Download Macrohonours Lecture 10 - Lecture Notes

Lecture 10 – The global financial crisis
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10.1 Introduction
10.2 Pre-crisis financial system
10.3 Upswing of the financial cycle
10.4 The crisis
10.5 Policy intervention in the crisis
10.6 Conclusion
10.1 Introduction
• The Great Recession of 2008-09 was the most severe contraction
the global economy has experienced since the Great Depression
(1929)
• In the 1990’s and early 2000’s there were conditions of tranquility
(low inflation and low levels of unemployment) of the the Great
Moderation
• Under these conditions, levels of debt of households and banks
increased dramatically, (see Fig 7.1 – rising debt in the US economy
• In the US, household debt rose by 8 percentage points between
1988 and 1998 and by 29 percentage points between 1998 and
2008, over the same periods financial sector debt rose by 30
percentage points and 48 percentage points)
• In Spain, households debt rose form 44% of GDP (1999) to 69% of
GDP (2008) and in the UK from 88% (1999) to 105% (2008)
• In the main, this rise in debt did not set off alarm bells amongst
macro economists at universities or at CB’s (See movie The Inside
Job)
Debt leads to Asset price booms
• The rise in household and bank debt fueled booms in asset
prices
• US house prices rose by 90% between 2000Q1 and 2006Q1
• Two views amongst macro-economists:
• Predominant view – CB’s should not lean against asset price
bubbles by raising interest rates, but instead should “focus
on policies to mitigate the fallout when it occurs and,
hopefully, ease the transition to the next expansion” (Alan
Greenspan 2002)
• Minority view – There have frequently been periods in
history where low stable inflation has coincided with the
build up of private sector debt that sowed the seeds for
future banking crises (Borio and White 2004) – steps should
be taken to regulate and prevent the housing bubble and
related risky conduct by the financial sector
Figure 7.1
10.2 Pre-crisis financial system
• Banks have an incentive to take on higher risks than is
socially optimal
• They can ‘bank on the state’ in that they take
advantage of the fact that banking sector gains are
privatised (i.e. accrue to bank shareholders, managers
and employees), but losses (at least partly) are
socialised (i.e. the banking systems is insured / bailedout by the state)
• A clear problems arises: Banks will choose too low a
capital cushion i.e. they will choose leverage that is
too high
• Note there are echoes of this problem as Barclays
seeks to sell off ABSA in SA in 2016 – dangers of shortrun private equity capital buying ABSA
In the period before the global
financial crisis
• Incentives encouraged banks to adopt strategies
that added to aggregate risk in the economy
• Regulators allowed banks to use their own
models to assess risk
• There was lack of concern that the financial
system was becoming a risk to the economy as a
whole – investors believed that regulators and
professional investors were managing risk
• The great moderation had the effect of
persuading households and banks that aggregate
risk in the economy had fallen
Financial Instruments
• There were three financial instruments at the
center of the 2008-09 financial crisis:
– The mortgage-backed security (MBS)
– The collateralised debt obligation (CDO)
– The credit default swap (CDS)
• Fig 7.2 shows how the innovation of these
instruments evolved during the 2000’s
Figure 7.2
Mortgage-backed securities (MBS)
• An MBS is a financial product secured by a collection of
mortgages and referred to as a securitised financial
assets ( a bundle of mortgages)
• The coupon on payment on MBS’s is generated by
homeowners paying their mortgage’s / bonds
• The risk on MBS’s is the credit risk on home owners not
being able to pay their mortgage’s / bonds
• MBS’s mitigate risk through two channels:
– Diversification e.g. from different regions around US
– Division into tranches – lower junior tranches have higher
risk and higher return, senior tranches – low risk, lower
return
Collaterilised debt obligations (CBO’s)
• CDO’s are like MBS, but they were originally
focused on corporate loans not housing loans
• Where the correlation of the underlying bundle
of loans is low (e.g. loans made into different
industrial sectors) then defaults are isolated
events and only the junior tranche is at risk
• When the correlation is high, defaults are subject
to clustering which can endanger the safer
tranches of the CDO
Credit ratings agencies (CRA)
• The risk of financial products is assessed by
the CRA’s using computer models and data on
past correlations and asset performance
• The safest securities are rated triple A (AAA),
which means the CRA assumes there is almost
0 probability of default
• The CRA’s rate many senior tranche CDO’s as
AAA (when correlations of underlying debts
are perceived to by very low)
CDO’s based on MBS’s
• When CDO’s came to be based on MBS they became
dangerous (early 2000s)
• Evaluating correlation of underlying MBS’s was difficult as
there was little historical data available on these financial
products (only about 20 years back to 1980’s)
• The CRA’s decided the correlations were low and gave the
senior tranches of the CDO’s based on MBS AAA ratings
• The AAA credit rating + the good returns on these CDO’s
made them very popular with institutional investors
globally
• But, paradoxically it was the geographical diversification of
individual MBS’s that led to CDO’s based on MBS’s
becoming homogenized and therefore highly correlated
• When house prices fell across the US it was not just some
MBS’s that would suffer losses but all of them
Credit Default Swaps
• There was a ‘super senior’ tranche of the CDO’s based
on MBS’s that was held mainly by banks (as it was not
popular investors due to its low return), bank bought
insurance on this ‘super senior’ tranche in the form of
CDS’s
• US insurance giant AIG sold this insurance to banks in
the form of CDS’s
• AIG received insurance premiums from the banks for
these CDS’s and ito of these CDS’s AIG pledged to repay
banks in full should the ‘super senior’ tranche of CDO’s
default
• When CDO’s collapsed this led to staggering loses for
AIG – leading to a USD180-bn government bailout of
AIG (AIG’s bail out was much bigger than that given to
any individual banks around USD25-bn)
Actors in 2008-09 Financial Crisis
• In the years before the crisis banks increased
their return on equity and reduced their
capital buffers, but regulators reported that
risk had gone down
• Strategies to increase the return on equity was
also called the ‘search for yield’ due to
different regulatory frameworks:
– in the US this meant banks lending into the ‘subprime’ (high risk) mortgage market,
– in Europe banks shifted their activities to their
‘trading book’
Actors in 2008-09 Financial Crisis
• De-regulation of banks in US (1999)
– Universal banks engage in retail, commercial,
wholesale and investment banking activities
– Europe had long had universal banks
– In the US in 1999 the Glass-Steagall Act (of 1933) was
repealed, this act had improved the safety of the
banking system by separating retail and investment
banking activities => Universal banks arose in the US
Incorrect rating of risk
• European banks had much higher leverage (See Fig 7.3) – poor
regulation on European banks mean that could massively increase
leverage – expand their assets relative to equity
• Under Basle II regulation – less capital cushion had to be held
against high rated assets (e.g. 0 capital cushion was required to be
held against a AAA-rated sovereign debt) and banks were allowed
to use their own models to calculate their risk-weighted assets
• Risk weights were falling as a result of the proliferation of AAArated CDO’s (e.g. pre-crisis there were fewer than 10 companies
with an AAA-rating, but there were over 50 000 CDO’s with AAArating) – effect of this banks could use CDO’s to increase their total
assets without requiring additional equity to be held (intense
leveraging)
• Contradiction due to regulatory failure: risk weights were falling
due to proliferation of AAA-rated assets, while aggregate risk in
the economy was rising
Figure 7.3
Concentration and interconnectedness of banks
• Concentration of banks saw the consolidation of national banking
systems into the hands of a small number of “too big to fail”
financial giants e.g. in UK 3 major banks held more than 70% of
total UK banking assets just prior to crisis
• Interconnectedness saw banks across the globe became more
intertwined and dependent on each other e.g. two thirds of
expansion in bank balance sheets were a result of claims from
within the financial system, rather than from non-financial agents.
– This increases the chances of systemic liquidity crises when key
institutions become distressed
– Also homogeneity in the banking systems increases system wide risk –
if all banks hold similar assets this may minimise their own risk of
failure (considered in isolation), but can make the system more liable
to collapse
• CB’s now more concerned with a macro-prudential regulatory
framework that seeks to minimise the risk of the system as a
whole, rather than for each bank individually (micro-prudential
regulation)
10.3 Upswing of the financial cycle
• (1) in the US and (2) globally
• The US govt promote home ownership – Clinton administration stated aim
to “add as many as 8 million new families to America’s home ownership
rolls by the year 2000”
• Rajan in 2010 showed how such policies helped to sustain AD in the US
economy following the bursting of the dotcom bubble in 2000, where real
wage growth for the majority workers had stagnated since the 1970’s
• Housing loans were extended to sections of society which were previously
credit constrained – sub-prime lending e.g. ninja loans (no income no job
or assets loans)
• As per the financial accelerator – more lending fuelled rising house prices
and rising house prices in turn increased the willingness of banks to lend
(as rising house prices increased bank collateral on loans they were
giving), extrapolative price expectations meant that households also had
an incentive to borrow more (i.e. increase their leverage)
• Households increased their leverage i.e. their debt to equity ratio
increased (this happened as their mortgage (debt) increased relative to
their equity (deposit/down payment on house)
Upswing of the financial cycle
• Households have an incentive to increase their leverage in order to
increase their return on equity
• e.g. if a house price is USD200 000 and the deposit paid is 10%
(USD20 000), the initial leverage ratio is 200/20 = 10, if the house
price rises by 10% to USD220 000 then the return on the equity the
household invested in 100% (increased from USD20 000 to USD 40
000)
• To get a high return households will seek to increase the leverage
eg return on equity if the deposit is 5% or USD10 000 would mean
an initial leverage of 200/10 = 20 and a return on equity from USD
10 000 to USD 40 000 = 300%
• But then all of the equity of households can be wiped out when
house prices are falling
– if leverage ratio is 10 then a fall in house prices of 10% (or USD 20 000)
wipes out equity
– If leverage ratio is 20 then a fall in house prices of 5% (or USD 10 000)
wipes out equity (i.e. if house prices fall by more than 5% then house
owners own an asset worth less then the amount they owe on it (USD
190 000) – called ‘negative equity’)
(2) Global financial upswing
• Due to cross border bank flows – the upswing
effected more countries and by a larger
magnitude than previously
• The financial boom had roots in the US subprime
mortgage sector, factors that facilitated
transmission from the US to other countries
• Post-2000: (1) US MBS began to be traded worldwide (2) growing domination of ‘too big to fail’
banks, (3) rise of importance and trust in ratings
agencies, (4) incentives in banks for ‘search for
yield’ behaviour rewarded by high bonuses
10.4 The crisis
• Empirics: Fig 7.5 shows (1) the GDP performance across
developed and developing countries, (2) the recession was
not uniform as some emerging and developing countries
managed to avoid recession
• Fig 7.6 shows key macro indicators for the US and other G7
economies
– The recession was not-V shaped i.e. recovery in GDP was not
faster than the pre-recession growth rate (in some countries like
the UK it was L-shaped)
– Consumption and Investment followed a similar pattern in the
G7 economies
– The Unemployment pattern in the US was different from other
G7 economies as unemployment in the US was rising before the
recession and rose much higher than in other G7 economies
(unemployment doubled in the US as result of the recession)
– As have seen in SA – GDP growth went negative, 1m jobs were
lost, investment fell, govt debt rose
Figure 7.5
Figure 7.6
Figure 7.7
“Fear index” – volatility of the S&P stock index (VIX)
peaked on 15 Sept 2008 when Lehman Brothers failed
Three stages of the credit crunch
• (1) Collapse of sub-prime housing market
• (2) Seizing up of the money market
• (3) Lehman Brothers collapse
(1) Collapse of sub-prime housing market
• US Fed started raising r in 2004 in response to inflation
pressures as oil and commodity prices rose
• Rising r depressed housing market as it became more
expensive to borrow and mortgage repayments rose
• Housing prices started to fall
• Borrowers struggled to make repayments and could no
longer make use of rising property prices to make more
loans (to help pay the mortgage)
• Negative financial accelerator came into effect (as
housing prices fell => AD fell)
• MBS and CDS values fell (Feb 2007)
• By August 2007 – BNP Paribas stated that the value of
the MBS assets it was holding was in doubt
(2) Seizing up of the money market
• Banks rely on two money markets to fund their need for s-r liquidity
(regulated ratios)
• (1) Repo market – banks sell securities and agree to repurchase them
at a particular repurchase (repo) rate, these loans are secured by
collateral
• (2) commercial inter-bank markets – banks lend to each other
overnight or for up to 2-3 months, these loans are unsecured (no
collateral)
• Problem:
– the value of MBS come to be included as collateral and when MBS started
losing value this introduced increased risk into the system
– in Aug 2007 interest rates in the inter-bank market started to rise as
perceived risk rose (indicative of a rising risk premium) (e.g. Fig 7.8 shows
the widening spread between the interest rate on inter-bank loans and
the official bank rate in the UK)
– In Sept 2007, Northern Rock UK bank experienced a bank-run and the
bank was insolvent and had to be nationalised, event though Northern
Rock was not directly involved in lending to the sub-prime market it relied
too heavily on s-r debt to finance its operations, so when fears hit the
money market it became impossible for Northern Rock fund its loans as
these came due
Figure 7.8
(3) Lehman Brothers collapse
• Lehman Brothers declared bankruptcy on 15 Sept
2008
• The US govt did not rescue Lehman Brothers and
the ramifications of this were bigger than
expected
• The collapse of Lehman Brothers has world-wide
consequences for financial markets and for the
real economy
• It was the key event that plunged the world
economy into the Great Recession
The crisis and the 3 equation model
• The spread between the policy rate rp and the money
market rate widened (as risk premium rose) (See Fig
7.8)
• The spread between the policy rate and the lending
rate also widened (See Fig 7.9)
• The IS-PC-MR model would predict a rise in the markup of the lending rate as per r = (1 + μB)rP due to higher
credit risk and a loss of risk tolerance
• This widening between the policy rate and the lending
rate leads to a breakdown of a key transmission
mechanism of monetary policy in the IS-PC-MR model
which relies on policy rate changes to change the
lending rate used by firms and households
Figure 7.9
The crisis and the 3 equation model
• See Fig 7.10 where IS-PC_MR model is used to show
the effects of the sub-prime crisis (which manifests as a
–ve AD shock)
• (1) the IS curve shifts left due to fall in AD
• (2) the interest rate r rises due to the rising spread
between the policy rate and lending rate
• (3) If Min rP is above the new stabilising rate of r’s the
economy experiences a deflation trap
• In Fig 7.10, the interest rate spread means that the best
y that can actually be achieved is at X
• As monetary policy is limited, What may be required is
fiscal expansion and unconventional monetary policy
(QE).
Figure 7.10
10.5 Policy intervention in the crisis
• (1) Know your history in order not to repeat it
– what was wrong with the policy response to
the Great Depression (1929 - early 1930’s)
• (2) Monetary and Fiscal response in the teeth
of the global financial crisis of 2008-09
• (3) Policy response in the Great Recession
that followed the global financial crisis
(1) What was wrong with the policy
response to the Great Depression?
• Two key mistakes were made by policy makers in
response to the Great Depression
• (1) contractionary monetary and fiscal policies
– Money supply contracted by a third between 1929 and
1933 due to failing banks and bad Fed policy i.e. the Fed
did increase money supply but not sufficiently to
counteract the falling money multiplier (as the currency to
deposit ratio rose and banks held excesses reserves)
– Government increased tax rates on individuals and
businesses
• (2) a rise in protectionism
– President Hoover introduced the Tariff Act of 1930, which
raised import tariffs on over 20 000 products. This was
met by retaliatory measures from the US’s main trading
partners and world trade plummeted.
Comparing 1929 and 2008
• Fig 7.11 shows that the two downturns looked
similar, but the bounce back was a lot more rapid
following 2008-09
• In 2008-09 Ben Bernanke was determined to
avoid the mistakes of 1929:
– Governments stepped in to support AD via fiscal
stimulus packages
– CB’s slashed interest rates and kept them at historical
lows for an extended period
– Expansionary monetary and fiscal policies were
adopted more decisively and applied more
consistently than in 1929
Figure 7.11
(2) Monetary and Fiscal response to
global financial crisis of 2008-09
• The 2008-09 policy response addressed three
key problems:
– The liquidity problem – CB took action to deal
with seizing up of money markets and bank
liquidity problems
– The Bank Solvency problem – CB’s and govt’s took
action to save failing banks and prevent contagion
– The stabilisation of AD and expectations – CB’s
used conventional and unconventional monetary
policy and govt’s used expansionary fiscal policy
Liquidity problem
• Bank of England made USD10-bn reserves
available for 3 month loans and widened
acceptable collateral
• ECB injected Euro 95-bn in overnight credit into
the interbank market
• Fed injected USD 24-bn
• While these interventions provided some respite
and injected significant liquidity into the banking
system, the spread remained high between
lending rates (which stayed high) and the policy
rate (which was lowered to historic lows)
Solvency problem
• Given bank high leverage the fall in the value of financial
assets mean that they risked insolvency (where assets <
liabilities)
• Banks needed capital urgently to plug the gaps in their
balance sheets and avoid failure
• Private capital markets were not willing to provide
additional capital (investment) so banks had not choice but
to turn to their govt’s in the following forms:
– Govt’s took equity / ownership stakes in financial institutions
and in exchange provided capital (eg Citigroup and Bank of
America in US)
– Banks were nationalised i.e. govt’s took control of financial
institutions by taking very high equity stakes (e.g. Northern Rock
and RBS in UK and AIG in US)
– MBS’s that had lost their value (had come to be called toxic
assets) so CB’s agree to buy these toxic assets (in US Fed bought
USD600-bn worth)
Stabilisation policy – prevent deflation
• Conventional monetary policy:
– responded with sharp interest rate cuts, aimed at stimulating AD and
preventing deflation (see Fig7.11 where interest rate cuts in 2008-09 were
much sharper than in 1929)
• Unconventional monetary policy:
– The zero bound of nominal interest rates restricted conventional monetary
policy, so unconventional policies were used to stimulate AD and prop up
inflation expectations
– The main unconventional instrument used was QE (quantitative easing)
where the CB used asset purchases (purchase govt bonds and financial
assets) to try to boost asset prices and bring down long term interest rates
(i.e. lower yields),
– The aim of such unconventional policy was to boost AD by encouraging
Consumption and Investment in the private sector by pushing down long
term interest rates
• Note:
• conventional monetary policy seeks to reduce short-run interest rates
• unconventional monetary policy seeks to reduce long-run interest rates
Monetary policy and the yield curve
• The yield curve shows the relationship between the nominal interest rate
of a bond and its time to maturity (i.e. the time remaining before the full
value of the bond must be repaid)
• At Fig 7.12(a) yield curve is upward sloping (normal) as investors demand a
higher rate for holding longer term bonds (iS<iL), this is due to:
– uncertainty about the longer run future
– uncertainty about inflation in the long-term as inflation impacts on the real
return on bonds
• At 7.12(b) If there is a negative demand shock then CB undertakes
conventional policy cuts short-run interest rate and assuming a constant
spread, the the yield curve (YC) shifts down to YC’ and the long term
interest rate falls to iL’
• At Fig 7.12(c) the CB undertakes unconventional policy buys govt bonds in
secondary markets, increases their prices reduces long-run rates,
swivelling the slope of the yield curve to YC” and reducing long run rates
to iL”
• Note: see an amazing 3D yield curve at this link:
http://www.nytimes.com/interactive/2015/03/19/upshot/3d-yield-curveeconomic-growth.html?_r=1&abt=0002&abg=0
Figure 7.12
Fiscal policy – automatic stabilisers
and fiscal stimulus
• In Fig 7.10 policy makers need to use fiscal policy to try and boost
output to that given by point C
• Fiscal policy shifts the IS curve up to the right based on the
understanding that the real interest rate is at rx given the interplay of:
– the zerobound on the nominal interest rate,
– deflation and
– the rising spread between the policy rate and the lending rate
• This fiscal policy response is made up of two components (1) automatic
fiscal stabilisers and (2) discretionary fiscal policy (also called ‘fiscal
stimulus packages’)
• IMF estimated that overall change in fiscal balances across G20 between
2007 and 2009 was 5.9% of GDP of which automatic stabilisers = 3.9%
and fiscal stimulus = 2%
• This excludes fiscal resources allocated to bail out the banking sector,
• Studies show the sorting out the banking sector should be done first, as
it is more costly in the long-run to have bad banks and zombie
companies sucking the fiscus dry e.g. compare the relative success of
Sweden in dealing with its banking crisis vs the stagnation of Japan
Fiscal Policy
• Fiscal Stimulus Packages took many forms
– UK cut VAT from 17.5% to 15%
– European countries introduced car scrapping schemes, paying
consumers to scrap their cars and buy a new one
– Australia gave tax bonuses, cash handouts to middle and low income
earners
• The size of stimulus packages pre March 2009 relative to GDP are
shown in Fig.7.13 – which shows how fiscal balances were
negatively effected) made up of announced tax cuts and increases
to spending Fiscal stimulus was coordinated across countries (eg
at G20 summits) to avoid a situation where some countries would
free ride on the stimulus of others e.g. benefit from increased
exports without incurring the fiscal costs
• Note: monetary policy not so co-ordinated – where US has been
criticized for not taking account of the costs of tapering its QE on
other countries e.g. who experience exchange rate shocks
(weakening) and / or interest rate shocks (eg US r up and Rand
weakens and SA’s r must rise)
Figure 7.13
Under what conditions is fiscal
stimulus likely to succeed
• When monetary policy supports expansionary fiscal policy by
preventing interest rates from rising
• When it takes the form of a temporary rise in govt spending as this
raises govt demand for goods and services directly (even if this is
accompanied by higher taxation, as the first round effect is still
stimulatory aka balanced budget multiplier)
• Even if govt borrows to fund extra spending there is a stimulatory first
round effect (even if Ricardian equivalence means that rising saving
(to prepare to pay tax for the borrowing) dampens second round
effects
• Where there are temporary tax cuts and households are credit
constrained, then the tax cut will lead to higher spending
• Conclusion: Fiscal stimulus, in response to a crisis which leads to fall
in AD and excess capacity in the economy, should be timely,
temporary and targeted (and co-ordinated across countries).
• The temporary nature of the intervention serves to shifts spending
decision forward and reduces concerns about long-run implications
for public debt.
Consolidation policies in the postcrisis recession
• In many countries fiscal stimulus was followed by
discretionary contractionary fiscal policy even
before they had exited the recession
• Why? The express aim was to reduce the debt to
GDP ratio (which trumped the aim of stabilising
AD)
• This process was called fiscal consolidation or
austerity and has been much debated (eg see
Paul Krugman’s criticism of austerity at:
• http://www.theguardian.com/business/nginteractive/2015/apr/29/the-austerity-delusion
Fiscal consolidation
• As per Fig7.14, shows that for the US, UK and other
advanced countries:
– In 2008-09 countries ran negative change in their structural
balance (indicating discretionary expansion in their fiscal
policies)
– In 2009-10 the US and advanced countries continued to run
(smaller) negative changes in their structural balances, but the
UK began introducing a positive change to their structural
balance (as they began a process of discretionary austerity)
– From 2010-11 onwards – all countries had moved to positive
change in their structural balances (discretionary austerity) in
order to avoid a national debt trap
• In Fig 7.14 fiscal policy is tighter if the change to the
structural balance is positive (even if a structural deficit
remains)
Figure 7.14
Was austerity premature?
• Was it an error to attempt to deal with mounting govt
debt via an early tightening of fiscal policy
• On the balance yes, as unlike an individual household
where debt is reduced by saving more, the paradox of
thrift implies that in an economy with spare capacity (y
below ye) the decision by the govt to borrow less in the
context where the private sector was still heavily
indebted meant that at an aggregate level the decision
to save more (pursue austerity) serves to reduce AD
and reduce output
• Paradoxically, austerity may mean that the debt/GDP
ratio rises
– as the denominator (GDP) may fall as AD falls, and
– as the numerator (debt) may rise if low AD / low growth
and related low tax revenues and rising debt
10.6 Conclusion
• The 2008-09 financial crisis highlighted the inadequacies of
the pre-crisis policy framework that combined Inflation
Targeting CB’s with light touch financial regulation
• A major theme of post-crisis policy debate is that measure
should be put in place to prevent the upswing of a financial
cycle with its pro-cyclical build up of debt and leverage and
makes the economy vulnerable to financial crisis
• At the root of the problem is that banks take excessive risks
when measured from a societal perspective – because
banks do not internalise the impact of their actions on
systemic risk and the are implicitly subsidised by the
prospect of being bailed out
• As a result - How to better regulate banks is one of the key
issues that is dealt with in policy discussion on how best to
protect economies from costly financial crises