making sense of the global financial crisis christopher ragan department of economics mcgill...
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Making Sense of the Global Financial CrisisMaking Sense of the Global Financial Crisis
Christopher Ragan
Department of EconomicsMcGill University
andClifford Clark Visiting Economist
Department of Finance
October 20, 2009
Christopher Ragan
Department of EconomicsMcGill University
andClifford Clark Visiting Economist
Department of Finance
October 20, 2009
2
Global savings glut
Regulatory arbitrage
Highly leveraged banks
Collateralized Debt Obligations (CDOs)
Sub-prime mortgages
Securitization
Shadow banking system
Global search for yield
Expansionary monetary policy
AIG
Credit crunch
Mortgage-backed securities
Bear Stearns
Systemic stability
Lehman Brothers
Fannie Mae & Freddie MacOriginate to distribute
Toxic assets
Counterparty risk
U.S. housing collapse
3
1. Crucial micro elements
2. Key macro pressures
3. Fatal interactions
4. Policy responses
5. Myths and lessons
Outline of Talk
Part 1Crucial Micro Elements
1. Home mortgages 101
2. The evolution of mortgage lending
3. Securitization
4. Regulatory arbitrage
5
Home mortgages 101Home 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:Specialization in mortgage lending:
Commercial bank or other mortgage lender
Individual borrower
Other financial institutions
Cash Mortgage (asset)
Cash
Mortgage (asset)
“originate to own”“originate to distribute”
7
What to do with all these mortgages?What to do with all these mortgages?
1. 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:Securitization of residential mortgages:
A B C D E F G H I J
K L M N O P Q R S T
U V W X Y Z 1 2 3 4
5 6 7 8 9 10 11 12 13 14
Diversified pool of residential mortgages
-- reduces risk
Each individual mortgage is a risky asset – individual and aggregate risks
Each mortgage-backed security is just a small piece of the overall diversified mortgage pool. MBS
MBS
MBSMBS
MBS
MBS
MBS
MBS
MBS
MBS
MBS MBS
MBSMBS
MBS
MBS
MBS
9
Commercial bank or other mortgage lender lends money to individuals and thereby creates a mortgage asset.
Financial institution assembles pools of mortgages and creates mortgage-backed securities (CDOs).Cash
Mortgage (asset)
Individual and institutional investors
CDOs Cash
This process keeps the cash flowing -- used to purchase more mortgage assetsThis process keeps the cash flowing -- used to purchase more mortgage assets
10
0
500
1,000
1,500
2,000
2,500
3,000
1990 1992 1994 1996 1998 2000 2002 2004 2006
Private-label
Fannie Mae
Freddie Mac
Ginnie Mae
Securitization of residential mortgages mushroomed over the past decadeSecuritization of residential mortgages mushroomed over the past decade
U.S. GSE versus Private-Label MBS IssuanceIn billions of US dollars
Source: International Monetary Fund, Global Financial Stability Report, October 2009.
11
Capital ratios, leverage, and the “shadow banking system”Capital ratios, leverage, and the “shadow banking system”
1. The power of leverage
2. Different rules for commercial banks versus investment banks
3. 1 + 2 “Regulatory arbitrage”
12
Growing securitization led to increased bank leverage … Growing securitization led to increased bank leverage …
10
15
20
25
30
35
2000 2001 2002 2003 2004 2005 2006 2007 2008
Canada US
UK Euro area
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.
Bank Leverage Ratios
13
… especially in the U.S. investment banks. … especially in the U.S. investment banks.
15
20
25
30
2000 2001 2002 2003 2004 2005 2006 2007 2008
US - Investment Banks
assets as a multiple of capital
Sources: Bloomberg; financial statements.
Leverage Ratios
Part 2 Key Macro Pressures
1. Expansionary monetary policy
2. The global savings glut
3. The global “search for yield”
15
After 2000, central banks loosened their monetary policies significantly … After 2000, central banks loosened their monetary policies significantly …
Policy Interest Ratesper cent
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
2000 2001 2002 2003 2004
U.S. Federal ReserveBank of Canada
European Central BankBank of England
Sources: Bank of Canada, U.S. Federal Reserve, European Central Bank and Bank of England.
16
5
6
7
8
9
10
11
12
13
1998 2000 2002 2004 2006
… which generated strong growth in business and household credit … … which generated strong growth in business and household credit …
0
2
4
6
8
10
12
14
1998 2000 2002 2004 2006
U.S. Total Business Credit U.S. Total Household Credit
Y/Y per cent changeY/Y per cent change
Source: U.S. Federal Reserve Board.
17
… and fuelled a booming U.S. housing market. … and fuelled a booming U.S. housing market.
index, 2000 Q1 =100
U.S. Existing Home Prices U.S. Housing Starts
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.
70
90
110
130
150
170
190
1998 2000 2002 2004 20061400
1500
1600
1700
1800
1900
2000
2100
2200
1998 2000 2002 2004 2006
18
What is the “global savings glut”?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 …Large current account imbalances …
Current Account Balance
Source: IMF’s WEO
-1000
-500
0
500
1000
1500
1992 1994 1996 1998 2000 2002 2004 2006 2008
China, Japan, OPEC, Russia and rest of Asia
United States
In billion USD
20
… and fast-rising oil prices … … and fast-rising oil prices …
Oil Prices
Source: Bridge CRB.
0
20
40
60
80
100
120
140
160
2001 2002 2003 2004 2005 2006 2007 2008
US$/bbl
21
… led to huge increases in foreign-exchange reserves. … led to huge increases in foreign-exchange reserves.
Growth in Selected Official Foreign-Exchange ReservesUS$ Billions
Sources: IMF’s IFS data September 2009
-100
100
300
500
700
2000 2001 2002 2003 2004 2005 2006 2007 2008
Japan
Russia
OPEC
China
22
Many of these assets were invested in U.S. Treasuries and longer-term assets … Many of these assets were invested in U.S. Treasuries and longer-term assets …
20
30
40
50
60
2001 2002 2003 2004 2005 2006 2007 2008
Foreigners
of which: Foreign Official Institutions
Sources: US Treasury
Share of US Treasuries held by Foreignersper cent
23
… which reduced longer-term interest rates … … which reduced longer-term interest rates …
G10 10-year Government Bond Yield
per cent
2.0
3.0
4.0
5.0
6.0
1998 2000 2002 2004 2006
Nominal
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”. ... and shifted down the entire “yield curve”.
US Yield Curveper cent
Source: Federal Reserve
3.0
4.0
5.0
6.0
7.0
O/N 3m 6m 1y 2y 3y 5y 7y 10y 20y 30y
August 2000 September 2006
Both dates represent similar phases in the monetary policy cycle.
25
These two forces produced a global “search for yield”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
Growing provision of mortgages
Rising demand for U.S. houses
Rising leverage in banks
Declining “quality” of mortgages
26
0
100
200
300
400
500
600
700
2001 2002 2003 2004 2005 2006 2007
0
5
10
15
20
25Sub-prime share of total mortgage
originations (right)
Sub-prime mortgage originations (left)
New U.S. Sub-prime MortgagesBillions USD
Per cent
Source: Inside Mortgage Finance, via Joint Center for Housing Studies of Harvard University
Declining “quality” of mortgages?Declining “quality” of mortgages?
27
As the process continued, there was an overall “spreading” of riskAs the process continued, there was an overall “spreading” of risk
1. Risks spread across the world as investors bought the U.S. mortgage-backed securities
2. Risks spread to other parts of the financial sector, as financial institutions insured their portfolios
Part 3Fatal Interactions
1. Falling U.S. house prices
2. Rising mortgage foreclosures
3. Financial losses and counterparty risks
4. Credit crisis Financial crisis
29
70
90
110
130
150
170
190
1997 Q2 2000 Q2 2003 Q2 2006 Q2 2009 Q2
U.S. house prices first slowed and then dropped off a cliff …U.S. house prices first slowed and then dropped off a cliff …
index, 2000 Q1 =100
U.S. Existing Home Prices
Note: S&P/Case Shiller Home Price Index.Sources: Standard & Poor's; Fiserv; MacroMarkets LLC.
Source: U.S. Bureau of Census
31%
U.S. Housing Starts
Level – 3-month moving average
0
500
1000
1500
2000
2500
1997 1999 2001 2003 2005 2007 2009
30
… which led to rising delinquencies of sub-prime mortgages … … which led to rising delinquencies of sub-prime mortgages …
0
5
10
15
20
25
30
35
40
0 10 20 30 40 50 60
60+ day delinquencies, in per cent of original balance
Source: International Monetary Fund, Global Financial Stability Report, October 2008.
U.S. Mortgage Delinquencies by Vintage Year
2007
2006
2005
2003
2004
2000 2001
2002
Months from origination
31
0
2
4
6
8
10
12
14
16
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Prime
Sub-prime
… and eventually increased foreclosures.… and eventually increased foreclosures.
Sources: Mortgage Bankers Association of America
Per cent Per cent
U.S. Delinquency Rates U.S. Share of Loans in Foreclosure
Foreclosure is a legal process that can take anywhere from 45 to 365 days
0
5
10
15
20
25
30
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Sub-prime Prime
The delinquency rate includes loans with payments 30, 60,
and 90 days or more past due, but are not yet 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 …
32
Foreclosures and falling house prices, in turn, led to large downgrades in MBSs … Foreclosures and falling house prices, in turn, led to large downgrades in MBSs …
In percent, as of June 30, 2009
Source: International Monetary Fund, Global Financial Stability Report, October 2009.
Ratings on MBSs (which were AAA when issued 2005-07)
0
10
20
30
40
50
60
AAA AA A BBB BB B <B
33
… which naturally led to a decline in their market value. … which naturally led to a decline in their market value.
In U.S. dollars
Prices of U.S. Mortgage-backed Securities
Source: International Monetary Fund, Global Financial Stability Report, October 2008.
0
20
40
60
80
100
120
Agency MBS
Jumbo MBS
Alt-A
ABX AAA
ABX BBB
2006 2007 2008
34
Rising “counterparty risk” led to a credit crunch …Rising “counterparty risk” led to a credit crunch …
Credit Spreads
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.
basis points
-40
0
40
80
120
160
200
240
280
320
360
400
Jan 2007 May 2007 Sep 2007 Jan 2008 May 2008 Sep 2008 Jan 2009 May 2009 Sep 2009
Canada (CDOR - OIS)
U.S. (LIBOR - OIS)
Euro area (LIBOR - OIS)
ABCP crisis
Lehman Brothers bankruptcy
… and eventually a full financial crisis …
Bear Stearns
35
0
200
400
600
800
1,000
1,200
America Europe Asia
0
20
40
60
80
100
120
140
160
Billions, USD
Mortgage-Related Write-downs and Credit Losses since 2007Q3
Since 2007Q3, financial institutions have posted over
US$1600 billion in write-downs and credit losses.
Sources: Bloomberg, September 28, 2009.
.. with enormous losses for many large financial institutions … .. with enormous losses for many large financial institutions …
36
… and huge declines in the world’s stock markets. … and huge declines in the world’s stock markets.
Source: Bloomberg.
-90
-80
-70
-60
-50
-40
-30
-20
-10
0
Canada (S&P/TSX) U.S. (S&P 500) U.K. (FTSE 100) EMU (DJ Euro STOXX)
Total
Banks
World Equity Markets% change from January 1, 2007 to March 2, 2009
Part 4Policy Responses
1. Financial sector vs. the “real economy”?
2. Monetary policy
3. Actions to assist financial markets
4. Fiscal policy
38
What was likely to happen?What was likely to happen?
1. Credit is like electricity to a modern economy, and banks are like the power company.
2. A decline in the flow of credit would inevitably lead to a significant global recession.
3. The financial sector is part of the real economy!
39
The largest global recession in many yearsThe largest global recession in many years
-2
-1
0
1
2
3
4
5
6
1980 1985 1990 1995 2000 2005 2010
Sources: IMF
Growth of world real GDP
per cent per year
Average 1980-2010: 3.2%
40
Unprecedented global monetary policy response … Unprecedented global monetary policy response …
Policy Interest Rates
per cent
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Sep 2007 Dec 2007 Mar 2008 Jun 2008 Sep 2008 Dec 2008 Mar 2009 Jun 2009 Sep 2009
U.S. Federal Reserve
Bank of Canada
European Central Bank
Bank of England
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. … included the use of “unconventional” monetary policy tools.
90
140
190
240
290
Jan 2008 Apr 2008 Jul 2008 Oct 2008 Jan 2009 Apr 2009 Jul 2009
Fed
BoC
BoE
ECB
Central Bank Assets
Index: January 2008 = 100
42
Most governments also introduced measures to support financial markets.Most governments also introduced measures to support financial markets.
Insured Mortgage Purchase Program 64
New 10-Year Canada Mortgage Bond 8
Canadian Lenders Assurance Facility N/A
Canadian Life Insurers Assurance Facility N/A
Crown Corporations Flexibilities including Business Credit Availability Program
7
Canadian Secured Credit Facility 12
Bank of Canada 40
Total 131
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 … G-20 leaders coordinated their substantial fiscal expansions …
Fiscal Stimulus Flowing in 2009 and 2010, G7 countries
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
ItalyUnited KingdomFranceGermanyUnited StatesJapanCanada
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 44
… and accepted the deterioration in their medium-term fiscal outlooks. … and accepted the deterioration in their medium-term fiscal outlooks.
Total Government Budget Deficits, 2009
-14
-12
-10
-8
-6
-4
-2
0
2
Canada France Germany Italy Japan United Kingdom United States
2007 2009
Per cent of GDP
Source: IMF WEO, October 2009.
Part 5Lessons and Myths
Part 5Lessons and Myths
1. Blame and greed?
2. “The end of laissez-faire”?
3. Regulatory reform
4. Baby and the bathwater
Thank you. Questions?Thank you. Questions?