Financial Crises, Financial Frictions, and Lost Decades

• The Great Depression, 1929 – 1939 • Emerging Market Crises

• 1980s Third World Debt Crisis• 1994-5 Tequila Crisis• 1997-8 East Asia Financial Crisis

• The Great Recession, 2007 –

Financial FrictionCombating adverse selection and moral hazard

Collateral

Net Worth (=$Assets - $Liabilities)

Net Worth – – The Foundation of Credit

Screening/Monitoring::

Cost of Credit Intermediation

Reduced frictions via:

Stylized First World Financial CrisesStage One• Mismanagement of

financial liberalization and innovations

• Asset price boom & bust• Spikes in interest rates• Increase in uncertainty

Stage two: Banking Crisis

Stage three: Debt Deflation

Stylized Emerging Market Financial Crises

Debt Deflation

Factors Causing Financial CrisesAsset Values Drop: Net Worth Down

Stock market decline Decreases net worth of corporations.Unanticipated deflation Debt burdens up/net worth downUnanticipated depreciation $ debts up/net worth downAsset write-downs (bad debts) Net worth down

• Deterioration in Financial Institutions’ Balance SheetsCapital Ratios Down Decline in lending.

Interest Rates Rise Worsens adverse selection (who would pay the high rates?)Increases business needs for external funds

worsens adverse selection and moral hazard problems. Government Fiscal Imbalances

Fear default of government debt Capital flight…Currency crisisBanking Crises

Loss of information production / disintermediation.• Increases in Uncertainty Decline in

lending.

Crises (and Threatened Crises) We Have Known• The L o n g Depression, 1873 – 1896 • The Great Depression, 1929 – 1939• Mexican Default, 1982• Continental Illinois, 1984…Oil patch loans…TBTF• Third World Debt Crisis, 1980s Lost Decade• Savings & Loan Debacle, 1986 – 1990• Black Monday, October 19, 1987• Tequila Crisis, 1994 – 1995• East Asia Financial Crisis, 1997 - 1998• Long Term Capital Management, 1998• dot.com bust, 2000• 911, 2001

• Subprime-triggered crisis – Run on shadow banks The Great Recession, 2007 –

The Great Depression: Mother of all Crises

Stock Market Crash Spending cutback

Bank Panic Monetary Contraction

Bank Failures Reduced Lending

Price Deflation/Deflationary Expectations Debt Deflation

Declining Net Worth Reduced Lending

Bernanke:Credit Channel

Friedman & Schwartz:Great Contraction

1/2/19

29

4/24/1

929

8/14/1

929

12/4/1

929

3/26/1

930

7/16/1

930

11/5/1

930

2/25/1

931

6/17/1

931

10/7/1

931

1/27/1

932

5/18/1

932

9/7/19

32

12/28

/1932

4/19/1

933

8/9/19

33

11/29

/1933

3/21/1

934

7/11/1

934

10/31

/1934

2/20/1

935

6/12/1

935

10/2/1

935

1/22/1

936

5/13/1

936

9/2/19

36

12/23

/1936

4/14/1

937

8/4/19

37

11/24

/1937

3/16/1

938

7/6/19

38

10/26

/1938

2/15/1

939

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

50.00

60.00

70.00

80.00

90.00

100.00

110.00

120.00

djia, left scale $/pound, right scaleproducer price index, right scale mfg employment, right scale

Producer Price Index

Onset of the Depression: Persistent Deflation…Persistent Job Loss

$/pound

DJIA

Manufacturing Employment

Villain Gold• Dysfunctional interwar gold-exchange standard

Deficit/surplus country asymmetry World Ms downUS and France sterilized gold inflows Deficit countries forced to contract Ms

Lack of central bank cooperationBritain weak/US clueless/France irresponsible

• Dysfunctional gold standard mindsetLiquidationist mantra...deflation welcomed/oppose militant laborDefend gold reserves...even if you’ve left gold standardReal bills doctrine...if economy tanks, who needs money?Balanced budget fetish...cut spending when revenue falls

1/2/19

29

4/24/1

929

8/14/1

929

12/4/1

929

3/26/1

930

7/16/1

930

11/5/1

930

2/25/1

931

6/17/1

931

10/7/1

931

1/27/1

932

5/18/1

932

9/7/19

32

12/28

/1932

4/19/1

933

8/9/19

33

11/29

/1933

3/21/1

934

7/11/1

934

10/31

/1934

2/20/1

935

6/12/1

935

10/2/1

935

1/22/1

936

5/13/1

936

9/2/19

36

12/23

/1936

4/14/1

937

8/4/19

37

11/24

/1937

3/16/1

938

7/6/19

38

10/26

/1938

2/15/1

939

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

50.00

60.00

70.00

80.00

90.00

100.00

110.00

120.00

djia, left scale $/pound, right scaleproducer price index, right scale mfg employment, right scale

New Deal Reflation: Great Expectations

DJIA

Manufacturing Employment

$/pound

Producer Price Index

New Deal Reflation: Regime Change• Secure the financial system

• Reconstruction Finance Corporation (RFC)—Hoover effort• Glass-Steagall: separation of commercial banking and investment banking• Federal deposit insurance• Security and Exchange Commission

• Dollar devaluation• Break golden fetters Monetary expansion• Great expectations...reverse expectations of deflation

Low and negative real interest rates Spur to spending• Cartelization—National Industrial Recovery Act (NIRA)

• Recover by limiting supply? Kill the pigs???• Great expectations...reverse expectations of deflation

• Public spending• Hoover Dam• Works Public Administration (WPA)• Civilian Conservation Corp (CCC)

1/2/19

29

4/24/1

929

8/14/1

929

12/4/1

929

3/26/1

930

7/16/1

930

11/5/1

930

2/25/1

931

6/17/1

931

10/7/1

931

1/27/1

932

5/18/1

932

9/7/19

32

12/28

/1932

4/19/1

933

8/9/19

33

11/29

/1933

3/21/1

934

7/11/1

934

10/31

/1934

2/20/1

935

6/12/1

935

10/2/1

935

1/22/1

936

5/13/1

936

9/2/19

36

12/23

/1936

4/14/1

937

8/4/19

37

11/24

/1937

3/16/1

938

7/6/19

38

10/26

/1938

2/15/1

939

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

50.00

60.00

70.00

80.00

90.00

100.00

110.00

120.00

djia, left scale $/pound, right scaleproducer price index, right scale mfg employment, right scale

DJIA

Manufacturing Employment

PPI

$/pound

Retrenchment: The Gold Standard Mindset Recession in Depression

Dynamics of Financial Crises in Emerging Market Economies

• Stage one: Initiation of Financial Crisis.• Path one: mismanagement of financial liberalization

• Weak supervision and lack of expertise lending boom.• Domestic banks borrow from foreign banks. • Fixed exchange rates give a sense of lower risk.• Securities markets not well-developed Banks important

• Path two: severe fiscal imbalances:• Governments force banks to buy government debt. • When government debt loses value, bank net worth down .

Additional factors:• Increase in interest rates (from abroad)• Asset price decrease• Uncertainty linked to unstable political systems

Ms

Dynamics of Financial Crises in Emerging Market Economies

• Stage two: currency crisisBank losses currency crises:

• Government cannot raise interest rates (doing so forces banks into insolvency)…

• … and speculators expect a devaluation. • Foreign and domestic investors sell the domestic currency.

• Stage three: Full-Fledged Financial Crisis:• The debt burden in terms of domestic currency up • Banks more likely to fail:

– Individuals are less able to pay off their debts (value of assets fall).

– Debt denominated in foreign currency increases (value of liabilities increase).

Financial Crises: Mexico 1994-1995 ...Tequila

• Financial liberalization in the early 1990s: – Lending boom/weak supervision/lack of expertise.– Banks accumulated losses/net worth declined.

• Rise in interest rates abroad.• Increased uncertainty (political instability).• Domestic currency devaluated Dec. 20, 1994.

– Tesobono burden • Rise in actual and expected inflation.

Financial Crises: East Asia 1997-1998

• Financial liberalization in the early 1990s: – Lending boom/weak supervision/lack of expertise.– Banks accumulated losses/net worth declined.

• Uncertainty increased – stock market declines and failure of prominent firms

• Domestic currencies devaluated (1997). • Rise in actual and expected inflation.• Contagion:

Thailand...Indonesia...Korea...Philippines...Malaysia ...Singapore...Taiwan...Brazil...Russia ....Long Term Capital Management

Financial Crises: Argentina 2001-2002• Currency board: 1 Peso = $1• Fiscal imbalance

– banks coerced to absorb government debt• Appreciation of $ & peso Argentine recession• Rise in interest rates abroad.• Uncertainty increased (ongoing recession).• Domestic currency devaluated, Jan. 6, 2002• Rise in actual and expected inflation.

The Subprime Triggered Financial Crisis

Prelude to Financial Crisis of 2007 – 2009

Simon Johnson, The Quiet Coup. The Atlantic, May 2009

Financial Crisis of 2007 - 2009• Financial innovations in mortgage markets:

– Subprime/Alt-A mortgages/Interest Only/NINJA– Mortgage-backed securities/Collateralized debt obligations

(CDOs, CDO2)• Housing price bubble forms

– World savings glutIncrease in liquidity from cash flows surging to the US

– Subprime mortgage market housing demand and prices up.• Agency problems arise

– “Originate to distribute” … “Moving, not storage” principal (investor) agent (mortgage broker) problem.

– Commercial and investment banks/rating agencies …weak incentives to assess quality of securities

• Information problems surface…A “Minsky Moment”Housing price bubble bursts/Crisis spreads globally

Housing Prices and the Financial Crisis of 2007–2009

Source: Case-Shiller U.S. National Composite House Price Index; www.macromarkets.com/csi_housing/index.asp.

Stock Prices and the Financial Crisis of 2007–2009

Source: Dow-Jones Industrial Average (DJIA). Global Financial Data; www.globalfinancialdata.com/index_tabs.php?action=detailedinfo&id=1165.

The Shadow Banking System: A Fragile Financial Infrastructure

Thus a long-term corporate bond could actually be sold to three different persons. One would supply the money for the bond; one would bear the interest rate risk, and one would bear the (credit) risk of default. The last two would not have to put up any capital for the bond, though they might have to post some collateral.

Fisher BlackFundamentals of Liquidity, 1970

Banks have public backing…and are heavily regulated•Lender of last resort, the Fed•Bank creditors (depositors) are insured, FDICShadow Banks: Lack Public Backing Substitutes•Liquidity put

•Underlying asset values fall•Short-term funders back off•Sponsor steps in per prior agreement…line of credit

•Credit put•Buy Credit Default Swaps from private insurers

•Private insurers can’t possibly reserve against systemic risk

The Shadow Banking System: A Fragile Financial Infrastructure

The Shadow Banking System: A Fragile Financial Infrastructure

Denizens of the shadows•Federal loan programs/GSEs•Investment banks/Pension funds•Finance companies•Monoline insurers/Mortgage insurers•Structured investment vehicles (SIVs)•Conduits (SPVs – liquidity support by bank sponsor)

•Achieve regulatory arbitrage—get assets off balance sheet •credit arbitrage conduit (conduit holds credit assets)•securities arbitrage conduit (conduit holds securities)•TRS/repo conduit (finances financial institutions using total return swaps and/or repos)

•Credit hedge funds•Money market intermediaries

Financial Crisis of 2007 - 2009 (cont’d)• Banks’ balance sheets deteriorate

– Write downs– Sale of assets and credit restriction

• High-profile firms fail– Bear Stearns (March 2008)– Fannie Mae and Freddie Mac (July 2008)– Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund

(MMMF) and Washington Mutual (September 2008).• Fed pumps up bank reserves: TARP/TALF,etc.

– Lend and lend freely • Bailout package enacted

– House votes down the $700 billion bailout package (9/29/08) Stock market slumps Bailout passes on October 3. – Congress approves a $787 billion economic stimulus plan on

February 13, 2009. • Recession deepens

Responses: No Bank Left BehindLender of Last Resort / Spender of Last Resort

• Tax Rebate $124 bil.• Fed Fund Rate Cuts• Fannie/Freddie $200 bil.• Bear-Stearns $29 bil.• AIG $174 bil.Fed “Facilities”• Primary Dealer Credit Facility (PDCF) $58 bil.• Treasury Security Loan Facility (TSLF) $133 bil.• Term Auction Facility (TAF) $416 bil.• Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil.• Money Market Investor Funding Facility (MMIFF) $540 bil.• More Fed Fund Rate Cuts … Hold At ~0%• Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil.• Term Asset-Backed Securities Loan Facility (TALF) $200 bil.• Emergency Economic Stabilization Act/TARP $700 bil.

Government LoansGovernment Equity

• Stimulus Package $787 bil. aka The American Recovery and Reinvestment Act

• TARP II• Stress Tests

Treasury Bill–to–Eurodollar Rate (TED) Spread

Source: www.federalreserve.gov/releases/h15/data.htm

Credit Spreads and the 2007–2009 Financial Crisis

Source: Federal Reserve Bank of St. Louis FRED database; http://research.stlouisfed.org/fred2/categories/22.