Financial Crisis and Market Panic

1. Financial Crisis and Market Panic Keith Maskus October 27, 2008

2. How did we get here? Big picture from globalization • Since 1980s financial disturbances have become more frequent, bigger and more global. Many are antecedents to current case. • Usually followed by significant rise in money and credit. • Dramatic integration and modernization of global capital and financial markets (chart).

4. How did we get here? Big picture from globalization • Massive growth in wealth and savings of emerging economies (some due to China’s currency policy): a “glut” of global savings (Bernanke, 2002) that could flow anywhere overnight. • This financed the unsustainably large (small) household consumption (savings) and government deficits, which built dangerous levels of debt in US, UK and elsewhere (chart).

6. How did we get here? Big picture from globalization • Commodity price inflation. • The US had no evident policy response other than to keep interest rates low and permit dollar to fall (chart).

7. Euro, Canadian $, Yuan per US$

8. How did we get here? Housing and finance • House price bubble fueled by: • Rapid growth in US credit conditions • Loose monetary policy and dollar decline • Low perceived investment risk in US housing • Expansion of subprime and Alt-A lending • Similar processes in UK, Ireland, Spain, E. Europe, etc. • Successive deregulation of financial markets to encourage risk-taking, eg, • 1999 repeal of Glass-Steagall Act permitted commercial banks to develop “shadow” lending instruments. • 2000 Commodity Futures Modernization Act essentially removed derivative instruments from capital requirements or other regulation. • A failure to regulate Fannie Mae and Freddie Mac after accounting scandals in 2003-04, instead a bargain to expand housing loans. • Astonishing expansion of credit derivatives (eg, credit-default swaps) through financial innovation not subject to capital requirements. • CDS forecast by financial economists in 2000 to peak around $100 billion. • Current global stock is thought to be around $55-60 trillion. • Unlimited use of leveraged lending based on bubble psychology. • Other involved markets: commercial real estate, commercial paper, credit card loans, state and local bonds.

9. What happened? • By mid-2006 rising interest rates burst bubble and increased foreclosures. Home prices began to collapse (chart).

11. What happened? • Significant use of credit derivatives by hedge funds to bet that housing prices would fall. • Financial firms through 2007 came to understand that their assets were: • Not transparent and subject to multiple claims (who owned them? Who paid for them?) • Difficult to value • Heavily interconnected • In 2008 the rescues or collapse of major real estate lenders, investment banks, and insurance companies destroyed confidence in system and trust that loans would be repaid. • Failure of government authorities and central banks to put forward a coherent, coordinated and systemic plan to recapitalize banks in timely way. • Results: dramatically higher costs for interbank lending (chart) and short-term commercial borrowing; and a weeding out of low-end borrowers (chart).

13. Didn’t anybody see this coming? • The Economist magazine began writing about housing bubble in 2004. • Report from BIS, 2006: situation unsustainable. • OECD, IMF in 2004-05: US should raise savings. • NY Fed president 2005: prepare for bad shocks. • Economists NourielRoubini and Robert Shiller have anticipated a crash since 2003-04. • But everybody else is in “shocked disbelief”.

14. Recession: how bad can it be? • Continuing fall in asset values reflects: • Ongoing deleveraging • Forced asset sales by hedge funds and others • Anticipations of global recession • Scope of recession depends on effectiveness of financial rescue projects and fiscal stimulus. • Major forecasts still predict small or zero growth in real GDP in 2009, recovery 2010. • Unemployment forecast to peak at 8% or so in 2009. • These are probably optimistic but no one expects a replay of Great Depression.

15. What to do? • Make it clear that Federal Reserve and Treasury are prepared to inject more capital and guarantee commercial paper. Basically demand that these funds get lent. • Develop an effective means of refinancing troubled mortgages. • Develop new mortgages that better reflect ability to pay. • Bring “shadow lending” back into regulated world with transparency requirements and capital ratios. • Stimulate the economy, focusing on infrastructure, extended unemployment insurance and retraining assistance. • Do it again. And again.

16. The global dimensions • All of this requires serious international policy coordination to: • Avoid regulatory arbitrage in finance; • Deal with macro imbalances; • Avoid ruinous currency depreciation in emerging economies (chart).

17. Emerging economy currencies falling (Brazilian Real, Mexican Peso, Korean Won & Hungarian Forint per $)

18. Global dimensions • We need also a renewed commitment not to raise trade and investment barriers. • China to the rescue? Oil exporters?

19. Is there any good news? • Stock market is probably overshooting. • Forecasting models still point to a mild recession. • From great crises come major revisions of policy and behavior. Maybe Americans will regain their fiscal sanity.