prior to the global financial crisis. However the radical innovations that were necessary during the global financial crisis also created a backlash. So while some of the peace time outside of crisis powers to try to prevent another crisis have been increased, some of the war time powers, the things that were used to actually rescue the system during the crisis, have been curtailed. This means is that, in the next crisis, it may be a more difficult job that we have to rescue the financial system. We hope you've learned on this tour of the global financial crisis. It's crucial that citizens understand the causes and dynamics of this crisis, so that we can best avoid a future one. And if necessary, fight that crisis together and more effectively. Like similar events in the past, the consequences of this global financial crisis will likely echo for many generations. And it will not be possible to fully understand the world without recognizing those echos. [SOUND] [MUSIC]
