2009 The Financial Crisis Steinar Holden Økonomisk institutt, UiO ECON 4325

2009 Outline Macroeconomic imbalances Weaknesses in financial markets Securitization Weaknesses in regulation What happened? Historical experiences Some lessons

2009 Predicted growth in world GDP, given at different points in time (IMF)

2009 Amplification mechanisms

2009 Background - macroeconomics Macroeconomic imbalances High 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 Economic growth and low interest rates High growth in asset values ”Search for yield”

2009 House prices

2009 Background – financial markets Extensive changes in financial markets last years Institutional changes (e.g. hedge funds, private equity funds) Deregulation – removal of artificial barriers Technology – increased access to information, communication, computer power, financial innovation Strong profit motives and incentive based remuneration Advantages Easier to borrow, better funding of investments Broader spectre of assets, diversification Increased efficiency and profitability

2009 Securitization 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 pieces Banks 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 Supply Regulatory 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 Demand Naiveté – risk underestimated due to past low correlation among regional housing markets Search for yield – accept tail risk

2009 Subprime –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 Subprime Percent 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 underestimated Rating ”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 financial sector Not only new, unknown risk, but also Low 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 the 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

Kilde: Reuters EcoWin House prices in the US, annual growth rates Årsvekst i 4. kvartal 2008 for 10 byområder: -19,2 prosent

2009 Difference 3-month money market rates and policy rates 1. januar 2008 – 2. februar Prosentpoeng Kilde: Reuters EcoWin

2009 Credit default swaps

2009 Amplification mechanisms Loss on bad loans, and fear of new losses Liquidity crisis Banks more reluctant to lend to other banks Difficult to obtain short term funding Banks must sell assets => asset prices fall Lower asset prices increase loss => sell more Asset markets become illiquid Solvency problems Downgrading of securities and institutions Procyclical behaviour and regulation

2009

The financial crisis leads to a recession Financial crisis leads to lower investment and lower consumption, so that GDP falls Demand falls Risk increases More 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 lending Firms have lower equity and lower sales, more uncertainty, becomes less credit worthy

2009 Historical experiences of financial crises after 1945 Reinhart og Rogoff, NBER Average change from top to bottom Longlasting reduction in asset prices House prices fall by 35 percent over six years Stock prices fall by 55 percent over 3 ½ years Fall in output and employment Unemployment 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 of 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 policy Monetary policy must reflect concern for financial stability Fiscal policy tighter in good times Global imbalances reduced International cooperation improved