1. Understanding the crisis
Francesco Giavazzi
Università Bocconi
Triennio Cles
October 13, 2008

2. U.S. : relative house prices since 1880
Source: S&P, Case-Shiller Index

3. U.S. nominal house prices

4. U.S. foreclosures: actual and predicted

5. How large is the shock? October 1987 Today, Fall 2008
S&P 500: % (in a single month)
Today, Fall 2008
an additional 10% fall in home prices would imply total residential mortgage credit losses $636 billion equivalente to an S&P 500 fall of about 4%

6. Leverage
Leverage = Assets/Equity
Assets
Liabilities
Equity
Debt

7. Why so much amplification?

8. Leverage of some financial institutions U.S. 2008
Commercial Banks 9.8
Credit Unions 8.7
Finance Companies
Brokers and Hedge funds
Fannie and Freddie

9. Increase bank capital to
Two problems
Increase bank capital to
absorb losses and
allow de-leveraging
minimizing asset sales
Reactivate the interbank market

10. Three-month LIBOR minus geometric average of expected daily policy rates

11. Banks’ leverage and the amplification of asset price changes
assets
liabilities
securities
100
equity 10
debt 90
leverage = assets = 100/10 = equity

12. Banks’ leverage and the amplification of asset price changes
assets
liabilities
securities
101
equity 11
debt 90
leverage = assets = 101/11 = 9, equity

13. Banks’ leverage and the amplification of asset price changes
assets
liabilities
securities
110
equity 11
debt 99
leverage = assets = 110/11 = equity

14. Banks’ leverage and the amplification of asset price changes
assets
liabilities
securities
109
equity 10
debt 99
leverage = assets = 99/9 = 10, equity

15. Banks’ leverage and the amplification of asset price changes
assets
liabilities
securities
100
equity 10
debt 90
leverage = assets = 100/10 = equity

17. Leverage and the slope of asset demands
targetting leverage implies an upward sloping demand for assets:
when asset prices ↑
demand for assets ↑

18. Leverage and the slope of asset demands
Banks increase leverage
Balance sheets strengthen: E
Balance sheets expand: A
Asset prices rise

19. Reducing leverage assets liabilities securities 109 equity 10 debt 99
Selling assets
Raising equity
assets
liabilities
securities
100
equity 10
debt 90
assets
liabilities
securities
109
equity
10,9
debt 99
leverage = 10

20. Reducing leverage assets liabilities securities 109 equity 10 debt 99
Swapping assets with the Fed (no haircut)
assets
liabilities
securities
110
equity 11
debt 99
leverage = 10

21. Losses and recapitalization so far

22. Is leverage kept constant as asset prices change?

23. Source: Tobian Adrian and Hyun S. Shin, 2007

24. Balance sheet size and leverage: non-financial corporations
Source: Tobian Adrian and Hyun S. Shin, 2007

25. Source: Tobian Adrian and Hyun S. Shin, 2007

26. Source: Tobian Adrian and Hyun S. Shin, 2007

27. Is why is banks’ leverage pro-cyclical?
Var (value at risk)
Prob (A < A 0 ─ Var) < 1 ─ c
Var is the equity capital the bank must have to stay solvent with prob c
Source: Tobian Adrian and Hyun S. Shin, 2007

28. Is why is banks’ leverage pro-cyclical?
K = λ * Var
K is the capital the banks holds to meet its Value at Risk
for λ = 1 the bank uses up all its K to face a loss of amount Var
thus in general λ > 1
Source: Tobian Adrian and Hyun S. Shin, 2007

29. Pro-cyclical leverage
L = (A / K) = (1 / λ) * (A / Var)
as Var ↓ L ↑
Source: Tobian Adrian and Hyun S. Shin, 2007

30. Leverage: commercial and investment banks
Source: Jan Hatzius, Goldman Sachs, BPEA, September, 2008

31. Losses, deleveraging and lending contraction
Relation between leverage after (A*/E*) and before (A/E) adjustment to reflect losses
(A*/E*) = μ (A/E)
(A*/A) = μ (E*/E) = μ [1 – (L(1-k) / E)]
where
L: losses
K: percent of recapitalization

32. Plans to cut leverage: 6 large banks
Source: Jan Hatzius, Goldman Sachs, BPEA, September, 2008

33. New capital raised so far
6 large banks
New capital raised so far
$83 billion (Citi $41 billion)
Current Tier 1 capital ratio
(ratio of sharholders’ equity to risk-weighetd assets)
8,5% – 11, 5% (Citi 8,6%)
Excess capital in normal times
+ $14 billion
Excess capital under current plans to shrink balance sheets
- $460 billion
Source: Jan Hatzius, Goldman Sachs, BPEA, September, 2008

34. Estimated effect of bank lending in the US
Normal trend growth of lending
5% per year (like nominal GDP)
= $500 billion per year
Estimated cut in lending (all banks)
$ 2 trillion over 2 years
Reduction in annual lending
$500 billion per year
Estimated effect on US growth
- 2% per year for 2 years
Source: Jan Hatzius, Goldman Sachs, BPEA, September, 2008

35. Increase bank capital to
Two problems
Increase bank capital to
absorb losses and
allow de-leveraging
minimizing asset sales
Reactivate the interbank market

36. U.S. three-month LIBOR minus geometric average of expected daily policy rates

37. Three-month LIBOR minus geometric average of expected daily policy rates