Credit Conditions

Overview International Credit conditions fuelled the bubble in some countries –But not all Deteriorating International Conditions have made the burst bubble even worse in Ireland, Baltic's etc Two Questions –How was Ireland affected? –Where did international Credit boom and subsequent Crunch come from?

Ireland Huge capital inflows to Ireland –Cap a/c surplus reflects insufficient savings –Banks foreign borrowing On the way up this financed the boom On the way down –Finance difficult to secure –But banks have debt to roll-over –Loan-Deposit ratio>300% reflects insufficient savings

National Savings Two identities –Y=C+I+G+NX –Y=C+S+T This imply –S+(T-G)+NX=I So insufficient domestic savings were supplemented by capital inflows Boom financed by cap inflows via banks Cutting off cap inflows causes problems Not inevitable

International Credit Boom US based phenomenon US ran large current account deficit financed by capital inflows –Circular flow of money –Volume of world credit is larger –Affects the whole world See data for UK Flows into US fuelled US bubble

UK Banks Lending to Non-Financial Corporations Very Stable Growth

Why Invest in US? Cap flows have to go somewhere –Far east –Oil exporters Seek higher returns and safety in U.S. Treasury US interest rates low due to heavy international demand for US assets –fed funds rate at 1% from July 03 to July 04 –steadily increased to 5.25 in Jan 07 and kept till July 07 –U.S. financial institutions stepping-in with high-yielding complex structures securities (i.e. US institutions create new instruments –CDOs –High risk

Banking Look at banks in detail later Banking suffers from an inherent liquidity problem –Banks assets and liabilities are of different maturities –Banks are required to keep reserves –If bank runs out of cash can borrow from CB If have lots of bad loans could be insolvent

Consequences of US Credit Boom Vast increase in credit (Quantity) See diagram US household Debt-to-Income Ratio Rose As Much In The Past 7 Years As It Did In The Previous 39 Years Liquidity issue –Mismatch of maturity See Brunnermeier JEP

Solvency issue Also Decline in quality of credit as all this money seeks a home –Subprime lending –40% of new mortgages in 2006 sub-prime (9% in 2001) “loose” lending criteria –NINJA More risk –Not necessarily a bad thing if priced correctly But wasn’t for two reasons –Housing market bubble –Financial innovation: CDO, SIV

Housing market bubble Already seen evidence of this Vulnerable to systematic shocks –NINJA loans in partciular –Seems stupid. Why do it? –Never a nationwide slowdown –Adverse selection Shiller’s story Incorrect evaluation of risk

Financial Innovation Competition to provide higher return Idea: loans not kept by the bank that initiated them but are re-sold to other investors –Value of €45tr in July 07 –Adverse selection: incentives for re-selling banks –Dodge rules: “off balance sheet” –Shorter maturity –Difficult to value: rating agencies Implications –Lack of transparency nobody knows who has what bad debts –Incorrect evaluation of risk: rating agencies –Low quality debt Result: Even more reluctant to lend –Worse liquidity crisis

What Triggered the Crisis? System vulnerable Default risk increasing in recent years –See diagram Housing bubble bursts in August –several banks shut down there in house hedge fund dues to losses on US sub-prime –Summer: Northern Rock goes bust due to liquidity because it looks like US Sub-prime

2008: –Jan: Bank of America buys mortgage lender Countrywide Financial –March: JP Morgan Chase buys brokerage firm Bear Stearns for $2/share –July: IndyMac is seized by the FDIC Sept 2008: –Fannie Mae and Freddie Mac are nationalized –Merrill Lynch agrees to be taken over by Bank of America. –AIG is rescued by US Gov –Investment bank Lehman Brothers files for Chapter 11 bankruptcy protection –Paulson Plan

Uncertainty Now that bubble is burst we know there are lots of bad debts: solvency issue Mismatch of assets and liabilities causes liquidity problems Key issue is uncertainty –We don’t know where the bad debts are –CDOs etc “off balance sheet” –hide extent of losses & who has them Bear Sterns bailed out Lehman’s not Don’t lend: counter-party risk Solution is to increase transparency Relevance for Ireland