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Making Sense of the Global Financial Crisis Christopher Ragan Department of Economics McGill University and Clifford Clark Visiting Economist Department of Finance October 20, 2009 Credit crunch Highly leveraged banks Shadow banking system AIG Systemic stability Global savings glut Toxic assets Counterparty risk Expansionary monetary policy Regulatory arbitrage Bear Stearns Collateralized Debt Obligations (CDOs) Sub-prime mortgages Securitization Lehman Brothers Global search for yield Mortgage-backed securities Fannie Mae & Freddie Mac 2 Originate to distribute U.S. housing collapse Outline of Talk 1. Crucial micro elements 2. Key macro pressures 3. Fatal interactions 4. Policy responses 5. Myths and lessons 3 Part 1 Crucial Micro Elements 1. Home mortgages 101 2. The evolution of mortgage lending 3. Securitization 4. Regulatory arbitrage Home mortgages 101 1. Bank accepts deposits 2. Lends money to home purchaser 3. Downpayments and collateral 4. Bank holds the mortgage asset 5 Specialization in mortgage lending: Mortgage (asset) Commercial bank or other mortgage lender Other financial institutions Cash Cash Mortgage (asset) Individual borrower “originate to own” “originate to distribute” 6 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” 7 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 9 10 11 12 13 14 8 Diversified pool of residential mortgages -- reduces risk Each individual mortgage is a risky asset – individual and aggregate risks MBS MBS MBS MBS MBS MBS MBS Each mortgage-backed security is just a small piece of the overall diversified mortgage pool. MBS MBS MBS MBS MBS MBS MBS MBS MBS MBS 8 This process keeps the cash flowing -used to purchase more mortgage assets Mortgage (asset) Commercial bank or other mortgage lender lends money to individuals and thereby creates a mortgage asset. Cash Financial institution assembles pools of mortgages and creates mortgage-backed securities (CDOs). CDOs Cash Individual and institutional investors 9 Securitization of residential mortgages mushroomed over the past decade U.S. GSE versus Private-Label MBS Issuance In billions of US dollars 3,000 Private-label Fannie M ae 2,500 Freddie M ac Ginnie M ae 2,000 1,500 1,000 500 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 Source: International Monetary Fund, Global Financial Stability Report, October 2009. 10 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” 11 Growing securitization led to increased bank leverage … Bank Leverage Ratios assets as a multiple of capital 35 30 Canada US UK Euro area 25 20 15 10 2000 2001 2002 2003 2004 2005 2006 2007 2008 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. 12 … especially in the U.S. investment banks. Leverage Ratios assets as a multiple of capital 30 US - Investment Banks 25 20 15 2000 2001 2002 2003 2004 2005 2006 2007 2008 Sources: Bloomberg; financial statements. 13 Part 2 Key Macro Pressures 1. Expansionary monetary policy 2. The global savings glut 3. The global “search for yield” After 2000, central banks loosened their monetary policies significantly … Policy Interest Rates per cent U.S. Federal Reserve Bank of Canada European Central Bank Bank of England 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 2000 2001 2002 2003 2004 Sources: Bank of Canada, U.S. Federal Reserve, European Central Bank and Bank of England. 15 … which generated strong growth in business and household credit … U.S. Total Business Credit U.S. Total Household Credit Y/Y per cent change Y/Y per cent change 14 13 12 12 11 10 10 8 9 6 8 4 7 2 0 1998 6 2000 2002 2004 2006 5 1998 2000 2002 2004 2006 Source: U.S. Federal Reserve Board. 16 … and fuelled a booming U.S. housing market. U.S. Existing Home Prices U.S. Housing Starts Level – 3-month moving average index, 2000 Q1 =100 190 2200 2100 170 2000 150 1900 130 1800 1700 110 1600 90 70 1998 1500 2000 2002 2004 Note: S&P/Case Shiller Home Price Index. Sources: Standard & Poor's; Fiserv; MacroMarkets LLC. 2006 1400 1998 2000 2002 2004 2006 Source: U.S. Bureau of Economic Analysis. 17 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? 18 Large current account imbalances … Current Account Balance In billion USD 1500 China, Japan, OPEC, Russia and rest of Asia 1000 United States 500 0 -500 -1000 1992 1994 1996 1998 2000 2002 2004 2006 2008 Source: IMF’s WEO 19 … and fast-rising oil prices … Oil Prices US$/bbl 160 140 120 100 80 60 40 20 0 2001 2002 2003 2004 2005 2006 2007 2008 Source: Bridge CRB. 20 … led to huge increases in foreignexchange reserves. Growth in Selected Official Foreign-Exchange Reserves US$ Billions 700 Japan Russia 500 OPEC China 300 100 -100 2000 2001 2002 2003 2004 2005 2006 2007 2008 Sources: IMF’s IFS data September 2009 21 Many of these assets were invested in U.S. Treasuries and longer-term assets … Share of US Treasuries held by Foreigners per cent 60 Foreigners of which: Foreign Official Institutions 50 40 30 20 2001 2002 2003 2004 2005 2006 2007 2008 Sources: US Treasury 22 … which reduced longer-term interest rates … G10 10-year Government Bond Yield per cent 6.0 Nominal 5.0 4.0 3.0 2.0 1998 2000 2002 2004 2006 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. 23 ... and shifted down the entire “yield curve”. US Yield Curve per cent 7.0 August 2000 September 2006 6.0 5.0 4.0 3.0 O/N 3m 6m 1y 2y 3y 5y 7y 10y 20y 30y Both dates represent similar phases in the monetary policy cycle. Source: Federal Reserve 24 These two forces produced a global “search for yield” Growing global demand for U.S. mortgage-backed securities Growing demand for credit by FIs Rising leverage in banks Growing provision of mortgages Growing demand for mortgage assets Rising demand for U.S. houses Declining “quality” of mortgages 25 Declining “quality” of mortgages? New U.S. Sub-prime Mortgages Billions USD Per cent Sub-prime share of total mortgage originations (right) 700 25 600 20 500 15 400 Sub-prime mortgage originations (left) 300 10 200 5 100 0 0 2001 2002 2003 2004 Source: Inside Mortgage Finance, via Joint Center for Housing Studies of Harvard University 2005 2006 2007 26 As 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 27 Part 3 Fatal Interactions 1. Falling U.S. house prices 2. Rising mortgage foreclosures 3. Financial losses and counterparty risks 4. Credit crisis Financial crisis U.S. house prices first slowed and then dropped off a cliff … U.S. Existing Home Prices U.S. Housing Starts Level – 3-month moving average index, 2000 Q1 =100 190 2500 170 2000 31% 150 1500 130 1000 110 500 90 70 1997 Q2 2000 Q2 2003 Q2 2006 Q2 Note: S&P/Case Shiller Home Price Index. Sources: Standard & Poor's; Fiserv; MacroMarkets LLC. 2009 Q2 0 1997 1999 2001 2003 2005 2007 2009 Source: U.S. Bureau of Census 29 … which led to rising delinquencies of sub-prime mortgages … U.S. Mortgage Delinquencies by Vintage Year 60+ day delinquencies, in per cent of original balance 40 2006 35 2005 30 2001 2000 25 2007 2002 20 2004 15 2003 10 5 0 0 10 20 30 40 50 60 Months from origination Source: International Monetary Fund, Global Financial Stability Report, October 2008. 30 … and eventually increased foreclosures. U.S. Delinquency Rates As foreclosures rise: U.S. Share of Loans in Foreclosure Per cent Per cent 30 16 25 20 15 10 5 The delinquency rate includes Foreclosure is a legal process that can loans with put payments 30, 60, houses on the take anywhere from 45 to 365 days banks the resale market and 90 days or more past due, but are not yet in foreclosure further depressing house prices more people walk away from their homes more delinquencies and foreclosures banks put more houses on the market Prime and soSub-prime on … Prime 14 12 10 8 6 4 2 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Sub-prime 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Sources: Mortgage Bankers Association of America 31 Foreclosures and falling house prices, in turn, led to large downgrades in MBSs … Ratings on MBSs (which were AAA when issued 2005-07) In percent, as of June 30, 2009 60 50 40 30 20 10 0 AAA AA A BBB Source: International Monetary Fund, Global Financial Stability Report, October 2009. BB B <B 32 … which naturally led to a decline in their market value. Prices of U.S. Mortgage-backed Securities In U.S. dollars 120 100 80 Agency MBS 60 Jumbo MBS Alt-A 40 ABX AAA 20 ABX BBB 0 2006 Source: International Monetary Fund, Global Financial Stability Report, October 2008. 2007 2008 33 Rising “counterparty risk” led to a credit crunch … … and eventually a full financial crisis … Credit Spreads basis points 400 Canada (CDOR - OIS) 360 U.S. (LIBOR - OIS) 320 Euro area (LIBOR - OIS) 280 240 Bear Stearns 200 Lehman Brothers bankruptcy 160 ABCP crisis 120 80 40 0 -40 Jan 2007 May 2007 Sep 2007 Jan 2008 May 2008 Sep 2008 Jan 2009 May 2009 Sep 2009 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. 34 .. with enormous losses for many large financial institutions … Mortgage-Related Write-downs and Credit Losses since 2007Q3 Billions, USD 1,200 160 Since 2007Q3, financial institutions have posted over US$1600 billion in write-downs and credit losses. 1,000 800 600 140 120 100 80 60 400 40 200 20 0 0 America Europe Asia Sources: Bloomberg, September 28, 2009. 35 … and huge declines in the world’s stock markets. World Equity Markets % change from January 1, 2007 to March 2, 2009 0 -10 -20 -30 -40 -50 -60 -70 Total -80 Banks -90 Canada (S&P/TSX) U.S. (S&P 500) U.K. (FTSE 100) EMU (DJ Euro STOXX) Source: Bloomberg. 36 Part 4 Policy Responses 1. Financial sector vs. the “real economy”? 2. Monetary policy 3. Actions to assist financial markets 4. Fiscal policy What was likely to happen? 1. Credit is like electricity to a modern economy, and banks are like the power company. 2. A decline in the flow of credit would inevitably lead to a significant global recession. 3. The financial sector is part of the real economy! 38 The largest global recession in many years Growth of world real GDP per cent per year 6 Average 1980-2010: 3.2% 5 4 3 2 1 0 -1 -2 1980 1985 1990 1995 2000 2005 2010 Sources: IMF 39 Unprecedented global monetary policy response … Policy Interest Rates per cent 7.0 U.S. Federal Reserve Bank of Canada 6.0 European Central Bank Bank of England 5.0 4.0 3.0 2.0 1.0 0.0 Sep 2007 Dec 2007 Mar 2008 Jun 2008 Sep 2008 Dec 2008 Mar 2009 Jun 2009 Sep 2009 Sources: Bank of Canada, U.S. Federal Reserve, European Central Bank and Bank of England. Daily data up to and including Sept. 30. 40 … included the use of “unconventional” monetary policy tools. Central Bank Assets Index: January 2008 = 100 290 Fed BoC BoE 240 ECB 190 140 90 Jan 2008 Apr 2008 Jul 2008 Oct 2008 Jan 2009 Apr 2009 Jul 2009 41 Most governments also introduced measures to support financial markets. Canadian Support to the Financial Sector ($ billions) 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 Source: Canada’s Economic Action Plan; A Third Report to Canadians, September 2009. 42 G-20 leaders coordinated their substantial fiscal expansions … Fiscal Stimulus Flowing in 2009 and 2010, G7 countries per cent of GDP 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Canada Japan United States Germany France United Kingdom Italy 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. 43 … and accepted the deterioration in their medium-term fiscal outlooks. Total Government Budget Deficits, 2009 Per cent of GDP 2 0 -2 -4 -6 -8 -10 2007 2009 -12 -14 Canada France Germany Italy Japan United Kingdom United States Source: IMF WEO, October 2009. 44 Part 5 Lessons and Myths 1. Blame and greed? 2. “The end of laissez-faire”? 3. Regulatory reform 4. Baby and the bathwater Thank you. Questions?