The Financial Crisis of 2008: Causes and Consequences

J. Peter FerdererMacalester College

21 October 2008

Outline

• A Chronology of the Collapse

• Eight Causes

• Maturity Mismatch and Leverage

• Another Great Depression?

• Q & A

Parallels to Natural Phenomena

Source: The Economist

Parallels to Natural Phenomena

Source: The Economist

Parallels to Children’s Stories

Source: The Economist

Bank Failures start in Europe

• German and French Special Investment Vehicles (SIVs) unable to rollover commercial paper and close funds (August 2007)

• U.K. experiences first bank run in more than a century (9/19/2007

14 March 2008: The First Investment Bank Collapses

- JPMorgan Chase takes over Bear Stearns

- Bear’s mortgage book might contain “whopping further losses” (The Economist)

- The Fed makes $30 billion loans to I-banks as well as regulated banks - a significant shift in policy

13 July 2008Federal Government Takes over

Freddie and Fannie Mac

- Fannie and Freddie own or guarantee $5.2 trillion in mortgage debt

16 September 2008: When things went from bad to worse

- Lehman Brothers – Wall Street’s 4th largest Investment Bank – collapses

- Barclay’s and Bank of America step away

- U.S. Treasury lets Lehman go

- Counterparty risk spikes as Lehman files for bankruptcy

17 September 2008:Size Matters

- American International Group (A.I.G.) fails due to credit-default swaps.

- The government takes control of the company

24 September 2008: And then there were None

- Goldman Sachs and Morgan Stanley convert into bank holding companies

- Mitsubishi UFJ buys 20% of Morgan

- Warren Buffett injects $5 billion into Goldman

September 25: The Biggest Bank Failure in History

- Regulators seize Washington Mutual, the country’s

largest savings and loan institution and sell most of its operations to JPMorgan Chase.

- More than $300 billion in assets (Continental Illinois, had $40 billion when it toppled in 1984).

3 October 2008 Bailout Bill Passes

• $750 billion ($2,500 per American)

• Initially created to buy “toxic” assets off financial institution balance sheets

• $250 used to buy ownership positions in banks.

The Magnitude of the Problem

• Estimated worldwide losses on debt: $1.4 trillion (IMF)

• $760 billion written down by banks, insurance companies, hedge funds and others

• Cost of average systemic banking crisis in OECD counties over the past few decades: 16% of GDP

• Cost of the U.S. bailout so far: $760 billion (7% of GDP)

The Housing Boom and Bust

Explanation #1Asymmetric Monetary Policy

- Too much borrowing

- Too much short-term borrowing

Explanation #2:The Savings Glut in the ROW

Rest of the World United States

Loanable Funds

Loanable Funds

r rSROW

IROW

r*

S

I

I0S0S0I0

NCOROW>0 NCOUS<0

r*

S1 I1

Explanation #3 Democraticisation of Home Ownership

- Community Reinvestment Act of 1977

- Fannie Mae and Freddie Mac (Government- sponsored mortgage buyers) were encouraged to guarantee a wider range of loans in the 1990s.

- Tax deductibility of mortgage interest payments

Explanation #3 Democraticisation of Home Ownership

61

62

63

64

65

66

67

68

69

1994 1996 1998 2000 2002 2004 2006 2008

U.S. Homeownership Rates

Explanation #4 The Great Moderation

Source: Dallas Federal Reserve Economic Letters (September 2007)

Explanation 5 Erosion of Lending Standards

• Adjustable Rate Mortgages (ARMs)

• No-documentation mortgages

• No down payments

• NINJA mortgages (“No income, no job or no assets”)

The Default Decision

$80,000

$100,000

$20,000

$90,000

$10,000

What does home owner do it they need cash due to loss of job or medical emergency?

$100,000

$100,000

$0- $10,000

20 Percent Down Nothing Down

Home Value

Mortgage

Equity

$90,000

Suppose the market price of homes falls

Mortgage Defaults

Explanation #6Innovation – New Financial Instruments

- New instruments allow risk spreading

- Options

- Interest-rate and credit-default swaps

- Securitization (Collateralized Debt obligations, CDO)

Securitization

Source: The Economist

Credit-Default Swaps

Source: The Economist

$20,000 per person

A.I.G.

Explanation #6Innovation – New Financial Instruments

1. Upside to greater risk spreading

- The cost of capital falls- Credit is “democratized” - The system is more resilient to shocks

2. Downside

- Large counterparty risk - Difficult for regulators to keep track of firm exposure (A.I.G.)

Explanation #7Innovation – Off the Balance Sheet

Solution: Basel Accord I (1988) mandates that banks must hold $0.08 in capital for every $1.00 in assets

Impact on Banks: Reduces their ability to increase profits through leverage

Bank Response: Create “Structured Investment Vehicles” (Basel capital requirements for credit linesto SIVs are less than 8%.)

Problem: Loan defaults expose banks to insolvency

Explanation #8Deregulation

The Old Model

$

mortgages

Commercial Banks SaversBorrowers

Investment BanksBonds

Stocks

Savings & Loans

Business loans

Savings Account

Demand Deposits

Bonds Stocks

$ $

$

$ $

The New Modelfunds

mortgages

Commercial Banks

SaversBorrowers

funds

deposits

InvestmentBanks

mortgages

structured products

Structured products (“Collateralized Debt Obligations”) are portfolios of mortgages, split into tranches.

- Diversification (regional)- Heterogeneous risk appetites (“Super Senior” v. “toxic waste”)

Pension Funds

Hedge Funds

Structured Investment Vehicles (SIVs)

Three Problems with the SIVs

• Maturity Miss-match (long-term assets funded by short-term liabilities) exposes them to funding and liquidity risk

• Excessive Leverage to Increase returns makes the system more fragile

• Liquidity Problems spill over to sponsoring Commercial and Investment Banks

Structured Investment Vehicles

Risk perceived to be low

Commercial Paper Outstanding

Source: Brunnermeier (2008)

Problems Rolling over ABCP

Liquidity injections by

Central Banks

BNP Paribus closes funds

Bear Stearns

fails

Lehman Brothers

fails

Leverage and Amplification

Leverage Example

Assets Liabilities

Financial Intermediary

Securities: $100

Debt: $90

Equity: $10

L = A/(A-L)

= 100/(100-90)= 10

Financial firm manages its balance sheet to maintain constant leverage

Event: Security Prices rise by 1%

Assets Liabilities

Financial Intermediary

Securities: $101

Debt: $90

Equity: $11

L = A/(A-L)

= 101/(101-90)

= 9.18

How must firm react to keep leverage at 10?Issue more debt and buy more securities

Event: Security Prices rise by 1%

Assets Liabilities

Financial Intermediary

Securities: $110

Debt: $99

Equity: $11

L = A/(A-L)

= 110/(110-99)

= 10

Thus a $1 rise in the price of securities leads to a $9 increase in debt and security purchases

Event: Security Prices fall by 1%

Assets Liabilities

Financial Intermediary

Securities: $110

Debt: $99

Equity: $11

L = A/(A-L)

= 109/(109-99)

= 10.9

How must firm react to keep leverage at 10?

$109 $10

Sell $9 of securities and pay off $9 in debtRole of Mark-to-Market

Balance sheet after assets sold

Assets Liabilities

Financial Intermediary

Securities: $100

Debt: $90

Equity: $10

L = A/(A-L)

= 100/(100-90)= 10

Implication: Positive feedback loops and amplification

- Contagion across balance sheets

rising/falling asset prices

Stronger/weaker balance sheets

The Cost of Making Markets Liquid

The average credit spread of the 15 largest credit derivative dealers (ABN Amro, Bank of America, BNP Paribas, Barclays Bank, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs Group, HSBC, Lehman Brothers, JP Morgan, Merrill Lynch, Morgan Stanley, UBS, and Wachovia.)

Another Great Depression?

Source: The Economist

Cartoon

Spillovers

The Economist

Fed Policy

The Economist

Reason for Optimism: Size of Government

Y = C + I + G + (EX – IM)

No External Constraint

Y2K9/11

Conclusion

Competing Views

Financial Market Efficiency

Eugene Fama

Financial Market Instability

Hyman Minsky

Financial Market Efficiency• Freer (deregulated) financial markets produce

superior outcomes.• Unencumbered capital flows to its most

productive use, boosting growth and economic welfare. (tech. boom)

• Innovations that spread risk more widely (e.g., credit default swaps) reduce the cost of capital, “democratize credit” and make the system more resilient to shocks.

Financial Instability

• Periods of stability lead to excess and eventual crisis.

• Stability encourages greater leverage and ambitious debt structures (e.g., reliance on short-term funding).

• Financial innovation allows banks to avoid regulatory hurdles (capital requirements and off-balance sheet vehicles).