Origins of the Crisis Drawing the Big Picture

September 22, 2014

Paul RamskoglerForeign Research Division, Oesterreichische Nationalbank

2

Determinants of the Crisis

1. The Supply of Credit

• Short-term interest rates

• Capital flows and long-term interest rates

2. The Demand for Mortgages and Securitized Bonds (SBs)

• Income inequality and debt

• Institutional investors and institutional funds

3. Institutional Factors

• Rise of shadow banking

• Enabling factors

3

Short-Term Interest Rates Made Leveraging Cheap

• Low interest rates reduced the cost of wholesale funding

• Lending standards were relaxed and credit supply increased

• The reliance on wholesale funding increased-1%

0%1%2%3%4%5%6%7%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008BOJ FED ECB

Policy Ratesin %

Source: Thomson Reuters.

1. The Supply of Credit

4

Net Capital Inflows Pushed Long-Term Interest Down

0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008Euro area Japan United States

Long-Term Interest Ratesin %

Source: OECD.

-1200

-700

-200

300

800

1300

1800

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008EU Japan Asia and Pacific China

Net Capital Flows to the USin bn. USD

Source: U.S. Bureau of Economic Analysis.

1. The Supply of Credit

5

Mainly European Inflows Fuelled Securitized Bond Issues

• European investors heavily invested in SBs

• US-based wholesale funding financed much of this investment

• This helped spread the crisis quickly to Europe

-1200

-700

-200

300

800

1300

1800

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008EU, in Japan, in Asia and Pacific, in China, inEU, out Japan, out Asia and Pacific, out China, out

GrossCapital Flows to and from the USin bn. USD

Source: U.S. Bureau of Economic Analysis.

1. The Supply of Credit

6

Household Debt Increased Along Rising Income Inequality

• Debt ratios of US households increased steadily

• There was a noticeable co-movement of inequality and debt in the US

• Some relate this to conspicuous consumption

0

0.02

0.04

0.06

0.08

0.1

0.12

0.280.290.300.310.320.330.340.350.360.370.38

1982 1987 1992 1997 2002 2007

Gini Coefficient (at disposable income, after taxes & transfers)Net Saving Rate (right axis)

Inequality and Debtin %

Source: OECD.

2. The Demand for Mortgages and Securitized Bonds

7

The Rise of Institutional Investors Changed Capital Demand

• There was an increasing shift toward capital-based pension schemes

• Increasing capital concentration shifted funds to institutional investors

• The liquidity preference of corporations increased, leading to a culmination of funds

44% 49% 53% 57% 59% 51%

76% 74% 76% 79% 78%63%

11% 11% 13% 15% 15%

13%

0%20%40%60%80%

100%120%140%160%

2003 2004 2005 2006 2007 2008EU (23 countries) USA Others

Total Assets of Institutional Investors

Source:OECD.

in % of total GDP

2. The Demand for Mortgages and Securitized Bonds

8

The Rise of Shadow Banking: Key Characteristics

Shadow banking implies:

• a term transformation providing deposit alternatives

• neither access to a lender of last resort nor conventional deposit insurance

• collateral provides some substitute for deposit insurance

• often an off-balance sheet transaction for the sponsoring institutions

3. Institutional Factors

9

Insured

Savings

The Rise of Shadow Banking: Securitization of Mortgages

Bank Borrower$

Loans

Depositor$

3. Institutional Factors

10

The Rise of Shadow Banking: Securitization of Mortgages

Institutional investors

Bank Borrower$

Loans

Loans

$

Securitize

d bonds

$AAA trancheAA tranche

...

...‘Toxic’ tranche

3. Institutional Factors

11

The Rise of Shadow Banking: Instruments

Guaranteed special purpose vehicles$

Securitize

d bonds

Originator Investors

$Asset-backed

commercial paper

Money market funds

Repurchase agreement

(repo)

$Securitized bonds

$

Shares

$

ReposRepos$

$Asset-backed commercial

paper

3. Institutional Factors

12

The Run on Shadow Banks

Repo Haircut Index (Gorton & Metrick 2012)

• The erosion of trust in the value of SBs triggered a run on shadow banks

• Only explicit guarantees stopped the run

3. Institutional Factors

-50

0

50

100

150

200

250

300

350

2004-01-01

2004-05-20

2004-10-07

2005-02-24

2005-07-14

2005-12-01

2006-04-20

2006-09-07

2007-01-25

2007-06-14

2007-11-01

2008-03-20

2008-08-07

2008-12-25

2009-05-14

2009-10-01

2010-02-18

2010-07-08

2010-11-25

Overnight Commercial Paper Spreads (Net of Fed Funds Rate)Spread in basis points

Source: Board of Governors of the Federal Reserve System.

Lehman'sbankruptcy

Start of Subprime-Turmoil

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2004 2005 2006 2007 2008

US Net Assets of Prime Money Market FundsBillion USD

Source: Thomson Reuters.

Lehman bankruptcy

Start of Subprime-Turmoil

13

Enabling Factors

• Failure in rating models tacitly changed the information value contained in ratings

• Banks accepted high tail risks causing high ratings

• Management incentives were flawed and risk management was insufficient

• Regulatory changes of the 1980s and 1990s allowed substantial increases in leverage

3. Institutional Factors

14

Major Findings: Determinants of the Crisis

1. The Supply of Credit

• Short-term interest rates

• Capital flows and long-term interest rates

2. The Demand for Mortgages and Securitized Bonds (SBs)

• Income inequality and debt

• Institutional investors and institutional funds

3. Institutional Factors

• Rise of shadow banking

• Enabling factors

15

Conclusions

The analysis of the roots of the crisis has shown the necessity to:

• consider gross capital flows in the analysis

• move toward an inclusive growth model

• ensure productive use of institutional capital

• clearly separate shadow banking from traditional banking