1. Making Sense of the Global Financial Crisis Christopher Ragan Department of Economics McGill University and Clifford Clark Visiting Economist Department of Finance October 20, 2009 Christopher Ragan Department of Economics McGill University and Clifford Clark Visiting Economist Department of Finance October 20, 2009

2. 2 Global savings glut Regulatory arbitrage Highly leveraged banks Collateralized Debt Obligations (CDOs) Sub-prime mortgages Securitization Shadow banking system Global search for yield Expansionary monetary policy AIG Credit crunch Mortgage-backed securities Bear Stearns Systemic stability Lehman Brothers Fannie Mae & Freddie Mac Originate to distribute Toxic assets Counterparty risk U.S. housing collapse

3. 3 1. Crucial micro elements 2. Key macro pressures 3. Fatal interactions 4. Policy responses 5. Myths and lessons Outline of Talk

4. Part 1 Crucial Micro Elements 1. Home mortgages 101 2. The evolution of mortgage lending 3. Securitization 4. Regulatory arbitrage

5. 5 Home mortgages 101 1. Bank accepts deposits 2. Lends money to home purchaser 3. Downpayments and collateral 4. Bank holds the mortgage asset

6. 6 Specialization in mortgage lending: “originate to own” “originate to distribute”

7. 7 What to do with all these mortgages? 1.Assemble a large portfolio of risky assets and “manage” it. OR 2. Assemble a large portfolio and then create lower-risk securities, each backed by the small piece of the large portfolio  “securitization”

8. 8 Securitization of residential mortgages: ABCDEFGHIJ KLMNOPQRST UVWXYZ1234 567891011121314 Diversified pool of residential mortgages -- reduces risk Each individual mortgage is a risky asset – individual and aggregate risks Each mortgage-backed security is just a small piece of the overall diversified mortgage pool. MBS

9. 9 Commercial bank or other mortgage lender lends money to individuals and thereby creates a mortgage asset. Financial institution assembles pools of mortgages and creates mortgage-backed securities (CDOs). Cash Mortgage (asset) Individual and institutional investors CDOs Cash This process keeps the cash flowing -- used to purchase more mortgage assets

10. 10 Securitization of residential mortgages mushroomed over the past decade U.S. GSE versus Private-Label MBS Issuance In billions of US dollars Source: International Monetary Fund, Global Financial Stability Report, October 2009.

11. 11 Capital ratios, leverage, and the “shadow banking system” 1. The power of leverage 2. Different rules for commercial banks versus investment banks 3. 1 + 2  “Regulatory arbitrage”

12. 12 Growing securitization led to increased bank leverage … assets as a multiple of capital Note: Based on data for the big six Canadian banks, seven major banks from the Euro area, six major UK banks and five large U.S. commercial banks. Canadian data are based on the regulatory ratio of assets (including some off-balance sheet items) to adjusted Tier 1 and Tier 2 capital. Leverage for other countries is measured as the ratio of balance sheet assets to shareholders' equity. Last data point is 2008Q2. Sources: Bloomberg; financial statements. Bank Leverage Ratios

13. 13 … especially in the U.S. investment banks. assets as a multiple of capital Sources: Bloomberg; financial statements. Leverage Ratios

14. Part 2 Key Macro Pressures 1. Expansionary monetary policy 2. The global savings glut 3. The global “search for yield”

15. 15 After 2000, central banks loosened their monetary policies significantly … Policy Interest Rates per cent Sources: Bank of Canada, U.S. Federal Reserve, European Central Bank and Bank of England.

16. 16 … which generated strong growth in business and household credit … U.S. Total Business Credit U.S. Total Household Credit Y/Y per cent change Source: U.S. Federal Reserve Board.

17. 17 … and fuelled a booming U.S. housing market. index, 2000 Q1 =100 U.S. Existing Home Prices U.S. Housing Starts Level – 3-month moving average Source: U.S. Bureau of Economic Analysis. Note: S&P/Case Shiller Home Price Index. Sources: Standard & Poor's; Fiserv; MacroMarkets LLC.

18. 18 What is the “global savings glut”? The large accumulation of foreign-exchange reserves by: 1. Large Asian economies with CA surpluses 2. Oil-exporting countries with large NOCs  What to do with all these FX reserves?

19. 19 Large current account imbalances … Current Account Balance Source: IMF’s WEO In billion USD

20. 20 … and fast-rising oil prices … Oil Prices Source: Bridge CRB. US$/bbl

21. 21 … led to huge increases in foreign- exchange reserves. Growth in Selected Official Foreign-Exchange Reserves US$ Billions Sources: IMF’s IFS data September 2009

22. 22 Many of these assets were invested in U.S. Treasuries and longer-term assets … Sources: US Treasury Share of US Treasuries held by Foreigners per cent

23. 23 … which reduced longer-term interest rates … G10 10-year Government Bond Yield per cent Sources: National Central Banks and National Statistical offices, Haver. Department of Finance Canada Calculations. The 10-year government yield is the weighted average of the yield on 10-year government bonds for the US, Canada, Japan, UK, Euro area, Switzerland, Sweden, Norway, Australia and New Zealand. The real measure is the weighted average of the yield on 10-year government bonds deflated by core inflation.

24. 24... and shifted down the entire “yield curve”. US Yield Curve per cent Source: Federal Reserve Both dates represent similar phases in the monetary policy cycle.

25. 25 These two forces produced a global “search for yield” Growing global demand for U.S. mortgage-backed securities Growing demand for credit by FIs Growing demand for mortgage assets Growing provision of mortgages Rising demand for U.S. houses Rising leverage in banks Declining “quality” of mortgages

26. 26 Sub-prime share of total mortgage originations (right) Sub-prime mortgage originations (left) New U.S. Sub-prime Mortgages Billions USD Per cent Source: Inside Mortgage Finance, via Joint Center for Housing Studies of Harvard University Declining “ quality ” of mortgages?

27. 27 As the process continued, there was an overall “spreading” of risk 1.Risks spread across the world as investors bought the U.S. mortgage-backed securities 2.Risks spread to other parts of the financial sector, as financial institutions insured their portfolios

28. Part 3 Fatal Interactions 1. Falling U.S. house prices 2. Rising mortgage foreclosures 3. Financial losses and counterparty risks 4. Credit crisis  Financial crisis

29. 29 U.S. house prices first slowed and then dropped off a cliff … index, 2000 Q1 =100 U.S. Existing Home Prices Note: S&P/Case Shiller Home Price Index. Sources: Standard & Poor's; Fiserv; MacroMarkets LLC. Source: U.S. Bureau of Census 31% U.S. Housing Starts Level – 3-month moving average

30. 30 … which led to rising delinquencies of sub-prime mortgages … 60+ day delinquencies, in per cent of original balance Source: International Monetary Fund, Global Financial Stability Report, October 2008. U.S. Mortgage Delinquencies by Vintage Year 2007 2006 2005 2003 2004 2000 2001 2002 Months from origination

31. 31 … and eventually increased foreclosures. Sources: Mortgage Bankers Association of America Per cent U.S. Delinquency RatesU.S. Share of Loans in Foreclosure Foreclosure is a legal process that can take anywhere from 45 to 365 days The delinquency rate includes loans with payments 30, 60, and 90 days or more past due, but are not yet in foreclosure As foreclosures rise:  banks put the houses on the resale market  further depressing house prices  more people walk away from their homes  more delinquencies and foreclosures  banks put more houses on the market  and so on …

32. 32 Foreclosures and falling house prices, in turn, led to large downgrades in MBSs … In percent, as of June 30, 2009 Source: International Monetary Fund, Global Financial Stability Report, October 2009. Ratings on MBSs (which were AAA when issued 2005-07)

33. 33 … which naturally led to a decline in their market value. In U.S. dollars Prices of U.S. Mortgage-backed Securities Source: International Monetary Fund, Global Financial Stability Report, October 2008. 200620072008

34. 34 Rising “counterparty risk” led to a credit crunch … Credit Spreads Notes: These spreads are a measure of banks’ funding costs relative to a risk-free rate and are a gauge of financial market stress and banks’ financing pressures. The rate on the overnight-indexed swap (OIS) is used as a proxy for expected overnight rates. LIBOR is the London Interbank Offered Rate. CDOR is the Canadian Dealer Offered Rate. Daily data up to and including September 28, 2009. Source: Bloomberg. basis points ABCP crisis Lehman Brothers bankruptcy … and eventually a full financial crisis … Bear Stearns

35. 35 Billions, USD Mortgage-Related Write-downs and Credit Losses since 2007Q3 Since 2007Q3, financial institutions have posted over US$1600 billion in write-downs and credit losses. Sources: Bloomberg, September 28, 2009... with enormous losses for many large financial institutions …

36. 36 … and huge declines in the world’s stock markets. Source: Bloomberg. World Equity Markets % change from January 1, 2007 to March 2, 2009

37. Part 4 Policy Responses 1.Financial sector vs. the “real economy”? 2.Monetary policy 3. Actions to assist financial markets 4. Fiscal policy

38. 38 What was likely to happen? 1.Credit is like electricity to a modern economy, and banks are like the power company. 2.A decline in the flow of credit would inevitably lead to a significant global recession. 3.The financial sector is part of the real economy!

39. 39 The largest global recession in many years Sources: IMF Growth of world real GDP per cent per year Average 1980-2010: 3.2%

40. 40 Unprecedented global monetary policy response … Policy Interest Rates per cent Sources: Bank of Canada, U.S. Federal Reserve, European Central Bank and Bank of England. Daily data up to and including Sept. 30.

41. 41 … included the use of “unconventional” monetary policy tools. Central Bank Assets Index: January 2008 = 100

42. 42 Most governments also introduced measures to support financial markets. Insured Mortgage Purchase Program64 New 10-Year Canada Mortgage Bond8 Canadian Lenders Assurance FacilityN/A Canadian Life Insurers Assurance FacilityN/A Crown Corporations Flexibilities including Business Credit Availability Program 7 Canadian Secured Credit Facility12 Bank of Canada40 Total131 Canadian Support to the Financial Sector ($ billions) Source: Canada’s Economic Action Plan; A Third Report to Canadians, September 2009.

43. 43 G-20 leaders coordinated their substantial fiscal expansions … Fiscal Stimulus Flowing in 2009 and 2010, G7 countries per cent of GDP Source: IMF, Update on Fiscal Stimulus and Financial Sector Measures, April 26, 2009, p.5. IMF estimates exclude loans, including those to the auto sector, for all countries. Figure for Canada includes additional provincial-territorial stimulus actions in addition to that assumed in the Economic Action Plan as estimated by the Department of Finance.

44. 44 … and accepted the deterioration in their medium-term fiscal outlooks. Total Government Budget Deficits, 2009 Per cent of GDP Source: IMF WEO, October 2009.

45. Part 5 Lessons and Myths 1.Blame and greed? 2.“The end of laissez-faire”? 3. Regulatory reform 4. Baby and the bathwater

46. Thank you. Questions?