2009

The Financial CrisisThe Financial Crisis

Steinar HoldenØkonomisk institutt, UiO

http://folk.uio.no/sholden/ECON 4325

2009

OutlineOutline

Macroeconomic imbalances Weaknesses in financial markets

Securitization Weaknesses in regulation What happened? Historical experiences Some lessons

2009

Predicted growth in world GDP, Predicted growth in world GDP, given at different points in time given at different points in time (IMF)(IMF)

-4

-3

-2

-1

0

1

2

3

4

5

6

7

Verden Industriland Fremvoksende økonomier

-4

-3

-2

-1

0

1

2

3

4

5

6

7Anslag oktoberAnslag novemberAnslag januar 2009Anslag mars 2009

2009

Amplification mechanismsAmplification mechanisms

2009

Background - macroeconomicsBackground - macroeconomics

Macroeconomic imbalancesHigh saving in China, Japan, Germany and oil exporting countries

High borrowing in the U.S, UK, Spain, etc

Fairly high economic growth at world level, yet low inflation partly due to cheap imports from low-cost countries

Central banks set low interest rates in 2002-2005

Economic growth and low interest ratesHigh growth in asset values”Search for yield”

2009

Boligpriser

Source: EcoWin, First Securities

86 88 90 92 94 96 98 00 02 04 06 08

25

50

75

100

125

150

175

200

225

250

275

25

50

75

100

125

150

175

200

225

250

275

Norge

Sverige

1999 = 100

Danmark

UK

USA

EMU

House pricesHouse prices

2009

Background – financial markets Background – financial markets

Extensive changes in financial markets last 20-30 years

Institutional changes (e.g. hedge funds, private equity funds)

Deregulation – removal of artificial barriersTechnology – increased access to information, communication, computer power, financial innovation

Strong profit motives and incentive based remuneration

AdvantagesEasier to borrow, better funding of investmentsBroader spectre of assets, diversification Increased efficiency and profitability

2009

SecuritizationSecuritization

Diversified portfolios formed on basis of mortgages, corporate bonds and other assets

Portfolios are sliced into tranches, sold to investors with different appetites for risk

Pension funds hold AAA rated assets due to restriction by charter

Hedge fund focus on more risky piecesBanks hold ”equity tranch” to ensure monitoring

But: most of risk stayed within banking sector (although spread across the world)

banks held leveraged AAA assets – tail risk

2009

Securitization – bad reasons

SupplyRegulatory arbitrage – Basel I required banks to hold capital of at least 8 percent of loans on balance sheets, but requirements were lower for SIVs (structured investment vehicles, i.e. off balance sheet entities created by banks)

Rating arbitrage – transfer assets to SIVs and issue AAA rated papers rather than A- rated papers

DemandNaiveté – risk underestimated due to past low correlation among regional housing markets

Search for yield – accept tail risk

2009

Subprime –mortgages in the USSubprime –mortgages in the US

Mortgages to household with weak financial background: NINJA – No Income, No Job or Assets

Often provided by agents paid on provision

Simplified credit evaluation

Often based on information from borrower

Teaser rates and ”piggyback” mortgages to avoid initial down payment

USA SubprimePercent of mortgages, stock

2009

Short term funding and leveraging (low equity shares)

Investors prefer assets with shorth maturity Provides liquidity Discipline device for banks

Most investment projects and mortgages have long maturities

Leads to ”maturity mismatch” for banks Increased reliance on extensive short-term

borrowing

Lower equity ratios to increase return on equity Earn 1 USD on loan of 100 USD 10 % equity => 10 % return on equity; 5 % equity => 20 % return on equity

2009

Rating agencies and credit default swaps CDS

AAA rating important for sale of CDOs Highly profitable business for rating

agencies Higher fees for structural products

Risk was underestimatedRating ”at the edge”, i.e. as ”risky as possible”

Insurance: Credit Default Swaps CDS Extensive reinsurance to other companies Insufficient capital – monoline insurers had

only 1 percent of amount at risk Possible to buy CDS without having

underlying asset

2009

Background – incentives in the Background – incentives in the financial sectorfinancial sector

Not only new, unknown risk, but alsoLow price on risk”Old, well known” risk, e.g. borrow in foreign currency

Incentive based remuneration, bonus for upside, but no punishment for downside

Measuring return relative to risk lead to search for other possibilities

Tail risk – win something 9 out of 10, loose a lot 1 out of 10

Herd behaviour – don’t do worse than others

2009

Background – weaknesses in Background – weaknesses in the regulationthe regulation

Large parts of financial markets without capital requirements and supervision

Half of the US credit market, including investment banks (because no depositors)

Holes in the regulation ”off-balance-sheet” Coordination problems and several regulatory authorities

Insufficient transparency Procyclical regulation

Good times: asset prices up => equity share up => lend more => asset prices up

Reverse in bad times

2009

15Kilde: Reuters EcoWin

House prices in the US, annual growth rates 1988 - 2008.

Årsvekst i 4. kvartal 2008 for 10 byområder: -19,2 prosent

Source: Reuters EcoWin

88 90 92 94 96 98 00 02 04 06 08

Pro

sent

-20

-15

-10

-5

0

5

10

15

20

Case-Shiller nasjonal indeks

Case-Shiller indeks for 10 byområder

2009Difference 3-month money market Difference 3-month money market

rates and policy ratesrates and policy rates1. januar 2008 – 2. februar 2009. Prosentpoeng1. januar 2008 – 2. februar 2009. Prosentpoeng

Kilde: Reuters EcoWin

USA

EurosonenNorge

-0,5

0,0

0,5

1,0

1,5

2,0

2,5

3,0

3,5

jan. 08 apr. 08 jul. 08 okt. 08 jan. 09

Prosentpoeng

2009Credit default swapsCredit default swaps

2009

Amplification mechanismsAmplification mechanisms

Loss on bad loans, and fear of new losses

Liquidity crisis Banks more reluctant to lend to other banksDifficult to obtain short term fundingBanks must sell assets => asset prices fallLower asset prices increase loss => sell moreAsset markets become illiquid

Solvency problemsDowngrading of securities and institutionsProcyclical behaviour and regulation

2009

2009

The financial crisis leads to a The financial crisis leads to a recessionrecession

Financial crisis leads to lower investment and lower consumption, so that GDP falls

Demand fallsRisk increasesMore difficult to finance investment projects, consumption and trade credits

Investments, cars, durables, manufacturing products severly hit

Recession involves real losses that amplifies financial crisis

Banks take losses, and must reduce lendingFirms have lower equity and lower sales, more uncertainty, becomes less credit worthy

2009

Historical experiences of Historical experiences of financial crises after 1945financial crises after 1945Reinhart og Rogoff, NBERReinhart og Rogoff, NBER

Average change from top to bottom Longlasting reduction in asset prices

House prices fall by 35 percent over six yearsStock prices fall by 55 percent over 3 ½ years

Fall in output and employmentUnemployment increases by 7 percent over four years

GDP falls by 9 percent over two years Public debt increases

Average increase is 86 percent (not a good measure, as it depends on initial debt)

2009

Some lessons for the regulation Some lessons for the regulation of financial marketsof financial markets

Supervision and regulation of all activity which involves system risk

Better information and transparency Make regulation less procyclical

Raw leverage caps, not only risk adjusted More emphasis on stability and less on

competition Market discipline must improve

Credit rating agencies Insentives in financial institutions

Liquidity regulation and better liquidity provision

2009

Lessons – economic policyLessons – economic policy

Monetary policy must reflect concern for financial stability

Fiscal policy tighter in good times

Global imbalances reduced

International cooperation improved