economics 458 - lecture 01 120112
TRANSCRIPT
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The Financial Crisis of 2007-2What Happened and Why?
Dale Henderson
January 12 2012
Eonomics 458 Lecture 1
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Introduction
How did we get into such a mess?
and nominal interest rates only mentione Savin s lut robabl better called investme
shortage.
Build up of reserves in Asia in aftermath of Asian fina
Chinese export-led growth strategy
Excessively expansionary monetary policy to c
recession that began before 9/11 but became after it
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Introduction
People had all the wrong incentives.
According to the Turner Review published
U.K. Financial Services Authority,
"There is a strong prima facie casethat
inappropriate incentive structures played a
encouraging behavior which contributed tofinancial crisis." (Turner Review, March 20
Understatement
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Introduction
Inappropriate incentive structures do not o
eo le to en a e in uestionable behavio
they certainly make it more likely that they Alan Greens an s oke for man when he
"Those of us who have looked to the self-interest
lending institutions to protect shareholder's equityespec a y -- are n a s a e o s oc e s e e .
(Congressional testimony, October 2008)
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Introduction
According to data available at the end of t
week in November, in the 3rd quarter of 20
US ended its longest economic contractioWorld War II. (3.5% growth)
Worst economic crisis since Great Depres
almost 80 years ago. Continuation of recovery by no means ins
Focus on housing market
Where the financial crisis began
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US
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UK
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Some Comparisons between Now and The
0 4 8 12 16 20 24 28 32 36 40 44 48 52 56
60
70
80
90
100
Index
USA Real GDP
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Some Comparisons between Now and The
0 20 40 60 80 100 120 140
5.00%
10.00%
15.00%
20.00%
25.00%
5.00%
10.00%
15.00%
20.00%
25.00%
Unemployme
nt
USA Unemployment (%)
Unemploy
Unemploy
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Some Comparisons between Now and The
85
90
95
100
105
110
115
120
125
130
0 10 20 30 40 50
85
90
95
100
105
110
115
120
125
130
Index
UK Real GDP
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Some Comparisons between Now and The
0 20 40 60 80 100 120 140
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
Unemployme
nt
UK Unemployment (%)
Unemploym
Unemploym
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Working Definition of Bubb
Elements
At least some observers regard (at least in retas being unrelated to increases in the intrinsic
of the asset
Usually followed by steep price declines.
investors focus on resale value of asset ra
.
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Measure of Housing Bubbl
For house, intrinsic value determined by h
services over lifetime
Value of housing services generated in a gear e ual to rent one a s for same serv
Price of a house should be related to how
would rent for. If price gets too high relativrent, everyone would want to rent
Might conclude that having housing bubbl
house prices to rents well above its aver
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Housing price "bubble"
How can we determine "fundamental value" of a house? Look at house price to rent ratio. Price (P) should be
related to present value of rents (R). For simplicity assume
interest rate and rent constant, that house can be rented
forn years
P=R
1+ i+
R
(1+ i)2+ :::+
R
(1+ i)n(1)
and when n is large, to a close approximation
P=R
i(2)
Reasoning at end of lecture for those interested.
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Observations
Housing bubbles in several countries but n
-
Interesting question as to why experiencesdifferent but not addressed here.
Housing bubbles recur
Often associated with financial dere ulation oinnovation.
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Traditional Model of Housing Fina
Traditional mortgage lending
the mortgage. ,
receives payments of principal and interes
Origination involves making assessment of whborrower can be expected to make payments.
Also involves explaining terms of loans to bo
. Since lending institution one of losers if loan g
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Originate and Distribute Modeof Housing Finance
In contrast, the originate and distribute (or
securitization model of housin
Se arates the ori ination and holdin functions
Introduces at least two additional functions: issuin
Separating these functions gives rise to a numbeincentive problems.
The originate and distribute process is a chain wi
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Originator
The first link is the originator
Receives a fee for work involved in ori inatin mo
Has an incentive to increase number of origination
To speed up origination can require less documen
ower s an ar s, spen ess me exp a n ng oan
worst of all, engage in fraud. Apparently, originato
of these things to some degree or another. Lax lending standards employed by lightly regulat
bank mortgage originators initiated a downward co
spiral which led to pervasive issuance of unsustain
mortgages, FDIC Chairman Sheila Bair
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Issuer
The second link is the issuer. The issuer p
the securitization. It collects to ether a ro
mortgages and issues a (mortgage backesecurity that is a claims to a share of the r
payments of principal and interest.
In order to convey information about qualitsecurity, issuer asks a rating agency to giv
security a rating. The issuer pays the age
.
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Rating Agency
The third link is the rating agency
Potential conflict of interest; an agency may ofadvice about how to structure a security to get
rating and then give that rating.
Competition for business; issuers pay for ratin
,
shade ratings upward to attract business.
Ratings agencies freely assigned AAA credit
the senior tranches of mortgage securitizationd i f d t l l i f d l i l
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Collateralized Debt Obligatio
Fourth link is entity that purchases rated m
backed securit from issuer
May be final link if entity holds security However entity may pool with other mortgage
securities getting rating for new security some
referred to as Collateralized Debt Obligations
.
Rating of CDO may exceed ratings of all its compon
Partly justified because of possible negative correlat
.
Still vulnerable to systemic risk
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Higher yield
Lower yieldLower risk
oalot
AAA
AA
A
BBB
BB
$750 mortgag
sec
5,000 mortgage loans of$150,000 each =
$750 million
8
2
AAA
AAA
AA
Financialinstitutionholds manymortgages
Homeownerssign mortgage
Financialinstitutions fundhome purchases
TranchesPool ofmortgage loans
GLOSSARYoF FINANCIAL TERMS
Mortgage-Backed Securities
Tranche
AAA rating
By the numbersThe mortgages are pooled into Mortgage-Backed Securities.Investors buy tranches of the securities
The word tranche is French for slice, section, series, or portion. Atranche is a portion of a structured product created such that eachdivided into multiple tranches that have different risk characteristics.
The highest available rating from a credit rarepresenting the lowest credit risk of any clFor example, the AAA tranches of a mortgagCDO, or a CDO squared are the highest rated
Take a hypothetical $750 million mortgage-b5,000 subprime mortgages of $150,000 each$600 million of these subprime mortgage-b
Now, if you take theBBB and lowertranches andrepackage them intoa CDO with otherBBB and lowertranches, over 83%
l $630
Structured ProductFor our purposes, a bond backed by a pool of assets, such as mortgages.
Investors buytranches of
securites
The mortgages arepooled into
Mortgage-BackedSecurities
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Higher yield
Lower yieldLower risk
oalot
AAA
AA
A
BBB
BB
$750 mortgag
sec
5,000 mortgage loans of$150,000 each =
$750 million
8
2
AAA
AAA
AA
Financialinstitutionholds manymortgages
Homeownerssign mortgage
Financialinstitutions fundhome purchases
TranchesPool ofmortgage loans
GLOSSARYoF FINANCIAL TERMS
Mortgage-Backed Securities
Tranche
AAA rating
By the numbersThe mortgages are pooled into Mortgage-Backed Securities.Investors buy tranches of the securities
The word tranche is French for slice, section, series, or portion. Atranche is a portion of a structured product created such that eachdivided into multiple tranches that have different risk characteristics.
The highest available rating from a credit rarepresenting the lowest credit risk of any clFor example, the AAA tranches of a mortgagCDO, or a CDO squared are the highest rated
Take a hypothetical $750 million mortgage-b5,000 subprime mortgages of $150,000 each$600 million of these subprime mortgage-b
Now, if you take theBBB and lowertranches andrepackage them intoa CDO with otherBBB and lowertranches, over 83%
l $630
Structured ProductFor our purposes, a bond backed by a pool of assets, such as mortgages.
Investors buytranches of
securites
The mortgages arepooled into
Mortgage-BackedSecurities
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Credit Insurance
Often one more link in the originate and distribut
issuer or ultimate holder bu s credit default insur
called a credit default swap (CDS).
Buyer pays a periodic premium.
security goes into default.
Problems with insurers Lack of experience in relatively new line of business be
to dealing with municipal bonds.
Incentive to expand business to collect insurance fees a
monitored Casino aspect of selling many CDSs on same credit e
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Light Touch Regulation
The essentials of the U.K. approach were the foll
A light touch in financial markets to enhance internatio
competitiveness. Better protection for consumers, thro
better information and advice when choices need to mbetter access to redress if thin s o wron . Alan Milb
17, 1999)
The better, and in my opinion the correct, modern mo
responsible company, the engaged employee and the
consumer, leading government to focus its attention w
,
justification, and no information requirements without
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Light Touch Regulation in the
When the SEC relaxed its net capital rule in 200
major investment banks were freed of the traditio
capital rules requirement of a basically 12-1 debt
ratio. Instead, the investment banks were able to
style internal models that arguably demonstrated
were sufficiently diversified. The investment ba
with all their Monte Carlo simulations, showing th
assets were never going to deteriorate in value. B
course they failed. (Professor John Coffee July 2Wh t i ht h it bl b f d t d it
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Is This Financial Crisis Unus
Considerable debate over whether this time
different Ro off and Reinhart 2009
R &R say no or at least not very Others ar ue that it is a tail event
Event observed infrequently
Likely that one has not occurred in recent pastanalysis based on recent data will not allow fo
Underestimate probability because distribution
Yet others (famously Nassim NicholasTaleb
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Copyright 1996, 1999 Gary L.Gastineau. First Edition. 1992 Swiss Bank Corporation.
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Illiquidity vs. Insolvency
Essence of financial intermediaries is that
have borrowin with a maturit shorter tha
maturity of their investments; situation callmaturity mismatch.
Extreme cases are demand deposits at ba
overnight borrowing by banks and hedge f In normal times there is no problem becau
short-term borrowing can be rolled over
re orrowe .
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Illiquidity vs. Insolvency
If depositors suddenly want to withdraw their dep
short-term lenders do not want to roll over their lo
financial intermediary must come up with funds.
If it has short-term assets like government bills, it
.
If it must sell long-term investments it is likely tha
be able to sell these illiquid assets for as much would yield if they were held to maturity; fire-sale
Situation arises because difficult for potential buy
.
has often made the investment on the basis of inf
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Illiquidity vs. Insolvency
Crucial question: Would intermediarys assets be suffici
repay its lenders if held to maturity? If so, illiquid, If not
Textbook answer is authorities should lend to intermedia
but should choose resolution if intermediary insolvent. Options for resolution fall into three general categories: c
operation with strings, merger, and liquidation. Each has
Unfortunately illiquidity/insolvency distinction not clear cu
assets would be if held to maturity.
Whether an institution insolvent depends on what else i
.
insolvent in the midst of a recession
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ConventionalMonetary Pol
Conventional monetary policy In normal times Federal Reserve stimulates economic a
lowering federal funds (FF) rate, rate at which banks len
another, by buying securities, usually Treasury bills.
Althou h commercial banks borrow relativel little in FF
FF rate plays central role because other rates tied close
Commercial banks raise most of their funds from the pu
deposits of various maturities; borrow short-term, especother financial institutions; sell longer-term debt; issue e
Banks cost of funds is determined by averaging the rat
to the public. It is closely related to the FF rate because
in the FF market is always an option.
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ConventionalMonetary Pol
Conventional monetary policy (continued
.
Make loans to households and to firms for consumptinvestment.
,
Rates earned on assets mark up over cost of f
a first approximation, . When assets mature
Banks either roll them over or use the repayments to
.
Interest rates or prices set for rollovers and new ass
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Conventional Monetary Policy S
These are not normal times in many count
In mid December 2008 Federal Reserve lower tarange for federal funds rate to 0 to .25 and not lik
ower.
Rates at which private sector can borrow have n
down nearl as much because s reads due to rihave increased.
U.S. Officials still want to stimulate economy
ursu ng unconven ona mone ary po cy
Article 13 3 of Federal Reserve Act
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Article 13.3 of Federal Reserve Act
Gave the Board of Governors the power to authorize
Federal Reserve Banks to make loans to any individual,
partnership, or corporation provided that the borrower is
unable to obtain credit from a banking institution.
Not used since 1930s
Different from Federal Funds rate decisions because
decided by Board of Governors not Federal Open MarketCommittee (FOMC)
Basis for loan to JP Morgan Chase which was part of
agreement under which it purchased Bear Stearns
Basis for Federal Reserve loan to AIG Basis for purchase of commercial paper through the
Commercial Paper Funding Facility (CPFF) and the Asset
Backed Commercial Paper Money Market Mutual Fund
Liquidity Facility (AMLF)
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Stylized Federal Reserve Balance
Before Unconventional Asset Purchases
Short-Term Government Securities Currency and CoinReserve Balances of Ba
er nconven ona sse urc ases
Assets Liabilities
-
Mortgage Backed Securities Reserve Balances of Ba
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Similar policy pursed in U.S. and several other co
Beginning in 2001 Bank of Japan set targets for bank re
(current account balances) when call money was zero.
several types of assets but focus was on quantity of ban In recent financial crisis U.K. undertook quantitati
Rationale was that BoE made asset purchases tha
increased money supply or at least bank reserves
In U.S. purchases of unconventional assets first cacredit easing by Bernanke. Rationale was that F
asset purchases that directly lowered either spend
related rates or rates clearly related.
Now policy of purchasing unconventional assets u
Unconventional Monetary P
Coordinating Monetary and Fiscal Pol
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Coordinating Monetary and Fiscal PolDuring Rescue Operations
Rescue operations in financial crises almost alwa
involve both monetary and fiscal policies
Loans extended and assets purchases made by cent
during a financial crisis may result in losses. Losses reduce transfer to Treasury so they must cut
or raise taxes either now or in the future.
Therefore, central banks and treasuries must agree o
handle any losses. If they do not the independence ocentral bank may be threatened.
Exchange of letters between the Chancellor of the Ex
and the Governor of the BoE about Asset Purchase
makes it clear that while the Bank manages Facility,
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Combating Bubbles
Suppose agreed that housing bubble in pr
but no evidence of overheatin elsewhere
What should the authorities do then?
monetary policy and supervision and regu
policy
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Monetary Policy
To prick or not to prick
Realize that economic activity outside the housing se
reduced.
Others argue better to wait and see.
Recommend gearing monetary policy to overall econactivity.
The monetary authorities should not raise interest ra
there is evidence of overheating in standard measur
inflation and unemployment. Be ready to deal with any damage caused by eventu
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Japanese Experience
Japanese experience beginning in 1989 re
market bubbles and were very explicit about w
were doing.
What followed was Japans lost decade.
Opponents of bubble pricking cite Japanese e
.
Proponents reply that monetary policy and fisc
in Japan following pricking were not conducted
as they might have been, so Japans experiennot be regarded as a clean test of desirability o
S
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Supervision and Regulation P
Monetary policy is a blunt instrument for d
with bubbles in the housin market.
Question is whether supervision and regulatiopolicy can be used instead.
My answer is a qualified yes.
I consider two S&R policy instruments: loan to
.
L V l R i
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Loan to Value Ratios
Loan to value (LTV) ratios
Ratio of the amount mort a e to value of house
Common during housing bubbles to see LTV ratincreaseas house prices rise, sometimes to abo
Lenders and borrowers feel safe in having higher LT
Both betting (betting is the right word) that prices wil
so little chance that value of house will fall below am Higher LTV ratios make it possible for more people t
market and bid up prices.
If ob ect is to kee bubble from continuin o o
should happen. LTV ratios should be decreasedi i t k it h d t bid f h
C it l R ti
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Capital Ratios
Capital ratios
suffer losses while still honoring its liabilitiesthe book value of equity plus retained earnin
With deposit insurance (explicit or implicit), banks
stock (common and preferred) than is socially des
.
To make sure banks sell a minimum amount of su
the authorities impose required capital ratios.
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C it l R ti C ti d
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Capital Ratios Continued
Constant capital ratio requirements have procyclical e
they tend to reinforce rather than counteract moveme
economy.
As economic conditions improve it is easier to raise cathrough stock sales or retained earning so capital ratios
a restraint on lending.
Conversely, when economic conditions deteriorate, it is
raise capital through stock sales or retained earning so rat os are more o a restra nt on en ng.
At times this procyclical influence has been increased
lowering capital ratios in booms and raising them in re
Several analysts have argued that capital ratios shout li l b k ld ll t k i d ti
C it l R ti C ti d
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Capital Ratios Continued
Natural to equate a banks capital to its net worth
measure it as assets minus liabilities.
Conceptual difficulties in measuring assets and li
Up until a few years ago used book values with re
m nor a us men s or c anges n mar e con o
More recently heavy reliance on market values;
market or fair value accountin basis of Basel Basel II agreements on bank regulation.
Much criticism of effects of mark to market accou
recen cr s s.
Role of preferred equity being reevaluated; more
Wa For ard T rner Re ie
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Way Forward: Turner Revie
Review of financial regulation by Lord Tur
head of U.K. Financial Services Authorit
The financial crisis has challenged the intellectuaassumptions on which previous regulatory approa
were arge y u t, an n part cu ar t e t eory o r
and self-correcting markets. Much financial innov
roved of little value, and market disci line of indbank strategies has often proved ineffective.
What Next?
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What Next?
If a company is too big to fail, it is too big to exist
(Senator Bernie Sanders)
At first it appeared to be no appetite for breaking
financial firms (Turner Review, Treasury White P
However, European Commission argues European banking sector too c
leading to institutions that are both not competitive and too big
Neelie Kroes, the Commissioner for Competition, said Novem2009, that [t]he European Commission is not destroying ban
simply helping this troubled sector to remain competitive whils
with the current crisis.
Holland break up of ING group ING in both banking & insu
(bancassurance); must sell insurance part
Reasoning for equation (2)
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Multiply equation (1) by 11+i
and subtract the result from
equation (1) to obtain
P
1
1+ i
P=
R
1+ i
R
(1+ i)n+1(3)
since other terms on right hand side cancel. Rearranging gives
i
1+ i
P=
R
1+ i
R
(1+ i)n+1(4)
Multiplying both sides by 1+ii
yields
P=R
i
R
i
1
(1+ i)n
(5)
The second term on the right hand side approaches zero as n
becomes large so equation (2) holds approximately.
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