Transcript COMPETITION POLICY: EUROPE - US

Structured Finance and the Global
Financial Crisis
Which Crisis?
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During the second half of the war, there was an
explosion of easy credit, driven by capital from
abroad.
This resulted in lavish displays of wealth — and
opulent living was seen, especially in New York.
Housing prices soared during the war.
But when credit tightened afterward– collapse of
real estate bubble and generalized crisis
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Structural Adjustment
in the US after 1970
Intermediate Patterns
Increasing Household
Indebtedness
Decline in Real Wages
Proximate Causes
Global Savings Glut
(Lower Long Term Rates
‘Market Keynesianism’
Collapse in Personal Savings
Hollowing out of Manufacturing
Finance and Market Ideology
Reign Supreme
Increasing Global
Imbalances
Financial Deregulation
Monetary Policy alone
Financial
Innovation
Growth of Shadow
Banking
Accommodative
Monetary
Policy (Low Short Term
Rate
= Housing Bubble
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Collapsed Real Wages
Real Wage Per Hour
9.50
9.30
9.10
8.90
8.70
8.50
8.30
8.10
7.90
7.70
7.50
19641 19663 19691 19713 19741 19763 19791 19813 19841 19863 19891 19913 19941 19963 19991 20013
Year (Q)
Destruction in Household Balance Sheets
(Personal Savings Rates)
Personal Savings Rate
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
19
52
19
55
19
58
19
61
19
64
19
67
19
70
19
73
19
76
19
79
19
82
19
85
19
88
19
91
19
94
19
97
20
00
20
03
20
06
0.0%
Growing Indebtedness of
Households
Ratio of Household Sector Debt to Personal Income
1.4
1.2
Total Debt
1
0.8
0.6
0.4
Mortgage Debt
0.2
0
1952-I 1957-I 1962-I 1967-I 1972-I 1977-I 1982-I 1987-I 1992-I 1997-I 2002-I 2007-I
Finance and Manufacturing as Percentage of
National Income
Percent of National Income Accounted for
35%
Different Defn'
30%
Manufacturing
25%
20%
15%
Finance, Insurance, Real Estate
10%
5%
0%
1948-I
1953-I
1958-I
1963-I
1968-I
1973-I
1978-I
1983-I
1988-I
1993-I
1998-I
2003-I
2008-I
Global Financial Imbalances
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U.S. borrows 50 % of the worlds capital
that is exported
Deficits and Debt
Ideology
“You mean to tell me that the
success of the economic
program and my re-election
hinges on the Federal Reserve
and a bunch of f***g bond
traders?”
Bill Clinton- 1994
From Woodward “ The
Agenda”
We’re Eisenhower
Republicans here…We
stand for lower deficits,
free trade and the bond
market. Isn’t that great?
Bill Clinton-1998
Financial Deregulation
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Gramm-Leach Bliley replaces Glass
Steagall in 1998
Commodities Futures Modernization Act
(1999)
Sarbanes Oxley Rule (2002)
SEC deregulation of brokers (2004)
‘Self Regulation’ and Trust in Ratings
Agencies
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Proximate Causes
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Easy Credit
Search for Yield
Regulatory Loopholes (particularly CFMA 1999,
SOX,2002 and Leverage Rule, 2004)
Shadow Banking/Securitization of Loan Chain
Discovery of Enormous (Hidden) Leveraging
Inadequate capitalization leading to Liquidity
and then Solvency Crises
Percent
9/1/2008
5/1/2008
1/1/2008
9/1/2007
5/1/2007
1/1/2007
9/1/2006
5/1/2006
1/1/2006
9/1/2005
5/1/2005
1/1/2005
9/1/2004
5/1/2004
1/1/2004
9/1/2003
5/1/2003
1/1/2003
9/1/2002
5/1/2002
1/1/2002
9/1/2001
5/1/2001
1/1/2001
9/1/2000
5/1/2000
1/1/2000
Easy Credit
Federal Funds Rate (Overnight)
8
7
6
5
4
3
2
1
0
Equity markets and the Search for
Yield
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Mortgage bubble took off in
the aftermath of declining
yield from shares
Structured finance:
The players in securitization
End borrowers
I&P ($)
Servicer
Broker places mortgage
loans to borrowers for fee
Broker
LEGEND KEY
O&G – interest and principal
SPV – special purpose vehicle
SPE – special purpose enterprise
SIV – special investment vehicle
MBS – mortgage backed securities
$
Mortgages
Typically a specialized
mortgage bank
Originator
$
I&P ($)
Manages the flow of
interests and principal
(I&P); usually, but not
necessarilly the Originator
Conduit/trust/
SPV/SPE/SIV
Exposure of founder: implicit
guarantee in case of large
losses.
Can assume part of
risks (insurance of
mortgage loans,
insurance of MBS
returns).
$
MBS
Investment bank
(underwriter)
Founder: loan originator or
investment bank
Purpose: transfering
ownerhship of claims (loans)
and collateral (mortgages) in
order to issue mortgage
backed securities (bonds).
Insurance
company
Mortgages
Mutual funds,
pension funds,
hedge funds…
$
CDOs, I&P ($)
Rating agency
Assigns credit
rating to issued
MBSs.
Organizes issuing of
MBSs and places
MBSs to investors in
financial markets.
Institutional
investor
$
Financial
returns ($)
End lenders
(wholesale)
A bank balance sheet
Assets
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Loans
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Liabilities
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Deposits
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Capital
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A shadow banking balance sheet
Assets
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Liabilities
Asset Backed
Securities
Mortgage Backed
Securities
Credit Default Swaps
Interest Rate Swaps
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Collateralized Debt
Obligations
Asset Backed
Commercial Paper
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Banking versus Shadow Banking
Shadow Banking
Banking
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FDIC
Risk Adjusted Capital
Adequacy Ratios
Interbank Market
sets price of liquidity
(money) (LIBOR)
Monetary Policy
affects price, interest
rates, macro balance
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No Equivalent of
FDIC
No Capital
Adequacy Ratios
No state control
over liquidity
creation
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IB Leverage
The ‘Magic’ of Securitization and
Structured Finance
The CDS Market
“Subprime” Growth
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Subprime growth shot up in 2003-2005
By 2006, most Subprime mortgages were securitized
Share of subprime
In total U.S. economy
(measured by GDP):
1% (2001), increasing
to 5% (2005)
Bubble in Housing Prices
The Crisis Begins...
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In August 2007, Crisis begins with first wave of sub
prime Failures
Overleveraged shadow banks (easy credit) were invest
ed in very bad bets (subprime), at scale, with no liqu
idity backstop (unregulated credit markets).
Counterparty Risk was perceived as much larger.
Liquidity starts freezing (Interbank markets start to
experience wild shifts in ability to borrow and lend and
much higher rates for borrowing)
Residential Real Estate Prices Crash
Crisis in Subprime Lending
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Crisis in Subprime
Lending
% of
delinquent
loans (60+
days)
Months from origination
MBS’s lose value
Total Predicted Losses 2.2-3.6
Trillion Dollars! (Oct 08)
TED-Spread: Liquidity Crisis
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LIBOR-Overnight Interest Swaps spread
(Measure of Interbank liquidity)
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Global Declines in Stock Markets
Famous Last Words
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"We have a good deal of comfort about
the capital cushions at these firms at
the moment."
- Christopher Cox, chairman of the U.S.
Securities and Exchange Commission,
March 11, 2008.
The Crisis of 2008--?
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Bailout of Fannie and Freddie,
Collapse of Lehman, Bailout of AIG….
The Paulson Plan -- $700 bn. rescue
Contagion to UK and EU….
The Paulson $200 bn.
TARP, Citi takeover
Recapitalization (still unclear)
Collapse of Aggregate Demand
Worldwide Crisis, Fiscal Stimulus?