The Financial and Economic Crisis Lecture One: Understanding the mechanism that drove the crisis Mike Kennedy

The world economic outlook: still fragile, especially among OECD economies

What’s happening in some individual OECD economies

A key question: why was the effect of the financial meltdown so large? The setting leading up to the housing bubble: Low interest rates: – Asia and effective pegging of the exchange rate (exports and past problems with speculative attacks) led to capital inflows. – Fed and other central banks had kept interest rates too low for too long (fears of deflation). Taylor thought that this was the most important. – Fed felt that any asset-market problem (a crash or correction) could be handled with monetary policy (post-2000 was a case in point). There had been a long expansion with low inflation leading to a feeling of complacency – never had it so good. Innovations in the financial sector, which were led to lower interest rates and easier lending terms for individual borrowers, reinforced the process. These features were not confined to just the US

The rise in house prices was a (mostly) world-wide phenomenon, fuelled by cheap credit

The picture leading up to the crisis: life was good

The banking industry is transformed Two trends are important here: (1)the move to originate and distribute and (2)the increase in financing using short-term instruments. Offloading risk by creating structured investment vehicles like collateralised debt obligations (CDOs) – These were portfolios of assets (often risky ones) which were divided into tranches, ranging from super senior (constructed to be rated as AAA ) to the equity stake (toxic waste). – Senor tranches were sold to investors while the toxic waste was held by the banks in question as an incentive to monitor loans. – Buyers of such assets also purchased insurance – called credit default swaps (CDS) – which had a notional value of $45 to $65 trillion in – With the purchase of such insurance, investors had reason to believe that their portfolios had little risk.

Banks (commercial and investment) were highly exposed to a maturity mismatch prior to the crisis Most investors prefer assets with short maturities: – They can withdraw funds at short notice for liquidity. – Possibly this is a type of commitment device to discipline banks. But investments are long term and banks financing of such investments result in a maturity mismatch. This maturity mismatch was transferred to the “shadow banking system”. – Raised funds by selling asset backed short-term securities. Investors in such products had the right to seize the underlying assets in case of defaults. At the same time these off-balance-sheet vehicle were exposed to “funding liquidity risk” so banks provided back-ups in the form credit lines. – The result was that banks were carrying this risk on their balance sheets but it was not evident – a lack of transparency. – There was also a move to “repos”, a very short-term instrument, which meant that these entities had to rollover an increasing large fraction of their funding on a daily basis. Adrian and Shin (2008) think that this is a good measure of credit expansion.

Why were these exotic products so popular? Interest rates were very low as was risk aversion and this led directly to a hunt for yield. The theory was that it allowed risk to be shifted to those who are in a position to bear it. Permitted certain investors to hold assets that they previously could not because now they were rated AAA; the ratings were very important. Regulatory arbitrage: – A problem with regulation is that banks can “game the system”. – Basil I required them to hold capital equal to 8% of loans but this requirement was lower for contractual lines of credit. – Banks could lower their capital charges by moving assets off their balance sheets and then issuing credit lines to the SIV. – Some credit had a zero capital requirement, like “reputational lines of credit”.

Risk aversion was low prior to the crisis

Why were these exotic products so popular (con’t)? VaRs were overly optimistic since they never allowed for the possibility of a fall in nation-wide house prices, something that had not happened in the post-WWII period. The low correlations across regions generated a perceived diversification benefit. Rating agencies and fees – the interconnection. Fund mangers liked the idea that they could have higher yields and lower risk. All this led to cheap credit and declining lending standards, which in turn led to the house price boom. Underlying all this was a view that house prices would only rise allowing borrowers to refinance. Many thought that a day of reckoning was coming but it was difficult to bet against the boom.

US real house prices

A chronology of the unfolding crisis The key to understanding the crisis is to note how inter- connected is the financial system – and it still is. Subprime defaults started to increase (Feb 2007) and prices of CDS started to rise in the wake of rating downgrades. ABCP started to dry up in the wake of a confidence crisis. A conduit of IKB, a small German bank, had funding problems (Jul 2007). BNP Paribas froze redemptions on three of its funds. House prices in the US started to fall from Jul 2007 onwards.

A chronology of the unfolding crisis (con’t) LIBOR and TED spreads (LIBOR less US T-Bill rate) backed up as banks become reluctant to lend to each other. Central banks respond as Fed and ECB injected funds into financial markets and the Fed began to cut interest rates. Continuing write-downs of mortgage related products affected the assets of money market funds. Monoline, an insurer of municipal bonds, came under pressure. The Bear Sterns problem – was considered too inter- connected to fail. Lehman Brothers, Merrill Lynch and AIG. Credit restraint kicks in and it is both for all segments (main street) and world-wide (across major OECD markets).

TED spreads

Equity markets plunged, with a loss of $8 trillion

Credit conditions were tightened

Banks get hit hard as bad loans accumulated

How did several hundred billion in losses in mortgages lead to the meltdown? Need to understand the types of risk institutions faced Funding liquidity – The ease with which investors can obtain funds from financiers. Risk here takes three forms: Margin or “haircut” may change They will not be able to rollover short-term borrowing (rollover risk) Investors may start to redeem their deposits (redemption risk) – Deleveraging occurs with consequent effects on asset prices – Only detrimental when liquidity is scarce Market liquidity – The ability to sell assets without affecting its price Bid-ask spreads (how much I would lose if I sold and immediately re-purchased an asset) Market depth (how many units can be traded without affecting prices) Market resiliency (how quickly prices bounce back)

How the crisis became amplified (con’t) Market and funding liquidity can interact so that a small shock can cause liquidity to dry up suddenly leading to a full-blown crisis. A loss spiral – When leveraged investors are forced to sell assets out of proportion to the initial fall in prices in an attempt to restore their leverage ratios. If asset prices are weak, then these prices will start to fall even faster – Driving mechanisms is the reaction of other investors who: may be facing the same constraints may not buy when prices are low, preferring to wait out the declines may engage in predatory trading The mechanism can be self-reinforcing.

How the crisis became amplified (con’t) A margin/haircut spiral – This can re-enforce the loss spiral now investors need to reduce leverage and lending gets restricted this leads to a vicious spiral Why don’t investors move on the buying opportunities, since the liquidity problem may be temporary? – Unexpected shocks may indicate future volatility – Asymmetric information (not sure about the quality of assets that investors are trying to sell) – Investors may be backward looking estimating future volatility based on recent movements – Investors as well may not have the deep pockets required to buy and hold

Two liquidity spirals: Loss spiral (margins held constant) and margin spiral (margins increase)

How the crisis became amplified (con’t) Lending channel – Following the shock banks began to restrict lending (precautionary holdings of cash increase) driven by concerns that: more shocks were coming funding would be difficult to obtain – These concerns led to a sharp spike in interbank financing costs as precautionary holdings by institutions increased. – The funding problem (or run) can happen electronically as debt holders rush to the exit – Equity holders in the fund also have an incentive to go early – First mover advantage can lead to runs on banks and financial institutions in general

Credit restraint was a world-wide phenomenon

How the crisis became amplified (con’t) Network risk – The distinction between a lending and a borrowing sector is artificial – in reality financial institutions are both lenders and borrowers – This can lead to great uncertainty, complicating the situation, especially when the counter-party risk and uncertainty about asset values rise

Crisis spreads to emerging markets