Good Afternoon (11/29)

1. Good Afternoon (11/29) Finish Asian Crisis Begin Russian Financial Crisis

2. Some Business • Please try your best to have stock trak stuff done and handed in on Thursday. • Movie and evals today • Hail Mary – should you throw a pass??? • Neat Discount rate article posted

3. Chaebol Crony Capitalism Japanese Model IMF Moral Hazard Excess Capacity – Glut Capital Flight – capital inflows to US Asian Monetary Fund Asian Crisis Terms (shut off projector and do these on board

4. Exchange Stabilization Fund Hubris Credibility Secrecy Corruption Transparency Credit Agencies – Credit Ranking Economies of Scale Asian Crisis Terms (cont)

5. Favoritism Exclusivity Unhedged Foreign Debt Interest Rate Differential Currency Pegs Command and Control Lax Banking Regulations Capital Controls Below Market Interest Rates Asian Crisis Terms (cont)

6. Introduce the Russian Crisis • Historical context – weathered the Asian Crisis much better than expected • Discuss the Fed’s outlook at the time • The 180 degree turnaround

8. The Russian Crisis • “You had an immediate and substantial collapse in risk appetite. Holders began selling bonds from South Korea, Greece, Turkey, Mexico, Brazil.” • Can we see the collapse in the following picture?

10. Discuss Fed Fumble article • What was the Fumble and what was the recovery? • The handful of Fed policy makers who had argued for a more dramatic half-percentage-point rate cut felt vindicated. Officials at the Federal Reserve Bank of New York worried that the rate cut had done little to reverse a stampede away from risky, and even not-so-risky, bonds.

11. Fed Fumble Article - continued • I thought the amount was irrelevant,” says Mr. Boehne, the Philadelphia Fed president. “The problem with 50 basis points”-jargon for a half percentage point-“was that people could have inferred that we knew more bad things than we did.” Mr. Greenspan made the same argument internally.

12. Fed Fumble - cont • But after the Fed’s Sept. 29 announcement, the stock market sagged, and the worrisome spreads in the bond market widened. • A week later, Mr. Greenspan delivered a rambling, off-the-cuff early morning speech to the National Association for Business Economics. He had two goals. The first was to dispel the sense of doom and gloom that had descended.

13. Fed Fumble - cont’d • The second goal, somewhat at odds with the first, was to lay the foundation for another rate cut by detailing the evidence that uncertainty and fear were causing investors to, as he put it, “disengage.” • This is referred to as jaw boning – the Fed Jaw Bones the Market all the time • Criticize George W ??

14. Fed Fumble - cont • By Thursday, Oct. 15, Mr. Greenspan figured the spreads in the bond market he had been tracking had grown so wide that they were bound to begin to narrow soon. It was time. He convened a telephone conference call of the FOMC.

15. Fed Fumble • On their TV sets and computer screens, Fed officials watched the instant analysis with a bit of trepidation. But the reaction was almost universally favorable, and the intended message was received: The Fed was prepared to do what was necessary. “Yes!” one Fed governor said late that afternoon after listening to a Wall Street pundit on CNBC, the business cable channel. “They got it right.”

16. What is a spread? • In the context of the Russian Crisis, people were very interested in the movements of the commercial paper – US T-bill spread (paper – bill spread for short) • Why is there a spread? • Which rate is higher and why?

17. Example with numbers • Suppose the current yield (or rate) on the 3 month US T-bill is 5.00% and the current yield on 90 day commercial paper is 5.50% • The difference 5.50 – 5.00 = 0.5% is referred to as the paper – bill spread • Historically, 0.5% is a ‘low’ paper-bill spread • What does a low spread indicate? • Suppose both rates are the same – what’s the implication?

18. The Spread and the crisis • The Risk aversion (the psychology of going from one side of the boat to the other) resulted in investors shunning away from commercial paper – a credit crunch • Importance – “For most large, highly rated corporations, the commercial paper market is now the primary source of short-term credit”

19. The Spread and the crisis – cont’d • The shunning away from paper resulted in lower prices which is the same as saying higher yields on paper • At the same time – investors flocked to the safe haven of US Tbills – WHY? • Result – prices of Tbills skyrocketed or equivalently – yields plummeted • Implications on spread?

20. With numbers • Before crisis – paper – bill spread = 0.5 % with paper yielding 5.5% and the bill at 5.00% • At ‘worst of crisis’ – paper – bill spread = 1.9% Yield on paper 5.5%, yield on bill = 3.6% • Why didn’t yield on paper rise indicating investors unwillingness to buy? • Think of volume rather than price • Some Pictures

21. Commercial Paper – Tbill Spread

22. US 3 month Tbill

23. Yields on Corporate Bonds vs US Tbills

24. Spreads – rates on corporate bonds minus rates on Tbills

25. Commercial Paper – Tbill Spread

26. Before getting to picture, discuss the federal funds market

28. Key Terms • Margin and collateral calls • Lack of liquidity - markets seized up • increase in the paper-bill spread • back up line of credit • diversity of credit markets - its like having a spare tire - Japan and E. Asia don’t - Europe?? - Sweden

29. Greenspan Excerpts • Following the Russian default of August 1998, public capital markets in the United States virtually seized up. For a time not even investment-grade bond issuers could find reasonable takers.

30. Greenspan Excerpts • Arguably, at least as relevant was the existence of backup financial institutions, especially commercial banks, that replaced the intermediation function of the public capital markets. • When American banks seized up in 1990, as a consequence of a collapse in the value of real estate collateral, the capital markets, largely unaffected by the decline in values, were able to substitute for the loss of bank financial intermediation.

31. Greenspan Excerpts • The speed with which the Swedish financial system overcame the crisis offers a stark contrast with the long-lasting problems of Japan, whose financial system is the archetype of virtually bank-only financial intermediation. The keiretsu conglomerate system, as you know, centers on a “main bank,” leaving corporations especially dependent on banks for credit.

32. Greenspan Excerpts • Thus, one consequence of Japan’s banking crisis has been a protracted credit crunch. • The failure to have backup forms of intermediation was of little consequence. The lack of a spare tire is of no concern if you do not get a flat.

33. Greenspan Excerpts • Despite its close trade and financial ties to Asia, the Australian economy exhibited few signs of contagion from contiguous economies, arguably because Australia already had well-developed capital markets as well as a sturdy banking system. But going further, it is plausible that the dividends of financial diversity extend to more normal times as well.

34. Greenspan Excerpts • The addition of distinct capital markets outside of banking systems is possible only if scarce real resources are devoted to building a financial infrastructure. It is a laborious process whose payoff is often experienced only decades later.

35. Greenspan Excerpts • It is thus not a simple matter to append financial infrastructure to an economy developed without it. Accordingly, full convergence across countries of domestic financial infrastructure or even of the international components of financial infrastructure is a very difficult task.