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The financial crisis: Initial conditions, basic
mechanisms, and appropriate policies.
Olivier Blanchard
Munich lecture, November 2008
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1. Introduction
Much too early to give a definitive assessment.
Not too early to think about the basic mechanisms, and whether/howwe can prevent similar events in the future.
A first pass, in the midst of the action. With thanks to the IMF team.
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The basic question: How could such a small trigger have such enormous effectson world output?
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Initial Subprime Losses and Subsequent Declines in World GDP,
US Households Real Estate Wealth, and US Stock Market Capitalization
(in Billions US Dollars)
Source: IMF Global Financial Stability Report; World Economic Outlook November update and estimates; Federal Reserve Flow ofFunds Accounts; World Federation of Exchanges.
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Organization
Initial conditions
Two amplification mechanisms
Interconnections and dynamics
Implications for policy now and in the future
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Setting the stage: Initial conditions
The trigger: The issuance of risky assets, with undervaluation of risk.Subprime mortgages (but not only).
Causes? Large world demand for safe assets, and bad regulation.
The determinants of amplification.
Complexity and opacity of assets on balance sheets of financialinstitutions, so low liquidity.
Causes? Better risk allocation, and bad regulation.
Increased leverage (lower capital relative to assets).
Causes? Bad, and sometimes perverse regulation.
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A visual sense of the complexity. From mortgages to securities
Subprime
Borrower
Subprime
Servicer
Subprime
Lender
SubprimeSecuritization
Structure
Loan
proceeds
Loan cash
flow
Lines of
credit
Bought by less
risk-seeking
investors
Subprime AAA
& AA bonds
Subprime BBB-
through Single A
bondsABS are bought
by CDOs and
tranched into
structured
products, financed
by issuing debt
Residuals
Bought by
more risk-
seeking
investors
BanksSecuritization
Underwriting
Banks provide liquidity
to lenders
Bamks provide
financing to CDOs
CDO
equity
Bought by more
risk-seeking
investors
CDO
debt
Bought by
other
CDOs
InsurersProvide insurance on
CDOs, ABS and some
SIVs
Banks provide credit
lines to conduits / SIVs
ABCP Conduits
/ SIVs buy ABS
and issue short-
term debt
Bought by both
low and high risk-
seeking investors
Loan cash
flow
Loan cash
flow
ABCP
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Amplification mechanism 1. Runs
Bad (or doubtful) assets on balance sheets
Runs (not only by depositors, but by other investors)
Need to sell assets.
Not enough deep pocket investors to buy (or investors waiting for theright moment to buy).
Firesale prices. P < E N P V .
Worse balance sheets. More incentives to run, etc
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Amplification mechanism 2. Capital
Bad (or doubtful) assets on balance sheets
Decrease in capital ratio (Assets minus liabilities, over Assets)
Need to sell assets (deleverage)
Not enough deep pocket investors to buy. (id)
Firesale prices. P < E N P V .
Lower capital ratio. More incentives to sell assets, etc
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The two mechanisms: Conceptually separate but strongly interacting
Run on financial institution 1
Cut credit to financial institution 2
Sale of assets at depressed prices
Low capital, so further sales
Or cut credit to financial institution 3
Examples. From US banks to Hungary. From subprimes to other assets.
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The dynamics in real time
Increase in probability of insolvency.
Increase in counterparty risk.
Decrease in volume and maturity of interbank lending.
Contagion across institutions. From direct exposure to subprime on-wards.
Contagion across countries. From the US to Europe, to emerging marketcountries.
Increasing effects on the ultimate borrowers: households and firms.
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Contagion across institutions, assets, and countries
Emerging markets
Corporate credit
Prime RMBS
Commercial MBS
Money markets
Financial institutions
Subprime RMBS
Jan- 0 7 Jul- 0 7 Jan- 0 8 Oct - 08
Heat Map: Developments in Systemic Asset Classes
Source: IMF, Global Financial Stability Report, October 2008
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Counterparty risk: Difference between the lending rate between banks and theriskless rate
0.0
1.0
2.0
3.0
4.0
5.0
01/01/07 08/01/07 03/01/08 10/01/08
US Euro Japan UK
Sep 15, 2008
Lehman Files for Bankruptcy
Ted Spreads: 3-month Libor Rate minus T-bill Rate
(in percent)
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Emerging market spreads
Emerging Markets Sovereign Srpeads - Composite Index
(1/2/06 - 11/12/08)
1/2/06
4/2/06
7/2/06
10/2/06
1/2/07
4/2/07
7/2/07
10/2/07
1/2/08
4/2/08
7/2/08
10/2/08
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Bank lending standards
-40
-20
0
20
40
60
80
100
3/30
/05
6/30
/05
9/30
/05
12/30/05
3/30
/06
6/30
/06
9/30
/06
12/30/06
3/30
/07
6/30
/07
9/30
/07
12/30/07
3/30
/08
6/30
/08
9/30
/08
U.S.: C&I loans U.S.: Mortgages
ECB: Large company loans ECB: Mortgages
Bank Lending Standards
Change in the Balance of Respondents Between Tightened Considerably-Tightened Somewhat and Eased Somewhat-EasedConsiderably in Percent of Respondents. Source: Haver Analytics.
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Financial policies for the short run
Need to dampen/eliminate the two amplification mechanisms.
Runs: Provide liquidity to a broader set of institutions.
Done. Still problem with institutions, countries without access to lenderof last resort (Iceland).
Capital.
Buy bad assets. For two reasons: Clarify price. Move price closerto EPDV.
Increase capital.
Many institutions may still need recapitalization. So need to add
capital (buy shares).
Second leg takes time to implement. May need guarantees for deposi-tors, and for interbank claims. To start interbank lending.
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Basic financial architecture in place in advanced countries
A crucial weekend in October, but:
Problems with speed/scope of recapitalization
Coherence across countries
Still hidden land mines. for example: CDS positions.
Problems in emerging market countries.
Sudden stops. Need access to international liquidity provision.
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Counterparty risk since September
3-month Libor Rate
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
8/1 8/16 8/31 9/15 9/30 10/15 10/30
US Euro Japan UK
Ted Spreads: 3-month Libor Rate
minus T-bill Rate
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
8/1 8/16 8/31 9/15 9/30 10/15 10/30
US Euro Japan UK
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Sovereign spreads since September
0
500
1000
1500
2000
2500
3000
3500
7/2/07 9/2/07 11/2/07 1/2/08 3/2/08 5/2/08 7/2/08 9/2/08 11/2/08
Current account deficit larger than 5% of 2007 GDP
Current account surplus, or small deficit
Sovereign CDS Spreads
(index 7/2/07=100)
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From the financial crisis to the economic crisis
Not a side show.
Direct effects: Credit growth, stock prices, exchange rates
Indirect effects, through confidence, and wait and see
A Keynesian recession
Worsens the financial crisis
Back to fiscal and monetary policy (in addition to financial policies)
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Decrease in stock prices
30
40
50
60
70
80
90
100
110
120
J
an-00
A
ug-00
M
ar-01
Oct-0
1
M
ay-02
Dec
-02Jul-0
3
Feb
-04
Sep
-04
A
pr-05
N
ov-0Ju
n-0
J
an-07
A
ug-07
M
ar-0Oc
t-08
WILSHIRE 5000 DJ EURO STOXX TOPIX
Equity Markets in Advanced Economies
(March 2000 = 100; national currency)
0
50
100
150
200
250
300
350
400
450
500
Jan-00
Aug-00
Mar-01
Oct-0
1
May-0
Dec-02
Jul-0
3
Feb-04
Sep-04
Apr-05
Nov-0
Jun-06
Jan-07
Aug-07
Mar-08
Oct-0
8
ASIA LATIN AMERICA EASTERN EUROPE
Equity Markets in Emerging Economies
(Index 2001=100; national currency)
Source: Bloomberg and IMF staff estimates.
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Decrease in confidence
-25
-20
-15
-10
-5
0
5
30
50
70
90
110
130
150
170
Jan-00
Aug-00
Mar-01
Oct-01
May-02
Dec-02
Jul-03
Feb-04
Sep-04
Apr-05
Nov-05
Jun-06
Jan-07
Aug
-07
Mar-08
Oct-08
EU (right scale)
U.S. (left scale)
Consumer Confidence(United States, 1985 = 100; Euro Area, percent balance)
35
40
45
50
55
60
65
Jan-00
Aug
-00
Mar-01
Oct-01
May
-02
Dec
-02
Jul-03
Feb-04
Sep-04
Apr-05
Nov
-05
Jun-06
Jan-07
Aug
-07
Mar-08
Oct-08
Euro area
United States
Emerging economies
Manufacturing PMIs(Values greater than 50 indicate expansion)
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Growth forecasts
-0.7-0.4 -0.2
5.2
-2
-1
0
1
2
3
4
5
6
7
8
United States Euro Area Japan Emerging & DevelopingEconomies
Real GDP Potential GDP
Real and Potential GDP Forecasted Growth Rates
for 2009; in percent
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Looking forward. How to avoid a repeat?
Back to the trigger and the two mechanisms: To limit the build up of systemic risk.
Broader regulation and monitoring systemic risk.
Limit leverage.
More transparent pricing and tracing of assets. Centralized trading
rather than over the counter.
For runs: Broader liquidity provision.
Across institutions, in exchange for regulation,
Across countries, for runs on claims in foreign currency.
For capital: Procyclical capital ratios.
A public fund to purchase illiquid assets at E N P V x?
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The international dimension
Need to coordinate regulation, national policies. Ireland and unilateralguarantees.
Need to monitor risk at a global level.
Exposure of Austria and Belgium to Hungary, of France to Belgium.
Exposure of emerging markets to sudden stops.
Need to organize multilateral liquidity provision. Swaps, and the newIMF facility.
Need for burden sharing rules if recapitalization. National approaches
have large spillovers.
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