La crisi finanziaria
(Slides in inglese +
pdf di «Macroeconomia della crisi» in
italiano al sito web del corso)
Francesco Daveri
The timeline of the crisis in one slide
• 2008, second half: deepest recession since WWII. Gdp and industrial production
went down abruptly in the advanced economies.
• A slow recovery started a year later (q3-2009), more strongly in the so-called
emerging market economies and only gradually in the advanced economies.
• Origin of the financial crisis in the USA in the summer of 2007, then spread to
Europe and eventually affected the entire world. Financial crisis originated in the
“sub-prime mortgage” market, a part of the US housing mortgage market intended
for borrowers with high probability of default.
• In these classes we explain how the financial shock was transmitted to the US
economy and from there to the rest of the world.
• In the next classes we shall describe the “real” side of the financial crisis and the
consequences of the macro policies put in place to contain the recession.
•These policies: successful in the short run but with less favorable longer-run
consequences. Some of these side effects popped up again with the sovereign
debt crisis of 2011-12. And next.
2
Crisis, what crisis? Big banks have not seen it
Stock market
capitalization
Bn Us$
HSBC
Holdings
Bank of
America
JP Morgan
Chase
Citigroup
Goldman
Sachs
Dec 31, 2007
197.8
183.1
166.5
146.6
85.5
Sep 23, 2014
196.0
180.2
229.5
160.4
85.2
3
Indeed, there have been a few ups and downs in the
stock mkt as well. To be explained.
Stock market
capitalization
Bn Us$
HSBC
Holdings
Bank of
America
JP Morgan
Chase
Citigroup
Dec 31, 2007
197.8
183.1
166.5
146.6
85.5
Jan 31, 2009
86.4
39.8
90.6
54.9
33.0
Sep 11, 2009
187.1
147.9
146.6
18.9
83.3
Apr 15, 2011
188.9
129.7
178.7
128.4
84.9
Oct 18, 2011
90.8
61.1
119.8
81.5
49.0
Oct 11, 2012
96.2
101.0
160.8
104.9
60.7
Sep 23, 2014
196.0
180.2
229.5
160.4
85.2
Four puzzles
1. Why the big fall between Dec 2007 and Jan 2009?
2. Why the swift increase between Jan and Sep 2009?
3. Why another big fall again between Apr 2011 and Oct 2011?
4. Why up again between October 2011 and Oct 2012 (and today)?
Goldman
Sachs
4
Why the four puzzles?
Quick answers:
(1) Fall after Dec 2007: the market value of mortgage-backed assets – a
big part of the asset side of banks’ balance sheet - suddenly and
abruptly fell after sudden and abrupt fall in the US housing market,
following unprecedented rise.
(3) Fall over the summer 2011: still caused by deteriorating asset side of
banks’ balance sheet. Yet the source of the deterioration is different:
over the summer 2011, perception of riskiness of European sovereign
bonds of Greece, Portugal, Ireland, Spain and Italy increased
dramatically.
Market valuation rallies in (2) and (4) are instead associated with superexpansionary monetary policy of Central Banks
 The US Federal Reserve playing a leading role in 2009
 The Fed, other central banks and the ECB since the end of 2011
Next pages: more details.
Bank A and its balance sheet
Bank A has
• 100 in assets (mortgages, commercial loans, Govt bonds. plus cash)
– assets = things that have value and could be sold to raise cash
• 90 in liabilities (deposit accounts, bonds issued, other financing)
– liabilities = promises to pay money to other people, debt
• 10 in capital (= assets minus liabilities)
– capital = net amount of value "owned" by common shareholders
– set aside to sustain potential losses on assets (computed through
statistical techniques e.g. Value at Risk, VaR)
NOTE: Accounting rule is fair value: if quality of credit deteriorates, this
has to be swiftly recorded in the banks’ balance sheets.
6
Why care about Bank A?
Bank A is a TYPICAL bank.
Bank A is average US commercial
bank before the crisis, with leverage
= assets/capital =10.
The leverage in investment banks
and “hedge funds” was 27.
• Lehman Brothers: 25 billions $ of K
and 680 billions of assets.
• AIG, extended Credit Default
Swaps to Lehman, Bear Stearns &
other investment banks: 25 of K and
3200 of assets.
7
The higher the leverage,
the more profitable (and riskier) the bank
Assets
Assets
Liabilities
300
Capital
10
Liabilities
290
Assets
Assets
Liabilities
100
Capital
10
Liabilities
90
Leverage = 30
Leverage = 10
Max loss: 3,3% of assets (10/300)
Max loss: 10% of assets (10/100)
Return on capital: 90% (assuming
3% return on assets and zero
costs)
Return on capital: 30%
(assuming 3% return on assets and
zero costs)
This is why investment banks such as Lehman were so profitable!
Write-offs and credit crunch in Bank A
Bank A’s assets are of two types:
•60 "good" assets (loans with no default risk)
•40 "bad" assets (loans with high default
probability. E.g. mortgage-backed securities or
Greek Government bonds).
At some point Bank A writes off a part of its
bad assets, say for an amount of 5. It is thus
left with 35 of bad assets whose cash value is,
say, 20.
After the write-off: Bank A’s balance sheet has 95 in assets, 90 in liabilities, and 5
in capital, so it is still solvent (K=5>0).
Yet everybody thinks that sooner or later there will be another write-off of 15 (=3520) in the future.
So everybody wants to sell Bank A’s stock. More importantly, no one wants to lend
it money, because Bank A borders insolvency.
Hence the Bank “hoards cash” and does not lend to people who would need the
money to consume and invest.
This is the “credit crunch”, how the financial crisis hits the real economy.
9
The rise and fall of the U.S. housing
market
10
.. With US sub-prime mortgage delinquency rates
and foreclosure rates suddenly up as a result
11
Other countries have been exposed to a housing market
sudden reversal: UK, Spain and Ireland
Germany and Switzerland: they were not.
Source: S&P, Case-Shiller Index. House prices deflated by CPI (consumer price index)
12
The housing market in Italy after Lehman (& Monti)
What happened? Why the bubble inflating first,
and why then the bursting of the bubble?
Before: everything goes up
After: everything goes down
Hosehold
debt up
Household
debt down
Loans made
safer (home
values up,
hence
collateral
values up)
Demand for
houses up
Housing
market
prices up
Loans
made
riskier
Demand for
houses
down
Housing
prices down
14
14
To see why the fall of the housing market in 2007-08
caused so much disruption, need to learn two
keywords

Sub-prime loans

Securitization
Keyword 1: Sub-prime loans
Sub-prime
lending: practice of lending to high-default-risk individuals, higher
than “prime” borrowers
 Low income earners: e.g. unemployed
 Bad borrowers: imperfect credit history; e.g. divorced single-mother with
kids
Only in the last few years subprime lending became an important “game in
town”
 2001-07: 3 trillion $ of mortgages originated each year
 Share of sub-primes went up from 7% in 2001 to 20% in 2006
 At end 2007: total outstanding stock of sub-primes was some 1.4 trillions $.

The share of defaulting subprime loans (by year of
mortgage approval) boomed
in 2006 and 2007.
16
Sub-primes economics:
How sub-prime lending works?
Sub-primes = adjustable-rate mortgages with “hybrid structure”,
partly variable and partly fixed rates
Example: 30-year mortgage; may be of “2/28” type
•
A fixed rate for the first 2 years, incorporating a premium (say:
6 ppts) over benchmark interest rate (LIBOR);
•
then switch to variable rate for the residual 28 years. After
switch, often much higher monthly payments.
17
Why be a “sub-primer”?
Why should an unemployed, with wife and dependent sons, be
so short-sighted to enter a contract like this?
All depends on the appreciation of the US housing market

“Sub-primers” allowed by intermediaries to refinance their
mortgage before the switch against increased house value.
So as to avoid (or postpone) default

Refinancing made 50-70% of new yearly mortgages in
2004-06
Sub-primers would also stick to the same intermediary for subprime contracts typically entail very high initial pre-payment fees
(exactly to discourage  intermediary!)
18
As such, though, the sub-prime problem and
the related house price shock was relatively
small

Black Monday (October 1987)
 S&P 500: - 20 %

2008
 U.S. house price, - 30%.
 bank losses on mortgages: US$650 billions equivalent to a 4% fall
in S&P 500
Mortgage securitization
20
“Mortgage securitization”: in words
• Mortgage contracts are differentiated over time and between borrowers (house
location, borrower’s profile, lender’s marketing strategy). Yet financial markets
may transform heterogeneous mortgage contracts in homogeneous products.
• Purpose: achieving RISK DIVERSIFICATION
• By issuing a mortgage to a borrower, a bank creates an asset that gives right to
cash flows paid regularly over time.
• Securitization occurs when these cash flows are sold to a Special Purpose
Vehicle (SPV) administered by a financial institution:
– Given that borrowers may default, value of this asset is risky for the SPV.
Then SPV holds diversified portfolio of such assets, pooling together many
borrowers with similar risks under some dimension, but not identical
– The SPV finances its purchase of cash flows by issuing securities (here is
“securitization”!) called Mortgage Backed Securities (MBS), the biggest part
of ABS (Asset-backed securities) in the US.
21
From risky mortgages to “asset-backed securities” (1)
•
How can this be? How can risky cash flow be turned into standardized
“asset-backed securities”?
•
Trick: cash flow from well-diversified pool of mortgages is a cake that can
be cut into slices (“tranches”) of increasing risk/return profiles in a
Collateralized Debt Obligation (CDO).
•
Then: the cash from the pool of assets is used to pay interest & principal
to the tranche with “senior” status; the remaining cash goes to pay the
holders of the second tranche, with intermediate status; and so on.
•
By appropriately choosing the loss threshold from which the senior
creditor is exempted, the SPV may generate at least one tranche of “AAA
securities” that can be certified by a rating agency. Then there will be
other tranches involving increasing risk and rated “AA mezzanine”, “BBB
subordinated” and “first-loss position” (the “garbage”).
22
From risky mortgages to “asset-backed securities” (2)
•
Goal of the process: transform a bunch of heterogeneous risky
mortgages into the largest possible pool of standardized, high-rating
Asset-Backed Securities.
•
Often certified by rating agencies (in conflict of interest for paid by the
administrator of the SPV). Moreover, given that rating agencies set
different criteria to award an AAA status, SPV would also shop around to
find the rating agency with the easiest-to-satisfy criteria.
•
On top of that, such securities have often been insured with insurance
companies (Credit Default Swaps, CDS). Example: AIG, American
Insurance Group, bailed out one day after Lehman has gone under.
•
Finally, liquidity was an essential ingredient of the overall process: the
ABS was usually of a shorter maturity than the underlying mortgages.
Hence, they had to be rolled over issuing new securities.
23
Sub-primes economics and securitization –
Keywords

Heterogeneous mortgages

Standardized Asset-Backed Securities (ABS) sliced
in tranches with different risk/return profiles (CDO)

Certification by rating agencies

ABS insured with insurance companies (Credit
Default Swaps, CDS)

Roll-over financing implied, liquidity crucial to the
whole system
24
Securitization may also be seen in pictures …
Learn about securitization from a messy picture with lots of acronyms …
CDO’s
Bank
CDS’s
Cash
loans
AIG
Conduits,
Special investment vehicles
AB commercial paper
CDO’s
Cash
Investors
… Or through an enjoyable cartoon …
Click on the following link and learn about securitization
the easy (but deep!) way
The subprime primer:
http://www.slideshare.net/guesta9d12e/subprime-primer277484
26
The spectacular rise (and fall) of asset-backed securities
Global
issuance of
asset-backed
securities (a)
Source: Dealogic.
(a) Quarterly issuance.
(b) Commercial mortgage-backed securities (CMBS)
(c) Residential mortgage-backed securities (RMBS).
‘Others’ includes auto, credit card and student loan ABS.
27
Derivative contracts – what they are for
Think of a Multinational company
For companies that become big and global, financial uncertainties
inevitably creep in:
 in foreign exchange valuation
 In the interest rate paid on debts or earned on deposits,
 In inflation
 In commodity prices of raw materials.
An unavoidable cost of doing business to be taken as such?
Or something to be gotten rid of.
How? Using DERIVATIVES
 financial products aimed at shaping, reducing, or perhaps even
increasing the different flavors of financial uncertainty
28
Most derivatives are interest swap contracts
504,098
500
Billion of $
400
300
200
100
5,982
28,633
42,609
Credit
default
swaps
Other assets
63,349
45,9
69,659
0
Commodities
& Stocks
Foreign
exchange
Interest rate World stock World Gdp
swaps
mkt
capitalization
Huge numbers
 14 times as much as the value of the world stock markets
 9 times as much as the value of world Gdp
29
Interest rate swaps
Consider the uncertainty in how companies borrow and invest cash.
A treasurer might tap short-term money markets in three-month stints,
facing the uncertainty of central bank rates spiking up. Or they could
use longer-term loans that tracked the interest rates paid by
governments on their bonds, perhaps getting locked into a
disadvantageous rate.
Imagine that once you had committed yourself to one of these two
financing routes, an invisible toggle switch allowed you to change your
mind, canceling out the interest payments you didn’t want to make in
return for making the payments that you did.
This is the interest rate swap, the world’s most popular derivative
30
The rising value of derivatives has made trading and
securitization much more important items on the
asset side of banks’ balance sheets
LCFIs= Large Complex Financial Institutions
Finance often blamed for creating a
“paper economy”
which doesn’t spill over
to the “real economy”
--Let’s see what happened
“Risk diversification” through derivatives fed into
much increased credit availability to the economy
(households and companies) ...
... also as a result of much lower borrowing costs
for companies issuing bonds
The “illiquidity risk” fell considerably (the disappearance of the
orange area means that the illiquidity risk premium went to
zero)
And credit from policy makers was also very cheap …
20.00
18.00
16.00
dot-com
crisis in
grey
14.00
12.00
10.00
8.00
AG
feeding
the
bubble
6.00
4.00
2.00
0.00
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007
Composite-10 Case Shiller housing index (Jan. 1887 = 5)
Federal Fund rate
Alan Greenspan (AG) kept the discount rate “low” for too long in 2003-04.
Perhaps. We will come back to this when discussing monetary policy.
35
Question: how have firms used the rivers of
available liquidity?
LBOs, Mergers and Acquisitions, e IPOs
“Indignados”, “Occupy Wall Street”, “Movimento Cinque Stelle”
and others question whether all this has been worthwhile at all.
Results from Leveraged Buy-outs (LBOs)?
Davis, Haltiwanger, Lernet et al (2014)
• Allegation: LBOs (Leveraged buy-outs) produce high profits for managers and
private equity funds, employment cuts andlittle value for the firm
The facts
Data for 3200 companies, 150 thousand plants, 1980-2005
1. Employment falls by 3% with respect to comparable plants in target firms in
the two years after the buy-out; by 6% in the five years after the buyout
• Yet the newborn companies (from the merger between the Newco and the
target) end up creating +2% of jobs more than comparable firms and plants.
• Netting out pluses and minuses, average job loss for target firms is 1% in the
two years after the LBO
• Overall, the gross creation and destruction of jobs goes up a lot (+14%) with
respect to comparable firms
2. Plant productivity goes up by 2,1 per cent in the two years after the LBO. Yet
productivity gains mostly stem from closing down of old (obsolete?) plants and
opening up of new plants, rather than from reorganization of existing plants
3. Profir margins: gain, as a result of a 2,5% fall in earnings per worker in the two
years after the LBO
Summing up: the timeline of the crisis
Fall of housing prices
1.
Losses in banks’ capital, risk of illiquidity or outright insolvency because
of extensive securitization of sub-prime loans
2.
“Deleveraging” (reduction in leverage) via
i.
Reduction in loans (“credit crunch”)
ii.
Selling of liquid assets (in turn causing further fall of their market
prices)
iii. Market re-capitalization (up to June 08)
3. Lehman Brothers goes bankrupt (15/09/08)
i.
Freezing of interbank market and extension of public guarantees
(Sep 08)
ii.
Asset burning and acceleration of asset deflation
4.
Fall in household housing and financial wealth, postponement or
cancellation of durable consumption and investment, falling aggregate
demand and policy response (Oct 08-)
The Paper Economy
or
how the shadow banking system operates
The process described so far operated through a
Parallel (or Shadow) Banking System
The parallel banking system is made of all the non-bank
financial institutions (including investment banks) taking part
in the process of credit creation for the rest of the economy.
(Names? Bear Stearns, Lehman Brothers)
What did the parallel banking system do?
 Financed vast amount of real estate lending and
consumer borrowing
 Made loans with no deposit base
 Used little operating capital and extremely high leverage
ratios (=assets/capital). As a result, lots of profits
 Extended loans usually securitized and traded among
financial firms
40
Where did such pressing credit needs come from?
Mario Draghi (then Bank of Italy Governor)
“Credit has become something to be bought and sold in
the market instead of being held onto the balance sheets
of financial intermediaries”
Response to well known myth in the American society:
the idea of the “ownership society”
 Founding myth of the US society
 Revived by GW Bush
41
Greenspan’s endorsement of leveraged finance
Alan Greenspan (Fed governor before Ben Bernanke, from
1987 to 2007) famously said in 2005
“The new instruments of risk diversification allowed bigger
and more sophisticated banks … to get rid of the bulk of
credit risk by shifting it to less exposed institutions.
These increasingly complex financial tools have contributed
to the development of a more flexible and efficient financial
sector, hence less exposed to shocks than the one that
existed only twenty five years ago.
After the bubble bursting of the stock market in 2000, no
major insolvency of any big financial institution, at odds with
what happened in the past in the wake of big financial
shocks”
(italics are mine)
Yes, the Maestro said: “LESS EXPOSED INSTITUTIONS”
and “LESS EXPOSED TO SHOCKS”
42
Was Alan Greenspan crazy? Or may be simply
captured by investment banks?
No. Simply, “modern” (leveraged) finance has its pros
Expansion of financial markets  financial development 
economic growth
Thanks to pooling and distribution of diverse risks
How?
Investor portfolios more diversified through creation of new
financial products entailing different risk-return
combinations
Reduction of ratio between required bank capital and
originated credits
 More loans for given capital, more credit, more profits
 As long as things square well ..
43
The wrong side of the parallel banking system
A fragile business model
Natural mismatch of maturities – implicit in the functioning of
modern credit systems - stretched to an extreme
 Loans are long term but their funding is short-term. Both with
banks and parallel banking system
 Non-banking institutions particularly vulnerable to disruptions
of money market funding, for their business model based on
really short-term roll-over of funds
Moreover, securitization converted loans into financial
instruments to be priced according to market conditions
 OK, as long as home prices kept rising
 When home prices fell, firms had to take large “mark-tomarket” losses
 Given low capital ratios, losses quickly wiped out firms’ thin
capital bases, thereby leading to a freeze of roll-over funding
44
Why the incentive system in place was distorted? (1)
Banks

interested in cashing hefty fees for structured
sophisticated financial products

Less interested in monitoring the quality of credit (risks
distributed to outside takers) or borrowers’ behavior
Brokers

Paid according to quantity of procured credit; in search of
the mortgage taker with no evaluation of creditworthiness
Rating agencies

supplied consulting on how to structure financial products
whose quality they were supposed to evaluate

Rating based on “optimistic” statistical models

Two reasons for optimism: (a) rating based on recent (typically:
two) “good” years and (b) no regard given to liquidity risk of
“unusual” financial products
45
Why the incentive system in place was distorted? (2)
Fund managers and desk traders

fee structure based on principle Heads I win, tails you
lose contributed to take excessive risk taking

Being a senior executive at an investment bank, even
if you knew you were in a bubble that was going to
collapse, it was still in your interests to play along

For at least two reasons


the enormity of the short-term compensation to be made
outweighed the financial risk of being fired in a bust (given
severance packages, and the fact that in a downturn all CEO
compensation would plummet)
bucking the trend entails “CV risk” in such a way that
playing along doesn’t
46
The US Financial sector reform
after the crisis
US Financial sector reform enacted
http://topics.nytimes.com/topics/reference/timestopics/subj
ects/c/credit_crisis/financial_regulatory_reform/index.html
Global credit crisis in 2008 called for financial sector
reform
July 2010: Congress passed Dodd-Frank Act expanding
the govt role in fin’l mkts, reflecting mistrust on the part of
politicians after decades of wide-eyed admiration of Wall
Street
Since then: stock market back up, banking profits back up,
economy is moving ahead
So: is enacted financial reform ok?
48
Dodd-Frank Act in a nutshell
The Dodd-Frank Act aims to tackle abusive lending
practices and high-risk bets on complex derivative
securities that nearly drove the banking system off a cliff
 It creates a bureau to protect consumers from fin’l fraud
 It cuts fees banks charge for debit-card use
 It calls public exchanges on which derivatives and other
complex financial instruments are traded
 Also included is the so-called “Volcker rule”


Rule, named for Paul Volcker, the former Federal Reserve
chairman who proposed the measure in early 2010,
restricts ability of banks whose deposits are federally insured
from trading for their own benefit. This is to counteract creation
of TBTF (Too Big To Fail) institutions
49
Lags of implementation
Hundreds of important decisions to be worked
out in one of the most complex processes ever
undertaken by govt
 By Sep 2011 only small portion of the law has
taken hold. Of the up to 400 regulations
called for in the act, only ¼ had even been
written, much less approved.
Key targets of opponents
 Too big powers of Consumer Financial
Protection Bureau
 Too strict limits on debit card fees
 Too generous budgets for S.E.C. (the US
Consob) and Commodity Futures Trading
Commission
50
Huge costs of implementation
Dodd-Frank (DF) Act: 848 pages


Example of legislative inflation
US banking system set up in 1864 with law of 29 pages; the Fed
established in 1913 with 32 pages; the Glass-Steagall Act that
enabled the shadow banking system to be so profitable spread out to
37 pages
Problem is not just length: sections 404 & 406 (to limit risk
exposure of TBTF institutions) add up to 2 pages only
Yet form based on such law provisions to be filled out by
hedge funds and other firms ran up to 192 pages
Cost of filling it out? According to informal survey of hedgefund managers, $100-150.000 in 1st yr and $40k in later years

Same for Volcker rule: 11 pages of DF became 300 pages of
proposal and up to 1420 questions to be answered by firms
51
Is the new web of agencies making the
occurrence of the next fin’l crisis less likely?
52