Download
1 / 138
1.38k likes | 1.51k Views
Globalization, Financial Stability and Depression Assaf Razin , Tel-Aviv University Fall 2008 Updated 2010. Chronology of Crisis. Sept 15 2008—Lehman Brothers went belly up. Sept 16, 2008: A.I.G. is effectively nationalized. Sept 18, 2008—Bank of America bought Merril Lynch.
E N D
Globalization, Financial Stability and Depression AssafRazin, Tel-Aviv University Fall 2008 Updated 2010
Chronology of Crisis • Sept 15 2008—Lehman Brothers went belly up. • Sept 16, 2008: A.I.G. is effectively nationalized • Sept 18, 2008—Bank of America bought Merril • Lynch. • December 2008—the Federal Reserve cuts interest rates virtually to zero
Understanding what’s going on: Like shooting at a moving target • Housing bubble. • Subprime mortgage crisis • Financial sector’s toxic assets • Liquidity crisis • Zero interest rate. • Unconventional central banking • Liquidity trap?
Credit Market : September 2008 • financial institutions hold significant assets that are backed by mortgage payments. Two years ago, many of those mortgage-backed securities (MBS) were rated AAA, very likely to yield a steady stream of payments with minimal risk of default. This made the assets liquid. If a financial institution needed cash, it could quickly sell these securities at a fair market price, the present value of the stream of payments. A buyer did not have to worry about the exact composition of the assets it purchased, because the stream of payments was safe.
Libor-OIS spreads reached 200 basis points in September 2008 when Congress failed to pass the Paulson plan
Sources for charts: Robert Shiller, Andrew Smithers; Thomson Datastream
Mortgage and Housing Prices • Because the amount owed on the mortgage loan does not depend on the value of the house, a decline in the house value below the amount of the mortgage has two effects.
Family Costs and Lender Costs • 1. family with no remaining home equity may walk away from the house. The family suffers the loss of equity and the cost of moving to another house. • 2. The lender suffers a decline in the value of the mortgage as house prices fall. The lender fixes the house and sells it. Foreclosure process take 6 to 9 months. The lender pays for the fix up and receives low price from distress sale.
Mortgage Finance • The common form of mortgage commits the household to make equal monthly payments for 30 years. These mortgages payy off with 10 years because households sell the property or does refinance. • New model: The borrower applies to a mortgage broker, receives money from a wholesale lender, and make payments to a servicer. The servicer passes on each payment to a master servicer, who pays it out to holders of a mortgage-based-security (MBS), who pass it on to the adminstrator of a collateralized debt obligation (CDO), who passes it on to investors in CDOs.
Mortgage-backed Securities • How to value MBSs? • Imagine you bought a $100,000 house a year ago, with a $10,000 down payment. • If the value of the house rises, you are “in the money”. • If it falls, you can walk away. You loose the original $10,000 investment, but are safe in the knowledge that the lender cannot seize your other assets..
Mortgage as option, not loan • This mortgage is therefore not a loan but an option: it allowed for gains if house prices rose, but cost relatively little if prices fell.
Akerlof’s Problem • When house prices started to decline, this has had bigger effect on some MBS than other MBSs, depending on the complexity of the mortgages that backed the securities. Owners of MBS have strong incentive to price each an every one of them. They have superior information over the market buyers. As in Akerlof’s Lemmons Problem, the market for MBS will collapse.
Market illiquidity • The buyer hopes that the seller sells the security because he needs cash. But the buyer worries that the seller will unloads the most troubled securities. This makes the market illiquid.
Fire sale • To buy MBS in such illiquid market you first need the asessment of the value of MBSs by an independent authority. The overpricing is built in because the worst quality MBSs will be unloaded by the bank. Their price is below the average hold-to-maturity value of MBS.
Hold-to-maturity price The True value of the average MBS may in fact be much higher. This is the hold to maturity price, adjusted to some average default probability.
Bidder’s auction valuation in the First Version of the Paulson’s Plan • Bidder’s auction valuation is not the “no bail-out” valuation. It is the opportunity cost for not selling the asset in the auction. This opportunity cost is the price the bidder can sell the asset on the open market immediately after the auction; when some big X percent of the asset are already removed from the market by the treasury.
$700bn of sub-prime and market valuations • Imagine artificially pulling $700bn of subprime off the market. This must dramatically increase market prices and auction valuations. This, in principle (not in actual magnitude; because the Paulson plan will work in stages) is a proxy for post-bail-out valuations.
Sub-prime default rates • Subprime default rates are highly correlated with real estate, the troubled asset class underpinning the value of MBSs.
Credit freeze as a Lemons’ problem for Financial institutions • Financial service institutions whose market values are based on their real estate investments, and MBS investments, suffer also from the Lemons’ problem. This is why they refuse to lend to each other. The inter bank credit market, and the money market comes to a halt.
Raising new capital • Banks fear that any bank that wants to borrow is on the verge • Of bankruptcy and they refuse to lend.
A “Theoretical” solution to Toxic Assets • The government could force owners to sell all their MBS portfolio, rather than the MBS that the financial institution would like to unload, at an average hold-to-maturity price .
Japan’s 1990s • Japan’s experience in the 1990s is cautionary example of the peril of propping up banks after a real estate boom ends. The Japanese government helped keep many troubled banks afloat, hoping to avoid the pain of bank failures, only to extend the economic downturn as consumer spending and job growth fell.
Japan’s Banks • THE 1990 COLLAPSE OF AN ASSET BUBBLE PROVOKED A SHARP FALL IN THE VALUE OF PROPERTY AND EQUITY THAT UNDERPINNED BANKS’ BALANCE SHEETS. BUT BANKS IGNORED THEIR PROBLEMS UNTIL 1997 WHEN SANYO SECURITIES, YAMAICHI SECURITIES AND HOKKAIDO TAKUSHOKU BANK ALL FAILED.
Reluctance to recapitalize by state funds • A RELUCTANCE TO ADMIT THE SCALE OF THE PROBLEM MEANT CAPITAL INJECTIONS TOOK PLACE IN THREE MAIN TRANCHES. THE FIRST CAME IN THE SPRING OF 1998, WHEN THE GOVERNMENT INJECTED Y1,800BN ($18BN, £11BN, €14BN) INTO 21 INSTITUTIONS. THE MONEY, WHICH CAME IN THE FORM OF PREFERENCE SHARES, HAD FEW STRINGS ATTACHED. THE SECOND FOLLOWED THE COLLAPSE IN 1998 OF NIPPON CREDIT BANK AND LONG TERM CREDIT BANK. A TIGHTENING OF RULES FORCED 32 INSTITUTIONS TO RAISE CAPITAL AND IN 1999 TO ACCEPT GOVERNMENT FUNDS TOTALLING Y8,600BN.
Conditions set by government • Conditions grew stricter. “The first time, the government injections were very generous, depending on the banks’ own will. The second time was more forcible,” says the former BoJ official. “The first priority was that in a certain period they had to return from red to black, second was to lend to SMEs [small and medium-sized enterprises] and third was a host of conditions, such as cutting their payroll,”
Non performing loans • By March 2005, non-performing loans were at 2.9 per cent of banks’ total assets from 8.4 per cent at the height of the crisis.
Sweden in the 1990s • Sweden in the early 1990s took a middle pathswiftly taking over many of its troubled banks. The American bailout plan, economists say, takes a page from the Swedish example by making the government a shareholder in banks participating in the program. But, they add, the American banking system is so much larger and diverse than Sweden’s that the parallels are limited.
Capital injection and tax payers • In exchange for the capital injection by the government, taxpayers might be protected through preferred shares (or warrants), giving them dividends in the future.
Fed buying unsecured loans • The problem in the interbank market is the lack of availability of longer than over night loans. Banks can get some short term funding, but only on a collateralized basis. Unsecured borrowing rates for , say three-month Libor rates, are sky high during liquidity crunch.
unsecured loans from the private market • There are two reasons for why banks cannot obtain short-term unsecured loans from the private market. • (1) the classic coordination problem: “I will not lend you money for a month if I think that everyone else will only lend you money for a day, allowing them to pull out tomorrow and leave me stranded.”- a liquidity risk. • (2)Credit risk of lending to banks.
Fed’s new scheme? • Fed is considering: • (1) Unsecured term loans by the Fed at a premium over the federal funds rate, that would provide a perfect substitute to the Libor. • (2)using unsecured lending to shore up the collapsing commercial paper market in which corporations raise funds.
Recapitalization of banks • A scheme, similar to the operation done by the Swedish government in the early 1990s, is government buying of All banks’ troubled assets.
Paulson’s Original Plan (TARP-Troubled Asset Relief Program) • In the current crisis, you do want to get rid of the bad assets from the banks, to get markets working again. But the key is going to be in the details of how the bailout works. You don’t want it to be a subsidy in disguise that keeps insolvent banks alive. That would just prolong the economic pain.
Pricing of mortgage based securities in trouble • the overriding question of how to price mortgage backed securities remains unanswered. The authorities appear to want something between fire-sale prices and the value of securities if held to maturity. Figuring out the latter is tricky without detailed information from the banks – and certainty on where house prices will eventually settle. Insisting on the former, however, would defeat the objective of ungumming the market while also adding more strain to banks’ balance sheets.
Differences between bailout and government spending • First, note that there is a major difference between a program to support the financial sector and $700bn in new outlays. No one is contemplating that the $700b in the Paulson plan will be given away. All of its proposed uses involve either purchasing assets, buying equity in financial institutions or making loans that earn interest.
2nd difference • Second, the usual concern about GOVERNMENT BUDGET DEFICITS IS THAT THE NEED FOR GOVERNMENT BONDS TO BE HELD BY INVESTORS WILL CROWD OUT OTHER, MORE PRODUCTIVE, INVESTMENTS OR FORCE GREATER DEPENDENCE ON FOREIGN SUPPLIERS OF CAPITAL. TO THE EXTENT THAT THE GOVERNMENT PURCHASES ASSETS SUCH AS MORTGAGE-BACKED SECURITIES WITH INCREASED ISSUANCE OF GOVERNMENT DEBT, THERE IS NO SUCH EFFECT.
Mark to market and illiquidity • Market-to-market accounting generates further illiquidity during credit crunches.
Keynes’ Metaphor for a Bubble Consider beauty competitions famously described by John Maynard Keynes, in which the winner was the contestant who chose the six faces most popular with all contestants. The result, Keynes observed, was that the task was not to choose the most beautiful face, but the face that average opinion would think that average opinion would find the most beautiful. In this way beliefs feed on themselves and become divorced from any underlying reality.
Written in 1859, in a history of the commercial crisis of 1857-58. Each separate panic has had its own distinctive features, but all have resembled each other in occurring immediately after a period of apparent prosperity, the hollowness of which it has exposed. So uniform is this sequence, that whenever we find ourselves under circumstances that enable the acquisition of rapid fortunes, otherwise than by the road of plodding industry, we may almost be justified in auguring that the time for panic is at hand."
History Carmen Reinhart of Maryland and Ken Rogoff of Harvard, have recently published an analysis of the current financial crisis in the context of what they identify as the previous 18 banking crises in industrial countries since the second world war. They find what they call "stunning qualitative and quantitative parallels across a number of standard financial crisis indicators" - the common themes that translate these individual dramas into the big-picture story of financial boom and bust. Their study is focused on the US,
THE LENDER OF LAST RESORT The role of lender of last resort was classically defined by Walter Bagehot. His great book Lombard Street was published in 1873, and set out what has become the guiding mantra for central banks in times of crisis ever since: lend freely at high rates against good collateral. Lend freely, in his words, "to stay the panic". At high rates, so that "no one may borrow out of idle precaution without paying well for it". And lend on all good banking securities to an unlimited extent - because the "way to cause alarm is to refuse someone who has good security to offer".
Fannie Mae and Freddie Mac • The GSEs backed more than 80 percent of recent US mortgages. • The US treasury , as of September 2008, owns • 80 percent of the stocks. In addition to taking controls of the companies, the treasury also invests in mortgage-backed securities to support for home buyers. • Debts of the institutions were held by foreign investors and foreign central banks. • A meltdown would have threatened the credibility of US government.
Emerging Markets • Emerging markets’ fiscal and monetary policy cannot “print” hard currency, and their attempt to refloat their economies may end up with high inflation or balance-of-payments crisis. This has led the Fed, and the IMF to offer liquidity credit lines and structural adjustment programs. • These measures may help offset effects of “sudden stops”, like the one in 1998.
