Economics 458 - Lecture 01 120112

8/3/2019 Economics 458 - Lecture 01 120112

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The Financial Crisis of 2007-2What Happened and Why?

Dale Henderson

January 12 2012

Eonomics 458 Lecture 1


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Introduction

How did we get into such a mess?

and nominal interest rates only mentione Savin s lut robabl better called investme

shortage.

Build up of reserves in Asia in aftermath of Asian fina

Chinese export-led growth strategy

Excessively expansionary monetary policy to c

recession that began before 9/11 but became after it


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Introduction

People had all the wrong incentives.

According to the Turner Review published

U.K. Financial Services Authority,

"There is a strong prima facie casethat

inappropriate incentive structures played a

encouraging behavior which contributed tofinancial crisis." (Turner Review, March 20

Understatement


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Introduction

Inappropriate incentive structures do not o

eo le to en a e in uestionable behavio

they certainly make it more likely that they Alan Greens an s oke for man when he

"Those of us who have looked to the self-interest

lending institutions to protect shareholder's equityespec a y -- are n a s a e o s oc e s e e .

(Congressional testimony, October 2008)


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Introduction

According to data available at the end of t

week in November, in the 3rd quarter of 20

US ended its longest economic contractioWorld War II. (3.5% growth)

Worst economic crisis since Great Depres

almost 80 years ago. Continuation of recovery by no means ins

Focus on housing market

Where the financial crisis began


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US


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UK


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Some Comparisons between Now and The

0 4 8 12 16 20 24 28 32 36 40 44 48 52 56

60

70

80

90

100

Index

USA Real GDP


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0 20 40 60 80 100 120 140

5.00%

10.00%

15.00%

20.00%

25.00%

5.00%

10.00%

15.00%

20.00%

25.00%

Unemployme

nt

USA Unemployment (%)

Unemploy

Unemploy


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85

90

95

100

105

110

115

120

125

130

0 10 20 30 40 50

85

90

95

100

105

110

115

120

125

130

Index

UK Real GDP


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0 20 40 60 80 100 120 140

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

Unemployme

nt

UK Unemployment (%)

Unemploym

Unemploym


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Working Definition of Bubb

Elements

At least some observers regard (at least in retas being unrelated to increases in the intrinsic

of the asset

Usually followed by steep price declines.

investors focus on resale value of asset ra

.


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Measure of Housing Bubbl

For house, intrinsic value determined by h

services over lifetime

Value of housing services generated in a gear e ual to rent one a s for same serv

Price of a house should be related to how

would rent for. If price gets too high relativrent, everyone would want to rent

Might conclude that having housing bubbl

house prices to rents well above its aver


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Housing price "bubble"

How can we determine "fundamental value" of a house? Look at house price to rent ratio. Price (P) should be

related to present value of rents (R). For simplicity assume

interest rate and rent constant, that house can be rented

forn years

P=R

1+ i+

R

(1+ i)2+ :::+

R

(1+ i)n(1)

and when n is large, to a close approximation

P=R

i(2)

Reasoning at end of lecture for those interested.
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Observations

Housing bubbles in several countries but n

-

Interesting question as to why experiencesdifferent but not addressed here.

Housing bubbles recur

Often associated with financial dere ulation oinnovation.


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Traditional Model of Housing Fina

Traditional mortgage lending

the mortgage. ,

receives payments of principal and interes

Origination involves making assessment of whborrower can be expected to make payments.

Also involves explaining terms of loans to bo

. Since lending institution one of losers if loan g


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Originate and Distribute Modeof Housing Finance

In contrast, the originate and distribute (or

securitization model of housin

Se arates the ori ination and holdin functions

Introduces at least two additional functions: issuin

Separating these functions gives rise to a numbeincentive problems.

The originate and distribute process is a chain wi


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Originator

The first link is the originator

Receives a fee for work involved in ori inatin mo

Has an incentive to increase number of origination

To speed up origination can require less documen

ower s an ar s, spen ess me exp a n ng oan

worst of all, engage in fraud. Apparently, originato

of these things to some degree or another. Lax lending standards employed by lightly regulat

bank mortgage originators initiated a downward co

spiral which led to pervasive issuance of unsustain

mortgages, FDIC Chairman Sheila Bair


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Issuer

The second link is the issuer. The issuer p

the securitization. It collects to ether a ro

mortgages and issues a (mortgage backesecurity that is a claims to a share of the r

payments of principal and interest.

In order to convey information about qualitsecurity, issuer asks a rating agency to giv

security a rating. The issuer pays the age

.


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Rating Agency

The third link is the rating agency

Potential conflict of interest; an agency may ofadvice about how to structure a security to get

rating and then give that rating.

Competition for business; issuers pay for ratin

,

shade ratings upward to attract business.

Ratings agencies freely assigned AAA credit

the senior tranches of mortgage securitizationd i f d t l l i f d l i l


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Collateralized Debt Obligatio

Fourth link is entity that purchases rated m

backed securit from issuer

May be final link if entity holds security However entity may pool with other mortgage

securities getting rating for new security some

referred to as Collateralized Debt Obligations

.

Rating of CDO may exceed ratings of all its compon

Partly justified because of possible negative correlat

.

Still vulnerable to systemic risk


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Higher yield

Lower yieldLower risk

oalot

AAA

AA

A

BBB

BB

$750 mortgag

sec

5,000 mortgage loans of$150,000 each =

$750 million

8

2

AAA

AAA

AA

Financialinstitutionholds manymortgages

Homeownerssign mortgage

Financialinstitutions fundhome purchases

TranchesPool ofmortgage loans

GLOSSARYoF FINANCIAL TERMS

Mortgage-Backed Securities

Tranche

AAA rating

By the numbersThe mortgages are pooled into Mortgage-Backed Securities.Investors buy tranches of the securities

The word tranche is French for slice, section, series, or portion. Atranche is a portion of a structured product created such that eachdivided into multiple tranches that have different risk characteristics.

The highest available rating from a credit rarepresenting the lowest credit risk of any clFor example, the AAA tranches of a mortgagCDO, or a CDO squared are the highest rated

Take a hypothetical $750 million mortgage-b5,000 subprime mortgages of $150,000 each$600 million of these subprime mortgage-b

Now, if you take theBBB and lowertranches andrepackage them intoa CDO with otherBBB and lowertranches, over 83%

l $630

Structured ProductFor our purposes, a bond backed by a pool of assets, such as mortgages.

Investors buytranches of

securites

The mortgages arepooled into

Mortgage-BackedSecurities


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Higher yield

Lower yieldLower risk

oalot

AAA

AA

A

BBB

BB

$750 mortgag

sec

5,000 mortgage loans of$150,000 each =

$750 million

8

2

AAA

AAA

AA

Financialinstitutionholds manymortgages

Homeownerssign mortgage

Financialinstitutions fundhome purchases

TranchesPool ofmortgage loans

GLOSSARYoF FINANCIAL TERMS

Mortgage-Backed Securities

Tranche

AAA rating

By the numbersThe mortgages are pooled into Mortgage-Backed Securities.Investors buy tranches of the securities

The word tranche is French for slice, section, series, or portion. Atranche is a portion of a structured product created such that eachdivided into multiple tranches that have different risk characteristics.

The highest available rating from a credit rarepresenting the lowest credit risk of any clFor example, the AAA tranches of a mortgagCDO, or a CDO squared are the highest rated

Take a hypothetical $750 million mortgage-b5,000 subprime mortgages of $150,000 each$600 million of these subprime mortgage-b

Now, if you take theBBB and lowertranches andrepackage them intoa CDO with otherBBB and lowertranches, over 83%

l $630

Structured ProductFor our purposes, a bond backed by a pool of assets, such as mortgages.

Investors buytranches of

securites

The mortgages arepooled into

Mortgage-BackedSecurities


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Credit Insurance

Often one more link in the originate and distribut

issuer or ultimate holder bu s credit default insur

called a credit default swap (CDS).

Buyer pays a periodic premium.

security goes into default.

Problems with insurers Lack of experience in relatively new line of business be

to dealing with municipal bonds.

Incentive to expand business to collect insurance fees a

monitored Casino aspect of selling many CDSs on same credit e


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Light Touch Regulation

The essentials of the U.K. approach were the foll

A light touch in financial markets to enhance internatio

competitiveness. Better protection for consumers, thro

better information and advice when choices need to mbetter access to redress if thin s o wron . Alan Milb

17, 1999)

The better, and in my opinion the correct, modern mo

responsible company, the engaged employee and the

consumer, leading government to focus its attention w

,

justification, and no information requirements without


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Light Touch Regulation in the

When the SEC relaxed its net capital rule in 200

major investment banks were freed of the traditio

capital rules requirement of a basically 12-1 debt

ratio. Instead, the investment banks were able to

style internal models that arguably demonstrated

were sufficiently diversified. The investment ba

with all their Monte Carlo simulations, showing th

assets were never going to deteriorate in value. B

course they failed. (Professor John Coffee July 2Wh t i ht h it bl b f d t d it


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Is This Financial Crisis Unus

Considerable debate over whether this time

different Ro off and Reinhart 2009

R &R say no or at least not very Others ar ue that it is a tail event

Event observed infrequently

Likely that one has not occurred in recent pastanalysis based on recent data will not allow fo

Underestimate probability because distribution

Yet others (famously Nassim NicholasTaleb


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Copyright 1996, 1999 Gary L.Gastineau. First Edition. 1992 Swiss Bank Corporation.


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Illiquidity vs. Insolvency

Essence of financial intermediaries is that

have borrowin with a maturit shorter tha

maturity of their investments; situation callmaturity mismatch.

Extreme cases are demand deposits at ba

overnight borrowing by banks and hedge f In normal times there is no problem becau

short-term borrowing can be rolled over

re orrowe .


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If depositors suddenly want to withdraw their dep

short-term lenders do not want to roll over their lo

financial intermediary must come up with funds.

If it has short-term assets like government bills, it

.

If it must sell long-term investments it is likely tha

be able to sell these illiquid assets for as much would yield if they were held to maturity; fire-sale

Situation arises because difficult for potential buy

.

has often made the investment on the basis of inf


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Crucial question: Would intermediarys assets be suffici

repay its lenders if held to maturity? If so, illiquid, If not

Textbook answer is authorities should lend to intermedia

but should choose resolution if intermediary insolvent. Options for resolution fall into three general categories: c

operation with strings, merger, and liquidation. Each has

Unfortunately illiquidity/insolvency distinction not clear cu

assets would be if held to maturity.

Whether an institution insolvent depends on what else i

.

insolvent in the midst of a recession


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ConventionalMonetary Pol

Conventional monetary policy In normal times Federal Reserve stimulates economic a

lowering federal funds (FF) rate, rate at which banks len

another, by buying securities, usually Treasury bills.

Althou h commercial banks borrow relativel little in FF

FF rate plays central role because other rates tied close

Commercial banks raise most of their funds from the pu

deposits of various maturities; borrow short-term, especother financial institutions; sell longer-term debt; issue e

Banks cost of funds is determined by averaging the rat

to the public. It is closely related to the FF rate because

in the FF market is always an option.


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ConventionalMonetary Pol

Conventional monetary policy (continued

.

Make loans to households and to firms for consumptinvestment.

,

Rates earned on assets mark up over cost of f

a first approximation, . When assets mature

Banks either roll them over or use the repayments to

.

Interest rates or prices set for rollovers and new ass


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Conventional Monetary Policy S

These are not normal times in many count

In mid December 2008 Federal Reserve lower tarange for federal funds rate to 0 to .25 and not lik

ower.

Rates at which private sector can borrow have n

down nearl as much because s reads due to rihave increased.

U.S. Officials still want to stimulate economy

ursu ng unconven ona mone ary po cy

Article 13 3 of Federal Reserve Act


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Article 13.3 of Federal Reserve Act

Gave the Board of Governors the power to authorize

Federal Reserve Banks to make loans to any individual,

partnership, or corporation provided that the borrower is

unable to obtain credit from a banking institution.

Not used since 1930s

Different from Federal Funds rate decisions because

decided by Board of Governors not Federal Open MarketCommittee (FOMC)

Basis for loan to JP Morgan Chase which was part of

agreement under which it purchased Bear Stearns

Basis for Federal Reserve loan to AIG Basis for purchase of commercial paper through the

Commercial Paper Funding Facility (CPFF) and the Asset

Backed Commercial Paper Money Market Mutual Fund

Liquidity Facility (AMLF)
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Stylized Federal Reserve Balance

Before Unconventional Asset Purchases

Short-Term Government Securities Currency and CoinReserve Balances of Ba

er nconven ona sse urc ases

Assets Liabilities

-

Mortgage Backed Securities Reserve Balances of Ba


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Similar policy pursed in U.S. and several other co

Beginning in 2001 Bank of Japan set targets for bank re

(current account balances) when call money was zero.

several types of assets but focus was on quantity of ban In recent financial crisis U.K. undertook quantitati

Rationale was that BoE made asset purchases tha

increased money supply or at least bank reserves

In U.S. purchases of unconventional assets first cacredit easing by Bernanke. Rationale was that F

asset purchases that directly lowered either spend

related rates or rates clearly related.

Now policy of purchasing unconventional assets u

Unconventional Monetary P

Coordinating Monetary and Fiscal Pol


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Coordinating Monetary and Fiscal PolDuring Rescue Operations

Rescue operations in financial crises almost alwa

involve both monetary and fiscal policies

Loans extended and assets purchases made by cent

during a financial crisis may result in losses. Losses reduce transfer to Treasury so they must cut

or raise taxes either now or in the future.

Therefore, central banks and treasuries must agree o

handle any losses. If they do not the independence ocentral bank may be threatened.

Exchange of letters between the Chancellor of the Ex

and the Governor of the BoE about Asset Purchase

makes it clear that while the Bank manages Facility,


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Combating Bubbles

Suppose agreed that housing bubble in pr

but no evidence of overheatin elsewhere

What should the authorities do then?

monetary policy and supervision and regu

policy


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Monetary Policy

To prick or not to prick

Realize that economic activity outside the housing se

reduced.

Others argue better to wait and see.

Recommend gearing monetary policy to overall econactivity.

The monetary authorities should not raise interest ra

there is evidence of overheating in standard measur

inflation and unemployment. Be ready to deal with any damage caused by eventu


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Japanese Experience

Japanese experience beginning in 1989 re

market bubbles and were very explicit about w

were doing.

What followed was Japans lost decade.

Opponents of bubble pricking cite Japanese e

.

Proponents reply that monetary policy and fisc

in Japan following pricking were not conducted

as they might have been, so Japans experiennot be regarded as a clean test of desirability o

S


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Supervision and Regulation P

Monetary policy is a blunt instrument for d

with bubbles in the housin market.

Question is whether supervision and regulatiopolicy can be used instead.

My answer is a qualified yes.

I consider two S&R policy instruments: loan to

.

L V l R i


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Loan to Value Ratios

Loan to value (LTV) ratios

Ratio of the amount mort a e to value of house

Common during housing bubbles to see LTV ratincreaseas house prices rise, sometimes to abo

Lenders and borrowers feel safe in having higher LT

Both betting (betting is the right word) that prices wil

so little chance that value of house will fall below am Higher LTV ratios make it possible for more people t

market and bid up prices.

If ob ect is to kee bubble from continuin o o

should happen. LTV ratios should be decreasedi i t k it h d t bid f h

C it l R ti


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Capital Ratios

Capital ratios

suffer losses while still honoring its liabilitiesthe book value of equity plus retained earnin

With deposit insurance (explicit or implicit), banks

stock (common and preferred) than is socially des

.

To make sure banks sell a minimum amount of su

the authorities impose required capital ratios.


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C it l R ti C ti d


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Capital Ratios Continued

Constant capital ratio requirements have procyclical e

they tend to reinforce rather than counteract moveme

economy.

As economic conditions improve it is easier to raise cathrough stock sales or retained earning so capital ratios

a restraint on lending.

Conversely, when economic conditions deteriorate, it is

raise capital through stock sales or retained earning so rat os are more o a restra nt on en ng.

At times this procyclical influence has been increased

lowering capital ratios in booms and raising them in re

Several analysts have argued that capital ratios shout li l b k ld ll t k i d ti

C it l R ti C ti d


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Capital Ratios Continued

Natural to equate a banks capital to its net worth

measure it as assets minus liabilities.

Conceptual difficulties in measuring assets and li

Up until a few years ago used book values with re

m nor a us men s or c anges n mar e con o

More recently heavy reliance on market values;

market or fair value accountin basis of Basel Basel II agreements on bank regulation.

Much criticism of effects of mark to market accou

recen cr s s.

Role of preferred equity being reevaluated; more

Wa For ard T rner Re ie


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Way Forward: Turner Revie

Review of financial regulation by Lord Tur

head of U.K. Financial Services Authorit

The financial crisis has challenged the intellectuaassumptions on which previous regulatory approa

were arge y u t, an n part cu ar t e t eory o r

and self-correcting markets. Much financial innov

roved of little value, and market disci line of indbank strategies has often proved ineffective.

What Next?


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What Next?

If a company is too big to fail, it is too big to exist

(Senator Bernie Sanders)

At first it appeared to be no appetite for breaking

financial firms (Turner Review, Treasury White P

However, European Commission argues European banking sector too c

leading to institutions that are both not competitive and too big

Neelie Kroes, the Commissioner for Competition, said Novem2009, that [t]he European Commission is not destroying ban

simply helping this troubled sector to remain competitive whils

with the current crisis.

Holland break up of ING group ING in both banking & insu

(bancassurance); must sell insurance part

Reasoning for equation (2)
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Multiply equation (1) by 11+i

and subtract the result from

equation (1) to obtain

P

1

1+ i

P=

R

1+ i

R

(1+ i)n+1(3)

since other terms on right hand side cancel. Rearranging gives

i

1+ i

P=

R

1+ i

R

(1+ i)n+1(4)

Multiplying both sides by 1+ii

yields

P=R

i

R

i

1

(1+ i)n

(5)

The second term on the right hand side approaches zero as n

becomes large so equation (2) holds approximately.
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Economics 458 - Lecture 01 120112

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