Download 2009

The Financial Crisis
2009
Steinar Holden
Økonomisk institutt, UiO
http://folk.uio.no/sholden/
ECON 4325
Outline


Macroeconomic imbalances
Weaknesses in financial markets




Weaknesses in regulation
What happened?
Historical experiences
Some lessons
2009

Securitization
Predicted growth in world GDP,
given at different points in time
7
6
5
7
Anslag oktober
Anslag november
Anslag januar 2009
Anslag mars 2009
6
5
4
3
3
2
2
1
1
0
0
-1
-1
-2
-2
-3
-3
-4
-4
Verden
Industriland
Fremvoksende økonomier
2009
4
(IMF)
Amplification mechanisms
2009
Background - macroeconomics

Macroeconomic imbalances


Fairly high economic growth at world
level, yet low inflation partly due to cheap
imports from low-cost countries


Central banks set low interest rates in 20022005
Economic growth and low interest rates


High growth in asset values
”Search for yield”
2009

High saving in China, Japan, Germany and oil
exporting countries
High borrowing in the U.S, UK, Spain, etc
House prices
2009
Background – financial markets

Extensive changes in financial markets last
20-30 years

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Advantages
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Easier to borrow, better funding of investments
Broader spectre of assets, diversification
Increased efficiency and profitability
2009

Institutional changes (e.g. hedge funds, private
equity funds)
Deregulation – removal of artificial barriers
Technology – increased access to information,
communication, computer power, financial
innovation
Strong profit motives and incentive based
remuneration
Securitization




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Pension funds hold AAA rated assets due to
restriction by charter
Hedge fund focus on more risky pieces
Banks hold ”equity tranch” to ensure monitoring
But:


most of risk stayed within banking sector
(although spread across the world)
banks held leveraged AAA assets – tail risk
2009

Diversified portfolios formed on basis of
mortgages, corporate bonds and other
assets
Portfolios are sliced into tranches, sold to
investors with different appetites for risk
Securitization – bad reasons

Supply


Demand


Naiveté – risk underestimated due to past low
correlation among regional housing markets
Search for yield – accept tail risk
2009

Regulatory arbitrage – Basel I required banks
to hold capital of at least 8 percent of loans on
balance sheets, but requirements were lower
for SIVs (structured investment vehicles, i.e.
off balance sheet entities created by banks)
Rating arbitrage – transfer assets to SIVs and
issue AAA rated papers rather than A- rated
papers
Subprime –mortgages in the US
Mortgages to household
with weak financial
background: NINJA – No
Income, No Job or Assets
Often provided by
agents paid on
provision
Simplified credit
evaluation
Often based on
information from
borrower
Teaser rates and
”piggyback” mortgages
to avoid initial down
payment

USA Subprime
Percent of mortgages, stock

2009
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
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Short term funding and
leveraging (low equity shares)

Investors prefer assets with shorth maturity

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Most investment projects and mortgages have
long maturities
Leads to ”maturity mismatch” for banks
Increased reliance on extensive short-term
borrowing
Lower equity ratios to increase return on equity


Earn 1 USD on loan of 100 USD
10 % equity => 10 % return on equity;
5 % equity => 20 % return on equity
2009

Provides liquidity
Discipline device for banks
Rating agencies and credit
default swaps CDS


AAA rating important for sale of CDOs
Highly profitable business for rating
agencies

Risk was underestimated

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Rating ”at the edge”, i.e. as ”risky as possible”
Insurance: Credit Default Swaps CDS
Extensive reinsurance to other companies
Insufficient capital – monoline insurers had
only 1 percent of amount at risk
Possible to buy CDS without having
underlying asset
2009

Higher fees for structural products
Background – incentives in the
financial sector

Not only new, unknown risk, but also


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Incentive based remuneration, bonus for
upside, but no punishment for downside
Measuring return relative to risk lead to
search for other possibilities


Tail risk – win something 9 out of 10, loose a lot
1 out of 10
Herd behaviour – don’t do worse than
others
2009

Low price on risk
”Old, well known” risk, e.g. borrow in foreign
currency
Background – weaknesses in
the regulation

Large parts of financial markets without
capital requirements and supervision

Holes in the regulation

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”off-balance-sheet”
Coordination problems and several regulatory
authorities
Insufficient transparency
Procyclical regulation


Good times: asset prices up => equity share
up => lend more => asset prices up
Reverse in bad times
2009

Half of the US credit market, including
investment banks (because no depositors)
House prices in the US,
annual growth rates 1988 - 2008.
20
Case-Shiller indeks for 10 byområder
15
10
Prosent
5
Case-Shiller nasjonal indeks
2009
0
-5
-10
-15
-20
88
90
92
94
96
98
00
02
04
06
08
Source: Reuters EcoWin
Årsvekst i 4. kvartal 2008 for 10 byområder: -19,2 prosent
Kilde: Reuters EcoWin
16
Difference 3-month money market
rates and policy rates
1. januar 2008 – 2. februar 2009. Prosentpoeng
3,5
USA
3,0
2009
Prosentpoeng
2,5
2,0
1,5
Norge
Eurosonen
1,0
0,5
0,0
jan. 08
-0,5
Kilde: Reuters EcoWin
apr. 08
jul. 08
okt. 08
jan. 09
Credit default swaps
2009
Amplification mechanisms


Loss on bad loans, and fear of new
losses
Liquidity crisis

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Banks more reluctant to lend to other banks
Difficult to obtain short term funding
Banks must sell assets => asset prices fall
Lower asset prices increase loss => sell more
Asset markets become illiquid
Solvency problems


Downgrading of securities and institutions
Procyclical behaviour and regulation
2009

2009
The financial crisis leads to a
recession

Financial crisis leads to lower
investment and lower consumption, so
that GDP falls
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Demand falls
Risk increases
More difficult to finance investment projects,
consumption and trade credits
Investments, cars, durables, manufacturing
products severly hit
Recession involves real losses that
amplifies financial crisis


Banks take losses, and must reduce lending
Firms have lower equity and lower sales, more
uncertainty, becomes less credit worthy
2009

Historical experiences of
financial crises after 1945
Reinhart og Rogoff, NBER

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Average change from top to bottom
Longlasting reduction in asset prices
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Fall in output and employment

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Unemployment increases by 7 percent over four
years
GDP falls by 9 percent over two years
Public debt increases

Average increase is 86 percent (not a good
measure, as it depends on initial debt)
2009

House prices fall by 35 percent over six years
Stock prices fall by 55 percent over 3 ½ years
Some lessons for the regulation
of financial markets
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More emphasis on stability and less on
competition
Market discipline must improve

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Raw leverage caps, not only risk adjusted
Credit rating agencies
Insentives in financial institutions
Liquidity regulation and better liquidity
provision
2009

Supervision and regulation of all activity
which involves system risk
Better information and transparency
Make regulation less procyclical
Lessons – economic policy

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Fiscal policy tighter in good times
Global imbalances reduced
International cooperation improved
2009
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Monetary policy must reflect concern for
financial stability