The Financial Crisis

1. The Financial Crisis Steinar Holden Økonomisk institutt, UiO http://folk.uio.no/sholden/ ECON 4325

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

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

4. Amplification mechanisms

5. 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 2002-2005 • Economic growth and low interest rates • High growth in asset values • ”Search for yield”

6. House prices

7. Background – financial markets • Extensive changes in financial markets last 20-30 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. House prices in the US, annual growth rates 1988 - 2008. Årsvekst i 4. kvartal 2008 for 10 byområder: -19,2 prosent Kilde: Reuters EcoWin

16. Difference 3-month money market rates and policy rates1. januar 2008 – 2. februar 2009. Prosentpoeng Kilde: Reuters EcoWin

17. Credit default swaps

18. 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

20. 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

21. Historical experiences of financial crises after 1945Reinhart 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)

22. 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

23. Lessons – economic policy • Monetary policy must reflect concern for financial stability • Fiscal policy tighter in good times • Global imbalances reduced • International cooperation improved