In 2009, the world was in the middle of a financial crisis which led to recession. The credit-crunch means that it is harder to borrow money from banks or it becomes more expensive to do so.

• The credit-crisis was caused by banks being involved in risky loans that resulted in bad debts. For example, banks lent customers money for mortgages to buy houses, but many customers were unable to repay their loans.
• Subprime mortgages, now often referred to as toxic mortgages, were sold to people with poor credit ratings. It is a combination of this type of risky lending, falling house prices and high interest rates which led to defaults on mortgage payments and foreclosures (=repossession). This in turn triggered the global financial crisis.
• This left the banks seriously out of pocket. Banks also lent money to other banks and big businesses, and now, these banks and businesses have problems with solvency.
• In order to help these banks, governments are giving banks financial injections. In the UK, this injection accounts for around a £37billion bail-out. The British government now owns large parts of many banks, which is seen as a return to nationalisation. In a further attempt to help out, banks have cut their interest rates, but inflation continues to rise. Besides, consumer confidence is low.
• People worry about losing their jobs, or being made redundant. Some industries are cutting their workforce, and laying off staff. These job losses / job cuts / redundancies mean that there will be more claimants (for unemployment benefit) – or more people on the dole. (dole = unemployment benefit).

 Video 1: Zombie bank

 Video 2: The crisis of credit

The crisis of credit. Visualised.

• What is the the credit crisis? It’s a worldwide financial fiasco involving the terms you’ve probably heard like sub-prime mortgages, collateralized debt obligations, frozen credit markets and credit default swaps. Who’s affected? Everyone.
• How did it happen? Here’s how. The credit crisis brings two groups of people together: home owners and investors. Home owners represent their mortgages and investors represent their money. These mortgages represent houses and this money represents large institutions like pension funds, insurance companies, sovereign funds, mutual funds, etc. These groups are brought together through the financial system, a bunch of banks and brokers commonly known as Wall Street. Although it may not seem like it, these banks on Wall Street are closely connected to these houses on Main Street. To understand how, let’s start at the beginning. Years ago, the investors are sitting on their pile of money looking for a good investment to turn into more money. 
• Traditionally, they go to the US Federal Reserve where they buy Treasury Bills, believed to be the safest investment but on the wake of the dot.com bust and September 11th, Federal Reserve Chairman Allen Greenspan lowers interest rate to only 1% to keep the economy strong. 1% is a very low return on investment so the investors say “no, thanks.”
• On the flipside, this means banks on Wall Street can borrow from the Fed for only 1%. Add to that general surpluses from Japan, China and the Middle East and there’s an abundance of cheap credit. This makes borrowing money easy for banks and causes them to go crazy with…leverage.
• Leverage is borrowing money to amplify the outcome of a deal. Here’s how it works: in a normal deal someone with $10,000 dollars buys a box for $10,000 dollars, even sells them to someone else for $11,000 dollars for a $1,000-dollar profit, a good deal. But using leverage, someone with $10,000 dollars would go borrow $990,000 more dollars, giving him $1,000,000 in hand. Then he goes and buys 100 boxes with his $1,000,000 dollars and sells them to someone else for $1,100,000 dollars. Then he pays back his $990,000 plus $10,000 in interest, and after his initial $10,000, he’s left with a $90,000-dollar profit versus the other guy’s $1,000. Leverage turns good deals into great deals. This is a major way banks make their money.
• So Wall Street takes out a ton of credit, makes great deals and grows tremendously rich and then pays it back. The investors see this and want a piece of the action and this gives Wall Street an idea: They can connect the investors to the home owners through mortgages. Here’s how it works: a family wants a house so they save for a down payment and contact the mortgage broker. The mortgage broker connects the family to a lender who gives them a mortgage; the broker makes a nice commission. The family buys a house, becomes home owners. This is great for them because housing prices have been rising practically forever, everything works out nicely.
• One day, the lender gets a call from an investment banker who wants to buy the mortgage; the lender sells it to him for a very nice fee, the investment banker then borrows millions of dollars and buys thousands more mortgages and puts them into a nice little box. This means that every month he gets the payment from the home owners of all the mortgages in the box, and then he fixes his banker wizards on it to work their financial magic which is basically cutting it into three slices: “Safe, Ok and Risky”. 
• They pack the slices back up in the box and call it the collateralized debt obligation or CDO. A CDO works like three cascading trays: as money comes in the top tray fills first then spills over into the middle and whatever is left into the bottom, the money comes from home owners paying off their mortgages. If some owners don’t pay and default on their mortgage, less money comes in and the bottom tray may not get filled. This makes the bottom tray riskier and the top tray safer. To compensate for the higher risk, the bottom tray receives a higher rate of return while the top receives a lower but still nice return.
• To make the top even safer, banks will insure it for a small fee called the credit default swap. The banks do all this work so the credit rating agencies will stamp the top slice as a safe triple-A rated investment, the highest safest investment there is. The OK slice is triple B, still pretty good and they don’t bother to rate the riskiest slice. Because of the triple-A rating, the investment banker can sell the safe slice to the investors who only want safe investments; he sells the ok slice to other bankers and the risky slices to hedge funds or other risk takers. The investment banker makes millions, he then repays this loans. Finally the investors have found a good investment for their money, much better than the 1% Treasury Bills.
• They’re so pleased that they want more CDO slices so the investment banker calls up the lender wanting more mortgages, the lender calls up the broker for more home owners but the broker can’t find anyone. Everyone that qualifies for a mortgage already has one.
• But they have an idea: when home owners default on their mortgage, the lender gets the house and houses are always increasing in value. Since they’re covered in the home owners default, lenders can start adding risk to new mortgages not requiring down payments, no proof of income, no documents at all and that’s exactly what they did. So instead of lending to responsible home owners called prime mortgages, they started to get, well, less responsible. These are sub-prime mortgages.
• This is the turning point. So just like always, the mortgage broker connects the family with the lender and the mortgage, making his commission. The family buys a big house. The lender sells the mortgage to the investment banker who turns it into a CDO and sells slices to the investors and others. This actually works out nicely for everyone and makes them all rich. No one was worried because as soon as they sold the mortgage to the next guy, it was his problem. If the home owners went to default, they didn’t care; they were selling off their risk to the next guy and making millions, like playing hot potato with a time bomb. Not surprisingly, the home owners default on their mortgage which at this moment is owned by the banker. This means forecloses on one of his monthly payment turns into a house. No big deal, he puts it up for sale but more and more his monthly payments turn into houses. Now there are so many houses for sale in the market creating more supply than there is demand and housing prices aren’t rising anymore, in fact, they plummet.
• This creates an interesting problem for home owners still paying their mortgages: as all the houses in their neighbourhood go up for sale, the value of their house goes down and they start to wonder why they’re paying back the $300,000-dollar mortgage when the house is now worth only $90,000 dollars. They decide that it doesn’t make sense to continue paying even though they can afford to, and they walk away from their house. Default rates sweep the country and prices plummet.
• Now the investment banker is basically holding a box full of worthless houses. He calls up his buddy the investor to sell his CDO but the investor isn’t stupid and says “no, thanks”. He knows that the stream of money isn’t even a dripper anymore. The banker tries to sell to everyone but nobody wants to buy his bomb. He’s freaking out because he borrowed millions, sometimes billions of dollars to buy this bomb and he can’t pay it back. Whatever he tries, he can’t get rid of it.But he’s not the only one: the investors have already bought thousands of these bombs. The lender calls up trying to sell his mortgage but the banker won’t buy it and the broker is out of work. The whole financial system is frozen and things get dark…
• Everybody starts going bankrupt. But that’s not all: the investor calls up the home owner and tells him that his investments are worthless. And you can begin to see how the crisis flows in a cycle. Welcome to the crisis of credit.

LESSONS WE LEARNT FROM FINANCIAL CRISIS OF 2008-2009

• The term “too big to fail” illustrates that business risks have been transferred to the taxpayer. Faced with the bankruptcy of General Motors and Chrysler in 2009, the US government —in other words, US taxpayers— took on billions of dollars’ of debt to give the companies a fresh start. In the UK and Europe, bank bailouts in 2008 and 2009 saved the private sector from huge losses. In Europe, what was put forward as a Eurozone government problem was in fact a private-sector problem, as banks faced nonrepayment of loans to businesses within Greece, Portugal, or Italy. The bailouts were arranged and financed by governments, meaning that taxpayers turned out to be the risk takers, even though nobody asked their opinion. American economist Nouriel Roubini summed this up by saying: “This is again a case of privatizing the gains and socializing the losses; a bailout and socialism for the rich, the well-connected, and Wall Street.” This issue has stretched far wider than the US and Europe, influencing the economic situation in both Japan and China in recent decades.

Case study: Asia: From the start of its 20-year depression in 1990, land prices in Japan fell by more than 80 percent, and today remain far below the levels reached in 1988 before the recession began. In effect, almost every bank in Japan was insolvent as a result of vast portfolios of nonperforming loans—loans that were made to companies that could neither repay the debt, nor pay the interest on that debt. Only the support of the Japanese central bank kept these commercial banks alive. The taxpayer took on the risks that are supposed to be taken by the private sector. Many analysts suggest that the same is true in China at present, although the opacity of the Chinese banking system makes this hard to verify.

• Roubini’s statement that losses are “socialized” (borne by the public) while profits remain in the private sector appears to be true. Income inequality has widened considerably around the world in recent decades, in countries including the US, UK, China, and India. For instance, between 1979 and 2007 in the US, the income of the top 1 percent of earners rose by 266 percent, while that of the bottom 20 percent rose by only 37 percent. Government bailouts for big business effectively mean that taxpayers are providing support for those who benefit most from today’s economic system. In the long run, businesses may enjoy substantial profits, and accept the rewards as recompense for the risks they take. But if the risks (and losses) are borne by the taxpayer, it is fair to question why only shareholders gain the profits in the good times. Often, employees and suppliers bear higher levels of risk than seems fair—shareholders, who enjoy the rewards of success, should bear the primary risk of failure. Even trade-union protection for workers has been eroded in recent decades—in the US and many countries around the world, unions account for no more than 10 percent of private-sector employees, which leaves workers unprotected when things go wrong. Although labor flexibility has its merits, imbalance between “my risk” and “your reward” has perhaps gone too far.

Case study: Richard “Dick” Fuld: Fuld was born in 1946 in New York City, NY. He graduated from the University of Colorado in 1969, and received an MBA from the Stern School of Business in 1973. He was CEO of Lehman Brothers investment bank from 1994 to the day of its collapse in 2008, and during that time, he received more than $500 million. Known as the “Gorilla of Wall Street,” Fuld was the domineering boss who pushed the company into the subprime mortgage business. For many critics, the decision that illustrated his hubris was his refusal of bailout funds from investor Warren Buffett and the Korea Development Bank, even though Lehman Brothers was in the throes of being toppled by the 2008 credit crunch. His reasoning was that the offers of cash did not match his own valuation of Lehman Brothers. Following the company’s bankruptcy in September 2008, Time Magazine named Fuld as one of the “25 People to Blame for the Financial Crisis,” and Condé Nast Portfolio magazine ranked him number one on its list of “Worst American CEOs of All Time.”

 Video 3: Margin call

1. What is the movie about?
2. What does it mean to be in a margin call?
3. Discuss these lines from the movie!: „What have I told you since the first day you stepped into my office? There are three ways to make a living in this business, be first, be smarter, or cheat. Now, I don't cheat. And although I like to think we have some pretty smart people in this building, it sure is a hell of a lot easier to just be first. Sell it all. Today.”

 Video 4: The Big Short

 Video 5: Analyze this part of the movie! 

 Video 6: How to Rob a Bank from Inside

The average bank robbery nets $7,500, but the really scary thing is when CEOs use dishonest accounting to claim record profits and defraud the economy as a whole. The last time this happened it cost $11 trillion and 10,000,000 jobs were lost. The common ‘recipe’ for this style of fraud is easy to see, and follows the same trends:

1. Grow like crazy
2. Buy or make crappy loans at a premium yield
3. Employ extreme yield
4. Keep only trivial loss reserves.

• This will give amazing returns to the bank, and easily enough to trigger massive executive bonuses. However a few years down the line, the bank is doomed to take a large hit.
• Appraisal fraud is when a bank will over-inflate the value of collateral against a loan. There were warnings of this before Enron collapsed, including a warning to the US government from some appraisers. These honest appraisers had been blacklisted by the banks for refusing to inflate the values of assets. The appraisal is a great defense against losses, so no honest bank should need to do it, but is a clear sign of accounting fraud.
• Liars loans are the second issue – where a bank will not check income of a borrower before lending them money. If a borrower overstates their income, it allows the bank to sell them a higher mortgage. Again, no honest bank should do this – it is a recipe for disaster to loan too much to someone who can’t pay. Between 2003 and 2006, liars loans increased by 500% – by 2006 40% of all loans were ‘liars loans’. This is despite the industry’s anti-fraud experts warning banks that they 90% of the stated incomes are fraudulent.
• Appraisal fraud was also increasing over the same time period – by 2007 90% of appraisers said they had experienced coersion from the banks to overstate values of assets. Banks were also giving up their federal deposit insurance, so were no longer under the gaze of the federal regulator. There was also the issue of the secondary market for these fraudulent loans- when banks will fraudulently sell the loans onto someone else. To do this it was necessary to hide the true value of the loan, or repackage the loans alongside better loans.
• The response after the savings and loans debacle of 1990s included 30,000 criminal referrals from regulators – one of the largest responses to white collar criminals. In response to the current crisis (GFC of 2009?), there were no criminal prosecutions. The FBI alone doesn’t have the expertise to investigate complex accounting fraud on its own – it needs guidance from regulators. In 2007 an alliance was formed between the Mortgage Bankers Association (an industry body) and the FBI to investigate mortgage fraud, but their definition of fraud was one where the banks were always the victim, and industry incapable of committing fraud. This led to criminal prosecutions against small business owners to protect the banks from them.
• William’s solution to banking regulation
  • abandon the ‘too big to fail’ mantra. They need to be shrunk to the point where their failure will not trigger wider losses.
  • we need to rework modern executive professional salaries. It is too big an incentive to defraud the system, and can create a situation where good ethics can be driven out of the system by bad ethics (unscrupulous appraisers).
  • deal with deregulation, de-supervision, and defacto decriminalisation. Over time, it has become trendy not to regulate banks, even when the regulators can see what is happening.

By making these changes, we can decrease the frequency and impact of future banking crises. We need to learn what the bankers learned – the recipe to rob a bank.