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

Presentation by Charles (Chuck) FreedmanScholar in Residence, Economics Department,

Carleton Universityat Wilfrid Laurier University

Waterloo, June 8, 2009

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

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

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

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)

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

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

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

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

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

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

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

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”

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

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)

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)

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

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)

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

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

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)

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

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

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

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

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

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

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

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

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

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

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

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)

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

Monetary easing

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

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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

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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

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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

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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

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

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

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

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

Financial sector restructuring and regulation

CAPITAL AND LIQUIDITY• (1) Higher capital and better quality capital • (2) Unweighted leverage ratios • (3) Countercyclical leverage of some sort• (4) Consolidation of off-balance-sheet entities • (5) Possible limitations on proprietary trading• (6) Liquidity requirements of some form

Financial sector restructuring and regulation

MARKET PRACTICES AND ARRANGEMENTS• (7) Increased use of strongly risk-proofed

clearing and settlement systems with central counterparties for clearing and settlement of derivative transactions of various kinds

• (8) Possible reorganization of the originate to distribute model to ensure that originators have incentive to monitor underlying loans

• (9) Role of credit rating agencies

Financial sector restructuring and regulation

COMPENSATION ARRANGEMENTS• (10) Attention to incentives at all levels of

organizations in the financial sector – may lead to compensation arrangements with increased focus on the medium term and even longer term

• Whether this will be done by boards themselves or with government involvement remains to be seen

• Boards will likely come under pressure by shareholders in setting of compensation

Financial sector restructuring and regulation

SUPERVISORY ARRANGEMENTS• (11) If entities previously unregulated turn out to be too

large to fail or too complex to fail or too interconnected to fail and likely to fall under safety net if run into serious difficulties , essential to bring them under some form of regulation.

• (12) Attention to financial sector that is large relative to size of the country

• (13) Much more attention to the role and influence of risk management units

• (14) Increased regulation of mortgage markets• (15) Greater transparency (reduced opacity), particularly in

the case of derivatives

Financial sector restructuring and regulation

• (16) More and higher quality (better paid) supervisory staff• (17) Legislation should not be overly rigid yet should

provide sufficient safety and stability to avoid repeat of financial crisis

• (18) Possible reorganization of entities responsible for supervision

• (19) In some countries, need for better mechanisms for closure of financial institutions and for crisis resolution

• (20) Possible reconsideration of mark to market accounting, but not necessarily elimination

Financial sector restructuring and regulation

MACRO PRUDENTIAL• (21) Macro prudential supervision will receive

greater attention. Central banks likely to play a leading role in this area.

• (22) Relatedly, the concept of systemically important financial institutions will play a greater role in regulatory and supervisory arrangements

Financial sector restructuring and regulation

SUPERVISORY COORDINATION DOMESTICALLY AND INTERNATIONALLY

• (23) Need for better coordination across the authorities in a given country and across countries

• (24) In terms of cross-border regulatory arrangements, there will undoubtedly be much discussion of how to deal with financial institutions with a worldwide footprint

Future macro and financial sector policies

• More generally, focus on implications of the policy decisions on incentives and potential behavior of financial institutions and financial market participants, as well as the authorities

• Essential to address moral hazard concerns

Canada• Why did Canada have far fewer financial sector problems than the

United States or many European countries?• First, the relatively conservative approach of Canadians (e.g.,

subprime mortgage market) • I would note in passing that Canadian authorities were not very

conservative in this context as for some time they were prepared to countenance low or zero down payments

• Second, Canadian banks were much more cautious than European banks with respect to purchase of CDOs backed by US subprime mortgages and indeed some refused to invest in such instruments altogether on the grounds that they were too risky

Canada

• Third, Canadian banks typically rely on retail deposits to a very considerable extent

• Fourth, since the largest Canadian investment banks (securities dealers) are now subsidiaries of the Canadian chartered banks, they are also indirectly supervised by OSFI (in addition to the securities commissions)

• Hence leverage ratios that apply to the consolidated bank put limits on the risks of the investment banks

• Fifth, Canadian supervisors may be at an advantage in having to deal with only a small number of large institutions and being able to focus more of their attention on such entities

• Sixth, the role of luck should never be underestimated

Canada• That said, Canadian institutions did not emerge unscathed• When liquidity dried up, they were faced with many of the same

liquidity problems as banks in other countries• And problems in the ABCP market had a special Canadian twist related

to the flawed contractual arrangements for liquidity support for certain types of ABCP

• Nonetheless, Canadian authorities had to introduce fewer special arrangements to deal with financial sector problems than their American and European counterparts

• Finally, in the context of the need for fiscal stimulus, Canada was much better off than most other countries because the Government of Canada had run fiscal surpluses over the previous decade of prosperity in order to reduce its debt to GDP ratio

Concluding remarks• Financial sectors and economies worldwide have been under

enormous stress in the last couple of years• Unprecedented actions by the authorities appear to have prevented

the situation from becoming even worse than it has been• Looking forward, important decisions will have to be made regarding

what is needed to restructure the financial system to avoid a recurrence of the problems that it has faced and whether some of the innovative techniques introduced by the authorities to combat the crisis should be retained for the longer term

• The interrelationship of monetary stability and financial stability and the possible role of financial stability issues in the conduct of monetary policy will also undoubtedly receive considerable attention