Building blocs of a credit crisis Presentation for Unitech students at TU Delft, 4 January 2010 by Dr Alfred Kleinknecht, Professor of Economics, TU Delft.

Building blocs of a credit crisisPresentation for Unitech students at TU Delft, 4 January 2010

by Dr Alfred Kleinknecht, Professor of Economics, TU Delft

What type of crisis?

• This is a crisis of over-speculation. Such crises happen quite frequently in history, but often they are restricted to certain markets or countries.

• This crisis is "historic" as it takes place on a World-wide basis, comparable to the great railway crash after 1873 and the Wall Street crash of 1929.

• Other than the classical business cycle (Juglar cycle) and the long-run Schumpeter-Kondratieff wave, however, it is a non-regular crisis.

There seems to be no reason for a crisis …

• After a fairly long Juglar recession (starting in 2001), the "classical" business cycle was just starting a new growth period around 2005/6; normally, such a period should take 5-7 years.

• In the mid-1990's we started a new phase of the Schumpeter-Kondratieff wave of higher growth, driven by ICT as a new key technology. ICT (as a General Purpose Technology) still has a great potential for economy-wide process, product- and service innovations and high productivity growth.

→ … reasons for optimism?

Building blocs of this crisis:

• Bonuses that encourage ruthless speculation• Regulating authorities have become weak

after a long neo-liberal campaign for the retreat of government, the "deregulation", "flexibilization" and "liberalization" of markets, driven by a strong belief in "efficient markets".

• A World-wide "savings glut": capital searching for investment opportunities is used for building up asset bubbles (petrol money; more uneven distribution of income).

Traditional credit business …

The bank is an intermediary between demand for credit and supply of savings

Savings → Bank → credit (e.g. mortgage)

(end of story)

The new credit business:

1. House owners obtain mortgages from banks2. Banks sell all rights and liabilities of the mortgages

to an investor, typically as 'packages' with different risk profiles (these packages become 'securities');

3. Advantages to the banks: • Risk of default in payment is shifted to a larger

number of investors → spreading of risks • As you spread risks, you can take more risks … (as

an airbag induces car drivers driving faster)• The revenues from selling the mortgages give

banks extra room for granting new mortgages

Problematic: the "rating" of risks

• A "Rating Agency" (Moodies; Standard & Poor or Fitch) judges the risks of default of (bundles of) mortgages (how reliable are the house owners?)

• The more favourable is the rating, the higher will be the price of the (bundle of) mortgages

• Rating Agency receives a fixed percentage of the value of the bundle of mortgages (Note: the value of these bundles is dependent on the rating!)

• Insight ex-post: "Ratings" have been systematically too optimistic (explanation?)

Another crucial thing: “Leverage”

An example of financing without leverage

(silly & dull!):

Firm X needs 100.000 Euro as its working capital; they make 10.000 Euro profit per year.

Financing all that capital with equity (i.e. with their own money), the Return on Equity (ROE) is: 10%

Note: this firm would be an ideal candidate for a Private Equity firm!

More sexy: a reasonable leverage

The working capital of 100.000 is financed as follows:30% equity + 70% bank credit, against 4% interest; total profits remain 10.000.

Return on Equity (ROE):10.000 profit – 2.800 interest = 7.200 (net profit on Euro 30.000 equity)

→ ROE becomes 24%! (i.e.: 7.200 / 30.000*100)

Much more sexy: A Wall Street type leverage

The firm's working capital is financed as follows:5% equity + 95% bank credit (against 4% interest; total profits remain 10.000)

ROE: 10.000 profit – 3.800 interest = 6.200 (you make 6.200 net profit on 5000 Euro of your own capital!)

→ your ROE is 124%! (i.e.: 6.200 / 5000*100)

Note: Profits and capital requirements remained unchanged; only the financial structure changed!

Summing up:

• As long as profits on your total invested capital are higher than interest rates, you can increase the Return on Equity (ROE) by financing with credit.

• The lower the interest rates and the higher the share of borrowed capital in total capital, the higher is your leverage.

• With higher leverages, you can offer higher returns to your suppliers of equity – which means higher bonuses!

The risk of leverage:

Your working capital of 100.000 is financed as follows:5% equity + 95% bank credit (against 4% interest);

Problem: your firm makes a loss of - 10.000

What is then your ROE?-10.000 'negative profit' plus 3.800 interest = - 13.800 (i.e. you make 13.800 net loss on your 5.000 equity!)

→ the negative ROE becomes –276%! (i.e.: -13.800 / 5.000*100 = -276%)

A popular leverage: Mister X inherited a land house from his parents, free of mortgages.Estimated market value: 2.000.000 euro

Step 1: He obtains from his bank a mortgage of 1.8 million, giving the land house as a guarantee (interest on the mortgage: 5%)Step 2: Mister X buys shares in the stock exchange worth 1.8 million (Expected gains: 10-20% per year)Step 3: Mister X obtains another bank credit of 1,4 million (against 5% interest); the package of shares previously bought (worth 1.8 million) serve as a guaranteeStep 4: Mister X buys shares worth 1.4 millionStep 5: Mister X obtains another bank credit of 0.9 million (against 5% interest); the package of shares previously bought (worth 1.4 million) serve as a guarantee, … etc.

2000-2003: the Amsterdam stock exchange falls by almost 60%

What happens to Mister X?

His bank is becoming nervous.Fortunately, they made a sophisticated credit contract …

Solution: → Sell all shares before they go down further!→ "House for sale!”

Unfortunately, there were many people that had the same splendid idea …

Second round effects of forced sales:

After 2001:

Many, many houses "for sale" → downward pressure on prices in the 'upper segment' of the housing market

Extra downward pressure on share prices

Macro economic background: The import surplus of the USA

Import surplus:• Exports minus

imports (billion US $):

1991 - 31,1

1995 - 104,0

2000 - 379,8

2002 - 423,7

2004 - 612,1

2005 - 714,4

2006 - 758,5

2007 - 711,6

Ca. 7% of US National Product!

The 'current account' (trade balance) of the USA in 2006

Imports(Goods and services)

Exports (Goods and services)

2.204,2 Billion US $ 1.445,7 Billion US $

Import surplus:

-758,5 Billion US $(This is about 7% of the US National Product)

Definitions:

(Net) Export surplus = "National savings surplus" If we export more goods than we import, we produce

more than we consume. Other countries are eating part of our National Product

(Net) Import surplus = "National savings deficit" If we import more goods than we export, we

consume more than we produce. We eat part of other countries' National Product.

Examples:

Import surplus of the USA in 2006: 758 billion dollars

Export surplus of the Netherlands in 2006: ca. 40 Billion Euro (ca. 7.5% of National Product)

Question: How is this compensated?

Through trade in valuable assets

The capital account covers trade in valuable assets (i.e. shares, bonds, real estate, art, and – more recently – mortgage securities) 

Capital account

Import of capital (Acquisition by foreigners of Dutch shares, bonds, real estate etc.)

Export of capital

(Acquisition by Dutch citizens of foreign shares,

bonds, real estate etc.)

The balance of payment

"Current Account" (goods and services)

+ "Capital account" (assets)

= "Balance of payments"

Important: Current Account + Capital Account need to

be jointly in (approximate) equilibrium (otherwise there will be a balance of payment crisis)

How do imbalances in goods trade influence the exchange rates of currencies?

If US imports are 758 billion higher than US exports: what should happen to the exchange rate of the US Dollar? (ceteris paribus)

If Dutch exports are 40 billion Euro higher than Dutch imports, what should happen to the exchange rate of the Dutch Guilder? (ceteris paribus)

Note: The value of a currency is determined simply by supply and demand!

The export surplus of the Netherlands leads to more supply of foreign currency and more demand for Guilders (Dutch exporters want to exchange their foreign currency export revenues into their national currency)→ Dutch Guilder

The import surplus of the US leads to more supply of dollars and more demand for foreign currencies (foreign exporters want to exchange their dollars into their national currencies)→ US Dollar

How do imbalances in assets trade influence the exchange rates of currencies?

The exact opposite holds for capital exports and capital imports:

• If Dutch investors buy assets in the US, they need dollars (offering their own currency in exchange)

US Dollar:

• If foreign investors buy Dutch assets, they have to buy Dutch Guilders and sell US Dollars

Dutch Guilder:

Summarizing:

• An export surplus of goods and services (Current Account) drives up the value of our currency; an import surplus of goods drives it down

• An export surplus of assets (Capital account) drives down our own currency; an import surplus of capital drives our currency up

• If the export surplus on the current account is approximately equal to the export surplus on the capital account, exchange rates are fairly stable

What does the current account deficit (import surplus) of 758 billion US dollars mean? (1)

The US have to sell every year assets (shares, bonds etc.) worth about 758 billion dollars to foreign investors in exchange for "too many" goods and services being imported

Note: This is a net amount: the US have to sell 758 billion more of assets than Americans buy abroad

What does the current account deficit (import surplus) of 758 billion US dollars mean? (2)

• In recent years, US assets sold to foreigners consist increasingly of bonds (debt paper) issued by US firms and the US government – and of mortgage-based securities

• The growing national debt translates into debts of individual actors such as:– government (national debt), – firms (bonds, bank loans) or – private citizens' debts (mortgage debt; consumer

credit; credit card debt)

How long can you continue building up debts?

Quite long: Export surpluses (= national savings surpluses) and import surpluses (= national savings deficits) are equal to each other on a World scale → There is, by definition, enough money to lend and borrow, as long as the surplus countries are ready to lend to the deficit countries.

Credit depends, however, on trust!

Trust has been damaged → e.g. the market for mortgage 'securities' has collapsed

Reasons for optimism

• National Central Banks have succeeded to orchestrate a gradual decline of the US Dollar (a sudden crash of the US Dollar would have been disastrous!)

• Thanks to a lower value of the dollar, the US can more easily export (and receive less imports).

• Buying of US assets becomes cheaper for foreign investors (and US investors buy less assets abroad, as they got more expensive).

Looking ahead (1):

There is a danger of higher inflation in the US:

1. The low value of the Dollar makes US exports cheaper and imports more expensive → more export / less imports (less aggregate supply, more aggregate demand)

2. The low dollar makes US imports more expensive → import of inflation!

3. The US Federal Reserve has lowered interest rates and widened money supply → inflation? (Think of the Fisher equation: MV = TP)

The Fisher equation:

M x V = P x T

Money supply

Velocity of money: number of times that a

piece of money changes its owner (assumed to be

constant)

Price level Transaction volume:

Goods and services traded in an economy

Discussion: Is a higher dollar inflation attractive to the US? (Their debts are nominated in dollars!)

Looking ahead (2):

Consequences of higher inflation in the US:

• Nominal interest rates might rise → value of (old) bonds (at lower interest rates) has to go down → what about risks of 'second round' effects of forced sales due to aggressive leverages??

• Foreign investors (in dollar priced assets) suffer strong losses and might demand higher risk premiums in the future

• It might become more expensive financing future US national savings deficits (import surpluses)

Looking ahead (3):

Solutions:• Americans have to consume less and save more

(higher exports, lower imports)• Europe and Asia have to do the exact opposite, as

the US are less able to absorb the national savings surpluses of Asia and Europe.

• This can lead to lower growth in the export-lead economies of Asia, but also in countries like Germany and the Netherlands that have large export surpluses.

• A solution could be higher domestic consumption and lower savings in Asia and Europe (otherwise: lower growth)

Looking ahead (4):

Difficult to judge:• There is a bubble of over-valued assets (shares,

bonds, art objects, houses, office rooms etc.) built up through a long period of low interest rates (Shiller Index)

Uncertainties: → A breakdown of prices due to panic sales or forced

sales? (leverage finance!)→ Lower consumer spending through losses on assets?→ More bankruptcies of banks, insurance companies,

high-leveraged hedge funds or private equity firms?→ Are there still more Bernard Madoffs? → Domino-effects?

Finally: Why did so many people not foresee the emerging debt crisis?

→ Strong believe in stable and efficient markets– Market are stable: they always strive towards equilibrium– Markets are efficient (welfare maximizing outcomes)– Actors are rational and act in the interest of their firm.

→ As long as a bubble is building up, there is a lot to be earned! ("We had to dance as long as the music was on!")

→ "Black Swan": Events may have small probabilities to occur, but if they occur, consequences can be disastrous!

Yet, there were clear symptoms of an emerging crisis …

• Enormous build-up of debt in the US• Tobin's Q gave a clear indication that stock markets

were over-valued• A World-wide tendency towards a more unequal

income distribution. Rich people save higher shares of their income → "A World-wide savings glut" (Bernanke).

• These excess savings have to be invested somewhere (high probability of asset bubbles).

US: Domestic debt as a percentage of GDP (1950-2007)"Household" = Consumer and mortgage debt"Business" = Total non-financial business sector debt"Financial" = Total financial sector debt"Public" = total public sector debt (local and federal)

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Leverage financing!

Rapid rise in housing prices

→ higher mortgages for consumption

US: Tobin's Q, 1932-2007Definition: Stock market value of firms, divided by the accounting value of their assets (3-year moving averages)

US: Average income of the bottom 90% and of the top 1%, 1933-2006)

Summarizing: There were strong indications of a coming crisis (for those who wanted to see them):

• A growing debt burden in the US: Earlier or later, the chain of credit had to brake (at its weakest link)

• A high value of Tobin's Q (comparable to the value in 1929!)

Why was this not seen (by so many people)?• Strong believe in stability and efficiency of free

markets (and in rational actors) → theoretical convictions and ideological beliefs influence perception of empirical facts

One more source of instability: The credit multiplier

The "credit multiplier" – how does it work?

Suppose your grandmother makes a deposit of 1000 euro into her savings account. The bank wants to use that money for giving credit to a client.

Problem: The bank is not allowed to lend the full amount; it has to keep 10% as a reserve

Note: For simplicity, we assume there is only one bank; all money transfers go through this bank's accounts

How can banks "create" money? (2)

Step 1: The bank lends 900 to a client. 100 is put aside as a reserveStep 2: The receiver of the credit pays his supplier → there is a new deposit of 900 on the supplier's bank account Step 3: The bank can again give a credit of 90% of this new deposit. New credit: 810 (90 is kept as reserve)Step 4: The receiver of this new credit pays somebody → there is a new deposit of 810 on somebody else's bank accountStep 5: The bank can again give 90% of that amount as credit …

How much credit can be given if we complete the whole chain?

Formula:

Credit volume = deposit x 1 / reserve ratio

Hence: 1000 x 1 / 0.10 = 10.000 (if the reserve ratio is 10%) → Thanks to the 1.000 euro savings of your grandmother, the bank can give 10.000 euro credit

Question:How can a central bank influence the supply of money?

Above we assumed there is only one bank – how does it work with several banks?

The chain: deposit → credit (+ reserve) → new deposit → new credit (+ reserve) → new credit … extends to several banks

Solution? Inter-bank credits

… but what if the banks do no more trust each other?

(Emergency solution: Central Bank gives credit)

Discussion:

Imagine people fear that their bank is in problems …

How could a speculator earn money with that?