Thanks to: Ralph Abraham and Luba Petersen

1. We have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. …Planet Finance was beginning to dwarf Planet Earth. …The total annual issuance of mortgage-backed securities, including fancy new “collateralized debt obligations” (C.D.O.’s), rose to more than $1 trillion. The volume of “derivatives”—contracts such as options and swaps—grew even faster, so that by the end of 2006 their notional value was just over $400 trillion. … Then, beginning in the summer of 2007, Planet Finance began to self-destruct in what the International Monetary Fund soon acknowledged to be “the largest financial shock since the Great Depression.” ---Niall Ferguson, “Wall Street Lays Another Egg ,” Vanity Fair, December 2008.

3. We have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. …Planet Finance was beginning to dwarf Planet Earth. …The total annual issuance of mortgage-backed securities, including fancy new “collateralized debt obligations” (C.D.O.’s), rose to more than $1 trillion. The volume of “derivatives”—contracts such as options and swaps—grew even faster, so that by the end of 2006 their notional value was just over $400 trillion. … Then, beginning in the summer of 2007, Planet Finance began to self-destruct in what the International Monetary Fund soon acknowledged to be “the largest financial shock since the Great Depression.” ---Niall Ferguson, “Wall Street Lays Another Egg ,” Vanity Fair, December 2008.

5. We have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. …Planet Finance was beginning to dwarf Planet Earth. …The total annual issuance of mortgage-backed securities, including fancy new “collateralized debt obligations” (C.D.O.’s), rose to more than $1 trillion. The volume of “derivatives”—contracts such as options and swaps—grew even faster, so that by the end of 2006 their notional value was just over $400 trillion. … Then, beginning in the summer of 2007, Planet Finance began to self-destruct in what the International Monetary Fund soon acknowledged to be “the largest financial shock since the Great Depression.” ---Niall Ferguson, “Wall Street Lays Another Egg ,” Vanity Fair, December 2008.

7. Beyond Fear and Greed:The Moral Roots of Financial CrisesbyDaniel FriedmanProfessor of EconomicsUCSC Faculty Research LectureFebruary 1, 2010 Thanks to: Ralph Abraham and Luba Petersen

8. Tonight we’ll take a 1-hour tour of Planet Finance. We’ll meet many bizarre creatures living in tangled webs. It is complicated at first …

9. To keep the tour on schedule, I’ll defer most questions until the end. I’m happy to revisit anything in more detail after we reach our destination. …but things will get simpler as we dig deeper.

10. The Crust…For most of the 20th century, financing a home was simple. $ $ $

11. Early in 21st Century, CDOs and other derivatives began to thrive $ $ $ C.D.O.

14. $ $ $ $ $

18. Crisis on Planet Finance

22. Crisis Response

23. Mantle • A volcano eruption is sudden manifestation of deep slow underlying forces or trends. • The big three…

24. 1. Globalization of Financial Markets

26. 2. Financial Engineering Heat Equation: Black-Scholes Equation:

27. JDs and MBAs listened to Quants when they felt like it.

28. 3. Keynes-Minsky-Kindleberger Financial markets tend to cycle irregularly • Phase 0: Normalcy. Consensus beliefs, prudent behavior. • Phase 1: An unusual opportunity arises • 1720 London: SSC to purchase national debt • 1980 Japan: new manufacturing system • 1998 Silicon Valley: e-commerce • 2004 US: Securitized mortgage assets go global • Divergent beliefs regarding its value

29. KMK Phase 2: Euphoria • The early optimists rack up impressive profits. • Trend followers pile in • help drive up prices further • Greed grows • Peer pressure on prudent investors • Sir Isaac Newton; Charles Prince • Keynes’ higher levels. • Financial innovations help to accommodate • subprime mortgages, CDOs, CDSs, … • Asset price inflates, as does leverage and exposure to risk

30. KMK Phase 3: Revulsion • Eventually the supply of dazzled investors (and financial innovation) runs dry. • 1/90 in Japan, 2/00 in Silicon Valley, 6/07 in US home sales • Then asset prices pause. • The most leveraged investors have to sell • Asset prices and perceived quality fall. • “financial distress” • Borrowers default, and lenders suffer losses • Fear prevails; pessimists regain their voice • Contagion: even fundamentally sound investments take a hit • Can have a soft or hard landing • Crash phase usually moves faster than the bubble phase

31. KMK Phase 4: Recovery • Lower asset prices eventually attract bargain hunters • Asset prices begin to stabilize • “Stimulus” and bailouts of key participants can reduce contagion • Bankruptcies re-allocate resources: transfers from the overoptimistic to the prudent. • Consensus beliefs gradually return • Immunization against future bubbles may last a generation or more.

32. Simulation

33. Down to the Core • The basic function of finance is to provide for the future by an exchange of promises. • Providing for the future usually requires widespread cooperation, e.g., • planting crops in the spring • building irrigation systems or city walls in ancient Mesopotamia • building high-speed rail link to LA • launching a Digital Arts/New Media major. • . • Cooperation is sustained by promises of a fair share, e.g., • if you help plant and cultivate, then you get a share of harvest • If you contribute to building rail link, then you get a return

34. Traditional Finance: Eranos • In Athens 2500 years ago, say that you want to ship 100 amphorae of olive oil to Alexandria and bring back a boatload of wheatthe opportunity. • Eranos loan: You call on your friends and relatives to help buy the oil and shipping: • you promise to return their money when you are paid • 0% interest but you will return the favor. • Your promise is backed by • your personal code of honor, plus • moral sanctions of your social network.

35. Limits to Eranos • Vulnerable to (and can help cause) discord in the personal network. • Draws only on your own personal network. • Only a few dozen individuals. • Huge gains from broadening and diversifying the lenders and borrowers. • Urban societies have always also had less personal lending. • see Morals and Markets Ch 7 on: • moneylenders, daneizein, medieval Florence’s banking networks, etc.

36. Financial Markets • Briefly appeared in Roman republic, launched again in Amsterdam 400 years ago.

37. Financial markets • Briefly appeared in Roman republic, launched again in Amsterdam 400 years ago. • What are they? • Where promises are bought and sold, by strangers. • Promises must be depersonalized and standardized. • Eg., mortgages, stocks, bonds, derivatives are all standardized promises to make specified payments. • Why have they come to dominate finance? • Last major alternative---state capitalism---collapsed 20 years ago. • Something lost in depersonalization, but much is gained in tradability.

38. Financial Market Magic, I • Markets scale up beautifully. • Draw on resources of all participants • Not just dozens as in eranos, • or hundreds as in Florence banking network, • But rather thousands, eventually millions and billions of individuals. • Can routinely raise vast sums of money for good-looking projects, • Chunnel, or DANM building, or a new software company.

39. Financial Market Magic, II • They aggregate information. • Draw on diverse minds (Hayek) • Asset price can reflect any piece of • information held by any participant (EMH) • Thus greedy investors can deliver results similar to mind-reading angels. • E.g., Netflix raised about $100M in 2 weeks when it went public in 2002, financed expansion etc. • Greedy investors steered resources towards Netflix and away from Blockbuster.

40. Financial Market Risks, I • Financial markets fail unless they have adequate moral infrastructure • To channel greed and fear productively. • Participants must compete to find value, not to fleece or steal from other participants. • Financial markets require eternal vigilance against expropriation and fraud. • Main reason for failure in ancient Rome, in 1990s Russia, in Zimbabwe, etc. • Hence the need for regulators and guarantors.

41. Financial Market Risks, II • Regulators’ and Guarantors’ safety nets can encourage riskier behavior • Clever entrepreneurs offer one way bets: heads I win, tails the taxpayers lose. • Called “moral hazard.” • KMK instability • Regulators become less vigilant after decades of stability. • The more confident are investors, the stronger the push towards the risky edge. • Can get positive feedback bubbles and crashes, where info fails to aggregate properly.

42. Highlights of the Tour • Crust: • 7 ring circus spins toxic assets • Homebuyers, lenders, brokers, investment bankers, raters, regulators, investors • Mantle: • Globalization • Innovation (derivative securities) • KMK ratchet • Core: • Promises of cooperation, market for promises • Market usually harnesses greed and fear

43. Lessons for 2008-09 • Not a sudden outbreak of greed and fear—they are never in short supply. Rather: • Decades of good performance lulled investors and regulators into overconfidence • awareness of inherent market instability faded • Globalization and innovation overstretched the markets’ moral sinews. • Responsibility (for liar loans, CDSs, etc) unclear for raters, regulators, dealers, brokers, originators, ... • Top managers and shareholders didn’t really understand the innovations. E.g., that CDO-sq distill systemic risk, not accounted for in Moody’s AAA.

44. Finance in the 21st Century More personalized finance? • Roscas and microfinance grow rapidly in emerging countries, now over 150 million borrowers

45. Web-enabled microlending also is growing in developed countries: Kiva, MicroPlace, Prosper, DonorsChoose • Tradeoff remains between direct personal connections and scalability (or efficiency). • Available data confirms that success is modest. • I expect growth to continue, especially in charitable giving, but that financial markets will continue to dominate.

46. Reforming Financial Markets • After the 2008-09 meltdown, our natural moral instinct is to: • find the bad guys, punish them severely, and • clamp down so it can’t happen again. • Natural, but perhaps misguided. • Should prosecute the lawbreakers (Madoff, …), but witch hunts are counterproductive • We risk losing huge advantages of financial markets if we try to return to the 1950s. • Need smarter reforms.

47. Rebuilding the Moral Infrastructure 1. Restore clear lines of responsibility among participants and regulators • Cheaters must not prosper (e.g. Madoff) • Legal one-way bets must be spotted quickly and the profits drained (e.g. AIG’s CDS traders) 2. Increase transparency. • Investors and rivals should see aggregate positions and prices. • Should encourage competition and info aggregation but discourage rent-seeking.

48. More Steps 3. Encourage true innovation, discourage evasive innovation • E.g., weather derivatives are good • SIVs for evading capital requirements, or • Avoiding a CDS exchange are bad 4. Measure systemic risk, and tax it • A Pigouvian tax, as for alcohol. • Hire “rocket scientists” with a conscience to help measure and monitor impact of new innovation. • Laboratory test beds and behavioral finance can help.

49. The Next Year is Critical • 1930s legislation shaped financial markets until recently. • as 100 year floods shape rivers, the major crises shape financial markets. • Here at UCSC we will do our part • SCIIE • Sury Initiative • Bruce Initiative

50. To Learn More • Morals and Markets, • Preface and Ch 7 cover previous bubbles and crashes, Ponzi schemes, origins of banking and financial markets, information aggregation, lab experiments, etc. • Other sources • The Big Short, Michael Lewis, Mar 2010 • Malmendier, JEL Dec 2009 • Friedman & Abraham, J Econ Dynamics and Control. April 2009 • http://www.vismath.org/research/landscapedyn/models/markets/ • Bureau of Economic Analysis (Flow of Funds data)