1. The Financial Crisis 1

2. 2 Not just a credit crisis Key aspects:  Origin, transmission, evolution expectations, future monetary strategies

3. The Financial Crisis3 Some concepts: i. Subprime Mortgage Loans  Worse credit history  Higher interest rate payments ii. Securitization  Commercial banks, hedge funds, investment banks  Asset-backed Securities (ABS): mortgage- backed securities

4. The Financial Crisis4 Commercial Bank 1 Commercial Bank 2 Commercial Bank 3 Investment Bank 1 Hedge Fund 1 Investment Bank 2 Hedge Fund 2 Other Financial Institution 1 Other Financial Institution 2

5. The Financial Crisis5 Why they do that? Get rid of risk Obtain liquidity Collateralized Debt Obligations Risk transferred all over the world

6. The Financial Crisis6 Timing of Events 2001: Fed cuts interest rates to fight recession Low int. rates + affordable housing prices people took mortgages higher demand switched on housing market prices ( interest rates continued to fall )  June 2004: Interbank Rate = 1.25%  Housing prices threaten inflation control  Fed increases interest rates

7. The Financial Crisis7 June 2006: Interbank Rate = 5.25% Increasing house prices + increasing int. rates = nearly impossible to buy a house or face mortgage payments 2006: subprime mortgage loans over 22% of total mortgage loans Excess housing supply prices slow down Assets value falls: Mortgage liquidation ABS and MBS prices fall Liquidity in Financial Institutions (FI): banks…

8. The Financial Crisis8 Uncertainty Credit Banks don’t trust each other Crunch Summer 2007: FI with those securities suffer enormous losses and file for bankruptcy ( domino effect ): Lehman B., AIG… Who’s to be blamed? Not easy: Families indebted beyond capacity Fed: regulation Financial system: financial innovations relied on refinancing (increasing prices since Great Depression)

9. The Financial Crisis9 Under-regulation Rating Agencies statistic models to evaluate securities Incorrect estimation of ABS risk and quality Why? Super complex net of financial assets. Risk widely spread impossible to trace assets Scarcity of data: young market, no cycle experience good financial system, needs right regulation “Financial Shock” (Mark Zandi, Chief Economist, Moody’s)

10. The Financial Crisis10 How long will it last? Hard to say. Hints: Housing market adjustment supply increase > demand increase Financial markets how deep it goes, portfolio reshaping Policy What can monetary authorities do? Monetary Policy Effectiveness? Immediate reaction: provide liquidity, right answer (inflation?)

11. The Financial Crisis11 Future Strategies  Fiscal reforms  M, i, enhance economic growth  Asset Prices Bernanke and Gertler (1999,2001): monetary policy should respond to asset price movements only if they affect inflation forecasts. Prices of housing and securities rose quickly Better understanding of the relationship between the value of underlying assets, the price of ABS, and interest rates.