financial crises lecture 1

7/30/2019 Financial Crises Lecture 1

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FinancialCrises

JoseScheinkman

Introduction

Financial Crises

Jose A. ScheinkmanColumbia University

Spring 2013

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FinancialCrises

JoseScheinkman

Introduction Program

(I) Introduction

(II) Classical crises• Bank runs• Currency crises

(III) Speculation•

Limits to arbitrage• Bubbles• Short-termism

(IV) The crisis of 2007...

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FinancialCrises

JoseScheinkman

Introduction Tools

(I) Economic models

(II) Case studies

(III) Formal empirical analyses

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FinancialCrises

JoseScheinkman

Introduction From Reinhart-Rogoff 12/08

Prop or t ion of Count r i es with Banking Cr i s es , 1900 -2008

Weighted by Their Share of World Income

0

5

10

15

20

25

30

35

40

45

1 9 0 0

1 9 0 3

1 9 0 6

1 9 0 9

1 9 1 2

1 9 1 5

1 9 1 8

1 9 2 1

1 9 2 4

1 9 2 7

1 9 3 0

1 9 3 3

1 9 3 6

1 9 3 9

1 9 4 2

1 9 4 5

1 9 4 8

1 9 5 1

1 9 5 4

1 9 5 7

1 9 6 0

1 9 6 3

1 9 6 6

1 9 6 9

1 9 7 2

1 9 7 5

1 9 7 8

1 9 8 1

1 9 8 4

1 9 8 7

1 9 9 0

1 9 9 3

1 9 9 6

1 9 9 9

2 0 0 2

2 0 0 5

2 0 0 8

P e r c e n t o f c o u n t i e s

The GreatDepression

Emerging Markets, Japan the

Nordic Countries, and US(S&L)

World War I

The Panicof 1907

The First Global Financial Crisis of 21stCentury

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FinancialCrises

JoseScheinkman

Introduction Financial Market Episodes in US - 80’s and 90’s1. Failure of Continental Illinois in 1984

• 7th largest bank in US in 1984. Largest bank failure in UShistory until Washington Mutual in 2008

• Losses exceeding $1billion in participations on loans madeby Penn Square, an Oklahoma bank that failed in 1981.

• Exposure to Lat Am

• Bank Run by large depositors, who are not insured byFDIC

• Solution: Bailout by FDIC and reorganization of bank.

• A change in the FDI Act in 1950 allowed the FDIC, if itsBoard of Directors deemed a bank “essential” to itscommunity, to keep a failing bank open through direct

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FinancialCrises

JoseScheinkman

Introduction Financial Market Episodes in US - 80’s and 90’s1. Failure of Continental Illinois in 1984

• Holding company bank holders were protected.

• Too big to fail - popularized by Representative McKinneyin hearings on Continental.

• Moral hazard

• Contemporary discussion of failure of supervision.

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FinancialCrises

JoseScheinkman

Introduction Financial Market Episodes in US - 80’s and 90’s2.Crash of 1987

• Financial engineering and portfolio insurance

• A put gives the owner the right (but not the obligation) tosell an asset to the seller of the put at a fixed price

• Black-Scholes formula shows that under some stringentassumptions, a put can be “synthesized” by a trading

strategy.• Assumption includes continuous pricing• Strategy requires selling an asset if the asset price goes

down

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FinancialCrises

JoseScheinkman


• 1982 - creation of futures market on S&P 500 index

(CME)• Portfolio insurance by Leland, O’Brien, Rubinstein

Associates (LOR): A dynamic strategy implemented onbehalf of clients

• To protect large portfolios with a predetermined maximum

loss (e.g. 5%)

• Licensees included Wells Fargo, Chase, J.P. Morgan...

• $60 billion of portfolio insurance on the S&P sold topension funds, money managers...

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FinancialCrises

JoseScheinkman


• Friday, October 16th, Dow drops 4.6%. Monday, Oct.

19th Dow drops 22.6%. Breakdown of trading + drop of 29% of 2 months S&P 500 index futures. Breakdown inindex arbitrage and put replication.

• Chicago Mercantile Exchange clearinghouse near collapse.

• Solution: FED told (ordered?) banks to extend credit to

investment banks.

• Initial fall in prices probably caused by other factors

• Brady commission blamed portfolio insurance foraccentuating the loss

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FinancialCrises

JoseScheinkman

Introduction Financial Market Episodes in US - 80’s and 90’s...3.Savings & Loans Crisis

•

Regulation• Failure of nearly 750 S&Ls. Cost to taxpayers exceed $300

billion.

• Asset-Liability mismatch. Long-term fixed interest loans(on average longer than 15 years) as assets and short-termvariable interest deposit liabilities

• inflation + competition from money market mutual funds(with unregulated interest rates) make it harder for S&Lsto retain and attract deposits

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FinancialCrises

JoseScheinkman

Introduction Financial Market Episodes in US - 80’s and 90’s...

3.Savings & Loans Crisis

• Garn-St Germain Act of 1982• mandates interest rates on deposit accounts equal to rates

of money market funds. Solves liquidity crisis but createsan insolvency crisis.

• Allows S&Ls to diversify their asset base (up to 40% of

commercial real estate and up to 30% consumer loans).Facilitates moral hazard in lending and gambling forresurrection.

• Regulatory response delayed by forbearance

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FinancialCrises

JoseScheinkman


3.Savings & Loans Crisis

• Solution:• Regulators FHLBB and FSLIC abolished in 1989 and

creation of the Office of Thrift Supervision (OTS). OTSlater was regulator of American International Group (AIG),Washington Mutual, and IndyMac.

• The Resolution Trust Corporation (RTC) is established in1989 to liquidate failed thrifts

• Federal Deposit Insurance Corporation Improvement Act of

1991 (FDICIA) tightens bank and S&L closure rules,establishes risk-based deposit insurance and raises capitalrequirements,

• Greater role for Freddie Mac and Fannie Mae and takeoff of mortgage backed securities (MBS)

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FinancialCrises

JoseScheinkman


4.LTCM failure

• Limits of arbitrage

• A hedge fund betting on “convergence” of similar assets

• High leverage

•

Initially very profitable, return to investors of more than40%/year.

• Lost $ 4.6 billion following Russian crisis

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FinancialCrises

JoseScheinkman

Introduction Some Financial Market Episodes in US - 2000’s

• Dot.com bubble.• Enron, Worldcom

• Corporate governance

• Subprime crisis.

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FinancialCrises

JoseScheinkman

Introduction Major Financial Crises Abroad Since 1980

• Latin American debt crisis in the 80’s• US hikes interest rates to fight inflation. At the same time

(consequence?) commodity prices plunge.• Widespread emerging markets sovereign debt crisis

• Sovereign debt held by banks (syndicated loans)• Debt overhang. Restructuring of sovereign debt required

agreement of banks• Solution: Brady Bonds, converting bank debts into

collateralized tradable bonds

•

Scandinavian banking crisis.• Japanese asset price bubble and crash.• Mexican crisis of 1995.• 1997 Asian financial crises.• 1998 Russian financial crisis.

• Sovereign debt crisis in Eurozone.15/21

Fi i l



FinancialCrises

JoseScheinkman

Introduction The credit crisis of 2007...

• Proximate causes• The US financial sector allocated substantial resources to

real estate.• Investments financed through new financial instruments.

• Originate and distribute model.

• Financial intermediaries kept a portion of the instrumentsthey were supposed to distribute and sold another sizable

portion to investment and commercial banks.• Buyers included financial institutions in countries that did

not experience a real estate bubble e.g. Germany

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FinancialCrises

JoseScheinkman

Introduction Real Estate and Crises (Reinhart-Rogoff 12/08)

Table 8. Real Housing Price Cycles and Banking CrisesCountry Crisis date Peak Trough Duration of

downturn

Magnitude of

decline(in percent)

Advanced economies: The Big 5Finland 1991 1989:Q2 1995:Q4 6 years –50.4

Japan 1992 1991:Q1 Ongoing Ongoing –40.2 Norway 1987 1987:Q2 1993:Q1 5 years –41.5Spain 1977 1978 1982 4 years –33.3Sweden 1991 1990:Q2 1994:Q4 4 years –31.7

Asian Crisis: The Big 6Hong Kong 1997 1997:Q2 2003:Q2 6 years –58.9

Indonesia 1997 1994:Q1 1999:Q1 5 years –49.9Malaysia 1997 1996 1999 3 years –19.0Philippines 1997 1997:Q1 2004:Q3 7 years –53.0South Korea 1997 2001:Q2 4 years –20.4Thailand 1997 1995:Q3 1999:Q4 4 years –19.9

Other emergingArgentina 2001 1999 2003 4 years –25.5Colombia 1998 1997:Q1 2003:Q2 6 years –51.2

Historical episodes Norway 1898 1899 1905 6 years –25.5US 1929 1925 1932 7 years –12.6

Current casesHungary 2008 2006 Ongoing Ongoing –11.3Iceland 2007 November

2007

Ongoing Ongoing –9.2

Ireland 2007 October 2006 Ongoing Ongoing –18.9Spain 2007 2007:Q1 Ongoing Ongoing –3.1UK 2007 October 2007 Ongoing Ongoing –12.1US 2007 December

2005 –16.6

Sources: Bank of International Settlements and the individual country sources described in the Data Appendix.

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FinancialCrises

JoseScheinkman


• Financial engineering promised the creation of safesecurity from pool of less safe assets.

• Example: Two mortgages each with a face value of $1million with a probability of 10% of non-payment.

Probabilities of default are assumed to be independent.• In the post WWII period a substantial US-wide fall in

housing prices had not occurred.

• Create pool of the two mortgages and create 2 securities.The first one pays to the owner the first million paid to

the pool. The other security has the right to the rest(equity portion).

• Probability of first security not receiving full payment isonly 1%.

•

What if independence assumption not true?18/21

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FinancialCrises

JoseScheinkman


• In the past banks had no option but to hold mortgage risk.

• In this episode financial intermediaries had a chance tohold a much smaller portion of the risk

• typically had to hold a piece of equity portion• ended up holding substantial amounts of AAA tranches,

viewed as less risky.• Why did they do it?

• Greed versus ignorance

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FinancialCrises

JoseScheinkman


(1) Crisis resulted from a realization that these exotic financial

instruments were worth less than previously anticipated?(2) Crisis was simply the result of a random “bank-run”

(liquidity shock)?• Financial intermediaries financed these investments with

short term debt.

• (2) is much more kind to financial intermediaries’management and regulators.

• Data on prices and default rates favors (1).

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FinancialCrises

JoseScheinkman


• Some observations• In run-up to crisis US ran a large current account deficit

• Current Account = Savings - Investment• Reinhart-Rogoff document that many banking crises in

1960-2007 were preceded by large current account deficits(“capital flow bonanzas”).

• Also true of many other countries in current crises(United Kingdom, Spain, Iceland, Ireland...)

• Why were foreigners willing to finance the US CA deficit atsuch low interest rates?

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financial crises lecture 1

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