ECON 354 Money and Banking Financial Crises and the subprime Meltdown Lecture 8 Financial Crises. The Great Recession of 2007 – 2009: Part I: Causes and Timeline of Events. Financial Crises in Emerging Market Economies. Money & Banking 4/21/2017

Role of Financial Intermediaries Recall: Financial intermediaries solve the 2 problems created by asymmetric information: Adverse Selection. Moral Hazard. If financial intermediaries are able to solve these problems, then why did the economy experience the recent financial crisis?. Money & Banking 4/21/2017

Summary: Asymmetric Information Problems and Tools to Solve Them 4/21/2017 Money & Banking

Factors Causing Financial Crises Asset Markets Effects on Balance Sheets: Stock market decline. Decreases net worth of corporations. Unanticipated decline in the price level. Liabilities increase in real terms and net worth decreases. Unanticipated decline in the value of the domestic currency. Increases debt denominated in foreign currencies and decreases net worth. Asset write-downs. Money & Banking 4/21/2017

Factors Causing Financial Crises Deterioration in Financial Institutions’ Balance Sheets. Decline in lending. Banking Crisis. Loss of information production and disintermediation. Increases in Uncertainty. Decrease in lending. Money & Banking 4/21/2017

Factors Causing Financial Crises Increases in Interest Rates. Increases adverse selection problem. Increases need for external funds and therefore adverse selection and moral hazard. Government Fiscal Imbalances. Create fears of default on government debt. Investors might pull their money out of the country. Money & Banking 4/21/2017

Dynamics of past U.S. Financial Crises Stage One: Initiation of Financial Crisis. Mismanagement of financial liberalization/ innovation. Asset price boom and bust. Spikes in interest rates. Increase in uncertainty. Stage two: Banking Crisis. Stage three: Debt Deflation. Money & Banking 4/21/2017

FIGURE 1 Sequence of Events in U.S. Financial Crises Money & Banking 4/21/2017

The 2007 - 2008 Financial Crisis and the Great Recession Three Parts: Part I: Origins of The 2007 – 2008 subprime Financial crisis. Covered in this lecture. Part II: Economic Policies used to tackle the global recession. Part III: Post Crisis and Future Outlook. Money & Banking 4/21/2017

Part I: Origins of The 2007 – 2008 subprime Financial crisis. Factors leading to the Financial Crisis Part I: Origins of The 2007 – 2008 subprime Financial crisis. Money & Banking 4/21/2017

A Quick Word Cloud … 4/21/2017 Money & Banking Created at Wordle.net

Key Factors Housing Market and Housing Prices. Global Savings Glut. Subprime lending and the subsequent rise in Interest Rates. Money & Banking 4/21/2017

Once Upon A Time … $$$ % Money & Banking 4/21/2017

Interest Rates Over the Last Two Decades Source: Board of Governors, Federal Reserve System Money & Banking 4/21/2017

The Subprime Financial Crisis of 2007 - 2008 Financial innovations emerge in the mortgage markets: Subprime and (Alternative) Alt -A mortgages. Mortgage-backed securities. Collateralized debt obligations (CDOs). Housing price bubble forms: Increase in liquidity from cash flows surging to the United States. Money & Banking 4/21/2017

House Price Bubble Housing Market Bubble? Money & Banking 4/21/2017

The Subprime Financial Crisis of 2007 - 2008 Housing price bubble forms (cont’d). Development of subprime mortgage market fueled housing demand and housing prices. Agency problems arise. “Originate to distribute” model is subject to principal (investor) agent (mortgage broker) problem. Borrowers had little incentive to disclose information about their ability to pay. Money & Banking 4/21/2017

Financial Crisis: How it Happened Asset (Mortgage) Backed Securities sold globally to investors Investment in high risk (subprime) sectors CDOs Credit $$$ $$$ Subprime Mortgages Banks/Lenders make high risk loans to people with poor credit histories (subprime mortgages). Money & Banking 4/21/2017

Middle of this Decade Collateralized debt obligations Subprime Mortgages Financing counterpart/ lender التموبل المناظر / المقرض Structured investment vehicles (SIVs) هيكل ادوات الاستثمار Hedges funds, صناديق التحوط These sub-prime mortgages, other loans, bonds and other assets are bundled into portfolios or Collateralized Debt Obligations (CDOs) and sold to investors globally. 4/21/2017 Money & Banking

The Subprime Financial Crisis of 2007 - 2008 Agency problems arise (cont’d) Commercial and investment banks (as well as rating agencies) had weak incentives to assess the quality of securities. Information problems surface. Housing price bubble bursts. Money & Banking 4/21/2017

Beginning of the Subprime Problem: 2004 - 2006 Between 2004–2006, US interest rates rose from 1% to 5.35%, triggering a slowdown in the US housing market. 4/21/2017 Money & Banking Note: These lecture notes are incomplete without having attended lectures

Beginning of the Subprime Problem: 2004 - 2006 Falling house prices CDOs Credit $$$ $$$ Default on Subprime Mortgages CDOs: Collateralized debt obligations Falling house prices and rising interest rates lead to a large number of people who cannot repay their mortgage in the subprime sector. In addition, for many in the subprime sector, mortgage rates become adjustable (after initially being fixed), which worsens the problem. 4/21/2017 Money & Banking

The Beginnings of a Global Credit Crunch Falling house prices CDOs Credit $$$ Default on Sub-prime Mortgages CDOs: Collateralized debt obligations As mortgage default rates rise, investors holding these mortgage backed securities suffer losses, making them more reluctant to take on CDOs. Credit markets start to freeze as banks are reluctant to lend to each other, not knowing how many bad loans they may be carrying. 4/21/2017 Money & Banking

Part II: Timeline of events Timeline of Key Events; Advent of a Global Recession Part II: Timeline of events Money & Banking 4/21/2017

The Subprime Financial Crisis of 2007 - 2008 Banks’ balance sheets deteriorate. Write downs. Sell of assets and credit restriction. High-profile firms fail. Bear Stearns (March 2008). Fannie Mae and Freddie Mac (July 2008). Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund (mutual fund) and Washington Mutual (September 2008). Money & Banking 4/21/2017

Key Events in the Economic Crisis Early Warning Signs Early 2007: Several large subprime mortgage lenders started to report losses, e.g. HSBC on 8th February 2007. New Century Financial (one of the largest subprime lenders in the US) files for Chapter 11 bankruptcy on April 2nd 2007, signaling to other lenders that something is wrong in the US subprime industry. Money & Banking 4/21/2017

The Subprime Financial Crisis of 2007 - 2008 Crisis spreads globally Sign of the globalization of financial markets. TED spread (3 months interest rate on Eurodollar minus 3 months Treasury bills interest rate) increased from 40 basis points to almost 240 in August 2007. TED: Treasury Bill–to–Eurodollar 4/21/2017 Money & Banking

Treasury Bill–to–Eurodollar Rate (TED) Spread TED: Treasury Bill–to–Eurodollar Source: www.federalreserve.gov/releases/h15/data.htm 4/21/2017 Money & Banking 28

Key Events in the Economic Crisis Early Warning Signs Mid (July/August) 2007, credit spreads (spread between risky and risk-free bonds) begin to widen. Federal Reserve chairman, Ben Bernanke, warns of an impending crisis in the subprime lending market that could cost up to $100bn of losses (July 20th). Money & Banking 4/21/2017

Key Events in the Economic Crisis Crisis Trigger: 9th August 2007 French investment bank BNP Paribas temporarily halts redemptions from two of its hedge funds because it cannot reliably value the assets backed by US subprime mortgage debt held in those funds. There is a “complete evaporation of liquidity” in the credit markets. Money & Banking 4/21/2017

Key Events in the Economic Crisis August 9th 2007 When an investment bank like BNP Paribas took such a step, others worldwide began to question the value of collateral they had been accepting in their lending operations, and consequently started to worry about the value of the assets on their balance sheets. Uncertainty about portfolios containing subprime mortgage backed securities spreads. Banks come reluctant to lend to each other not knowing how much bad loans could be in their borrower’s books. Interbank lending literally came to a halt overnight as the credit market started to freeze. This led to severe liquidity constraints on many financial institutions. Sources: Cecchetti (2009), BBC , CNN, Newsweek, Bloomberg Money & Banking 4/21/2017

Global Event… Subprime Crisis Spreads The impact of the subprime mortgage crisis has repercussions beyond the United States. Losses are felt by investment banks even in Australia. Money & Banking 4/21/2017

Bond Spreads Mature Credit Markets Emerging Markets Money & Banking Sources: Bloomberg Financial Markets, Bank of Japan, European Central Bank, Federal Reserve Board of Governors, and the IMF’s World Economic Outlook Money & Banking 4/21/2017 Note: These lecture notes are incomplete without having attended lectures

Key Events in the Economic Crisis August 9th 2007 Contraction in short-term funds causes overnight interest rates to shoot up, e.g. the 3 month London Interbank Offered Rate (LIBOR). ECB pumps approx €95 billion worth of overnight repos (largest short-term liquidity injection in its 9 year history). Over the next few days, they add a further €108.7 billion. In addition, the US Federal Reserve, the Bank of Canada and the Bank of Japan begin to intervene in the markets. August 17th: In a surprise move, the Fed cuts the primary lending (discount) rate by 50 basis points from 6.25% to 5.75% and warns that the credit crunch could be a risk to growth. ECB: Europe central banking Money & Banking Sources: Cecchetti (2009), BBC , CNN, Newsweek, Bloomberg 4/21/2017

Key Events in the Economic Crisis Banks worry about runs on the bank 13th September 2007: In the UK, savers start to withdraw their savings from the Northern Rock Building Society after news emerges that it received emergency financial support from the Bank of England. A bank run ensues. Northern Rock ends up being nationalized later (on 17th February 2008). Money & Banking 4/21/2017

Key Events in the Economic Crisis Central Bank Interventions in Financial Markets December 13th 2007: US Federal Reserve , ECB, Bank of England, Bank of Canada and Central bank of Switzerland co-ordinate efforts in an unprecedented action to offer billions of dollars in loans to banks. They attempt to bolster the money markets by making funds available for banks to borrow on more favorable terms, whilst cutting interest rates. ECB: Eurobin central bank. 4/21/2017 Money & Banking

Key Events in the Economic Crisis Banks in Turmoil Despite the short term injections of liquidity, credit crunch continues as banks remain cautious about lending to each other. March 13th 2008: Wall Street’s fifth largest bank, Bear Stearns is acquired by larger rival JP Morgan Chase for $240 million, in a deal brokered by the Fed. Bear Stearns had been worth $18 Billion a year earlier. Money & Banking 4/21/2017

Treasury Bill–to–Eurodollar Rate (TED) Spread Source: www.federalreserve.gov/releases/h15/data.htm Money & Banking 4/21/2017 38

Key Events in the Economic Crisis April 8th 2008: The International Monetary Fund (IMF) warns that the potential losses resulting from the credit crunch could exceed $1 trillion. April – July 2008: House prices continue to slow. More news of foreclosures. Deterioration continues in values of asset backed securities. July 14th 2008: US Treasury steps in to assist the two largest mortgage companies in the US:- Freddie Mac and Fannie Mae. As owners or guarantors of $5 trillion worth of home loans, they play a crucial role in the US housing market, and steps are taken to ensure they do not fail. September 5th, 2008: US labor market figure show unemployment rate rising to 6.1%; Unemployment numbers are also starting to climb in the G7 countries. Sources: Cecchetti (2009), BBC , CNN, Newsweek, Bloomberg Money & Banking 4/21/2017

Key Events in the Economic Crisis September 7th 2008: US Government take Fannie Mae and Freddie Mac into temporary public ownership after they reveal huge losses on the US subprime mortgage market. It is one of the largest bailouts to date in US history. If they had failed, it might have triggered a run on the dollar, since many foreign governments had bought their bonds believing they were guaranteed by the government. September 10th 2008: Wall Street Bank Lehman Brothers post a loss of $3.9 billion for the three months to August. Sources: Cecchetti (2009), BBC , CNN, Newsweek, Bloomberg Money & Banking 4/21/2017

Key Events in the Economic Crisis September 15th 2008: Investment Banks in Turmoil The US’ fourth largest investment bank, Lehman Brothers, files for Chapter 11 bankruptcy protection after the US government refuses to bail it out. It becomes the first major bank to collapse since the start of the credit crisis. Merrill Lynch agrees to be taken over by Bank of America for $50bn. Share prices plummet across the world markets. Money & Banking 4/21/2017

Key Events in the Economic Crisis September 16th 2008: US Federal Reserve announces an $85bn rescue package for AIG, the country’s biggest insurance company to save it from bankruptcy. AIG had issued approximately $440bn worth of Credit Default Swaps (kind of like insurance for debt instruments) for mortgage backed securities to investment banks, insurance companies and other lenders; it defaulted on approximately $14bn worth of CDs. AIG who had trillions of dollars in assets, policy holders in more than 100 countries and insures bank loans, deals and investments around the world was not to fail. Its failure would have had more far reaching consequences than say the failure of Lehman Brothers. Government gets 80% stake in AIG. AIG: American international Group. CDs: Credit Defaults. Sources: Cecchetti (2009), BBC , CNN, Newsweek, Bloomberg 4/21/2017 Money & Banking

Key Events in the Economic Crisis September 17th 2008: Lloyds takes over HBOS in the UK Lloyds agrees to a £12.2bn takeover of Halifax Bank of Scotland (HBOS), the UK’s largest mortgage lender after its shares drop over concerns about the firm’s future. The UK government invokes a “national interest” clause to bypass competition law since the bank is now responsible for approximately one third of the UK’s savings and mortgage market. Money & Banking 4/21/2017

Key Events in the Economic Crisis September 28th 2008: Credit crunch hits Europe’s banking sector as the European bank and insurance giant, Fortis, is partly nationalized. The ECB, as well as the governments of the Netherlands, Belgium and Luxembourg, stepped in after a bidder for the whole of the Fortis group could not be found. Plans announced for $700 billion package to buy mortgage backed securities (to be approved by Congress). September 29th 2008: US House of representatives reject $700 billion rescue plan for US Financial system; stock market plummet further. Sources: Cecchetti (2009), BBC , CNN, Newsweek, Bloomberg Money & Banking 4/21/2017

Key Events in the Economic Crisis October 3rd 2008: US Congress approves bailout US House of representatives pass a revised version of the $700bn funds for Troubled Asset Relief Program (TARP). The bill includes a provision for the FDIC to raise deposit insurance limits from $100 000 per account to $250 000 per account. FDIC: Fed Deposit Insurance Corporation. 4/21/2017 Money & Banking

Key Events in the Economic Crisis Early October 2008: Banks in Trouble Irish government says it will guarantee all deposits in the country’s main bank for two years. Germany announces a 50bn euro plan to save one of the country’s biggest banks – Hypo Real Estate. Iceland announces part of a plan to shore up its troubled banking sector and takes control over Landsbanki, the country’s second largest bank. The UK government announces details of a rescue package for the banking system worth at least £50bn and also offers £200bn in short term lending support. Money & Banking 4/21/2017

Key Events in the Economic Crisis October 13th 2008: UK government rescues RBS and Lloyds-HBOS The UK government steps in to rescue two of the UK’s major banks – the Royal Bank of Scotland (RBS), who had merged with ABN-AMRO, and Lloyds-TSB who just took over HBOS in September. The UK government injects £37bn in order to stabilize both banks and nationalizes them, with a 60% stake in RBS and 40% stake in Lloyds-HBOS. Money & Banking 4/21/2017

Key Events in the Economic Crisis October 14th, 2008: US Government unveils $250bn plan to purchase stakes in a wide variety of banks in order to restore confidence in the banking sector. October 24th 2008: The UK appears to be on the brink of a recession based on figures released by the Office of National Statistics. The economy shrank for the first time in 16 years between July and September as economic growth falls by 0.5%. Early November: The Fed, Bank of England, ECB and other central banks slash interest rates. China sets out a two-year $586bn economic stimulus package to help boost its economy. Sources: Cecchetti (2009), BBC, CNN, Newsweek, Bloomberg Money & Banking 4/21/2017

Key Events in the Economic Crisis November 12th, 2008: US Treasury Secretary Henry Paulson says that the government will not use all the TARP funds to buy back troubled assets; instead the money will be used to help improve the flow of credit for the US consumer. November 14th: Eurozone officially slips into a recession after EU figures show that the economy shrank by 0.2% in the third quarter. Late November 2008: US Federal Reserve announces that it will inject another $800bn into the economy. Approx $600bn will be used to buy mortgage backed securities; $200bn will be used to unfreeze consumer credit market. The European Commission unveils an economic recovery plan worth 200bn Euros aimed to stimulate spending and boost consumer confidence. TARP: Troubled Asset Relief Program . 4/21/2017 Money & Banking

Key Events in the Economic Crisis December 2008: December 1st, 2008: The US is recession is officially declared by the NBER. The NBER business cycle dating committee concludes that the US economy started to contract in December 2007. December 4th 2008: French president Nicolas Sarkozy announces a 26bn euro stimulus plan to help France. Late December: Central Banks around the world slash interest rates. The US Federal reserve lowers the fed funds rate to a range of 0 – 0.25%, the lowest in recorded history. The Bank of England follows suit in early February of 2009, to a record low of 1%. NBER: National Bank Economic Relief . 4/21/2017 Money & Banking

Key Events in the Economic Crisis February 14th 2009: US Congress passes $787bn Stimulus Package Congress approves a huge economic recovery package aimed at preventing the US falling into a recession. February 17th 2009: US President Barack Obama signs $787bn economic stimulus package into law. Money & Banking 4/21/2017

Key Events in the Economic Crisis March 14th 2009: G20 finance ministers meet in London Finance ministers from the G20 group pledge to make a “sustained effort” to pull the world economy out of a recession. April 2nd 2009: G20 leaders meet in London Leaders of the worlds largest economies reach an agreement at the summit to tackle the global financial crisis, with measures worth $1.1 trillion. FTSE 100 index 4/21/2017 Money & Banking

Policy Measures Used To Tackle Financial Crisis?. Three Parts: Part I: Origins of The 2007 – 2008 subprime Financial crisis. Part II: Economic Policies used to tackle the global recession. Part III: Post Crisis and Future Outlook. We will return to Parts II and III once we cover monetary policy and central banking in a later lecture. Money & Banking 4/21/2017

Part II: Financial crises in emerging market economies Money & Banking 4/21/2017

Dynamics of Financial Crises in Emerging Market Economies Stage one: Initiation of Financial Crisis Path one: mismanagement of financial liberalization/globalization: Weak supervision and lack of expertise leads to a lending boom. Domestic banks borrow from foreign banks. Fixed exchange rates give a sense of lower risk. Banks play a more important role in emerging market economies, since securities markets are not well developed yet. Money & Banking 4/21/2017

Dynamics of Financial Crises in Emerging Market Economies Path two: severe fiscal imbalances: Governments in need of funds sometimes force banks to buy government debt. When government debt loses value, banks lose and their net worth decreases. Additional factors: Increase in interest rates (from abroad). Asset price decrease. Uncertainty linked to unstable political systems. Money & Banking 4/21/2017

Dynamics of Financial Crises in Emerging Market Economies Stage two: currency crisis Deterioration of bank balance sheets triggers currency crises: Government cannot raise interest rates (doing so forces banks into insolvency)… … and speculators expect a devaluation. How severe fiscal imbalances triggers currency crises: Foreign and domestic investors sell the domestic currency. Money & Banking 4/21/2017

Dynamics of Financial Crises in Emerging Market Economies Stage three: Full-Fledged Financial Crisis: The debt burden in terms of domestic currency increases (net worth decreases). Increase in expected and actual inflation reduces firms’ cash flow. Banks are more likely to fail: Individuals are less able to pay off their debts (value of assets fall). Debt denominated in foreign currency increases (value of liabilities increase). Money & Banking 4/21/2017

Financial Crises: Mexico 1994-1995 Financial liberalization in the early 1990s: Lending boom, coupled with weak supervision and lack of expertise. Banks accumulated losses and their net worth declined. Rise in interest rates abroad. Uncertainty increased (political instability). Domestic currency devaluated on December 20, 1994. Rise in actual and expected inflation. Money & Banking 4/21/2017

Financial Crises: East Asia 1997-1998 Financial liberalization in the early 1990s: Lending boom, coupled with weak supervision and lack of expertise. Banks accumulated losses and their net worth declined. Uncertainty increased (stock market declines and failure of prominent firms). Domestic currencies devaluated by 1997. Rise in actual and expected inflation. Money & Banking 4/21/2017

Financial Crises: Argentina 2001-2002 Government coerced banks to absorb large amounts of debt due to fiscal imbalances. Rise in interest rates abroad. Uncertainty increased (ongoing recession). Domestic currency devaluated on January 6, 2002 Rise in actual and expected inflation. Money & Banking 4/21/2017

FIGURE 3 Sequence of Events in Emerging Market Financial Crises Adverse selection and moral hazard problems worsen. Foreign exchange crisis. Economic activity declines. 4/21/2017 Money & Banking