The Financial Crisis of 2008: Causes and Consequences J. Peter Ferderer Macalester College 21 October 2008

Outline A Chronology of the Collapse Eight Causes Maturity Mismatch and Leverage Another Great Depression? Q & A

Parallels to Natural Phenomena Source: The Economist

Parallels to Natural Phenomena Source: The Economist

Parallels to Children’s Stories Source: The Economist

Bank Failures start in Europe German and French Special Investment Vehicles (SIVs) unable to rollover commercial paper and close funds (August 2007) U.K. experiences first bank run in more than a century (9/19/2007

14 March 2008: The First Investment Bank Collapses - JPMorgan Chase takes over Bear Stearns - Bear’s mortgage book might contain “whopping further losses” (The Economist) - The Fed makes $30 billion loans to I-banks as well as regulated banks - a significant shift in policy

13 July 2008 Federal Government Takes over Freddie and Fannie Mac - Fannie and Freddie own or guarantee $5.2 trillion in mortgage debt

16 September 2008: When things went from bad to worse - Lehman Brothers – Wall Street’s 4 th largest Investment Bank – collapses - Barclay’s and Bank of America step away - U.S. Treasury lets Lehman go - Counterparty risk spikes as Lehman files for bankruptcy

17 September 2008: Size Matters - American International Group (A.I.G.) fails due to credit-default swaps. - The government takes control of the company

24 September 2008: And then there were None - Goldman Sachs and Morgan Stanley convert into bank holding companies - Mitsubishi UFJ buys 20% of Morgan - Warren Buffett injects $5 billion into Goldman

September 25: The Biggest Bank Failure in History - Regulators seize Washington Mutual, the country’s largest savings and loan institution and sell most of its operations to JPMorgan Chase. - More than $300 billion in assets (Continental Illinois, had $40 billion when it toppled in 1984).

3 October 2008 Bailout Bill Passes $750 billion ($2,500 per American) Initially created to buy “toxic” assets off financial institution balance sheets $250 used to buy ownership positions in banks.

The Magnitude of the Problem Estimated worldwide losses on debt: $1.4 trillion (IMF) $760 billion written down by banks, insurance companies, hedge funds and others Cost of average systemic banking crisis in OECD counties over the past few decades: 16% of GDP Cost of the U.S. bailout so far: $760 billion (7% of GDP)

The Housing Boom and Bust

Explanation #1 Asymmetric Monetary Policy - Too much borrowing - Too much short-term borrowing

Explanation #2: The Savings Glut in the ROW Rest of the World United States Loanable Funds rr S ROW I ROW r* S I I0I0 S0S0 S0S0 I0I0 NCO ROW >0 NCO US <0 r* S1S1 I1I1

Explanation #3 Democraticisation of Home Ownership - Community Reinvestment Act of Fannie Mae and Freddie Mac (Government- sponsored mortgage buyers) were encouraged to guarantee a wider range of loans in the 1990s. - Tax deductibility of mortgage interest payments

Explanation #3 Democraticisation of Home Ownership

Explanation #4 The Great Moderation Source: Dallas Federal Reserve Economic Letters (September 2007)

Explanation 5 Erosion of Lending Standards Adjustable Rate Mortgages (ARMs) No-documentation mortgages No down payments NINJA mortgages (“No income, no job or no assets”)

The Default Decision $80,000 $100,000 $20,000 $90,000 $10,000 What does home owner do it they need cash due to loss of job or medical emergency? $100,000 $0 - $10, Percent DownNothing Down Home Value Mortgage Equity $90,000 Suppose the market price of homes falls

Mortgage Defaults

Explanation #6 Innovation – New Financial Instruments - New instruments allow risk spreading - Options - Interest-rate and credit-default swaps - Securitization (Collateralized Debt obligations, CDO)

Securitization Source: The Economist

Credit-Default Swaps Source: The Economist $20,000 per person A.I.G.

Explanation #6 Innovation – New Financial Instruments 1. Upside to greater risk spreading - The cost of capital falls - Credit is “democratized” - The system is more resilient to shocks 2. Downside - Large counterparty risk - Difficult for regulators to keep track of firm exposure (A.I.G.)

Explanation #7 Innovation – Off the Balance Sheet Solution: Basel Accord I (1988) mandates that banks must hold $0.08 in capital for every $1.00 in assets Impact on Banks: Reduces their ability to increase profits through leverage Bank Response: Create “Structured Investment Vehicles” (Basel capital requirements for credit lines to SIVs are less than 8%.) Problem: Loan defaults expose banks to insolvency

Explanation #8 Deregulation

The Old Model $ mortgages Commercial Banks Savers Borrowers Investment Banks Bonds Stocks Savings & Loans Business loans Savings Account Demand Deposits Bonds Stocks $ $ $ $ $

The New Model funds mortgages Commercial Banks SaversBorrowers funds deposits Investment Banks mortgages structured products Structured products (“Collateralized Debt Obligations”) are portfolios of mortgages, split into tranches. - Diversification (regional) - Heterogeneous risk appetites (“Super Senior” v. “toxic waste”) Pension Funds Hedge Funds Structured Investment Vehicles (SIVs)

Three Problems with the SIVs Maturity Miss-match (long-term assets funded by short-term liabilities) exposes them to funding and liquidity risk Excessive Leverage to Increase returns makes the system more fragile Liquidity Problems spill over to sponsoring Commercial and Investment Banks

Structured Investment Vehicles Risk perceived to be low

Commercial Paper Outstanding Source: Brunnermeier (2008)

Problems Rolling over ABCP Liquidity injections by Central Banks BNP Paribus closes funds Bear Stearns fails Lehman Brothers fails

Leverage and Amplification

Leverage Example AssetsLiabilities Financial Intermediary Securities: $100 Debt: $90 Equity: $10 L = A/(A-L) = 100/(100-90) = 10 Financial firm manages its balance sheet to maintain constant leverage

Event: Security Prices rise by 1% AssetsLiabilities Financial Intermediary Securities: $101 Debt: $90 Equity: $11 L = A/(A-L) = 101/(101-90) = 9.18 How must firm react to keep leverage at 10? Issue more debt and buy more securities

Event: Security Prices rise by 1% AssetsLiabilities Financial Intermediary Securities: $110 Debt: $99 Equity: $11 L = A/(A-L) = 110/(110-99) = 10 Thus a $1 rise in the price of securities leads to a $9 increase in debt and security purchases

Event: Security Prices fall by 1% AssetsLiabilities Financial Intermediary Securities: $110 Debt: $99 Equity: $11 L = A/(A-L) = 109/(109-99) = 10.9 How must firm react to keep leverage at 10? $109$10 Sell $9 of securities and pay off $9 in debt Role of Mark-to-Market

Balance sheet after assets sold AssetsLiabilities Financial Intermediary Securities: $100 Debt: $90 Equity: $10 L = A/(A-L) = 100/(100-90) = 10

Implication: Positive feedback loops and amplification - Contagion across balance sheets rising/falling asset prices Stronger/weaker balance sheets

The Cost of Making Markets Liquid The average credit spread of the 15 largest credit derivative dealers (ABN Amro, Bank of America, BNP Paribas, Barclays Bank, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs Group, HSBC, Lehman Brothers, JP Morgan, Merrill Lynch, Morgan Stanley, UBS, and Wachovia.)

Another Great Depression? Source: The Economist

Cartoon

Spillovers The Economist

Fed Policy The Economist

Reason for Optimism: Size of Government Y = C + I + G + (EX – IM)

No External Constraint Y2K 9/11

Conclusion

Competing Views Financial Market Efficiency Eugene Fama Financial Market Instability Hyman Minsky

Financial Market Efficiency Freer (deregulated) financial markets produce superior outcomes. Unencumbered capital flows to its most productive use, boosting growth and economic welfare. (tech. boom) Innovations that spread risk more widely (e.g., credit default swaps) reduce the cost of capital, “democratize credit” and make the system more resilient to shocks.

Financial Instability Periods of stability lead to excess and eventual crisis. Stability encourages greater leverage and ambitious debt structures (e.g., reliance on short-term funding). Financial innovation allows banks to avoid regulatory hurdles (capital requirements and off-balance sheet vehicles).