Making Sense of the Global Financial Crisis

1
Making Sense of the Global Financial Crisis

• Christopher Ragan
• Department of Economics
• McGill University
• and
• Clifford Clark Visiting Economist
• Department of Finance
• October 20, 2009

2
Highly leveraged banks
Credit crunch
Shadow banking system
Systemic stability
AIG
Global savings glut
Counterparty risk
Toxic assets
Expansionary monetary policy
Regulatory arbitrage
Bear Stearns
Collateralized Debt Obligations (CDOs)
Sub-prime mortgages
Lehman Brothers
Global search for yield
Securitization
Mortgage-backed securities
Fannie Mae Freddie Mac
Originate to distribute
U.S. housing collapse
3
Outline of Talk

• 1. Crucial micro elements
• 2. Key macro pressures
• 3. Fatal interactions
• 4. Policy responses
• 5. Myths and lessons

4

• Part 1
• Crucial Micro Elements

1. Home mortgages 101 2. The evolution of
mortgage lending 3. Securitization 4.
Regulatory arbitrage
5
Home mortgages 101
1. Bank accepts deposits 2. Lends money to home
purchaser 3. Downpayments and collateral 4.
Bank holds the mortgage asset
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Specialization in mortgage lending
originate to own
originate to distribute
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What to do with all these mortgages?

• Assemble a large portfolio of risky assets and
  manage it.
• OR
• 2. Assemble a large portfolio and then create
  lower-risk securities, each backed by the small
  piece of the large portfolio
• ? securitization

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Securitization of residential mortgages
A B C D E F G H I J
K L M N O P Q R S T
U V W X Y Z 1 2 3 4
5 6 7 8 9 10 11 12 13 14
Diversified pool of residential mortgages --
reduces risk
Each individual mortgage is a risky asset
individual and aggregate risks
MBS
MBS
MBS
MBS
MBS
MBS
MBS
MBS
MBS
MBS
MBS
MBS
Each mortgage-backed security is just a small
piece of the overall diversified mortgage pool.
MBS
MBS
MBS
MBS
MBS
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This process keeps the cash flowing -- used to
purchase more mortgage assets
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Securitization of residential mortgages
mushroomed over the past decade
U.S. GSE versus Private-Label MBS Issuance
In billions of US dollars
Source International Monetary Fund, Global
Financial Stability Report, October 2009.
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Capital ratios, leverage, and the shadow banking
system

• The power of leverage
• Different rules for commercial banks
• versus investment banks
• 3. 1 2 ? Regulatory arbitrage

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Growing securitization led to increased bank
leverage
Bank Leverage Ratios
assets as a multiple of capital
Note Based on data for the big six Canadian
banks, seven major banks from the Euro area, six
major UK banks and five large U.S. commercial
banks. Canadian data are based on the regulatory
ratio of assets (including some off-balance sheet
items) to adjusted Tier 1 and Tier 2 capital.
Leverage for other countries is measured as the
ratio of balance sheet assets to shareholders'
equity. Last data point is 2008Q2. Sources
Bloomberg financial statements.
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especially in the U.S. investment banks.
Leverage Ratios
assets as a multiple of capital
Sources Bloomberg financial statements.
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• Part 2
• Key Macro Pressures

1. Expansionary monetary policy 2. The global
savings glut 3. The global search for yield
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After 2000, central banks loosened their monetary
policies significantly
Policy Interest Rates
per cent
Sources Bank of Canada, U.S. Federal Reserve,
European Central Bank and Bank of England.
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which generated strong growth in business and
household credit
U.S. Total Household Credit
U.S. Total Business Credit
Y/Y per cent change
Y/Y per cent change
Source U.S. Federal Reserve Board.
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and fuelled a booming U.S. housing market.
U.S. Existing Home Prices
U.S. Housing Starts
index, 2000 Q1 100
Level 3-month moving average
Source U.S. Bureau of Economic Analysis.
Note SP/Case Shiller Home Price Index. Sources
Standard Poor's Fiserv MacroMarkets LLC.
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What is the global savings glut?

• The large accumulation of foreign-exchange
  reserves by
• 1. Large Asian economies with CA surpluses
• 2. Oil-exporting countries with large NOCs
• ? What to do with all these FX reserves?

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Large current account imbalances

• Current Account Balance

In billion USD
Source IMFs WEO
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and fast-rising oil prices
Oil Prices
US/bbl
Source Bridge CRB.
21
led to huge increases in foreign-exchange
reserves.
Growth in Selected Official Foreign-Exchange
Reserves
US Billions
Sources IMFs IFS data September 2009
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Many of these assets were invested in U.S.
Treasuries and longer-term assets
Share of US Treasuries held by Foreigners
per cent
Sources US Treasury
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which reduced longer-term interest rates
G10 10-year Government Bond Yield
per cent
Sources National Central Banks and National
Statistical offices, Haver . Department of
Finance Canada Calculations. The 10-year
government yield is the weighted average of the
yield on 10-year government bonds for the US,
Canada, Japan, UK, Euro area, Switzerland,
Sweden, Norway, Australia and New Zealand. The
real measure is the weighted average of the yield
on 10-year government bonds deflated by core
inflation.
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... and shifted down the entire yield curve.
US Yield Curve
per cent
Both dates represent similar phases in the
monetary policy cycle.
Source Federal Reserve
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These two forces produced a global search for
yield
Growing global demand for U.S. mortgage-backed
securities
Growing demand for credit by FIs
Growing demand for mortgage assets
Rising demand for U.S. houses
Declining quality of mortgages
Growing provision of mortgages
Rising leverage in banks
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Declining quality of mortgages?
New U.S. Sub-prime Mortgages
Billions USD
Sub-prime share of total mortgage originations
(right)
Per cent
Sub-prime mortgage originations (left)
Source Inside Mortgage Finance, via Joint Center
for Housing Studies of Harvard University
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As the process continued, there was an overall
spreading of risk

1. Risks spread across the world as investors bought
   the U.S. mortgage-backed securities
2. Risks spread to other parts of the financial
   sector, as financial institutions insured their
   portfolios

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• Part 3
• Fatal Interactions

1. Falling U.S. house prices 2. Rising mortgage
foreclosures 3. Financial losses and
counterparty risks 4. Credit crisis ?
Financial crisis
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U.S. house prices first slowed and then dropped
off a cliff
U.S. Existing Home Prices
U.S. Housing Starts
index, 2000 Q1 100
Level 3-month moving average
31
Source U.S. Bureau of Census
Note SP/Case Shiller Home Price Index. Sources
Standard Poor's Fiserv MacroMarkets LLC.
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which led to rising delinquencies of sub-prime
mortgages
U.S. Mortgage Delinquencies by Vintage Year
60 day delinquencies, in per cent of original
balance
2006
2005
2001
2000
2007
2002
2004
2003
Months from origination
Source International Monetary Fund, Global
Financial Stability Report, October 2008.
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and eventually increased foreclosures.
U.S. Delinquency Rates
U.S. Share of Loans in Foreclosure

• As foreclosures rise
• banks put the houses on the resale market
• further depressing house prices
• more people walk away from their homes
• more delinquencies and foreclosures
• banks put more houses on the market
• and so on

Per cent
Per cent
Foreclosure is a legal process that can take
anywhere from 45 to 365 days
The delinquency rate includes loans with payments
30, 60, and 90 days or more past due, but are not
yet in foreclosure
Sources Mortgage Bankers Association of America
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Foreclosures and falling house prices, in turn,
led to large downgrades in MBSs
Ratings on MBSs (which were AAA when issued
2005-07)
In percent, as of June 30, 2009
Source International Monetary Fund, Global
Financial Stability Report, October 2009.
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which naturally led to a decline in their
market value.
Prices of U.S. Mortgage-backed Securities
In U.S. dollars
2006
2007
2008
Source International Monetary Fund, Global
Financial Stability Report, October 2008.
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Rising counterparty risk led to a credit crunch

and eventually a full financial crisis
Credit Spreads
basis points

Lehman Brothers bankruptcy
Bear Stearns
ABCP crisis
Notes These spreads are a measure of banks
funding costs relative to a risk-free rate and
are a gauge of financial market stress and banks
financing pressures. The rate on the
overnight-indexed swap (OIS) is used as a proxy
for expected overnight rates. LIBOR is the London
Interbank Offered Rate. CDOR is the Canadian
Dealer Offered Rate. Daily data up to and
including September 28, 2009. Source Bloomberg.
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.. with enormous losses for many large financial
institutions
Mortgage-Related Write-downs and Credit Losses
since 2007Q3
Billions, USD
Since 2007Q3, financial institutions have posted
over US1600 billion in write-downs and credit
losses.
Sources Bloomberg, September 28, 2009.
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and huge declines in the worlds stock
markets.
World Equity Markets
change from January 1, 2007 to March 2, 2009
Source Bloomberg.
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• Part 4
• Policy Responses

• Financial sector vs. the real economy?
• Monetary policy
• 3. Actions to assist financial markets
• 4. Fiscal policy

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What was likely to happen?

1. Credit is like electricity to a modern economy,
   and banks are like the power company.
2. A decline in the flow of credit would inevitably
   lead to a significant global recession.
3. The financial sector is part of the real economy!

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The largest global recession in many years
Growth of world real GDP
per cent per year
Average 1980-2010 3.2
Sources IMF
40
Unprecedented global monetary policy response
Policy Interest Rates
per cent
Sources Bank of Canada, U.S. Federal Reserve,
European Central Bank and Bank of England. Daily
data up to and including Sept. 30.
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included the use of unconventional monetary
policy tools.
Central Bank Assets
Index January 2008 100
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Most governments also introduced measures to
support financial markets.

• Canadian Support to the Financial Sector (
  billions)

Insured Mortgage Purchase Program 64
New 10-Year Canada Mortgage Bond 8
Canadian Lenders Assurance Facility N/A
Canadian Life Insurers Assurance Facility N/A
Crown Corporations Flexibilities including Business Credit Availability Program 7
Canadian Secured Credit Facility 12
Bank of Canada 40
Total 131
Source Canadas Economic Action Plan A Third
Report to Canadians, September 2009.
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G-20 leaders coordinated their substantial fiscal
expansions

• Fiscal Stimulus Flowing in 2009 and 2010, G7
  countries

per cent of GDP
Source IMF, Update on Fiscal Stimulus and
Financial Sector Measures, April 26, 2009, p.5.
IMF estimates exclude loans, including those to
the auto sector, for all countries. Figure for
Canada includes additional provincial-territorial
stimulus actions in addition to that assumed in
the Economic Action Plan as estimated by the
Department of Finance.
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and accepted the deterioration in their
medium-term fiscal outlooks.
Total Government Budget Deficits, 2009
Per cent of GDP
Source IMF WEO, October 2009.
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Part 5Lessons and Myths

• Blame and greed?
• The end of laissez-faire?
• 3. Regulatory reform
• 4. Baby and the bathwater

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Thank you. Questions?