From the financial crisis to the euro area debt sovereign crisis: facts, interpretations and policy actions

4 Lectures

1. The financial crisis of 2007-09

2. How banking regulation is changing

3. The euro area crisis and the Italian economy

4. The new European governance, the ECB monetary policy and theBanking Union

Facoltà di Economia, Sapienza Università di Roma, 2013Riccardo De Bonis

The crisis of 2007-09

It has been the worst financial crisis since the Great Depression

Outline of the lecture i) Facts ii) Interpretations iii) Final remarks

The chronology of the 2007/09 crisis

• The story of the crisis may be divided into two periodsa) the financial turmoil started in the summer of 2007; b) the eruption of the crisis in September 2008 when Lehman Brothers collapsed

• After large actions by governments and central banks, there were signs of stabilization from March 2009

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The Stock Market in the US and Italy (31//12/1994=100)

Most of industrial countries recorded credit booms, and house and share prices increases, until 2007

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1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

DJ USA

MIB IT

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The start of the crisis: the subprime market

•In the US signals of increase in subprime mortgage defaults were first noted in February 2007

•June-July 2007: the mortgage subprime market shows a more severe stress and new home sales and house prices started to decline

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The first measures taken by the Central banks

•July-August 2007: subprime exposure drags down two German banks, IKB and Sachsen Landesbanken, a State owned bank

•August 2007: strong turmoil in the interbank market, where rates increased

•August 2007: in response to the freezing up of the interbank market the ECB injected 95 billions of euro in overnight credit to banks. The FED injected 24 billions of dollars

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The Northern Rock crisis •September 2007: a bank run hits the English bank

Northern Rock

• In the nine years from 1998 to 2007, NR’s lending increased 6.5 times and was mainly financed by wholesale funding, not by retail deposits

•The run on retail deposits after the Bank of England announced the intention to provide emergency liquidity support to NR

• In the last quarter of 2007, to alleviate the liquidity crunch, central banks reduced their rates, broadened the type of collateral that banks could post and lengthened the lending horizon

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The Bearn Stearns’ bail-out• March 2008: bail out of the US investment bank Bearn

Stearns

• BS was highly leveraged and had a large mortgage exposure. It was unable to secure funding on the repo market

• BS was too entangled to fail, having 150 million trades spread across various counterparts

• The FED decided to bail-out BS to minimize counterparty credit risk

• The bail-out was financed by the FED, through a loan of $30 billion to JP Morgan Chase

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The summer of 2008: the bail-out of Fannie Mae and

Freddie Mac • In 2008 mortgage delinquency rates continued to

increase

• Fannie Mae e Freddie Mac were two publicly traded but government chartered institutions that securitized a large part of US mortgages and had about $1.5 trillion of bonds outstanding

• July 2008: the US Treasury made its implicit government guarantee explicit

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The AIG’s collapse

•AIG - a global insurance company – had a large derivative business

•September 2008: AIG’s stock price fell more than 90 per cent

•Owing to AIG’s links in the credit derivatives market, the FED organized a bail-out of $85 billions

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The Lehman Brothers’ crisis

•15 September 2008: bankruptcy of the investment bank Lehman Brothers

•The stock price of LB in January 2008 was about $65: on September 12 it was under $4

•The bank was highly leveraged, having about 700 billion of assets against a capital of approximately $25 billions

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The Lehman Brothers’ crisis

•LB is a story of excessive risk taking, excessive leverage, bad corporate governance and nondisclosure

•LB had long term illiquid assets – commercial real estate and private equity-like investments - mainly financed through short term repos

•LB ensured the public that it had sufficient liquidity to overcome any foreseeable economic downturn

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Why was Lehman Brothers not bailed-out?

•Some intermediaries did not want to buy LB or refused to take over LB without a government guarantee

•Eventually, the Fed and the Treasury decided not to offer a guarantee funded by taxpayers

•The previous bail-outs of Bearn Stearns, Fannie Mae, Freddie Mac and AIG created a cultural bias against further State aid

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The reactions of Central banks • October 2008: financial crisis spreads to Europe

• 3 October: US Congress approved the Troubled Asset Relief Program (TARP), authorizing expenditures of 700 billions of dollars

• October 8: there was a coordinated reduction in policy rates by six major central banks

• Governments of OECD countries decide to back banks, providing State aid, extending the coverage of deposit insurance and enlarging the insurance to bank bonds

The end of the financial crisis• Conditions of financial markets improved since

March 2009. However the real effects of the financial crisis persisted for many months: 2009 was a recession year for many economies. Real GDP contracted by 5,5% per cent in Italy

• The reaction of governments and central banks to the crisis was very different from what we observed in the Thirties. Both fiscal and monetary stances were very expansive

• There was a Great Recession, not a Great Depression

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Now we turn to the interpretations of the crisis

•We will first look at the macro scenario and then at the microeconomic explanations of the crisis

The macro scenario showed global imbalances

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Global imbalances

•From traditional net absorbers of financial capital from the rest of the world many emerging countries – notably China – became net exporters of financial capital

•The US run a current deficit of the balance of payments and had a large net debtor position with the rest of the world, becoming the main absorber of international capital flows

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Monetary policy in the US before the crisis • In 2000 the US underwent the burst of the internet

economy started in 1995 (the dot.com bubble)

•Monetary policy became expansionary: the Greenspan’s put. Low interest rates favoured loan demand

•American politicians looked with favour at a larger homeownership and at mortgage equity withdrawal. House prices started increasing

•The increase of house prices increased the value of collateral for banks, boosting a new rise of mortgages

•Household leverage increased, while saving was negative

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Which were the causes of the crisis?

•Around mid 2007 the insolvencies on subprime lending hit the US economy

but to assign the responsibility of the crisis to the subprime defaults is like to assign the responsibility of the I World War to the assassination of Archduke Franz Ferdinand of Austria in Sarajevo on 28 June 1914 …

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The key question

How the original loss of some hundred billion dollars in the mortgage market was sufficient to trigger an extraordinary series

of global financial and economic consequences (Blanchard 2009)?

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The crisis amplification mechanisms

There were global unbalances in the world economy but amplification mechanisms transformed a relatively small trigger – the subprime market collapse - in the Great Recession (Brunnermeier, 2009)

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First amplification mechanism: the interbank market

• From August 2007 to February 2009 banks reduced drastically loans granted to other intermediaries and raised their cost

• But interbank markets were and are indispensable for banks

• Since the 1990s the growth of loans was higher than the growth of deposits

• Therefore interbank resources were indispensable to cover the “funding gap”

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The interbank market

The block of the interbank market contributed to the “credit crunch” of 2008-09

• Two explanations of why interbank markets did not work

a) A perception of high counterpart crisis

b)Banks wanted to remain liquid because they were afraid that liquidity could be indispensable in the future

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A run took place on the interbank market

• It was similar to the Diamond – Dybvig story but it was not a run of small depositors that want to withdraw their funds from banks

On the contrary intermediaries run the repo market and the commercial paper market

Central banks reacted increasing the supply of liquidity and introducing innovation in monetary policy instruments (Cecioni, Ferrero and Secchi, 2011)

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The interbank market The run on the repo market explains why investment

banks suffered more than commercial banks

• Bearn Stearns was bought by JP Morgan Chase

• Lehman Brothers was liquidated

• Merril Lynch was bailed-out by Bank of America

• Only Morgan Stanley and Goldman Sachs survived but asked the FED to receive the commercial bank license, in order to be able to receive liquidity from the central bank

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The interbank market A large part of investment banks funding derived from

repos and commercial paper

• On the asset side their portfolios were full of securities linked to the mortgage market. Therefore the liquidity of their assets decreased since the summer of 2007

• Regulation of investment banks was light

• The idea was that regulation must put the emphasis on commercial banks, especially on the defense of small depositors’ saving

• But investment banks do not collect deposits from the public …

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The interbank market

The presumption was that investment banks’ assets could be always liquidated and that their

liabilities – repos and commercial paper – cannot be object of a run

•Leverage of investment banks was very high, also because capital requirements applied only to commercial banks

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Second amplifications mechanism: securitizations

Since the Nineties commercial banks increased their securitization business to get new liquidity and

therefore to increase their supply of loans

• From “originate to hold” to “originate to distribute”

• Mortgages were the first object of securitizations. Special purpose vehicles bought the loans from banks issuing asset backed securities (ABS).

• Then also ABS have been securitized. Other vehicles invested in ABS issuing for instance collateralized debt obligations (CDOs), multiplying securities with a AAA rating

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Second amplifications mechanism: securitizations

• Since 2007 markets lost trust in financial instruments linked to securitizations

• Notwithstanding their high ratings, securitization products became impossible to liquidate

• Diversification of risk theoretically ensured by securitizations was illusory (Rajan 2005): the risk was always held by banks or other intermediaries

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Third amplification mechanism: excessive Leverage

Investment banks and non-bank financial intermediaries were excessively leveraged

Low leverage implied that banks and other intermediaries were not able to bear the first losses and were forced to sell assets, then contributing to a general decrease of asset prices

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Fourth amplification mechanism: regulatory and supervisory mistakes

In the US regulation and supervision of non bank intermediaries was poor

• What is the shadow bank system?

• Prudential rules were insufficient for vehicles that invested into securitization products, for money-market mutual funds, and for investment banks

• In the US and the UK there was a “competition in laxity”, often inspired by an ideological bias against State regulation and in favor of self-regulation

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From the web site of the Nobel Prize Paul Krugman (photo taken on 3/6/2003)

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Final remarks

Some elements of the 2007-09 crisis are recurrent in all the crises (Reinhart and Rogoff 2009):

- excessive leverage: today not of industrial firms, but especially of households and intermediaries

- crash of share prices (in Italy -49 per cent in 2008), after a bubble (with herd behavior and“irrational exuberance”, according to Shiller)

- decrease of house prices, after a bubble in many countries

- defaults and subsequent State bail-outs of banks, leading to a worsening of public finance

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Final remarksBut there were are also new characteristics of the crisis and new causes of instability

1) The systemic impact was analogous only to that of the Great Depression in the Thirties

2) Interbank markets did not work properly

3) Securitizations – and rating agencies - created wrong incentives

4) High leverage of intermediaries

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Final remarks

5) Liquidity risk was more important than credit risk

6) There where mainly market failures but also supervisory mistakes, in an intellectual environment that was sceptical versus State intervention in banking

Like the Great Depression, no single account of the 2007-09 financial crisis is sufficient to describe it (Rephrasing Tolstoj: every financial crisis takes place in its own way)

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References • Blanchard O. (2009), “The Crisis: Basic Mechanisms, and Appropriate

Policies”, IMF Working paper, April, n. 80• Brunnermeier M. K. (2009), “Deciphering the Liquidity and Credit Crunch

2007-2008”, Journal of Economic Perspectives, n. 1, 77-100 • Cecioni M., Ferrero G. and Secchi A. (2011), “Unconventional monetary

policy in theory and in practice”, Bank of Italy Occasional papers, 102 • Gorton G. B. and A. Metrick (2012), “Getting-up to speed on the financial

crisis: a one-week-end-reader’s guide”, NBER working paper n. 17778. • Lo A. L. (2012), “Reading About the Financial Crisis: A Twenty-One-

Book Review”, Journal of Economic Literature, n. 1, 151-178• Rajan R. (2005), “Has Financial Development Made the World Riskier?,

NBER WP n. 11728, October• Reinhart, C. M. and K. S. Rogoff (2009), “This Time is Different: Eight

Centuries of Financial Folly”, Princeton, NJ: Princeton University Press