Building blocs of a credit crisis
Presentation for Unitech students at TU Delft,
4 January 2010
by Dr Alfred Kleinknecht,
Professor of Economics, TU Delft
What type of crisis?
• This is a crisis of over-speculation. Such crises
happen quite frequently in history, but often they are
restricted to certain markets or countries.
• This crisis is "historic" as it takes place on a Worldwide basis, comparable to the great railway crash
after 1873 and the Wall Street crash of 1929.
• Other than the classical business cycle (Juglar
cycle) and the long-run Schumpeter-Kondratieff
wave, however, it is a non-regular crisis.
There seems to be no reason for a crisis …
• After a fairly long Juglar recession (starting in 2001),
the "classical" business cycle was just starting a
new growth period around 2005/6; normally, such a
period should take 5-7 years.
• In the mid-1990's we started a new phase of the
Schumpeter-Kondratieff wave of higher growth,
driven by ICT as a new key technology. ICT (as a
General Purpose Technology) still has a great
potential for economy-wide process, product- and
service innovations and high productivity growth.
→ … reasons for optimism?
Building blocs of this crisis:
• Bonuses that encourage ruthless speculation
• Regulating authorities have become weak
after a long neo-liberal campaign for the
retreat of government, the "deregulation",
"flexibilization" and "liberalization" of
markets, driven by a strong belief in "efficient
markets".
• A World-wide "savings glut": capital
searching for investment opportunities is
used for building up asset bubbles (petrol
money; more uneven distribution of income).
Traditional credit business …
The bank is an intermediary between demand for credit
and supply of savings
Savings → Bank → credit (e.g. mortgage)
(end of story)
The new credit business:
1. House owners obtain mortgages from banks
2. Banks sell all rights and liabilities of the mortgages
to an investor, typically as 'packages' with different
risk profiles (these packages become 'securities');
3. Advantages to the banks:
• Risk of default in payment is shifted to a larger
number of investors → spreading of risks
• As you spread risks, you can take more risks … (as
an airbag induces car drivers driving faster)
• The revenues from selling the mortgages give
banks extra room for granting new mortgages
Problematic: the "rating" of risks
• A "Rating Agency" (Moodies; Standard & Poor or
Fitch) judges the risks of default of (bundles of)
mortgages (how reliable are the house owners?)
• The more favourable is the rating, the higher will be
the price of the (bundle of) mortgages
• Rating Agency receives a fixed percentage of the
value of the bundle of mortgages (Note: the value of
these bundles is dependent on the rating!)
• Insight ex-post: "Ratings" have been systematically
too optimistic (explanation?)
Another crucial thing: “Leverage”
An example of financing without leverage
(silly & dull!):
Firm X needs 100.000 Euro as its working capital; they
make 10.000 Euro profit per year.
Financing all that capital with equity (i.e. with their own
money), the Return on Equity (ROE) is: 10%
Note: this firm would be an ideal candidate for a Private
Equity firm!
More sexy: a reasonable leverage
The working capital of 100.000 is financed as
follows:
30% equity + 70% bank credit, against 4%
interest; total profits remain 10.000.
Return on Equity (ROE):
10.000 profit – 2.800 interest = 7.200 (net profit
on Euro 30.000 equity)
→ ROE becomes 24%! (i.e.: 7.200 / 30.000*100)
Much more sexy:
A Wall Street type leverage
The firm's working capital is financed as follows:
5% equity + 95% bank credit (against 4% interest; total
profits remain 10.000)
ROE: 10.000 profit – 3.800 interest = 6.200 (you make
6.200 net profit on 5000 Euro of your own capital!)
→ your ROE is 124%! (i.e.: 6.200 / 5000*100)
Note: Profits and capital requirements remained
unchanged; only the financial structure changed!
Summing up:
• As long as profits on your total invested capital are
higher than interest rates, you can increase the
Return on Equity (ROE) by financing with credit.
• The lower the interest rates and the higher the share
of borrowed capital in total capital, the higher is your
leverage.
• With higher leverages, you can offer higher returns
to your suppliers of equity – which means higher
bonuses!
The risk of leverage:
Your working capital of 100.000 is financed as follows:
5% equity + 95% bank credit (against 4% interest);
Problem: your firm makes a loss of - 10.000
What is then your ROE?
-10.000 'negative profit' plus 3.800 interest = - 13.800
(i.e. you make 13.800 net loss on your 5.000 equity!)
→ the negative ROE becomes –276%!
(i.e.: -13.800 / 5.000*100 = -276%)
A popular leverage: Mister X inherited a land house
from his parents, free of mortgages.
Estimated market value: 2.000.000 euro
Step 1: He obtains from his bank a mortgage of 1.8
million, giving the land house as a guarantee (interest
on the mortgage: 5%)
Step 2: Mister X buys shares in the stock exchange
worth 1.8 million (Expected gains: 10-20% per year)
Step 3: Mister X obtains another bank credit of 1,4
million (against 5% interest); the package of shares
previously bought (worth 1.8 million) serve as a
guarantee
Step 4: Mister X buys shares worth 1.4 million
Step 5: Mister X obtains another bank credit of 0.9
million (against 5% interest); the package of shares
previously bought (worth 1.4 million) serve as a
guarantee, … etc.
2000-2003: the Amsterdam stock
exchange falls by almost 60%
What happens to Mister X?
His bank is becoming nervous.
Fortunately, they made a sophisticated credit
contract …
Solution:
→ Sell all shares before they go down further!
→ "House for sale!”
Unfortunately, there were many people
that had the same splendid idea …
Second round effects of forced sales:
After 2001:
 Many, many houses "for sale" → downward
pressure on prices in the 'upper segment' of
the housing market
 Extra downward pressure on share prices
Macro economic background:
The import surplus of the USA
Import surplus:
• Exports minus
imports (billion
US $):
Ca. 7% of US
National Product!
1991
- 31,1
1995
- 104,0
2000
- 379,8
2002
- 423,7
2004
- 612,1
2005
- 714,4
2006
- 758,5
2007
- 711,6
The 'current account' (trade balance) of
the USA in 2006
Imports
Exports
(Goods and services)
(Goods and services)
2.204,2 Billion US $
1.445,7 Billion US $
Import surplus:
-758,5 Billion US $
(This is about 7% of the US
National Product)
Definitions:
(Net) Export surplus = "National savings surplus"
 If we export more goods than we import, we produce
more than we consume. Other countries are eating
part of our National Product
(Net) Import surplus = "National savings deficit"
 If we import more goods than we export, we
consume more than we produce. We eat part of other
countries' National Product.
Examples:
Import surplus of the USA in 2006: 758 billion dollars
Export surplus of the Netherlands in 2006: ca. 40
Billion Euro (ca. 7.5% of National Product)
Question: How is this compensated?
Through trade in valuable assets
The capital account covers trade in
valuable assets (i.e. shares, bonds, real
estate, art, and – more recently –
mortgage securities)
Capital account
Import of capital
(Acquisition by foreigners of
Dutch shares, bonds, real
estate etc.)
Export of capital
(Acquisition by Dutch
citizens of foreign shares,
bonds, real estate etc.)
The balance of payment
"Current Account" (goods and services)
+ "Capital account" (assets)
= "Balance of payments"
Important:
 Current Account + Capital Account need to
be jointly in (approximate) equilibrium
(otherwise there will be a balance of payment
crisis)
How do imbalances in goods trade influence
the exchange rates of currencies?
 If US imports are 758 billion higher than US exports:
what should happen to the exchange rate of the US
Dollar? (ceteris paribus)
 If Dutch exports are 40 billion Euro higher than
Dutch imports, what should happen to the exchange
rate of the Dutch Guilder? (ceteris paribus)
Note: The value of a currency is determined
simply by supply and demand!
The export surplus of the Netherlands leads to more
supply of foreign currency and more demand for
Guilders (Dutch exporters want to exchange their
foreign currency export revenues into their national
currency)
→ Dutch Guilder
The import surplus of the US leads to more supply of
dollars and more demand for foreign currencies
(foreign exporters want to exchange their dollars into
their national currencies)
→ US Dollar
How do imbalances in assets trade influence
the exchange rates of currencies?
The exact opposite holds for capital exports and
capital imports:
• If Dutch investors buy assets in the US, they need
dollars (offering their own currency in exchange)
US Dollar:
• If foreign investors buy Dutch assets, they have to
buy Dutch Guilders and sell US Dollars
Dutch Guilder:
Summarizing:
• An export surplus of goods and services (Current
Account) drives up the value of our currency; an
import surplus of goods drives it down
• An export surplus of assets (Capital account) drives
down our own currency; an import surplus of capital
drives our currency up
• If the export surplus on the current account is
approximately equal to the export surplus on the
capital account, exchange rates are fairly stable
What does the current account deficit (import
surplus) of 758 billion US dollars mean? (1)
The US have to sell every year assets (shares, bonds
etc.) worth about 758 billion dollars to foreign investors
in exchange for "too many" goods and services being
imported
Note:
This is a net amount: the US have to sell 758 billion
more of assets than Americans buy abroad
What does the current account deficit
(import surplus) of 758 billion US dollars
mean? (2)
• In recent years, US assets sold to foreigners
consist increasingly of bonds (debt paper)
issued by US firms and the US government –
and of mortgage-based securities
• The growing national debt translates into
debts of individual actors such as:
– government (national debt),
– firms (bonds, bank loans) or
– private citizens' debts (mortgage debt; consumer
credit; credit card debt)
How long can you continue building up
debts?
 Quite long: Export surpluses (= national savings
surpluses) and import surpluses (= national savings
deficits) are equal to each other on a World scale →
There is, by definition, enough money to lend and
borrow, as long as the surplus countries are ready to
lend to the deficit countries.
 Credit depends, however, on trust!
 Trust has been damaged → e.g. the market for
mortgage 'securities' has collapsed
Reasons for optimism
•
•
•
National Central Banks have succeeded to
orchestrate a gradual decline of the US Dollar (a
sudden crash of the US Dollar would have been
disastrous!)
Thanks to a lower value of the dollar, the US can
more easily export (and receive less imports).
Buying of US assets becomes cheaper for foreign
investors (and US investors buy less assets
abroad, as they got more expensive).
Looking ahead (1):
There is a danger of higher inflation in the US:
1. The low value of the Dollar makes US exports
cheaper and imports more expensive → more export
/ less imports (less aggregate supply, more
aggregate demand)
2. The low dollar makes US imports more expensive →
import of inflation!
3. The US Federal Reserve has lowered interest rates
and widened money supply → inflation? (Think of
the Fisher equation: MV = TP)
The Fisher equation:
MxV=PxT
Money supply
Velocity of money: number
of times that a piece of
money changes its owner
(assumed to be constant)
Price
level
Transaction volume:
Goods and services
traded in an economy
Discussion: Is a higher dollar inflation attractive to the US?
(Their debts are nominated in dollars!)
Looking ahead (2):
Consequences of higher inflation in the US:
• Nominal interest rates might rise → value of (old)
bonds (at lower interest rates) has to go down →
what about risks of 'second round' effects of forced
sales due to aggressive leverages??
• Foreign investors (in dollar priced assets) suffer
strong losses and might demand higher risk
premiums in the future
• It might become more expensive financing future US
national savings deficits (import surpluses)
Looking ahead (3):
Solutions:
• Americans have to consume less and save more
(higher exports, lower imports)
• Europe and Asia have to do the exact opposite, as
the US are less able to absorb the national savings
surpluses of Asia and Europe.
• This can lead to lower growth in the export-lead
economies of Asia, but also in countries like
Germany and the Netherlands that have large export
surpluses.
• A solution could be higher domestic consumption
and lower savings in Asia and Europe (otherwise:
lower growth)
Looking ahead (4):
Difficult to judge:
• There is a bubble of over-valued assets (shares,
bonds, art objects, houses, office rooms etc.) built up
through a long period of low interest rates (Shiller
Index)
Uncertainties:
→ A breakdown of prices due to panic sales or forced
sales? (leverage finance!)
→ Lower consumer spending through losses on assets?
→ More bankruptcies of banks, insurance companies,
high-leveraged hedge funds or private equity firms?
→ Are there still more Bernard Madoffs?
→ Domino-effects?
Finally: Why did so many people not foresee
the emerging debt crisis?
→ Strong believe in stable and efficient markets
– Market are stable: they always strive towards equilibrium
– Markets are efficient (welfare maximizing outcomes)
– Actors are rational and act in the interest of their firm.
→ As long as a bubble is building up, there is a lot to
be earned! ("We had to dance as long as the music
was on!")
→ "Black Swan": Events may have small probabilities
to occur, but if they occur, consequences can be
disastrous!
Yet, there were clear symptoms of an emerging
crisis …
• Enormous build-up of debt in the US
• Tobin's Q gave a clear indication that stock markets
were over-valued
• A World-wide tendency towards a more unequal
income distribution. Rich people save higher shares
of their income → "A World-wide savings glut"
(Bernanke).
• These excess savings have to be invested
somewhere (high probability of asset bubbles).
US: Domestic debt as a percentage of GDP (1950-2007)
"Household" = Consumer and mortgage debt
"Business" = Total non-financial business sector debt
"Financial" = Total financial sector debt
"Public" = total public sector debt (local and federal)
Source: US Federal Reserve
Leverage
financing!
Rapid rise in
housing prices
→ higher
mortgages for
consumption
US: Tobin's Q, 1932-2007
Definition:
Stock market value of firms, divided by the accounting value of
their assets (3-year moving averages)
US: Average income of the bottom 90%
and of the top 1%, 1933-2006)
Summarizing:
There were strong indications of a coming
crisis (for those who wanted to see them):
• A growing debt burden in the US: Earlier or later, the
chain of credit had to brake (at its weakest link)
• A high value of Tobin's Q (comparable to the value in
1929!)
Why was this not seen (by so many people)?
• Strong believe in stability and efficiency of free
markets (and in rational actors) → theoretical
convictions and ideological beliefs influence
perception of empirical facts
One more source of instability:
The credit multiplier
The "credit multiplier" – how does it work?
Suppose your grandmother makes a deposit of 1000
euro into her savings account. The bank wants to use
that money for giving credit to a client.
Problem: The bank is not allowed to lend the
full amount; it has to keep 10% as a reserve
Note: For simplicity, we assume there is only one
bank; all money transfers go through this bank's
accounts
How can banks "create" money? (2)
Step 1: The bank lends 900 to a client. 100 is put aside
as a reserve
Step 2: The receiver of the credit pays his supplier →
there is a new deposit of 900 on the supplier's bank
account
Step 3: The bank can again give a credit of 90% of this
new deposit. New credit: 810 (90 is kept as reserve)
Step 4: The receiver of this new credit pays somebody
→ there is a new deposit of 810 on somebody else's
bank account
Step 5: The bank can again give 90% of that amount as
credit …
How much credit can be given if we complete
the whole chain?
Formula:
Credit volume = deposit x 1 / reserve ratio
Hence:
1000 x 1 / 0.10 = 10.000 (if the reserve ratio is 10%) →
Thanks to the 1.000 euro savings of your grandmother,
the bank can give 10.000 euro credit
Question:
How can a central bank influence the supply of money?
Above we assumed there is only one bank –
how does it work with several banks?
The chain: deposit → credit (+ reserve) → new deposit
→ new credit (+ reserve) → new credit … extends to
several banks
Solution? Inter-bank credits
… but what if the banks do no more trust each other?
(Emergency solution: Central Bank gives credit)
Discussion:
Imagine people fear that their bank is in problems …
How could a speculator earn money with that?