Combating adverse selection and moral hazard :

1. Combating adverse selection and moral hazard: • Collateral • Net Worth (=$Assets - $Liabilities) Net Worth – – The Foundation of Credit

2. Factors Causing Financial Crises Asset Values Drop: Net Worth Down Stock market decline  Decreases net worth of corporations. Unanticipated deflation  Debt burdens up/net worth down Unanticipated depreciation  $debts up/net worth down Asset write-downs (bad debts)  Net worth down Deterioration in Financial Institutions’ Balance Sheets Capital Ratios Down  Decline in lending. Interest Rates Rise Worsens adverse selection (who would pay the high rates?) Increases business needs for external funds  worsens adverse selection and moral hazard problems. Government Fiscal Imbalances Fear default of government debt Capital flight…Currency crisis Banking Crises Loss of information production / disintermediation. Increases in UncertaintyDecline in lending.

3. Crises (and Threatened Crises) We Have Known • The L o n g Depression, 1873 – 1896 • The Great Depression, 1929 – 1939 • Mexican Default, 1982 • Continental Illinois, 1984…Oil patch loans…TBTF • Third World Debt Crisis, 1980s  Lost Decade • Savings & Loan Debacle, 1986 – 1990 • Black Monday, October 19, 1987 • Tequila Crisis, 1994 – 1995 • East Asia Financial Crisis, 1997 - 1998 • Long Term Capital Management, 1998 • dot.com bust, 2000 • 911, 2001 • Subprime-triggered crisis – Run on shadow banks •  The Great Recession, 2007 –

4. The Great Depression: Mother of all Crises Stock Market Crash  Spending cutback Bank Panic  Monetary Contraction Bank Failures  Reduced Lending Declining Net Worth  Reduced Lending Price Deflation/Deflationary Expectations  Debt Deflation

5. Onset of the Depression: Persistent Deflation…Persistent Job Loss Manufacturing Employment $/pound DJIA

6. $/pound Producer Price Index

7. New Deal Reflation

8. Stimulus and Retrenchment: Recession in Depression

9. U.S. Financial Crises • Stage One • Mismanagement of financial liberalization and innovations • Asset price boom & bust • Spikes in interest rates • Increase in uncertainty Stage two: Banking Crisis Stage three: Debt Deflation

10. Financial Crisis of 2007 - 2009 Financial innovations in mortgage markets: Subprime and Alt-A mortgages Mortgage-backed securities Collateralized debt obligations (CDOs) Housing price bubble forms World savings glut Increase in liquidity from cash flows surging to the US Subprime mortgage market  housing demand and prices up. Agency problems arise “Originate to distribute” … “Moving, not storage”  principal (investor) agent (mortgage broker) problem. Commercial and investment banks/rating agencies …weak incentives to assess quality of securities Information problems surface…A “Minsky Moment” Housing price bubble bursts/Crisis spreads globally http://www.nytimes.com/interactive/2009/04/29/business/2009-wide-housing-graphic.html

12. A “Global Saving Glut” The best of times Capital Inflows Escalating House Prices Easy Money Policy Eager Home Buyers Ambitious Mortgage Brokers Developer Clout Innovative Banks Rating Agencies Securitization MBSs Bank Regulators Gov’t Sponsored Enterprises

13. The Shadow Banking System: A Fragile Financial Infrastructure Thus a long-term corporate bond could actually be sold to three different persons. One would supply the money for the bond; one would bear the interest rate risk, and one would bear the (credit) risk of default. The last two would not have to put up any capital for the bond, though they might have to post some collateral. Fisher Black Fundamentals of Liquidity, 1970

14. The Shadow Banking System: A Fragile Financial Infrastructure Banks have public backing…and are heavily regulated Lender of last resort, the Fed Bank creditors (depositors) are insured, FDIC Shadow Banks: Lack Public Backing  Substitutes Liquidity put Underlying asset values fall Short-term funders back off Sponsor steps in per prior agreement…line of credit Credit put Buy Credit Default Swaps from private insurers Private insurers can’t possibly reserve against systemic risk

15. The Shadow Banking System: A Fragile Financial Infrastructure Denizens of the shadows Federal loan programs/GSEs Investment banks/Pension funds Finance companies Monoline insurers/Mortgage insurers Structured investment vehicles (SIVs) Conduits: repos/total return swaps, securities arbitrage Credit hedge funds Money market intermediaries

16. The Shadow Banking System: A Fragile Financial Infrastructure Steps in Shadow Credit Intermediation (example) Loan origination by finance company using CP Loan warehousing by conduit using ABCP Asset backed security (ABS) issued by special purpose vehicle (SPV) selling ABS ABS warehsing by TRS/repo conduit using ABCP ABS Collateralized debt obligation (CDO) issued by SPV selling ABS CDOs or CDO2 ABS intermediation by Special Investment Vehicle (SIV) using ABCP or repo Wholesale funding of all of the above by MMMF using $1 Net Asset Value (NAV) shares

17. The best of times Capital Inflows Escalating House Prices Easy Money Policy Eager Home Buyers Ambitious Mortgage Brokers Developer Clout Innovative Banks Rating Agencies Securitization MBSs Bank Regulators Gov’t Sponsored Enterprises

18. Vicious Spirals Unleashed Demand – Jobs – Wages – Income – Spiral House Price – Foreclosure Spiral Deleveraging – Debt Deflation Spiral Government Revenue – Cutback Spiral Global Repercussion Spiral Macroeconomic Linkages and Feedbacks

19. Financial Crisis of 2007 - 2009 (cont’d) Banks’ balance sheets deteriorate Write downs Sale of assets and credit restriction High-profile firms fail Bear Stearns (March 2008) Fannie Mae and Freddie Mac (July 2008) Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund (MMMF) and Washington Mutual (September 2008). Fed pumps up bank reserves: TARP/TALF,etc. Lend and lend freely Bailout package enacted House votes down the $700 billion bailout package (9/29/08)  Stock market slumps  Bailout passes on October 3. Congress approves a $787 billion economic stimulus plan on February 13, 2009. Recession deepens

20. Responses: No Bank Left BehindLender of Last Resort / Spender of Last Resort • Tax Rebate $124 bil. • Fed Fund Rate Cuts • Fannie/Freddie $200 bil. • Bear-Stearns $29 bil. • AIG $174 bil. Fed “Facilities” • Primary Dealer Credit Facility (PDCF) $58 bil. • Treasury Security Loan Facility (TSLF) $133 bil. • Term Auction Facility (TAF) $416 bil. • Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil. • Money Market Investor Funding Facility (MMIFF) $540 bil. • More Fed Fund Rate Cuts … Hold At ~0% • Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil. • Term Asset-Backed Securities Loan Facility (TALF) $200 bil. • Emergency Economic Stabilization Act/TARP $700 bil. Government Loans Government Equity • Stimulus Package $787 bil. aka The American Recovery and Reinvestment Act • TARP II • Stress Tests

21. Vicious Spirals Reversed? Tackle them all together! Vicious Spirals Unleashed Refinance Mortgages • Stimulus • Program • Infrastructure • Spending • Tax Cuts Demand – Jobs – Wages – Income – Spiral House Price – Foreclosure Spiral Deleveraging – Debt Deflation Spiral • Revive dual banking system • Cash for Trash • Recapitalize banks • Revive securitization Government Revenue – Cutback Spiral Federal Aid To States Global Repercussion Spiral • G – 20 • Coordinated Stimulus Macroeconomic Linkages and Feedbacks Macroeconomic Linkages and Feedbacks

22. FIGURE 2 Treasury Bill–to–Eurodollar Rate (TED) Spread Source: www.federalreserve.gov/releases/h15/data.htm

23. Dynamics of Financial Crises in Emerging Market Economies Stage one: Initiation of Financial Crisis. Path one: mismanagement of financial liberalization Weak supervision and lack of expertise  lending boom. Domestic banks borrow from foreign banks. Fixed exchange rates give a sense of lower risk. Securities markets not well-developed  Banks important Path two: severe fiscal imbalances: Governments force banks to buy government debt. When government debt loses value, bank net worth down . Additional factors: Increase in interest rates (from abroad) Asset price decrease Uncertainty linked to unstable political systems

24. Dynamics of Financial Crises in Emerging Market Economies Stage two: currency crisis Bank losses  currency crises: Government cannot raise interest rates (doing so forces banks into insolvency)… … and speculators expect a devaluation. Foreign and domestic investors sell the domestic currency. Stage three: Full-Fledged Financial Crisis: The debt burden in terms of domestic currency up Banks more likely to fail: Individuals are less able to pay off their debts (value of assets fall). Debt denominated in foreign currency increases (value of liabilities increase).

25. Financial Crises: Mexico 1994-1995 ...Tequila Financial liberalization in the early 1990s: Lending boom/weak supervision/lack of expertise. Banks accumulated losses/net worth declined. Rise in interest rates abroad. Increased uncertainty (political instability). Domestic currency devaluated Dec. 20, 1994. Tesobono burden Rise in actual and expected inflation.

26. Financial Crises: East Asia 1997-1998 Financial liberalization in the early 1990s: Lending boom/weak supervision/lack of expertise. Banks accumulated losses/net worth declined. Uncertainty increased stock market declines and failure of prominent firms Domestic currencies devaluated (1997). Rise in actual and expected inflation.

27. Financial Crises: Argentina 2001-2002 Currency board: 1 Peso = $1 Fiscal imbalance banks coerced to absorb government debt Appreciation of $  Argentine recession Rise in interest rates abroad. Uncertainty increased (ongoing recession). Domestic currency devaluated, Jan. 6, 2002 Rise in actual and expected inflation.

28. Sequence of Events in Emerging Market Financial Crises