1. The Global Financial Crisis
Geoffrey Carliner
Palacký University
26 November 2008

2. Immediate Causes of the US Crisis
US Mortgage Lending
Home buyers borrowed too much
Banks lent foolishly
No downpayment
Interest-only loans
Teaser interest rates for 2-3 years, then +3%
No proof of income required
Securitized mortgages. Bundled, sliced up
Decline in house prices → Borrowers default → Prices decline more

3. Derivatives Leverage More trouble ahead Credit Default Swaps
Insurance policies with no reserves
On securitized mortgages, corporate and local govt bonds
Other unhedged options on interest rates, forex, stocks
Leverage
Commercial banks. 12 – 15 times
Hedge funds and investment banks. 30 times
More trouble ahead
Consumer debt. Credit cards, auto loans
Commercial real estate and corporate debt

4. Underlying Problems Global Saving Imbalance
US trade deficit < 0 and very large
China and oil exporters trade surplus > 0 and very large
Large capital inflows to US banks → lower lending standards
Behavior of Financial Sector
Short term incentives. Pay based on this year´s profit
Short term memories by CEO and Board of Directors
Herding

5. Bank Regulation and US Politics
Long term trend to less regulation, US and elsewhere
Political pressure to lend to poor home buyers
Political pressure from financial sector for weak regs
Free market ideology: markets work, governments make things worse
Greenspan
Bush administration
Behavior of Borrowers
Rational behavior if down payment is very low
Bad memories. Housing prices only go up
Exploitation. Didn´t understand mortgages or risks

6. Consequences of the Crisis
Collapse of US Financial Markets
Banks stop lending as panic spreads
Serious US Recession
Crisis Spreads to Banks in Other Countries
Iceland, Ireland banks made similar mistakes
UK, Germany banks bought toxic US debt
Innocent emerging markets caught in credit contraction. Hungary, Denmark, S Korea, Brazil
World Recession
Credit contraction spreads
Decreased demand for imports → recession in countries not hurt by credit contraction. Czechia
Underline the difference between trend and cycle

7. Short Term Solutions to the Crisis
Restart Bank Lending
Guarantee bank deposits
Increase bank capital by investing in bank shares
Order banks to resume lending
Lower Interest Rates
Prevent Exchange Rate Crises. Swaps, Loans
Especially to well behaved countries. Denmark
Even to countries with bad policies. Iceland
Does IMF have enough money? Borrow from China?
Fiscal Stimulus
Increase spending, even on infrastructure
Cut taxes for people who will spend

8. Long Term Solutions Tighter Regulation of Financial Sector
Less risk taking by banks
Larger reserves, less leverage
No OTC derivatives, prevent counterparty risk
Will regulators be tough enough as memories fade?
Should Central Banks raise interest rates to prevent asset bubbles?
Should small countries
Join the euro
Restrict short term capital inflows
Accumulate large foreign exchange reserves

9. Correct Global Saving Imbalance
Higher saving in US, but don´t encourage it now
Higher consumption in China, East Asia
Higher Chinese consumption won´t avoid worldwide recession. Too small, takes too long
Crisis may convince other countries to save more, build up foreign exchange reserves
Oil exporters need to save
Improve Corporate Governance
Incentives based on long term performance
Avoid herd behavior, don´t forget history
All Solutions Require Int‘l Coordination