The Global Financial Crisis Geoffrey Carliner Palacký University 26 November 2008

Immediate Causes of the US Crisis US Mortgage Lending Home buyers borrowed too much Banks lent foolishly No downpayment Interest-only loans Teaser interest rates for 2-3 years, then +3% No proof of income required Securitized mortgages. Bundled, sliced up Decline in house prices → Borrowers default → Prices decline more

Derivatives Leverage More trouble ahead Credit Default Swaps Insurance policies with no reserves On securitized mortgages, corporate and local govt bonds Other unhedged options on interest rates, forex, stocks Leverage Commercial banks. 12 – 15 times Hedge funds and investment banks. 30 times More trouble ahead Consumer debt. Credit cards, auto loans Commercial real estate and corporate debt

Underlying Problems Global Saving Imbalance US trade deficit < 0 and very large China and oil exporters trade surplus > 0 and very large Large capital inflows to US banks → lower lending standards Behavior of Financial Sector Short term incentives. Pay based on this year´s profit Short term memories by CEO and Board of Directors Herding

Bank Regulation and US Politics Long term trend to less regulation, US and elsewhere Political pressure to lend to poor home buyers Political pressure from financial sector for weak regs Free market ideology: markets work, governments make things worse Greenspan Bush administration Behavior of Borrowers Rational behavior if down payment is very low Bad memories. Housing prices only go up Exploitation. Didn´t understand mortgages or risks

Consequences of the Crisis Collapse of US Financial Markets Banks stop lending as panic spreads Serious US Recession Crisis Spreads to Banks in Other Countries Iceland, Ireland banks made similar mistakes UK, Germany banks bought toxic US debt Innocent emerging markets caught in credit contraction. Hungary, Denmark, S Korea, Brazil World Recession Credit contraction spreads Decreased demand for imports → recession in countries not hurt by credit contraction. Czechia Underline the difference between trend and cycle

Short Term Solutions to the Crisis Restart Bank Lending Guarantee bank deposits Increase bank capital by investing in bank shares Order banks to resume lending Lower Interest Rates Prevent Exchange Rate Crises. Swaps, Loans Especially to well behaved countries. Denmark Even to countries with bad policies. Iceland Does IMF have enough money? Borrow from China? Fiscal Stimulus Increase spending, even on infrastructure Cut taxes for people who will spend

Long Term Solutions Tighter Regulation of Financial Sector Less risk taking by banks Larger reserves, less leverage No OTC derivatives, prevent counterparty risk Will regulators be tough enough as memories fade? Should Central Banks raise interest rates to prevent asset bubbles? Should small countries Join the euro Restrict short term capital inflows Accumulate large foreign exchange reserves

Correct Global Saving Imbalance Higher saving in US, but don´t encourage it now Higher consumption in China, East Asia Higher Chinese consumption won´t avoid worldwide recession. Too small, takes too long Crisis may convince other countries to save more, build up foreign exchange reserves Oil exporters need to save Improve Corporate Governance Incentives based on long term performance Avoid herd behavior, don´t forget history All Solutions Require Int‘l Coordination