recession-2008 and role of financial institutions

Final Project

International Business

Submitted To:

Sir Imran Bashir

Submitted By:

Hassan Shafique (123218)

Zeeshan Azam (123220)

M. Asad Bin Asif (113245)

INTERNATIONAL BUSINESS Final Project

The Institute Of Management Sciences 2

Table of Contents

Introduction

How we got here

Background

The Regan Administration in united states

Financial Engineering

Colleteral debt obligations

Sub prime

The Bubble

Insurer and investors

Goldmen Sachs

The Beginning of crisis

Accountability of loss recorded

After Crisis effect

Some notable Quotations

Refrences



Our assigned project proceeds with a case study of Iceland, a nation that was possessed by

the cancer of free radical finance. Iceland was stable low

crime, strong education, and strong stability in social and

financial systems. Multinational corporations such as Alcoa

were then allowed to come into Iceland and install their

business thereby disrupting the integrity of the system.

Three of their largest banks were privatized and in only five years, they combined to borrow

a sum equal more than 10 times Iceland’s total GDP. Reckless borrowing and lax lending

became commonplace.

A businessman named Jon Asgeir Johannesson, former head of the major retail company

Bagur, is noted for taking out a loan amounting to billions of dollars. Jon used this money to

purchase investments such as other top retail businesses and consumer goods such as a $40m

yacht and a fashionably designed private jet. Beginning with the introduction of Alcoa into

Iceland, whose aluminum plants were colonizing some of the richest portions of Iceland’s

greenery and continuing with various provisions of deregulation such as bank privatization

and lax requirements for bank loans some of which were massive the dominion of finance

was interfacing Iceland. Gylfi Zoega, Professor of Economics at the University of Iceland,

comments on this financial possession by stating simply, Finance took over, and uh more or

less wrecked the place.

Credit rating agencies analyzed a vastly overleveraged and indebted Iceland and, reflecting a

pattern throughout the global financial system, gave Iceland a satisfactory or spectacular

rating. Sigridur Benediktsdottir, member of the special investigative committee of the

Icelandic Parliament says regarding the three Icelandic banks that combined to borrow over

ten times Iceland’s entire GDP, in February 2007, the rating agency decided to upgrade the

banks to the highest possible rating triple A.

In a word, due to the dominion of chaotic finance, Iceland was being drained of financial

resources and other resources that are related to finance, such as the natural land, education,

civil stability, personal quality of life, and trust in the system. Iceland began this journey into

the dangerous power known as excess money, and has been struggling with incredible debts

material and immaterial since the journey began.

Introduction



During the forty years of economic growth in the United States, investment banks were small.

A prominent investment bank named Morgan Stanley, in 1972, had 110 employees and $12m

in capital and now in 2009 has 50,000 employees and several billions in capital. In the 1980s,

the financial sector quantum leaped because investment banks were going public which

brought them vast sums of stockholder capital in return. From 1978-2008, the average salary

for workers outside of investment banking in the US increased from $40k to $50k a 25

percent salary increase and the average salary in investment banking increased from $40k to

$100k a 150 percent salary increase.

Background:



The Reagan administration of the United States in the early 1980s began a thirty-year period

of financial deregulation. By then end of the 1980s, many workers in the financial sector

were going to jail for fraud and many people were losing their life savings. Large investment

banks began merging and developing monopolies.

By the end of the 1990s, many internet companies dropped and massive investments in

internet stocks amounting to $5t - were lost, and once again, financial regulators allowed the

excessive betting and subsequent crisis to occur. Eliot Spitzer, Former Governor of New

York and Former New York Attorney General, conducted an investigation into the internet

crisis that revealed investment banks were promoting stocks they knew were likely to fail,

because they earned commissions based upon how much business they brought in another

pattern in the global financial crisis.

Spritzer’s case resulted in ten investment banks - Citigroup, Goldman Sachs, UBS, Morgan

Stanley, Merrill Lynch, Lehman Brothers, J.P. Morgan, Deutsche Bank, Credit Suisse, and

Bear Stearns paying a total of $1.4b as punishment.

The Reagan administration of the United States:



Financial engineering became a new field of study and derivatives were developed.

Derivatives are basically bets, various types of bets. A well-known derivative is an option.

When investing in an option rather than a stock, I am investing in the opportunity to buy or

sell a stock rather than the stock itself – thus, the option is a „spinoff‟ of the stock, and is

derived from the stock, hence the name „derivative‟. I can invest in options and I can trade

options, as if they were stocks. With derivatives, there are all sorts of bets speculators can

make – derivatives can include bets on a company‟s stock, commodities prices, the

likelihood of a company‟s bankruptcy, and even the weather. An issue with derivatives is that

if I choose to make a bet with my personal funds, then that is okay, although if I choose to

make a bet with the equity in my business, then I am betting with other people‟s money and

lives. In the current financial system, I can make these bets on investments other than

derivatives, although derivatives are special simply because their existence makes pool of

possible bets much larger.

Enter the securitization food chain, the new system that birthed extravagant mortgage lending

and the incredible housing bubble. There are five positions, in sequential order in the chain.

Home buyers

lenders

Investment banks

Investors

Insurance companies

A single loan payment passes along this chain, earning material gain for each position along

the way.

Financial Engineering

Collateral Debt Obligations



Home buyers come to the lenders for a mortgage to buy a home

lenders extend the loan to the home buyers and home buyers receive a home

lenders sell the mortgage to investment banks and receive a commission

Investment banks mix the mortgages with other debts such as corporate buyout debts,

car loans, student loans, and credit card debts and this mix is named Collateralized

Debt Obligations (CDOs), then they pay rating agencies to grade the CDOs and then

the investment banks sell the CDOs to investors and receive a commission

Insurance companies, particularly AIG, would earn commissions by selling insurance

to investors for the CDOs they purchased from the investment banks, which is named

Credit Default Swaps – if there was a default on the CDO, then AIG would cover the

losses furthermore, AIG would also sell Credit Default Swaps to speculators who did

not own any CDOs, therefore if there was a default on a single CDO, then since an

investor and speculators have insurance on this same CDO, AIG would have to pay

money to the investor who actually owned the CDO and the speculators who did not

own the CDO.

The rating agencies grading the CDOs that investment banks sold to investors often gave the

CDOs triple A ratings the highest possible which means investors often purchased these

CDOs as secure investments. CDOs made their way into retirement funds, which needed to

be secure because people were depending on these funds for their retirement money, although

CDOs were generally graded inaccurately and extremely risky. The reason many CDOs were

risky was because lenders still received their commission whether the mortgage was repaid or

not, because they sold the mortgage to the investment banks. Since lenders were removed

from risk, they could lend extravagantly and receive a commission in return. The investment

banks and the rating agencies were also able to receive commissions regardless of how the

CDOs performed. Gillian Tett, United States Managing Editor for The Financial Times

summarizes the extravagant mortgage lending, “You weren’t going to be on the hook and

there weren’t regulatory constraints, so it was a green light to just pump out more, and more

and more loans.” The number of mortgage loans made each year from 2000-2003 nearly

quadrupled



A type of loan which is granted to individuals with poor credit ratings, who then are not able

to qualify for conventional mortgages. Because subprime borrowers present a high risk of

lenders, interest charges above their prime lending rate

The riskiest mortgages, termed „subprime‟, were combined with other debts in the CDO

package and thereby received a high rating when the CDO received a high rating, even

though the subprime mortgages were the riskiest mortgages of all.

Also, because subprime loans were riskier, they demanded higher interest rates to compensate

for the likelihood the borrower would default on the loan; therefore, subprime loans were in

high demand because they would bring greater commissions when sold.

The sweet nectar of subprime loans – the forbidden fruit – sparked a wave or „predatory

lending‟, which resulted in more borrowers than usual being identified as subprime and

having to pay higher interest rates and many borrowers receiving loans that they could not

repay.

Robert Gnaizda, Former Director of the Greenlining Institute explains the situation, “All the

incentives that the financial institutions offered to their mortgage brokers were based on

selling the most profitable products, which were predatory loans.”

The uncertainty argument about the existence and size of a bubble one of the two leading arguments presented by Bernanke (2002) to argue against monetary policy targeting of asset

prices – is a very weak argument on which to base a view against monetary policy targeting of asset prices. All economic policy decisions are based on some degree of uncertainty – uncertainty about the data (observation uncertainty), uncertainty about the parameters of the

right economic model (parameter uncertainty) and, even, uncertainty as to whether certain economic variables matter for economic activity (model/paradigm uncertainty). As far as data

observation uncertainty goes, knowing about the existence and size of asset bubbles is not easy, but it is also not easy to estimate the output gap when there are radical changes in the economic structure or to estimate expected inflation. The fact that it was hard to estimate the

output gap or changes in the NAIRU and the inflation process in the mid-late 1990s did not

Sub Prime

The Bubble:



prevent Greenspan, Bernanke and the other Fed governors from doing their best to find the best forecast of these changing variables. The Fed did not drop inflation or output from the

Taylor rule because it was hard to estimate output gaps and expected inflation in a rapidly changing economic structure.

Since anyone could get a mortgage, home sales and housing prices exploded, creating the

largest financial bubble in history.

Notably, Countrywide Financial issued nearly $100b in mortgage loans. Investment

firms that traded debts in the securitization chain were earning massive sums of

money and their CEOs were receiving huge bonuses. The CEO of the investment

bank Lehman Brothers, Richard Fuld, received nearly $500m in bonuses. Nouriel

Roubini, Professor of Economics at New York University, comments on the

significance of growth of the financial sector in the global financial market, “By 2006,

about forty percent of all profits of S&P 500 firms was coming from financial

institutions.” Martin Wolf, Chief Economics Commentator for The Financial Times

adds, “It wasn’t real profits, it wasn’t real income….Two, three years down the road

there’s a default – it’s all wiped out. I think, in retrospect, it’s been a great

big…global ponzi scheme.”

Once again, regulators allowed the financial extravagance to ensue. Investment banks

were seeking to borrow more money to trade more debt and earn more profits. Early

on, for every one dollar the investment bank invested from its own funds, it invested

an additional three dollars of borrowed funds. Daniel Alpert, Managing Director of

Westwood Capital comments on the growth of excessive leverage, “The degree of

leverage in the financial system became, absolutely frightening. Investment banks

leveraging up to level – thirty-three to one which means that a tiny three percent

decrease in the value of their asset base would leave them insolvent.”



Remember AIG, the company that provided insurance on CDOs? Well, AIG was promising

to cover the costs if there was a default on the insured CDOs, although it did not have the

money to do so. Rather than setting aside the income from selling insurance on CDOs, it

divided that income between its higher level managers paying over $3b in corporate bonuses

during this period. Since firms were able to earn profits upfront and worry about paying for

their bets later, there was an incentive to take bets that could put their entire firm and even the

global financial system at risk in exchange for large immediate bonuses.

Investment bankers were spending bonuses on luxury items such as jets, yachts, mansions,

and vacation homes, as well as drugs and prostitutes. Often, the bankers used corporate funds

for these purchases and identified them as common business expenses such as computer

repair or routine cleanings.

Prominent investment bank, Goldman Sachs, began betting against the CDOs it was issuing.

Goldman Sachs knew those risky CDOs were primed for default and figured it could profit

from trading the CDO and then profit when there was a default on that same CDO. Goldman

Sachs also purchased Credit Default Swaps from AIG in order to bet against CDOs it did not

own. Goldman realized AIG was itself primed for bankruptcy and began betting against

AIG‟s collapse, therefore, the more bets Goldman purchased through AIG, the more unlikely

AIG would be able to follow through on its insurance, the more likely Goldman would profit

from AIG‟s collapse. Although Goldman Sachs saw it reasonable to bet against the CDOs,

they continued to trade the CDOs as if they were safe. Further, Goldman began trading CDOs

that paid them more when their clients lost more.

When executives of Goldman Sachs testified before Congress regarding it selling securities

that it bet against, the executives generally show that they do not see this as an issue. When

executives of the credit rating agencies that graded risky CDOs as stellar testified before

Congress, they emphasized the fact that their ratings are merely opinions and the agencies

assume no responsibility for the securities they rate.

Insurers and Investors:

Goldman Sachs:



The Federal Reserve System ignored repeated warnings of a major crisis from global

financial analysts such as Raguram Rajan of the IMF, Domnique Strauss-Kahn of the

IMF, Nouriel Roubini of New York University, and Allan Sloan of Fortune

Magazine.

Now it is 2008, and the debts are coming due. Those risky mortgages are now

ripening into foreclosures and bankruptcies. Bear Stears runs out of money in March

2008 and is acquired by J.P. Morgan for two dollars per share. Fannie Mae and

Freddie Mac, two major mortgage lenders are acquired by the US government.

Lehman Brothers reports recorded losses and a stock collapse.

Numerous investment firms were still rated double and triple A shortly before their

collapse

The narrator says, “The men who destroyed their own companies and plunged the world

into crisis, walked away with their fortunes intact.”

The CEOs of major investment firms received millions of dollars in bonuses, despite their

companies‟ collapse.

Investment firms enlisted advisors from academia through companies such as Compass

Lexicon, to speak in the media and write papers on their behalf. Academia does not comment

on academic conflicts of interest.

The beginning of Crisis

Accountability of the Loss recorded



The United States was declining, as shown through wealth gaps and outsourcing.

Manufacturing jobs are diminishing and information technology jobs were becoming more

abundant, although these jobs typically require an education that most Americans cannot

afford. Tax policies in the United States were increasingly favoring the wealthy, such as the

elimination of the estate tax. Wealth inequality was the highest in the United States of all the

developed nations. Although the Presidential administration of the United States has

officially changed, the same Wall Street players are now economic advisors in the new

administration.

After crisis effects:



The narrator concludes: “For decades, the American financial system was stable and safe, but

then something changed. The financial industry turned its back on society, corrupted our

political system, and plunged the world economy into crisis…the men and institutions that

caused the crisis are still in power and that needs to change.

They will tell us that we need them, and that what they do is too complicated for us to

understand. They will tell us it won‟t happen again. They will spend billions, fighting reform.

It won‟t be easy, but some things, are worth fighting for.”

Some notable Quotations:



Lee Hsien Long - “When you start thinking that you can create something out of nothing, it‟s

very difficult to resist.”

Narrator - “This crisis, was not an accident.”

Charles Morris - “I had a friend - he was a bond trader with Merrill Lynch in the 1970s. He

had a job as a train conductor at night, because he had three kids and couldn‟t support

them with what a bond trader makes. By 1986, he was making millions of dollars and

thought it was because he was smart.”

Eliot Spitzer - “High-tech is a fundamentally creative business where value generation and

the income is derived from actually creating something new and different.”

Andrew Sheng - “Why should a financial engineer be payed…four times more than a real

engineer? A real engineer builds bridges, a financial engineer builds dreams. And those

dreams turn out to be nightmares – other people pay for them.”



Refrences

1. “Junk Mortgages under Microscope” by Allan Sloan

Fortune Magazine October 16, 2007

2. “Has Financial Development made the world Riskier”

by Raghurar G. Rajan

3. “Why Central Banks Should Burst Bubbles” by Nouriel

Roubini

4. “Who’s holding the Bag?” May 2007 Pershing Square

Capital Management, L.P.

5. “Inside Job” a Documentary film by Andri Magnason

recession-2008 and role of financial institutions

Economy & Finance