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Making Sense of the Global Financial Crisis Christopher Ragan Department of Economics Mc. Gill Making Sense of the Global Financial Crisis Christopher Ragan Department of Economics Mc. Gill University and Clifford Clark Visiting Economist Department of Finance October 20, 2009

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

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

Part 1 Crucial Micro Elements 1. Home mortgages 101 2. The evolution of mortgage Part 1 Crucial Micro Elements 1. Home mortgages 101 2. The evolution of mortgage lending 3. Securitization 4. Regulatory arbitrage

Home mortgages 101 1. Bank accepts deposits 2. Lends money to home purchaser 3. Home mortgages 101 1. Bank accepts deposits 2. Lends money to home purchaser 3. Downpayments and collateral 4. Bank holds the mortgage asset 5

Specialization in mortgage lending: “originate to own” “originate to distribute” 6 Specialization in mortgage lending: “originate to own” “originate to distribute” 6

What to do with all these mortgages? 1. Assemble a large portfolio of risky What to do with all these mortgages? 1. Assemble a large portfolio of risky assets and “manage” it. 2. 3. OR 4. 2. Assemble a large portfolio and then create lowerrisk securities, each backed by the small piece of the large portfolio 5. “securitization” 7

Securitization of residential mortgages: A B C D E F G H I J 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 Each mortgage-backed security is just a small piece of the overall diversified mortgage pool. MBS MBS MBS 8

This process keeps the cash flowing -used to purchase mortgage assets Mortgage (asset) Commercial This process keeps the cash flowing -used to purchase mortgage assets Mortgage (asset) Commercial bank or other mortgage lender lends money to individuals and thereby creates a mortgage asset. Cash Financial institution assembles pools of mortgages and creates mortgage-backed securities (CDOs). CDOs Cash Individual and institutional investors 9

Securitization of residential mortgages mushroomed over the past decade U. S. GSE versus Private-Label 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. 10

Capital ratios, leverage, and the “shadow banking system” 1. The power of leverage 2. Capital ratios, leverage, and the “shadow banking system” 1. The power of leverage 2. Different rules for commercial banks versus investment banks 3. 1 + 2 “Regulatory arbitrage” 11

Growing securitization led to increased bank leverage … Bank Leverage Ratios assets as a 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 2008 Q 2. Sources: Bloomberg; financial statements. 12

… especially in the U. S. investment banks. Leverage Ratios assets as a multiple … especially in the U. S. investment banks. Leverage Ratios assets as a multiple of capital Sources: Bloomberg; financial statements. 13

Part 2 Key Macro Pressures 1. Expansionary monetary policy 2. The global savings glut Part 2 Key Macro Pressures 1. Expansionary monetary policy 2. The global savings glut 3. The global “search for yield”

After 2000, central banks loosened their monetary policies significantly … Policy Interest Rates per 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. 15

… which generated strong growth in business and household credit … U. S. Total … which generated strong growth in business and household credit … U. S. Total Business Credit Y/Y per cent change U. S. Total Household Credit Y/Y per cent change Source: U. S. Federal Reserve Board. 16

… and fuelled a booming U. S. housing market. U. S. Existing Home Prices … and fuelled a booming U. S. housing market. U. S. Existing Home Prices index, 2000 Q 1 =100 Note: S&P/Case Shiller Home Price Index. Sources: Standard & Poor's; Fiserv; Macro. Markets LLC. U. S. Housing Starts Level – 3 -month moving average Source: U. S. Bureau of Economic Analysis. 17

What is the “global savings glut”? The large accumulation of foreign-exchange reserves by: 1. 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? 18

Large current account imbalances … Current Account Balance In billion USD Source: IMF’s WEO Large current account imbalances … Current Account Balance In billion USD Source: IMF’s WEO 19

… and fast-rising oil prices … Oil Prices US$/bbl Source: Bridge CRB. 20 … and fast-rising oil prices … Oil Prices US$/bbl Source: Bridge CRB. 20

… led to huge increases in foreignexchange reserves. Growth in Selected Official Foreign-Exchange Reserves … led to huge increases in foreignexchange reserves. Growth in Selected Official Foreign-Exchange Reserves US$ Billions Sources: IMF’s IFS data September 2009 21

Many of these assets were invested in U. S. Treasuries and longer-term assets … 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 22

… which reduced longer-term interest rates … G 10 10 -year Government Bond Yield … which reduced longer-term interest rates … G 10 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. 23

. . . and shifted down the entire “yield curve”. US Yield Curve per . . . 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 24

These two forces produced a global “search for yield” Growing global demand for U. These two forces produced a global “search for yield” Growing global demand for U. S. mortgage-backed securities Growing demand for credit by FIs Rising leverage in banks Growing provision of mortgages Growing demand for mortgage assets Rising demand for U. S. houses Declining “quality” of mortgages 25

Declining “quality” of mortgages? New U. S. Sub-prime Mortgages Billions USD Sub-prime share of 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 26

As the process continued, there was an overall “spreading” of risk 1. Risks spread 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 27

Part 3 Fatal Interactions 1. Falling U. S. house prices 2. Rising mortgage foreclosures 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

U. S. house prices first slowed and then dropped off a cliff … U. U. S. house prices first slowed and then dropped off a cliff … U. S. Existing Home Prices index, 2000 Q 1 =100 U. S. Housing Starts Level – 3 -month moving average 31% Note: S&P/Case Shiller Home Price Index. Sources: Standard & Poor's; Fiserv; Macro. Markets LLC. Source: U. S. Bureau of Census 29

… which led to rising delinquencies of subprime mortgages … U. S. Mortgage Delinquencies … which led to rising delinquencies of subprime mortgages … U. S. Mortgage Delinquencies by Vintage Year 60+ day delinquencies, in per cent of original balance 2006 2005 2000 2001 2007 2002 2004 2003 Months from origination Source: International Monetary Fund, Global Financial Stability Report, October 2008. 30

… and eventually increased foreclosures. U. S. Delinquency Rates As foreclosures rise: Per cent … and eventually increased foreclosures. U. S. Delinquency Rates As foreclosures rise: Per cent è è è The delinquency rate includes U. S. Share of Loans in Foreclosure Per cent Foreclosure is a legal process that can loans with payments 30, 60, take anywhere from 45 to 365 days banks put the houses on the resale market and 90 days or more past due, but are not depressing house prices furtheryet in foreclosure more people walk away from their homes more delinquencies and foreclosures banks put more houses on the market and so on … Sources: Mortgage Bankers Association of America 31

Foreclosures and falling house prices, in turn, led to large downgrades in MBSs … 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. 32

… which naturally led to a decline in their market value. Prices of U. … which naturally led to a decline in their market value. Prices of U. S. Mortgage-backed Securities In U. S. dollars 2006 Source: International Monetary Fund, Global Financial Stability Report, October 2008. 2007 2008 33

Rising “counterparty risk” led to a credit crunch … … and eventually a full Rising “counterparty risk” led to a credit crunch … … and eventually a full financial crisis … Credit Spreads basis points Bear Stearns Lehman Brothers bankruptcy 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. 34

. . with enormous losses for many large financial institutions … Mortgage-Related Write-downs and . . with enormous losses for many large financial institutions … Mortgage-Related Write-downs and Credit Losses since 2007 Q 3 Billions, USD Since 2007 Q 3, financial institutions have posted over US$1600 billion in write-downs and credit losses. Sources: Bloomberg, September 28, 2009. 35

… and huge declines in the world’s stock markets. World Equity Markets % change … and huge declines in the world’s stock markets. World Equity Markets % change from January 1, 2007 to March 2, 2009 Source: Bloomberg. 36

Part 4 Policy Responses 1. Financial sector vs. the “real economy”? 2. Monetary policy Part 4 Policy Responses 1. Financial sector vs. the “real economy”? 2. Monetary policy 3. Actions to assist financial markets 4. Fiscal policy

What was likely to happen? 1. Credit is like electricity to a modern economy, 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! 38

The largest global recession in many years Growth of world real GDP per cent The largest global recession in many years Growth of world real GDP per cent per year Average 1980 -2010: 3. 2% Sources: IMF 39

Unprecedented global monetary policy response … Policy Interest Rates per cent Sources: Bank of 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. 40

… included the use of “unconventional” monetary policy tools. Central Bank Assets Index: January … included the use of “unconventional” monetary policy tools. Central Bank Assets Index: January 2008 = 100 41

Most governments also introduced measures to support financial markets. Canadian Support to the Financial 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: Canada’s Economic Action Plan; A Third Report to Canadians, September 2009. 42

G-20 leaders coordinated their substantial fiscal expansions … Fiscal Stimulus Flowing in 2009 and G-20 leaders coordinated their substantial fiscal expansions … Fiscal Stimulus Flowing in 2009 and 2010, G 7 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. 43

… and accepted the deterioration in their medium-term fiscal outlooks. Total Government Budget Deficits, … and accepted the deterioration in their medium-term fiscal outlooks. Total Government Budget Deficits, 2009 Per cent of GDP Source: IMF WEO, October 2009. 44

Part 5 Lessons and Myths 1. Blame and greed? 2. “The end of laissez-faire”? Part 5 Lessons and Myths 1. Blame and greed? 2. “The end of laissez-faire”? 3. Regulatory reform 4. Baby and the bathwater

Thank you. Questions? Thank you. Questions?