1. MBA35 Managerial Excellence The economic crisis (2 lectures) The firm and its environment (part 1) Francesco Giavazzi

2. Outline 1.Origins 2.Amplification: leverage cycles 3.Legacy of the crisis 4.Where are we now ? 5.The world after the crisis

3. United States: house prices since 1880 Source: S&P, Case-Shiller Index

4. U.S. house prices, per cent of households disposable income

5. “Real” house prices in eight countries

6. Defaults on sub-prime mortgages by year of mortgage approval (U.S.)

7. A relativel small shock Black Monday (October 1987) –S&P 500: - 20 % Today –U.S. house price, - 30%. –bank losses on mortgages: US$650 miliardi equivalent to a 4% fall in S&P 500

8. Derivaties and banks’ balance sheets

9. The growth of the derivatives’ market Source: Bank of England

10. Benefits of diversification The growth of credit to the economy

11. Two problems 1.Illusory diversification 2.Amplification

12. Conduits, Special investment vehicles AB commercial paper investors Bank Before the crisis CDO’s, CDS’s, etc. loans cash How did diversification happen ?

13. Had risk really been removed from banks’ balance sheets?

14. conduit Market (Cdo’s etc.) equity commitment Bank (Cdo’s etc) liquidity central bank When liquidity disapperared

15. Securitization

16. Amplification Leverage = (Assets / Capital) Capital = λ * Expected losses (Value at Risk)

17. Asset prices and leverage assetsliabilities assets100capital10 liabilities90 assetsliabilities assets101capital11 liabilities90 leverage = 9,18leverage = 10 assetsliabilities assets110capital11 liabilities99 leverage = 10

19. The leverage of non-financial companies

20. leverage and losses: firesales assetsliabilities securiti es 100capital10 debt90 assetsliabilities securities 109capital10 debt99 assetsliabilities securiti es 109capital10,9 debt99 leverage = 10,9 Sale of assets Capital increase leverage = 10

21. 21 The leverage cycle

22. Asset prices and leverage assetsliabilities securities100capital10 debt90 assetsliabilities securities101capital11 debt90 assetsliabilities securities110capital11 debt99 leverage = 9,18leverage = 10 assetsliabilities securities115capital11 debt104 leverage = 10,45

23. The leverage of investment banks

25. Leverage of U.S. financial institutions (sector averages) Commercial banks 9.8 Credit Unions 8.7 Finance Companies 10.0 Investiment banks and hedge funds 27.1 Fannie&Freddie 23.5

26. Why did leverage increase ? leverage = (assets / capital) capital = λ * Expected losses (Value at Risk) A bank’s capital is proportional to its expected losses

27. Why did leverage increase ? leverage = (assets / capital) capital = λ * Var (value at risk) –Var is the capital the bank must have to remain solvent with prob c Prob (A < A 0 ─ Var) < 1 ─ c –for λ = 1 the bank uses all its capital to face a loss equal to Var –in general λ > 1

28. Why did leverage increase ? leverage = (assets /capital) = (1 / λ) * (assets / Var) For a given λ when Var ↓ leverage ↑

29. How did banks use the liquidity freed by diversification through derivatives?