The Financial Crisis of 2007-2009:

What Happened and Why?

Dale Henderson
January 12, 2012
Eonomics 458 Lecture 1
Introduction
How did we get into such a mess?
Contributing macroeconomic factors low real Contributing macroeconomic factors low real
and nominal interest rates only mentioned here
Savings glut probably better called investment g g p y
shortage.
Build up of reserves in Asia in aftermath of Asian financial crisis
in July1997 in July1997
Chinese export-led growth strategy
Excessively expansionary monetary policy to combat
recession that began before 9/11 but became worse
after it.
Introduction
People had all the wrong incentives.
According to the Turner Review published by the
U.K. Financial Services Authority,
"There is a strong prima facie case that
inappropriate incentive structures played a role in
encouraging behavior which contributed to the
financial crisis." (Turner Review, March 2009)
Understatement
Introduction
Inappropriate incentive structures do not oblige
people to engage in questionable behavior, but people to engage in questionable behavior, but
they certainly make it more likely that they will.
Alan Greenspan spoke for many when he said, p p y ,
"Those of us who have looked to the self-interest of
lending institutions to protect shareholder's equity -- myself
i ll i t t f h k d di b li f " especially -- are in a state of shocked disbelief."
(Congressional testimony, October 2008)

Introduction
According to data available at the end of the 1
st
week in November, in the 3
rd
quarter of 2009, the
US ended its longest economic contraction since
World War II. (3.5% growth)
Worst economic crisis since Great Depression
almost 80 years ago.
Continuation of recovery by no means insured.
Focus on housing market
Where the financial crisis began
Where it is having its most devastating effects..
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Home > Tr ack i ng t he Gl obal Recessi on
Tracking the Global Recession: United States

Track t he Economic I ndicat ors Tr ack t he GDP Dat a Business Cycles Dat es
PDF ver si on of char t s and dat a r ef er ences.

NOTE: The chart s plot Real Gross Domest ic Product ( SAAR, Chn. 2000$) and it s maj or component s; each series is indexed t o 100 at t he st art of t he
recession. The current recession ( red line) st ar t ed in t he fourt h quart er of 2007. The solid blue line indicat es t he average over t he past t en recessions.
The t wo dashed lines report t he highest and lowest values recorded across t he past t en recessions.
Choose...
Page 1 of 2 St. Louis Fed: Tracking the Recession
7/21/2009 http://research.stlouisfed.org/recession/gdpdata.html
US
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Economic Research
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Employment | Seminars | Monet ary Aggr egat es
Home > Tr ack i ng t he Gl obal Recessi on
Tracking the Global Recession: United Kingdom

Track t he Economic I ndicat ors Tr ack t he GDP Dat a Business Cycles Dat es

PDF v er si on of char t s and dat a r ef er ences.

NOTE: The chart s plot Real Gross Domest ic Product ( SA, Chained) and it s maj or component s; each series is indexed t o 100 at t he business cycle peak.
The red line indicat es t he current recession. The solid blue line indicat es t he average of t he previous seven recessions, st art ing wit h t he June 1973 peak.
The t wo dashed lines report t he highest and lowest values recorded across t hese previous recessions.
Choose...
Page 1 of 2 St. Louis Fed: Tracking the Recession - United Kingdom
7/21/2009 http://research.stlouisfed.org/recession/uk/gdpdata.html
UK

Some Comparisons between Now and Then (cont.)
0 4 8 12 16 20 24 28 32 36 40 44 48 52 56
50
60
70
80
90
100
0 2 4 6 8 10 12 14
I
n
d
e
x
Time (Years)
Source: US Bureau of Economic Analysis
USA Real GDP
Index 1 (1929=100)
Index 2(2008 Q1=100)

Some Comparisons between Now and Then (cont.)
0 20 40 60 80 100 120 140
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
0 2 4 6 8 10 12
U
n
e
m
p
l
o
y
m
e
n
t
Years
(IMF International Financial Statistics <http://www.imfstatistics.org/imf>
Mitchell, Brian. "International Historical Statistics: The Americas 1750-2000" )
USA Unemployment (%)
Unemployment (1929-1940)
Unemployment (M1 2007-M2 2010)

Some Comparisons between Now and Then (cont.)
80
85
90
95
100
105
110
115
120
125
130
0 10 20 30 40 50
80
85
90
95
100
105
110
115
120
125
130
0 2 4 6 8 10 12 14
I
n
d
e
x
Years
(Source: Angus Maddison <http://www.ggdc.net/Maddison/>,
IMF International Financial Statistics <http://www.imfstatistics.org/im
UK Real GDP
Index 1 (1929=100)
Index 2 (2008 Q1 = 100)

Some Comparisons between Now and Then (cont.)
0 20 40 60 80 100 120 140
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
0 2 4 6 8 10 12
U
n
e
m
p
l
o
y
m
e
n
t
Years
(IMF International Financial Statistics <http://www.imfstatistics.org/imf>
Mitchell, Brian. "International Historical Statistics: Europe 1750-2000" )
UK Unemployment (%)
Unemployment (1929-1940)
Unemployment (2007 M1-2009 M11)
Housing-Price Bubbles
What Is a housing-price bubble What Is a housing price bubble
Bubble is not technical term with precise definition.
Approach of Justice Stewart of U.S. Supreme Court. Approach of Justice Stewart of U.S. Supreme Court.
First wrote that he would not attempt to define obscenity
Then famously declared I know it when I see it.
While some of us may think we know bubbles when
we see them, the rest might want to probe a little
deeper deeper.
Working Definition of Bubble
Elements
Extended period of increases in an asset price Extended period of increases in an asset price
At least some observers regard (at least in retrospect)
as being unrelated to increases in the intrinsic value
f h of the asset
Usually followed by steep price declines.
Defining characteristic of bubble market is that Defining characteristic of bubble market is that
investors focus on resale value of asset rather
than on its intrinsic value than on its intrinsic value.
Measure of Housing Bubble
For house, intrinsic value determined by housing
services over lifetime services over lifetime
Value of housing services generated in a given
year equal to rent one pays for same services. y q p y
Price of a house should be related to how much it
would rent for. If price gets too high relative to
rent, everyone would want to rent
Might conclude that having housing bubble if ratio
house prices to rents well above its average.
In several countries bubbles have grown and
grown and then burst

Housing price "bubble"
How can we determine "fundamental value" of a house?
Look at house price to rent ratio. Price (P) should be
related to present value of rents (R). For simplicity assume
interest rate and rent constant, that house can be rented
for n years
P =
R
1 + i
+
R
(1 + i)
2
+ ::: +
R
(1 + i)
n
(1)
and when n is large, to a close approximation
P =
R
i
(2)
Reasoning at end of lecture for those interested.
Observations
Housing bubbles in several countries but not all.
Not just an Anglo-Saxon phenomenon Not just an Anglo Saxon phenomenon
Interesting question as to why experiences
different but not addressed here.
Housing bubbles recur
Often associated with financial deregulation or g
innovation.
housing_bubbles_chart.png (image) http://1.bp.blogspot.com/_Et4TQ-a0gGU/Sg7WE-vBCII/AAAAAAAAC...
1 of 1 5/18/2009 12:14 PM
CFN682.gif (GIF Image, 290x335 pixels) http://www.economist.com/images/20100102/CFN682.gif
1 of 1 1/14/2010 9:11 AM
FHFA Home Price Index rose 0.9% in June
S&P/Case-Shiller Home Price Index Data To Be Released August 30th at 9:00 a.m. EST
Comparing Countries: House Prices in US, UK, France
and Spain
David Blitzer
Chairman of the Index Committee
S&P Indices
August 26 - 9:00 am
Comments: 0
Some five years after house prices peaked in the U.S., debates over the cause of the boom and bust continue. Some of the
leading theories Fed policy or sub-prime mortgages to name two of the most common are U.S. centric with little to
say about other countries. However, one part of the puzzle is the experience in other parts of the world. The Bank for
International Settlements, sometimes described as the central bankers bank, maintains data on property prices around the
world. The chart compares the U.S. experience to home prices in the UK, Spain and France. The data are quarterly; the
U.S. data are the S&P/Case-Shiller National Home Price Index, the data for the other countries come from the BIS. These
series use somewhat different calculating approaches and coverage varies across countries; nevetheless, one can get a
sense of differing results in different countries.
Home Prices in the U.S. and Europe
Using 1996 as the base date, the U.S. boom was not the largest in terms of price gains but the U.S. was the biggest drop
from the peak. Further, U.S. prices peaked first possibly suggesting that the bust in the U.S. was part of the spark that sent
other prices down. If one dates the financial crisis from the fall of 2008 when Lehman Brothers failed, the stock market
plunge deepened and TARP began, one could almost argue from the chart that these events sent house prices in the other
countries into a tailspin. The debate over the housing boom and bust is far from over.
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FHFA Home Price Index rose 0.9% in June

Page 1 of 2 Comparing Countries: House Prices in US, UK, France and Spain | Standard & Poor's HousingViews
1/12/2012 http://www.housingviews.com/2011/08/26/comparing-countries-house-prices-in-us-uk-france-and-spain/
Traditional Model of Housing Finance
Traditional mortgage lending
One institution performs all functions related to One institution performs all functions related to
the mortgage.
Originates loan holds it on its balance sheet and Originates loan, holds it on its balance sheet, and
receives payments of principal and interest.
Origination involves making assessment of whether g g
borrower can be expected to make payments.
Also involves explaining terms of loans to borrowers
so that they can make informed decisions so that they can make informed decisions.
Since lending institution one of losers if loan goes bad,
it has every incentive to make thorough assessments y g
and provide accurate information during origination.
Originate and Distribute Model
of Housing Finance
In contrast, the originate and distribute (or
securitization) model of housing securitization) model of housing
Separates the origination and holding functions p g g
Introduces at least two additional functions: issuing, rating.
Separating these functions gives rise to a number of
incentive problems.
The originate and distribute process is a chain with many
links links
Originator
The first link is the originator
Receives a fee for work involved in originating mortgage. g g g g
Has an incentive to increase number of originations.
To speed up origination can require less documentation,
l t d d d l ti l i i l t d lower standards, spend less time explaining loan terms, and,
worst of all, engage in fraud. Apparently, originators did all
of these things to some degree or another.
Lax lending standards employed by lightly regulated non-
bank mortgage originators initiated a downward competitive
spiral which led to pervasive issuance of unsustainable
mortgages, FDIC Chairman Sheila Bair
The desire to build up a good reputation was often not
strong enough or was missing entirely strong enough or was missing entirely
Issuer
The second link is the issuer. The issuer performs
the securitization. It collects together a group of the securitization. It collects together a group of
mortgages and issues a (mortgage backed)
security that is a claims to a share of the regular
payments of principal and interest.
In order to convey information about quality of
security, issuer asks a rating agency to give the
security a rating. The issuer pays the agency for
this service this service.
Rating Agency
The third link is the rating agency
Incentive problems associated with rating agencies Incentive problems associated with rating agencies.
Potential conflict of interest; an agency may offer
advice about how to structure a security to get a certain
rating and then give that rating.
Competition for business; issuers pay for ratings and
have a choice among agencies so an agency may have a choice among agencies, so an agency may
shade ratings upward to attract business.
Ratings agencies freely assigned AAA credit ratings to
the senior tranches of mortgage securitizations without
doing fundamental analysis of underlying loan quality.
FDIC Chairman Sheila Bair FDIC Chairman Sheila Bair
Collateralized Debt Obligations
Fourth link is entity that purchases rated mortgage
backed security from issuer backed security from issuer
May be final link if entity holds security
However entity may pool with other mortgage backed
securities getting rating for new security sometimes
referred to as Collateralized Debt Obligations (CDOs)in
the process the process.
Rating of CDO may exceed ratings of all its component MBSs.
Partly justified because of possible negative correlation, but
probably overdone probably overdone.
Still vulnerable to systemic risk
Higher yield
Higher risk
Lower yield
Lower risk
otheiAA
anu
lowei
tianches
otheiAA
anu
lowei
tianches
AAA
AA
A
BBB
BB-
unrated
$7Sumillion
moitgage-backeu
secuiity
S,uuumoitgageloansof
$1Su,uuueach=
$7Sumillion
AAA
AA and
lower
tranches
80%
20%
$6uu
million
$1Su
million
AAA
AA and
lower
tranches
CDO
AAA
AAA
AAA
AA
Financial
institution
holds many
mortgages
Homeowners
sign mortgage
Financial
institutions fund
home purchases
Tranches Pool of
mortgage loans
GLOSSARY oF FINANCIAL TERMS
CDO
2
(or CDO squared)
Mortgage-Backed Securities
Tranche
AAA rating
By the numbers
ThemoitgagesaiepooleuintoNoitgage-BackeuSecuiities.
Investoisbuytianchesofthesecuiities
ThewoiutiancheisFienchfoislice,section,seiies,oipoition.A
tiancheisapoitionofastiuctuieupiouuctcieateusuchthateach
poition has the same cash low chaiacteiistics A stiuctuieu piouuct is
uiviueuintomultipletianchesthathaveuiffeientiiskchaiacteiistics.
Thehighestavailableiatingfiomacieuitiatingagency,
iepiesentingthelowestcieuitiiskofanyclassofuebtsecuiities.
Foiexample,theAAAtianchesofamoitgage-backeusecuiity,a
CB0,oiaCB0squaieuaiethehighestiateu,lowestiisktianches.
Astiuctuieupiouuctwhichgivesthebonuholueistheiighttoieceive
thecash lows fiom a pool of tianches of uiffeient CB0s
Astiuctuieupiouuctwhichgivesthebonuholueistheiighttoieceive
thecash lows fiom a pool of othei secuiities often incluuing moitgage
backeusecuiities.ACB0isuiviueuintomultipletianchesthathave
uiffeientiiskchaiacteiistics.
Takeahypothetical$7Sumillionmoitgage-backeusecuiitybackeuby
S,uuusubpiimemoitgagesof$1Su,uuueach.Typically,about8u%oi
$6uumillionofthesesubpiimemoitgage-backeusecuiitiesaieiateuAAA.
Now,ifyoutakethe
BBBanulowei
tianchesanu
iepackagetheminto
aCB0withothei
BBBanulowei
tianches,ovei8S%
oineaily$6Su
millionofthe
oiiginal$7Sumillion
inmoitgage-ielateu
assetshasnowbeen
tianslateuinto
AAA-iateubonus.
Now,ifyoutaketheAAanuAtianchesoftheCB0anuiepackagetheminto
aCB0squaieuwithotheiAAanuAtianches,ovei84%oineaily$6SS
millionoftheoiiginal$7Sumillioninmoitgage-iateuassetshasnowbeen
tianslateuintoAAA-iateubonus.
Structured Product
Foiouipuiposes,abonubackeubyapoolofassets,suchasmoitgages.
CDO
Investors buy
tranches of
securites
The mortgages are
pooled into
Mortgage-Backed
Securities
.8(37.5) = 30
.8(6.25) = 5
Higher yield
Higher risk
Lower yield
Lower risk
otheiAA
anu
lowei
tianches
otheiAA
anu
lowei
tianches
AAA
AA
A
BBB
BB-
unrated
$7Sumillion
moitgage-backeu
secuiity
S,uuumoitgageloansof
$1Su,uuueach=
$7Sumillion
AAA
AA and
lower
tranches
80%
20%
$6uu
million
$1Su
million
AAA
AA and
lower
tranches
CDO
AAA
AAA
AAA
AA
Financial
institution
holds many
mortgages
Homeowners
sign mortgage
Financial
institutions fund
home purchases
Tranches Pool of
mortgage loans
GLOSSARY oF FINANCIAL TERMS
CDO
2
(or CDO squared)
Mortgage-Backed Securities
Tranche
AAA rating
By the numbers
ThemoitgagesaiepooleuintoNoitgage-BackeuSecuiities.
Investoisbuytianchesofthesecuiities
ThewoiutiancheisFienchfoislice,section,seiies,oipoition.A
tiancheisapoitionofastiuctuieupiouuctcieateusuchthateach
poition has the same cash low chaiacteiistics A stiuctuieu piouuct is
uiviueuintomultipletianchesthathaveuiffeientiiskchaiacteiistics.
Thehighestavailableiatingfiomacieuitiatingagency,
iepiesentingthelowestcieuitiiskofanyclassofuebtsecuiities.
Foiexample,theAAAtianchesofamoitgage-backeusecuiity,a
CB0,oiaCB0squaieuaiethehighestiateu,lowestiisktianches.
Astiuctuieupiouuctwhichgivesthebonuholueistheiighttoieceive
thecash lows fiom a pool of tianches of uiffeient CB0s
Astiuctuieupiouuctwhichgivesthebonuholueistheiighttoieceive
thecash lows fiom a pool of othei secuiities often incluuing moitgage
backeusecuiities.ACB0isuiviueuintomultipletianchesthathave
uiffeientiiskchaiacteiistics.
Takeahypothetical$7Sumillionmoitgage-backeusecuiitybackeuby
S,uuusubpiimemoitgagesof$1Su,uuueach.Typically,about8u%oi
$6uumillionofthesesubpiimemoitgage-backeusecuiitiesaieiateuAAA.
Now,ifyoutakethe
BBBanulowei
tianchesanu
iepackagetheminto
aCB0withothei
BBBanulowei
tianches,ovei8S%
oineaily$6Su
millionofthe
oiiginal$7Sumillion
inmoitgage-ielateu
assetshasnowbeen
tianslateuinto
AAA-iateubonus.
Now,ifyoutaketheAAanuAtianchesoftheCB0anuiepackagetheminto
aCB0squaieuwithotheiAAanuAtianches,ovei84%oineaily$6SS
millionoftheoiiginal$7Sumillioninmoitgage-iateuassetshasnowbeen
tianslateuintoAAA-iateubonus.
Structured Product
Foiouipuiposes,abonubackeubyapoolofassets,suchasmoitgages.
CDO
Investors buy
tranches of
securites
The mortgages are
pooled into
Mortgage-Backed
Securities
.8(37.5) = 30
.8(6.25) = 5
Credit Insurance
Often one more link in the originate and distribute chain.
issuer or ultimate holder buys credit default insurance, y ,
called a credit default swap (CDS).
Buyer pays a periodic premium.
Seller promises to make good any loss the buyer suffers if the Seller promises to make good any loss the buyer suffers if the
security goes into default.
Problems with insurers
Lack of experience in relatively new line of business because used
to dealing with municipal bonds.
Incentive to expand business to collect insurance fees and not well
monitored
Casino aspect of selling many CDSs on same credit event
Light Touch Regulation
The essentials of the U.K. approach were the following:
A light touch in financial markets to enhance international
competitiveness. Better protection for consumers, through
better information and advice when choices need to made, and
better access to redress if things go wrong. (Alan Milburn, June g g g ( ,
17, 1999)
The better, and in my opinion the correct, modern model of
regulation the risk based approach is based on trust in the regulation the risk based approach is based on trust in the
responsible company, the engaged employee and the educated
consumer, leading government to focus its attention where it
should: no inspection without justification no form filling without should: no inspection without justification, no form filling without
justification, and no information requirements without
justification, not just a light touch but a limited touch. (Gordon
Brown November 28 2005) Brown November 28, 2005)
Light Touch Regulation in the U.S.
When the SEC relaxed its net capital rule in 2004the
major investment banks were freed of the traditional net
capital rules requirement of a basically 12-1 debt-to-equity
ratio. Instead, the investment banks were able to leverage
up to their eyeballs, so long as they could point to Basel II- up to their eyeballs, so long as they could point to Basel II
style internal models that arguably demonstrated that they
were sufficiently diversified. The investment banks were
miles ahead of the SEC in developing computer models miles ahead of the SEC in developing computer models
with all their Monte Carlo simulations, showing that these
assets were never going to deteriorate in value. But of
course they failed. (Professor John Coffee July 2009)
What might uncharitably be referred to as do it yourself
regulation turned out to be woefully inadequate regulation turned out to be woefully inadequate
File:Leverage Ratios.png
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Contents
1 Summary
2 Explanation
3 Source Data
4 Licensing:
Description
Leverage ratios of investment banks
Source
Annual Reports; Chart by Farcaster
Date
October 16 2008
Author
Farcaster (talk) 19:59, 16 October 2008 (UTC)
Permission
(Reusing this
image)
See below.
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Is This Financial Crisis Unusual
Considerable debate over whether this time is
different (Rogoff and Reinhart 2009) ( g )
R &R say no or at least not very
Others argue that it is a tail event g
Event observed infrequently
Likely that one has not occurred in recent past so
analysis based on recent data will not allow for them
Underestimate probability because distribution of
returns not a normal distribution but rather has fat tails returns not a normal distribution but rather has fat tails
Yet others (famously Nassim NicholasTaleb) argue
that it is a black swan event so unique that it is not t at t s a b ac s a e e t so u que t at t s ot
susceptible to standard probability analysis


Fat-Tailed Distribution
A reference to the tendency of many financial instrument price and return distributions to
have more observations in the tails and to be thinner in the midrange than a normal
distribution. Assets prone to price jumps tend to exhibit fat-tailed distributions. See
Leptokurtosis, Lognormal Distribution (diagram), Normal Distribution.

Copyright 1996, 1999 Gary L.Gastineau. First Edition.
1992 Swiss Bank Corporation.
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File:Cygnus Atratus Singapore.jpg
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Description
A Black Swan (Cygnus Atratus) in the Singapore Botanical Gardens.
Date
Nov 2006 (AR Recee)
Source
self made
Author
Img by Calvin Teo
Permission
(Reusing this
image)
copyleft
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Illiquidity vs. Insolvency
Essence of financial intermediaries is that they
have borrowing with a maturity shorter than the have borrowing with a maturity shorter than the
maturity of their investments; situation called
maturity mismatch.
Extreme cases are demand deposits at banks and
overnight borrowing by banks and hedge funds.
In normal times there is no problem because
short-term borrowing can be rolled over
( b d) (reborrowed).
Illiquidity vs. Insolvency
If depositors suddenly want to withdraw their deposits or
short-term lenders do not want to roll over their loans, the
financial intermediary must come up with funds.
If it has short-term assets like government bills, it can sell
these liquid assets without taking a loss these liquid assets without taking a loss.
If it must sell long-term investments it is likely that it will not
be able to sell these illiquid assets for as much as they
would yield if they were held to maturity; fire-sale prices.
Situation arises because difficult for potential buyers to
correctly value these assets The financial intermediary correctly value these assets. The financial intermediary
has often made the investment on the basis of information
that is not easy to transfer.
Illiquidity vs. Insolvency
Crucial question: Would intermediarys assets be sufficient to
repay its lenders if held to maturity? If so, illiquid, If not, insolvent.
f Textbook answer is authorities should lend to intermediary if illiquid
but should choose resolution if intermediary insolvent.
Options for resolution fall into three general categories: continued
operation with strings, merger, and liquidation. Each has variants.
Unfortunately illiquidity/insolvency distinction not clear cut.
Hard for officials to determine what the value of intermediarys Hard for officials to determine what the value of intermediary s
assets would be if held to maturity.
Whether an institution insolvent depends on what else is going
on Institution ruled solvent in normal times might be ruled on . Institution ruled solvent in normal times might be ruled
insolvent in the midst of a recession
Intermediary might be too big or too interconnected to fail. e.g.
American International Group Lehman Brothers American International Group, Lehman Brothers
ConventionalMonetary Policy
Conventional monetary policy
In normal times Federal Reserve stimulates economic activity by y y
lowering federal funds (FF) rate, rate at which banks lend to one
another, by buying securities, usually Treasury bills.
Although commercial banks borrow relatively little in FF market, g y
FF rate plays central role because other rates tied closely to it.
Commercial banks raise most of their funds from the public: offer
deposits of various maturities; borrow short-term, especially from p p y
other financial institutions; sell longer-term debt; issue equity.
Banks cost of funds is determined by averaging the rates they pay
to the public. It is closely related to the FF rate because borrowing p y g
in the FF market is always an option.
ConventionalMonetary Policy
Conventional monetary policy (continued)
Banks use the funds to acquire assets. Banks use the funds to acquire assets.
Make loans to households and to firms for consumption and
investment.
Also purchase securities including MBSs in some cases Also purchase securities, including MBSs in some cases.
Rates earned on assets mark up over cost of funds, to
a first approximation, .
When assets mature
Banks either roll them over or use the repayments to acquire
new assets new assets.
Interest rates or prices set for rollovers and new assets usually
not too different from those for maturing assets.
Conventional Monetary Policy Stymied
These are not normal times in many countries.
Problem of zero lower bound on policy rate Problem of zero lower bound on policy rate
In mid December 2008 Federal Reserve lower target
range for federal funds rate to 0 to .25 and not likely to go
llower.
Rates at which private sector can borrow have not come
down nearly as much because spreads due to risk premia y p p
have increased.
U.S. Officials still want to stimulate economy
P i ti l t li Pursuing unconventional monetary policy
Article 13.3 of Federal Reserve Act
Gave the Board of Governors the power to authorize
Federal Reserve Banks to make loans to any individual,
partnership, or corporation provided that the borrower is
unable to obtain credit from a banking institution.
Not used since 1930s
Different from Federal Funds rate decisions because
decided by Board of Governors not Federal Open Market
Committee (FOMC)
Basis for loan to JP Morgan Chase which was part of
agreement under which it purchased Bear Stearns
Basis for Federal Reserve loan to AIG
Basis for purchase of commercial paper through the
Commercial Paper Funding Facility (CPFF) and the Asset
Backed Commercial Paper Money Market Mutual Fund
Liquidity Facility (AMLF)
Stylized Federal Reserve Balance Sheet
Before Unconventional Asset Purchases
Assets Liabilities Assets Liabilities
Short-Term Government Securities Currency and Coin
Reserve Balances of Banks
After Uncon entional Asset P rchases After Unconventional Asset Purchases
Assets Liabilities
Short Term Government Securities Currency and Coin Short-Term Government Securities Currency and Coin
Mortgage Backed Securities Reserve Balances of Banks
Long-term Government Bonds
Commercial Paper
Corporate Bonds
2009 Federal Reserve Bank of St . Louis
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Descript ion of growt h rat es and US recession dat es
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Similar policy pursed in U.S. and several other countries
Beginning in 2001 Bank of Japan set targets for bank reserves
(current account balances) when call money was zero. Bought
several types of assets but focus was on quantity of bank reserves.
In recent financial crisis U.K. undertook quantitative easing.
Rationale was that BoE made asset purchases that directly
increased money supply or at least bank reserves.
In U.S. purchases of unconventional assets first called
credit easing by Bernanke. Rationale was that Fed made
asset purchases that directly lowered either spending-
related rates or rates clearly related.
Now policy of purchasing unconventional assets usually
referred to as quantitative easing: QEI for purchases
before the fall of 2010 and QE2 for new round of purchases
after that time.
Unconventional Monetary Policy
Coordinating Monetary and Fiscal Policies
During Rescue Operations
Rescue operations in financial crises almost always
involve both monetary and fiscal policies
Loans extended and assets purchases made by central banks
during a financial crisis may result in losses.
Losses reduce transfer to Treasury so they must cut spending
or raise taxes either now or in the future.
Therefore, central banks and treasuries must agree on how to
handle any losses. If they do not the independence of the
central bank may be threatened.
Exchange of letters between the Chancellor of the Exchequer
and the Governor of the BoE about Asset Purchase Facility
makes it clear that while the Bank manages Facility, Treasury
sets limits and is responsible for losses.
In financial crisis Fed consulted with Treasury voluntarily but
Dodd-Frank Bill requires the Fed to obtain Treasury approval.
Combating Bubbles
Suppose agreed that housing bubble in progress
but no evidence of overheating elsewhere but no evidence of overheating elsewhere
What should the authorities do then?
Two types of policy are usually considered Two types of policy are usually considered,
monetary policy and supervision and regulation
policy
Monetary Policy
To prick or not to prick
Some argue should raise interest rates to prick bubble Some argue should raise interest rates to prick bubble
Realize that economic activity outside the housing sector would
reduced.
Argue total damage to economy is minimized in this way Argue total damage to economy is minimized in this way.
Others argue better to wait and see.
Recommend gearing monetary policy to overall economic
activity.
The monetary authorities should not raise interest rates unless
there is evidence of overheating in standard measures such as
inflation and unemployment.
Be ready to deal with any damage caused by eventual collapse
when it occurs.
Japanese Experience
Japanese experience beginning in 1989 relevant
Japanese used monetary to prick stock and land stock Japanese used monetary to prick stock and land stock
market bubbles and were very explicit about what they
were doing.
Wh f ll d J l d d What followed was Japans lost decade.
Opponents of bubble pricking cite Japanese experience
to support their case to support their case.
Proponents reply that monetary policy and fiscal policy
in Japan following pricking were not conducted as well
as they might have been, so Japans experience should
not be regarded as a clean test of desirability of
pricking bubbles. p g
Supervision and Regulation Policy
Monetary policy is a blunt instrument for dealing
with bubbles in the housing market. with bubbles in the housing market.
Question is whether supervision and regulation (S&R)
policy can be used instead.
My answer is a qualified yes.
I consider two S&R policy instruments: loan to value
ratios and (two types of) capital requirements ratios and (two types of) capital requirements.
Loan to Value Ratios
Loan to value (LTV) ratios
Ratio of the amount mortgage to value of house Ratio of the amount mortgage to value of house
Common during housing bubbles to see LTV ratios
increase as house prices rise, sometimes to above one!
L d d b f l f i h i hi h LTV ti Lenders and borrowers feel safe in having higher LTV ratio.
Both betting (betting is the right word) that prices will increase
so little chance that value of house will fall below amount owed.
Higher LTV ratios make it possible for more people to enter
market and bid up prices.
If object is to keep bubble from continuing, opposite j p g, pp
should happen. LTV ratios should be decreased as house
prices rise to make it harder to bid for houses.
Experience with and prescription for loan to (borrower) Experience with and prescription for loan to (borrower)
income (LTI) ratios is analogous.
Capital Ratios
Capital ratios
Bank capital is a measure of ability of the bank to Bank capital is a measure of ability of the bank to
suffer losses while still honoring its liabilities, e.g.
the book value of equity plus retained earnings
With deposit insurance (explicit or implicit), banks sell less
stock (common and preferred) than is socially desirable
since it costs more. since it costs more.
To make sure banks sell a minimum amount of such stock,
the authorities impose required capital ratios.
Capital Ratios
A capital adequacy ratio is a ratio of a measure of
capital to some measure of assets p
Two frequently discussed capital ratios are
Ratio of capital to risk weighted assets. Measure protection
against credit risk. Borrowers might default on their loans.
Ratio of capital to total assets. Often referred to as the
leverage ratio. Viewed by some as measure of protection leverage ratio . Viewed by some as measure of protection
against liquidity risk. Even if borrowers would not default,
may need to sell quickly may not get good price. More a
problem the bigger the bank. problem the bigger the bank.
Capital Ratios Continued
Constant capital ratio requirements have procyclical effects. i.e.,
they tend to reinforce rather than counteract movements in the
economy.
As economic conditions improve it is easier to raise capital
through stock sales or retained earning so capital ratios are less of
t i t l di a restraint on lending.
Conversely, when economic conditions deteriorate, it is harder to
raise capital through stock sales or retained earning so capital
ti f t i t l di ratios are more of a restraint on lending.
At times this procyclical influence has been increased by
lowering capital ratios in booms and raising them in recessions.
Several analysts have argued that capital ratios should be
countercyclical; banks would sell stock in good times and build
up assets that could be used to offset loan losses in bad times. up assets that could be used to offset loan losses in bad times.
Seems likely to be important part of new regulations.
Capital Ratios Continued
Natural to equate a banks capital to its net worth and
measure it as assets minus liabilities.
Conceptual difficulties in measuring assets and liabilities.
Up until a few years ago used book values with relatively
minor adjustments for changes in market conditions minor adjustments for changes in market conditions.
More recently heavy reliance on market values; mark to
market or fair value accounting basis of Basel I and g
Basel II agreements on bank regulation.
Much criticism of effects of mark to market accounting in
t i i recent crisis.
Role of preferred equity being reevaluated; more attention
being paid to (tangible) common equity. This measure of be g pa d to (ta g b e) co o equ ty s easu e o
capital was used in U.S. stress tests. Citicorp example.
Way Forward: Turner Review
Review of financial regulation by Lord Turner
head of U.K. Financial Services Authority head of U.K. Financial Services Authority
The financial crisis has challenged the intellectual
assumptions on which previous regulatory approaches
l l b ilt d i ti l th th f ti l were largely built, and in particular the theory of rational
and self-correcting markets. Much financial innovation has
proved of little value, and market discipline of individual p , p
bank strategies has often proved ineffective.
What Next?
If a company is too big to fail, it is too big to exist
(Senator Bernie Sanders)
At first it appeared to be no appetite for breaking up large
financial firms (Turner Review, Treasury White Paper)
However,
European Commission argues European banking sector too concentrated
leading to institutions that are both not competitive and too big to fail.
Neelie Kroes, the Commissioner for Competition, said November 13,
2009, that [t]he European Commission is not destroying banks, it is
simply helping this troubled sector to remain competitive whilst dealing
with the current crisis.
Holland break up of ING group ING in both banking & insurance
(bancassurance); must sell insurance part
U.K. break up of Royal Bank of Scotland and Lloyds Banking Group.
Reasoning for equation (2)
Multiply equation (1) by
1
1+i
and subtract the result from
equation (1) to obtain
P

1
1 + i

P =
R
1 + i

R
(1 + i)
n+1
(3)
since other terms on right hand side cancel. Rearranging gives

i
1 + i

P =
R
1 + i

R
(1 + i)
n+1
(4)
Multiplying both sides by
1+i
i
yields
P =
R
i

R
i

1
(1 + i)
n

(5)
The second term on the right hand side approaches zero as n
becomes large so equation (2) holds approximately.