Welcome back to our course on FinTech Security and Regulation.
In today's session, we're going to talk about what happens when regulation gets it wrong.
Why is weak regulation good,
and why is weak regulation bad,
and what happened in 2008 with the financial crisis,
and how is that related to regulation?
Now, let's go back in history and I could spend 10 hours on the financial crisis.
I'm not going do that, so don't worry,
I'm not going to talk for 10 hours,
I'm going to trying to talk for about 10 minutes.
So, what happened?
Well, starting in about, let's say,
about the mid 1970's to 1980 time frame,
we saw decreasing regulations in financial services in the US.
More and more restrictions were dropped,
more and more flexibility was given to finance firms and as a result,
we saw an era of prosperity,
booms in profitability, booms in bonuses,
lots of money being made not,
just by financial professionals but by people across the society,
investors did very well,
people working in the finance industry did very well,
many MBAs got very enthusiastic about going to work in
finance because the amount of money that could be made in finance and banking exploded.
It went up by a factor of,
literally, by a factor of 100.
Someone going to work in a middle level position in an investment bank in 1970,
might get paid $30,000 or $40,000 a year.
They might be able to make 10 or even 100 times that two decades later.
So, the amount of money was huge.
So, the enthusiasm was very large for jumping into the finance gain.
Now, that lasted a long time and so we had 20 plus years of prosperity.
We had some cycles, some booms,
some busts, some issues,
we had the dot-com boom and bust,
we had some other issues but banks in general,
were making money in good years and bad years,
this was very, very profitable times by enlarge.
A few crises of modest amounts and a few bailouts here and there but
nothing systematic or pervasive as we saw in 2008.
By 2008, bankers had got more and more creative,
and one of the things they had learned to do is to
package loans in a way that they could then sell them off to investors,
and get these loans off of their balance sheet.
So, they weren't subject to reserve requirements and they were able to
package these loans as a bundle and argue that even risky loans,
like a car loan to a lower-income buyer could
be packaged with other car loans and as a bundle,
this overall package was lower risk than the components of it.
They could get accountants to then say, "Yeah.
Yeah. Because of the nature of the bundle,
the risk goes down of this portfolio of mortgages,
of these portfolios of credit card debts,
or this portfolio of auto loans."
And so, therefore, we'll give this a very high rating in terms of risk.
Therefore investors will pay a lot for this,
a lot more than the banks lent out.
So, there was profit to be made on collateralizing this debt obligation.
That's what a CDO was, collateralizing debt,
packaging loans that you'd made to other people into
a bundled product that was arguably less risky than the investments underneath it.
And because of diversification of the risk and inherently,
it was less risky but what people underestimated as investors, and bankers,
and others is the potential degree to which
risks could be systematic or could be correlated and
maybe all of these loans would default at
the same time due to changes in market conditions and environment,
then maybe it's more risky than you thought and so,
the risk was underestimated.
Now, banks were not totally ignorant of
this idea of correlation of risk and potential meltdown.
So, what they did to make sure investors would be
okay and banks buying these packages also would be okay,
is they bought security on the risk.
They went to an insurance company who said,
"We will ensure this collateralized debt obligation against
default and we will provide insurance that if it defaults, we'll pay out."
Now, because the rating agencies had said,
"These things are very, very secure.
The odds of crisis or a meltdown is low and therefore,
the risk of this insurance is low."
Then, companies like AIG,
one of the biggest writers of this insurance policy,
weren't really at that much risk of having to pay out.
This was the argument of the Accountants,
of the auditors, and arguments with the regulators is,
"This is not that risky of a product.
In fact, it kind of looks like premiums with almost no risk.
We've never had to pay out on this,
we get to collect money every year,
this is a great product.
We sell it, we get paid,
we don't have any claims,
and we're just printing profit."
So, AIG looks like a superhero.
They're making lots of money for investors and then market conditions change.
Someone realizes that the economy has become overheated too much,
that many of these loans really are bad loans and they're systematically bad
because real estate has become excessively
valued as it becomes easier and easier to get loans,
easier and easier, without income verification,
just betting on somebody else buying the property at a higher price and so,
it's become a speculative bubble.
However, as with any bubble,
when it bursts, it becomes painful.
So, when the real estate market became more and more clear that it was overheating,
AIG started to realize, "Oh, shoot.
These insurance policies are going to all
come due at the same time and we have taken on much,
much more risk than we ever realized and we don't have enough reserves.
We don't have enough capital to pay out all these claims."
So, AIG was bankrupt and they go to the banks and say, "Sorry, we're bankrupt."
Now, the banks have all of
these collateralized debt obligations that they've guaranteed for their investors,
people buying them because they had insurance from AIG and they have to say,
"Oh sorry, we can't honor our commitments."
And so, the banks are now bust and so
this weaker regulations and weaker controls of insurance on
a financial firms led to a situation where
things were off the balance sheet but being guaranteed by banks but of course,
they had an insurance company behind them guaranteeing them.
So, it looked like no risk,
but the risk just cascaded down
the financial system until it got to individual investors and they're in trouble.
The large financial institution said to the government, "We need help."
and as often is the case with crisis and a meltdown they said,
"If you don't help us to solve this problem,
we're all going to fail,
we're all going under.
We're going to have another Great Depression.
All the banks are going to have a run on the banks and that's going to be a disaster."
and the federal government has federal deposit insurance in the US.
They're going to have to bail out all the banks and so,
it's going to cost the government a lot of money regardless of what you do.
The argument was, large banks are too big to fail.
Theodore Henry King CLARKAssociate Professor
