Download Financial crisis and economic downturn: Where did they come from

Financial crisis and economic
downturn: Where did they come
from and where are they going?
Presentation by Charles (Chuck) Freedman
Scholar in Residence, Economics Department,
Carleton University
at Wilfrid Laurier University
Waterloo, June 8, 2009
Outline of presentation
• Causes of financial crisis
• Unfolding of financial crisis
• Macro developments and interaction with
financial crisis
• Reaction of authorities to financial crisis
• Reaction of authorities to macro downturn
• Exit strategies
• Financial sector restructuring
• Canadian situation
Introductory remarks
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Complex relationships and interactions
Many explanations
Interactions among the various elements
Presentation sets out main factors behind the
crises (“what”, “how” and “why”) and their
linkages with each other, as well as kinds of
changes under consideration that are aimed at
avoiding a recurrence of the financial crisis
Subprime mortgage markets
• Begin with problems in US subprime mortgage
markets
• Many weaknesses.
• First, perhaps in part as a result of the originate
to distribute model, decline in lending standards
and monitoring of mortgages
• Second, financial institutions should have been
much more aware that housing prices typically do
not rise forever
Subprime mortgage markets
• Third, some of the practices of originators and brokers
worsened outcomes
(a) encouraged borrowers into variable rate mortgages
(b) initial “teaser” interest rates
(c) compensation of agents arranging such mortgages
• Fourth, in the United States, view of governments and
governmental authorities that homeownership should be
encouraged and subsidized
• Fifth, legal situation of no recourse in most states in the
United States (and one Canadian province)
Derivatives
• Risk with derivatives that “the inherent complexity of
the instruments raises the concern that management
will not understand or be able to control effectively
the amount or type of risk being taken on by the
firm”.
• In many cases, either companies did not understand
the underlying risks that they were taking and/or
underestimated probability of tail events
• For many years, mortgage-backed securities
operated very effectively
Derivatives
• Then came collateralized debt obligations (CDOs)
with tranches that could be tailored to the needs
and desires of purchasers
• Credit rating agencies played important role in
providing ratings to the various tranches of these
instruments
• Neither rating agencies nor purchasers of these
instruments had a very clear understanding of
the probabilities with respect to the outcomes of
the payment flows from these instruments
Derivatives
• Purchasers rarely did due diligence themselves,
relying excessively on the CRAs
• Among the problems that the CRAs had difficulty in
addressing were – default probabilities (in absence of
long history with subprime mortgages); sensitivity to
small errors in estimation of riskiness of tranches of
CDOs and especially CDO-squared; underestimate of
correlations of returns on assets backing the CDOs
• And some concerns have been expressed about the
CRAs’ conflicts of interest
Derivatives
• Credit default swaps (CDSs) also played important
role in the development of the financial crisis
• In many cases, sellers of CDSs underestimated
the probability of unlikely negative outcomes
(“tail events”) occurring
• And purchasers frequently underestimated or
ignored the risk that the counterparty (e.g., AIG,
monoline insurers) would be unable to pay off
the insurance if the insured event occurred
Derivatives
• A fundamental problem in this and other areas was
the failure of risk management
• Either risk management units did not recognize the
extent of risk involved in the strategy being
followed or senior management did not pay
sufficient attention to the concerns of risk
management units
• Problems with compensation arrangements that
took insufficient account of what might happen in
coming years
Regulation/supervision
• Either authorities did not recognize the risks being
undertaken or pressures from governments to provide
light regulation outweighed any concerns they might
have had
• Some financial entities that did not appear to fall under
safety net less supervised than those that did fall under
the safety net
• In practice, it turned out that a number of such entities
were either too large to fail or too complex to fail or too
interconnected to fail and therefore in the end did fall
under a form of safety net provided by the authorities
Assumptions about liquidity
• Another problem was the assumption that
there would always be liquidity in the markets
for the financial instruments and therefore
arrangements for dealing with potential
liquidity problems insufficiently robust
• Indeed, the business case of some financial
institutions based on the assumption that
they would always be able to access wholesale
markets for funding
The unfolding of the financial crisis
• Housing prices started to fall and default rates began
to rise sharply in mortgage markets, particularly
subprime
• With little past experience, great uncertainty as to
value of mortgages and even more so as to the value
of complex derivatives based on such mortgages
• Markets began to dry up, with investors unwilling to
purchase instruments whose value was so uncertain
• Lack of transparency also meant no-one was sure
who was holding the “bad assets”
The unfolding of the financial crisis
• Resulted in a number of problems
• Originating institutions stuck with holdings of
mortgages they had intended to sell
• Banks had to provide support to structured
financial instruments that they had previously
sold, either by extending liquidity to the SIVs or
bringing the assets back on to their own balance
sheet
• Short-term financing dried up
The unfolding of the financial crisis
• Liquidity of interbank lending markets in turn began to
dry up
• (1) financial institutions increasingly desired to hold
liquid assets
• (2) concerns about counterparties’ solvency because of
increased uncertainty about the value of assets held by
financial institutions in general
• Spreads between interest rates faced by “risky”
borrowers and those faced by “riskless” borrowers
began to increase, at times sharply (have declined in
more recent period but still relatively high)
The unfolding of the financial crisis
• Also, concern about quality of household and
business loans on balance sheets of financial
institutions
• Highly leveraged market makers (e.g.,
investment banks, hedge funds) under
particular pressure
• CDS spreads rose and the sellers of CDSs faced
ever increasing exposures, which in turn
raised questions about their own solvency
(e.g., AIG)
The unfolding of the financial crisis
• Potential for insolvency in financial institutions – (i)
holdings of subprime mortgages; (ii) holdings of
asset-backed securities and CDOs as an investment;
(ii) holdings of equities and/or investment in nonmarket assets such as participation in buyouts as the
prices of such assets declined; (iv) holdings of
commercial mortgages, business loans, credit card
other personal loans where borrowers fell into
arrears as the economy weakened; (v) exposure to
CDSs
The unfolding of the financial crisis
• Decline of capital as losses spread
• Absence of markets for certain kinds of assets and
uncertainty regarding the quality of those assets
made it very difficult to gauge whether liquidity or
solvency problem
• Considerable uncertainty about status of non-deposit
creditors and of shareholders, especially because of
different treatment of different entities by the
authorities (Bear Stearns, Lehmann Brothers)
Macroeconomic developments and
interaction with financial crisis
• Before the onset of the crisis in 2007, the global
economy had had a long period of fairly steady growth
• Low inflation
• Globalization
• Nonetheless, concerns about the “quality” of the
economic expansion
• Large imbalances in the world economy
• Concerns about the increase in the ratio of household
debt to personal disposable income
Macroeconomic developments and
interaction with financial crisis
• Persistence of low real interest rates in the context of stable
growth and low inflation led to a willingness to take on more
risk as part of a search for yield
• The resulting asset price bubble in turn underpinned the
economic expansion on the part of both households and
businesses
• Turnaround in house prices and the onset of the financial
crisis began to change the economic situation
• Over time, the real-financial linkages interacted in a way that
caused deterioration in both the financial sector and the real
economy
Macroeconomic developments and
interaction with financial crisis
• First, downturn in housing prices played an
important role in putting downward pressure on
household spending
• Second, there was a significant decline in stock
prices
• Third, the psychological worries on part of
households as financial sector came under pressure
and as unemployment began to rise led to reduction
in spending, especially on big-ticket items (autos,
housing)
Macroeconomic developments and
interaction with financial crisis
• Fourth, banks became increasingly reluctant to make
new loans – (a) liquidity pressure; (b) could not move
recently-originated mortgage loans off balance sheet; (c)
movement of assets back onto balance sheet as financial
markets dried up (outstanding lines of credit); (d) desire
to reduce size of balance sheet because of shortfalls in
capital (deleveraging); and (e) concern about quality of
loans and effect on future losses
• Fifth, growth of emerging economies slowed significantly
-- weakness in export markets, significant difficulties in
obtaining trade credits, and financial sector problems in
some countries
Macroeconomic developments and
interaction with financial crisis
• Problems in the financial sector led to
weaknesses in spending while weaknesses in
spending led to further problems in the
financial sector
• Concern of authorities was to prevent
downward spiral and to break these linkages
Reaction of the authorities
• Authorities faced multiple challenges – liquidity
problems; solvency problems; rapidly weakening macro
situation; and, in longer run, how to
restructure/reregulate the financial system to avoid
future such crises
• In examining reaction of the authorities to the financial
crisis, it is important to keep in mind that their principal
objective was initially to avoid a meltdown or implosion
of the financial sector, as this was seen to be one of the
major factors in bringing about the Great Depression of
the 1930s (Bernanke) and subsequently to provide
support to the macro economy
Reaction of authorities to financial
crisis -- liquidity
• Initial issue desire by banks for increased liquidity
• Central banks carried out traditional lender of last resort
function by supplying the increased liquidity desired by banks
• Over time, this part of central banks’ support function
broadened in a number of ways
• First, term loans
• Second, loans to non-traditional institutions
• Third, purchase of riskier assets
• Fourth, higher risk collateral
• Fifth, foreign exchange swap arrangements
• Sixth, securities lending facilities
Reaction of authorities to financial
crisis -- solvency
• Authorities willing to do whatever was necessary in order to
be prevent financial sector from imploding
• Focused on financial entities believed to be either “too big to
fail” or “too complex to fail” or “too interconnected to fail”,
i.e., the institutions that were believed to pose risks to the
entire system (systemically important financial institutions)
• Governments bailed out a number of institutions
• Four principal approaches were taken – assisted mergers,
injections of equity capital or preferred shares, purchase or
guarantee of “toxic assets”, guarantee of liabilities
Reaction of authorities to financial
crisis -- solvency
• While each of these had the effect of
preventing losses to depositors, their
implications for non-deposit creditors and
shareholders differed
• Assisted mergers typically involve government
role in placing a limit on the acquiring
institutions’ potential loss from accepting
problematic assets of acquired institutions
Reaction of authorities to financial
crisis -- solvency
• Injections of equity capital or preferred shares
(with or without option to convert) improved 1
capital ratios (leverage ratios)
• Depending on the size of the injection of capital by
the authorities, such actions amounted to partial
or total nationalization
• Raised questions of government’s involvement in
the credit granting process and the exit strategy
that would be needed once the situation stabilized
Reaction of authorities to financial
crisis -- solvency
• Addressing toxic assets via guarantee or
purchase by “bad bank” were ways of minimizing
bank losses on specific types of assets
• Difficult issues of pricing – when markets are not
functioning well and only limited price discovery,
how determine market prices; how much loss to
shareholders and how much to taxpayers;
distribution of gains if markets rebound;
involvement of private sector in purchasing such
assets (private-public partnerships), possibly with
subsidy from public funds
Reaction of authorities to financial
crisis -- solvency
• Guarantee of liabilities can provide bank in difficulty
time to restructure or to wait for improvement in
markets, but does not in itself address solvency
problem
• There is not very much literature on the advantages
and disadvantages of these various techniques, and
governments have been using “seat-of-the-pants”
approach to decision-making in this area
• Need more study as to which approaches are best in
different circumstances
Reaction of authorities to financial
crisis -- solvency
• Authorities, in particular US authorities, have tried
number of these ways of bailing out financial sector
• Uncertainty with respect to intentions of US
authorities have made it difficult for potential
investors in US financial institutions to assess likely
outcomes
• Bear Stearns, Lehman Brothers – failure of latter
caused massive increase in uncertainty with respect
to risk of counterparties
Reaction of authorities to financial
crisis
• Other issues have arisen in context of liquidity and
solvency problems
• Proper coordination among the various authorities
responsible for financial stability
• Division of responsibility for financial stability in the
euro area (ECB versus national central banks)
• Countries in which banks have grown very large
relative to the size of the economy (Iceland, Ireland)
• Role of international organizations
Reaction of authorities to
macroeconomic downturn
• Principal concern to avoid self-reinforcing
downward spiral that would turn fairly sharp
downturn into much deeper and more prolonged
contraction, possibly including deflationary
pressures that would intensify the downturn
• Both monetary and fiscal tools were used
• Moreover, once policy interest rates approached
zero lower bound, central banks began to consider
unconventional measures (quantitative easing)
Monetary easing
• Quantitative easing means different things to different people
• Recent practice has been to distinguish between quantitative
easing and credit easing or qualitative easing
• One set of definitions is as follows (Buiter)
• Quantitative easing is an increase in the size of the balance
sheet of the central bank through an increase in its monetary
liabilities (base money), holding constant the composition of its
assets
• Credit or qualitative easing is a shift in the composition of the
assets of the central bank towards less liquid and riskier assets,
holding constant the size of the balance sheet and the official
policy rate
Monetary easing
• In my view, quantitative easing so defined will have relatively little effect
on the economy
• In circumstances where many assets already yielding zero return and in
which loans seem very risky, the banks may be perfectly happy to simply
hold excess reserves
• Example from Japan from the 1990s – high base growth, moderate money
growth, negative loan growth
• Of course, part of the problem in Japan was the continued weakness of
financial sector
• Qualitative easing has the potential of having considerable effect
• It could work through reductions of risk premiums of various sorts and
perhaps through its effect on expectations
• Also, could improve functioning of markets that were in difficulty
Fiscal policy--introduction
• In face of continued weakness of global economy, focus of
macro policy turned to fiscal policy
• Questions with respect to the effectiveness of temporary
fiscal stimulus and with respect to the preferred mix of policy
• Research at the IMF in which I was involved concluded that
certain types of global fiscal measures along with
accommodative monetary policy can make an important
contribution to underpinning the global economy
• But stressed importance of availability of fiscal space and
credibility – need clear commitment to long-run fiscal
discipline
42
Simulations of fiscal stimulus
• Investment expenditures have much larger effect on
GDP than lump-sum transfers
• Expenditures have a direct effect on GDP while
transfers perceived to be temporary have only limited
effect on behaviour of households that are not handto-mouth consumers
• Targeted transfers have considerably larger effect than
regular lump-sum transfers because hand-to-mouth
households have higher propensity to consume
• Effects on GDP of fiscal stimulus much larger in all
cases with monetary accommodation than without
monetary accommodation
43
Conclusions regarding fiscal policy
• Fiscal policy has to take on important role in the economic
recovery during the period in which monetary policy constrained
by the zero lower bound (even with quantitative and credit
easing) and in which financial sector is recovering and may not
be able or willing to extend credit to the normal extent
• In countries in which fiscal space is limited, especially important
to focus fiscal stimulus actions on measures having the largest
effect on aggregate demand (expenditures or targeted
transfers), although political considerations may require
governments to adopt second-best measures
• Important that fiscal stimulus is global and that monetary policy
is accommodative
44
Conclusions regarding fiscal policy
• Danger if stimulus packages being considered
create a perception of lack of fiscal discipline,
and more so if lack of fiscal discipline is not just
perceived but also realized
• Credibility concern could be addressed through
appropriate and credible medium-term fiscal
frameworks such as the introduction of fiscal
rules (e.g., long-run targets for ratio of fiscal
deficit or fiscal debt to GDP)
• Also important to avoid protectionist elements
in fiscal packages
45
Exit strategy -- macro
• Aggressive monetary and fiscal strategies along
with support for the financial sector have
prevented even worse outcomes
• Appears that the recovery will start later this year
or early next year
• However, because of the ongoing weakness of the
financial sector and some continued underlying
macro problems, likely to be a more gradual
recovery than is typical at this stage of the cycle
Exit strategy -- macro
• Importance of reversal of both monetary and fiscal easing
as economies come out of recession and settle into
stronger phase of the recovery
• On the monetary policy side, the very high level of stimulus
that is currently in place will have to be removed
• And at least some of the special initiatives introduced by
central banks in the form of credit easing and to deal with
liquidity problems will likely be withdrawn
• However, consideration may well be given to retaining
some of these initiatives as part of the restructuring of the
financial system
Exit strategy -- macro
• On the fiscal side, it will be essential to return
to a credible track for the debt to GDP ratio
• In the absence of such measures, we can
expect to see higher long-term real interest
rates (and hence lower growth of potential
output) than otherwise
• Consideration should be given to the
introduction of fiscal rules as a way of
facilitating appropriate budgetary behavior
Exit strategy -- macro
• Of course, the main challenge to both monetary
and fiscal policy is to get the timing “right”
• Premature tightening could slow down an
incipient recovery
• Excessive delays in tightening could eventually
result in inflationary pressures developing
• As is always the case, the monetary and fiscal
authorities will have to rely upon forecasts, but in
the current circumstances of both financial and
macro uncertainties, forecasting is especially
difficult
Financial sector restructuring and
regulation
• Much attention is being paid to changes in regulation
and supervision of the financial sector
• But will want to avoid regulation that will stifle useful
innovation
• G20 work plan grouped reform efforts under three
headings – improving domestic regulation; crossborder regulation and cooperation; and IFI reform
and refinancing
• My own listing of possible reform efforts is as follows
Financial sector restructuring and
regulation
CAPITAL AND LIQUIDITY
• (1) Higher capital and better quality capital
• (2) Unweighted leverage ratios
• (3) Countercyclical leverage of some sort
• (4) Consolidation of off-balance-sheet entities
• (5) Possible limitations on proprietary trading
• (6) Liquidity requirements of some form
Financial sector restructuring and
regulation
MARKET PRACTICES AND ARRANGEMENTS
• (7) Increased use of strongly risk-proofed
clearing and settlement systems with central
counterparties for clearing and settlement of
derivative transactions of various kinds
• (8) Possible reorganization of the originate to
distribute model to ensure that originators
have incentive to monitor underlying loans
• (9) Role of credit rating agencies
Financial sector restructuring and
regulation
COMPENSATION ARRANGEMENTS
• (10) Attention to incentives at all levels of
organizations in the financial sector – may lead to
compensation arrangements with increased focus
on the medium term and even longer term
• Whether this will be done by boards themselves or
with government involvement remains to be seen
• Boards will likely come under pressure by
shareholders in setting of compensation
Financial sector restructuring and
regulation
SUPERVISORY ARRANGEMENTS
• (11) If entities previously unregulated turn out to be too
large to fail or too complex to fail or too interconnected to
fail and likely to fall under safety net if run into serious
difficulties , essential to bring them under some form of
regulation.
• (12) Attention to financial sector that is large relative to size
of the country
• (13) Much more attention to the role and influence of risk
management units
• (14) Increased regulation of mortgage markets
• (15) Greater transparency (reduced opacity), particularly in
the case of derivatives
Financial sector restructuring and
regulation
• (16) More and higher quality (better paid) supervisory staff
• (17) Legislation should not be overly rigid yet should
provide sufficient safety and stability to avoid repeat of
financial crisis
• (18) Possible reorganization of entities responsible for
supervision
• (19) In some countries, need for better mechanisms for
closure of financial institutions and for crisis resolution
• (20) Possible reconsideration of mark to market
accounting, but not necessarily elimination
Financial sector restructuring and
regulation
MACRO PRUDENTIAL
• (21) Macro prudential supervision will receive
greater attention. Central banks likely to play a
leading role in this area.
• (22) Relatedly, the concept of systemically
important financial institutions will play a
greater role in regulatory and supervisory
arrangements
Financial sector restructuring and
regulation
SUPERVISORY COORDINATION DOMESTICALLY
AND INTERNATIONALLY
• (23) Need for better coordination across the
authorities in a given country and across
countries
• (24) In terms of cross-border regulatory
arrangements, there will undoubtedly be much
discussion of how to deal with financial
institutions with a worldwide footprint
Future macro and financial sector
policies
• More generally, focus on implications of the
policy decisions on incentives and potential
behavior of financial institutions and financial
market participants, as well as the authorities
• Essential to address moral hazard concerns
Canada
• Why did Canada have far fewer financial sector problems than
the United States or many European countries?
• First, the relatively conservative approach of Canadians (e.g.,
subprime mortgage market)
• I would note in passing that Canadian authorities were not very
conservative in this context as for some time they were
prepared to countenance low or zero down payments
• Second, Canadian banks were much more cautious than
European banks with respect to purchase of CDOs backed by
US subprime mortgages and indeed some refused to invest in
such instruments altogether on the grounds that they were too
risky
Canada
• Third, Canadian banks typically rely on retail deposits to a very
considerable extent
• Fourth, since the largest Canadian investment banks (securities
dealers) are now subsidiaries of the Canadian chartered banks,
they are also indirectly supervised by OSFI (in addition to the
securities commissions)
• Hence leverage ratios that apply to the consolidated bank put
limits on the risks of the investment banks
• Fifth, Canadian supervisors may be at an advantage in having to
deal with only a small number of large institutions and being
able to focus more of their attention on such entities
• Sixth, the role of luck should never be underestimated
Canada
• That said, Canadian institutions did not emerge unscathed
• When liquidity dried up, they were faced with many of the same
liquidity problems as banks in other countries
• And problems in the ABCP market had a special Canadian twist related
to the flawed contractual arrangements for liquidity support for certain
types of ABCP
• Nonetheless, Canadian authorities had to introduce fewer special
arrangements to deal with financial sector problems than their
American and European counterparts
• Finally, in the context of the need for fiscal stimulus, Canada was much
better off than most other countries because the Government of
Canada had run fiscal surpluses over the previous decade of prosperity
in order to reduce its debt to GDP ratio
Concluding remarks
• Financial sectors and economies worldwide have been under
enormous stress in the last couple of years
• Unprecedented actions by the authorities appear to have prevented
the situation from becoming even worse than it has been
• Looking forward, important decisions will have to be made
regarding what is needed to restructure the financial system to
avoid a recurrence of the problems that it has faced and whether
some of the innovative techniques introduced by the authorities to
combat the crisis should be retained for the longer term
• The interrelationship of monetary stability and financial stability and
the possible role of financial stability issues in the conduct of
monetary policy will also undoubtedly receive considerable
attention