The Global Financial Crisis: Is It Like The Great Depression? Trento Economics Festival May 2009 Overview by AssafRazin Tel-Aviv University and Cornell University
Current Global Crisis: 3 Acts • Act I: Credit-fed Asset Bubble • Act II: Financial Collapse after the Burst of the bubble • Act III: spill overs to the real economy
Under currents • Financial innovation, globalization, and reduced transparency in the financial sector • Panicky in free fall of asset prices • Under capitalized banking system and credit crunch
Historical Precedents? • The great depression? • Japan in the 1990s? • Sweden in the 1980s? • The saving and loan crisis in the US in the 1980?
History Carmen Reinhart of Maryland and Ken Rogoff of Harvard, have recently published an analysis of the current financial crisis in the context of what they identify as the previous 18 banking crises in industrial countries since the second world war. They find what they call "stunning qualitative and quantitative parallels across a number of standard financial crisis indicators" - the common themes that translate these individual dramas into the big-picture story of financial boom and bust. Their study is focused on the US, 5
Banking Crises BANKING CRISES ARE PROTRACTED, THEY NOTE, WITH OUTPUT DECLINING, ON AVERAGE, FOR TWO YEARS. ASSET MARKET COLLAPSES ARE DEEP, WITH REAL HOUSE PRICES FALLING, AGAIN ON AVERAGE, BY 35 PER CENT OVER SIX YEARS AND EQUITY PRICES DECLINING BY 55 PER CENT OVER 3½ YEARS. THE RATE OF UNEMPLOYMENT RISES, ON AVERAGE, BY 7 PERCENTAGE POINTS OVER FOUR YEARS, WHILE OUTPUT FALLS BY 9 PER CENT.
Two historical precedents The Great Depression in the 1930s The Japanese Deflation(Mid -90s) The shocks that played a role in each: (1)An asset price correction, in real estate and equities (reducing consumption through a “wealth effect”) (2)Impairmaint of financial institutions’ balance sheets (reducing credit)
Irving Fisher’s debt deflation • As the great American economist Irving Fisher pointed out in the 1930s, the things people and companies do when they realize they have too much debt tend to be self defeating: when every one tries to do them, AT THE SAME TIME, the attempts to sell assets and pay off debt deepen the plunge in asset prices. This further reduces a net worth and the process repeats itself.
Keynes’ Metaphor for a Bubble Consider beauty competitions famously described by John Maynard Keynes, in which the winner was the contestant who chose the six faces most popular with all contestants. The result, Keynes observed, was that the task was not to choose the most beautiful face, but the face that average opinion would think that average opinion would find the most beautiful. In this way beliefs feed on themselves and become divorced from any underlying reality.
THE LENDER OF LAST RESORT The role of lender of last resort was classically defined by Walter Bagehot. His great book Lombard Street was published in 1873, and set out what has become the guiding mantra for central banks in times of crisis ever since: lend freely at high rates against good collateral. Lend freely, in his words, "to stay the panic". At high rates, so that "no one may borrow out of idle precaution without paying well for it". And lend on all good banking securities to an unlimited extent - because the "way to cause alarm is to refuse someone who has good security to offer". 12
Investment Banks By forcing the fourth largest investment bank, Lehman Brothers, into bankruptcy and Merrill Lynch into a distressed sale to Bank of America, they helped to facilitate a badly needed consolidation in the financial services sector. However, at the 2008 juncture, the credit crisis radiated out into corporate, consumer and municipal debt. Regardless of the Fed and Treasury’s most determined efforts, the political pressures for a much larger bail-out, and pressures from the continued volatility in financial markets, are going to be irresistible.
Bail Outs the financial crisis has probably already added at most $200bn-$300bn to net debt, taking into account the likely losses on nationalising the mortgage giants Freddie Mac and Fannie Mae, the costs of the $29bn March bail-out of investment bank Bear Stearns, the potential fallout from the various junk collateral the Federal Reserve has taken on to its balance sheet in the last few months, and finally, Wednesday’s $85bn bail-out of the insurance giant AIG.
Moral Hazard A HOUSE INSURED FOR MORE THAN ITS VALUE IS ALWAYS CONSIDERED A FIRE RISK. BUT HOME INSURANCE IS REGULATED AND ARSON IS A CRIMINAL OFFENCE THAT KEEPS PEOPLE HONEST, MOST OF THE TIME
Bank recapitalization A severe fall in the market value of a financial institution's assets raises the risk and lowers the market value of its debt, as well as its equity. Bringing in new equity capital produces an equal (dollar for dollar) increase in the market value of assets. This lowers the risk and raises the market value of the institution's debt. As a result, part of the new equity capital shows up not as equity but as a transfer to debt holders. (This is the debt overhang problem.)
Who pays for the transfer? Not the new private stockholders. They will not invest unless they get stock with market value at least equal to the funds they provide. This means the transfer of wealth to the old debt holders must come from the old stockholders. They pay via the dilution of their ownership share (and the drop in the share price) caused by bringing in new equity.
Value of old stock If the market value of the old stock before the equity issue is low, it may be insufficient to cover the transfer of wealth to debt holders that new equity capital produces. As a result, the market value of a stock issue would be less than the funds provided, and the financial institution's attempt to issue equity to meet its capital requirement will fail.
Subsidy If the Treasury steps in when the private market refuses to provide equity capital to a financial institution, we are in subsidy land. Again, the subsidy arises because a large part of the equity injection by the government does not end up as government (taxpayer) equity but rather goes to prop up the financial institution's debt holders.
FDIC If a bank cannot raise private equity to meet its FDIC capital requirement, the powers of the FDIC kick in. For example, the FDIC can seize the bank and auction it off. The bidders are typically other banks. Acquiring a seized bank is often an attractive option for a strong bank since it can be a cost effective way to expand deposits and acquire links to profitable borrowers.
Price of acquiring a bank The maximum price the acquiring bank should be willing to pay is the market value of the seized bank's assets minus the seized bank's deposits. This net amount is then distributed to the bank's non-deposit liability holders, in order of priority. What this means is that the seized bank's stockholders and some of its lower priority debt often get nothing.
Global Saving Glut Behind this Global Saving Glut lie three phenomena 1.–excess of retained profits (corporate saving) over investment, of the corporate sectors of the advanced countries, 2. --the persistent savings surpluses of a number of mature economies, particularly Japan and post-unification Germany. 24
The US moves into: debtor status, and vast increase in cross-holdings. In 1996, on the eve of the Asian crisis, the US had assets overseas equal to 52 percent of GDP, and liabilities equal 57 percent of GDP. By 2007, these numbers were up to 128 percent and 145 percent, respectively.
Risk sharing and globalization This is change is supposes to reduce risk: US investors held much of their assets abroad(less exposed to a slump in the US); foreign investors held much of their wealth in the US (they were less exposed to a slump in their domestic economies). But, large parts of the increase in globalization came from investments in highly leveraged financial institutions (making various riskycross border bets).
Four vicious cycles “Four vicious cycles are simultaneously under way: falling asset prices are forcing levered holders to sell, driving prices further down; losses at financial institutions are reducing their ability to finance investment, which in turn reduces asset values, causing further losses; the weakness of the financial system is reducing growth, which in turn weakens the financial system; and falling output is hitting employment, which in turn leads to reduced demand for output”—Larry Summers.
Debt accumulation and deflation in the US • The big US debt accumulations were not by non-financial corporations but by households and the financial sector. The gross debt of the financial sector rose from 22 percent of GDP in 1981, to 117 percent of GDP in the third quarter of 2008; the debt of non financial corporations rose from 53 percent to 76 percent, in the same period. Thus, the desire of financial institutions to shrink balance sheet may be a cause of the recession.
Akerlof’s Problem • When house prices started to decline, this has had bigger effect on some MBS than other MBSs, depending on the complexity of the mortgages that backed the securities. Owners of MBS have strong incentive to price each an every one of them. They have superior information over the market buyers. As in Akerlof’s Lemmons Problem, the market for MBS will collapse.
Market illiquidity • The buyer hopes that the seller sells the security because he needs cash. But the buyer worries that the seller will unloads the most troubled securities. This makes the market illiquid.
Mortgage Finance • The common form of mortgage commits the household to make equal monthly payments for 30 years. These mortgages payy off with 10 years because households sell the property or does refinance. • New model: The borrower applies to a mortgage broker, receives money from a wholesale lender, and make payments to a servicer. The servicer passes on each payment to a master servicer, who pays it out to holders of a mortgage-based-security (MBS), who pass it on to the adminstrator of a collateralized debt obligation (CDO), who passes it on to investors in CDOs.
Mortgage as option, not loan • This mortgage is therefore not a loan but an option: it allowed for gains if house prices rose, but cost relatively little if prices fell.
Barriers to Lending • The Problem: most banks no longer hold the loans they make, content to collect interest until the debt comes due. Instead, the loans are bundled into securities and sold to investors. But the securitization market broke. The result is a drastic contraction of credit available throughout the economy. • Banks have come to depend on selling mortgages and other loans to investors like hedge funds and insurance companies. This allows banks to make more loans and earn bigger profits.
Mortgage-backed Securities • How to value MBSs? • Imagine you bought a $100,000 house a year ago, with a $10,000 down payment. • If the value of the house rises, you are “in the money”. • If it falls, you can walk away. You loose the original $10,000 investment, but are safe in the knowledge that the lender cannot seize your other assets..
counterparty risk • DEFINITION:The risk that the other party in an agreement will default. In an option contract, the risk to the option buyer that the writer will not buy or sell the underlying as agreed. • In general, counterparty risk can be reduced by having an financial organization with extremely good credit reputation which acts as an intermediary between the two parties.
Investors behavior in the asset bubble -“Disaster” Myopia : Equity markets lost by 2009 all the gains from the 1997-8 crises • A tendency to underestimate the probability of disastrous outcomes, especially for low-frequency events last experienced in the distant past. • The risk of falling victim to this syndrome was particularly acute in the recent period of unusual economic stability known as the “great moderation”. Investors were confronted by falling yields against a background of declining volatility in markets. Many concluded that a new era of low risk and high returns had dawned.
Investors in FX markets: Carry Trade—”depreciation myopia” • EQUALLY POPULAR WERE TRADING STRATEGIES SUCH AS CARRY TRADES, WHICH INVOLVED BORROWING AT LOW INTEREST RATES AND INVESTING AT HIGHER RATES, ESPECIALLY VIA THE CURRENCY MARKETS. FAVOURITE TRADES INCLUDED BORROWING IN JAPANESE YEN TO INVEST IN AUSTRALIA OR NEW ZEALAND, AND BORROWING IN SWISS FRANCS TO INVEST IN ICELANDIC ASSETS.
The danger in Carry Trade • Carry trade WAS DANGEROUS BECAUSE THE INTEREST RATE SPREAD COULD BE WIPED OUT IN SHORT ORDER BY VOLATILE CURRENCY MOVEMENTS. YET BECAUSE VOLATILITY REMAINED LOW FOR SO LONG, DISASTER MYOPIA PREVAILED. CARRY TRADERS WERE LULLED INTO A FALSE SENSE OF SECURITY, WHILE MORE SCEPTICAL COMPETITORS JOINED IN FOR FEAR OF UNDERPERFORMING.
The Credit Crunch • 1. Overnight credit is blocked by the asymmetric information held across banks regarding each other’s assets’ quality. • 2. Fear of the bank of being short of funds to meet creditor demands; thus the bank is reluctant to lend. • 3. fear of the bank of being short of funds if investment opportunities get better.
Moral Hazard • Moral hazard, a situation in which one person makes a decision about How much risk to take while someone else bears the cost if things go badly; • Treasury proposes to make low-interest, non-recourse, loans to private investors who buy bad assets —this is a plan to drive up the prices of toxic assets by creating a lot of moral hazard. • By offering low interest non-recourse loans, these public-private entities can pay a higher than market price for the toxic assets (since there is no downside risk). This amounts to a direct subsidy from the taxpayers to the banks.
Four distinct economic mechanisms that played a role in the liquidity and credit crunch • 1. . The effects of large quantities bad loan write-downs on borrowers' balance sheets caused two "liquidity spirals“: • 1a. As asset prices dropped, financial institutions not only had less capital; • 1b. financial institutions also had harder time borrowing, because of tightened lending standards. • The two spirals forced financial institutions to shed assets and reduce their leverage. This led to fire sales, lower prices, and even tighter funding, amplifying the crisis beyond the mortgage market.
Mechanisms (continued) • 2. Lending channels dried up when banks, concerned about their future access to capital markets, hoarded funds from borrowers regardless of credit-worthiness. • 3. Runs on financial institutions, as occurred at Bear Stearns, Lehman Brothers, and others following the mortgage crisis, can and did suddenly erode bank capital. • 4. The mortgage crisis was amplified and became systemic through network effects, which can arise when financial institutions are lenders and borrowers at the same time. Because each party has to hold additional funds out of concern about counterparties' credit, liquidity gridlock can result.
The Geithner Public-private scheme to buy toxic assets from banks • One or more giant investment fund will be created to buy up toxic assets. • Its balance sheet: for every $1 of toxic assets they buy from banks, the FDIC will lend 85.7 percent (6/7 th of $1), and the US treasury and private investors will each put 7.15 cents in equity to cover the remaining balance.