cllt dl collateral damage: the financial crisis and its

Kellogg School of Management Northwestern University

(c) Janice Eberly 2009 1

C ll t l D Collateral Damage: The financial crisis and its economic Impact

1

Janice EberlyJohn L. and Helen Kellogg Professor of FinanceKellogg School of ManagementNorthwestern University

Impact of the financial crisis:Current economic situation

What is good news and what is bad news?

Fiscal policy and the fiscal stimulus

Monetary policy (the new fiscal policy?)

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Other worries



GDP, the broadest measure of economic performance, has fallen dramatically since fall 2008.

Q4 2008, -6.3%

3

Q1 2009, -6.1%

The 2008-09 decline in GDP is reminiscent of pre-1990s recessions.

4

Now

1982



Breaking down GDP

Inventory management is working well (but it hurts GDP in the short run)

The structure of the economy is changing The housing sector went out of control and is collapsing (that’s the good news)collapsing (that s the good news)

Productive investment recently dropped also (that’s the bad news)

Consumption is weak (bad news?), which means savings is recovering (good news),

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Inventories have collapsed, but inventory management is very flexible.

6



Overall investment has fallen about 25% from its peak in 2006.

N

7

Now

1982

Most of this decline is residential investment, which is about half its 2006

peak level.

N

8

Now

1982



But there has also been a decline in nonresidential investment

(equipment, etc) more recently.

N

9

Now

1982

This decline, only in the last two quarters, has been huge compared to past

recessions.

2008 09

10

2008-09

-17%



100%

The collapse in residential investment restores the downward trend in the housing share of investment.

20%

30%

40%

50%

60%

70%

80%

90%

Above trend in 2000s

Non residential

0%

10%

20%

1947

-01-

0119

49-0

1-01

1951

-01-

0119

53-0

1-01

1955

-01-

0119

57-0

1-01

1959

-01-

0119

61-0

1-01

1963

-01-

0119

65-0

1-01

1967

-01-

0119

69-0

1-01

1971

-01-

0119

73-0

1-01

1975

-01-

0119

77-0

1-01

1979

-01-

0119

81-0

1-01

1983

-01-

0119

85-0

1-01

1987

-01-

0119

89-0

1-01

1991

-01-

0119

93-0

1-01

1995

-01-

0119

97-0

1-01

1999

-01-

0120

01-0

1-01

2003

-01-

0120

05-0

1-01

2007

-01-

0120

09-0

1-01

Residential NonResidential

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Residential

Household savings similarly shows some signs of recovery.

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Unemployment has risen markedly.

Current unemployment

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unemployment rate = 8.5%

The increase in unemployment is also reminiscent of pre-1990s recessions.

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8.5% unemployment, March 2009



Initial Claims for Unemployment Insurance January 1965 to February 2009 (thousands)Also similar to 1982 values – have shot up dramatically.

15

The stimulus package is expected to reduce peak unemployment, but not eliminate the spike.

16The Unemployment Rate (percent, CBO)



Unused productive capacity, measured by capacity utilization less than 100, is also estimated to be at levels similar to 1981-’82.

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How did this happen?Problems started in credit marketsProblems started in credit markets.

Mortgage markets are big.Household net worth is $50 trillion (Dec 2008)

Residential housing is worth ~$20 trillion, and mortgage debt is ~$10 trillion

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Distress is concentrated in sub‐primeSub‐prime is only about $700 billion

How could so much damage be done?



Mortgage debt grew dramaticallyMortgage debt grew from 42% of GDP inMortgage debt grew from 42% of GDP in 1990 to 78% of GDP in 2006 in the US.

Low interest rates

New financial instrumentsRetail: sub‐primes, Alt‐A’s, etc.

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p

Secondary: securitizations, CDOs, etc.

By‐passing banks had been happening for a long time already, taken to the extreme

MBS outstanding doubled from $3 trillion in 2000 to almost $6 trillion in the beginning of 2007.

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But “agency” rose only by 50%, the rest was jumbo, Alt-A, and subprime; subprime rose from 3% of the market to 12%.



The concept is simple diversification

Pool loans geographically and diversifyPool loans geographically and diversify local/regional economic and default risk

Interest rate risk remains as a common or systemic risk

What about house‐price risk?Subprimes are vulnerable to falling house prices: high

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Subprimes are vulnerable to falling house prices: high loan‐to‐value, plus prepay fees

Historically this was a regional phenomenon – crashes in California, New England, etc.

The fatal flaw:

Home price growth started slowing in 2005, and home prices have been declining since 2006. The December 2008 year‐over‐year decline was 18.4% nationally, with some cities (Las Vegas, Phoenix, Miami, San Francisco) down 30% or more. Others (Boston, Dallas, Denver) were down only 4 to 7% for the year.



250.00

300.00

Case-Shiller House Price Index2000 - 2008

100.00

150.00

200.00

Inde

x, J

anu

ary

20

00

= 1

00

AZ-Phoenix

CA-Los Angeles

CA-San Francisco

DC-Washington

FL-Miami

IL-Chicago

NV-Las Vegas

NY-New York

23

0.00

50.00 Composite-20 SPCS20R

As of March 2009 delinquency rate is 7.9% overall, an additional 3.3% of loans are in foreclosure. Most of the action is in subprimes; 48% of subprime ARMs are delinquent (in Florida, 60% are delinquent.)

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The housing collapse revealed and propagated fragility in the global financial system.

Spread Between the Three‐Month Libor and the Expected Federal Funds Rate, January 2007 to March 2009 (percentage points)

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Market volatility has exploded.

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Meanwhile, the Fed has been hard at work trying to shore up financial markets….



Policy: the Fed steps inFederal Reserve Act (1913)

SECTION 2A—Monetary Policy ObjectivesThe Board of Governors of the Federal Reserve System and ythe Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

SECTION 13(3) –Authorization to extend credit in “unusual and exigent circumstances” for institutions which cannot obtain it privately (Bear Stearns, AIG, etc.)

Current Fed Funds Rate

The Federal Funds rate (the rate at which banks lend to each other, in principle) has been driven to zero since late 2008

=> Quantitative Easing

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The Fed’s most recent monetary policy release:

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economicfunds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this

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year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion.Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. …

US banks (excludes AIG = $110)

$ billions, total = $358

Fannie Mae & Freddie Mac $200

Direct liquidity injections to US banks

Fannie Mae & Freddie Mac $200

Wachovia $12

Citigroup $25

JPMorgan Chase $25

Bank of America $20

Merrill Lynch $5

Wells Fargo $25g $

Goldman Sachs $10

Morgan Stanley $10

Bank of New York Mellon up to $3

State Street up to $3



UK and European banks £, € billions, total = £96.5 + €134

Bradford and Bingley £18

Royal Bank of Scotland £20

Direct liquidity injections to UK and European banks

Royal Bank of Scotland £20

HBOS £11.5

Lloyds TSB £5.5

Fortis €11.2

Hypo Real Estate €50

Glitnir €0.6

Dexia €6.4Dexia €6.4

UBS €3.9

ING €10

Credit Agricole €3

BNP Paribas €2.5

Societe Generale €1.7

Federal Reserve Assets (millions)

00

2500

000

Term Asset-Backed Securities

Federal Agency Debt Securities

Mortgage-backed Securities

Credit to AIG

Other Credit

Net Portfolio Holdings Comm Paper

1000

000

1500

000

2000

000

Asset-Backed Commercial Paper

Maiden Lane 3

Maiden Lane 2

Maiden Lane 1

Seasonal Credit

Secondary Credit

Primary Credit

Primary/Other Broker Dealer

0

5000

00

1/3/0

7

3/3/0

7

5/3/0

7

7/3/0

7

9/3/0

7

11/3/

07

1/3/0

8

3/3/0

8

5/3/0

8

7/3/0

8

9/3/0

8

11/3/

08

1/3/0

9

3/3/0

9

y

Term Auction Credit

Currency Sw aps

Other Fed Assets

Repurchase Agreements

Securities Lent to Dealers

Traditional Security Holdings



Exit strategiesThe Fed’s balance sheet is almost three timesThe Fed s balance sheet is almost three times its size in 2007

Avoiding inflation requires shrinking again!

Short term loans will naturally expire, but what about the rest?

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Meanwhile, the fiscal side has been busy with stimulus, too… the budget deficit tripled from last fall to January 09, and it’s not done.



The Federal Budget Deficit2009 deficit projection is $1.2 trillion = 8.3% of GDP

Since then the stimulusSince then the stimulus package has been passedEstimated to add $185bn to the deficit in FY 2009, and $400 bn in FY2010

Including the proposed budget, the 2010 deficit would fall to 9.6 percent of GDP, or nearly $1.4 trillion —$241 billion more than the deficit of $1.1 trillion that CBO projects under current laws and policies.

The difference is largely attributable to t bili i fi i l k t ($125 billi )

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• stabilizing financial markets ($125 billion); • defense spending, primarily for Iraq and Afghanistan ($50 billion); and• various revenue reductions ($45 billion).

In total, outlays next year would measure 25.5 percent of GDP under the new budget, and revenues would amount to 15.9 percent.



Meanwhile, consumption has been falling. Modest growth in Q1 2009 is a mixed message – households need to consume less in the long run.

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Real Personal Consumption Expenditures, January 1965 to January 2009(Percentage change from previous year)

Also good news on the trade balance (especially excluding petroleum); the drop in consumption has closed the trade deficit by more than half.

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The Trade Balance, 1965 to 2008(Percentage of gross domestic product)



Why is this so hard to solve?Policy uncertaintyy y

Usual suppliers of liquidity (sovereign wealth funds, private equity, etc) are afraid that the government will step in front of them.

Holders of financial sector debt may have to take lossesThere is no bankruptcy/reorganization process for financial institutionsSo far the government is the only debt-holder to convert to equity

t k lor take a loss.

There is no illusion that the crisis is only about liquidityBoth borrowers and lenders are likely insolvent => losses must be borne by someoneForebearance (that is, waiting) just furthers the uncertainty.

Other risks:Rising interest rates/falling $

Constrained spending on infrastructure and other needs

Anti‐immigrant movements

Anti‐market sentiment

Attacks on Fed independence (since it is now doing fiscal

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(s ce t s o do g scapolicy)

Economic instability => political instability globally

cllt dl collateral damage: the financial crisis and its

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