THE FINANCIAL CRISIS: CAUSES AND REACTIONS Philipp Bagus

1. THE FINANCIAL CRISIS: CAUSES AND REACTIONS Philipp Bagus

2. INDEX • Introduction • The time dimension of savings • Maturity mismatching • Limits to maturity mismatching on a free market • Excessive maturity mismatching • What was done? VII. The private bailout alternative

3. I. INTRODUCTION Maturity mismatching Artificial boom Credit expansion = MM Tragic efects Bust What about other types of MM?

4. I. INTRODUCTION The golden rule For the activity of the banks as negotiators of credit the golden rule holds, that an organic connection must be created between the credit transactions and the debit transactions. The credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. More exactly expressed, ‘The date on which the bank’s obligations fall due must not precede the date on which its corresponding claims can be realized.’ Only thus can the danger of insolvency be avoided. (Mises 1953, 263)

5. II. THE TIME DIMENSION OF SAVINGS How long will it last? Subsistence fund

6. II. THE TIME DIMENSION OF SAVINGS

7. II. THE TIME DIMENSION OF SAVINGS Is Roger Garrison´s modell of one market for loanable funds too simple? Two dimensions of money savings In reality several markets for loanable funds They constitute together the yield curve

8. II. THE TIME DIMENSION OF SAVINGS i Yield curve term

9. II. THE TIME DIMENSION OF SAVINGS Uncertainty aversion Time preference (for liquidity) Preference for longer term Normally upward sloping

10. III. MATURITY MISMATCHING 3 Months LOAN 1 Month Need to roll over

11. III. MATURITY MISMATCHING MM may be successful Future availability of savings correctly antipated MM beneficial in a free market

12. IV. LIMITS TO MATURITY MISMATCHING ON A FREE MARKET Endangers the whole project LIMITS Speculators Competitors Customers Traditional rules of finance Positive net working capital

13. IV. LIMITS TO MATURITY MISMATCHING ON A FREE MARKET Assets Liabilities Long term assets Long term liabilities Short term assets Working capital Short term liabilities

14. V. EXCESSIVE MATURITY MISMATCHING Credit expansion as a special case of maturity mismatching In extremis Roll-over possible Money supply Differences to other types of MM Legal difference

15. 1000 € deposit Immediate 5 years 900 € Loan for investment project 1000 € 3-month commercial paper 3 months Hedge fund Investment bank GSE, SIV 30 years 1000 € mortgage, ABS, CDO

16. V. EXCESSIVE MATURITY MISMATCHING Bank´s balance sheet Assets Liabilities Mortgages Corporate loans Consumer loans Stocks Equity Long term bond Negative Working capital Demand deposits 3 month commercial paper Repo´s Cash Short term loans

17. V. EXCESSIVE MATURITY MISMATCHING Incentives for maturity mismatching and effects „Borrow short – lend long“ i Yield curve before mm Yield curve after mm Term

18. V. EXCESSIVE MATURITY MISMATCHING Fractional reserve banking as a promoter of MM Interbank market FRB promoter Demand deposits as substitutes Constantly growing money supply

19. V. EXCESSIVE MATURITY MISMATCHING Central banking as a promoter of MM Boosts interbank market liquidity by accepting long term assets Roll-over lender of last resort promoter Removes competition barrier Prevents fire sale

20. V. EXCESSIVE MATURITY MISMATCHING Government as a promoter of MM Implicit guarantees (too big to fail) Government Moral hazard in MM Public institutions (Freddie, Fannie now) Explicit guarantees

21. V. EXCESSIVE MATURITY MISMATCHING Consequences Maturity mismatching Long term i S of long term funds People not willing to reduce C Artificial boom More long term projects than resources Recession

22. V. EXCESSIVE MATURITY MISMATCHING Implications MM may cause unsustainable projects 100% reserves not enough Our present crisis caused by MM (investment banks, GSE, AIG, etc.) Need for total freedom in monetary system (including 100 % reserves)

23. VI. WHAT WAS DONE? Prevention of a cumulative process possible? Real problems Falling Housing prices Defaults Less collateral, falling optimism Bank solvency deteriorates Not rolling over any more Credit contraction Liquidity problems Falling Asset prices Bankrupticies

24. V. EXCESSIVE MATURITY MISMATCHING Bank´s balance sheet Assets Liabilities Mortgages Corporate loans Consumer loans Stocks Equity Long term bond Losses Demand deposits 3 month commercial paper Repo´s Cash Short term loans

25. VI. WHAT WAS DONE? Bank´s losses (Lehman collapse) Low capital ratios Credit market collapses Secondary contraction Necessary liquidations

26. VI. WHAT WAS DONE? Two measures: Central banks substituted interbank market We analyze: tomorrow Capital infusion into financial institutions Prevention of a secondary recession

27. VI. WHAT WAS DONE? Costs of bail out plan: Indiscriminate bail out of unsustainable business modells Public debt Crowding out of private capital Private credit Moral hazard (risk premium)

28. VI. WHAT WAS DONE? Costs of bail out plan: Regulation of decision making (dividends, etc.) Problem of exit strategies Regime uncertainty

29. V. EXCESSIVE MATURITY MISMATCHING Two possibilities Assets Liabilities Mortgages Corporate loans Consumer loans Stocks Equity Long term bond Losses Demand deposits 3 month commercial paper Repo´s Cash Short term loans

30. VII. The private bailout alternative 1. Debt into equity conversion Automatic recapitalization Advantages Avoids costs of public bailout Allows functioning until long term assets mature Avoids liquidation

31. VII. The private bailout alternative Avoids costs of public bailout Creditors decide on viability No crowding out No moral hazard Free decision making No exit stragegy problem Defends private property

32. VII. The private bailout alternative 2. Equity increase via capital markets

33. VII. The private bailout alternative What about traditional liquidity problems? Capital was available

34. VII. The private bailout alternative Advantages of private capital increase: Investors decide on viability No crowding out No moral hazard Free decision making No exit stragegy problem Defends private property

35. VII. The private bailout alternative Public vs. Private Bailout Free market Debt into equity conversion Private capital increase Implies important costs Avoids secondary depression and costs of public bailout

36. VIII CONCLUSIONS Excessive maturity mismatching as cause of crisis Public bail out with harmful consequences Private bail out would have been possible

37. Thank you very much ! Questions?