Financial crisis and economic downturn: Where did they come from and where are they going?

1. Financial crisis and economic downturn: Where did they come from and where are they going? Presentation by Charles (Chuck) Freedman Scholar in Residence, Economics Department, Carleton University at Wilfrid Laurier University Waterloo, June 8, 2009

2. Outline of presentation • Causes of financial crisis • Unfolding of financial crisis • Macro developments and interaction with financial crisis • Reaction of authorities to financial crisis • Reaction of authorities to macro downturn • Exit strategies • Financial sector restructuring • Canadian situation

3. Introductory remarks • Complex relationships and interactions • Many explanations • Interactions among the various elements • Presentation sets out main factors behind the crises (“what”, “how” and “why”) and their linkages with each other, as well as kinds of changes under consideration that are aimed at avoiding a recurrence of the financial crisis

4. Subprime mortgage markets • Begin with problems in US subprime mortgage markets • Many weaknesses. • First, perhaps in part as a result of the originate to distribute model, decline in lending standards and monitoring of mortgages • Second, financial institutions should have been much more aware that housing prices typically do not rise forever

5. Subprime mortgage markets • Third, some of the practices of originators and brokers worsened outcomes (a) encouraged borrowers into variable rate mortgages (b) initial “teaser” interest rates (c) compensation of agents arranging such mortgages • Fourth, in the United States, view of governments and governmental authorities that homeownership should be encouraged and subsidized • Fifth, legal situation of no recourse in most states in the United States (and one Canadian province)

6. Derivatives • Risk with derivatives that “the inherent complexity of the instruments raises the concern that management will not understand or be able to control effectively the amount or type of risk being taken on by the firm”. • In many cases, either companies did not understand the underlying risks that they were taking and/or underestimated probability of tail events • For many years, mortgage-backed securities operated very effectively

7. Derivatives • Then came collateralized debt obligations (CDOs) with tranches that could be tailored to the needs and desires of purchasers • Credit rating agencies played important role in providing ratings to the various tranches of these instruments • Neither rating agencies nor purchasers of these instruments had a very clear understanding of the probabilities with respect to the outcomes of the payment flows from these instruments

8. Derivatives • Purchasers rarely did due diligence themselves, relying excessively on the CRAs • Among the problems that the CRAs had difficulty in addressing were – default probabilities (in absence of long history with subprime mortgages); sensitivity to small errors in estimation of riskiness of tranches of CDOs and especially CDO-squared; underestimate of correlations of returns on assets backing the CDOs • And some concerns have been expressed about the CRAs’ conflicts of interest

9. Derivatives • Credit default swaps (CDSs) also played important role in the development of the financial crisis • In many cases, sellers of CDSs underestimated the probability of unlikely negative outcomes (“tail events”) occurring • And purchasers frequently underestimated or ignored the risk that the counterparty (e.g., AIG, monoline insurers) would be unable to pay off the insurance if the insured event occurred

10. Derivatives • A fundamental problem in this and other areas was the failure of risk management • Either risk management units did not recognize the extent of risk involved in the strategy being followed or senior management did not pay sufficient attention to the concerns of risk management units • Problems with compensation arrangements that took insufficient account of what might happen in coming years

11. Regulation/supervision • Either authorities did not recognize the risks being undertaken or pressures from governments to provide light regulation outweighed any concerns they might have had • Some financial entities that did not appear to fall under safety net less supervised than those that did fall under the safety net • In practice, it turned out that a number of such entities were either too large to fail or too complex to fail or too interconnected to fail and therefore in the end did fall under a form of safety net provided by the authorities

12. Assumptions about liquidity • Another problem was the assumption that there would always be liquidity in the markets for the financial instruments and therefore arrangements for dealing with potential liquidity problems insufficiently robust • Indeed, the business case of some financial institutions based on the assumption that they would always be able to access wholesale markets for funding

13. The unfolding of the financial crisis • Housing prices started to fall and default rates began to rise sharply in mortgage markets, particularly subprime • With little past experience, great uncertainty as to value of mortgages and even more so as to the value of complex derivatives based on such mortgages • Markets began to dry up, with investors unwilling to purchase instruments whose value was so uncertain • Lack of transparency also meant no-one was sure who was holding the “bad assets”

14. The unfolding of the financial crisis • Resulted in a number of problems • Originating institutions stuck with holdings of mortgages they had intended to sell • Banks had to provide support to structured financial instruments that they had previously sold, either by extending liquidity to the SIVs or bringing the assets back on to their own balance sheet • Short-term financing dried up

15. The unfolding of the financial crisis • Liquidity of interbank lending markets in turn began to dry up • (1) financial institutions increasingly desired to hold liquid assets • (2) concerns about counterparties’ solvency because of increased uncertainty about the value of assets held by financial institutions in general • Spreads between interest rates faced by “risky” borrowers and those faced by “riskless” borrowers began to increase, at times sharply (have declined in more recent period but still relatively high)

18. The unfolding of the financial crisis • Also, concern about quality of household and business loans on balance sheets of financial institutions • Highly leveraged market makers (e.g., investment banks, hedge funds) under particular pressure • CDS spreads rose and the sellers of CDSs faced ever increasing exposures, which in turn raised questions about their own solvency (e.g., AIG)

19. The unfolding of the financial crisis • Potential for insolvency in financial institutions – (i) holdings of subprime mortgages; (ii) holdings of asset-backed securities and CDOs as an investment; (ii) holdings of equities and/or investment in non-market assets such as participation in buyouts as the prices of such assets declined; (iv) holdings of commercial mortgages, business loans, credit card other personal loans where borrowers fell into arrears as the economy weakened; (v) exposure to CDSs

20. The unfolding of the financial crisis • Decline of capital as losses spread • Absence of markets for certain kinds of assets and uncertainty regarding the quality of those assets made it very difficult to gauge whether liquidity or solvency problem • Considerable uncertainty about status of non-deposit creditors and of shareholders, especially because of different treatment of different entities by the authorities (Bear Stearns, Lehmann Brothers)

21. Macroeconomic developments and interaction with financial crisis • Before the onset of the crisis in 2007, the global economy had had a long period of fairly steady growth • Low inflation • Globalization • Nonetheless, concerns about the “quality” of the economic expansion • Large imbalances in the world economy • Concerns about the increase in the ratio of household debt to personal disposable income

24. Macroeconomic developments and interaction with financial crisis • Persistence of low real interest rates in the context of stable growth and low inflation led to a willingness to take on more risk as part of a search for yield • The resulting asset price bubble in turn underpinned the economic expansion on the part of both households and businesses • Turnaround in house prices and the onset of the financial crisis began to change the economic situation • Over time, the real-financial linkages interacted in a way that caused deterioration in both the financial sector and the real economy

25. Macroeconomic developments and interaction with financial crisis • First, downturn in housing prices played an important role in putting downward pressure on household spending • Second, there was a significant decline in stock prices • Third, the psychological worries on part of households as financial sector came under pressure and as unemployment began to rise led to reduction in spending, especially on big-ticket items (autos, housing)

26. Macroeconomic developments and interaction with financial crisis • Fourth, banks became increasingly reluctant to make new loans – (a) liquidity pressure; (b) could not move recently-originated mortgage loans off balance sheet; (c) movement of assets back onto balance sheet as financial markets dried up (outstanding lines of credit); (d) desire to reduce size of balance sheet because of shortfalls in capital (deleveraging); and (e) concern about quality of loans and effect on future losses • Fifth, growth of emerging economies slowed significantly -- weakness in export markets, significant difficulties in obtaining trade credits, and financial sector problems in some countries

27. Macroeconomic developments and interaction with financial crisis • Problems in the financial sector led to weaknesses in spending while weaknesses in spending led to further problems in the financial sector • Concern of authorities was to prevent downward spiral and to break these linkages

28. Reaction of the authorities • Authorities faced multiple challenges – liquidity problems; solvency problems; rapidly weakening macro situation; and, in longer run, how to restructure/reregulate the financial system to avoid future such crises • In examining reaction of the authorities to the financial crisis, it is important to keep in mind that their principal objective was initially to avoid a meltdown or implosion of the financial sector, as this was seen to be one of the major factors in bringing about the Great Depression of the 1930s (Bernanke) and subsequently to provide support to the macro economy

29. Reaction of authorities to financial crisis -- liquidity • Initial issue desire by banks for increased liquidity • Central banks carried out traditional lender of last resort function by supplying the increased liquidity desired by banks • Over time, this part of central banks’ support function broadened in a number of ways • First, term loans • Second, loans to non-traditional institutions • Third, purchase of riskier assets • Fourth, higher risk collateral • Fifth, foreign exchange swap arrangements • Sixth, securities lending facilities

31. Reaction of authorities to financial crisis -- solvency • Authorities willing to do whatever was necessary in order to be prevent financial sector from imploding • Focused on financial entities believed to be either “too big to fail” or “too complex to fail” or “too interconnected to fail”, i.e., the institutions that were believed to pose risks to the entire system (systemically important financial institutions) • Governments bailed out a number of institutions • Four principal approaches were taken – assisted mergers, injections of equity capital or preferred shares, purchase or guarantee of “toxic assets”, guarantee of liabilities

32. Reaction of authorities to financial crisis -- solvency • While each of these had the effect of preventing losses to depositors, their implications for non-deposit creditors and shareholders differed • Assisted mergers typically involve government role in placing a limit on the acquiring institutions’ potential loss from accepting problematic assets of acquired institutions

33. Reaction of authorities to financial crisis -- solvency • Injections of equity capital or preferred shares (with or without option to convert) improved 1 capital ratios (leverage ratios) • Depending on the size of the injection of capital by the authorities, such actions amounted to partial or total nationalization • Raised questions of government’s involvement in the credit granting process and the exit strategy that would be needed once the situation stabilized

34. Reaction of authorities to financial crisis -- solvency • Addressing toxic assets via guarantee or purchase by “bad bank” were ways of minimizing bank losses on specific types of assets • Difficult issues of pricing – when markets are not functioning well and only limited price discovery, how determine market prices; how much loss to shareholders and how much to taxpayers; distribution of gains if markets rebound; involvement of private sector in purchasing such assets (private-public partnerships), possibly with subsidy from public funds

35. Reaction of authorities to financial crisis -- solvency • Guarantee of liabilities can provide bank in difficulty time to restructure or to wait for improvement in markets, but does not in itself address solvency problem • There is not very much literature on the advantages and disadvantages of these various techniques, and governments have been using “seat-of-the-pants” approach to decision-making in this area • Need more study as to which approaches are best in different circumstances

36. Reaction of authorities to financial crisis -- solvency • Authorities, in particular US authorities, have tried number of these ways of bailing out financial sector • Uncertainty with respect to intentions of US authorities have made it difficult for potential investors in US financial institutions to assess likely outcomes • Bear Stearns, Lehman Brothers – failure of latter caused massive increase in uncertainty with respect to risk of counterparties

37. Reaction of authorities to financial crisis • Other issues have arisen in context of liquidity and solvency problems • Proper coordination among the various authorities responsible for financial stability • Division of responsibility for financial stability in the euro area (ECB versus national central banks) • Countries in which banks have grown very large relative to the size of the economy (Iceland, Ireland) • Role of international organizations

38. Reaction of authorities to macroeconomic downturn • Principal concern to avoid self-reinforcing downward spiral that would turn fairly sharp downturn into much deeper and more prolonged contraction, possibly including deflationary pressures that would intensify the downturn • Both monetary and fiscal tools were used • Moreover, once policy interest rates approached zero lower bound, central banks began to consider unconventional measures (quantitative easing)

39. Monetary easing • Quantitative easing means different things to different people • Recent practice has been to distinguish between quantitative easing and credit easing or qualitative easing • One set of definitions is as follows (Buiter) • Quantitative easing is an increase in the size of the balance sheet of the central bank through an increase in its monetary liabilities (base money), holding constant the composition of its assets • Credit or qualitative easing is a shift in the composition of the assets of the central bank towards less liquid and riskier assets, holding constant the size of the balance sheet and the official policy rate

40. Monetary easing • In my view, quantitative easing so defined will have relatively little effect on the economy • In circumstances where many assets already yielding zero return and in which loans seem very risky, the banks may be perfectly happy to simply hold excess reserves • Example from Japan from the 1990s – high base growth, moderate money growth, negative loan growth • Of course, part of the problem in Japan was the continued weakness of financial sector • Qualitative easing has the potential of having considerable effect • It could work through reductions of risk premiums of various sorts and perhaps through its effect on expectations • Also, could improve functioning of markets that were in difficulty

42. Fiscal policy--introduction • In face of continued weakness of global economy, focus of macro policy turned to fiscal policy • Questions with respect to the effectiveness of temporary fiscal stimulus and with respect to the preferred mix of policy • Research at the IMF in which I was involved concluded that certain types of global fiscal measures along with accommodative monetary policy can make an important contribution to underpinning the global economy • But stressed importance of availability of fiscal space and credibility – need clear commitment to long-run fiscal discipline

43. Simulations of fiscal stimulus • Investment expenditures have much larger effect on GDP than lump-sum transfers • Expenditures have a direct effect on GDP while transfers perceived to be temporary have only limited effect on behaviour of households that are not hand-to-mouth consumers • Targeted transfers have considerably larger effect than regular lump-sum transfers because hand-to-mouth households have higher propensity to consume • Effects on GDP of fiscal stimulus much larger in all cases with monetary accommodation than without monetary accommodation

44. Conclusions regarding fiscal policy • Fiscal policy has to take on important role in the economic recovery during the period in which monetary policy constrained by the zero lower bound (even with quantitative and credit easing) and in which financial sector is recovering and may not be able or willing to extend credit to the normal extent • In countries in which fiscal space is limited, especially important to focus fiscal stimulus actions on measures having the largest effect on aggregate demand (expenditures or targeted transfers), although political considerations may require governments to adopt second-best measures • Important that fiscal stimulus is global and that monetary policy is accommodative

45. Conclusions regarding fiscal policy • Danger if stimulus packages being considered create a perception of lack of fiscal discipline, and more so if lack of fiscal discipline is not just perceived but also realized • Credibility concern could be addressed through appropriate and credible medium-term fiscal frameworks such as the introduction of fiscal rules (e.g., long-run targets for ratio of fiscal deficit or fiscal debt to GDP) • Also important to avoid protectionist elements in fiscal packages

46. Exit strategy -- macro • Aggressive monetary and fiscal strategies along with support for the financial sector have prevented even worse outcomes • Appears that the recovery will start later this year or early next year • However, because of the ongoing weakness of the financial sector and some continued underlying macro problems, likely to be a more gradual recovery than is typical at this stage of the cycle

47. Exit strategy -- macro • Importance of reversal of both monetary and fiscal easing as economies come out of recession and settle into stronger phase of the recovery • On the monetary policy side, the very high level of stimulus that is currently in place will have to be removed • And at least some of the special initiatives introduced by central banks in the form of credit easing and to deal with liquidity problems will likely be withdrawn • However, consideration may well be given to retaining some of these initiatives as part of the restructuring of the financial system

48. Exit strategy -- macro • On the fiscal side, it will be essential to return to a credible track for the debt to GDP ratio • In the absence of such measures, we can expect to see higher long-term real interest rates (and hence lower growth of potential output) than otherwise • Consideration should be given to the introduction of fiscal rules as a way of facilitating appropriate budgetary behavior

49. Exit strategy -- macro • Of course, the main challenge to both monetary and fiscal policy is to get the timing “right” • Premature tightening could slow down an incipient recovery • Excessive delays in tightening could eventually result in inflationary pressures developing • As is always the case, the monetary and fiscal authorities will have to rely upon forecasts, but in the current circumstances of both financial and macro uncertainties, forecasting is especially difficult

50. Financial sector restructuring and regulation • Much attention is being paid to changes in regulation and supervision of the financial sector • But will want to avoid regulation that will stifle useful innovation • G20 work plan grouped reform efforts under three headings – improving domestic regulation; cross-border regulation and cooperation; and IFI reform and refinancing • My own listing of possible reform efforts is as follows