the financial crisis of 2008: causes and consequences
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The Financial Crisis of 2008: Causes and Consequences
J. Peter FerdererMacalester College
21 October 2008
Outline
• A Chronology of the Collapse
• Eight Causes
• Maturity Mismatch and Leverage
• Another Great Depression?
• Q & A
Parallels to Natural Phenomena
Source: The Economist
Parallels to Natural Phenomena
Source: The Economist
Parallels to Children’s Stories
Source: The Economist
Bank Failures start in Europe
• German and French Special Investment Vehicles (SIVs) unable to rollover commercial paper and close funds (August 2007)
• U.K. experiences first bank run in more than a century (9/19/2007
14 March 2008: The First Investment Bank Collapses
- JPMorgan Chase takes over Bear Stearns
- Bear’s mortgage book might contain “whopping further losses” (The Economist)
- The Fed makes $30 billion loans to I-banks as well as regulated banks - a significant shift in policy
13 July 2008Federal Government Takes over
Freddie and Fannie Mac
- Fannie and Freddie own or guarantee $5.2 trillion in mortgage debt
16 September 2008: When things went from bad to worse
- Lehman Brothers – Wall Street’s 4th largest Investment Bank – collapses
- Barclay’s and Bank of America step away
- U.S. Treasury lets Lehman go
- Counterparty risk spikes as Lehman files for bankruptcy
17 September 2008:Size Matters
- American International Group (A.I.G.) fails due to credit-default swaps.
- The government takes control of the company
24 September 2008: And then there were None
- Goldman Sachs and Morgan Stanley convert into bank holding companies
- Mitsubishi UFJ buys 20% of Morgan
- Warren Buffett injects $5 billion into Goldman
September 25: The Biggest Bank Failure in History
- Regulators seize Washington Mutual, the country’s
largest savings and loan institution and sell most of its operations to JPMorgan Chase.
- More than $300 billion in assets (Continental Illinois, had $40 billion when it toppled in 1984).
3 October 2008 Bailout Bill Passes
• $750 billion ($2,500 per American)
• Initially created to buy “toxic” assets off financial institution balance sheets
• $250 used to buy ownership positions in banks.
The Magnitude of the Problem
• Estimated worldwide losses on debt: $1.4 trillion (IMF)
• $760 billion written down by banks, insurance companies, hedge funds and others
• Cost of average systemic banking crisis in OECD counties over the past few decades: 16% of GDP
• Cost of the U.S. bailout so far: $760 billion (7% of GDP)
The Housing Boom and Bust
Explanation #1Asymmetric Monetary Policy
- Too much borrowing
- Too much short-term borrowing
Explanation #2:The Savings Glut in the ROW
Rest of the World United States
Loanable Funds
Loanable Funds
r rSROW
IROW
r*
S
I
I0S0S0I0
NCOROW>0 NCOUS<0
r*
S1 I1
Explanation #3 Democraticisation of Home Ownership
- Community Reinvestment Act of 1977
- Fannie Mae and Freddie Mac (Government- sponsored mortgage buyers) were encouraged to guarantee a wider range of loans in the 1990s.
- Tax deductibility of mortgage interest payments
Explanation #3 Democraticisation of Home Ownership
61
62
63
64
65
66
67
68
69
1994 1996 1998 2000 2002 2004 2006 2008
U.S. Homeownership Rates
Explanation #4 The Great Moderation
Source: Dallas Federal Reserve Economic Letters (September 2007)
Explanation 5 Erosion of Lending Standards
• Adjustable Rate Mortgages (ARMs)
• No-documentation mortgages
• No down payments
• NINJA mortgages (“No income, no job or no assets”)
The Default Decision
$80,000
$100,000
$20,000
$90,000
$10,000
What does home owner do it they need cash due to loss of job or medical emergency?
$100,000
$100,000
$0- $10,000
20 Percent Down Nothing Down
Home Value
Mortgage
Equity
$90,000
Suppose the market price of homes falls
Mortgage Defaults
Explanation #6Innovation – New Financial Instruments
- New instruments allow risk spreading
- Options
- Interest-rate and credit-default swaps
- Securitization (Collateralized Debt obligations, CDO)
Securitization
Source: The Economist
Credit-Default Swaps
Source: The Economist
$20,000 per person
A.I.G.
Explanation #6Innovation – New Financial Instruments
1. Upside to greater risk spreading
- The cost of capital falls- Credit is “democratized” - The system is more resilient to shocks
2. Downside
- Large counterparty risk - Difficult for regulators to keep track of firm exposure (A.I.G.)
Explanation #7Innovation – Off the Balance Sheet
Solution: Basel Accord I (1988) mandates that banks must hold $0.08 in capital for every $1.00 in assets
Impact on Banks: Reduces their ability to increase profits through leverage
Bank Response: Create “Structured Investment Vehicles” (Basel capital requirements for credit linesto SIVs are less than 8%.)
Problem: Loan defaults expose banks to insolvency
Explanation #8Deregulation
The Old Model
$
mortgages
Commercial Banks SaversBorrowers
Investment BanksBonds
Stocks
Savings & Loans
Business loans
Savings Account
Demand Deposits
Bonds Stocks
$ $
$
$ $
The New Modelfunds
mortgages
Commercial Banks
SaversBorrowers
funds
deposits
InvestmentBanks
mortgages
structured products
Structured products (“Collateralized Debt Obligations”) are portfolios of mortgages, split into tranches.
- Diversification (regional)- Heterogeneous risk appetites (“Super Senior” v. “toxic waste”)
Pension Funds
Hedge Funds
Structured Investment Vehicles (SIVs)
Three Problems with the SIVs
• Maturity Miss-match (long-term assets funded by short-term liabilities) exposes them to funding and liquidity risk
• Excessive Leverage to Increase returns makes the system more fragile
• Liquidity Problems spill over to sponsoring Commercial and Investment Banks
Structured Investment Vehicles
Risk perceived to be low
Commercial Paper Outstanding
Source: Brunnermeier (2008)
Problems Rolling over ABCP
Liquidity injections by
Central Banks
BNP Paribus closes funds
Bear Stearns
fails
Lehman Brothers
fails
Leverage and Amplification
Leverage Example
Assets Liabilities
Financial Intermediary
Securities: $100
Debt: $90
Equity: $10
L = A/(A-L)
= 100/(100-90)= 10
Financial firm manages its balance sheet to maintain constant leverage
Event: Security Prices rise by 1%
Assets Liabilities
Financial Intermediary
Securities: $101
Debt: $90
Equity: $11
L = A/(A-L)
= 101/(101-90)
= 9.18
How must firm react to keep leverage at 10?Issue more debt and buy more securities
Event: Security Prices rise by 1%
Assets Liabilities
Financial Intermediary
Securities: $110
Debt: $99
Equity: $11
L = A/(A-L)
= 110/(110-99)
= 10
Thus a $1 rise in the price of securities leads to a $9 increase in debt and security purchases
Event: Security Prices fall by 1%
Assets Liabilities
Financial Intermediary
Securities: $110
Debt: $99
Equity: $11
L = A/(A-L)
= 109/(109-99)
= 10.9
How must firm react to keep leverage at 10?
$109 $10
Sell $9 of securities and pay off $9 in debtRole of Mark-to-Market
Balance sheet after assets sold
Assets Liabilities
Financial Intermediary
Securities: $100
Debt: $90
Equity: $10
L = A/(A-L)
= 100/(100-90)= 10
Implication: Positive feedback loops and amplification
- Contagion across balance sheets
rising/falling asset prices
Stronger/weaker balance sheets
The Cost of Making Markets Liquid
The average credit spread of the 15 largest credit derivative dealers (ABN Amro, Bank of America, BNP Paribas, Barclays Bank, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs Group, HSBC, Lehman Brothers, JP Morgan, Merrill Lynch, Morgan Stanley, UBS, and Wachovia.)
Another Great Depression?
Source: The Economist
Cartoon
Spillovers
The Economist
Fed Policy
The Economist
Reason for Optimism: Size of Government
Y = C + I + G + (EX – IM)
No External Constraint
Y2K9/11
Conclusion
Competing Views
Financial Market Efficiency
Eugene Fama
Financial Market Instability
Hyman Minsky
Financial Market Efficiency• Freer (deregulated) financial markets produce
superior outcomes.• Unencumbered capital flows to its most
productive use, boosting growth and economic welfare. (tech. boom)
• Innovations that spread risk more widely (e.g., credit default swaps) reduce the cost of capital, “democratize credit” and make the system more resilient to shocks.
Financial Instability
• Periods of stability lead to excess and eventual crisis.
• Stability encourages greater leverage and ambitious debt structures (e.g., reliance on short-term funding).
• Financial innovation allows banks to avoid regulatory hurdles (capital requirements and off-balance sheet vehicles).
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