International Finance FINA 5331 Lecture 8: Exchange rate regimes and financial crises Aaron Smallwood Ph.D.

The Asian currency crisis reviewed On July 2, 1997, Thai Baht is devalued. July 11 Philippines devalues the peso July 14: Malaysia floats the ringgit July 17: Singapore devalues August 14: Thailand moves to a float October 14: Taiwan devalues November 14: Korea floats August 17, 1998: Russia abandons its peg Hong Kong: At one point, Hong Kong monetary authority raises rates to 500%.

Asian currency preview: The causes Liberalization of capital markets in a weak domestic financial environment. –Crony capitalism –Surge in risky real estate investment –Maturity mismatch Secondary cause: Over-valued real exchange rates.

Review: Asian currency crisis Crony capitalism: A very close connection between government leaders and private enterprise, “lending decisions were often influenced by political considerations” (page 49, Eun and Resnick). Violation of the trillema Maturity mismatch: –Given capital inflow, Asian economies become reliant on short term debt instruments. Aftermath: Average economic growth of Indonesia, Korea, Malaysia, Philippines, and Thailand (source: Krugman and Obstfeld, 6 th Edition): 1996: 7.0%1997: 4.5%1998: -8.1%

Financial Crisis Overview: In an era of lax monetary policy and rising home prices (a “housing boom”) with questionable mortgage underwriting practices, banks originated loans that were securitized. When housing prices stabilized, interest rates rose, defaults rose, and mortgage backed securities, held by many investment banks, dramatically lost their value.

Housing Prices

US Monetary Policy

Additional Background From Sept 2002 – Aug 2004, the targeted Fed Funds rate was no higher than 1.25% Under Bush administration, expansionary fiscal policy is used. As seen in the graph, housing prices steadily rose from Subprime loans grow: In June 2004, 40% of conventional single family mortgages were “ARMs.”

The subprime issue According to Demyanyk and Hermet: “Rapid appreciation in housing prices masked the deterioration in the subprime mortgage market and thus the true riskiness of subprime loans.” St Louis Federal Reserve Working paper.

Regulatory Background “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief,” Alan Greenspan (speaking before Congress on Oct 23). A new banking model: In a largely unregulated environment, banks are encouraged to originate loans. The loans are then “securitized.” –The securitized share of the sub-prime market was 75% in 2006 as compared to 54% in 2001 (Demyanyk and Hemert, 2008, St Louis Fed working paper).

A new banking model: Originate to Distribute MBS: Mortgage backed securities. Investment banks demand is high for MBS: they are also poorly leveraged. Investment banks borrow to acquire MBS. CDS: Credit default swaps: Buyer makes regular payments and receives a payoff if an underlying credit instrument (like an MBS) goes into default.

The bubble bursts In 2005, housing prices stabilize and begin to fall. ARMs begin to reset…Defaults and foreclosures are up. According to Realty Trac, foreclosures were up 79% in 2007 from Almost instantly, liquidity freezes. Credit ratings of several investment banks and insurance companies come under scrutiny.

Aftermath February 2008: President Bush signs into law the Economics Stimulus Act. March 28, 2008 Bear Sterns is acquired by JP Morgan in a deal brokered by the Federal Reserve Bank of New York (for $1.2 billion). On Aug 22, 2008, Freddie Mac and Fannie Mae’s credit rating is reduced by Moody’s. In September, Fannie and Freddie Mac are placed under legal authority of the Federal Housing Finance Agency. On Sept 15, 2008, Lehman Brothers declares bankruptcy. In Sept Merrill Lynch is acquired by Bank of America. Washington Mutual declares bankruptcy.

Aftermath In September, the Federal Reserve bails out AIG, supplying an emergency loan of $85 billion. In exchange, the US government obtains an almost 80% ownership claim in AIG. In Oct, The Emergency Economic Stabilization Act authorizes the Treasury Department to spend up to $700 billion to purchase MBSs November 2008: Quantitative Easing (round I) is launched. Under this program the Federal Reserve will purchase up $500 billion in mortgage backed securities backed by Fannie Mae and Freddie Mac. February 2009: President Obama signs the American Recovery and Reinvestment Act into law. The total size of the bill is $787 billion. March 2009: The Federal Reserve expands the total size of QE1 to $1.25 trillion.

Aftermath April 2010: QE1 ends. Nov : QE2 is announced. The Federal Reserve will purchase $600 billion in longer term government securities beginning in the first quarter of June 2011: The second round of QE2 ends as planned.

Aftermath September 13, 2012: As the US economy continues to struggle, Ben Bernanke announces a plan to implement QEIII. By December, it is announced that the FED will buy $85 billion a month in agency backed mortgage backed securities and longer term Treasury securities. Currently, the monetary policy is extremely accommodative. Fed’s target for the Fed funds rate remains at %, with additional asset purchases of $85 billion every month. In June, the Fed announced that they may begin to decrease the size of the program by September if economic conditions improve. Unemployment was 7.6% in June in the most recently released data from the Bureau of Economic Analysis.