1. Financial Crises, Financial Frictions, and Lost Decades The Great Depression, 1929 – 1939 Emerging Market Crises 1980s Third World Debt Crisis 1994-5 Tequila Crisis 1997-8 East Asia Financial Crisis The Great Recession, 2007 –

2. Financial Friction Combating adverse selection and moral hazard Collateral Net Worth (=$Assets - $Liabilities) Net Worth – – The Foundation of Credit Screening/Monitoring : Cost of Credit Intermediation Reduced frictions via:

3. Stylized First World Financial Crises Stage One Mismanagement of financial liberalization and innovations Asset price boom & bust Spikes in interest rates Increase in uncertainty Stage two: Banking Crisis Stage three: Debt Deflation

4. Stylized Emerging Market Financial Crises Debt Deflation

5. Factors Causing Financial Crises Asset Values Drop: Net Worth Down Stock market decline  Decreases net worth of corporations. Unanticipated deflation  Debt burdens up/net worth down Unanticipated depreciation  $ debts up/net worth down Asset write-downs (bad debts)  Net worth down Deterioration in Financial Institutions’ Balance Sheets  Capital Ratios Down  Decline in lending. Interest Rates Rise Worsens adverse selection (who would pay the high rates?) Increases business needs for external funds  worsens adverse selection and moral hazard problems. Government Fiscal Imbalances Fear default of government debt  Capital flight…Currency crisis Banking Crises Loss of information production / disintermediation. Increases in Uncertainty  Decline in lending.

6. Crises (and Threatened Crises) We Have Known The L o n g Depression, 1873 – 1896 The Great Depression, 1929 – 1939 Mexican Default, 1982 Continental Illinois, 1984…Oil patch loans…TBTF Third World Debt Crisis, 1980s  Lost Decade Savings & Loan Debacle, 1986 – 1990 Black Monday, October 19, 1987 Tequila Crisis, 1994 – 1995 East Asia Financial Crisis, 1997 - 1998 Long Term Capital Management, 1998 dot.com bust, 2000 911, 2001 Subprime-triggered crisis – Run on shadow banks  The Great Recession, 2007 –

7. The Great Depression: Mother of all Crises Stock Market Crash  Spending cutback Bank Panic  Monetary Contraction Bank Failures  Reduced Lending Price Deflation/Deflationary Expectations  Debt Deflation Declining Net Worth  Reduced Lending Bernanke: Credit Channel Friedman & Schwartz: Great Contraction

8. Onset of the Depression: Persistent Deflation…Persistent Job Loss $/pound DJIA Manufacturing Employment

9. Villain Gold Dysfunctional interwar gold-exchange standard Deficit/surplus country asymmetry  World M s down US and France sterilized gold inflows Deficit countries forced to contract M s Lack of central bank cooperation Britain weak/US clueless/France irresponsible Dysfunctional gold standard mindset Liquidationist mantra...deflation welcomed/oppose militant labor Defend gold reserves...even if you’ve left gold standard Real bills doctrine...if economy tanks, who needs money? Balanced budget fetish...cut spending when revenue falls

10. $/pound Producer Price Index

11. New Deal Reflation: Regime Change Secure the financial system Reconstruction Finance Corporation (RFC)—Hoover effort Glass-Steagall: separation of commercial banking and investment banking Federal deposit insurance Security and Exchange Commission Dollar devaluation Break golden fetters  Monetary expansion Great expectations...reverse expectations of deflation  Low and negative real interest rates  Spur to spending Cartelization—National Industrial Recovery Act (NIRA) Recover by limiting supply? Kill the pigs??? Great expectations...reverse expectations of deflation Public spending Hoover Dam Works Public Administration (WPA) Civilian Conservation Corp (CCC)

12. New Deal Reflation

13. Retrenchment: The Gold Standard Mindset  Recession in Depression

14. Dynamics of Financial Crises in Emerging Market Economies Stage one: Initiation of Financial Crisis. Path one: mismanagement of financial liberalization Weak supervision and lack of expertise  lending boom. Domestic banks borrow from foreign banks. Fixed exchange rates give a sense of lower risk. Securities markets not well-developed  Banks important Path two: severe fiscal imbalances: Governments force banks to buy government debt. When government debt loses value, bank net worth down. Additional factors: Increase in interest rates (from abroad) Asset price decrease Uncertainty linked to unstable political systems MsMs

15. Dynamics of Financial Crises in Emerging Market Economies Stage two: currency crisis Bank losses  currency crises: Government cannot raise interest rates (doing so forces banks into insolvency)… … and speculators expect a devaluation. Foreign and domestic investors sell the domestic currency. Stage three: Full-Fledged Financial Crisis: The debt burden in terms of domestic currency up Banks more likely to fail: –Individuals are less able to pay off their debts (value of assets fall). –Debt denominated in foreign currency increases (value of liabilities increase).

16. Financial Crises: Mexico 1994-1995...Tequila Financial liberalization in the early 1990s: –Lending boom/weak supervision/lack of expertise. –Banks accumulated losses/net worth declined. Rise in interest rates abroad. Increased uncertainty (political instability). Domestic currency devaluated Dec. 20, 1994. –Tesobono burden Rise in actual and expected inflation.

17. Financial Crises: East Asia 1997-1998 Financial liberalization in the early 1990s: –Lending boom/weak supervision/lack of expertise. –Banks accumulated losses/net worth declined. Uncertainty increased –stock market declines and failure of prominent firms Domestic currencies devaluated (1997). Rise in actual and expected inflation. Contagion: Thailand...Indonesia...Korea...Philippines...Malaysia...Singapore...Taiwan...Brazil...Russia....Long Term Capital Management

18. Financial Crises: Argentina 2001-2002 Currency board: 1 Peso = $1 Fiscal imbalance –banks coerced to absorb government debt Appreciation of $ & peso  Argentine recession Rise in interest rates abroad. Uncertainty increased (ongoing recession). Domestic currency devaluated, Jan. 6, 2002 Rise in actual and expected inflation.

19. The Subprime Triggered Financial Crisis

20. Prelude to Financial Crisis of 2007 – 2009 Simon Johnson, The Quiet Coup. The Atlantic, May 2009

21. Financial Crisis of 2007 - 2009 Financial innovations in mortgage markets: –Subprime/Alt-A mortgages/Interest Only/NINJA –Mortgage-backed securities/Collateralized debt obligations (CDOs, CDO 2 ) Housing price bubble forms –World savings glut  Increase in liquidity from cash flows surging to the US –Subprime mortgage market  housing demand and prices up. Agency problems arise –“Originate to distribute” … “Moving, not storage”  principal (investor) agent (mortgage broker) problem. –Commercial and investment banks/rating agencies …weak incentives to assess quality of securities Information problems surface…A “Minsky Moment” Housing price bubble bursts/Crisis spreads globally

23. Housing Prices and the Financial Crisis of 2007–2009 Source: Case-Shiller U.S. National Composite House Price Index; www.macromarkets.com/csi_housing/index.asp.

24. Stock Prices and the Financial Crisis of 2007–2009 Source: Dow-Jones Industrial Average (DJIA). Global Financial Data; www.globalfinancialdata.com/index_tabs.php?action=detailedinfo&id=1165. www.globalfinancialdata.com/index_tabs.php?action

25. Easy Money Policy Capital Inflows Eager Home Buyers Innovative Banks Rating Agencies Ambitious Mortgage Brokers Securitization  MBSs Escalating House Prices Gov’t Sponsored Enterprises Developer Clout Bank Regulators The best of times A “Global Saving Glut”

26. The Shadow Banking System: A Fragile Financial Infrastructure Thus a long-term corporate bond could actually be sold to three different persons. One would supply the money for the bond; one would bear the interest rate risk, and one would bear the (credit) risk of default. The last two would not have to put up any capital for the bond, though they might have to post some collateral. Fisher Black Fundamentals of Liquidity, 1970

27. Banks have public backing…and are heavily regulated Lender of last resort, the Fed Bank creditors (depositors) are insured, FDIC Shadow Banks: Lack Public Backing  Substitutes Liquidity put Underlying asset values fall Short-term funders back off Sponsor steps in per prior agreement…line of credit Credit put Buy Credit Default Swaps from private insurers Private insurers can’t possibly reserve against systemic risk The Shadow Banking System: A Fragile Financial Infrastructure

28. Denizens of the shadows Federal loan programs/GSEs Investment banks/Pension funds Finance companies Monoline insurers/Mortgage insurers Structured investment vehicles (SIVs) Conduits (SPVs – liquidity support by bank sponsor) Achieve regulatory arbitrage—get assets off balance sheet credit arbitrage conduit (conduit holds credit assets) securities arbitrage conduit (conduit holds securities) TRS/repo conduit (finances financial institutions using total return swaps and/or repos) Credit hedge funds Money market intermediaries

29. The Shadow Banking System: A Fragile Financial Infrastructure Steps in Shadow Credit Intermediation (example) Loan origination by finance company using CP Loan warehousing by conduit using ABCP Asset backed security (ABS) issued by special purpose vehicle(SPV) selling ABS backed by loans ABS warehsing by TRS/repo conduit using ABCP ABS collateralized debt obligation (CDO) issued by SPV selling ABS CDOs or CDO 2 ABS intermediation by Special Investment Vehicle (SIV) using ABCP or repo Wholesale funding of all of the above by MMMF using $1 Net Asset Value (NAV) shares

30. Easy Money Policy Capital Inflows Eager Home Buyers Innovative Banks Rating Agencies Ambitious Mortgage Brokers Securitization  MBSs Escalating House Prices Gov’t Sponsored Enterprises Developer Clout Bank Regulators The best of times

31. House Price – Foreclosure Spiral Demand – Jobs – Wages – Income – Spiral Deleveraging – Debt Deflation Spiral Government Revenue – Cutback Spiral Global Repercussion Spiral Macroeconomic Linkages and Feedbacks Vicious Spirals Unleashed

32. Financial Crisis of 2007 - 2009 (cont’d) Banks’ balance sheets deteriorate –Write downs –Sale of assets and credit restriction High-profile firms fail –Bear Stearns (March 2008) –Fannie Mae and Freddie Mac (July 2008) –Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund (MMMF) and Washington Mutual (September 2008). Fed pumps up bank reserves: TARP/TALF,etc. –Lend and lend freely Bailout package enacted –House votes down the $700 billion bailout package (9/29/08)  Stock market slumps  Bailout passes on October 3. –Congress approves a $787 billion economic stimulus plan on February 13, 2009. Recession deepens

33. Responses: No Bank Left Behind Lender of Last Resort / Spender of Last Resort Tax Rebate $124 bil. Fed Fund Rate Cuts Fannie/Freddie $200 bil. Bear-Stearns $29 bil. AIG $174 bil. Fed “Facilities” Primary Dealer Credit Facility (PDCF) $58 bil. Treasury Security Loan Facility (TSLF) $133 bil. Term Auction Facility (TAF) $416 bil. Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil. Money Market Investor Funding Facility (MMIFF) $540 bil. More Fed Fund Rate Cuts … Hold At ~0% Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil. Term Asset-Backed Securities Loan Facility (TALF) $200 bil. Emergency Economic Stabilization Act/TARP $700 bil. Government Loans Government Equity Stimulus Package $787 bil. aka The American Recovery and Reinvestment Act TARP II Stress Tests

34. Treasury Bill–to–Eurodollar Rate (TED) Spread Source: www.federalreserve.gov/releases/h15/data.htm

35. Credit Spreads and the 2007–2009 Financial Crisis Source: Federal Reserve Bank of St. Louis FRED database; http://research.stlouisfed.org/fred2/categories/22.