Download Origins: Financial Innovation

Origins of the Current Crisis
and Economic Policy of the
NCM
Philip Arestis
Cambridge Centre for Economic and Public Policy
Department of Land Economy
University of Cambridge
University of the Basque Country
Department of Applied Economics V
Presentation
1.
2.
2a.
2b.
2c.
2d.
2e.
3.
Introduction: The global financial system has
been under enormous stress since August
2007, and has well spilled over to the global
economy more broadly. Is it over now?
Origins of Current Financial Crisis: Five
features:
Distributional Effects
Financial Liberalisation
Financial Innovation
International Imbalances
Monetary Policy
Summary and Conclusions
Origins: Distributional Effects
 Feature 1: Distributional Effects
 We begin by referring to the first major feature of the origins of
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the ‘great recession’;
We argue that it is the steady but sharp rise in inequality,
especially in the US and the UK but elsewhere, too;
The share of national output taken up by profits had reached
close to a post World War II high before the onset of the
recession;
While real wages had fallen even behind productivity;
The declining wage and rising profits share, were compounded
by another long-term economic term: the increasing
concentration of earnings at the top, especially in the financial
sector;
See relevant figures;
Origins: Distributional Effects
Figure 1: UK Wages as Percentage
of GDP
Origins: Distributional Effects
Figure 2: UK Wages Relative to
Productivity
Origins: Distributional Effects
Figure 3:US and Rest of the World
Profits as Percentage of GDP
Origins: Distributional Effects
 Similar observations can be made in Europe,
excluding the UK;
 The rising profits share aped financial
institutions thereby increasing leveraging
(debt to assets ratio) and high risk-taking in
financial institutions;
 This, along with financial liberalisation in the
US, promoted the financial engineering based
on the US subprime mortgages as we explain
below.
Origins: Financial Liberalization
 Feature 2: Financial Liberalization;
 It is justified by the ‘efficient markets hypothesis’,
which assumes that all unfettered markets clear
continuously thereby making disequilibria, such as
bubbles, highly unlikely;
 Economic policy designed to eliminate bubbles would
lead to ‘financial repression’, a very bad outcome in
this view;
 The experience with financial liberalization is that it
caused a number of deep financial crises and
problems unparalleled in world financial history in
terms of their depth and frequency.
Origins: Financial Liberalization
 US financial liberalization did also begin in the 1970s;
 There was the deregulation of commissions for stock trading in
the 1970s;
 The removal of Regulation Q in the 1980s, that is placing
ceilings on interest rates on retail deposits;
 The repeal of the key regulation Glass-Steagall Act (of 1933) in
1999 (promoted by the US financial sector, complaining about
the financial Bing Bank liberalisation of 1986 in the UK);
 And the Commodity Futures Modernisation Act (CFMA) of
December 2000, which repealed the Shad-Johnson
jurisdictional accord, which had banned single-stock futures in
1982 (the financial instrument that allows selling now but
delivering in the future);
Origins: Financial Liberalisation
 When fixed commissions were in place, investment
banks would book stock trades for their customers;
deregulation meant greater competition, entry by lowcost brokers and thinner margins;
 Removing Regulation Q allowed the fluctuation in
interest rates, thereby forcing commercial banks to
compete for deposits on price, which led them to
pursue new lines of business;
 Such new business emerged in response to the
investment banks’ needs for short-term funding;
 It created, however, a financial crisis in the 1970s and
1980s when savings banks could not fund
themselves in view of the narrowing of the margins of
lending and borrowing rates;
Origins: Financial Liberalisation
 Investment banks proceeded into originating
and distributing complex derivative securities,
like collateralized bond obligations (normal
investment bonds backed by pools of junk
bonds);
 that was not a great success and collapsed in
the second half of the 1980s;
Origins: Financial Liberalisation
 That originate-and-distribute failure was followed by a
new initiative of asset-backed and mortgage-backed
securities, which gained a clientele in the 1990s;
 We had in 1997 the Broad Index Secured Trust
Offering (BISTRO), a buddle of credit derivatives
based on pools of corporate bonds;
 And later the Collateralised Debt Obligations (CDOs),
based on debt in general terms (including subprime
mortgages), and Collateralised Mortgage Obligations
(CMOs), based mainly on pools of subprime
mortgages;
Origins: Financial Liberalisation
 BISTRO was not a great success in view of
the corporate sector’s booms and recessions
at that time;
 CDOs and CMOs became a success in view
of the steady growth path of the housing
market;
 That was the first cause of the crisis: the
originate-and-distribute model of
securitization and the extensive use of
leverage (NB: leverage is the ratio
debt/equity);
Origins: Financial Liberalisation
 This raises the issue of the difference between
originate-and-distribute and originate-and-hold;
 In the originate-and-hold model bank loans are held
in the banks’ own portfolios;
 In the originate-and- distribute (or originate-tosecuritize) model bank loans are re-packaged and
sold to other banks, foreign banks and the domestic
and foreign personal sector;
 The latter model transfers the loan risk from the bank
to whoever buys the Asset Backed Securities (ABS);
Origins: Financial Liberalisation
 Then came the Commodity Futures Modernization
Act (CFMA) of December 2000, which deregulated
single-stock futures trading, and provided certainty
that products offered by banking institutions would
not be regulated as futures contracts;
 CFMA enabled the creation and legitimisation of
credit-default swaps (CDSs, credit derivative
contracts between two parties, whereby there is
guarantee in case of default);
 Thereby creating a potentially massive vector for the
transmission of financial risk throughout the global
system;
Origins: Financial Liberalisation
 The apotheosis of the financial liberalization in the
US, however, had already come about with the repeal
of the 1933 Glass-Steagall Act in 1999;
 Although it should be said that relaxing the 1933 Act
began in 1987 (when the Fed allowed 5% of bank
deposits to be used for investment banking, and
further promoted in 1996 when 25% of deposits were
allowed for the same purpose);
 The 1933 Glass-Steagall Act was designed to avoid
the experience of the 1920s/1930s in terms of the
conflict of interest between the commercial and the
investment arms of large financial conglomerates
(whereby the investment branch took high risk
tolerance);
Origins: Financial Liberalisation
 The ultimate aim of the 1933 Glass-Steagall Act was
to separate the activities of commercial banks and
the risk-taking ‘investment or merchant’ banks along
with strict regulation of the financial services industry;
 The goal was to avoid a repetition of the speculative,
leveraged excesses of the 1920s/1930s;
 Without access to retail deposits and with money
market instruments tightly regulated, investment
banks funded themselves using their partners capital;
Origins: Financial Liberalisation
 The repeal of the Act in 1999 changed all that:
 It forced investment banks to branch into new
activities;
 And it allowed commercial banks to encroach on the
investment banks’ other traditional preserves
 Not just commercial banks but also insurance
companies, like the American International Group
(AIG), were also involved in the encroaching;
Origins: Financial Innovation
 Feature 3: Financial Innovation;
 The repeal of the Glass-Seagull Act in 1999 allowed
the merging of commercial and investment banking,
thereby enabling financial institutions to separate
loan origination from loan portfolio; thus the originateand-distribute model;
 Indeed financial institutions were able to use risk
management in their attempt to dispose of their loan
portfolio;
 This led to an important financial innovation;
Origins: Financial Innovation
 Financial institutions can now provide risky
loans without applying the three Cs:
Collateral, Credit history and Character;
 This engineered a new activity that relied on
interlinked securities mainly emerging from
and closely related to the subprime mortgage
market;
 Subprime mortgage is a financial innovation
designed to enable home ownership to risky
borrowers;
Origins: Financial Innovation
 The term subprime refers to borrowers who
are perceived to be riskier than the average
borrower because of a poor credit history;
 Rising home prices encouraged
remortgaging, thereby expanding the
subprime mortgage market substantially;
Origins: Financial Innovation
 The growth of loans in the subprime mortgage market
was substantial: as a percentage of total mortgages:
 1994: 5%;1996: 9%;1999:13%; 2006: 20%; 2007:
47%;
 Also, between 1998 and 2007 mortgage debt as a
percentage of disposable income increased by more
than 50% from 61% to 101%;
 In fact, by the first quarter of 2007 virtually all
subprime originations were securitised, and subprime
mortgage securities outstanding totalled more than
$900bn;
Origins: Financial Innovation
 Banks set up trusts or limited liability
companies with small capital base, i.e.
separate legal entities, known as Structural
Investment Vehicles (SIVs);
 Parallel banking is thereby created outside
the control and the regulatory umbrella of the
authorities;
 This SIVs operation is financed by borrowing
from the short end of the capital markets at a
rate linked to the inter-bank interest rate;
Origins: Financial Innovation
 The short-term capital thereby raised, is used by the SIVs to buy
the risky segment of the loan portfolio of the mother company,
mainly risky mortgages;
 The risky loan portfolio is then repackaged in the form of CDOs
and CMOs, sold to other banks and personal sector;
 The securities purchased from the SIVs by the banks were
combined with other asset-backed securities to form collateral
for yet other securities: the structured finance collateralised debt
obligations;
 These securities were issued in different tranches ranging from
the AAA-rated super senior tranche that carried the lowest risk
down to the unrated equity tranche that carried all the residual
risk;
Origins: Financial Innovation
 At each stage of this slicing and dicing and
transfer of credit risk, the banks took
commission, as did the credit rating agencies
that were paid not only for rating the credit
products but also for helping the banks and
their vehicles to structure these products;
 So long as the short-term rate of interest is
lower than the long-term rate, big profits
materialise, which helps the housing market
to produce a bubble;
Origins: Financial Innovation
 When the yield curve was inverted, that is long-term
interest rates became lower than short-term rates,
the subprime mortgage market simply collapsed;
 It occurred following a period of rising policy interest
rates (mid-2004 to mid-August 2007) after a
prolonged period of abnormally low interest rates
(initially 1997-1998 but more aggressively after the
internet bubble of March 2000);
 The collapse of the subprime mortgage market by
early 2007, also meant the end of the housing boom
and the burst of the housing bubble;
Origins: Financial Innovation
 Defaults on mortgages spread to investment
banks and commercial banks in the US and
across the world via the elaborate network of
CDOs and CMOs;
 It should be noted that the complacency, the
greed and even the outright corruption of the
various financial institutions that created and
distributed the structured credit products,
were important contributory factors to the
financial crisis;
Origins: Financial Innovation
 However, other factors were also important.
The volume of these assets that had got into
the global financial system grew to the point
where the system could no longer cope;
 That critical mass was only reached because
of the pressure of demand, and a principle
source of that pressure was the large
concentration of wealth ownership;
Origins: Financial Innovation
 The complex structure of the CDO and CMO markets
complicated the task of credit rating institutions,
which erroneously assigned AAA-status to many
worthless papers;
 The overstated credit rating contributes to the growth
of the CDO and CMO markets in the upswing but
also to its downfall in the downswing;
 In fact in the aftermath of the subprime crisis in the
US, credit rating agencies were blamed for their initial
ratings of structured finance securities in that they did
not reflect the true risks inherent on those securities;
Origins: Financial Innovation
 The sale of CDOs and CMOs to international
investors made the US housing bubble a global
problem and provided the transmission mechanism
for the contagion to the rest of the world;
 The collapse of the subprime market spilled over into
the real economy through the credit crunch and
collapsing equity markets;
 And all this led to the freezing of the interbank
lending market since August 2007;
 Although the first signs of the problem may be dated
as March 2007, when major losses were announced
by US subprime investors;
Origins: Financial Innovation
 A significant recession is well with us by now:
the ‘great recession’! And with $4.1tr. losses
in the world financial system, less than half of
which has been formally written off;
 A policy debate has been triggered about the
need to strengthen the regulatory framework
for credit rate agencies; the G20 London
agreement contains relevant regulatory
provisions – see next lecture for a summary
of the relevant issues;
Origins: International Imbalances
 Feature 4: International Imbalances;
 The process described so far was also accentuated
by the international imbalances, which were built up
over a decade or more;
 The rise of China and the decline of investment in
many parts of Asia following the 1997 crisis there,
created a great deal of savings;
 That amount of savings was channeled mainly into
the US, encouraged and enabled by the ‘privilege’
enjoyed by the US dollar as the world’s currency;
 It helped to put downward pressure on US interest
rates, which along with the Fed low interest rate
policy pursued at the same time, enabled households
there to live well beyond their means;
Origins: International Imbalances
 Also, the increasing allocation of manufacturing jobs
to the relatively low wage areas of Asia, and China in
particular, helped to keep down wages and hence low
inflationary pressures in the US and elsewhere;
 This along with the channeling of savings into the US
also enabled the US low-to-mid-income households
to increasingly rely on credit as a means of survival;
 Low interest rates at the same time helped to push
up asset prices, especially house prices, thereby
enabling the financial sector to explode;
 The explosion of the banking sector enabled lending
to households and businesses to expand
substantially along with lending to other banks;
Origins: International Imbalances
 All these imbalances created a more buoyant
market for financial institutions thereby
feeding the originate-and-distribute culture
and machine;
 The build up of household debt and asset
holdings made household expenditure more
sensitive to short-term interest rate changes;
 This helped to change the transmission
mechanism of Monetary Policy as we
examine in what follows.
Origins : NCM Monetary Policy
 Feature 5: NCM Monetary Policy;
 This feature springs from the monetary policy
emphasis on frequent interest rate changes
as a vehicle to controlling inflation;
 This type of monetary policy is based on the
New Consensus Macroeconomics (NCM)
model, which we have already discussed.
Origins: NCM Monetary Policy
 The impact of this policy has been the
creation of enormous liquidity and household
debt in the major economies, which reached
unsustainable magnitudes and helped to
promote the current crisis;
 Especially so after the collapse of the IT
bubble (March 2000) when central banks, led
by the Fed, pursued highly accommodative
monetary policies to avoid a deep recession;
Origins: NCM Monetary Policy
 Looking at debt statistics (see, BIS Annual Report,
June 2008, p. 29), we find the following:
 Between 1998 and 2002 outstanding household
debt, including mortgage debt, in the UK was 72.0
percent of GDP; between 2003 and 2007 it shot to
94.3 percent of GDP;
 In the same periods, outstanding household debt
jumped from 76.7 percent to GDP to 97.6 percent of
GDP in the case of the US;
 And in the Euro Area from 48.5 to 56.6 respectively;
Origins: NCM Monetary Policy
 As a result of these developments, the transmission
mechanism of Monetary Policy has changed:
 The build up of household debt and asset holdings
has made household expenditure more sensitive to
short-term interest rate changes;
 Furthermore, the current high debt levels, combined
with the difficulties in the ‘real’ sector, imply that
lenders and equity holders stay away from the market
place;
 Not forgetting the presence and magnitude of toxic
assets, which pose real problems that still need to be
sorted out’;
Origins: NCM Monetary Policy
 We should remember, however, that ‘all debt
is a bad thing’ under current circumstances
may not be the solution;
 A sense of proportion is important;
 For if everybody started saving the economic
situation can only get worse;
 Lack of aggregate demand is a serious
problem at the moment;
 The following summary of GDP growth rate
data make the point;
Origins: NCM Monetary Policy
 Eurostat annualized estimates for the OECD real
GDP growth rate suggest that it plunged by 4.2% on
average in 2008 (with the UK recording a decline by
4.1%, Germany by 6.9% and Japan by 9.1%);
 Also annualized Eurostat estimates, suggest that the
UK contracted by 5 percent in 2009 but expected to
return to a small positive number in 2010;
 Still in line with Eurostat estimates, the Euro Area
GDP growth rate, on a quarter to quarter basis, was
0.4 percent in the third quarter of 2009, but only 0.1
in the fourth quarter;
Origins: NCM Monetary Policy
 ECB staff projections for the Euro Area GDP
annual growth rate, expect it to be between
0.4 percent and 1.2 percent for 2010;
 According to IMF estimates the US economy
contracted by 2.5 percent in 2009, which is
expected to be followed by a modest revival
in 2010;
 Current unemployment rates are: US: 9.7%;
UK: 7.8%; Euro Area: 9.9%; Spain: 18.8%;
Origins: NCM Monetary Policy
 An important lesson from the NCM conduct of
monetary policy is important;
 This is that there are serious dangers with the NCM
type of conduct of monetary policy: frequent changes
in interest rates can have serious effects;
 Low interest rates cause bubbles; high interest rates
work through applying economic pressures on
vulnerable social groups;
 There are, thus, severe distributional effects.
Final Comments
 This lecture should not end without a comment on the
failures of policy makers to appreciate the coming of
the August 2007 crisis; two quotes make the point;
 The first comes from the IMF: “..... this World
Economic Outlook sees global economic risks as
having declined since ..... September 2006 ..... we
actually see the continuation of strong global growth
as the most likely scenario ..... the overall U.S.
economy is holding up well ..... the signs elsewhere
are very encouraging” (IMF, 2007, p. xii);
 Not merely did the IMF fail to appreciate the looming
crisis but other monetary authorities now
acknowledge the degree and depth of the problem;
Final Comments
 Greenspan (2010) readily admits as much very
clearly: “In the growing state of high euphoria, risk
managers, the Federal Reserve, and other regulators
failed to fully comprehend the underlying size, length,
and impact of the negative tail of the distribution of
risk outcomes that was about to be revealed as the
post-Lehman crisis played out. For decades, with
little, to no, data, most analysts, in my experience,
had conjectured a far more limited tail risk. This is
arguably the major source of the critical risk
management system failures” (p. 12).
Presentation
1.
2.
2a.
2b.
2c.
2d.
2e.
3.
Introduction: The global financial system has
been under enormous stress since August
2007, and has well spilled over to the global
economy more broadly. Is it over now?
Origins of Current Financial Crisis: Five
features:
Distributional Effects
Financial Liberalisation
Financial Innovation
International Imbalances
Monetary Policy
Summary and Conclusions
Summary and Conclusions
 We have highlighted the origins of the current
financial crisis;
 Five features have been highlighted: distributional
effects; financial liberalization, financial innovation,
international imbalances and current economic
policy;
 The first three belong to the main cause of the crisis
and the other two to the contributory factors to the
crisis;
 A number of main conclusions follow, which we may
summarise as follows:
Summary and Conclusions
 The first is that the distributional and financial
liberalisation effects, examined above, led to the
financial innovation, also discussed above, which
have created huge risks; the latter have been
mismanaged thereby creating enormous costs
because of this failure;
 The second conclusion is that the deregulatory
approach, which engineered the current financial
crisis, does not have ‘healthy’ grounding in economic
theory or historical experience. ‘Good’ economic
theory, and historical experience, explain why the
government should have an active role, especially in
terms of regulating financial markets. It is true that
good regulation promotes confidence in financial
markets.
Summary and Conclusions
 The third conclusion is that we need to have
a properly regulated and functioning banking
system to allow economic activity to expand.
 The fourth conclusion is that although a wellfunctioning financial system is desirable, the
interests of financial markets are not always
compatible with those of others in the
economy – workers, small business, etc.
Regulation and proper institutional design
are, thus, necessary.
Summary and Conclusions
 The fifth conclusion comes from Ben Bernanke who
suggests that “although the subprime debacle
triggered the crisis, the developments in the U.S.
mortgage market were only one aspect of a much
larger and more encompassing credit boom whose
impact transcended the mortgage market to affect
many other forms of credit. Aspects of this broader
credit boom included widespread declines in
underwriting standards, breakdowns in lending
oversight by investors and rating agencies, increased
reliance on complex and opaque credit instruments
that proved fragile under stress, and unusually low
compensation for risk-taking” (Stamp Lecture,
London School of Economics, 13 January 2009);
Summary and Conclusions
 The sixth conclusion emerges from the type
of monetary policy in place over the relevant
period: the NCM type of monetary policy that
is associated with gyrations in interest rates
that creates enormous debts in the system
with serious distributional effects as explained
above;
 The seventh and final conclusion is that
regulatory and prudential controls become
very necessary. Indeed, more intervention on
the policy front is desperately needed.