The Economics of the Financial Crisis

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The Economics of the Financial Crisis
Elmer Sterken

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Unique event.

• This financial crisis is unprecedented
• Hopefully a once in a lifetime experience
• First serious economic problem in this part of
  the world since 1979-1982
• We are right in the middle! And should be
  interested!
• So our Faculty of Economics and Business pays
  attention to the Financial Crisis
• Today is the first session, next week Professor
  Harry Garretsen, our expert in financial crises,
  will continue!

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Overview of today

• A Brief History of the financial crisis
• Main mechanisms the economics of the current
  crisis
• A view on the core of banking fragility
• Real impact transmission of financial
  disturbances will the real economy suffer? And
  how does it work?
• Predictions, speculations, and policy advice
• I speak for about 45 minutes after that
  everyone is free to go, but I will be happy to
  discuss remaining items

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History of the 2006-2008 crisis

• The current financial crisis started with the
  sub-prime crisis in the US. There is no precise
  starting date, but it is around the end of
  2005/beginning 2006
• The main cause is the risky mortgage market
  structure (sub-prime loans and adjustable rate
  mortgages) and decreasing US house prices
• This sub-prime crisis triggered a larger crisis
  of the banking/financial sector itself
• First, lets look at the problems of sub-prime
  lending and the US housing market

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Sub-prime lending

• Financial institutions providing credit to
  borrowers that have a heightened perceived risk
  of default (history of loan delinquency or
  default, recorded bankruptcy, or limited debt
  experience)
• Sub-prime lending includes a variety of credit
  types mortgages, auto loans, credit cards
• But, in 2006 about 60 of all sub-prime borrowers
  had credit scores high enough to qualify for
  prime loans!
• The value of US sub-prime mortgages was estimated
  to be 1.3 trillion US as of March 2007 (7.5
  million contracts) total US mortgage market is
  about 12 trillion US in size

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Adjustable Rate Mortgages

• Mortgage loans where the interest rate is
  periodically adjusted based on a variety of
  indices (mostly the money market rate)
• 16 of sub-prime loans where ARMs with 90-days
  delinquent or foreclosure procedures. By May 2008
  the delinquency rate was 25
• Especially in a downturn ARMs can enforce
  negative dynamics
• What causes the downturn decreasing housing
  prices!

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Case-Shiller Housing price US
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Regional differences
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Initial impact on US financial institutions

• Drop in the value of assets like mortgage-backed
  securities (MBSs)
• MBS cash flow is backed by the principle and
  interest payments on a set of mortgage loans. In
  most cases packages of mortgage loans were
  securitized in so-called special purpose
  vehicles
• Lot of banks (about 8400 in total in the US) had
  speculated on an increasing house price. They
  used financial leverage borrowing against a low
  rate and invest the money in risky equity/other
  assets
• No real intensive supervision by the SEC/FDIC or
  FED

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Expansion of the crisis

• Investors pulled back out of the mortgage loan
  market and invested in e.g. oil contracts/other
  raw materials/ speculative contracts
• Banks became unwilling to lend to other banks
  inter-bank money markets failed to work
• Other assets, like Commercial Paper became
  affected
• International linkages between banks spread out
• Stock market indices decreased worldwide
• Trust in debt markets lowered and most in
  particular trust in the banking sector decreased
  dramatically

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Over-The-Counter derivatives BIS-data
(billions US dollars)
Steep increase after 2005
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Credit default swaps

• Two agents B and C transfer the credit risk of
  agent A. How does this work?
• Suppose company A issues a bond with a return of
  10. Agent B owns this bond, but dislikes the
  default risk of company A.
• Agents B and C use a CDS B pays a fixed amount
  of the principle of the bond, and C carries the
  burden of default risk and repays B if default
  occurs
• This is a market that banks used to trade risks!

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OTC credit default swaps (BIS, billions US
dollars)
Enormous increase
No data available
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Seven Economic Insights we need

• Private nature of loans and opaque balance sheets
  of banks
• Trade-off between stability and efficiency
• The conquest of the capitalist system market-
  versus bank-based economies and remuneration
• Speculative bubbles
• Cheap money the build-up of world-wide liquidity
• Knut Wicksell overinvestment theory
• Trust

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First insight private nature of loans

• Private contract single supplier and unique
  buyer. Could be a solution to market failures a
  private contract is a typical banking product
• Elements to contracts (1) interest rate, (2)
  terms of maturity, (3) other repayment
  obligations, (4) collateral (think of real estate
  in mortgage contracts)
• Private nature of the contract value of the
  asset is opaque to other market participants
• This is precisely one of the banking problems!

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First insight banks balance sheets
Liabilities
Assets
Uncertain
Loans
Deposits
Opaque
Money/Capital market sensitive
Securities
Non-deposits
Risky
Stock market sensitive
Equity
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Second insight trade-off

• Important trade-off that we face in the banking
  industry efficiency versus stability
• We want banks to be competitive, looking for
  large profits. But we also want banks to stable.
  There is a clear trade-off
• In the Anglo-Saxon market economy the emphasis is
  on efficiency in countries with other
  institutions, stability is more important

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Third insight conquest of capitalism and
market-based versus bank-based

• Since 1989 the capitalist system has no real
  opponents liberalization and internationalization
  are fully developed especially in finance
• Market-based economies e.g. US and UK. Market
  capitalization is high, private markets are
  smaller, bank loans are less important,
  short-term contracts dominant
• Bank-based economies e.g. Japan, Germany. Market
  capitalization low, large private markets,
  long-term bank-relations (Hausbanks)

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Fourth insight speculative bubbles

• Suppose we have an asset a with a price p and
  demandat ? (Etpt1 - pt). Et is an
  expectations operator
• Suppose there is a fixed supply process
  at K, so independent of
  time t
• We assume rational expectations all market
  participants know the information in the market.
  The price solution has the form pt B (K/?) t
• B can be anything! So multiple price processes
  are consistent in case of agents with rational
  expectations
• If I believe that you believe that your brother
  believes. The stock price can increase without
  any fundamental cause

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Fifth insight cheap money

• Greenspan probably has increased liquidity too
  much between 2003 and 2005
• Other economies had to follow this policy via
  fixed exchange rates
• Also the ECB has had a too large M3-growth rate
  after 2002
• Conclusion liquidity growth has been too large
  no real expenditures, but flight to assets
  housing, equity, commodities

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US Federal Funds Rate Taylor rule
Taylor-rule implied rate above the actual rate
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Money growth in Europe
Excessive growth
Excessive growth
Target 4.5
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Sixth insight Wicksells overinvestment theory
Investment over the top Interest rate too low
GDP
Time
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Seventh insight trust

• Money is a product of trust
• Banks are products of trust
• Trust is asymmetric it takes a long time to get
  it it can be lost at a high pace
• Trust can be a substitute for financial
  contracts. If I lend my friend 10 euro, I dont
  need a contract (at least I hope so)

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The core of the banking problem
Trust in liquidity insurance

• Idea consumers are uncertain about the timing of
  consumption and invest their funds at the bank in
  a deposit as an insurance
• Banks are a pool of liquidity they should
  provide liquidity when needed
• If households vary in risk profiles, banks do not
  need to hold full cash (reserves) for deposits
• But consumers face liquidity shocks
• This model is the Diamond-Dybvig-model

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How does Diamond-Dybvig work?

• We have two groups of consumers
• Group 1 is patient hands in deposits at time 0
  and returns to the bank at date 2
• Group 2 is impatient they return at date 1
• As long as the bank knows how large group 1 and
  group 2 are no problem
• They hold cash for group 2 and invest in a
  long-term, but risky, project, and payout a
  higher interest to the patient group 1 (this is
  the first equilibrium outcome it is a good
  outcome IT OPITMIZES SOCIAL WELFARE)

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But there is a second, bad, equilibrium

• If all depositors believe that this solution
  works no problem. The bank will function
  normally
• But, suppose that a patient consumer (group 2)
  anticipates that all other patient consumers will
  withdraw at date 1 (liquidity shocks). The bank
  will be forced to liquidate the long-run
  activities early
• There will be no capital at date 2 and the
  rational depositor will withdraw at date 1

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The causes of instability

• If the relative return of date 2 deposits is less
  than an opportunity return, depositors will
  withdraw early
• There might also be mistrust in the capabilities
  of the bank (or management of the bank)
• There might be negative signals about the bank a
  consumer sees this as a liquidity shock

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Solutions to instability 1 narrow banking hold
enough reserves

• A bank needs enough liquidity to guarantee
  repayment to all depositors even in the case of a
  bank run
• A bank obtains enough liquidity after liquidation
  of its long-run investment technology
• A bank obtains enough liquidity after
  securitization of its long-run technology
• Anyhow, all these options are likely to be
  unattractive, due to low profits

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Solution 2 suspension of convertibility

• Suspension of convertibility. If the proportion
  of impatient consumers is known, the bank
  announces that it will serve only the
  pre-announced repayment at date 1. After this
  threshold convertibility is suspended. This is
  the initial ICESAVE-case

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Solution 3 Deposit insurance

• Banks create a deposit insurance company,
  contribute the premium
• The central bank can help in extreme cases
• Discussion on the maximum amount to be insured
• Main problem moral hazard. If banks know that
  deposits are insured, they will go for riskier
  investments

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Solution 4 equity

• A bank can try to attract more equity. If private
  markets dont work, the government can supply
  capital. This is the FORTIS case
• A major drawback is that a nationalized bank
  disturbs competition. Some people advocate full
  nationalization to avoid a domino-effect
• But, both investors and banks are dependent on
  market beliefs

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Conclusion liquidity insurance

• We want banks to transform deposits into loans
  this leads to optimal welfare. We also want
  knowledge about the loans to be WITHIN THE BANK
• This equilibrium is risky. Both the good and
  bad solutions are rational
• Regulation should help to keep the banking model
  alive
• Universal banking, or bankinsurance, or
  investment banking activities, can blur the
  liquidity insurance idea

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How can banking problems spread out in the real
economy? Main arguments

• If financial assets are imperfect substitutes
  bonds and loans (or public and private contracts)
• If internal wealth becomes low external
  financing premium will increase. Especially the
  interaction is nasty
• If assets are used as productive assets and
  collateral houses and land reuse of financial
  assets as working capital
• If financial leverage varies a lot between
  agents some classes of firms and households are
  affected more than average

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IS-LM lower income
Interest rate
Money market equilibrium
Monetary contraction
Real equilibrium
Income
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Bernanke modern versions of debt deflation models

• Internal wealth affects current spending
  decisions
• Lower internal wealth will increase the so-called
  external financing premium (think of risk spreads
  on private bonds)
• The combination of a general cost increase,
  higher leverage, and so higher EFP, will slow
  down demand
• Information problems cause this interaction
  between costs and leverage

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Bernanke IS-LM
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The empirics of the financial crisis part I
summer 2007-august 2008

• Main focus on the US estimates of the impact of
  foreclosures and house price decreases on
  expenditure
• Two main channels (1) costs, (2) wealth effects
• The cost channel is relatively unimportant. The
  user cost of capital elasticity of investment is
  about -0.25, for consumption almost 0
• So it is the wealth effect

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Wealth effects so far in the US

• Mean wealth in houses in total private wealth is
  about 30 median wealth about 70 median
  loan-to-value is 80. So about 10-15 of total
  private wealth is in housing
• In March 2008 about 11 of the households had 0
  equity in housing potentially about 30 could be
  in this group. This implies that about 3 to 4.5
  of total private US wealth could be lost
• Given normal relationships between wealth and
  consumption about 1 to 1.5-point consumption
  growth could be lost this is the case in 2008!

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What can we expect? Part II August 2008-?

• US growth will at least slow down to about 0 in
  2009 (see the World Economic Outlook 2009 of the
  IMF). Note Iceland -3!.
• Janet Yellen (San Francisco FED) predicts
  negative growth rates in 2008.3-2009.1. The US
  economy starts its recession right now. So it is
  more likely that growth rates will turn negative
  to about -1/-2
• Europe will follow contraction might even be
  stronger due to higher rates of indebtedness and
  lower flexibility of labor and goods markets

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Policies

• Return of trust (1) lower money market rates by
  at least 100 basis points goal is to lower
  costs, (2) through that increase liquidity
  further by supporting inter-bank markets (the
  current EU-initiative), (3) buy
  equity/nationalize some banks (not all),
• Future supervision should be improved (1) start
  of a European/maybe worldwide bank supervisor,
  (2) end of universal banking, (3) cope with moral
  hazard issues, (4) end of market-based (fair
  value!) accounting, (5) limit the use of
  derivatives
• Fiscal policies should support financial and
  monetary policies. To avoid a recession taxes
  should be lowered