Economic crisis of 2008

1. Economic crisis of 2008

2. I. part: Causes and processes

3. How we define „crisis”? USA Bureau of Statistics: the Recession: the GDP falls in two consecutive quarters Depression: the aggregate fall exceeds 10% The straight line development of the economy is a human „invention” US NBER: 1854─2001: 32 cycles 1930─2008 16 years when US GDP falls... Is an economic crisis surprising?

4. How did the deepest crisis ever looked like? During the 1929─33 crisis the GDP was almost halved, it reached the previous maximum (1929 level) by 1940...

5. Economists explain the 1929─33 crises according their theoretical background. Among the causes may one can find: Underconsumption (keynesians) Tight monetary policy in 1928─29 (monetarists) Loose monetary policy before 1928 (austrian school) Overproduction (marxists) etc. There are several explanations of the today crisis too... Explanations of economic crisis

6. They explain with one simple cause: The „greed” of capitalism But: human greed is eternal it’slike gravitation: it’s always with us... The neoliberal economic policy Serious deregulation in 1982 and in 1999.Does it take such a long time to have an effect? The behavior of fin. institutions It’s not sufficient as a cause in itselfno one is forced to borrow money or to make an investment... Simple explanations of today’s crisis

7. The crises is not „monocausal” individual and institutional decisions, behavior etc. are behind it.. The reality is more complex

8. From the 1990s: Propensity to risk increases, perception of risk changes In the investment market owners disappear or remain hidden the market are often moved by special managerial interests The background of decisions Sweeping financial innovation, legging state regulation

9. Political aims Decent housing for low income families, stimulated by state guarantees New lending techniques securitization, credit risk management credit quality improvement, rating agencies Capital abundance Enormous USD reserves in countries withtrade surplus (BRIC countries) Low interest rate credits are flooding thefinancial markets Institutional background

10. The keyword (from Clinton to Bush): monetary policy It’s good for the economy: The output of construction and other industries increases The over-spilling effects generate further growth But not everyone is qualified for credit!!! What can we do to reach the aims? Institutional factors : politicalcauses

11. Prime debtors (cca. 80% of all debts): Good credit quality and history Well documented income Proper collateral and downpayment „Jumbo” and near-prime (cca. 6%): Above $417 000, but with government guarantee, or Slightly above qualification level and/or unstable income Nonprime („subprime”) (cca. 14%): Bad credit history, low credit qualification Instable income perspectives Low or missing downpayment, no proper collateral In 2006: 40% of all new mortgages is subprime!!! They represent high risk and would get credit for higher (or changing) interest. The aim can’t be reached... Institutional factors: what are the US mortgage takers like?

12. Special guarantees Banks can’t take this risk, if they canthey have to charge highinterest rates In order to avoid it The mortgage bonds issuedby banks, are guaranteed by „quasi-governmental”financial institutions(Fannie Mae, Freddie Mac, Ginnie Mae) Institutional factors: how to make the borrowing possible?

13. New financial techniques: Methods successfully applied in car financing have been taken over (i.e.: zero down-payment) Financial innovation for risk management and interest rate decrease: securitization „repackaging” New financial theories (new methods of risk analysis and portfolio building) New regulations of financial activity and institutions Specialized institutions are replaced by „universal” ones „all activities under the same roof- financial supermarkets” The spread of new collective investment forms Investment funds, mutual funds, etc.. „hedge funds” Enormous leverage, gigantic investments with high risk and small capital At the height more than $3.000 billion (25 times the Hungarian GDP) They represent more than half of the total world financial turnover... Institutional factors: how the changes of the financial system make this possible?

14. Institutional factors: how the loaning techniques have changed? Banks Classical solution Mortgage with prime collaterals Deposits Prime mortgage debtors Savers and investors Issue & purchaseof guaranteed securities Collection of funds withquasi-governmental guarantee Mortgage with prime collaterals Investement Bankok, jelzálog- hitelintézetek Issue of non-guaranteed securities Subprime mortgage Collection of fundsafter2000 Credit rating institutions,credit quality enhancement,credit insurances, underwriters Subprime mortgagedebtors

15. How can we sell risky mortgage assets with low returns to the investors? I.e.: in form of collaterized debt obligations (CDOs) The cash flow from mortgage pay back is organized into packages with different risk, which absorb the risk according a prearranged plan The lowest graded package absorbs the risk of first nonperforming debts, the higher rated ones one by one, later But! All the packages are devaluedwhen the risk is higher than theforecasted In most cases they repackage the assets Financial innovations: credit „enhancement”, repackaging

16. How repackaging works? 70 000 $ AAA 0,3% = 210 $ 50 000 $ BBB ratedRMBS 3% = 1500 $ After they are collected „re-rated” and selected into new packages 100 000 $ BBB rated RMBS 3% = 3000 $ 20 000 $ BBB + 2,8% = 560 $ 20 000 $ BBB rated RMBS 3%= 600 $ 30 000 $ BBB rated RMBS 3%= 900 $ 10 000 $ without rating: 2230 $ RMBS─Residential Mortgage Backed Securities, the BBB rating means that the probability of lossis 3%,the expected loss is 3% of nominal value

17. US: savings are very low, in practice zero... Several countries accumulated enormous USD reserves and they invest it in the USA I.e.: China has $2.000 billion reserves!! This creates the inflow of „easy money” to US: Make for the indebted population: The further borrowing and consumption easy The entrepreneurial sector can also be financed Where the investors come from?

18. The background of individual decisions Cultural pressure: to own a home • Its is strengthened by media/promotion • Easy access to credits Homes are very good investments, because • Interest on bank deposits are low • The stock exchange investments are riskythe memories of „dotcom” crisis are vivid • Home prices increase at an annual rat of a 7-9% from 1999 to2007! • There are tax advantages if you generate revenue by selling a home Bubble psychology: • On the waves of „secure, good” investments more and more, people would like to surf. Everyone who can, invests in housing (flock effect) • Banks are over-loaning, banks calculating with quick price increases US home price index1999 =100%

19. The direct causes of the crisis The housing bubble deflates... • Oversupply makes the prices to fall • The collateral value of houses declines • The borrowed amount exceeds the collateral value of the house • Construction of new homes goes down • The circumstances of bad debtors deteriorate • The bad debtors cease to pay the installments • The bank launches a foreclosure process • The foreclosed houses increase the supply on the market and press the prices down... Number of homes with foreclosure activity in the US

20. The process of the crisis Over-supply Home prices fal Financing stops Mortgage crisis Housing bubble Fall of constructionindustry, growing unemployment Banks & investmentcompanies go bankrupt Investors’capital loss Losses in thefinancial sector Fall of investments Growth of unemployment Fall of stock exchanges Licvidity crisis

21. Banks raise their funds in the inter-bank capital markets There the credits are provided without collaterals But now they can’t calculate the risk, so they can’t calculate the prices... As a result, no credits are offered Banks try to collect funds from their borrowers, branches and maiden companies The financing of enterprises stops Consumption credits are tightened or suspended Car – car industry Housing – construction industry The crisis is overspilling to the real economy In many countries protectionist measures are taken The consequences of the crisis

22. II. part: Effects and therapies

23. Concrete consequences The „poisoned papers” generate giant losses (bankruptcies, insolvencies) • Bear Stearns, Lehman Brothers, Merryll Lynch, AIG etc. Interbank markets are paralysed: • The risks can’t be priced • Investors escape to safe heavens: T-papers, the returns fall • USA: the return is 0,02% on the 3 Month T-notes the lowest since 1941! The financing of industrial and service sector stops...

24. Financial rescue packages to the financial sector (USA: $700 billion!) State subsidies and supports (capital and credit) Buying out of poisonous, troubled securities Nationalization Loans to companies Consolidation of nonperforming debtors I.e.: rescue of non performing mortgagers Rescue actions in the world

25. Increase of budget expenditures Increase of the deficit, where possible Living up the reserves, where they have Stimulate entrepreneurs Interest rate decrease FED 0─0,25%! ECB 1,0%, SNB 0,25%, JNB 0,1%, Bank of England 0,5% ─ lowest in315 years... they navigate themselves into a liquidity trap Tax reductions „Sales promotion” i.e.: „rust premiums” in car markets Stimulus packages

26. „Obama Stimulus Plan” $787 billion from which: Tax reduction $286 billion Infrastructure development $120 billion Social programs, expenditure up by 381 billion Protectionist voices are heard: buy American! US stimulus program

27. Mixed reception among Nobel-laurates: J. Stiglitz and P. Krugman Support it, they want strongerintervention and government involvement. Unemployment and deficit will go down. R. Lucas, V. Smith, E.C. Prescott, J. Buchanan Are against, it will increase unemployment, and thebudget deficit... Is this a solution?

28. Increase of bank deposit insurance levels Strengthening the supervision Special governmental entitlements (i.e.: right to nationalize) In the EU: The joint measures are slowly accepted Budget deficits exceed the Maastricht limits Protectionism, search for individual solutions shows up A lot of steps against the treaties ind directives i.e.: subsidies against the regulations in competition directive Legal measures in order to stabilize

29. Lack of liquidity, the credit flow stops, because There are no household savings (formerly negative real interest...) The banking system can’t acquire external financing Formerly the mother institutions financed them from the money they borrowed in international markets in foreign exchanges The mother banks ar not able to provide sufficient funds Investors’ trust is falling, foreigners: Sell their securities Don’t buy the new issues of Hungarian government papers, (October: the treasury paper market is literally paralyzed...) How the crises affected Hungary – a case study?

30. The change of forint assets in foreign hands (source: HNB) One can see when foreign investors started to sell T-papers HNB bonds shares

31. The first wave of Forint weakening (around: 280 Ft/€) „Natural” as lending in FX stops, and foriegn capital is withdrawn Speculative dangers increase Financing of high foreign debt service seems to be in danger The weakening HUF increases theforeign debt T-paper returns jump high The market based financing ofbudget deficit is in doubt State bankruptcy was not far...!!! Threats

32. October 22.: the HNB increases the base interest rate... A $20 billion IMF, ECB, IBRD joint credit package is quickly organized According to calculations the financial collapse of the country is postponed at least till spring of 2010 Reactions and „life-belts”

33. Further credit tightening Though the high base rate is decreased Foreign banks’ Hungarian daughters do not have funds to lend The stabile countries suck the resources Erosion of real economy (GDP min. ─6,7%) export and home markets are shrinking Output is down Unemployment is up Home markets are further shrinking Second wave

34. Households: From the household creditst 60% of mortgages, 73% of consumer credits, 68,5% of all credits is in foreign currencis (6.552 billion Ft) As a result of weakening forint The credit stock increases with around1.100 billion HUF, The bank deposit stock increases with around 230 billion HUF The state Indebtedness is increasing The foreign debt service is growing... The CDS of new borrowings becomes striking (more than 5%) Further exchange rate erosion

35. The economic situation forces the government to take the opposite of the measures in other EU countries: Base rate increase ... Later as it endangered the operation of companiesand deepened the crises, a radicaldecrease was going on... ... But it was blocked by the second wave of HUF exchange rate fall (more than 310 Ft/€) Expenditure reduction Taxes remain the same ... Sometimes we follow the international trends: Bank rescue package (HUF 300 billion capital; HUF 300 billion credit guarantee) Financial support to companies Hungarian therapies...

36. A base interest rate decrease is needed ... but this would weaken the HUFincreasing the debt burdens andthe default risk of mortgage and credit holders the high currency risk keeps theforeign investors away Neither decrease, nor increase is possible. The defense of exchange rate is viable only by market interventions (buying HUF against €) but the resources may be limited Certain central bank instruments are exhausted by HNB:

37. Further debts are out of reach, reserves are limited, so: No money to increase the expenditures The need for radical structural change in expenditures is inevitable, In the given framework No intention of genuine budgetary reforms To get rid of the risks generated by the high debt Superficial changes, killing the time, no real programs, permanent political crisis The economic policy of the government is trapped

38. No consensus in the measures to be taken... A radical, paradigmatic change seems to be necessary • A serious reduction of redistribution • The transformation of social benefit system • Transformation of pension system • Restructure the social security and health service system • Transformation of higher educational system • Restructuring the subsidies and supports of enterprises • Tax reform, extend the number of tax subjects etc. It’s not viable without conflicts with certain social and political groups...