Understanding the crisis Francesco Giavazzi Università Bocconi October 13, 2008

U.S. : relative house prices since 1880 Source: S&P, Case-Shiller Index

U.S. nominal house prices

U.S. foreclosures: actual and predicted

How large is the shock? October 1987 Today, Fall 2008 S&P 500: - 20 % (in a single month) Today, Fall 2008 an additional 10% fall in home prices would imply total residential mortgage credit losses $636 billion equivalente to an S&P 500 fall of about 4%

Leverage Leverage = Assets/Equity Assets Liabilities Equity Debt

Why so much amplification?

Leverage of some financial institutions U.S. 2008 Commercial Banks 9.8 Credit Unions 8.7 Finance Companies 10.0 Brokers and Hedge funds 27.1 Fannie and Freddie 23.5

Increase bank capital to Two problems Increase bank capital to absorb losses and allow de-leveraging minimizing asset sales Reactivate the interbank market

Three-month LIBOR minus geometric average of expected daily policy rates

Banks’ leverage and the amplification of asset price changes assets liabilities securities 100 equity 10 debt 90 leverage = assets = 100/10 = 10 equity

Banks’ leverage and the amplification of asset price changes assets liabilities securities 101 equity 11 debt 90 leverage = assets = 101/11 = 9,18 equity

Banks’ leverage and the amplification of asset price changes assets liabilities securities 110 equity 11 debt 99 leverage = assets = 110/11 = 10 equity

Banks’ leverage and the amplification of asset price changes assets liabilities securities 109 equity 10 debt 99 leverage = assets = 99/9 = 10,9 equity

Banks’ leverage and the amplification of asset price changes assets liabilities securities 100 equity 10 debt 90 leverage = assets = 100/10 = 10 equity

Leverage and the slope of asset demands targetting leverage implies an upward sloping demand for assets: when asset prices ↑ demand for assets ↑

Leverage and the slope of asset demands Banks increase leverage Balance sheets strengthen: E Balance sheets expand: A Asset prices rise

Reducing leverage assets liabilities securities 109 equity 10 debt 99 Selling assets Raising equity assets liabilities securities 100 equity 10 debt 90 assets liabilities securities 109 equity 10,9 debt 99 leverage = 10

Reducing leverage assets liabilities securities 109 equity 10 debt 99 Swapping assets with the Fed (no haircut) assets liabilities securities 110 equity 11 debt 99 leverage = 10

Losses and recapitalization so far

Is leverage kept constant as asset prices change?

Source: Tobian Adrian and Hyun S. Shin, 2007

Balance sheet size and leverage: non-financial corporations Source: Tobian Adrian and Hyun S. Shin, 2007

Source: Tobian Adrian and Hyun S. Shin, 2007

Source: Tobian Adrian and Hyun S. Shin, 2007

Is why is banks’ leverage pro-cyclical? Var (value at risk) Prob (A < A 0 ─ Var) < 1 ─ c Var is the equity capital the bank must have to stay solvent with prob c Source: Tobian Adrian and Hyun S. Shin, 2007

Is why is banks’ leverage pro-cyclical? K = λ * Var K is the capital the banks holds to meet its Value at Risk for λ = 1 the bank uses up all its K to face a loss of amount Var thus in general λ > 1 Source: Tobian Adrian and Hyun S. Shin, 2007

Pro-cyclical leverage L = (A / K) = (1 / λ) * (A / Var) as Var ↓ L ↑ Source: Tobian Adrian and Hyun S. Shin, 2007

Leverage: commercial and investment banks Source: Jan Hatzius, Goldman Sachs, BPEA, September, 2008

Losses, deleveraging and lending contraction Relation between leverage after (A*/E*) and before (A/E) adjustment to reflect losses (A*/E*) = μ (A/E) (A*/A) = μ (E*/E) = μ [1 – (L(1-k) / E)] where L: losses K: percent of recapitalization

Plans to cut leverage: 6 large banks Source: Jan Hatzius, Goldman Sachs, BPEA, September, 2008

New capital raised so far 6 large banks New capital raised so far $83 billion (Citi $41 billion) Current Tier 1 capital ratio (ratio of sharholders’ equity to risk-weighetd assets) 8,5% – 11, 5% (Citi 8,6%) Excess capital in normal times + $14 billion Excess capital under current plans to shrink balance sheets - $460 billion Source: Jan Hatzius, Goldman Sachs, BPEA, September, 2008

Estimated effect of bank lending in the US Normal trend growth of lending 5% per year (like nominal GDP) = $500 billion per year Estimated cut in lending (all banks) $ 2 trillion over 2 years Reduction in annual lending $500 billion per year Estimated effect on US growth - 2% per year for 2 years Source: Jan Hatzius, Goldman Sachs, BPEA, September, 2008

Increase bank capital to Two problems Increase bank capital to absorb losses and allow de-leveraging minimizing asset sales Reactivate the interbank market

U.S. three-month LIBOR minus geometric average of expected daily policy rates

Three-month LIBOR minus geometric average of expected daily policy rates