Financial+Crisis notes

7/29/2019 Financial+Crisis notes

1/29

Journey over the next 3 weeks

Financial crisis and European Debt Crisis

The South African economy

The goods market (IS) The financial market (LM)

The IS-LM model

European debt crisis and the liquidity trap


2/29

The Financial Crisis and the

European Debt Crisis

A Depressed World Economy


3/29

Financial Crisis & European Debt Crisis

Why are we looking at this?

Relevant to current macroeconomic environment

SA exists within a global economy

Most significant economic slowdown since GreatDepression (event from which the discipline ofmacroeconomics emerged). So there must be somesignificance.

The IS-LM model is great for understanding the policyresponse to the depression

Relevant to your essay (incentive)

Hopefully interesting


4/29

08/09 Financial Crisis

World recession

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GDPgrowth(PPPUS$)

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5/29

Increased unemployment

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Unemploymentrate

USA EU OECD


6/29

What happened?

It started in the US with the collapse of the US

housing bubble

Who to blame? Greedy banks or

government?

So, the story begins...


7/29

In wake of dot-com bubble and recession, declining

and very low US interest rates

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Interestrate(%)

US Lending and Real interest rates

Lending interest rate (%) Real interest rate (%)

Cheap money


8/29

Growing housing bubble - highly debt leveraged economy

Heading for a Minsky moment...

Low i (cheapmoney)

lending bybanks

Creation ofmortgages

Securitisationprocess

DD houses

P houses

Debt andleverage


9/29

Once this massive credit crunch hit, it didnt take long before wewere in recession. The recession in turn, deepened the creditcrunch as demand and employment fell, and credit losses of

financial institutions surged. Indeed, we have been in the gripsof precisely this adverse feedback loop for more than a year. Aprocess of balance sheet deleveraging has spread to nearlyevery corner of the economy. Consumers are pulling back onpurchases, especially on durable goods, to build their savings.Businesses are cancelling planned investments and laying off

workers to preserve cash. And, financial institutions areshrinking assets to bolster capital and improve their chances ofweathering the current storm. Once again, Minsky understoodthis dynamic. He spoke of the paradox of deleveraging, in whichprecautions that may be smart for individuals and firms and

indeed essential to return the economy to a normal state nevertheless magnify the distress of the economy as a whole.

Janet Yellen, vice chair of the FED from a speech entitled A Minsky Meltdown: Lessonsfor Central Bankers. April 16, 2009


10/29

What is this Minsky moment?

Financial instability hypothesis

Focus of hypothesis = leverage (build up of debt relative toassets and income

Leverage feels good until it feels terrible

Period ofeconomicstabilitywith low

debt

Borrowing Debt Overall

level ofleverage

Sets stagefor Minskymoment

Economic stability/expansion and rising prices leads to complacency,

perception that debt is safe, borrowing as a habit and lessons of past

forgotten (relaxation of lending standards)

As long as nothing bad happens in the economy, lending doesnt seem

very risky


11/29

The trigger

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Interestrate(%)

US Lending and Real interest rates

Lending interest rate (%) Real interest rate (%)

The catalyst - i


12/29

Debt levels andleverage high

enough

Trigger risinginterest rate

Collapse of housingbubble

Minsky moment

Lenders rediscoverrisks of debt and

debtors are forcedto start deleveraging

Debt-deflation spiral

Recession

Minsky moment and the debt-deflation spiral


13/29

The debt-deflation spiral

Borrowers cantmake

repayments andunder threat ofdefault

Sell houses topay off mortgage

SS housesP houses

Borrowersunderwater

At the same time...

fi


14/29

Deleveragingconsumers

slash spending

DD

Production&

Investment

Ue

Deflation

Burden ofconsumer

debt becomesworse

The debt-deflation spiral

At the same time...

Debtors cant spend,

creditors wontspend

Slump in demand

Recession in US


15/29

Banking sector collapses

Increasing numberof defaults

Banks realisebalance sheets are

not healthy

Realise otherBanks balancesheets arent

healthy

Stop lending to oneanother

Credit markets dryup

Threat of a bankrun

Banking systemcollapses


16/29

End result

Worst recession since the Great Depression Bailouts of some of the biggest and most

successful banks and investment banks in theworld

Recession spreads to rest of world

SA has first recession since dawn ofdemocracy

Current world economy still feeling effects(e.g. European debt crisis)


17/29

How did this happen?

The low interest rate cheap moneyenvironment enabled excessive lending in theeconomy

A financial system marked by deregulation sincethe 1980s allowed for increasingly risky lendingpractices

Together, low interest rates and deregulation fedthe housing bubble

Perverse incentives evident in the financial sector

One of the most notable sources of risk withinthe financial system was the securitisationprocess (mortgage backed securities)


18/29

Recent regulatory reform, coupled with innovative

technologies, has stimulated the development of

financial products, such as asset backed securities,

collateral loan obligations, and credit default swaps,

that facilitate the dispersion of risk...These increasingly complex financial instruments have

contributed to the development of a far more flexible,

efficient, and hence resilient financial system than the

one that existed just a quarter century ago.Alan Greenspan, October 12, 2005


19/29

Banking back in the day

2 core functions

Hold deposits and facilitatetransactions

Assess and manage risk and

create loans

Lubricant to the economy

match those with excess savings

to those who need finance

Efficient allocation of financialresources to more productive

use

$R1m loan (10 yr)

at 10%

Stream of payments R10k each year and R1m

in tenth year bank gets R1.1m

1000

loans 1000 x R1m loans at 10%Means R1.1bn stream of

income

Banks made money from

differential between lending

rate and deposit rate

k b d


20/29

Banking gone badStream of payments R10k each year and R1m in

tenth year bank gets R1.1m x 1000 loans = R1.1bn

$

R1m loan x 1000 =

R1bn worth of

loans

1000

loans

I$

Investment bank pays bank

R1bn (plus some fees) for

rights to future stream of

income from loans

Bank bundles

loans and sellsfuture stream of

income to

investment bank

ki b d


21/29

Banking gone bad

I$

1000

loans

Stream of payments

R10k each year and

R1m in tenth year

bank gets R1.1m x

1000 loans = R1.1bn

Transfers rights to

future stream of

payments to Company

Divides company up

into shares an sellsshares (profit)

Creates company (SPE)

1 000 000 shares at

R1100 per share (at

least)

Owners of shares entitled to

1/1000000th of future stream of income

These are mortgage (loan) backed

securities

SH


22/29

A volatile system created by deregulation and perverse incentives

Mortgage

Originator

$ I$

Ratings

Agencies

Shareholdersof MBSs

Loans

Stream of future payments

Stream of future

payments

SPE


23/29


Mortgage originators incentivised to

make more mortgages (fees)

Quantity over quality

Trusted bosses to check risk of

mortgages

Banks did not check riskiness ofmortgages because selling them off

in bundles to investment banks (no

incentive to be cautious because no

longer their loan)

l l d b d l d


24/29


Post Great Depression eraregulations (to protect borrower

and society as a whole fromexcessive risk taking andexploitation from banks) removedin 80s and 90s

Deposit insurance and moral hazard

necessitated regulation - lessonsforgotten

Banks used to make profit from interest differential change in

banking cultureits all about the fees Because banks sold off bundles of mortgages, they designed

products that simply maximised fees (Perverse incentive once

mortgage sold, not their problem)

l il d b d l i d i i


25/29


Bad products:

100% non-recourse loans (moralhazard)no equity of the debtorinvolved. Could just up and move. Loselose situation for both bank and debtorthough

Mortgages that allowed borrowers todecide on value of payments (negative

amortisation) Liar loans

Greenspan encouraged flexible interestrate loans

Constant refinancing

E.g. Doris Canales refinanced home13 times in 6 years with no-docmortgages

Many others... All based on incentive tomax fees

Perverse incentive of

borrower (moral hazard)and lender (did not bear

risk of bad loans) aligned

to get biggest house

possible

A l il d b d l i d i i


26/29


Deregulation Glass-

Steagal Act repealed in

1999 (too big to fail moral hazard i.e

commercial banks were

under the same umbrella

as investment banks andso were not expected to

fail with such resources)

A l il d b d l ti d i ti


27/29


Should have recognised the risk

of products whose safety they

were asked to certify Incentive to give AAA rating to

client whose paying them

Race to the bottom

Flawed investment models

Pension funds in jeopardy

A l til t t d b d l ti d i ti


28/29


No link to communities loss ofincentive for bank to be a reliablelender to the communities it services (loss of channel for

renegotiation


29/29

Summary

Housing bubble pops

US economy in recession

Spreads to global economy

Ultimately sets the scene for the Euro Debt

Crisis

US response to recession (more about this is

week 3)

Financial+Crisis notes

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