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Making Sense of the Global Financial Crisis

Making Sense of the Global Financial Crisis. Christopher Ragan Department of Economics McGill University and Clifford Clark Visiting Economist Department of Finance October 20, 2009. Credit crunch. Highly leveraged banks. Shadow banking system. Systemic stability. AIG.

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Making Sense of the Global Financial Crisis

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  1. Making Sense of the Global Financial Crisis • Christopher Ragan • Department of Economics • McGill University • and • Clifford Clark Visiting Economist • Department of Finance • October 20, 2009

  2. Credit crunch Highly leveraged banks Shadow banking system Systemic stability AIG Global savings glut Counterparty risk Toxic assets Expansionary monetary policy Regulatory arbitrage Bear Stearns Collateralized Debt Obligations (CDOs) Sub-prime mortgages Lehman Brothers Global search for yield Securitization Mortgage-backed securities Fannie Mae & Freddie Mac Originate to distribute U.S. housing collapse

  3. Outline of Talk • 1. Crucial micro elements • 2. Key macro pressures • 3. Fatal interactions • 4. Policy responses • 5. Myths and lessons

  4. 1. Home mortgages 101 2. The evolution of mortgage lending 3. Securitization 4. Regulatory arbitrage • Part 1 • Crucial Micro Elements

  5. Home mortgages 101 1. Bank accepts deposits 2. Lends money to home purchaser 3. Downpayments and collateral 4. Bank holds the mortgage asset

  6. Specialization in mortgage lending: “originate to own” “originate to distribute”

  7. What to do with all these mortgages? • Assemble a large portfolio of risky assets and “manage” it. • OR • 2. Assemble a large portfolio and then create lower-risk securities, each backed by the small piece of the large portfolio •  “securitization”

  8. Securitization of residential mortgages: Diversified pool of residential mortgages -- reduces risk Each individual mortgage is a risky asset – individual and aggregate risks MBS MBS MBS MBS MBS MBS MBS MBS MBS MBS MBS MBS Each mortgage-backed security is just a small piece of the overall diversified mortgage pool. MBS MBS MBS MBS MBS

  9. This process keeps the cash flowing -- used to purchase more mortgage assets Mortgage (asset) Financial institution assembles pools of mortgages and creates mortgage-backed securities (CDOs). Commercial bank or other mortgage lender lends money to individuals and thereby creates a mortgage asset. Cash Cash CDOs Individual and institutional investors

  10. Securitization of residential mortgages mushroomed over the past decade U.S. GSE versus Private-Label MBS Issuance In billions of US dollars Source: International Monetary Fund, Global Financial Stability Report, October 2009.

  11. Capital ratios, leverage, and the “shadow banking system” • The power of leverage • Different rules for commercial banks • versus investment banks • 3. 1 + 2  “Regulatory arbitrage”

  12. Growing securitization led to increased bank leverage … • Bank Leverage Ratios assets as a multiple of capital Note: Based on data for the big six Canadian banks, seven major banks from the Euro area, six major UK banks and five large U.S. commercial banks. Canadian data are based on the regulatory ratio of assets (including some off-balance sheet items) to adjusted Tier 1 and Tier 2 capital. Leverage for other countries is measured as the ratio of balance sheet assets to shareholders' equity. Last data point is 2008Q2. Sources: Bloomberg; financial statements.

  13. … especially in the U.S. investment banks. • Leverage Ratios assets as a multiple of capital Sources: Bloomberg; financial statements.

  14. 1. Expansionary monetary policy 2. The global savings glut 3. The global “search for yield” • Part 2 • Key Macro Pressures

  15. After 2000, central banks loosened their monetary policies significantly … • Policy Interest Rates per cent Sources: Bank of Canada, U.S. Federal Reserve, European Central Bank and Bank of England.

  16. … which generated strong growth in business and household credit … U.S. Total Household Credit • U.S. Total Business Credit Y/Y per cent change Y/Y per cent change Source: U.S. Federal Reserve Board.

  17. … and fuelled a booming U.S. housing market. U.S. Existing Home Prices U.S. Housing Starts index, 2000 Q1 =100 Level – 3-month moving average Source: U.S. Bureau of Economic Analysis. Note: S&P/Case Shiller Home Price Index. Sources: Standard & Poor's; Fiserv; MacroMarkets LLC.

  18. What is the “global savings glut”? • The large accumulation of foreign-exchange reserves by: • 1. Large Asian economies with CA surpluses • 2. Oil-exporting countries with large NOCs •  What to do with all these FX reserves?

  19. Large current account imbalances … • Current Account Balance In billion USD Source: IMF’s WEO

  20. … and fast-rising oil prices … • Oil Prices US$/bbl Source: Bridge CRB.

  21. … led to huge increases in foreign-exchange reserves. • Growth in Selected Official Foreign-Exchange Reserves US$ Billions Sources: IMF’s IFS data September 2009

  22. Many of these assets were invested in U.S. Treasuries and longer-term assets … • Share of US Treasuries held by Foreigners per cent Sources: US Treasury

  23. … which reduced longer-term interest rates … • G10 10-year Government Bond Yield per cent Sources: National Central Banks and National Statistical offices, Haver . Department of Finance Canada Calculations. The 10-year government yield is the weighted average of the yield on 10-year government bonds for the US, Canada, Japan, UK, Euro area, Switzerland, Sweden, Norway, Australia and New Zealand. The real measure is the weighted average of the yield on 10-year government bonds deflated by core inflation.

  24. ... and shifted down the entire “yield curve”. • US Yield Curve per cent Both dates represent similar phases in the monetary policy cycle. Source: Federal Reserve

  25. These two forces produced a global “search for yield” Growing global demand for U.S. mortgage-backed securities Growing demand for credit by FIs Growing demand for mortgage assets Rising demand for U.S. houses Declining “quality” of mortgages Rising leverage in banks Growing provision of mortgages

  26. Declining “quality” of mortgages? New U.S. Sub-prime Mortgages Billions USD Sub-prime share of total mortgage originations (right) Per cent Sub-prime mortgage originations (left) Source: Inside Mortgage Finance, via Joint Center for Housing Studies of Harvard University

  27. As the process continued, there was an overall “spreading” of risk • Risks spread across the world as investors bought the U.S. mortgage-backed securities • Risks spread to other parts of the financial sector, as financial institutions insured their portfolios

  28. 1. Falling U.S. house prices 2. Rising mortgage foreclosures 3. Financial losses and counterparty risks 4. Credit crisis  Financial crisis • Part 3 • Fatal Interactions

  29. U.S. house prices first slowed and then dropped off a cliff … U.S. Existing Home Prices U.S. Housing Starts index, 2000 Q1 =100 Level – 3-month moving average 31% Source: U.S. Bureau of Census Note: S&P/Case Shiller Home Price Index. Sources: Standard & Poor's; Fiserv; MacroMarkets LLC.

  30. … which led to rising delinquencies of sub-prime mortgages … • U.S. Mortgage Delinquencies by Vintage Year 60+ day delinquencies, in per cent of original balance 2006 2005 2001 2000 2007 2002 2004 2003 Months from origination Source: International Monetary Fund, Global Financial Stability Report, October 2008.

  31. … and eventually increased foreclosures. U.S. Delinquency Rates U.S. Share of Loans in Foreclosure • As foreclosures rise: • banks put the houses on the resale market • further depressing house prices • more people walk away from their homes • more delinquencies and foreclosures • banks put more houses on the market • and so on … Per cent Per cent The delinquency rate includes loans with payments 30, 60, and 90 days or more past due, but are not yet in foreclosure Foreclosure is a legal process that can take anywhere from 45 to 365 days Sources: Mortgage Bankers Association of America

  32. Foreclosures and falling house prices, in turn, led to large downgrades in MBSs … • Ratings on MBSs (which were AAA when issued 2005-07) In percent, as of June 30, 2009 Source: International Monetary Fund, Global Financial Stability Report, October 2009.

  33. … which naturally led to a decline in their market value. • Prices of U.S. Mortgage-backed Securities In U.S. dollars 2006 2007 2008 Source: International Monetary Fund, Global Financial Stability Report, October 2008.

  34. Rising “counterparty risk” led to a credit crunch … … and eventually a full financial crisis … • Credit Spreads basis points Lehman Brothers bankruptcy Bear Stearns ABCP crisis Notes: These spreads are a measure of banks’ funding costs relative to a risk-free rate and are a gauge of financial market stress and banks’ financing pressures. The rate on the overnight-indexed swap (OIS) is used as a proxy for expected overnight rates. LIBOR is the London Interbank Offered Rate. CDOR is the Canadian Dealer Offered Rate. Daily data up to and including September 28, 2009. Source: Bloomberg.

  35. .. with enormous losses for many large financial institutions … Mortgage-Related Write-downs and Credit Losses since 2007Q3 Billions, USD Since 2007Q3, financial institutions have posted over US$1600 billion in write-downs and credit losses. Sources: Bloomberg, September 28, 2009.

  36. … and huge declines in the world’s stock markets. World Equity Markets % change from January 1, 2007 to March 2, 2009 Source: Bloomberg.

  37. Financial sector vs. the “real economy”? • Monetary policy • 3. Actions to assist financial markets • 4. Fiscal policy • Part 4 • Policy Responses

  38. What was likely to happen? • Credit is like electricity to a modern economy, and banks are like the power company. • A decline in the flow of credit would inevitably lead to a significant global recession. • The financial sector is part of the real economy!

  39. The largest global recession in many years • Growth of world real GDP per cent per year Average 1980-2010: 3.2% Sources: IMF

  40. Unprecedented global monetary policy response … • Policy Interest Rates per cent Sources: Bank of Canada, U.S. Federal Reserve, European Central Bank and Bank of England. Daily data up to and including Sept. 30.

  41. … included the use of “unconventional” monetary policy tools. • Central Bank Assets Index: January 2008 = 100

  42. Most governments also introduced measures to support financial markets. • Canadian Support to the Financial Sector ($ billions) Source: Canada’s Economic Action Plan; A Third Report to Canadians, September 2009.

  43. G-20 leaders coordinated their substantial fiscal expansions … • Fiscal Stimulus Flowing in 2009 and 2010, G7 countries per cent of GDP Source: IMF, Update on Fiscal Stimulus and Financial Sector Measures, April 26, 2009, p.5. IMF estimates exclude loans, including those to the auto sector, for all countries. Figure for Canada includes additional provincial-territorial stimulus actions in addition to that assumed in the Economic Action Plan as estimated by the Department of Finance.

  44. … and accepted the deterioration in their medium-term fiscal outlooks. Total Government Budget Deficits, 2009 Per cent of GDP Source: IMF WEO, October 2009. 44

  45. Part 5Lessons and Myths • Blame and greed? • “The end of laissez-faire”? • 3. Regulatory reform • 4. Baby and the bathwater

  46. Thank you. Questions?

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