Download The Financial and Economic Crisis

The Financial and
Economic Crisis
Lecture One: Understanding the
mechanism that drove the crisis
Mike Kennedy
History of the Financial Crisis
The situation in perspective:
OECD-wide output gap before and after recessions
4
1970s; Peak at time t: 1974Q3
1980s; Peak at time t: 1980Q1
2000s; Peak at time t: 2008Q1
2
0
-2
-4
-6
-8
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
OECD-wide domestic demand
before and after recessions
1.2
1970s; Peak at time t: 1974Q3
1.15
1980s; Peak at time t: 1980Q1
2000s; Peak at time t: 2008Q1
1.1
1.05
1
0.95
0.9
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
What’s happening in some individual
OECD economies
2007-09 Recession
1
0.98
Canada
United States
0.96
Euro Area
0.94
Japan
United Kingdom
0.92
0.9
1
2
3
4
5
6
7
8
9
10
11
Quarters
12
13
14
15
16
17
18
19
20
A key question: why was the effect of
the financial meltdown so large?
• The setting leading up to the housing bubble
• There had been a long expansion with low inflation and steady growth
leading to a feeling of complacency – “the great moderation”.
• In the wake of the “dot.com” problem, there was a feeling that monetary
policy could solve asset price busts.
• Low interest rates:
– Asia and effective pegging of the exchange rate (exports and past problems with
speculative attacks) led to capital inflows into the US.
– Fed and other central banks had kept interest rates too low for too long (fears of
deflation). Taylor thought that this was the most important.
– Fed felt that any asset-market problem (a crash or correction) could be handled
with monetary policy (post-2000 was a case in point).
• Innovations in the financial sector (securitization), which led to lower
interest rates and easier lending terms for individual borrowers, reinforced
the process.
• These features were not confined to just the US.
We start with house prices, where the rise was a (mostly)
world-wide phenomenon, fuelled by cheap credit
6
USA
5
JPN
DEU
FRA
4
ITA
GBR
CAN
AUS
3
BEL
DNK
ESP
2
FIN
IRL
NLD
1
NOR
NZL
SWE
0
CHE
Another look at real house prices
The picture leading up to the crisis: life was
good
The great moderation in Canada …
… and in the United States
Low long-term interest rates when
short rates were rising was a puzzle
Why were interest rates so low
• In “Factors behind low long-term interest rates”,
published in 2006, we examined the question of low
interest rate and attributed them to:
– Low expected inflation which appeared resilient to shocks. This
likely reflected, in part, improved credibility of monetary policy
– Global financial markets in which it was possible to easily
finance large developed-economy deficits – mainly by funds
from emerging market economies – without raising interest
rates
– Possibly portfolio shifts by pension funds needing bonds to
meet retirement obligations
– All in all, we seemed to be returning to the 1950s
Inflation was low virtually everywhere
and resilient to shocks
The most important factor: The banking sector
was being transformed
• Two trends are important here:
(1) the move to originate and distribute; and
(2) the increase in financing using short-term instruments.
• Offloading risk by creating structured investment vehicles like
collateralised debt obligations (CDOs)
– These were portfolios of assets (often risky ones) which were divided
into tranches, ranging from super senior (constructed to be rated as
AAA ) to the equity stake (toxic waste).
– Senor tranches were sold to investors while the “toxic waste” was held
by the banks in question as an incentive to monitor loans.
– Buyers of such assets also purchased insurance – called credit default
swaps (CDS) – which had a notional value of $45 to $65 trillion in
2007.
– With the purchase of such insurance, investors had reason to believe
that their portfolios had little risk.
Banks (commercial and investment) were highly
leveraged – a maturity mismatch – prior to the
crisis
• Most investors prefer assets with short maturities:
– They can withdraw funds at short notice to meet liquidity needs.
– Possibly this is a type of “commitment device” to discipline banks.
• But investments are long term and bank financing of such investments
results in a maturity mismatch.
• Some part of this maturity mismatch was transferred to the “shadow
banking system”.
– Raised funds by selling asset backed short-term securities. Investors in such
products had the right to seize the underlying assets in case of defaults. At the
same time these off-balance-sheet vehicle were exposed to “funding liquidity
risk” so banks provided back-ups in the form credit lines.
– The result was that banks were carrying this risk on their balance sheets but it
was not evident – a lack of transparency.
– There was also a move to “repos”, a very short-term instrument, which meant
that these entities had to rollover an increasing large fraction of their funding
on a daily basis. Adrian and Shin (2008) think that this is a good measure of
credit expansion.
Why were these exotic products so
popular?
• Interest rates were very low as was risk aversion and this led
directly to a hunt for yield.
• The theory was that risk had been shifted to those who were
in a position to bear it.
• Permitted certain investors to hold assets that they previously
could not because now they were rated AAA; the ratings were
very important in this respect.
• Regulatory arbitrage:
– A problem with regulation is that banks can “game the system”.
– Basil I required them to hold capital equal to 8% of loans but this requirement
was lower for contractual lines of credit.
– Banks could lower their capital charges by moving assets off their balance
sheets and then issuing credit lines to the SIV.
– Some credit had a zero capital requirement, like “reputational lines of credit”.
Risk aversion was low prior to the crisis
6
70
Comparing the risk measure with other measures
5
4
60
Risk measure (first two principal components)
St Louis Fed Stress Index
3
50
VIX (right hand scale)
40
2
30
1
20
0
-1
-2
10
0
Why were these exotic products so popular (con’t)?
• VaR (Value at Risk) estimates were overly optimistic since they
never allowed for the possibility of a fall in nation-wide house
prices, something that had not happened in the post-WWII period.
• The low correlations across regions also generated perceived
diversification benefit.
• Rating agencies and fees – the interconnection.
• Fund mangers liked the idea that they could have higher yields and
lower risk.
• All this led to cheap credit and declining lending standards, which
in turn led to the house price boom. Underlying all this was a view
that house prices would only rise (or worse stay flat) allowing
borrowers to refinance or sell-out.
• Many thought that a day of reckoning was coming but it was
difficult to bet against the boom – this is always the case .
A chronology of the unfolding crisis
• The key to understanding the crisis is to note how interconnected is the financial system – and it still is.
• Subprime defaults started to increase (Feb 2007) and
prices of CDS (insurance against defaults) started to rise
in the wake of rating downgrades.
• ABCP started to dry up in the wake of a confidence
crisis.
• A conduit of IKB, a small German bank, had funding
problems (Jul 2007).
• BNP Paribas froze redemptions on three of its funds.
• Nominal house prices in the US started to fall from
Jul 2007 onwards.
What we (OECD) saw as the risks
to house prices – probit analysis
The bad thing happened:
Nominal prices did fall starting in early 2007
120
100
Nominal House Prices (USA)
80
60
40
20
0
The price of credit swaps soared
A chronology of the unfolding crisis
(con’t)
• LIBOR and TED spreads (LIBOR less US T-Bill rate) backed up as
banks become reluctant to lend to each other.
• Central banks respond as the Fed and the ECB injected funds
into financial markets and the Fed began to cut interest rates.
• Continuing write-downs of mortgage related products affected
the assets of money market funds.
• Monoline, an insurer of municipal bonds, came under pressure.
• The Bear Sterns problem – was considered too inter-connected
to fail.
• Lehman Brothers, Merrill Lynch and AIG.
• Credit restraint kicks in, both for all segments (Wall street and
main street) and world-wide (across major OECD markets and
elsewhere).
A closer look at risk aversion
Costs of funds in international financial
markets sky-rocketed
Equity markets plunged,
with a loss of $8 trillion
1
2100
0.9
1900
0.8
1700
0.7
0.6
1500
0.5
0.4
0.3
1300
Recession US
S&P
1100
0.2
900
0.1
0
Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08
700
Credit conditions were tightened
Banks get hit hard as bad loans accumulated
6.00
1
1
5.00
US non-performing loans
per cent of total loans
1
1
4.00
1
3.00
1
0
2.00
0
0
1.00
0
0.00
0
How did several hundred billion in losses in
mortgages lead to the meltdown?
• Need to understand the types of risk institutions faced
• Funding liquidity
– The ease with which investors can obtain funds from financiers.
Risk here takes three forms:
• Margin or “haircut” may change
• They will not be able to rollover short-term borrowing (rollover risk)
• Investors may start to redeem their deposits (redemption risk)
– Deleveraging occurs with consequent effects on asset prices
– Only detrimental when liquidity is scarce
• Market liquidity
– The ability to sell assets without affecting its price
• Bid-ask spreads (how much I would lose if I sold and immediately repurchased an asset)
• Market depth (how many units can be traded without affecting prices)
• Market resiliency (how quickly prices bounce back)
How the crisis became amplified (con’t)
• Market and funding liquidity can interact so that a small
shock can cause liquidity to dry up suddenly leading to a
full-blown crisis.
• A loss spiral
– When leveraged investors are forced to sell assets out of
proportion to the initial fall in prices in an attempt to restore
their leverage ratios. If asset prices are weak, then these prices
will start to fall even faster
– Driving mechanisms is the reaction of other investors who:
• may be facing the same constraints
• may not buy when prices are low, preferring to wait out the declines
• may engage in predatory trading
• The mechanism can be self-reinforcing.
How the crisis became amplified (con’t)
• A margin/haircut spiral
– This can re-enforce the loss spiral
• now investors need to reduce leverage and lending gets restricted
• this leads to a vicious spiral
• Why don’t investors move on the buying opportunities,
since the liquidity problem may be temporary?
– Unexpected shocks may indicate future volatility
– Asymmetric information (not sure about the quality of
assets that investors are trying to sell)
– Investors are likely backward looking estimating future
volatility based on recent movements
– Investors as well may not have the deep pockets required
to buy and hold
Two liquidity spirals: Loss spiral (margins held constant)
and margin spiral (margins increase)
How the crisis became amplified (con’t)
• Lending channel
– Following the shock banks began to restrict lending
(precautionary holdings of cash increased) driven by
concerns that:
• more shocks were coming
• funding would be difficult to obtain
– These concerns led to a sharp spike in interbank financing
costs as precautionary holdings by institutions increased.
– The funding problem (or run) can happen electronically as
debt holders rush to the exit
– Equity holders in the fund also have an incentive to go early
– First mover advantage can lead to runs on banks and
financial institutions in general
Tight credit was a world wide
phenomenon
6
4
United States
2
Euro area
Japan
0
-2
-4
-6
Note: A unit increase (decline) in the index implies an easing (tightening) in financial conditions
sufficient to produce an average increase (reduction) in the level of GDP of ½ to 1% after 4 to 6
quarters.
The effect of a restriction of credit on
the economy – the credit channel
An expansion of the money supply
16
Some evidence of a credit or lending channel
11
15
10
14
9
USHYM
US10
13
8
12
7
11
6
10
5
9
4
8
3
7
2
6
1
A model of the credit channel effect on
risk
• Risk should be a negative function of credit
demand and a positive function of credit
supply.
• We’re uncertain about the effects of monetary
policy.
Risk t  0  1Ctd  2Cts  3MonPolt
J
Risk t  (Risk t 1  Risk t )   j Shocksjt
j
Estimating an equation for risk based
on the credit channel
How the model does
How the crisis became amplified (con’t)
• Network risk
– The distinction between a lending and a
borrowing sector is artificial – in reality financial
institutions are both lenders and borrowers
– This can lead to great uncertainty, complicating
the situation, especially when the counter-party
risk and uncertainty about asset values rise
30
The response of various interest rates
US10
EU10
USHGL
EUHGL
USHYM
USHYL
EUHYL
EUHYM
25
20
15
10
5
0
Crisis spreads to emerging markets
Response of Some Emerging Market Bond Spreads During the Crisis
850
750
650
550
450
350
250
150
50
BRA
BUL
COL
IND
MEX
PAN
PER
PHL
RUS
SAF
TUR
3000
Response of Emerging Market Interest Rates During Two Crises
`
2500
BRA
BUL
CHI
CHN
COL
DOR
EGY
ELS
GHA
HUN
IND
MAL
MEX
NIG
PAK
PAN
PER
PHL
PLD
RUS
SAF
TUN
TUR
VEN
2000
1500
1000
500
0