USC Graduate Series Week 2 speaker: Naikaj P. Bhobe ! !Topic: Understanding the 2008 Financial Crisis!Date: 31 January 2014

�1UNDERSTANDING THE 2008 FINANCIAL CRISIS- NAIKAJ P. BHOBE

Understanding the Financial crisis- The greatest crisis since the great depression

Any capitalist economy is like a see-saw. It keeps moving on either side depending on the weights. In case of the US economy, these weights are real money and promises about money. They keep on changing thus constantly changing balance. This is called credit. To further elaborate this, let us consider the example of a house.

1. Houses are expensive. So, people promise a bank more money later to borrow a little money today. This promise (the document that writes this promise down is informally called IOU) specifically in relation to the housing market is called mortgage. Thus, people get the house today but the bank actually owns the house (this is called collateral). Every month they pay a little bit back. The bank actually makes a lot of money in the long run (principle +interest). Institutions having the money to lend are called depository banks and they need to maintain a huge balance in order to run.

Let’s consider another example of promises and money. Let’s talk about investing.

2. Businesses intend to make more money than they spend. But sometimes they need money to get started or to run. So they promise some of the excess money in the future to get starting money now. This promise they make is called security. Handling securities is a lot like handling money, so these banks are called investment banks.

So basically broadly speaking:

Until about 12 years ago, the rule set by the US government after the depression kept depository activities and investment activities separate. Then in 1999 the government eliminated some of these rules in what they called the financial services modernization act. (The Gramm leach bailey act superseded he glass Steagall act). Suddenly, modern financial companies could do both. And this mixing of activities was the main cause of this fiasco. For example: Groups of mortgages were bundled together and sold to investors. These mortgage backed securities looked safe. After all, don’t people always pay for their houses? Shortly after this, the federal government to prevent further damage from the dot com bust lowered the interest rate to help more people buy houses. In addition they also lowered the depository promise to help more people get started. Millions of people, who couldn’t have afforded houses before, suddenly could. It turned into a boom and lots of people wanted to buy faster than what could be built. So the price went up. People and more importantly economists forgot that up is always balanced by down. Many big financial companies started selling Mortgage backed securities (MBS). Since house prices were going up, investors thought they would return a lot of money. But, the thing depended on most home owners making their mortgage payments. After all, no loan repayment would mean no returns at all. Then the market reached its tipping point. Some people found loan repayment lot more expensive and some people who had promised mortgage payments couldn’t afford them. They basically had to jump of the end and the only option left was foreclosure. As this fire spread, house prices dropped and the boom disappeared. On the other end, the collateral houses weren’t worth as much as they were when the loans were made thus making them worth much less than the mortgage payments promised to the investors. Without these, the banks had to pay from their own pockets to the investors. They soon ran out of money and when a bank runs out of money, to meet its promises, it

�2UNDERSTANDING THE 2008 FINANCIAL CRISIS- NAIKAJ P. BHOBE

BANKS • Depository banks- Sell money for promises • Investment banks- Sell promises for money

has no option but to close down. And this is just what happened. A total of 15 American banks, 14 British banks and 16 other banks worldwide went bankrupt. The fall of several signature banks namely- AIG, Merrill Lynch, UBS, RBS, Wachovia, Lehmann Brothers, Citigroup, Fannie Mae, and Freddie Mac etc. led to a viral spread of public distrust making the situation even worse. The government then had to step in to take control of the situation and decided to pump in money either in the banks, help home owners or help investors. This lack of trust, liquidity has affected businesses, currencies, hospitals and everything. We changed the rules to modernize our financial system but in fact we made it worst.

�3UNDERSTANDING THE 2008 FINANCIAL CRISIS- NAIKAJ P. BHOBE