The Great Depression_assignment # 1

7/30/2019 The Great Depression_assignment # 1

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The Great Depression

Overview

Few periods in history compare to the Great Depression. Stock market crashes, bread

lines, bank runs, and wild currency speculation were worldwide phenomena--all

occurring with war looming in the background. Great Depression was by far the worst

economic catastrophe of the 20th century and, perhaps, the worst in our nations history.

Between 1929 and 1933, the quantity of goods and services produced in the United

States fell by one-third, the unemployment rate soared to 25 percent of the labor force,

the stock market lost 80 percent of its value and some 7,000 banks failed. At the store,

the price of chicken fell from 38 cents a pound to 12 cents, the price of eggs droppedfrom 50 cents a dozen to just over 13 cents, and the price of gasoline fell from 10 cents

a gallon to less than a nickel. Still, many families went hungry, and few could afford to

own a car.

The Great Depression.

The Great Depression was a period of global economic disaster that lasted from the

early 1930's until the early 1940's. Caused by a combination of factors - including a

comedown from the 1920's era of speculative success - the Great Depression caused

misery in many countries. In the US, which is widely regarded by many historians as

having been at the root of the crisis, thousands of people lost their homes and millions

found their spending power dramatically reduced. The crisis would last until World War

II, and is now regarded by many analysts as the benchmark for economic disasters. The

recent global credit crunch, for example, is often compared to the Great Depression as

a measure of its severity. This indicates the degree to which the Great Depression was

a cultural as well as an economic phenomenon.

During the Depression, US real GDP fell from around $1,000bn in 1930 to less than

750bn in 1933, a catastrophic drop of more than 25%. Meanwhile the unemploymentrate rocketed from just under 5% in 1929 to more than 20% in 1933 (Ahamed, 2010). In

both cases, these economic indicators only tell part of the story. By far the worst hit

parts of the US, for example, were the agricultural heartlands and the cities. In the

agricultural belts, families lost their farms as banks foreclosed on rents, while house

loan foreclosures also left thousands homeless in the country's major cities.

International trade fell by around 50%, and protectionist tariffs imposed by the


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administration of President Hoover failed to deliver any benefit and - in some historians'

estimations - actually made things considerably worse.

The US was far from the only country to be devastated by the Depression. In Germany,

the economy was hit hard by the cessation of American loans, which had previously

been helping to rebuild the German economy after World War 1. The economic decline

that followed led to the rise of the National Socialist Party under Adolf Hitler and

consequently, it could be argued, to the rise of Nazism and the outbreak of World War

2. Russia, isolated from the capitalist world economy thanks to the Marxism of their

leader Joseph Stalin did not suffer unduly, and was briefly regarded by some US

economists as a model for recovery. In the UK, the brunt of the economic disaster was

felt in the industrial north.

Wall Street Crash of 1929 - Black Tuesday

The Great Depression was a global event but, like the recent economic crisis, itoriginated for the most part in the US. Many historians regard the Wall Street Crash of

1929 (aka Black Tuesday) as marking the start of the Great Depression. The Crash

followed a massive speculative boom (not unlike the tech and dotcom bubble of the

1990's), during which hundreds of thousands of Americans invested heavily in the stock

market. This was a period in which the mechanisms of US financial growth were

opening up to the common man, and more than $8.5bn was on loan by the time of the

morning of October 24th 1929, when a decade-long rise began to turn down and panic

selling began. It is likely that the market could have absorbed a modest scale-back, but

when panicking consumers sought to withdraw their money, the result was a massive

bank-run that no economic system in history could have dealt with.

However, some historians believe that this explanation is too simple. They argue,

instead, that the Wall Street Crash was simply a symptom of a wider malaise that had

set in some years earlier (Galbraith, 1954). Looking at the data, it is clear that the Crash

- devastating though it was - was actually followed by a small upswing that saw early

1929 levels regained by April 1930. The idea that the Crash brought about instant

economic ruin is simply not supported by the facts. However, by the middle of 1930

there were more ominous signs permeating the US economy. Automobile sales and

household spending were both declining, and house prices were no longer increasing at

the rate they had previously achieved.

Unfortunately, this coincided with a severe drought that ravaged farms in the US

agricultural heartlands. A deflationary spiral began in 1931, and attempts to shore up

the economy with protectionist tariffs were, in fact, counter-productive. By late 1931, the

US (like many other global economies) was locked into a downward spiral, and it is at

this point that the Great Depression began to truly bite. Some historians note that there
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was an element of inevitability about a crash following a speculative boom such as the

one that dominated the world - and particularly the US - in the 1920's (Ferguson, 2009),

and it is for this reason that many still warn against allowing booms to run unchecked.

However, others argue that the common thread that binds the Great Depression to the

recent economic crisis was the relatively unregulated actions of bankers, who in both

cases overextended their loan facilities on the basis that they saw no end to the boom in

sight.

By the time that President Hoover was voted out of office and replaced by President

Franklin D. Roosevelt in 1933, the Great Depression in the US had entered a new

phase.

Drought and erosion in the Midwest led to the development of the Dust Bowl, which

made farming in these areas virtually impossible and led to mass economic migration,

mostly to California. Roosevelt recognised that his primary task in the early months ofhis presidency was not to fight the existing depression, but in fact to prevent a whole

new, second depression from developing. Running according to a Keynesian model of

supply and demand, Roosevelt's New Deal program was set up to provide work for

millions of unemployed Americans. The New Deal is widely credited with reversing the

US economic decline and beginning the process of recovery.

Roosevelt also set up the Securities and Exchange Commission (SEC) to regulate

financial institutions in the US, a measure that remains in place today. Many of

Roosevelt's other programs, such as regulations to fight inflation and minimum wages

and labour standards were controversial at the time, as was his attempt to driveeconomic stimulation by increasing the purchasing power of the working class. By 1936,

there were strong signs of economic recovery in most areas, though crucially not in the

unemployment figures for another couple of years. By 1937-1938, recovery was

sufficiently complete for conservatives to block further expansion of Roosevelt's New

Deal on the grounds that it was perceived to be wasteful and a step too far in the

direction of socialism. Similar arguments surround the recent attempts by President

Obama to stimulate the current moribund US economy.

As the Great Depression came to an end, US attention turned to the developing

tensions in Europe, which would soon lead to the start of World War 2. The Great

Depression had a hand in creating the circumstances in which the war began, and also

helped create the environment in which the US was able to eventually enter the war on

the back of a massive investment program. In fact the US need to develop equipment

for the war helped to drive the country's economy further still in the recovery years.

Arguably this began a process of economic growth that was only checked in 2008 with


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the development of the recent financial crisis. The Great Depression can therefore be

said to have been one of the defining moments of 20th century global history.

Predominant Factor leading to the Great Depression

The predominant factor leading to the Great Depression was over-indebtedness, whichfueled speculation and asset bubbles. [23] Nine factors showing chain of eventsinteracting with one another under conditions of debt and deflation to create themechanics of boom to bust are outlined here as follows:

1. Debt liquidation and distress selling2. Contraction of the money supply as bank loans are paid off

3. A fall in the level of asset prices

4. A still greater fall in the net worths of business, precipitating bankruptcies

5. A fall in profits

6. A reduction in output, in trade and in employment.

7. Pessimism and loss of confidence

8. Hoarding of money

Causes of Great Depression

1. Agricultural Drought and erosion - Dust Bowls

During the 1930s, almost the entire plains of the US were experiencing drought. A lot of

crops were damaged due to the high temperatures, insufficiency in rainfall, high winds

and the infestation by insects on the crops. It is argued that this depression in the

agricultural sector played a high role in bringing about the great depression.

2. Stock Market Crash of 1929

The depression began in the United States immediately after the crash of the New York

stock market in 1929. The crisis lasted till 1939. It is identified that by the year 1932, the

values of stock had fallen very fast to around 20% from their original value.

The crash in the stock market was faced in 1925-1929 and during this time, the price

doubled in the New York stock exchange market for the common stocks. The rise in
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stock price means that investors were attracted into investing in the stocks with an

anticipation of making high returns due to the rise in the same stocks' price in future.

Instead of thee rise of prices as most of them anticipated, there was a drop in the

prices.

The drop in the stocks that took place in the 24 th of October 1929 was termed to as theBlack Thursday (Rothbard, 2000). The two days following the black Thursday saw a

maintenance of steady prices of the stocks and on Monday, there a was another decline

in the prices. This continuous decline in the stock prices caused a lot of panic among

the traders leading to majority of them selling their stocks on the next day, Tuesday the

29th. A record of 16,410,030 shares of stock was sold on that day.

3. Collapse of Banking And Financial Institutions

In 1933, around 11,000 out of the 25,000 banks and financial institutions in the united

states had collapsed due to a number of reasons that included a decline in the value of

property, lack of customers due to the panic that arose and loan defaults (Bernstein,

2004). Apart from these factors, other factors that were related to the issue of monetary

policy made the situation worse especially those that were associated to adhering to the

gold standards.

4. Rising unemployment

Due to the collapsing of many companies in United States as result of the decrease of

the demand of the goods and services they were offering due to the reduction of

purchasing power of the customers necessitated companies to cut operations to reduce

cost and avert making losses further. For the companies to reduce costs of operations,

they had to lay off staffs and reduce the salaries and other benefits of those who were

retained. Loss of jobs in the economy as the companies reduces their operations led to

the evil of the rapid unemployment, resulting reduction of the purchasing power of the

customers and thus increasing further the problem of lack of demand of goods

produced in the economy and thus accelerating economic crisis (Smith, Horisaka &

Nishijima, 2007).

This was the period when the highest unemployment rates and low incomes wereexperienced; business was also low especially keeping in mind that these were modern

times. The depression led to factories, banks and major business entities collapsing

leaving thousands of citizens both jobless and with no money to put food on the table.

7. Imposing Tariffs Restricting Trades


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There was a sharp fall in the world market as all the countries tried to increase their

taxes as a way of trying to salvage their domestic industries that had heavily been

impacted on by the crisis. According to Brasch, (2009), the effect o the crisis led to a

number of states and countries changing their leaders and government as a way of

trying to respond and come up with ways of tackling the problem.

4. loan defaults / housing bubbles

5. monetary policy / gold standards

Lessons learnt from the Great

DepressionEconomists basically have two simple macro-economic policy answers to that kind ofcollapse.

The first is the lesson that John Maynard Keynes already taught in the 1930s in theface of a collapse in private demand, there is a need for new public sector demand orfor fiscal activism.

The second is the lesson above all drawn by Milton Friedman and Anna Schwartz inthe 1960s. In their view, the Depression was the result of the Feds policy failure in the

aftermath of 1929. There was a massive monetary contraction, which was responsiblefor the severity of the downturn. In the future, central banks should commit themselvesto providing extra liquidity in such cases.

The problem is that there are several different lessons from the Great Depression. They

are confusing when we conflate them. Especially in the US, the Great Depression is

usually identified with the stock market crash of 1929. Economists have two simple

macro-economic policy answers to that kind of collapse. The first is the lesson that John

Maynard Keynes already taught in the 1930s in the face of a collapse in private

demand, there is a need for new public sector demand or for fiscal activism.

The second is the lesson above all drawn by Milton Friedman and Anna Schwartz in the

1960s. In their view, the Depression was the result of the Feds policy failure in the

aftermath of 1929. There was a massive monetary contraction, which was responsible

for the severity of the downturn. In the future, central banks should commit themselves

to providing extra liquidity in such cases.
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Both lessons have been applied, consistently and quite successfully, not just to deal

with the turmoil of 2007-08. Stock market panics in 1987, or 1998, or 2000-01, were

treated with the infusion of liquidity. The fact that these anti-crisis measures were

applied in many countries after 2007 also explains why the fallout is milder than it might

have been.

There is another reason that the aftermath of Lehman looks reminiscent of the world of

depression economics. The international economy spreads problems fast. Austrian and

German bank collapses would not have knocked the world from recession into

depression had they occurred in isolated or self-contained economies. But these

economies were built on borrowed money in the second half of the 1920s, with the chief

sources of the funds lying in America. The analogy of that dependence is the way

money from emerging economies, mostly in Asia, flowed to the US in the 2000s, and an

apparent economic miracle was based on Chinas willingness to lend. The bank

collapses in 1931 and in 2008 shook the confidence of the international creditor: then

the US, now China.

As in the Great Depression, the attention focuses on the big states and their policy

responses. This is true of the by now classic answers to a 1929 problem. Smaller

countries find it harder to apply Keynesian fiscal policies, or pursue autonomous

monetary policies. Some countries, such as Greece or Ireland, have reached or

exceeded the limits for fiscal activism; and there is as in the 1930s a threat of

countries going bankrupt.

From the perspective of the US, debate has been distorted by fears that something like

this could hit America. That is unrealistic. But even the default of an agglomeration of

smaller countries would end any hope of an open international economy and inaugurate

an age of financial nationalism.

In the recently ended era of financial globalisation, in the 20-year period since the

collapse of Soviet communism, the most dynamic and richest states were generally

small open economies: Singapore, Taiwan, Chile, New Zealand and in Europe theformer communist states of central Europe, Ireland, Austria and Switzerland. In the

world after the crisis, the centre of economic gravity has shifted to really large

agglomerations of power. There has been an obsession with the Brics (Brazil, Russia,

India, China) as new giants. The continuation of the crisis will turn them into Big Really

Imperial Countries.


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Great Recession

Economic recessions are caused by a decline in GDP growth, which was itself causedby a slowdown in manufacturing orders, falling housing prices and sales, and a drop-off

in business investment. The result of this slowdown is falling employment, and rising

unemployment, which causes a slowdown in retail sales. This creates a downward

spiral in manufacturing and increased layoffs. A stock market decline, known as a bear

market, can either be a result of a recession but is often a cause itself.

Errors or Misunderstanding of the (mainly US) Regulators and Financial

Authorities

Bad policies of the US Government, its Politicians, and the Federal Reserve System

contributed greatly to the development of the Great Recession.

Primary causes of the great recession are several:

One was the inordinately easy monetary policy pursued by Alan Greenspan and the

Federal Reserve system for many years starting in 1997 during the Asian financial

crisis. The Fed's easy policies continued in 1998 (when a large hedge fund failed); in

1999 when Greenspan feared "Y2K" accounting problems (caused by computers that

could not properly calculate dates starting with 2000 rather than 1999) would cause

financial confusion; in 2001 after the "9/11" attacks; and in the 2002 recession and in

subsequent post-recession years. As a result, interest rates fell to inordinately low levels

due to the continuing floods of easy money and much "malinvestment" (bad investment)

occurred as many projects were funded that would not have qualified for funding if

interest rates had not been artificially depressed. Furthermore, because of the low Fed-

induced interest rates, pension funds, insurance companies, and other investors who

had promised to earn guaranteed rates of return for their customers had to take more

risk in order to try to earn satisfactory returns. Unfortunately, as they did so, they made

too many investments that did not earn a high enough rate of return to cover their risks,

and risk-premia on investments declined to ridiculously low levels--thereby exposingthose investors to potentially great future losses should the risk become more apparent

at some time in the future.

Second cause was the Democratic Party led Congressional support and

encouragement for the two major "Government Sponsored Enterprises" or "GSEs"--

Fannie Mae and Freddie Mac--to extend easy credit in the mortgage markets to
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encourage home ownership by people who otherwise wouldn't qualify for mortgage

loans. The pressure became most apparent in the early 2000s after the Democratic-

appointed leaders (particularly Franklin Raines and cohorts at Fannie Mae) of those

institutions had engaged in some questionable accounting in order to earn larger

bonuses. In order to retain Congressional support, the institutions gladly adopted the

easy mortgage origination policies pushed by Democratically controlled Congressional

Committees. Those institutions and their easy credit policies came to dominate the

mortgage markets because the GSEs could borrow at low interest rates since they had

implicit (now explicit) government support, and therefore could outcompete private

lenders to force mortgage interest rates and credit standards down. In fairness, it should

be said that Republican legislators also encouraged Fannie Mae and Freddie Mac to

adopt easy credit policies, because they had constituents who hoped to benefit from

booming housing markets fueled by easy mortgage credit. Thus, while much of the

pressure for the GSEs to make irresponsibly easy mortgage loans came from

Democrats in Congress who wanted to make sure every one of their constituents(regardless of qualifications) could qualify for a mortgage loan, both Democratic and

Republican legislators were quick to push easy mortgage money policies by the GSEs

to please other constituents in their districts as well.

Third, the process of extending easy mortgage credit was encouraged by financial

institution regulators who aggressively enforced the "Community Reinvestment

Act--"CRA"-- from the time of Bill Clinton's administration onward. The CRA made

financial institutions support lending to people and community groups in their trade area

even if those institutions and individuals would have not otherwise qualified for funding

on relatively easy terms.

Fourth, in 1999, the Gramm-Leach-Bliley Act was passed with bipartisan support in a

Republican dominated Congress and signed by the Democratic President, Bill Clinton.

That Act allowed took away many of the safeguards that the Glass-Steagall Act of 1933

had erected during the Great Depression. That act had prevented commercial banks

(who accepted deposits and made loans to business) and investment banks (who sold

and underwrote securities like stocks and bonds) from entering many of the same lines

of business. The Gramm-Leach-Bliley Act (GLB Act) was passed because the major

Wall Street Investment Banks and Commercial Banks provided substantial funding to

Washington politicians and the President and provided for many well-funded lobbyistswho argued that commercial banks and investment banks needed to pursue combined

operations in order to compete better with Europe's Universal Banking entities and to

better serve their customers. The lobbyists forgot to mention that the Glass-Steagall Act

had initially been passed because legislators in the 1930's thought that excessive risk

taking by combined commercial and investment banks had contributed to the severity of

the great depression. One consequence of the GLB act was that the large commercial


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bank holding company sector could hold less capital (their own money) to back their

risky assets since investment banking operations were not required to hold as much

capital as deposit taking banks. The process of holding less capital was aggravated by

the fact that large banks could now "securitize" their loans and sell interests in their

loans to others, retaining only a small or zero portion of the initial loan on their balance

sheets. They could earn fees on the loans they originated and sold while not having to

retain their own funds (capital) to support large loan holdings. against the risk of loss.

Unfortunately, often the income streams they expected to earn from securitizing loans

and the residual pieces of the loan pools they held exposed them to far greater risks

than they had anticipated. Thus, their earnings and balance sheet risk was far greater

as the result of reckless securitization, and the small amount of their own money

(capital) that they held subsequently proved inadequate to cover their potential losses.

That is why in 2008, several major investment banks (Bear Sterns and Lehmann) failed

and many large commercial and investment banks (think, in particular, Citicorp and

Merrill Lynch, among others) either failed or needed to be bailed out with Federal Funds(i.e. taxpayer provided TARP money) on the assumption that they were "too big to fail."

In addition, the large insurance firm, AIG, also basically failed and became a ward of the

U.S. government, at great expense, so other major banks or investment banks--think

Goldman Sachs--which was politically well connected to both major political parties,

particularly the Democratic Party, in the U.S.--and European banks would not fail in the

event AIG defaulted upon its credit default swaps.(CDSs).

The excessive leverage (ratio of borrowed money to their own money --capital) used

by U.S. investment banks became even more excessive during the early 2000s after the

U.S. Securities and Exchange Commission allowed them to lower their capital ratios(increase their leverage) so they could compete better with European banking entities.

By holding only $1 of their own money for every $30 to $40 of assets they held, the

largest U.S. investment banks faced the prospect of being wiped out if they lost only 2

1/2 to 3% of their asset values--which is easy to do almost overnight if an institution

holds risky assets.

Fifth, the process of excessive risk-taking by banks and U.S. investment banks was

aggravated by the use of Credit Default Swaps (CDSs) and the sloppy bookkeeping and

inadequate collateral requirements involved for institutions who traded in those

instruments. Credit Default Swaps are basically "bets" as to whether an institution or asecurity will default upon its debts. The buyer of a credit default swap pays a large fee

(the premium) to the seller in the form of a premium interest rate for the underlying

security). If the security defaults, the buyer of the credit default swap will receive a large

payment from the seller of the swap, dependent upon its value after default. In order to

guarantee that the payment will be made if necessary, the seller of the swap must post

collateral, with the amount varying with the seller's credit rating and the riskiness of the


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underlying security being guaranteed. If the seller was AAA rated by a rating agency,

often it did not have to post explicit collateral. If the underlying security was highly rated

(AAA) the collateral requirement would be slight in any case. Large banks and

investment banks with AAA ratings liked to write credit default swaps since they did not

have to post much if any collateral--thereby earning fees without posting their own

capital. Compliant rating agencies, such as Moody's and Standard and Poors who had

to be sanctioned by the U.S. Government and , therefore, had oligopoly powers, were

often quick to hand out good ratings to large institutions and the debts they wished to

swap in order to earn repeat business from those institutions. In retrospect, they were

too willing to give high ratings to many large financial institutions and many large pools

of risky mortgage derivative securities.

Because credit default swaps were lucrative and traded over the counter in opaque

markets, large financial institutions found they could make a great deal of money from

originating and trading credit default swaps. Outside participants were not well informedabout buying and selling prices for various swaps, so institutions who sold the swaps

could often make substantial profits by originating and trading CDSs. Furthermore,

since many people traded the swaps, once they had originated the swap, they could

often lay off their risk by taking the opposite position with another swap market

participant at a slightly better price--thereby locking in a quick profit (and large potential

bonus) with essentially no capital requirement (i.e., no money of their own at risk).

Because of the rapid trading of CDSs, the market grew rapidly as daisy chains of swaps

developed as one bank or dealer might originally sell a CDS contract, then turn around

and buy a similar swap at a better price from another dealer, who, in turn, might buy a

similar swap from another dealer or institution, etc.--all the while creating a chain ofobligations that linked all the highly rated dealers together in a daisy chain of

obligations, while the traders collected commissions or future bonus benefits from the

book value of the profits they made while trading.

Unfortunately, the incentive for traders and institutions was to engage in numerous

transactions in credit default swaps and the nominal value of the swap market soon

grew to equal many times the value of the underlying securities. Furthermore, since

trades took place at a rapid pace, bookkeeping was often inadequate, and any collateral

requirements that may have existed tended to be poorly documented or enforced. Since

the swap dealing largely took place among New York commercial and investmentbanks and other highly rated institutions with New York offices, the Federal Reserve

Bank of New York became aware of the sloppy bookkeeping and daisy chain nature of

the swap market. Gerald Corrigan, the President of the New York Federal Reserve

Bank tried to get the firms involved to increase their back room functions and the

transparency of the CDS market in the mid 2000s. He also tried to get Alan Greenspan

to get the entire Federal Reserve System involved in trying to regulate the burgeoning


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market. However, Greenspan demurred. Subsequently, Corrigan was hired away at a

high salary by the most politically influential major investment bank, Goldman Sachs,

and, the New York Federal Reserve Bank (headed by Tim Geitner, our present

Secretary of the Treasury after Corrigan left) apparently diminished its enforcement

efforts, as the CDS market continued to grow dramatically.

While a valid case may be made for the existence of CDSs for debts that otherwise

would be hard to insure against loss, such as various sovereign debts, it is less

reasonable to argue that one should have swaps available to guarantee every possible

security against default. However, the originators of swaps can profit if swaps are

issued against more securities because appropriate risk information is harder to

calculate for individual securities with varying default probabilities and debt covenants.

Therefore, since market information was less perfect for individual securities, writers of

credit default swaps can often make greater profits by writing swaps on such securities.

Consequently. participants in the swap market have vociferously defended their right tooriginate credit default swaps on any security they wish and , further, to issue such

swaps as "over-the counter" contracts between individual entities, where those

contracts do not trade on exchanges where appropriate bid and ask prices are readily

available to all participants. The argument that credit default swaps should not be

limited to either the number or type of securities covered or to exchange-related trades

was still being made by the lobbyists for large banks and financial institutions who arrive

in Congress carrying loads of money to support politicians who are opposed to imposing

serious restrictions on the CDS market.

Credit default swaps conyributed to our present great recession in various ways. Inparticular, they could be written on pools of mortgage backed securities. Even though a

pool of securities might contain risky loans, on the assumption that not all loans would

default, at least part, if not most, of each pool of mortgages could obtain a AAA rating

from compliant rating agencies who assumed that real estate prices would always

increase and most mortgages would not default. Thus, those securities would be eligible

for credit default swaps and the worst part of the pool could either be held by the

originating institution or sold to another institution who would combine them into a new

pool of securities that, once again, was not assumed to suffer simultaneous defaults of

all its components. Thus, most of the new risky mortgages being originated became

eligible for credit guarantees in the credit default swap market, This gave a greatincentive to originators of mortgage securities and the commercial and investment

banks that pooled them up to create mortgage backed securities--often exploiting

guarantees from Fannie Mae or Freddie Mac in the process-- to originate all the

mortgages they could, form them into mortgage-backed securities, and sell them to

others, who could insure them, if necessary, in the CDS market. All the time, at each

step in these transactions, the brokers and investment banks, and commercial banks


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and traders, created fee income for themselves, commissions, and potentially large

bonuses, which they recorded as profits and/ or extracted from the market. At the same

time, because of high rating s and low capital requirements, they were able to report

high returns on invested capital since they had to post very little or no money to

underwrite (i.e. guarantee) their transactions.

Because this whole operation was so lucrative, the mortgage markets kept expanding

and the investment banks and large commercial banks kept profiting by originating more

and more mortgage securities for risky borrowers on generous terms, originating pools

of mortgage backed securities, getting Fannie or Freddie to guarantee the loans, and

issuing and trading credit default swaps on the pools of mortgages. Since they all could

record instant commissions, trading, or fee income by so doing, the frenzied dance of

mortgage origination continued even though they eventually started to originate

mortgages to people who didn't document their income and jobs, or didn't make any

downpayment, or didn't have to pay any interest (or very little interest) for many years.

In order to continue to sell more pools of mortgages, the credit default swap market

also exploded. as people sought CDSs on pools of mortgages to guarantee eventual

repayment. Unfortunately, this gave some unscrupulous institutions an incentive to

peddle bad pools of mortgages along with credit default swaps that they could pass on

to someone else in the daisy chain of CDSs.

Once mortgages and institutions started to default, people found that they had taken

too much risk and had made too many malinvestments. The housing market collapsed

as mortgage credit dried up. Furthermore, as shell shocked financial institutions withinadequate capital cut back on all lending, the general economy suffered.

Before the BeginningLike all previous cycles of booms and busts, the seeds of the subprime meltdown weresown during unusual times. In 2001, the U.S. economy experienced a mild, short-livedrecession. Although the economy nicely withstood terrorist attacks, the bust of thedotcombubble, and accounting scandals, the fear of recession really preoccupiedeverybody's minds. (Keep learning about bubbles in Why Housing Market Bubbles Popand Economic Meltdowns: Let Them Burn Or Stamp Them Out?)

To keep recession away, the Federal Reserve lowered the Federal funds rate 11 times -from 6.5% in May 2000 to 1.75% in December 2001 - creating a flood of liquidity in theeconomy. Cheap money, once out of the bottle, always looks to be taken for a ride. Itfound easy prey in restless bankers - and even more restless borrowers who had noincome, no job and no assets. These subprime borrowers wanted to realize their life'sdream of acquiring a home. For them, holding the hands of a willing banker was a newray of hope. More home loans, more home buyers, more appreciation in home prices. Itwasn't long before things started to move just as the cheap money wanted them to.
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This environment of easy credit and the upward spiral of home prices made investmentsin higher yielding subprime mortgages look like a new rush for gold. The Fed continuedslashing interest rates, emboldened, perhaps, by continued low inflation despite lowerinterest rates. In June 2003, the Fed lowered interest rates to 1%, the lowest rate in 45

years. The whole financial market started resembling a candy shop where everythingwas selling at a huge discount and without any down payment. "Lick your candy nowand pay for it later" - the entire subprime mortgage market seemed to encourage thosewith a sweet tooth for have-it-now investments. Unfortunately, no one was there to warnabout the tummy aches that would follow. (For more reading on the subprime mortgagemarket, see ourSubprime Mortgages special feature.)

But the bankers thought that it just wasn't enough to lend the candies lying on theirshelves. They decided to repackage candy loans into collateralized debt obligations(CDOs) and pass on the debt to another candy shop. Hurrah! Soon a big secondarymarket for originating and distributing subprime loans developed. To make things

merrier, in October 2004, the Securities Exchange Commission (SEC) relaxed the netcapital requirement for five investment banks - Goldman Sachs (NYSE:GS), MerrillLynch (NYSE:MER), Lehman Brothers, Bear Stearns and Morgan Stanley (NYSE:MS) -which freed them to leverage up to 30-times or even 40-times their initial investment.Everybody was on a sugar high, feeling as if the cavities were never going to come.

The Beginning of the EndBut, every good item has a bad side, and several of these factors started to emergealongside one another. The trouble started when the interest rates started rising andhome ownership reached a saturation point. From June 30, 2004, onward, the Fedstarted raising rates so much that by June 2006, the Federal funds rate had reached5.25% (which remained unchanged until August 2007).

Declines BeginThere were early signs of distress: by 2004, U.S. homeownership had peaked at 70%;no one was interested in buying or eating more candy. Then, during the last quarter of2005, home prices started to fall, which led to a 40% decline in the U.S. HomeConstruction Index during 2006. Not only were new homes being affected, but manysubprime borrowers now could not withstand the higher interest rates and they starteddefaulting on their loans.

This caused 2007 to start with bad news from multiple sources. Every month, one

subprime lender or another was filing for bankruptcy. During February and March 2007,more than 25 subprime lenders filed for bankruptcy, which was enough to start the tide.

In April, well-known New Century Financial also filed for bankruptcy.

Investments and the Public

Problems in the subprime market began hitting the news, raising more people's

curiosity. Horror stories started to leak out.
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According to 2007 news reports, financial firms and hedge funds owned more than $1

trillion in securities backed by these now-failing subprime mortgages - enough to start a

global financial tsunami if more subprime borrowers started defaulting. By June, Bear

Stearns stopped redemptions in two of its hedge funds and Merrill Lynch seized $800

million in assets from two Bear Stearns hedge funds. But even this large move was only

a small affair in comparison to what was to happen in the months ahead.

August 2007: The Landslide Begins

It became apparent in August 2007 that the financial market could not solve the

subprime crisis on its own and the problems spread beyond the UnitedState's borders.

The interbank market froze completely, largely due to prevailing fear of the unknown

amidst banks. Northern Rock, a British bank, had to approach the Bank of England for

emergency funding due to a liquidity problem. By that time, central banks and

governments around the world had started coming together to prevent further financial

catastrophe.

Multidimensional Problems

The subprime crisis's unique issues called for both conventional and unconventional

methods, which were employed by governments worldwide. In a unanimous move,

central banks of several countries resorted to coordinated action to provide liquidity

support to financial institutions. The idea was to put the interbank market back on its

feet.

The Fed started slashing the discount rate as well as the funds rate, but bad news

continued to pour in from all sides. Lehman Brothers filed for bankruptcy, Indymac bank

collapsed, Bear Stearns was acquired by JP Morgan Chase (NYSE:JPM), Merrill Lynch

was sold to Bank of America, and Fannie Mae and Freddie Mac were put under the

control of the U.S. federal government.

By October 2008, the Federal funds rate and the discount rate were reduced to 1% and

1.75%, respectively. Central banks in England, China, Canada, Sweden, Switzerland

and the European Central Bank (ECB) also resorted to rate cuts to aid the world

economy. But rate cuts and liquidity support in itself were not enough to stop such awidespread financial meltdown.

The U.S. government then came out with National Economic Stabilization Act of 2008,

which created a corpus of $700 billion to purchase distressed assets, especially

mortgage-backed securities. Different governments came out with their own versions of

bailout packages, government guarantees and outright nationalization.
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Crisis of Confidence after all

The financial crisis of 2007-08 has taught us that the confidence of the financial market,

once shattered, can't be quickly restored. In an interconnected world, a seeming liquidity

crisis can very quickly turn into a solvency crisis for financial institutions, a balance of

payment crisis for sovereign countries and a full-blown crisis of confidence for the entireworld. But the silver lining is that, after every crisis in the past, markets have come out

strong to forge new beginnings.

The Great Depression_assignment # 1

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