The Credit Crunch of 2007-2008

1. The Credit Crunch of 2007-2008

2. The Credit Cycle • Commonly observed as a result of human nature • When there is a general increase in prices, people think they are getting richer, though for most people, that is not true. • When asset prices rise, more loans are made available using those assets as collateral. This increases the ability to buy the attractive assets. A bubble may form as asset prices spiral higher. • There is a tendency to become careless in lending money. “The good times …of high price almost always engender much fraud. All people are most credulous when they are most happy;” • As prices rise, more loanable money is needed and desired. Interest rates eventually rise. • Interest rates may rise suddenly when fraud/irresponsible lending is exposed (our crisis), or if the Central Bank suddenly intervenes (Japan in the late 80s) • John’s law: Banks lend to the point of borrowers’ insolvency. • The Central Bank attempts to influence the interest rate, more often down than up

3. The credit boom’s primal factor: lots of liquidity • Petrodollars • Asian countries with current account surpluses • US and other pensioners • Loose monetary policy to protect against recessions – early 1990s - late 90s, Japan - 9/11 Liquidity drives up prices as money looks for things to buy, investments to make.

4. One reaction: subprime mortgages • Mortgage brokers earn money by matching borrowers to banks, and often earn money from both parties. Their responsibility ends once the contract has been signed. By charging the borrower a higher rate of interest than the bank asked for, brokers can use the money they are rewarded by the bank to pay some of the closing fees associated with a house sale. • Politicians and intellectuals were happy that poor people were able to get into the housing market. • Homeowners were told that their interest rate would jump after three years or so, but by that time, with their house appreciating in value (?), and with their credit scores improved (?) they would be able to get a new mortgage somewhere. • Banks can pass on the risk of default via securitization. Securitization means packaging, then selling your accounts receivable. This practice began to take off in the 1980s. It is now a huge industry, larger than the ordinary stock market. • There was an understanding, which was violated, that banks would not pass on the worst risks.

5. Next action: CDOs spread around • When securitized, the high-risk mortgages were mixed with better mortgages, and with other loans such as car loans. • These “collateralized debt obligations” (CDOs) or mortgage-backed securities (MBS) were then brought to a rating agency to be rated. The banks paid the agency. Conflict of interest? • The rating agency failed to consider that, in a general downturn, there can be mass default on loans. The CDOs were given high ratings, indicating low risk. • People and institutions buying the CDOs did not have detailed information about what was actually in the CDOs. • Institutions buying the CDOs turned around and used them as collateral against which to borrow money in the short term. • Institutions often issued bonds which were backed by CDOs. These bonds are called “Asset-backed commercial paper” (ABCP). • Other entrepreneurs got into the game by issuing insurance against a decline in the value of the CDOs and other assets. These are called “credit default swaps”. Meanwhile, as they had since they were founded in the 30s/70s, Fannie Mae and Freddie Mac guaranteed the value of mortgages and CDOs they purchased for resale.

6. Vulnerability factor 1: highly leveraged citizens • US citizens and others are pressured to buy more than they currently can afford. • Average U.S. household savings as a fraction of after-tax income has been dropping. It reached -0.4% in 2005, before the crisis. However this calculation imputes a rent expense to homeowners. • Credit cards and store financing have kept spending high • “Subprime credit cards” continue to operate. • Individuals have been given more responsibility for retirement savings: enough savings, enough diversification?

7. Thanks to: Perot Charts

8. Vulnerability Factor 2: Highly-leveraged Banks, Investment Banks, and Hedge Funds • Banks take deposits and make loans. They are subject to regulations, since the federal government ensures their deposits. In Canada, no reserve requirements for banks since 1992. In US, 10% of transaction deposits must exist in cash in a vault or at the Central Bank. • Investment banks may or may not have deposits. They buy and sell assets for themselves and for clients. There are limits on their leverage, but these have been loose: this past July, Goldman Sachs leverage ratio was 28, Morgan Stanley’s, 33. The leverage ratio is assets:equity. (The debt:equity ratios are lower). • In the 1980s, chartered banks were allowed to begin offering investment banking. Their leverage ratios are typically about 10:1. • Hedge funds can do whatever they want, provided their clients are “accredited” i.e. very wealthy individuals, corporations, or other organizations. They are even more highly leveraged and engage in all kinds of simultaneous bets which are supposed to limit risk but actually increase risk if the entire market moves in the same direction and everyone attempts to sell at once.

9. Bagehot (1873) believed that leverage is inevitable: • “If a merchant have $50,000 all his own, to gain 10 % on it he must make $5000 a year, and must charge for his goods accordingly…” • [But if another has only $10,000, and borrows $40,000, he has the same capital of $50,000 to use, and can sell much cheaper. This is how: If the interest rate at which he borrows be 5%, he will have to pay $2000 a year; and if, like the old trader, he makes $5000 a year, he will still, after paying his interest, obtain $3000 a year, or 30%, on his own 10,000. So he will be able to forego some of that profit, lower the price of his goods, and drive the old-fashioned trader – the man who trades on his own capital – out of the market.]

10. Trigger • Housing construction occurred, until supply began to outstrip demand, and house prices began to fall. This led to some homeowners being unable to refinance their houses. They could not afford the higher interest rates on their mortgages. • Once the defaulting homeowners attracted attention, people began to worry about the underlying value of CDOs and assets based on them. This was difficult to disentangle. • Last summer, people and institutions began to stop buying CDD-based products like ABCP. • Institutions, no longer able to sell ABCP, needed cash, and stopped buying one business’ bonds. Banks made fewer loans to one another and to businesses. This makes the average interest rate rise. • Falling prices for houses and for financial products made everyone’s balance sheet look bad, and made everyone look less credit-worthy.

11. Vulnerability factor 3: Highly leveraged government • The US government’s net external debt is 6 trillion; however: • this is only 44% of its GDP. • the amount of interest/debt service paid to the United States exceends the amount of interest/debt service paid by the United States! • The US federal deficit in 2007 was 160 billion. • The trade deficit is 700 billion. The persistent trade deficit means Americans are borrowing to finance their imports. • Foreigners own 25% of US government debt. China alone has about 900 billion dollars’ worth which it could attempt to cash in at any time.

12. Proposed plan • 700 billion USD (5% of GDP) will be spent trading cash for ABCP from struggling firms. • Government had revenues equal to 2.6 trillion last year. • Central Bank had reserves equal to 814 billion last year. • How to price the ABCP? Who will make the decisions? • Moral hazard and unfairness vs. necessity for intervention to protect credit and pensions • Will the government take an equity share? • How about getting to the root of the problem by helping homeowners? Only about 6% of mortgages are subprime, about the same percentage are adjustable-rate.

13. Lessons from Bagehot (1873) • It is possible for Central Banks to go under. All that is required is that sufficiently many chartered banks withdraw their deposits. The Bank of England received assistance three times between 1844-1873. • Simply printing money will reduce the value of money (inflation, reputation) • “The ultimate banking reserve of a country (by whomsoever kept) is not kept out of show, but for certain essential purposes, and one of these purposes is meeting a demand for cash caused by alarm within the country.” • A large reserve helps preclude panic. • “The peculiar essence of our banking system is an unprecedented trust between man and man: and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.”