Transcript Financial Meltdown

Confluence: A workshop on the
current financial crisis.
Steve
Beckman
Quick Tour of Economy
Consumption / Income
.72
.70
.68
.66
.64
.62
.60
55
60
65
70
75
80
85
90
95
00
05
Government Spending / Income
.250
Total
.225
.200
.175
Federal
.150
.125
.100
.075
State and Local
.050
55
60
65
70
75
80
85
90
95
00
05
Investment / Income
.20
.19
.18
.17
.16
.15
.14
.13
.12
55
60
65
70
75
80
85
90
95
00
05
Current Account / Income
.02
.01
.00
-.01
-.02
-.03
-.04
-.05
-.06
-.07
55
60
65
70
75
80
85
90
95
00
05
Consumption / Income
Investment / Income
.72
.20
.19
.70
.18
.68
.17
.66
.16
.15
.64
.14
.62
.13
.60
.12
55
60
65
70
75
80
85
90
95
00
05
55
60
65
70
75
80
85
90
95
00
05
00
05
Current Account / Income
Government Spending / Income
.250
.02
Total
.225
.01
.00
.200
-.01
.175
Federal
-.02
.150
-.03
.125
-.04
.100
.075
-.05
-.06
State and Local
.050
-.07
55
60
65
70
75
80
85
90
95
00
05
55
60
65
70
75
80
85
90
95
Summary
• Consumption’s share rises 8%.
– Probably because wealth increases due to stock and
housing booms.
• Investment share is about stable.
• Government share falls 2%.
– Massive shift to state and local spending from federal.
• Current Account share falls 6%.
– If we buy more goods and services than we sell we must
sell our assets. That is, foreigners own larger and larger
chunks of America. This is widely seen as unsustainable
Predicted unwinding
• Krugman, and the film
IOUSA, speculate that a
falling $ will force imports
and consumption down.
The film argues strongly for
reduced federal deficits.
• Krugman focuses on the
slowly falling $ and
relatively low US interest
rates as an anomaly.
A Surprise Ending
• Euro falls in
value!
Pound versus PPP rate
450
400
350
300
250
200
150
100
50
55
60
65
70
75
SPOT
80
85
PPP
90
95
00
05
Public wants T-Bills despite new debts.
As night follows day • The housing and stock market booms generate high
wealth, high consumption and large trade deficits.
• So, housing and stock market busts will reduce
consumption and reduce the trade deficit.
• This generation of economists, though, was taught that
markets are efficient and incorporate all future
information, including the probability of a bust.
• The result is that asset prices are a random walk and
booms do not forecast busts. Or so we thought…
Robert Shiller’s P/E series
50
20
2000
45
1981
40
14
Long-Term Interest Rates
Price-Earnings Ratio
16
1929
35
30
12
1901
Price-Earnings Ratio
25
1966
10
20
8
15
6
1921
10
5
18
4
Long-Term Interest Rates
0
1860
1880
1900
2
1920
1940
Year
1960
1980
2000
0
2020
Shiller’s Hypothesis
• Shiller claims asset prices have an irrational
cyclical component associated with manias
and crashes.
• The P/E ratio is not a random walk because it
keeps returning to a value of 15.
• Bounces around 15 are “excess volatility”.
• An investor that always gambles on a return to
15 will not do well in the short run.
Unemployment Rate
Second Tributary - Asian Crisis
• Large stock market and housing bubbles fueled by
thinly capitalized finance companies.
• Massive inflow of $ in the mania phase. Massive
outflow as panic breaks.
• Thai companies have agreed to repay debt in $.
• Central bank tries valiantly to keep exchange rate fixed.
Gamble everything and lose. Ask IMF for assistance.
• IMF demands realistic exchange rate (depreciation) and
Thai companies must offer more Baht per $ to pay debt
but this accelerates the depreciation.
Asia – Multiple equilibria
• As baht falls, companies fail.
• As companies fail, exports fall and baht falls.
• Reinforcing cycle where depreciation makes recession
worse.
• This is new, in 1992, depreciation in UK shortened
recession by increasing exports. UK companies were
not as exposed to $ debt.
• Asia learns not to trust IMF or Rubin and Summers at
the US Treasury.
• Rubin and Summers believe their pressure on Asian
countries to open up to foreign capital markets is
justified.
Third Tributary – Finance
• In the 1980’s Savings and Loan associations are stuck with
lots of low interest loans as inflation and interest rates rise.
• Congress lets S&L’s and banks bundle loans together and
sell them. This is “securitization”.
• Collateralized Debt Obligations or CDO’s – the loans sold by
banks are collateralized by the houses (or cars) purchased
with the loan.
• CDO’s are divided into tranches – first tranche is paid first.
Last tranche is paid last this is the equity tranche or “toxic
waste”. Higher risk tranches pay higher interest.
• Sometimes banks hold toxic waste as incentive to make
good loans, but not always.
Finance part II
• Banks sell CDO’s to SIV’s (Structured Investment
Vehicles) These are essentially subsidiaries that allow
bank to move CDO off the balance sheet freeing up
capital.
• SIV gets a letter of credit in case the loan customer
defaults.
• Possible to buy insurance in case the CDO defaults. The
purchaser pays periodic payments in return for a
promise to pay the default amount. These are credit
default swaps and the market is unregulated.
• Roughly $60 trillion in CDS’s now.
Finance – Hedge Companies
• Say the HF borrows $4 for every $1 it puts up. Leveraging is
5:1
• HF buys $100 million of toxic waste from $2 billion CDO.
($80 million from bank, $20 million own funds).
• A 1% loss on the CDO generates losses of $20 million which
is all charged against the toxic waste. The HF equity is
gone. So, in effect leverage is 100 to 1.
• HF must sell assets to restore its equity stake.
• If all other funds are selling assets then it is in deep trouble.
• HF bought toxic waste to get high returns in normal times.
If it goes bad, HF folds but managers are paid fees.
Confluence – The headwaters.
• Massive capital inflow from Asia after 1997 crisis.
– Do not trust IMF, want own $.
– Want $ to hedge against currency risk.
• Fed reduces interest rates after stock bubble bursts.
• Banks have lots of money to invest, need clients.
– Loan quality falls, piggyback loans, NINJA loans.
– Bad loans sold off. Evidence good loans were
held.
Subprime to prime in 6 months
• Rising Losses on Mortgage Credit
Default Swaps. The ABX index is
based on a basket of 20 credit
default swaps referencing assetbacked securities containing
subprime mortgages (rated, for
example, BBB-). An investor
seeking to insure against the
default of the underlying
securities pays a periodic fee
(spread) which – at initiation of
the series – is set to guarantee an
index price of 100. As the price of
the ABX drops, the protection
buyer has to pay an additional fee
of (100 – ABX price), when
purchasing the default insurance.
Default, lower prices, more default.
• As default rates rise on poorly documented, high
risk loans, CDO’s experience losses.
• HF and others must sell assets to cover positions.
• Banks make good on letters of credit to SIV’s and
begin to hoard cash and cut back on new home
loans.
• Lower home prices convince more people to
default on the loan.
• We have same sort of dynamic that created Asian
Crisis but in out backyard and in a much larger
market.
The timeline
• August 2007: first large liquidity crisis as HFs sell assets.
Fed and ECB inject money.
• October 2007: Major write downs at banks, sovereign
wealth funds recapitalize banks.
• March 2008: Fed allows Investment banks to borrow from
Fed. Seen as bad omen. Bear Stearns has major loan to HFs
exposed to Freddie Mac and Fannie Mae securities. False
rumor spreads further doubts about Bear-Stearns.
• Bear-Stearns relies heavily on overnight Repo’s for
financing and finds it can not borrow. Sold for $2 a share
(later $10 a share – had been $150 12 months earlier.)
• July 13, Government guarantees debt of Freddie and Fannie.
• Sept 7. Government conservatorship of Freddie and Fannie
• Sept 12. Paulson calls banks and investment banks to NY Fed
to say no more government help. Krugman calls it Russian
Roulette and says there is a bullet in the chamber.
• Sept 16: AIG stock value falls 90% Fed organizes $85 billion
bail out.
• Ted spread widens and there is a global decline in stock
values
• Sept 19: Paulson announces $700 billion bail out.
• Nov 25? : Additional $800 billion announced, $600 B. for
Fannie and Freddie, $200 B. for auto, student and consumer
credit.
Case / Shiller Housing Price Indexes
280
DC
240
200
SF
160
Denver
120
80
40
88
90
92
94
96
98
00
02
04
06
08
The TED spread
Fed has done its best…