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Making Sense of the
Global Financial Crisis
Christopher Ragan
Department of Economics
McGill 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
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
4. Policy responses
5. Myths and lessons
3
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. Downpayments and collateral
4. Bank holds the mortgage asset
5
Specialization in mortgage lending:
Mortgage
(asset)
Commercial bank or
other mortgage lender
Other financial
institutions
Cash
Cash
Mortgage
(asset)
Individual borrower
“originate to own”
“originate to distribute”
6
What to do with all these mortgages?
1. Assemble a large portfolio of risky assets and
“manage” it.
OR
2. Assemble a large portfolio and then create lower-risk
securities, each backed by the small piece of the
large portfolio
 “securitization”
7
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
9
10 11 12 13 14
8
Diversified pool of
residential mortgages
-- reduces risk
Each individual mortgage is a risky asset
– individual and aggregate risks
MBS
MBS
MBS
MBS
MBS
MBS
MBS
Each mortgage-backed security
is just a small piece of the overall
diversified mortgage pool.
MBS
MBS
MBS
MBS
MBS
MBS
MBS
MBS
MBS
MBS
8
This process keeps the cash flowing -used to purchase more 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 MBS Issuance
In billions of US dollars
3,000
Private-label
Fannie M ae
2,500
Freddie M ac
Ginnie M ae
2,000
1,500
1,000
500
0
1990
1992
1994
1996
1998
2000
2002
2004
2006
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. 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 multiple of capital
35
30
Canada
US
UK
Euro area
25
20
15
10
2000
2001
2002
2003
2004
2005
2006
2007
2008
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 2008Q2.
Sources: Bloomberg; financial statements.
12
… especially in the U.S. investment banks.
Leverage Ratios
assets as a multiple of capital
30
US - Investment Banks
25
20
15
2000
2001
2002
2003
2004
2005
2006
2007
2008
Sources: Bloomberg; financial statements.
13
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 cent
U.S. Federal Reserve
Bank of Canada
European Central Bank
Bank of England
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
2000
2001
2002
2003
2004
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 Business Credit
U.S. Total Household Credit
Y/Y per cent change
Y/Y per cent change
14
13
12
12
11
10
10
8
9
6
8
4
7
2
0
1998
6
2000
2002
2004
2006
5
1998
2000
2002
2004
2006
Source: U.S. Federal Reserve Board.
16
… and fuelled a booming U.S. housing
market.
U.S. Existing Home Prices
U.S. Housing Starts
Level – 3-month moving average
index, 2000 Q1 =100
190
2200
2100
170
2000
150
1900
130
1800
1700
110
1600
90
70
1998
1500
2000
2002
2004
Note: S&P/Case Shiller Home Price Index.
Sources: Standard & Poor's; Fiserv; MacroMarkets LLC.
2006
1400
1998
2000
2002
2004
2006
Source: U.S. Bureau of Economic Analysis.
17
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
1500
China, Japan, OPEC, Russia and rest of Asia
1000
United States
500
0
-500
-1000
1992
1994
1996
1998
2000
2002
2004
2006
2008
Source: IMF’s WEO
19
… and fast-rising oil prices …
Oil Prices
US$/bbl
160
140
120
100
80
60
40
20
0
2001
2002
2003
2004
2005
2006
2007
2008
Source: Bridge CRB.
20
… led to huge increases in foreignexchange reserves.
Growth in Selected Official Foreign-Exchange Reserves
US$ Billions
700
Japan
Russia
500
OPEC
China
300
100
-100
2000
2001
2002
2003
2004
2005
2006
2007
2008
Sources: IMF’s IFS data September 2009
21
Many of these assets were invested in U.S.
Treasuries and longer-term assets …
Share of US Treasuries held by Foreigners
per cent
60
Foreigners
of which: Foreign Official Institutions
50
40
30
20
2001
2002
2003
2004
2005
2006
2007
2008
Sources: US Treasury
22
… which reduced longer-term interest
rates …
G10 10-year Government Bond Yield
per cent
6.0
Nominal
5.0
4.0
3.0
2.0
1998
2000
2002
2004
2006
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 cent
7.0
August 2000
September 2006
6.0
5.0
4.0
3.0
O/N
3m
6m
1y
2y
3y
5y
7y
10y
20y
30y
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.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
Per cent
Sub-prime share of total mortgage
originations (right)
700
25
600
20
500
15
400
Sub-prime mortgage
originations (left)
300
10
200
5
100
0
0
2001
2002
2003
2004
Source: Inside Mortgage Finance, via Joint Center for Housing Studies of Harvard University
2005
2006
2007
26
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
3. Financial losses and counterparty risks
4. Credit crisis  Financial crisis
U.S. house prices first slowed and then
dropped off a cliff …
U.S. Existing Home Prices
U.S. Housing Starts
Level – 3-month moving average
index, 2000 Q1 =100
190
2500
170
2000
31%
150
1500
130
1000
110
500
90
70
1997 Q2
2000 Q2
2003 Q2
2006 Q2
Note: S&P/Case Shiller Home Price Index.
Sources: Standard & Poor's; Fiserv; MacroMarkets LLC.
2009 Q2
0
1997
1999
2001
2003
2005
2007
2009
Source: U.S. Bureau of Census
29
… which led to rising delinquencies of
sub-prime mortgages …
U.S. Mortgage Delinquencies by Vintage Year
60+ day delinquencies, in per cent of original balance
40
2006
35
2005
30
2001
2000
25
2007
2002
20
2004
15
2003
10
5
0
0
10
20
30
40
50
60
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:
U.S. Share of Loans in Foreclosure
Per cent
Per cent
30
16






25
20
15
10
5
The delinquency rate includes
Foreclosure is a legal process that can
loans with put
payments
30, 60, houses on the
take anywhere
from 45
to 365 days
banks
the
resale
market
and 90 days or more past due,
but are not yet
in foreclosure
further
depressing
house prices
more people walk away from their homes
more delinquencies and foreclosures
banks put more houses on the market
Prime
and soSub-prime
on … Prime
14
12
10
8
6
4
2
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Sub-prime
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Sources: Mortgage Bankers Association of America
31
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
60
50
40
30
20
10
0
AAA
AA
A
BBB
Source: International Monetary Fund, Global Financial Stability Report, October 2009.
BB
B
<B
32
… which naturally led to a decline in their
market value.
Prices of U.S. Mortgage-backed Securities
In U.S. dollars
120
100
80
Agency MBS
60
Jumbo MBS
Alt-A
40
ABX AAA
20
ABX BBB
0
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 financial crisis …
Credit Spreads
basis points
400
Canada (CDOR - OIS)
360
U.S. (LIBOR - OIS)
320
Euro area (LIBOR - OIS)
280
240
Bear Stearns
200
Lehman
Brothers
bankruptcy
160
ABCP crisis
120
80
40
0
-40
Jan 2007
May 2007
Sep 2007
Jan 2008
May 2008
Sep 2008
Jan 2009
May 2009
Sep 2009
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 Credit Losses since 2007Q3
Billions, USD
1,200
160
Since 2007Q3, financial
institutions have posted over
US$1600 billion in write-downs
and credit losses.
1,000
800
600
140
120
100
80
60
400
40
200
20
0
0
America
Europe
Asia
Sources: Bloomberg, September 28, 2009.
35
… and huge declines in the world’s stock
markets.
World Equity Markets
% change from January 1, 2007 to March 2, 2009
0
-10
-20
-30
-40
-50
-60
-70
Total
-80
Banks
-90
Canada (S&P/TSX)
U.S. (S&P 500)
U.K. (FTSE 100)
EMU (DJ Euro STOXX)
Source: Bloomberg.
36
Part 4
Policy Responses
1. Financial sector vs. the “real economy”?
2. Monetary policy
3. Actions to assist financial markets
4. Fiscal policy
What was likely to happen?
1. Credit is like electricity to a modern economy,
and banks are like the power company.
2. A decline in the flow of credit would inevitably
lead to a significant global recession.
3. The financial sector is part of the real
economy!
38
The largest global recession in many years
Growth of world real GDP
per cent per year
6
Average 1980-2010: 3.2%
5
4
3
2
1
0
-1
-2
1980
1985
1990
1995
2000
2005
2010
Sources: IMF
39
Unprecedented global monetary policy
response …
Policy Interest Rates
per cent
7.0
U.S. Federal Reserve
Bank of Canada
6.0
European Central Bank
Bank of England
5.0
4.0
3.0
2.0
1.0
0.0
Sep 2007
Dec 2007
Mar 2008
Jun 2008
Sep 2008
Dec 2008
Mar 2009
Jun 2009
Sep 2009
Sources: Bank of Canada, U.S. Federal Reserve, European Central Bank and Bank of England. Daily data up to and including Sept. 30.
40
… included the use of “unconventional”
monetary policy tools.
Central Bank Assets
Index: January 2008 = 100
290
Fed
BoC
BoE
240
ECB
190
140
90
Jan 2008
Apr 2008
Jul 2008
Oct 2008
Jan 2009
Apr 2009
Jul 2009
41
Most governments also introduced
measures to support financial markets.
Canadian Support to the Financial Sector ($ 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 2010, G7 countries
per cent of GDP
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Canada
Japan
United States
Germany
France
United Kingdom
Italy
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, 2009
Per cent of GDP
2
0
-2
-4
-6
-8
-10
2007
2009
-12
-14
Canada
France
Germany
Italy
Japan
United Kingdom
United States
Source: IMF WEO, October 2009.
44
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?