The Global Financial Crisis: Is It Like The Great Depression?

1

• The Global Financial Crisis Is It Like The
  Great Depression?
• Trento Economics Festival May 2009
• Overview by Assaf Razin
• Tel-Aviv University and Cornell University

2
Current Global Crisis 3 Acts

• Act I Credit-fed Asset Bubble
• Act II Financial Collapse after the Burst of the
  bubble
• Act III spill overs to the real economy

3
Under currents

• Financial innovation, globalization, and reduced
  transparency in the financial sector
• Panicky in free fall of asset prices
• Under capitalized banking system and credit crunch

4
Historical Precedents?

• The great depression?
• Japan in the 1990s?
• Sweden in the 1980s?
• The saving and loan crisis in the US in the 1980?

5
History

• Carmen Reinhart of Maryland and Ken Rogoff of
  Harvard, have recently published an analysis of
  the current financial crisis in the context of
  what they identify as the previous 18 banking
  crises in industrial countries since the second
  world war. They find what they call "stunning
  qualitative and quantitative parallels across a
  number of standard financial crisis indicators" -
  the common themes that translate these individual
  dramas into the big-picture story of financial
  boom and bust. Their study is focused on the US,

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6
Banking Crises

• BANKING CRISES ARE PROTRACTED, THEY NOTE, WITH
  OUTPUT DECLINING, ON AVERAGE, FOR TWO YEARS.
  ASSET MARKET COLLAPSES ARE DEEP, WITH REAL HOUSE
  PRICES FALLING, AGAIN ON AVERAGE, BY 35 PER CENT
  OVER SIX YEARS AND EQUITY PRICES DECLINING BY 55
  PER CENT OVER 3½ YEARS. THE RATE OF UNEMPLOYMENT
  RISES, ON AVERAGE, BY 7 PERCENTAGE POINTS OVER
  FOUR YEARS, WHILE OUTPUT FALLS BY 9 PER CENT.

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Banking crises follow ups
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Two historical precedents

• The Great Depression in the 1930s
• The Japanese Deflation(Mid -90s)
• The shocks that played a role in each (1)An
  asset price correction, in real estate and
  equities (reducing consumption through a wealth
  effect)
• (2)Impairmaint of financial institutions balance
  sheets (reducing credit)

9
Great Depression
10
Tracking the Great Depression by months into the
Crisis
Eichengreen and ORourke point out that the
original Great Depression was most severe in
America, while this one is more severe in a
number of other countries.
11
Chronology of Crisis

• May 2008 Bear Stearns crushed and forced to be
  sold to JP Morgan
• Sept 15 2008Lehman Brothers went belly up.
• Sept 16, 2008 A.I.G. is effectively nationalized

• Sept 18, 2008Bank of America bought Merril
• Lynch.
• December 2008the Federal Reserve cuts interest
  rates virtually to zero

12
Understanding whats going on is Like shooting
at a moving target

• Housing bubble.
• Subprime mortgage crisis
• Financial sectors toxic assets
• Liquidity crisis

• Zero interest rate.
• Unconventional central banking
• Liquidity trap?

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The Current Crisis vs. the Great Depression

• (1) Both crises followed asset bubbles.
• (2) Both crises started in the financial sector
  and gradually spread to the real sector. During
  both crises many financial institutions either
  defaulted or had to be bailed out.
• (3)In both cases the crisis appears to have
  started with the bursting of a bubble.
• (4) In both cases banking credit dried up.
• (5) In both cases the lower zero bound on the
  policy rate became effective.
• (6) In both cases the crisis started in the US
  and then US and subsequently spread to other
  countries.

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Key Differences

• 1. Responses of both fiscal and monetary policies
  today are much swifter and vigorous than they
  were during the first three years of the great
  depression
• The deficit declined in fiscal 1935 by roughly
  the same amount it had risen in 1934.
• The US was on a gold standard throughout the
  Depression. In April 1933, Rosevelt temporaryily
  suspended the convertibility to gold and let
  Dollar depreciate substantially. When US went
  back on gold at the new higher price of gold,
  large quantities of gold flowed in and caused
  expansion of money supply. The expansion of
  money broke expectations of deflation. .

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Budget Balance and Monetary Base

• 2. Hoovers Federal budget was largely balanced
  budget deficit in the current crisis is 8-10
  percent of GDP.
• Friedman and Schwartz (1963) claim that, during
  the first three years of the great depression,
  the Fed tolerated and even reinforced a
  substantial shrinkage of the money
• The monetary base was flat during 1929-33 it
  was doubled during 2008.

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Differences

• 3. Unemployment in 1930 25
• in May 2009 9.4
• Change in output 1929-(peak) to 1933 (trough)
  -25
• 2007 (peak) last qtr 2008 (before trough) 2
• Change in prices 1929-1934 deflation 2008-9
  low inflation/deflation? See next slide

17
The graph, from the Cleveland Fed, shows
inflation as gauged by the consumer price index
and by a measure called the median CPI. As every
grade school student learns when the teacher
reports results of the latest test, the average
of any data set can be thrown off by a few
extreme outliers the median is a more robust
statistic to estimate the central tendency in the
data.
18
Monetary institutions

• 4. There are two important differences in
  monetary institutions
• First there was no banking deposit insurance at
  the time. As a matter of fact deposit insurance
  was introduced only after Roosevelt became
  president in March 1933. .

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Gold Standard

• the 5. US was in the great depression on the gold
  standard. The maintenance of a fixed parity with
  gold collided with the use of monetary policy to
  offset domestic unemployment during the first
  three years of the great depression. For this
  reason the US abandoned the gold standard under
  Roosevelt. Obviously, since the is floating
  vis-à-vis other major currencies, no such
  constraint operates in the current crisis.

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Contractionary Policies under the Gold Standard

• Central banks discount rates in the US, UK and
  Germany, in the late 1920s and early 1930s were
  pushed up to prevent gold leakages. The good news
  is that we donot have the Gold Standard now. But
  East European countries in crisis are now jacking
  up interest. Especially those who are trying to
  enter the Euro zone.

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Informational capital

• 5. Fourth, the fact that a relatively large
  number of banks disappeared during the great
  depression led to the destruction of banking
  informational capital about the credit
  worthiness of potential borrowers.

22
Tariff War

• 6. The great depression was characterized by
  beggar thy neighbor policies. In mid 1930 the US
  Congress passed the Smoot-Hawley Tariff Act that
  raised tariffs on over 20,000 imported goods to
  record levels. Other countries retaliated by also
  imposing restrictions on imports and engaged in
  competitive devaluations. This led to a serious
  contraction of international trade.

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The recession tracks the Great Depression
24
Irving Fishers debt deflation

• As the great American economist Irving Fisher
  pointed out in the 1930s, the things people and
  companies do when they realize they have too much
  debt tend to be self defeating when every one
  tries to do them, AT THE SAME TIME, the attempts
  to sell assets and pay off debt deepen the plunge
  in asset prices. This further reduces a net
  worth and the process repeats itself.

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Keynes Metaphor for a Bubble

• Consider beauty competitions famously described
  by John Maynard Keynes, in which the winner was
  the contestant who chose the six faces most
  popular with all contestants. The result, Keynes
  observed, was that the task was not to choose the
  most beautiful face, but the face that average
  opinion would think that average opinion would
  find the most beautiful. In this way beliefs feed
  on themselves and become divorced from any
  underlying reality.

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THE LENDER OF LAST RESORT

• The role of lender of last resort was classically
  defined by Walter Bagehot. His great book Lombard
  Street was published in 1873, and set out what
  has become the guiding mantra for central banks
  in times of crisis ever since lend freely at
  high rates against good collateral. Lend freely,
  in his words, "to stay the panic". At high rates,
  so that "no one may borrow out of idle precaution
  without paying well for it". And lend on all good
  banking securities to an unlimited extent -
  because the "way to cause alarm is to refuse
  someone who has good security to offer".

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Investment Banks

• By forcing the fourth largest investment bank,
  Lehman Brothers, into bankruptcy and Merrill
  Lynch into a distressed sale to Bank of America,
  they helped to facilitate a badly needed
  consolidation in the financial services sector.
  However, at the 2008 juncture, the credit crisis
  radiated out into corporate, consumer and
  municipal debt. Regardless of the Fed and
  Treasurys most determined efforts, the political
  pressures for a much larger bail-out, and
  pressures from the continued volatility in
  financial markets, are going to be irresistible.

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Bail Outs

• the financial crisis has probably already added
  at most 200bn-300bn to net debt, taking into
  account the likely losses on nationalising the
  mortgage giants Freddie Mac and Fannie Mae, the
  costs of the 29bn March bail-out of investment
  bank Bear Stearns, the potential fallout from the
  various junk collateral the Federal Reserve has
  taken on to its balance sheet in the last few
  months, and finally, Wednesdays 85bn bail-out
  of the insurance giant AIG.

29
Repo market and liquidity
In repo agreements borrowers transfer securities
to lenders with an agreement to repurchase them
later, often the next day. They enable banks and
shadow banks to fund long-term, high-yield
investments with short-term low-cost loans
which they did enthusiastically during the credit
bubble by 2008 the top US investment banks
funded half their balance sheets in a repo market
exceeding 10,000bn.
30
What is a Bank?
Banks take peoples money, promise to give it
back on demand and lock it up in less liquid
investments. This works marvellously while few
enough lenders want their money back. It
collapses when all want to hoard their cash at
the same time. That is what happened to Lehman
Brothers the equivalent of a bank run in the
repo market.
31
Lehman as a Custodian
The panic was made worse, the Fed thinks, by the
custodians exposure to losses as Lehmans
lenders left it to its fate. Custodians also
faced conflicts of interest as counterparties to
the repo-funded banks in other markets.
32
Limited Liability

• The core of the crisis lies in the legal
  provisions of limited liability creditors have
  no claims against the personal assets of the
  owners (shareholders). These liability
  constraints lead to a systematic disregard of
  systemic disaster risks-ocurrences only with a
  small probability about gigantic losses.

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Risk taking bahavior

• Investors that opt for high-risk projects with
  high potential gains and losses instead of safe
  projects with similar average profits, can expect
  to gain, since they only have to bear a portion
  of the possible losses. If things go well,
  investors reap the full profit. If things go
  badly, at worst their losses are limited by the
  stock of equity they invest.

34
Moral Hazard

• A HOUSE INSURED FOR MORE THAN ITS VALUE IS ALWAYS
  CONSIDERED A FIRE RISK. BUT HOME INSURANCE IS
  REGULATED AND ARSON IS A CRIMINAL OFFENCE THAT
  KEEPS PEOPLE HONEST, MOST OF THE TIME

35
Bank recapitalization

• A severe fall in the market value of a financial
  institution's assets raises the risk and lowers
  the market value of its debt, as well as its
  equity. Bringing in new equity capital produces
  an equal (dollar for dollar) increase in the
  market value of assets. This lowers the risk and
  raises the market value of the institution's
  debt. As a result, part of the new equity capital
  shows up not as equity but as a transfer to debt
  holders. (This is the debt overhang problem.)

36
Who pays for the transfer?

• Not the new private stockholders. They will not
  invest unless they get stock with market value at
  least equal to the funds they provide. This means
  the transfer of wealth to the old debt holders
  must come from the old stockholders. They pay via
  the dilution of their ownership share (and the
  drop in the share price) caused by bringing in
  new equity.

37
Value of old stock

• If the market value of the old stock before the
  equity issue is low, it may be insufficient to
  cover the transfer of wealth to debt holders that
  new equity capital produces. As a result, the
  market value of a stock issue would be less than
  the funds provided, and the financial
  institution's attempt to issue equity to meet its
  capital requirement will fail.

38
Subsidy

• If the Treasury steps in when the private market
  refuses to provide equity capital to a financial
  institution, we are in subsidy land. Again, the
  subsidy arises because a large part of the equity
  injection by the government does not end up as
  government (taxpayer) equity but rather goes to
  prop up the financial institution's debt holders.

39
FDIC

• If a bank cannot raise private equity to meet its
  FDIC capital requirement, the powers of the FDIC
  kick in. For example, the FDIC can seize the bank
  and auction it off. The bidders are typically
  other banks. Acquiring a seized bank is often an
  attractive option for a strong bank since it can
  be a cost effective way to expand deposits and
  acquire links to profitable borrowers.

40
Price of acquiring a bank

• The maximum price the acquiring bank should be
  willing to pay is the market value of the seized
  bank's assets minus the seized bank's deposits.
  This net amount is then distributed to the bank's
  non-deposit liability holders, in order of
  priority. What this means is that the seized
  bank's stockholders and some of its lower
  priority debt often get nothing.

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Credit Crunch 2008
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Interbank Lendings Squeeze
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Global Saving Glut

• Behind this Global Saving Glut lie three
  phenomena
• 1.excess of retained profits (corporate saving)
  over investment, of the corporate sectors of
  the advanced countries,
• 2. --the persistent savings surpluses of a
  number of mature economies, particularly Japan
  and post-unification Germany.

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Global imbalances
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Currency reserves
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The US moves into debtor status, and vast
increase in cross-holdings.

• In 1996, on the eve of the Asian crisis, the US
  had assets overseas equal to 52 percent of GDP,
  and liabilities equal 57 percent of GDP. By 2007,
  these numbers were up to 128 percent and 145
  percent, respectively.

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Risk sharing and globalization

• This is change is supposes to reduce risk US
  investors held much of their assets abroad(less
  exposed to a slump in the US) foreign investors
  held much of their wealth in the US (they were
  less exposed to a slump in their domestic
  economies).
• But, large parts of the increase in globalization
  came from investments in highly leveraged
  financial institutions (making various riskycross
  border bets).

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Four vicious cycles

• Four vicious cycles are simultaneously under
  way falling asset prices are forcing levered
  holders to sell, driving prices further down
  losses at financial institutions are reducing
  their ability to finance investment, which in
  turn reduces asset values, causing further
  losses the weakness of the financial system is
  reducing growth, which in turn weakens the
  financial system and falling output is hitting
  employment, which in turn leads to reduced demand
  for outputLarry Summers.

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Debt accumulation and deflation in the US

• The big US debt accumulations were not by
  non-financial corporations but by households and
  the financial sector. The gross debt of the
  financial sector rose from 22 percent of GDP in
  1981, to 117 percent of GDP in the third quarter
  of 2008 the debt of non financial corporations
  rose from 53 percent to 76 percent, in the same
  period. Thus, the desire of financial
  institutions to shrink balance sheet may be a
  cause of the recession.

54
Akerlofs Problem

• When house prices started to decline, this has
  had bigger effect on some MBS than other MBSs,
  depending on the complexity of the mortgages that
  backed the securities. Owners of MBS have strong
  incentive to price each an every one of them.
  They have superior information over the market
  buyers. As in Akerlofs Lemmons Problem, the
  market for MBS will collapse.

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Market illiquidity

• The buyer hopes that the seller sells the
  security because he needs cash. But the buyer
  worries that the seller will unloads the most
  troubled securities. This makes the market
  illiquid.

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Mortgage Finance

• The common form of mortgage commits the household
  to make equal monthly payments for 30 years.
  These mortgages payy off with 10 years because
  households sell the property or does refinance.
• New model The borrower applies to a mortgage
  broker, receives money from a wholesale lender,
  and make payments to a servicer. The servicer
  passes on each payment to a master servicer, who
  pays it out to holders of a mortgage-based-securit
  y (MBS), who pass it on to the adminstrator of a
  collateralized debt obligation (CDO), who passes
  it on to investors in CDOs.

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Mortgage as option, not loan

• This mortgage is therefore not a loan but an
  option it allowed for gains if house prices
  rose, but cost relatively little if prices fell.

58
Barriers to Lending

• The Problem most banks no longer hold the loans
  they make, content to collect interest until the
  debt comes due. Instead, the loans are bundled
  into securities and sold to investors. But the
  securitization market broke. The result is a
  drastic contraction of credit available
  throughout the economy.
• Banks have come to depend on selling mortgages
  and other loans to investors like hedge funds and
  insurance companies. This allows banks to make
  more loans and earn bigger profits.

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Mortgage-backed Securities

• How to value MBSs?
• Imagine you bought a 100,000 house a year ago,
  with a 10,000 down payment.
• If the value of the house rises, you are in the
  money.
• If it falls, you can walk away. You loose the
  original 10,000 investment, but are safe in the
  knowledge that the lender cannot seize your other
  assets..

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US Borrowings
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US banks, undermine willingness to expand credit,
Destroy Confidence
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House Price Bubble
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US GDP
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US Unemployment
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counterparty risk 

• DEFINITIONThe risk that the other party in an
  agreement will default. In an option contract,
  the risk to the option buyer that the writer will
  not buy or sell the underlying as agreed.
• In general, counterparty risk can be reduced by
  having an financial organization with extremely
  good credit reputation which acts as an
  intermediary between the two parties.

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Investors behavior in the asset bubble
-Disaster Myopia Equity markets lost by 2009
all the gains from the 1997-8 crises

• A tendency to underestimate the probability of
  disastrous outcomes, especially for low-frequency
  events last experienced in the distant past.
• The risk of falling victim to this syndrome was
  particularly acute in the recent period of
  unusual economic stability known as the great
  moderation. Investors were confronted by falling
  yields against a background of declining
  volatility in markets. Many concluded that a new
  era of low risk and high returns had dawned.

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Investors in FX markets Carry Tradedepreciation
myopia

• EQUALLY POPULAR WERE TRADING STRATEGIES SUCH AS
  CARRY TRADES, WHICH INVOLVED BORROWING AT LOW
  INTEREST RATES AND INVESTING AT HIGHER RATES,
  ESPECIALLY VIA THE CURRENCY MARKETS. FAVOURITE
  TRADES INCLUDED BORROWING IN JAPANESE YEN TO
  INVEST IN AUSTRALIA OR NEW ZEALAND, AND BORROWING
  IN SWISS FRANCS TO INVEST IN ICELANDIC ASSETS.

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The danger in Carry Trade

• Carry trade WAS DANGEROUS BECAUSE THE INTEREST
  RATE SPREAD COULD BE WIPED OUT IN SHORT ORDER BY
  VOLATILE CURRENCY MOVEMENTS. YET BECAUSE
  VOLATILITY REMAINED LOW FOR SO LONG, DISASTER
  MYOPIA PREVAILED. CARRY TRADERS WERE LULLED INTO
  A FALSE SENSE OF SECURITY, WHILE MORE SCEPTICAL
  COMPETITORS JOINED IN FOR FEAR OF UNDERPERFORMING.

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The Credit Crunch

• 1. Overnight credit is blocked by the asymmetric
  information held across banks regarding each
  others assets quality.
• 2. Fear of the bank of being short of funds to
  meet creditor demands thus the bank is reluctant
  to lend.
• 3. fear of the bank of being short of funds if
  investment opportunities get better.

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Moral Hazard

• Moral hazard, a situation in which one person
  makes
• a decision about How much risk to take while
• someone else bears the cost if things go
  badly
• Treasury proposes to make low-interest,
  non-recourse, loans to private investors who buy
  bad assets this is a plan to drive up the prices
  of toxic assets by creating a lot of moral
  hazard.
• By offering low interest non-recourse loans,
  these public-private entities can pay a higher
  than market price for the toxic assets (since
  there is no downside risk). This amounts to a
  direct subsidy from the taxpayers to the banks.

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Four distinct economic mechanisms that played a
role in the liquidity and credit crunch

• 1. . The effects of large quantities bad loan
  write-downs on borrowers' balance sheets caused
  two "liquidity spirals
• 1a. As asset prices dropped, financial
  institutions not only had less capital
• 1b. financial institutions also had harder time
  borrowing, because of tightened lending
  standards.
• The two spirals forced financial institutions to
  shed assets and reduce their leverage. This led
  to fire sales, lower prices, and even tighter
  funding, amplifying the crisis beyond the
  mortgage market.

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Mechanisms (continued)

• 2. Lending channels dried up when banks,
  concerned about their future access to capital
  markets, hoarded funds from borrowers regardless
  of credit-worthiness.
• 3. Runs on financial institutions, as occurred at
  Bear Stearns, Lehman Brothers, and others
  following the mortgage crisis, can and did
  suddenly erode bank capital.
• 4. The mortgage crisis was amplified and became
  systemic through network effects, which can arise
  when financial institutions are lenders and
  borrowers at the same time. Because each party
  has to hold additional funds out of concern about
  counterparties' credit, liquidity gridlock can
  result.

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The Geithner Public-private scheme to buy toxic
assets from banks

• One or more giant investment fund will be created
  to buy up toxic assets.
• Its balance sheet for every 1 of toxic assets
  they buy from banks, the FDIC will lend 85.7
  percent (6/7 th of 1), and the US treasury and
  private investors will each put 7.15 cents in
  equity to cover the remaining balance.

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The Geithner Public-private scheme to buy toxic
assets from banks (continue)

• The FDIC loan is non-recourse, meaning that if
  the toxic assets purchased by private investors
  fall in value below the amount of the FDIC loans,
  the investment fund will default, and the FDIC
  will end up holding the toxic assets.

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Tax payer giveaway in the Geithner Plan

• An Example (Jeff Sachs)
• Consider a portfolio of toxic assets with a face
  value of 1 trillion. Assume that they have a 20
  percent chance of paying out their full face
  value (1 trillion) and an 80 percent chanceof
  paying out only 200 billion.
• The market value of these assets is given by
  their expected payout (.2x10.8x.2)360 billion.
• Because the FDIC is lending money at a low
  (bidding up the market value of toxic assets)
  interest rate on a non-recourse basis is likely
  to experience a massive default on the loan.
• The FDIC subsidy subsidy shows up as a bid price
  for the toxic assets as it above 360 billion.

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Over pricing the toxic assets through the
government non-recourse loan

• Investor is prepared to bid 714, 000 for the the
  asset that a risk-neutral would pay 360,000
  only.
• How is this number derived?
• The investor uses 71,000 of her own money and
  643,000 of the government loan adding up to
  714, 000 bid.
• If the asset pays in full, the investor repays
  the loan with a profit of 357,000 (1,000000-
  643,000) so that with 20 percent of the time,
  which bring an expected profit of 71,000.
• The other 80 percent of the time the investor
  defaults on the loan, getting a profit of 0, and
  the government ends up with 200,000.
• Summing up the investor just breaks even by
  bidding 714, 000, as would beexpected in
  competitive auction.

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Price Discovery or Overpricing?

• The idea of price discovery of the toxic asset
  would be genuine if the government loan has to be
  repaid whether or not the asset paid of in full
  or not. But, with the non-recourse loan it leads
  to overpricing of the toxic asset.

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Gaming the System Jeff Sachs Example

• Consider a toxic asset held by Citibank with a
  face value of 1 million, but with zero
  probability of any payout and therefore with a
  zero market value. An outside bidder would not
  pay anything for such an asset.

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More..

• Suppose, however, that Citibank itself sets up a
  Citibank Public-Private Investment Fund (CPPIF)
  under the Geithner-Summers plan. The CPPIF will
  bid the full face value of 1 million for the
  worthless asset, because it can borrow 850K from
  the FDIC, and get 75K from the Treasury, to make
  the purchase! Citibank will only have to put in
  75K of the total.

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potential rip-off

• Citibank thereby receives 1 million for the
  worthless asset, while the CPPIF ends up with an
  utterly worthless asset against 850K in debt to
  the FDIC. The CPPIF therefore quietly declares
  bankruptcy, while Citibank walks away with a cool
  1 million. Citibank's net profit on the
  transaction is 925K (remember that the bank
  invested 75K in the CPPIF) and the taxpayers
  lose 925K. Since the total of toxic assets in
  the banking system exceeds 1 trillion, and
  perhaps reaches 2-3 trillion, the amount of
  potential rip-off in the Geithner-Summers plan is
  unconscionably large.

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the insider-bidding route

• The earlier criticisms of the Geithner-Summers
  plan showed that even outside bidders generally
  have the incentive to bid far too much for the
  toxic assets, since they too get a free ride from
  the government loans. But once we acknowledge the
  insider-bidding route, the potential to game the
  plan at the cost of the taxpayers becomes
  extraordinary. And the gaming of the system
  doesn't have to be as crude as Citibank setting
  up its own CPPIF. There are lots of ways that it
  can do this indirectly, for example, buying
  assets of other banks which in turn buy Citi's
  assets. Or other stakeholders in Citi, such as
  groups of bondholders and shareholders, could do
  the same.

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Ersatz Capitalism?

• Ersatz is a German word meaning compensation or
  idemnity (or still, substitute). Ersatz
  capitalism is when the government in effect
  insure loses, so that loses are socialized but
  gains are privatized. The Geithner plan would
  not determine the fair price of toxic assets in
  the ailing banks. It sets a mechanism to price
  discovery on a put on the toxic asset but not
  on the value of the asset. Its success in
  helping capitalize the banks is negatively
  related to loses to tax payers.

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Sources for charts Robert Shiller, Andrew
Smithers Thomson Datastream
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Just under half of corporate debt in America was
rated as speculative (BB or below) at the end
of 2008
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Global Trends
86
Financial crises over the history
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Global Crisis
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US CREDIT MARKET
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Volume of asset backed securities
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House price index
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The Global Picture a la Krugman

• we used to talk about the subprime crisis .
• Today we know that subprime lending was only a
  small fraction of the problem.
• Ben Barnanke (2005), The Global Saving Glut and
  the U.S. Current Account Deficit, offered a
  novel explanation for the rapid rise of the U.S.
  trade deficit in the early 21st century. The
  causes, argued Bernanke, lay not in America but
  in Asia.

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Global Picture (Continued)

• In the mid-1990s, Bernanke pointed out, the
  emerging economies of Asia had been major
  importers of capital, borrowing abroad to finance
  their development. But after the Asian financial
  crisis of 1997-98, these countries began
  protecting themselves by amassing huge war chests
  of foreign assets, in effect exporting capital to
  the rest of the world.

93
Global Picture (Continued)

• Most of the Asia cheap money went to the United
  States hence our giant trade deficit, because a
  trade deficit is the flip side of capital
  inflows. But as Mr. Bernanke correctly pointed
  out, money surged into other nations as well. In
  particular, a number of smaller European
  economies experienced capital inflows that, while
  much smaller in dollar terms than the flows into
  the United States, were much larger compared with
  the size of their economies.

94
Global Picture (Continued)

• wide-open, loosely regulated financial systems
  characterized the US shaddow banking system and
  mortgage institutions, as well as many of the
  other recipients of large capital inflows. This
  may explain the almost eerie correlation between
  conservative praise two or three years ago and
  economic disaster today. Reforms have made
  Iceland a Nordic tiger, declared a paper from
  the Cato Institute. How Ireland Became the
  Celtic Tiger was the title of one Heritage
  Foundation article The Estonian Economic
  Miracle was the title of another. All three
  nations are in deep crisis now.

95
Global Picture (Continued)

• For a while, the inrush of capital created the
  illusion of wealth in these countries, just as it
  did for American homeowners asset prices were
  rising, currencies were strong, and everything
  looked fine. But bubbles always burst sooner or
  later, and yesterdays miracle economies have
  become todays basket cases, nations whose assets
  have evaporated but whose debts remain all too
  real. And these debts are an especially heavy
  burden because most of the loans were denominated
  in other countries currencies.

96
Global Picture (end)

• Nor is the damage confined to the original
  borrowers. In America, the housing bubble mainly
  took place along the coasts, but when the bubble
  burst, demand for manufactured goods, especially
  cars, collapsed and that has taken a terrible
  toll on the industrial heartland. Similarly,
  Europes bubbles were mainly around the
  continents periphery, yet industrial production
  in Germany which never had a financial bubble
  but is Europes manufacturing core is falling
  rapidly, thanks to a plunge in exports.

97
Europe vs. the US

• 27 EU countries lack ways of boosting their
  overall fiscal and monetary firepower by acting
  collectively.
• Europe has fallen short in terms of both fiscal
  and monetary policy its facing at least as
  severe a slump as the United States, yet its
  doing far less to combat the downturn.
• On the fiscal side, Americas actions dwarf
  anything the Europeans are doing.
• Monetary policy The European Central Bank has
  been far less proactive than the Federal Reserve
  it has been slow to cut interest rates (it
  actually raised rates July 2008!), and it has
  shied away from any strong measures to unfreeze
  credit markets.
• The only thing working in Europes favor is the
  very thing for which it takes the most criticism
  the size and generosity of its welfare states,
  which are cushioning the impact of the economic
  slump.

98
Stimulus packages
99
No two fiscal packages are ever launched amid the
same circumstances
It is wrong to extrapolate from the past!
Measuring the separate effect of any One-off
fiscal boost from the automatic Extra spending
that was anticipated Is hard.
100
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101
Fed Rate
102
Emerging stars buffeted by global storm
103
Triggers of credit bubbles and depression
Economics
1. Moral hazard, a situation in which one person
makes a decision about How much risk to take
while someone else bears the cost if things go
badly 2. Self fulfilling panics, as in bank runs.
104
Credit Market September 2008

• financial institutions hold significant assets
  that are backed by mortgage payments. Two years
  ago, many of those mortgage-backed securities
  (MBS) were rated AAA, very likely to yield a
  steady stream of payments with minimal risk of
  default. This made the assets liquid. If a
  financial institution needed cash, it could
  quickly sell these securities at a fair market
  price, the present value of the stream of
  payments. A buyer did not have to worry about the
  exact composition of the assets it purchased,
  because the stream of payments was safe.

105
Libor-OIS spreads reached 200 basis points in
September 2008 when Congress failed to pass the
Paulson plan
106
Bank bailouts
107
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108
Japans 1990s

• Japans experience in the 1990s is cautionary
  example of the peril of propping up banks after a
  real estate boom ends. The Japanese government
  helped keep many troubled banks afloat, hoping to
  avoid the pain of bank failures, only to extend
  the economic downturn as consumer spending and
  job growth fell.

109
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110
Japans Banks

• THE 1990 COLLAPSE OF AN ASSET BUBBLE PROVOKED A
  SHARP FALL IN THE VALUE OF PROPERTY AND EQUITY
  THAT UNDERPINNED BANKS BALANCE SHEETS. BUT BANKS
  IGNORED THEIR PROBLEMS UNTIL 1997 WHEN SANYO
  SECURITIES, YAMAICHI SECURITIES AND HOKKAIDO
  TAKUSHOKU BANK ALL FAILED.

111
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112
Japans Current Account
113
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114
Reluctance to recapitalize by state funds

• A RELUCTANCE TO ADMIT THE SCALE OF THE PROBLEM
  MEANT CAPITAL INJECTIONS TOOK PLACE IN THREE MAIN
  TRANCHES. THE FIRST CAME IN THE SPRING OF 1998,
  WHEN THE GOVERNMENT INJECTED Y1,800BN (18BN,
  11BN, 14BN) INTO 21 INSTITUTIONS. THE MONEY,
  WHICH CAME IN THE FORM OF PREFERENCE SHARES, HAD
  FEW STRINGS ATTACHED. THE SECOND FOLLOWED THE
  COLLAPSE IN 1998 OF NIPPON CREDIT BANK AND LONG
  TERM CREDIT BANK. A TIGHTENING OF RULES FORCED 32
  INSTITUTIONS TO RAISE CAPITAL AND IN 1999 TO
  ACCEPT GOVERNMENT FUNDS TOTALLING Y8,600BN.

115
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116
Conditions set by government

• Conditions grew stricter. The first time, the
  government injections were very generous,
  depending on the banks own will. The second time
  was more forcible, says the former BoJ official.
  The first priority was that in a certain period
  they had to return from red to black, second was
  to lend to SMEs small and medium-sized
  enterprises and third was a host of conditions,
  such as cutting their payroll,

117
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118
Non performing loans

• By March 2005, non-performing loans were at 2.9
  per cent of banks total assets from 8.4 per cent
  at the height of the crisis.

119
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120
Sweden in the 1990s

• Sweden in the early 1990s took a middle
  pathswiftly taking over many of its troubled
  banks. The American bailout plan, economists say,
  takes a page from the Swedish example by making
  the government a shareholder in banks
  participating in the program. But, they add, the
  American banking system is so much larger and
  diverse than Swedens that the parallels are
  limited.

121
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122
Capital injection and tax payers

• In exchange for the capital injection by the
  government, taxpayers might be protected through
  preferred shares (or warrants), giving them
  dividends in the future.

123
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124
Differences between bailout and government
spending

• First, note that there is a major difference
  between a program to support the financial
  sector and 700bn in new outlays. No one is
  contemplating that the 700b in the Paulson plan
  will be given away. All of its proposed uses
  involve either purchasing assets, buying equity
  in financial institutions or making loans that
  earn interest.

125
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126
2nd difference

• Second, the usual concern about GOVERNMENT
  BUDGET DEFICITS IS THAT THE NEED FOR GOVERNMENT
  BONDS TO BE HELD BY INVESTORS WILL CROWD OUT
  OTHER, MORE PRODUCTIVE, INVESTMENTS OR FORCE
  GREATER DEPENDENCE ON FOREIGN SUPPLIERS OF
  CAPITAL. TO THE EXTENT THAT THE GOVERNMENT
  PURCHASES ASSETS SUCH AS MORTGAGE-BACKED
  SECURITIES WITH INCREASED ISSUANCE OF GOVERNMENT
  DEBT, THERE IS NO SUCH EFFECT.

127
Whats Next?

• Green Shoots?
• Persistent and high unemployment?
• Non functioning financial sector?
• Debt overhang?
• Inflation?
• Prolong risk and volatility?

128
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129
The yield curve as a predictor of future growth

• This graph shows the difference between the
  10-year and 2-year yield on Treasuries. In
  general, a steep yield curve--that is, a high
  value of this variable--is a positive indicator
  of future economic growth. In many ways, however,
  this is an unusual downturn, so it is not
  entirely clear to what extent historical
  relationships are a useful guide going forward

130
Treasuries (May 2009) sell-off

• The sell-off may reflect fears of future
  inflation
• The downgrade of treasuries in the presence of
  huge US government debt