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Getting to the Root of the Cause MACROFINANCE CRASH OF 2008 Landmark Events in Crisis Winter 2006-07 Real Estate Prices Fall Summer 2007 Countrywide Mortgage in distress Fannie Mae, Freddie Mac in distress Summer-Fall 2007 British Lender Northern Rock in bankruptcy Spread between T-Bill and LIBOR grows large Recession begins Spring 2008 Bear Stearns in distress Summer 2008 Oil & other commodity prices spike September 2008 Lehman Bros. fails AIG in distress Parts of payments system freezes; “Runs” on parts of system LIBOR; Commercial Paper Wachovia (bank) in distress Stock market plunges Fed begins/expands unusual interventions Financial Stress Leading up to Sept 08 TED = T-Bill Rate – LIBOR (usually equal) KCFSI = Kansas City Fed Financial Stress Index 6 5 4 3 6 3.5 5 3.0 1 4 2.5 0 3 2.0 2 1.5 1 1.0 0 0.5 -1 0.0 -2 -0.5 2 -1 07M01 07M07 08M01 08M07 TED 09M01 09M07 KCFSI 90 92 94 96 98 00 TED (Libor -TB3) 02 04 06 KCFSI 08 Relative Size of Financial & Macroeconomic Losses Time Frame Stock Market Change (DIJA) 1907-08 Length GDP Change (Real) Stock Change/ GDP Change Highest Unemp. Rate -40% 13 months -5% 8 8.00% 1919-20 -46% 15 months -23% 2 11.30% 1929-33 -83% 43 months -29% 3 25.20% 1937-38 -49% 15 months -7% 7 19.10% 1946-48 -35% 21 months -5% 7 4.00% 1973-75 -51% 25 months -5% 10 9.00% 1978-82 -37% 48 months -7% 5 10.80% 1987-88 -28% 5 months >0% NA 5.80% 2000-01 -18% 16 months -1% 18 6.10% 2007-2009 -53% 16 months -4% 13 10.10% Key Questions Cause/Effect What was the gasoline, what was the match? Responses Get rid of gasoline? Get rid of matches? Store in safer places? Answers “The Gasoline” (Fuel) Debt: very high amount relative to incomes/revenues Includes but not limited to mortgage debt Non-mortgage commercial loans a big part of the story Amplified by “moral hazard” Implied or explicit guarantees to banking/financial system contributed to too much risk-taking, too much debt (TBTF) “The Match” (Ignition) Falling real estate prices & mortgage defaults beginning in 2006-2007 Oil Price (and many other basic commodities) Spikes of 2008 Oil from $70/barrel to $145/barrel Oil price spikes leading all but 1 post WWII recession Income & Debt Constraints Economy-wide Budget Constraint: Income + Debt Value = Debt Payments + Consumption Over the long run: Debt Value = Debt Payment “No Ponzi Game” Consumption must be based on Income (not debt) Debt at Root of Problem Debt Growth (right-billions $); Debt/GDP (left) 4.0 60000 3.5 50000 3.0 40000 2.5 30000 Debt/GDP - left scale 2.0 20000 1.5 10000 U.S. Debt -- right scale 1.0 0 20 30 40 50 60 70 80 90 00 Mortgage Debt only Part of the Story, Commercial Lending a Bigger Part 4.0 3.5 Total Debt/GDP 3.0 2.5 2.0 Non-house-govt/gdp 1.5 1.0 House-debt/gdp 0.5 Govt Debt/gdp 0.0 50 55 60 65 70 75 80 85 90 95 00 05 “Poster” Project for Commercial (nonmortgage) Debt (Artist Image) $11 Billion City Center Project Las Vegas – MGM Mirage Bank Loan/Bond Funded The Real Thing Why So Much Attention on Mortgage Debt? Mortgage market was the first “on fire” Many interpreted as “the cause” Mortgage debt traded daily in markets Quickly reflecting change in valuations Info on this appearing by 2007 Commercial bank loans not traded in markets Change in value reported slowly by banks over time Info on this not really appearing until into 2009 Causes of Debt/GDP Expansion: Cheap Credit 9 8 7 6 5 1990-99 2003-07:7 4 3 2 1 0 Prime AAA BBB Fed Funds ComPaper Causes of Cheap Credit: Public Sector Backing of Debt (Fannie Mae, Freddie Mac, and others) 9000 GSE Assets + Govt-MBS (in Billions $) 8000 7000 6000 5000 4000 3000 2000 1000 90 92 94 96 98 00 02 04 06 08 Cheap Credit: Foreign Investors Liked U.S. .06 Capital Inflows Relative to GDP .05 .04 U.S. .03 .02 .01 .00 Euro Area -.01 97 98 99 00 01 02 03 04 05 06 07 08 09 Causes of Cheap Credit: Expansion of “Wholesale” Money Markets Cheap Credit: Wholesale Market Expansion Cheap Credit: Wholesale Market Expansion Securitization, e.g. CDOs Pooling mortgage (other debt) risk (CDOs, SPVs) Credit Insurance Transferring Risk (CDS) Cheap Credit: Fed Responsible? 20 16 Inflation Rate & Smoothed (HP Filter) 12 8 4 0 -4 -8 82 84 86 88 90 92 94 96 98 00 02 04 06 08 Limiting Future Problems? Tradeoff: How to promote “sound” borrowing and lending without promoting too much risk taking Tradeoff: How to provide insurance to system (Fed) without promoting too much risk taking Higher “Equity Standards” on loans “Equity” = amount owners put in Size-Risk Issues Limit financial firm size? Charge insurance fee based on size More regulation or wiser regulation? Code Fed Regulations already 200,000 pages; financial regulation apx. 30,000