2008+ GLOBAL CRISIS

Hasan Ersel

HSE

May 25, 2011

MARKET SYSTEM IS NOT MANNA FROM HEAVEN

• Market system is a human product. If it is well designed it works well, otherwise it doesn’t...

• Markets don’t operate in a vacuum. Their performance depends on the environment in which they are operating.

• Environment consists of regulations, ethics, traditions, institutions, information dissemination, incentives etc.

• Bad incentives and bad information generate bad behavior [Jean Tirole]

PRE-CRISIS DEVELOPMENTS

• Low interest rates and housing boom (Notably in the USA and UK) [Pure Economic Policy Decision]

• A dangerously rising debt to equity ratios in various financial institutions (Regulatory forebearence: refraining from doing something that one has a legal right to do. A delay in enforcing a legal right.)

• The rise in homeownership in the USA• The US government agencies’ policies that discriminate

in favor of housing for the poor • Financial Innovations (MBS, CDO, CDS)

PRE CRISIS MONETARY POLICY IN THE USA: THE GREENSPAN PUT

• The term "Put" refers to a “put option”, in which the buyer of the put acquires the right to sell an asset at a particular price to a counterparty; as such it is exercised if prices decline beneath this level.

• During this period (1987 to 2000s), when a crisis arose, the Fed would lower the Fed Funds rate, often resulting in a negative real yield. In essence, the Fed pumped liquidity back into the market to avert further deterioration.

• The Fed did so after the 1987 stock market crash, the Gulf War, the Mexican, the Asian, the Long Term Capital Management crises, Y2K, the burst of the international bubble, the 9/11 and repeatedly from the early stages of the Global Financial Crisis to the present.

FINANCIAL INNOVATIONS

• MBS: Mortgage Backed Securities is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization.

• CDO: Collateralized Debt Obligation is a structured asset-backed security (ABS) whose value and payments are derived from a portfolio of fixed income underlying assets)

• CDS: Credit Default Swap is a form of insurance that protects a lender if a borrower of capital defaults on a loan. When a lender purchases a CDS from an insurance company, the liability of the loan becomes a credit that may be swapped for cash upon the loan defaulting.)

WERE THERE WARNINGS?

Yes... Many! For example:

• Raghuram Rajan (University of Chicago)• Nouriel Roubini (New York University)• Robert Shiller (Yale University)• Joseph E. Stiglitz (Columbia University)

• What happened? They were omitted...

THE CHRONOLOGY OF THE CRISIS-2007(1)

• US home sales fell,• US home prices year-on-year declined for the first time

since 1991,• Subprime Mortgage Business Collapses,• Foreclosures double versus 2006 Foreclosure is the legal process by which a mortgagee,

usually a lender, obtains a termination of a mortgagor’s equitable right of redemption (Redemption value is the price at which the issuing company may choose to repurchase a security before its maturity date)

• Interest rate increases.

THE CHRONOLOGY OF THE CRISIS-2007(2)

• April 2: New Century Financial, largest US subprime lender, files for bankruptcy (subprime lending means making loans to people who may have difficulty maintaining the repayment schedule.)

• June 7: Bear Sterns announces halting redemptions for two of its funds

• August 9: European bank BNP Paribas follows• August 9: ECB injects € 95,5 billion overnight!• September 14: Bank of England injects liquidity to

support Northern Rock• November 20: Freddie Mac announces third quarter loss• November 1: FED injects US$ 41 billion

THE CHRONOLOGY OF THE CRISIS-2008(1)

• January 15: Citigroup announced that it is to rise US$ 14,5 billion in new capital

• February 11: American International Group (AIG) announces that its auditors have found material weakness in its internal controls over the valuation of a portfolio of credit default swaps.

• February 17: UK government announced temporary nationalization of Northern Rock.

• March 16: J.P. Morgan Chase agreed to purchase Bear Stearns. FED provided US$ 30 billion funding.

• September 7: Fannie Mae and Freddie Mac taken into conservatorship.

THE CHRONOLOGY OF THE CRISIS-2008(2)

• September 15: Lehman Brothers files for bankruptcy (The crisis becomes global)

• September 16: US government provides emergency loan to AIG of US$ 85 billion and takes 79,9% stake and the right to veto on dividend payments.

• September 18: Financial Services Authority of the UK announced temporary prohibition of short-selling of financial shares.

• September 19: SEC followed...• September 20: US Treasury announced its plan to

purchase up to US$ 700 billion of troubled assets [Troubled Asset Relief Program (TARP)]

THE CHRONOLOGY OF THE CRISIS-2008(3)

• September 29: Iceland Government buys stake in Glitnir Bank as part of rescue

• September 29: Belgian, Dutch and Luxemburg governments to invest € 11,2 billion in Fortis Bank.

• October 3: Dutch government acquired Fortis Bank’s Netherlands business.

• October 6-10: Worst week for the stock market for 75 years. DJ-Industrial Average losses 22,1%

• October 6: German government announced package to save Hypo Real Estate

• October 6: BNP Paribas announce takeover of Fortis’ operations in Belgium and Luxemburg as well as the international banking division of Fortis.

THE CHRONOLOGY OF THE CRISIS-2008(4)

• October 6: FED announced that it will provide US$ 900 billion in short term loans to banks.

• October 7: FED made emergency move to lend US$ 1,3 trillion to companies outside the financial sector.

• October 11: DJ Industrial Average recorded its highest volatility day ever in its 112 year history

• October 14: US government announced Capital Purchase Plan (CPP) up to US$ 250 billion to take stakes in US banks.

• October 19: Dutch government injects € 10 billion into ING

THE CHRONOLOGY OF THE CRISIS-2008(5)

• October 21: FED announced that it will spend US$ 540 billion to purchase short term debt from money market mutual funds with the intention of unfreezing credit markets

• November 12: US Treasury Secretary Hank Paulson abandons plan to buy toxic asset under US$ 700 billion TARP. The remaining US$ 410 billion will be spent in capitalizing financial companies.

• November 23: Citigroup to issue preferred shares to the US Treasury and FDIC in exchange for protection against its unusually large losses.

• November 24: UK government announces temporary cut in VAT from 17,5 % to 15%.

THE CHRONOLOGY OF THE CRISIS-2008(6)

• November 25: FED pledges US$ 800 billion more to help the financial system (US$ 600 billion will be used to buy mortgage bonds issued or guaranteed by Fannie Mae, Freddie Mac and Federal Home Loan Banks) The US Treasury will invest an additional US$ 20 billion in Citigroup from TARP, taking its input to US$ 45 billion.

• November 26: FED approved the notice by Bank of America to acquire Merrill Lynch.

• December 4: Bank of England reduces bank rate to 2%.• December 16: FED establishes target range for the

federal funds rate of 0% to 0,25%.

THE CHRONOLOGY OF THE CRISIS-2009(1)

• January 19: UK government announced the Asset Protection Scheme to protect financial institutions against exposure to exceptional future credit losses on certain portfolios of assets.

• January 19: FSA issues statement indicating that banks are expected to maintain a minimum core Tier 1 capital ratio of 4% and expressing preference to incorporate countercyclical measures(!)

• March 5: Bank of England reduced bank rate to 0,5% and announced GB£ 75 billion asset purchase program

• March 18: FED Announced an expansion of over US$ 1 trillion in its planned asset purchases this year.

THE CHRONOLOGY OF THE CRISIS-2009(2)

• April 9: German government begins the process to take over Hypo Real Estate.

• May 7: FED releases the results of the stress test of 19 largest US bank holding companies. It finds that losses at the firms in 2009 and 2010 could be US$ 600 billion and ten firms would need to add, US$ 185 billion to their capital to maintain adequate buffers if the economy were to record the more adverse scenario considered.

• May 7: ECB Lowers its interest rate to 1%• And it still continues...

AN EXTERNAL FINANCIAL SHOCK

• An external financial shock not only affects the financial sector of a country but can easily spread other sectors. (Linkage)

• Therefore an external financial shock affects both domestic financial sector and the real sector. The effect on real sector can be both direct (external financing) and indirect (through domestic financial system)

• The total effect on the real side of the economy, therefore, may be much stronger and more widespread than is observed from financial sector accounts.

FINANCIAL SECTOR RESPONSE TO EXTERNAL SHOCKS

• It is well known that, financial sector has the tendency and capability to amplify the business cycles.

• This problem was first posed by Irvin Fisher in 1933. Later, Bernanke & Gertler (1989) discussed the problem and offered an explanation known as “financial accelerator theory”.

• More generally “pro-cyclicality” of the financial sector became a major concern and research area, especially after a series of crises in 1990s that hit both developed and developing countries.

FINANCIAL ACCELERATOR AND THE CREDIT CHANNEL

• A weak banking system grappling with nonperforming loans and insufficient capital or firms whose creditworthiness has eroded because of high leverage or declining asset values are examples of financial conditions that could undermine growth.  

• Changes in financial and credit conditions are important in the propagation of the business cycle, a mechanism that has been dubbed the "financial accelerator." 

• Changes in financial conditions may amplify the effects of monetary policy on the economy, the so-called credit channel of monetary-policy transmission. 

EXTERNAL FINANCE PREMIUM

• The effects of a real shock (such as a shock to productivity) on financial conditions could lead to persistent fluctuations in the economy, even if the initiating shock had little or no intrinsic persistence (Bernanke and Gertler, 1989)

• Moreover, the theory predicts that the external finance premium that a borrower must pay should depend inversely on the strength of the borrower's financial position, measured in terms of factors such as net worth, liquidity, and current and future expected cash flows.

HOW FINANCIAL ACCELERTAOR WORKS?

• The inverse relationship of the external finance premium and the financial condition of borrowers creates a channel through which otherwise short-lived economic shocks may have long-lasting effects. 

• An improvement in the cash flows and balance sheet positions of firms leads in turn to lower external finance premiums in subsequent periods, which extends the expansion as firms are induced to continue investing even after the initial productivity shock has dissipated. 

• This "financial accelerator" effect applies in principle to any shock that affects borrower balance sheets or cash flows.  

INFORMATIONAL CAPITAL OF BANKS

• A central function of banks is to screen and monitor borrowers, thereby overcoming information and incentive problems. 

• By developing expertise in gathering relevant information, as well as by maintaining ongoing relationships with customers, banks and similar intermediaries develop "informational capital." 

• During banking panics banks facing the risk of runs by depositors, were forced to constrain lending to keep their balance sheets as liquid as possible. Banks were thus prevented from making use of their informational capital in normal lending activities. 

• The resulting reduction in the availability of bank credit inhibited consumer spending and capital investment, worsening the contraction.

HOW DOES A FINANCIAL SHOCK AFFECTS A COUNTRY (1)

Finance Channel

i) External borrowing of the real sector (and if applicable, government’s )

ii) Bank borrowing from international financial system

HOW DOES A FINANCIAL SHOCK AFFECTS A COUNTRY (2)

Trade Channel

i) Decline in world demand for country’s exports. This may reflect as a decline in export prices and/or physical volume.

ii) Similar effects also observed for imports

HOW DOES A FINANCIAL SHOCK AFFECTS A COUNTRY (3)

Expectations Channel• Change in global environment may affect the

behavior of domestic agents, notably banks. That may lead banks to curb credits, consumers to reduce their demands and producers to revise their production plans downward.

2008 CRISIS: THREE SHOCK WAVES

1) The initial shock: The direct effects of the recession in the USA and the EU (the center) on other countries.

2) The secondary shock: The indirect effect through the economic relations of one country with other countries that also affected by the crisis at the center. (Dubai crisis)

3) The tertiary shock: The direct and indirect effects of the measures taken by other countries on the country in question.

HOW DID 2008+ CRISIS AFFECTED RUSSIA?

MAY IT BE AN EXAM QUESTION?