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The financial crisis: Initial conditions, basic
mechanisms, and appropriate policies.
Olivier Blanchard
Munich lecture, November 2008
Nr. 1
1. Introduction
• Much too early to give a definitive assessment.
• Not too early to think about the basic mechanisms, and whether/how
we can prevent similar events in the future.
• A first pass, in the midst of the action. With thanks to the IMF team.
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The basic question: How could such a small trigger have such enormous effects
on world output?
Initial Subprime Losses and Subsequent Declines in World GDP,
US Households Real Estate Wealth, and US Stock Market Capitalization
(in Billions US Dollars)
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Source: IMF Global Financial Stability Report; World Economic Outlook November update and estimates; Federal Reserve Flow of
Funds Accounts; World Federation of Exchanges.
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Organization
• Initial conditions
• Two amplification mechanisms
• Interconnections and dynamics
• Implications for policy now and in the future
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Setting the stage: Initial conditions
• The trigger: The issuance of risky assets, with undervaluation of risk.
Subprime mortgages.
Causes? Large world demand for safe assets, and bad regulation.
• The determinants of amplification.
– Complexity and opacity of assets on balance sheets of financial
institutions, so low liquidity.
Causes? Better risk allocation, and bad regulation.
– Increased leverage (lower capital relative to assets).
Causes? Bad, and sometimes perverse regulation.
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A visual sense of the complexity. From mortgages to securities
Residuals
Loan
proceeds
Subprime
Borrower
Loan cash
flow
Lines of
credit
Subprime
Servicer
Loan cash
flow
Bought by both
low and high riskseeking investors
Banks provide liquidity
to lenders
Subprime
Lender
Loan cash
flow
Bought by
more riskseeking
investors
Subprime
Securitization
Structure
Securitization
Underwriting
Bought by less
risk-seeking
investors
ABCP Conduits
/ SIVs buy ABS
and issue shortterm debt
Bam ks prov ide
financing to CDOs
Subprime BBBthrough Single A
bonds
Subprime AAA
& AA bonds
Banks provide credit
lines to conduits / SIVs
Banks
ABCP
ABS are bought
by CDOs and
tranched into
CDO
structured
debt
products, financed
Bought by
by issuing debt
other
CDOs
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Provide insurance on
CDOs, ABS and some
SIVs
Insurers
CDO
equity
Bought by more
risk-seeking
investors
Amplification mechanism 1. Runs
• Bad (or doubtful) assets on balance sheets
• Runs (not only by depositors, but by other investors)
• Need to sell assets.
• Not enough deep pocket investors to buy.
• Firesale prices. P < EN P V .
• Worse balance sheets. More incentives to run, etc
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Amplification mechanism 2. Capital
• Bad (or doubtful) assets on balance sheets
• Decrease in capital ratio (Assets minus liabilities, over Assets)
• Need to sell assets (deleverage)
• Not enough deep pocket investors to buy.
• Firesale prices. P < EN P V .
• Lower capital ratio. More incentives to sell assets, etc
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The two mechanisms: Conceptually separate but strongly interacting
• Run on financial institution 1
• Cut credit to financial institution 2
– Sale of assets at depressed prices
Low capital, so further sales
– Or cut credit to financial institution 3
Examples. From US banks to Hungary. From subprimes to other assets.
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The dynamics in real time
• Increase in probability of insolvency.
• Increase in counterparty risk.
• Decrease in volume and maturity of interbank lending.
• Contagion across institutions. From direct exposure to subprime onwards.
• Contagion across countries. From the US to Europe, to emerging market
countries.
• Increasing effects on the ultimate borrowers: households and firms.
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Contagion across institutions, assets, and countries
Heat Map: Developments in Systemic Asset Classes
Emerging markets
Corporate credit
Prime RMBS
Commercial MBS
Money markets
Financial institutions
Subprime RMBS
Jan-07
Jul-07
Jan-08
Source: IMF, Global Financial Stability Report, October 2008
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Oct-08
Counterparty risk: Difference between the lending rate between banks and the
riskless rate
5.0
Ted Spreads: 3-month Libor Rate minus T-bill Rate
(in percent)
4.0
Sep 15, 2008
Lehman Files for Bank ruptcy
3.0
2.0
1.0
0.0
01/01/07
08/01/07
US
03/01/08
Euro
Japan
10/01/08
UK
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Emerging market spreads
Emerging Markets Sovereign Srpeads - Composite Index
(1/2/06 - 11/12/08)
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08
/2
/
10
08
7/
2/
08
4/
2/
08
1/
2/
07
/2
/
10
07
7/
2/
07
4/
2/
07
1/
2/
06
/2
/
10
06
7/
2/
06
4/
2/
1/
2/
06
Bank lending standards
100
80
Bank Lending Standards
60
40
20
0
-20
3/
30
/0
6/ 5
30
/0
9/ 5
30
/0
5
12
/3
0/
05
3/
30
/0
6/ 6
30
/0
9/ 6
30
/0
6
12
/3
0/
0
3/ 6
30
/0
6/ 7
30
/0
9/ 7
30
/0
7
12
/3
0/
0
3/ 7
30
/0
6/ 8
30
/0
9/ 8
30
/0
8
-40
U.S.: C&I loans
U.S.: Mortgages
ECB: Large company loans
ECB: Mortgages
Change in the Balance of Respondents Between “Tightened Considerably-Tightened Somewhat” and “Eased Somewhat-Eased
Considerably” in Percent of Respondents. Source: Haver Analytics.
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Financial policies for the short run
Need to dampen/eliminate the two amplification mechanisms.
• Runs: Provide liquidity to a broader set of institutions.
Done. Still problem with institutions, countries without access to lender
of last resort (Iceland).
• Capital.
– Buy bad assets. For two reasons: Clarify price. Move price closer
to EPDV.
– Increase capital.
Many institutions may still need recapitalization. So need to add
capital (buy shares).
• Second leg takes time to implement. May need guarantees for depositors, and for interbank claims. To start interbank lending.
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Basic financial architecture in place in advanced countries
• A crucial weekend in October, but:
• Problems with speed/scope of recapitalization
• Coherence across countries
• Still hidden land mines. for example: CDS positions.
• Problems in emerging market countries.
Sudden stops. Need access to international liquidity provision.
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Counterparty risk since September
3-month Libor Rate
5.0
8.0
Ted Spreads: 3-month Libor Rate
minus T-bill Rate
4.5
7.0
4.0
6.0
3.5
5.0
3.0
4.0
2.5
2.0
3.0
1.5
2.0
1.0
1.0
0.5
0.0
0.0
8/1
8/16
US
8/31
9/15
Euro
9/30
Japan
10/15 10/30
UK
8/1
8/16
8/31
US
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9/15
Euro
9/30
Japan
10/15 10/30
UK
Sovereign spreads since September
3500
3000
Sovereign CDS Spreads
(index 7/2/07=100)
2500
2000
1500
1000
500
0
7/2/07
9/2/07
11/2/07
1/2/08
3/2/08
5/2/08
7/2/08
9/2/08
Current account deficit larger than 5% of 2007 GDP
Current account surplus, or small deficit
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11/2/08
From the financial crisis to the economic crisis
• Not a side show.
Direct effects: Credit growth, stock prices, exchange rates
Indirect effects, through confidence, and wait and see
• A Keynesian recession
Worsens the financial crisis
Back to fiscal and monetary policy (in addition to financial policies)
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Decrease in stock prices
500
120
110
Equity Markets in Advanced Economies
(March 2000 = 100; national currency)
450
Equity Markets in Emerging Economies
(Index 2001=100; national currency)
400
100
350
90
300
80
250
70
200
60
150
50
100
40
50
30
WILSHIRE 5000
DJ EURO STOXX
TOPIX
n0
Au 0
g0
Ma 0
r -0
Oc 1
tMa 01
yD e 02
c0
Ju 2
l- 0
Fe 3
bS e 04
p0
Ap 4
r-0
No 5
v0
Ju 5
n0
Ja 6
n0
Au 7
g0
Ma 7
r -0
Oc 8
t -0
8
Ja
Ja
nA u 00
gMa 00
r -0
Oc 1
tMa 01
yD e 02
c0
Ju 2
lFe 03
bS e 04
pA p 04
r-0
No 5
vJu 0 5
nJa 06
nA u 07
gMa 07
rOc 08
t -0
8
0
ASIA
LATIN AMERICA
EASTERN EUROPE
Source: Bloomberg and IMF staff estimates.
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Decrease in confidence
65
170
60
150
5
0
130
55
-5
110
50
-10
90
45
-15
Euro area
40
70
United States
Emerging economies
50
EU (right scale)
-20
U.S. (left scale)
35
-25
Manufacturing PMIs
(Values greater than 50 indicate expansion)
Ja
n
Au -00
gM 00
ar
O 01
ct
M -01
ay
De -02
c0
Ju 2
l-0
Fe 3
bSe 04
pAp 04
r
No -05
vJu 05
nJa 06
nAu 07
gM 07
ar
O 08
ct
-0
8
Ja
n0
Au 0
g0
M 0
ar
-0
Oc 1
tM 01
ay
-0
De 2
c02
Ju
l-0
Fe 3
b0
Se 4
p0
Ap 4
r-0
No 5
v0
Ju 5
n0
Ja 6
n07
Au
g0
M 7
ar
-0
Oc 8
t-0
8
30
Consumer Confidence
(United States, 1985 = 100; Euro Area, percent balance)
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Growth forecasts
8
Real and Potential GDP Forecasted Growth Rates
for 2009; in percent
7
5.2
6
5
4
3
2
1
0
-0.7
-0.4
-0.2
-1
-2
United States
Euro Area
Real GDP
Japan
Emerging & Developing
Economies
Potential GDP
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Looking forward. How to avoid a repeat?
• Back to the trigger and the two mechanisms:
• To limit the build up of systemic risk.
Broader regulation and monitoring systemic risk.
Limit leverage.
More transparent pricing and tracing of assets. Centralized trading
rather than over the counter.
• For runs: Broader liquidity provision.
Across institutions, in exchange for regulation,
Across countries, for runs on claims in foreign currency.
• For capital: Procyclical capital ratios.
A public fund to purchase illiquid assets at EN P V − x?
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The international dimension
• Need to coordinate regulation, national policies. Ireland and unilateral
guarantees.
• Need to monitor risk at a global level.
Exposure of Austria and Belgium to Hungary, of France to Belgium.
Exposure of emerging markets to sudden stops.
• Need to organize multilateral liquidity provision. Swaps, and the new
IMF facility.
• Need for burden sharing rules if recapitalization. National approaches
have large spillovers.
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