Everything you wanted to know about the financial crisis but were afraid to ask

1. Everything you wanted to know about the financial crisis but were afraid to ask 16 October 2008 Shawn Donnelly (UD, European Economic Governance) Master ES Regulation Track Centre for European Studies LEGS Department

2. Overview • Financial crisis of 2008 Impact of the crisis • Nature of the crisis • Collapse and contagion • Government responses • International responses • Prospects

3. 1: Financial Crisis of 2008 • US mortgage market collapses • Many US mortgage banks collapse • All US investment banks dead • Widespread nationalisation of American banks to prevent total collapse of financial system • Global contagion threatens meltdown

4. 2: Impact of the crisis • Massive cash injections slow crash • Nationalisations stabilise banks, prevent bank runs, at great cost • Governments consider tougher regulation on banking (and need to!) • Poor European or global responses • Recession, unemployment, inflation growing over next 2 years

5. 2: Nature of the crisis • Crisis of confidence in bank solvency • Collapse of mutual assistance of banks • Government remains only lender of last resort to the financial system • Banks became insolvent due to government lifting regulations on the banking industry

6. 2: Nature of the Crisis • Shift from reserve-based banking and risk management • Banks ration and price loans according to (own assessment of) credit-worthiness • Banks retain risk of default • Government regulations focus on minimum reserves to offset risk of default • Results in rationing of loans for home ownership • Others must rent in the private market or from public housing

7. 2: Nature of the Crisis • Shift to ‘pipeline’ banking, risk management • Banks price loans according to credit-worthiness • But banks lend as much as they can to people who can’t pay back their mortgages (esp. USA) • Mortgages packaged as Asset-Backed Securities (ABS) and Collateralised Debt Obligations (CDOs) together with ‘good mortgages’ • Sold through investment banks to financial markets (other banks, insurance companies, etc.), within and outside the US at attractive interest rates

8. 2: Nature of the Crisis Pipeline banking (continued): Why buy this stuff? • Credit Rating Agencies (CRAs) assure investors that the instruments are safe • Government regulations rely on CRAs • Investors manage risk by insurance and Credit Default Swaps (CDSs): $64 trn (2008) • Special Investment Vehicles (Shadow banks) legally responsible for potential trading losses, protecting banks from risk of bankruptcy. But! • Investment banks pay for losses to retain customers, and then go bankrupt anyway.

9. 3: Collapse & Contagion Collective confidence in derivative value determines price • First sell-offs of investment portfolios by American hedge funds, investment banks start chain reaction • The ‘money’ banks are holding as CDOs and ASBs are worth increasingly less

10. 3: Collapse & Contagion • Investment bank / SIV buffer proves untenable: • Allowing SIVs to fail damages investor confidence • Absorbing SIVs damages bank balance sheets • Confidence crisis spills over to investment banks

11. 3: Collapse & Contagion • Credit contraction and insolvency: • Widespread investment in CDOs, ABS paper by investment banks, also outside the United States • Chain reaction of collapsing derivative values requires reduction of covered credit • Breakdown of collective action and illiquidity: • Overnight lending shuts down • Illiquidity problem threatens to cause lasting problems insolvency

12. 3: Collapse & Contagion • Bank losses (plus multiplier effect 10): • 5-10 trillion (biljoen) USD (as of mid-year 2008) • Stock market losses • 6 trillion USD losses alone 5-10 October • (multiplier: 60 trillion) • Contrast: EU & US economies combined: 28 trillion USD in 2007

13. 4: Government Responses • Cash injections by central banks • Autumn/winter 2007/8: $800bn by US, EU • Extension of longer-term discount lending to banks • US gives companies cash for unsellable assets • US investment banks still bankrupt • Bank, insurance company nationalisations as alternative to just cash

14. 5: International Responses • G7 / Eurogroup spend more (12 Oct) to buy bad assets • (but what is a worthless asset worth?) • (normal accounting rules suspended) • $700 bn (US) • £50 bn (+ £50 bn= £100 bn)(UK) • €830 bn (France, Germany, Spain)

15. 5: International Responses • EU Governments • No European fund: member states pay • Member states compete to guarantee savings to prevent bank runs • Problem: beggar-thy-neighbour policies of member states instead of cooperation • Rush away from commercial banks to public banks and cooperatives (Rabobank)

16. 5: International responses • EU stops current accounting rules • Worthless paper can be listed as worth something (but what?) • Brown’s (UK) call for Bretton Woods II • ‘Remake the financial architecture’ • More restrictions on creating and trading derivatives likely • New roles for the IMF?

17. 6: Prospects • 2 years of economic decline • Strong need for government to regulate the creation of credit by banks • Especially financial derivatives • Direct control through nationalisations • Increased need to demand realistic credit ratings (i.e. regulate CRAs) • Back-to-basics focus on the needs of the real economy, not solely of finance