The Economic Crisis

ECOC:
Economics of Crises (Massenot) SS16
Introduction: Economics of Crises

The Great Recession
Around 2008: took everyone by surprise

o Unemployment peaks
o Financial markets go crazy
o Worst US recession since 30s
o Failure of Lehman

how?

Perspective of people
Crisis led to anger

o Financial frauds (that most ppl dont understand)
o Many Americans lose homes & hobs
o Many businesses go bankrupt
o Large destruction of wealth
o Government desperate for revenues
o Taxpayers have to pay for mistakes of others
Rise of populist political movements
o Tea party
o Occupy Wall Street
A very brief history of the crisis
Preliminary history (crisis not over yet!)

Recession ends in 2009 unemployment still high
US financial system experienced a storm 2007-2009 due to
o Fragility
o Complexity
o Too little regulation

Financial Meltdown
Start: housing bubble burst
bond bubble
stock market collapses
o pensions of Americans disappear
ruin spread to other parts of the financial system
o Lehman fails
o Citigroup bailout

Economic Crisis
Spread to the real economy: jobs, factories, shops
People think of finance as some independent entity WRONG!
o Finance = circulatory system of the economy
o (businesses often survive because of credit)

Credit Crisis
If financial institutions face difficulties lend less economy experiences cardiac arrest
o people dont buy houses
o firms become credit constrained, stop investing & hiring

ECOC: Economics of Crises (Massenot) SS16
Before: too much credit

Afterwards: too little credit

Policy response
US government mobilises enormous resources to alleviate the financial distress
o Expand social safety net (= duration of unemployment benefits)
o Large scale fiscal stimulus
o Fed:
drop interest rates to the floor
expand balance sheet (make loans, purchase assets, issue guarantees)

Did it work?
FAIL: US experienced worst recession since the 30s
Still... what wouldve happened without government intervention?

How? Link between financial ruin & unemployment
Credit becomes more expensive/unavailable
o Business lose ability to finance everyday needs (payrolls, investment, equipment)
o Consumers buy less
Sales down, credit more expensive businesses have to scale back operations
o more layoffs
o less hiring
o unemployment +

Unemployment
job losses: employment kept falling for

than 2 years (from 2008 on)
deficit of 12 million jobs (job loss + not hiring)

more

Cost of unemployment
short-term unemployment: not problematic
o helps people to change jobs
long-term unemployment: problematic
o harder to find a job
o decreases expected wages
o during crisis at 45%

GDP
= size of the economy
Recession = GDP declines for 2 or more consecutive quarters
o Only 9x since WWII
o 2x for 3 consecutive quarters

2008/Q1,2 2009: declined for 4 consecutive quarters (5 in total)

like income loss of 8% pp
if 10% of the population loses 80%

Slow recovery
makes recession worse: currently close to 2%
2 post-WWII large recessions followed by strong growth rates (6%)

Before the crash
Homebuilding grew
o 1.6m (4.5% of GDP) 2.1m (6%) new homes
o Peak of homebuilding & house prices in 2005
o house price bubble bursts
o ... homebuilding decreases
Business investment grew at same rate

Hints of trouble

House prices fall

Employment growth almost at 0 by 2007
Huge debt
The collapse
Sep 2008: Lehman Brothers files for bankruptcy
real GDP falls to 3.7% annual rate in Q3 2008
falls to 8.9% in Q4

Comparing with other financial crises

Conclusion
Banking crises share striking similarities:

o Run-up in assert prices
o Debt accumulation
o Growth patterns
o Current account deficits
Most crises preceded by financial liberalisation
o Shadow banking sector seen as less regulated
Aftermath
The aftermath of financial crises, Reinhart & Rogoff (2009)

Banking crises in
unemployment increase
flexibility (less worker
emerging economies: lower

greater downward wage
protection)
Conclusion
Aftermath of severe financial crises is characterised by deep & lasting effects on
o Asset prices
o Output (only 2 yrs here)
o Employment
o Government debt
Different today?
o Better monetary policy
o ( Great Depression, Japans Lost Decade)
Bubbles

The 7 Culprits

1.
2.
3.
4.
5.
6.
7.
Asset price bubbles

Excessive leverage
Lax financial regulation
Disgraceful banking practices
Complexity of financial securities
Poor performance of rating agencies
Perverse compensation system in financial institutions
I Asset price bubbles

2 burst bubbles in the last decade:

o housing bubble

o bond bubble

main culprit of the crisis

bond bubble prolonged it

Bubble?
= large & long-lasting deviation of the price of some assets from its fundamental value
(house, stock, bond)
usually: upward deviation (overvaluation)

The fundamental
= value of the dividends & capital gains that are expected to accrue to its owner in the future
correct price of an asset fundamental
sentimental value
interest rate high future dividend worth less
o
interest rate = time value of money

Fundamental of houses
dividends: monthly rental fees saved by owning (rather than renting)
lower interest rate higher fundamental value of house (discounting)
difficult to compute: each house is different

Large deviation?
Asset prices go up and down small asset price movement bubble
if all house prices increase by 20-30% looks like a bubble rather
SUBJECTIVE (10% premium on a price might be sentimental)

Long-lasting?
Prices bounce on a daily basis
Stock prices soar by 50% during one week and then return back to normal bubble
Long lasting = prices stay elevated long enough that its easily confused with a higher fundamental value

So? Whats a bubble?
= large & long-lasting price deviation from its fundamental
difficult to assess the presence of a bubble
fundamentals difficult to compute
bubble can be accompanied by an increase in fundamentals (dot-com bubble)

The housing bubble

US bubble 2000 2009 (quite unique)

CPI-deflated housing prices:

Main observations
Relative prices of housing barely changed over the century
After 2000:
o if thats not a bubble, housing bubbles have never occurred
In hindsight, easy:
o Few people saw bubble
o Paul Krugman in 2001 in NYT, The Economist in 2002
o lack of agreement


Burst becomes commonplace around 2004

Could we spot the housing bubble?
At earlier stages: US had already experienced such price increases
Interest rates very low increased fundamental value of houses
o Bernanke: strong increase in house prices reflect strong fundamentals

How to measure house prices?
Federal Housing Finance Agency:
o Identified a 2000-2006 increase in real prices of 34%
o Understatement of bubble
Looks at subsample of house prices
Ignores low end: subprime mortgages
Case-Shiller index:
o Identified a 71% increase
o Overstatement of bubble
Looks at subsample of more urban areas (more volatile prices)

Consequences of bubbles
Bubbles leave mark on economies

o Internet bubble: left US with unused fibre
optic
o House bubble: left many vacant or
underwater houses

Signs of a bubble
Huge decrease in building activity & house prices
around 2006
signs of a bubble burst
not obvious, though

Origins of the bubble
Conventional wisdom in America: belief that house prices will keep increasing forever cannot lose by
investing!
Too many Americans took on too much debt bought houses they couldnt afford
Amplified by media
Reasons
Crazy beliefs hard to justify, usually house prices normally follow inflation path
People formed EXTRAPOLATIVE EXPECTATIONS

Leverage
Buy a $200k house: put $40k down, take out $160k
Acquire a 200k asset with 40k of equity leveraged 5:1 asset is worth 5x the equity
House prices follows inflation: 20% in 5yrs house prices at $240k
o Equity doubled from 40 to 80k


o
o
= 100% return in 5 yrs

nice!
(Germans reluctant to buy stocks: trauma of dot-com bubble)

Inflation?
even adjusting for inflation: annual return still at 10%!
o Impressive
o BUT: real value of house didnt rise at all!
o because of LEVERAGE

Additional Explanations
after dot-com bubble crash in 2000: people look for safe investment housing perceived safe
Bernanke: fundamentals were strong (income growth, low interest rates)
Bankers helped to lever even more
House prices rose homeowners could refinance their mortgages at cheaper rates

Role of Monetary Policy
Loose MP?
Fed kept interest rates extraordinarily low fuel to the housing boom
BUT: bubble started many years before 2003
! Bubble kept on inflation after Fed started raising rates again !
Other countries:
o UK observed house price bubble despite higher interest rates

Bubble Burst
Bubbles always eventually burst

Not predictable when and how but burst is for sure!
Crash started in 2006/2007

See it coming?
Some people did! No broad agreement, though
o even a broken clock is right twice a day
o reliable theory to predict bubble bursts not available at that time!
Policy makers betted on the no bubble

The Bond Bubble

Bond = fixed income security

o Promises fixed payment at dates set in advance
o Payment independent of how well company is doing (corporate bond)
Unless it goes bankrupt
o Contrast to stock: dividends & capital gains rise/fall with fortunes of the company
Fundamental
Fundamental value of a bond: easy to compute if there is no default risk

o Compute PV of all interest & principal payments (fixed & known)
o Lower interest rates future payments worth more higher bond price
Risk of Default
US government bond: no default risk

o Fundamental value = PV future payments
Other types of bonds carry risk of default
o Complicates valuation of bonds possibility of bubble
o Fundamental of corporate bond or MBS: depends on
PV
Perceived probability of loss from default
o Underestimating risk of default = overestimating fundamental value
Mortgage backed securities
Financial security backed by mortgage or pool of mortgages

Overestimation of fundamental value of an MBS = underestimation of default probability of mortgages
Parallel to house price bubble:
o Investors falsely believed that probability of mortgage default was low
o Probability of all mortgages in an MBS defaulting at the same time even lower

Fundamentals
Bubbles inflate fundamentals often increase at same time
True for bonds & MBS
o Prosperous times: default rates low
o Investors extrapolate, anticipate low future defaults
Investors willing to pay high price for securities

Spread
Spread = risk premium
Measure of perceived probability of default
Difference between: interest rate paid by risky and risk-free security (US government bond)
Higher interest rates = compensation for risk of default
o Treasuries < Corporate bonds < Junk bonds
Perceived default probability low spread also low
Perceived default probability high spread also high

Mortgage default
In the 1990s: banks lost only 0.15% on mortgages

o For ever 1m$ invested, banks lost only 1500$ home mortgage = exceptionally safe investment
In 2004: rate fell to less than 0.1%

Invest in mortgage?
2005
house prices soaring for past 8 yrs
mortgage default falling to historic lows
safe investment, pays more than treasuries? good idea?


Charge-off rates (default)

Not a good idea after all
After 2008
Impossible to forecast this surge
Bad idea: extrapolation of superlow default rates in 2003-2006
Especially when many mortgages were junk
o Subprime lending
o NINJA loans (No income, no jobs, no assets)

Forecasting?
Many forecasting models used by banks relied on 3 yrs of historical data

o Investors underestimate default risk
o Spreads too low
o Bond prices too high
o Bond bubble
Reasons
Partly: very loose monetary policy
In 2001: US economy had trouble recovering from recession
o GDP growth sluggish, employment declining
o Inflation low & falling
Fear of deflation:
o Fed stimulated economy decrease overnight interest rate down to 1% (1st time since 1954)
Stimulus helped economy!

Arbitrage
Aggressive MP: investors reach foe yield
Low yields on Treasuries look for alternative investments
MBS looked ideal!
o Paid a lot better
o Perceived safe
Investors:
o Sell treasuries buy MBS
o TAKE A LOT OF RISK WITHOUT REALISING

10
III Excessive leverage

Introduction
A bit of leverage good, a lot bad

Leverage magnifies return on the upside & downside
Highly leveraged company/investor/household dangerous
2007: leverage everywhere in the US
Leverage at home
American homebuyers:
o 20% down payment
o leveraged 5-1
in times of soaring house prices, safe harbour of housing investment: rule of thumb abandoned
o mortgages with 5% down common
o if house value declines by 5% (not much): 0 equity, lost everything
Some people: take on 2nd mortgage to pay the down payment
o Infinitely leveraged
o Slightest los underwater (mortgage worth more than value of house)
o Sell house not enough money to pay mortgage
Leverage and financial returns
Leverage = use borrowed funds to purchase assets

Name: Archimeded declared he could move the earth with a large enough lever
Leverage magnifies gains & losses
Jane invests 1m$ in one-year corporate bonds, 6% interest rate

o At end of year: gets back 1m$ principal + 60k$ interest
o ROR = 6%
John invests 10m$ in same instrument
o Down 1m$ (as Jane) + borrows 9m$ at 3%
o At end of year: gets back 10m$ principal + 600k$ interest = 10.6m$
o Pay back loan of 9.27m$
o Earns 1.33m$ on a 1m$ investment
o ROR = 33%

Leverage allows John to obtain much higher ROR than Jane

Smarter?
Suppose: Bond falls 5% in value (equity) during year
Jane:
o Only 950k$ principal + 60k$ interest = 1.01m$
o ROR = 1%
John: MORE RISK
o Only 9.5m$ principal + 600k$ interest = 10.1m$
o Has to repay 9.27m$ to bank
o 830k$ on 1m$ investment
o ROR = - 17%

11
Debt explosion
Mortgage debt exploded 2000-2008

Total household debt: 100% of GDP 140% in 8
yrs
Large share: mortgage indebtedness
Leverage at the bank

SIV
Banks also levered up

o Borrow money from depositor
o Invest money in e.g. loans
If banks capital amounts to 10% of its asset leveraged 10-to-1
Normally: safe leverage (loan losses rarely to 10%)
In boom: accounting & legal tricks to increase leverage special investment vehicles (SIV)
= off-balance-sheet entity
o (never heard before the crisis)

Example: simple bank
10b$ shareholders equity
leveraged 10-to-1:
o raise 90b$ of deposits
o make 100b$ worth of loans

BS of Bank:
Assets
Liabilities
Loans of 100b$
Deposits 90b$

Equity 10b$

grow without raising more capital? sponsor a SIV: sell 50b$ of its loans
Bank gives tacit/explicit guarantee against most loan losses SIV seems to be in safe position!
E.g.
o SIV holds 1b$ of capital
o Raises additional 49b$ in commercial paper market
o SIV leverage = 50-1 (seems higher, some were even higher)

BS of SIV:
Assets
Liabilities
Loans 50b$
Commercial paper 49b$

Equity 1b$

Meanwhile:
o bank sold 50b$ of its loans
o received in return: 49b$ cash, 1b$ in SIV stock
will lend the cash

12

Banks still appears to be leveraged 10-1

New BS of bank:
Assets
Liabilities
Loans 99b$
Deposits 90b$
Stock in SIV 1b$
Equity 10b$

Consolidated BS:
Assets
Liabilities
Loans 149b$
Deposits 90b$

Commercial paper 49b$

Equity 10b$

Consolidated leverage
Bottom line: SIV allows bank to look less leveraged than it actually is
Looks like: Bank leveraged 10-1 looks relatively safe to regulators
But: SIV dependent on parent bank true leverage 14.9 to 1
SIV wiped out if loss of only 2% ensuing losses accrue to bank

Leverage on Wall Street

Bear Stearns, Lehman, Merrill Lynch, Morgan Stanley, Goldman Sachs (big 5): operated 40-1
Only a 2.5% decline in asset value wipes out all shareholder value

Consequences
Following housing & bond bubble burst: big 5 ill prepared
o Lehman failed
o Bear & Merrill absorbed into commercial banks
o Morgan & Goldman got help from Fed

Difference with banks
Leverage not enough risk, want more

Traditional bank: funding with deposits only
Investment bank: funding with borrowing
o 40-1 leverage: equity at 2.5%, remaining 97.5% borrowed!
Long-term (bonds)
Great deal is short-term (up to overnight)

Short vs long-run financing
Risky investment bank (RIB) borrows:
o Issue 10-year bond
o = financing guaranteed for 10 years
interest rates higher than interest on overnight, collateralised loans: repurchase agreements (repos)
o collateralised safer lower interest rates
RIB prefers to finance with repos

But: have to return to capital markets every day
Markets view RIB as credit worthy one day and risky on another day RIB in trouble!
o Cannot roll over debt = modern version of bank run

13
runs killed Big 5
Derivatives
create synthetic leverage

example: stock options
o at end of Feb 2012: Google shares traded for 610$ per share
o same day: 7-month call option (give buyer the right to buy shares at 610$) selling at 48$
o If Google shares were worth 658$ in September: option buyer breaks even
Buy share at 610$ sell for 658$ return = 0
o If Google shares were worth 710$ in September: net profit of 100$
!""#$%
108% return on stock
(
100)
$%
*!"#+!"
stock only increased by 16%

(
100)
+!"
If Google share worth less than 610$ option useless
Lose 48$ 100% loss
Returns are magnified

Value of stock
610
658
Return: buy stock
0%
8%
Return: buy option
-100%
0%

Magnification of returns!
no actual borrowing synthetic leverage

Derivatives during the crisis
Derivatives in crisis more complicated
Place high-risk bets on whether
o Losses in mortgage pool would exceed certain threshold
o Company would default on its bonded debt
Some poorly understood
All created synthetic leverage, increased risk

710
16%
108%
Conclusion
Leverage everywhere prior to crisis: households, banks, investment banks

High leverage accident more likely to happen
Regulation shouldve prevented such high leverage?
14
IV Lack of regulation
Regulation
Why regulations?
o Prevent collapse like this
o Limit contagion from one institution to the other
o Minimise costs to taxpayer (socialisation of costs)
o Ensure square dealing
ensure safe & sound operation of financial institutions
Financial regulators
Most important: Federal Reserve

o Led by Alan Greenspan during boom period crisis
Feds unwatchful eye: banks proliferated use of SIVs
o Invested in bad subprime mortgages many designed to default
o Invested huge sums in risky assets that they portrayed as safe
Sometimes: blame Fed for failing to regulate bankers
o But bankers dealt much more with
Office of Controller of the Currency (OCC)
Now abolished Office of Thrift Supervision (OTS)
Federal Deposit Insurance Corporation (FDIC)
o Everyone just asleep as Fed
o Each agency headed by a Bush appointee (firmly believed in deregulation)
Subprime lending
regulators were too permissive

Subprime lending constituted 7% of all mortgages granted in 2001
o increased to 20% in 2005
o Total outstanding subprime mortgage lending: 1.25t$
Explosive growth of any new form of lending should set off regulators alarms
o Standard red flag!
Regulators received plenty of unsolicited warnings
o Journalists were writing about risky lending as early as 2004
o = open secret
Why did regulators do nothing?
Deregulation & free-market ideology

o Recent default experiences favourable (therefore underestimation of risk)
Regulators may have reasoned just the same
o prices will keep rising because fundamentals are improving
Political pressure
o Clinton & Bush administration: agenda of increasing home ownership (also low-income families)
Ownership society (Bush)
o Raghuram Rajan (Fault lines): agenda responsible to rising inequality
o Regulators shouldve been independent and resisted political influence

Excuse??
Large share of riskiest subprime mortgages: not actually issued by banks but by nonbank lenders
Lenders held mortgages for a few days sold them to securitisers

15

o
o
E.g. one of the top 10 subprime mortgage originators: regulated commercial bank Wells Fargo
only 20% of all subprime mortgages in 2005 came from regulated banks
The shadow banking sector
non-bank mortgage lender part of shadow banking sector

Includes:
o Non-bank loan originators
o Government-sponsored housing agencies (Fannie Mae, Freddie Mac)
o SIVs
o Hedge funds
In common: not subject to standard bank regulation
Involved in markets:
o
o
o
o
o
o
Mortgage, other asset-backed securities

Commercial paper
Repos
Verious derivatives
Collateralised debt obligations (CDOs)
Credit default swaps (CDSs)

shadow banking sector > conventional banking sector
unregulated!

Derivatives
Around for centuries in modern form since 80s

Back then: market < 1t$ (most interest rate swaps)
2001: estimated at 69t$
2007: estimated 445t$

market mostly only visible to specialist
o
until mid-90s, caught some attention: some firms/municipalities wiped out by losses from derivatives

What is it?
= generic term for any security/contract whose value is derived from some underlying natural security
o e.g. stock, bond
Instead of owning the asset (and profiting/losing as its price rises/falls) derivative = bet on some aspect
of its behaviour
o Call option: right to buy the underlying security
Value of a CDS depends on whether underlying bond defaults
other derivatives: based on currencies, interest rates

Classification:
o Underlying (bond, mortgage, currency, interest rate)
o Standardised (traded on organised exchange, e.g. stock options) vs. traded OTC (e.g. CDS)
Standardised safer & more transparent than OTC

What are they used for?
Hedge against/to create risk
E.g. airline uses derivatives to insure against fluctuations of future fuel prices
Derivatives are zero-sum gambles: one party wins, one loses
Most derivatives embed synthetic leverage

16

Regulation of derivatives
Anti-regulatory ideology prevailed despite bad experience in 90s
Argumentation: regulation of derivatives
o creates legal uncertainties
o stifles innovations
o sends derivatives trading offshore

Why believe in laissez-faire tales?
o Excessive faith in free markets
o Efficient market hypothesis
o
Good times: asset values rising, loan defaults rare (people forget things can crash)
o Proponent: Minsky (crisis = Minsky moment)

Efficient markets hypothesis
Efficient = how investors use information
Efficient market: every bit of new information is processed correctly & immediately by investors
market prices react instantly & appropriately to any relevant news about assets
o no 100$ bills left on the sidewalk
o = to profit from news must be really fast!
o = cannot beat the market
in theory: prices do not react to unfounded rumours or madness of crowds bubbles cant exist!

approximation of reality
fits data well on widely traded stocks
not so well for thinly traded, poorly understood securities

CDS: Credit Default Swaps (type of derivative)
2000: new derivative called CDS by JP Morgan

o regulators barely knew what they were about, didnt know it could play such an important role

What is it?
CDS = insurance contract
Seller insures buyer against loss from default of a particular bond
o Bond defaults insurer pays off
o In Return: buyer makes periodic payments (like every insurance)
Defaults?
o Never defaults: seller wins, buyer loses
o Defaults: seller loses a lot

original goal: insurance
People started using it to gamble
o Didnt even own some of the underlying bonds they insured themselves against
Principle:
o One party thinks: borrower is going to default
o Other party thinks: borrower is not going to default
o mutual advantage in trading a CDS
= naked CDS (no underlying actually owned)

17

Naked CDS
derivative creates risk (instead of hedging)
o TOTAL RISK RISES
Just like call options. DS embed synthetic leverage
Buyer:
o Makes just a few premium payments before default
o Wins huge multiple of his investment
Seller:
o Suffers equally huge loss

Justification?
Deals = zero-sum games
o hence: innocuity of CDS to society
but what if seller is not able to honour his payments?
AIG:
o Issued many CDS
o Had to be rescued by government
o AIGs liabilities became taxpayers liabilities

The CDS market
One of the biggest boom-bust stories
2001: worth < 1t$
2007: 62t$
2008: 80% of CDS = naked
Risk of risky subprime mortgages was magnified
o Americans had a stake in these bets without knowing it
o Markets should have been regulated!

IV Disgraceful practices

Subprime mortgages led into this mess

Part of the blame: regulators who allowed them
How about banks & lenders creating the mortgages?
How about securitisers who bought mortgages & transformed them into allegedly safe securities?
Famous Example
Alberto & Rosa Ramirez: strawberry pickers in CA

Annual income 14k$
Obtain mortgage of 720k$ without down payment from New Century Financial Corporation
o 50x their income!!
Bank confused annual income with monthly income
Ramirez managed to meet monthly payments for a few years then defaulted lost home to foreclosure
18

many such loans were made prior to crisis
Logic:
o Make loan
o Picket commission
o Sell loan to someone else let them worry about consequences

Subprime mortgages
= mortgages to borrowers below a minimum credit score

some of these borrowers may still qualify for some reason
o reasonable in context of rising price
1994: mortgage originations: 35b$ (5% of total originations)

2005: 625b$ (20% of total originations)
Explanation?
o Number of borrowers qualifying for subprime mortgage exploded
o Underwriting standards dropped
New types of loans

New types prior to crisis
o Low-doc/no-doc mortgages (mortgages without or little documentation)
= 1/3 of all subprime loans
o Liar loans
o NINJA loans

Many of these loans designed to default
o 2/28 ARM: 30 year adjustable-rate mortgages with fixed rate for first 2 years (8%), LIBOR-indexed
rate for remaining 28 years (LIBOR + 6%)
LIBOR usually around 5%, most people have no idea anyways
Very few borrowers could afford such high rates

Like a bet on rising house prices, hoping for foreclosure in near future
If house prices increase refinance your mortgage in order to avoid higher rate
If house prices dont increase high rate forces you to default

Even more exoctic forms:
Option ARM: every month choice between
o Making the contractual payment
o Pay only the interest
o Pay less than interest & adding the unpaid amount to the principal
too complicated for most people to understand financial illiteracy

Fannie Mae & Freddie Mac

government-sponsored agencies (GSE)
1992: congressional mandate to support low- and moderate-income housing
early 2000: increased competition from private securitisers
o - become involved in subprime mortgages
Market pressure or political pressure?
19
V Complexity

why so many bad loans in the first place?

everyone downstream (i.e. securitisers) thought they had something to gain

Mortgage securitisation
Suppose: bank made 1000 subprime mortgages 200k$ in narrow geographical area, e.g. Vegas
o = highly concentrated portfolio of 200m$ risky
economic downturn, natural disaster hits LV many homeowners will stop payments
risk: bank would like to find a buyer for these loans while still good
o investment bank offers to buy loans in exchange of cash
o bank can use cash to lend to other borrowers

investment bank: combines mortgages with others from other locations package them into well
diversified MBS = securitisation
o resulting security: less risky due to geographical diversification
house prices may fall in LV, not likely they will fall everywhere in the country at the same time
Investment bank spreads risk by selling pieces of this security around the world

sounds like a good idea!
o Portfolio better diversified
o Risk spread over many agents
o Bank relieved from risk (thatd threat its existence)
o Investment bank earns fee in exchange for its service

not a good idea?
o Mortgage-related assets far more complicated than in this example
o Investors did not understand what they really owned
o Complexity tranching

Tranching

Instead of selling straightforward shares in mortgage pool: slice the pool into tranches
o Most junior tranche (toxic waste):
Absorbs first 8% of losses in pool (no matter which mortgage defaults)
o Middle/Mezzanine tranche:
Might absorb next 2%
o Senior tranches: only vulnerable to tranches above 10% (thought to be impossible)
Complexity
Typical CDOs had >7 tranches

Most senior: AAA rating (traded at high price)
o Junior tranches rated at discount

20

What happens when there is a mortgage meltdown?
Many of the underlying mortgages are designed to default
Price of junior tranches drops (maybe also mezzanine)
Dont know which kind of mortgages are in your pool?
o even price of AAA senior tranches might drop

Further tranching
example above overly simple
Financial engineers create pool of junior tranches of CDOs and tranche them again
o CDO of CDO
o = CDO square
New junior tranches absorb first 8% losses of this pool
If each of initial CDOs viewed has having independent risk looks like further diversification
Senior tranches of these new CDOs (CDO square) received AAA
Further complication:
o Create derivatives on complex securities
Buy/sell a CDS on a CDO

Complexity
Complex new securities opacity & confusion

Originator of mortgage: some idea about creditworthiness of mortgage
Investment bank: pools thousands of mortgages, knows little
o Dont care just quickly sell the pool as MBS
Ultimate investor (e.g. portfolio managers, treasurers of small Norwegian towns): buys these complex
securities knows almost nothing
o some Wall Street name behind security
o some rating agency rated AAA

Why create a complex system?
Complexity = source of profit
o The more complex & customised, the harder the comparison fair price?
o reduces competition, increases margins
Therefore: Wall Street tries hard to standardise derivatives trade them on organised exchanges
o Increases transparency
o Increases competition

Compare: car repair
Dont know how cars work mechanic can charge you more

Possible Solutions

1.
2.
3.
4.
5.

Only allow simple securities

Require greater transparency
Standardise derivatives
Trade them on organised exchanges (not OTC)
Require mortgage originators & securities to retain ownership of some mortgages (dont just pass them on)
21
VI Rating agencies

Key link in crisis: AAA ratings granted by agencies on senior tranches of mortgage-related securities
Long before crisis:
o Only 6 American corporations
o Only 6/50 States

granted AAA
3 big agencies:
o Standard & Poors
o Moddys
o Fitch Group
Agencies = safety rails (prevent system from going off road)
Became part of the problem
Issues
Rating agencies: consult same companies they graded

o ask agency what you need to do
o fulfil get top rating
Competition among agencies allowed rating shopping
o Incentive for agency to inflate grades (to keep customers)
Most investors relied exclusively on rating agencies
o For small investors: reasonable
o What about giant asset managers & regulators?
Possible Solutions
1. Include 3rd party: e.g. exchange/regulator pay the rating agencies

2. Assign rating agencies randomly (like with judges)
3. Give rating agencies legal liability (makes them more cautious)
VII Compensation Systems

Structure of the pay creates perverse incentives to take excessive risk with other peoples money
Compensation schemes
Traders: selective to have large appetites for money/risk

Compensation amplified this tendency:
o Take high risk bets
Best scenario: large bonus
Worst scenario: comfortable base salary
22
Shareholder:
o Get share of winnings
o Or absorb all losses
Debtor:
o Get nothing in case of winnings
o Or lose everything

not always like this:
Before: companies & investment banks = partnership
o Invest own money (instead of someone elses)
o Less incentive to take risky bets
Like Hedge funds today still
o Operate with less leverage than investment banks
o (traders still get high compensation)

usually not a problem as long as consequences stay inside the firm
would only cost shareholders money (but they knew what they were getting into)
Problematic:
o Risk taking has broader consequences
E.g. bailouts

Possible solutions
1. Regulate compensation schemes? quite difficult (lawyers, accountants are imaginative)
2. Alternative: more power to corporate boards in terms of compensation schemes better represent
interests of shareholders
a. E.g.: pay bonuses in form of shares (become shareholder yourself) align interests of managers
and shareholders

Summary
Financial system = precarious construction based on

o Asset price bubbles
o High leverage
o Skewed compensation schemes
o Excessive complexity
o Low underwriting standards
o Lax financial regulation
o Biased rating agencies
Each: positive feedback loop
o Low lending standard increase demand for housing increase housing prices reinforce idea of
rising housing prices reinforces idea that lending is safe activity induce bankers to lend more
induce regulators not to worry
o Leverage increased gains
o
23
VIII The collapse

by 2006: everyone convinced of a house bubble

o When will it burst?
Disagreement: How far will prices fall?
o Optimists: prices level off
o Pessimists: 20-30% decline
o Future contracts (market expectations): 6.4%
House of cards tumbles
House prices stopped rising subprime mortgages designed to default defaulted!

People believed: subprime mortgage market small part of financial markets
o Treasure secretary Paulson (April 2007): subprime mortgage problems largely contained
o Bernanke: didnt expect significant spillover from subprime market to financial system
Problem:
o Huge leverage multiplied damages
o Complexity helped spread ruin far
o Mortgage-related securities appeared safe (geographically diversified)
But: house prices fell everywhere
o Risk higher than initially thought
House price bubble burst
House price bubbles confined to particular parts of the country

o hard to anticipate bubble burst at national level
Mortgage-related securities far less diversified than initially thought

o
Most mortgages from: CA, FL, NV, AZ

Securities not as widely distributed as initially thought
o Holders all over the world, still mostly owned by financial US institutions
Securities regarded as so profitable that investment banks willing to keep them even at low rating
Hence: failure of large banks attributed to exposure to mortgage-related risk
Now idea how much these funds were worth because securities not traded anymore

See
July 2007: Bear Stearns announces its mortgage-related funds have become worthless
August 2007: BNP Paribus stopped withdrawals on subprime mortgage funds

Market Panics
Combo of asset value fall & high leverage solvency for debtors?
One doubt trust disappears liquidity/funding disappears (counterpart risk)
o flight to quality: people only trust treasury bills
Interbank market
trust lost sharp rise in interbank lending rates
Key rate: LIBOR (rate at which large banks lend to each other)
risk that big banks would not repay each other
24
The Fed
Early August 2007: primary concern = inflation keep funds rate at 5.25%
o Acknowledgment of downside risk to growth (rather secondary)
Mid-August: acknowledge higher downside risk to growth, inflation no longer primary concern
o still didnt cut funds rate
o reduced less important discount rate!
Jackson Hole
Late August: members of FOMC (Federal Open Market Operations), economists, bankers meet in Jackson
Hole, Wyoming
Funds rate at 5.25%
Topic: housing & monetary policy
Shiller warned of house price crash
Other economists: housing collapses are historically central ingredients in recession
Few others: predict catastrophe
Rates untouched
FOMC

FOMC meeting mid-September: members agreed to decrease funds rate by 50 basis points
Argument: tightening credit conditions intensify housing decline, harm economic growth
Two competing views on crisis

Liquidity crisis
Liquidity crisis view = investors need more cash than is available

o Caused by increased counterparty risk (i.e. assets initially believed to be safe look risky now)
o Caused by fear that bank customers withdraw funds (hence BNP says thats no longer possible)

Lender of last resort
In case of liquidity crisis: CB can inject cash
1873 Bagehot instructed CBs what to do in case of liquidity crisis
Lend freely against good collateral but at penalty rate
Why?
o Acute shortage can even push solvent institutions over the edge
o If banks dont have enough cash rumours bank runs
Serve as lender of last resort CB can stop that
ECB:
o cut rates only in October 2008 (4 3.25%)
o again in January 2009 (3.25 2%)
Fed:
o Hit 0% in October 2008

Dramatic view: impairment of economys credit-granting institutions
Liquidity scarcity = tip of the iceberg

Whats to come: major losses of wealth, deleveraging, possible insolvencies, severe damage to banking
system
firms would starve of credit businesses would fail workers would lose jobs
25
The Fed
Bernanke convinced committee that something big is happening

Central banker classification:
o Dovish:
Prefer low interest rates
Inflation secondary
Growth/unemployment more important
o Hawkish:
Prefer keep inflation in check
Favour higher interest rates
At that time: committee rather hawkish against decreasing interest rates
September 18 2007:
o committee acknowledged that tightening of credit conditions has potential to restrain growth
o Cut rate by 0.5%
o But: some inflation risk remains!
A few days before: BoE rescued Northern Rock from bank run (first one since 1866)
Failure of several mortgage-lending companies
o Fed only cuts rate by 0.25 at next meeting in December
FOMC less than convinced Bernanke very keen!
2 days later: Fed opens liquidity-providing facilities
o First, opened currency swap lines with foreign CBs
From 24b$ to 583b$ at end of 2008
o Second, term auction facility (TAF)
Designed to do lending to banks for longer periods (up to 4 weeks)
TAF
Fear of stigma earlier attempts to banks failed

TAF can be used by any bank anonymously
Important programme: 493b$ of lending facilities in March 2009 (until March 2010)
Success influenced subsequent policies trying to avoid stigma!
Fed
January 2008: another FOMC meeting notes increase in downside risks to growth
o Still not ready to cut rates
End of January:
o agreed on 0.75% cut
o again 0.5% one week later
2 fronts for Fed:
o Provide liquidity
o Cut interest rates
ECB
Less concerned
Had to fight liquidity crisis
Took much longer to cut rates
Treasury

February 2008: Bush implemented temporary tax cut

Secretary: Hank Paulson (former Goldman executive)
26
Treasury lacked money!
Treasury securities

TSLF
Another way to provide liquidity = Term Securities Lending Facility (TSLF)

Markets were craving Treasury securities flight to quality/safety
Fed had a lot of them could lend them
Shortage of highly liquid treasury securities in market

Surplus of other securities (less liquid, less safe)
Fed willing to swap!
o Alleviates liquidity squeeze
Fed doesnt have to expand balance sheet or reserves to provide liquidity
o No associated money-supply expansion!
IX Bear and Lehman

March 2008: Fed + Treasury kicked in $30b facilitate merger of Bear to JPM
Why?
o Failure of Bearn wouldve devastated the financial system
6 months later: Fed + Treasury refuse to provide money to facilitate sale of Lehman
o devastation
o = real start of the crisis
Bear Stearns
smallest & most disorganised of the big 5 Wall Street IBs

Culture of buying distressed assets & selling them back in normal times for profit
not scared when subprime mortgage market started to falter
o (not even when 2 of its own subprime funds failed in July 2007)
Became huge player in mortgage business
o Mortgage securitisation = largest component of its fixed-income division
o most profitable line of business: generates almost 50% of its revenues
March 2008: rumours Bear has liquidity problems? (denied by company!)
Bears financing: overnight repos
o Rolled over every day
o Routine procedure unless bad news come

March 10: Bear starts day with 18b$ of cash + highly liquid securities
At end of the day: only 12.5b$ left
People got nervous dealing with Bear access to repo market disappears
March 13: only 2b$ left
BANKRUPTCY?
27

Insolvency vs illiquidity
Bear insists: problem insolvency, but illiquidity
Insolvent = value of liabilities > value of assets negative net worth bankruptcy court
Illiquid = short on cash, even if BS shows positive net worth
o firm needs short-term credit
o bankruptcy
o problem: might be forced into fire sales of its less liquid assets
= selling at low prices
reduces net worth!
Bagehot: lend freely to illiquid banks against good collateral
o only solvent institutions have good collateral

Problem worse for financial companies
o High leverage small decline in asset value implies large percentage decline in net worth
o Daily inflow & outflow of cash much larger than for regular company
Problem worse if lenders lose confidence in you
o lose all your access to credit

liquidity crunch can destroy financial company even if its BS is okay
can turn illiquidity into insolvency
distinction not clearcut anymore!!!

Regulators
on March 13 night: regulators discuss whether or not to bailout Bear

next morning: Fed lent 13b$ to Bear using JP Morgan as an intermediary to make it through the night
o Bear was not a bank, not under supervision/responsibility of the Fed!
o Technically: loan went to JPM
Justification: little known clause in Federal Reserve Act, section 13(3)
o A supermajority of the governors (5 out of 7) can make emergency loans to any individual,
partnership, corporation under unusual and exigent circumstances
o Last time used in 1936

Bear made it for 1 more day
Next day: find buyer for Bear only interested buyer = JPM deal organised by Fed
Bear had >30b$ of mortgage-related assets JPM didnt want them (had plenty themselves) (too risky)
What to do? Fed bought bad assets
o Controversial!!! (shareholders of the Fed = taxpayers)
What choice?
o Buy assets make taxpayer liable for likely losses
o Let Bear fail what consequences?

Moral hazard
Bear. Technically bailed out
Bear absorbed by JPM dead
Bears creditors wouldve lost money in a bankruptcy proceeding
Bailout heavily criticised creates moral hazard!

How?
Moral hazard: incentives for risk-taking
Idea from insurance industry
o People who are insured against some risk are more reckless

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o If insurer takes more risk increases cost higher insurance premium

Financial application: government intervenes to insure against the risk of loss
o E.g. deposit insurance, mortgage guarantees to GSEs
o Moral hazard: financial institutions induced to take more financial risk

Stop insuring then?
Trade-off
Not insuring is also costly!
o E.g. bank runs
Bailout might mitigate serious problems today
might also sow seeds of future problems: signal markets that government will bail you out in future

Bears bailout
criticism: moral hazard, mere idea of government intervention

Reinhart: worst policy mistake in a generation
o
from now on any time a large institution fails, the Fed will be expected to bail out

Why did Fed then bail out Bear?
= too big to fail doctrine
so large that failure would damage the whole economy
Is Bear that big?
o It was the smallest of the Big 5
o Smaller than many commercial banks & insurance companies
maybe not too big, but too interconnected to fail
o closely linked to other financial companies, especially hedge funds
o Bears major business: primary broking for many hedge funds
Funds accounted for substantial share of trading in many markets
PRO
Fear: markets all over the globe will be disrupted (domino effect)
o Bear was counterparty to 1000+ derivatives transactions (exact number unknown)
o Bear gone? large number of counterparties would have tried to sell their collateral (fire sale)
drive down prices create even bigger loss
Bernanke: Bear heavily involved in the repo market
o failure would bring this market down
o implications for other firms
Arguments = guess work
o Regulators had too little experience with too interconnected to fail

CONTRA
Bailout sets precedent: other large firms expect to be bailed out
Moral hazard problem: creditor less careful in lending to these institutions (expected to be bailed out
anyways)
= present of taxpayers to creditors

29
After Bears bailout
things went quiet

o stock market recovered by half of what it had lost
o Risk spreads declined
o Many big banks and big 4 successfully raised capital
But: things were actually getting worse
o House prices further declined
o Mortgage finance and foreclosure problems got worse
Fannie and Freddie

Fannie Mae = originally Federal National Mortgage Association (FNMA)

o Established in 1938
o Government-sponsored enterprise
o Purpose:
increase flow of funds into housing
create liquid secondary market (where mortgage loans could be traded)
enable more people to own a house
o Converted into publicly held corporation in 1968 to get it off federal budget
Freddie Mac = originally Federal Home Loan Mortgage Corporation (FHLMC)

o Established in 1971
o Purpose:
compete with Fannie
make secondary mortgage market more efficient

both companies have shareholders that seek capital gains & dividends (executives of the GSE have to please)

both: many special features make them look like quasi-government enterprises
IMPORTANT: credit line from the Treasury
o Presumption: government would intervene in case of trouble (implicit guarantee)
o No explicit guarantee!
F&Fs securities considered almost as safe as Treasury securities
o But: with a higher yield
o Perfect deal!
o F&F able to borrow easily at low rates
o competitive edge in the mortgage market (exploited to multiply their size, though)

F&F = awkward mix of public purpose & private gains
allows them to operate at higher leverage
o end of 2007: 75-1
o 1.4% loss on their assets forces them to default
Charter: not allowed to diversify into other asset classes (only in mortgage market)
o Mortgages, mortgage-related securities, mortgage guarantees = 100% of their assets

Bubble & Crisis
Change in their business strategies during the bubble more vulnerable
Pressured by affordable housing goals vs. competition for market share from Wall Street

30
start to guarantee & buy riskier mortgages

had to keep higher underwriting standards than others!!!
After Bears bailout:
o Regulators reduced companies capital requirements
o Could operate at even higher leverage!
o Why? support more support to the housing market
Losses in the housing market equity evaporates
Government received approval from Congress to inject capital
o Also extend line of credit
o Implicit explicit
By 2012: US had spent 140b$ to keep them alive
Lehman
Sept 2008: F&F got better Lehman bankrupt

Lehman = old name on Wall Street
o 158 years old
o Survived most crisis
Just before crisis: looks like typical investment bank
o Heavily exposed to mortgage-related securities, especially commercial
o High leverage
o Reliance on short-term borrowing
May 2008:
o Own 93b$ of real estate & mortgage-backed securities
o For an equity of 26b$
o Likely: assets overrated
o 30% decline in value would destroy all equity
o Lehman was using accounting subterfuges to conceal some of its debt
March 2008: talks of saving Lehman emerge
o Similar process as with Bear
o Barclays ready to buy if Fed absorbs toxic assets
o All before F&F problems
Save Lehman?
o Saving Bear: badly publicised, Government committed a lot of money to save GSEs
September 2008: no public money for Lehman!!
o Paulson = Mr. Bailout
Save Bear? Same trade-off as with Bear
o Bailout reinforces moral hazard problem
o Failure contagion
Bernanke: bailout necessary and desirable!

Why let Lehman then fail?
Lehman twice the size of Bear
Bernanke & Paulson: markets not ready financially & psychologically for possible failure of Lehman
o talks of failure had been around for months
o believed: Lehman less interconnected than Bear
Argument: collateral of Lehman not good enough thus insolvent
Deal with Barclays (UK): too complicated for legal & political reasons than with Bear
September 15, 2008: Regulators let Lehman fail
panic ensued
financial system falls apart

31
X Panic of 2008

Lehmann Brothers fails in September 2008

Rapid succession of events:
o The insurance company AIG is nationalised
o Stock broker Merrill Lynch is sold to BoA
o Goldman Sachs & Morgan Stanley become bank holding companies
o Many other financial institutions fail
Lehman was too interconnected after all
AIG
In 2004: largest insurance company in the world

AAA rated (rare in the corporate world)
Could borrow cheaply
o Didnt have to post collateral to its counterparties
o Had credibility to sell CDS
AIG abused its privileges

In 2006: stopped selling CDS, but it was the dominant seller
o in a market that was destined to collapse
Second advantage: lax regulation compared to commercial banks or insurance
Subsidiary that traded CDS: AIG financial products
o Regulated by office of thrift supervision
Normally regulates small savings banks
No idea about derivatives
CDS not classified as insurance policies derivatives! (they are both)

CDS:
o Seller collects small fees
o Liable for huge payment in case things go wrong
Like fire or life insurance
Insurers:
o Supposed to hold capital reserves against possible losses
o AIG manages to escape those requirements
o like an uninsured insurer!
Bernanke: AIG exploited a huge gap in the regulatory system
o No oversight of their financial products division
AIG like a hedge fund making irresponsible bets that are attached to a large & stable insurance company
1998-2007: AIG accumulated 0.5t$ position in credit risk
o most deals with big 5
AIG took a lot of risk
o Risk concentrated in a few counterparties
o Highly correlated from one CDS to the next
o Company neither hedged nor set aside capital reserves (any insurance company wouldve done so)
combination of high risk and low safeguards failure of risk management!
Bets seemed safe at that time! (AAA mortgage-related securities)
32
Only in 2005: AIG starts worrying about excessive risk

Early 2006: stop writing new CDS
2007: value of securities AIG insured started to decline
o counterparties ask for collateral
o AIG unprepared to post collateral for its huge positions
September 2008: AIG has trouble accessing credit markets because of its high exposure on derivatives
o Perception: AIG was on the losing side of many bets
When Lehman failed:
o AIG forced to post 19b$ worth of collateral to its CDS counterparties
o 7.6b$ to Goldman alone
Rating agencies warn of potential downgrade of AIG
o Would trigger further calls for collateral AIG didnt have that collateral
September 12: AIG face severe liquidity crisis

Should the Fend lend to them?
Fed had little experience with insurance companies
All their attention was on Lehman
o AIG was almost 2x Lehman, very interconnected
Once Lehman failed: liquidity evaporated, no way AIG could be saved by a private solution
Next morning:
o All 3 rating agencies downgrade AIG
o Trigger additional 13b$ in collateral calls
o AIGs stock dropped 60% in one day
Next FOMC meeting: Fed agreed to lend a massive 85b$ to AIG
o Lend total of 182b$
o Got paid back in full
deviation from Bagehots principle: AIG more insolvent than illiquid
Action was heavily criticised!
o though, it turned into a profit in the end
The magnitude was unprecedented: 182b$ vs. 29b$ for Bear
Fed nationalised a failing company at the expense of the taxpayer
o As partial payment: Fed took convertibles, preferred stock

Embarrassing?
Significant share of loans passed directly through Goldman (Paulsons former firm...)
Large bonuses paid to almost 400 employees of AIG financial products, among them highly paid traders &
executives
o Seven of whom were supposed to receive >4m$
o Bonuses had been agreed upon long ago
o passionate public debate over whether these bonuses should be paid
Creditors of AIG got paid back in full
o although they lent to an insolvent company
o couldve only gotten a share of repayment = bail in
Could lead to moral hazard
o Why should you care about default risk if you will be bailed out anyways?

Should AIGs creditors have suffered haircuts?
They got 100% back sounds unfair
Decisions had to be taken within days, nobody prepared to take them
Haircuts couldve made the situation worse undermines initial efforts of the Fed

33
Contagion and Financial Panics

When a financial institution is in trouble investors suspects that all other institutions might be in trouble
o = guilt by association
Some might be rational:
o If banks fail counterparties in trouble
o If an assert price plunges imperils large number of financial institutions
o If several institutions operate on the same business model, i.e. high leverage, reliance on short-term
debt
o Contrast: AIG was the only financial company to harbour a gigantic hedge fund
Did not cause investors to flee insurance companies
o If strike from rational reasons:
Remedy = provide liquidity & capital to firms that are victim of guilt by association

Contagion can be irrational:
o Lehman failed investors suspected that General Electric might default too
o In such cases: policy makers must reassure markets by backing up cash

Difficult to differentiate between rational & irrational contagion
Run on money funds

Not clear whether Lehman was responsible for AIGs failure
AIG probably wouldve failed anyways given its risky positions
Lehman probably caused a run on the money market fund
o Lehman tightly linked to the oldest money market mutual fund: Reserve Primary Fund

In 2006: Reserve began investing heavily in commercial papers
By September 2008: it had 785m$ (1.2% of the fund) invested in Lehmans CPs
o Investing in Lehman sounded safe since the government had bailed out Bear 6 months ago
moral hazard
2 days after Lehman declared bankruptcy: Reserve was flooded with redemption requests about 50% of
the funds balances
September 16: management announced Lehman paper was worthless
o Reserve has to break the buck! (redeem shares at <1$)
some investors got out at par other CP prices fell in panicky environment shares of Reserve at 0.97%
worth
o 3% decline not much SIGNAL that trigged the panic of 2008

Money market funds: great invention

o Like checking accounts with higher yields
o Share price of money fund always at 1$ removed any risk of capital gains/losses
o Achieved by investing funds assets in money-market instruments that fluctuate very little, e.g.
short-term US treasury bills
o Never had to break the buck in history! started including CPs
o CP yield > treasury boosted yields
o Investors considered money funds just as safe as bank accounts! But no guarantee (no FDIC)
o In 2008: industry worth 3.4t$ = 50% of all insured deposits
when Reserve lost 3% like losing money on your bank account

FDIC (1933) created to prevent bank runs
34
o Successful!
o Insures deposits up to 250k$
Money funds look like deposits, but not insured by FDIC
o when they start to lose money runs!
o First to the Reserve, then others
Within a week: investors withdrew 350b$
o Fund managers had to liquidate an equal volume of CP, T-bills to meet redemption calls
After Lehman-CP-losses: no fund managers wanted to buy CP (anyones!)
o Supply increases, demand drops
o Prices of CP fall, yield spike
o = run on CP
Problem for big US companies:
o frequently use CP paper to bridge gap between liquidity & receipts (e.g. large cash outflows on pay
days)
o Access to CP: shut down rumours that large companies might be unable to meet payrolls
Treasury: 50b$ to back a new insurance fund for money market balances
o First time that Treasury put its own money!
o No limit amount insured money funds made attractive (compared to bank account)
Plan set up in a rush
o Banks start to complain that bank run may ensue
Treasury later amended plan: only ensure funds already there before September 19
ended incentives for bank runs
Fed: Asset-backed Commercial Money Market Mutual Fund Liquidity Facility (AMLF)
o Extend nonrecourse loans at low interest rates to banks willing to purchase CP from money market
funds
o Funds needed desperately to sell this CP because they were experiencing runs
o Nonrecourse loan:
If asset defaults, the lender (Fed) can claim back only the collateral on the loan
It cannot go after any other assets owned by borrower (bank)
Nonrecourse loans highly skewed: borrower upside risk, lender downside risk
Collateral in question = CP
If CP appreciates in value, bank that borrowed from Fed keeps value
If CP depreciates, Fed makes loss
o Good deal for banks
o By October 2008: Fed was lending 150b$ to banks to purchase CP
o AMLF + Treasury guarantee ended runs on money market funds

Avert run on CP
CP invoked clause 13(3) creation of the Commercial Paper Funding Facility (CPFF)
Objective: provide liquidity backstop to US issuers of CP
Market for CP shut down Fed stepped in to directly buy CP on taxpayers behalf
in the end it made a profit of >5b$

issuer of CP involved industrial companies: GM, GE, IBM, banks
even lent to foreign banks: BNP, UBS, Dexia
result: market for CP stabilised, back on its feet by 2010
CPFF: turning point in the Feds policy
o Until September 2008: Feds focus on saving specific institutions like Bear
o After: attention towards saving markets

35
Merrill Lynch
Largest US brokerage firm

Along with failure of two large commercial banks (WaMu & Wachovia): failure of Merrill market new stage
in financial crisis
Crisis on Wall Street crisis on Main Street

What happened?
During boom: became #1 global underwriter of CDOs
Also issued mortgages securitised them
2006: bought nations biggest subprime lender First Franklin
2006: Mortgage-related markets start to deteriorate
Merrill got rid off most toxic CDOs, only kept the super senior tranches thought to be super safe
By September 2008: had lost >52b$ in its mortgage-backed securities (sum > remaining net worth)
Merrill Lynch sold for 50b$ to Bank of America (just before Lehman imploded)

Goldman & Morgan Stanley
2 big five IBs still alive

had more liquidity, were larger
their business model also relied on high leverage, heavily invested in subprime mortgage business
after Lehman, also runs!
September 2008:
o Both successfully applied to become banks
o Stopped runs
Wall Street opens on September 22 (one week after Lehman): no big independent IBs left!
Washington Mutual
WaMu: largest savings & loans association

> 2000 retail branch offices
> 300b$ of assets
o 3rd largest US mortgage lender
o = too big to fail
September 2008: held large stock of subprime mortgages
o Lehman day: credit rating downgrade
o Small-scale run (silent bank run)
o Banking operations immediately sold to JPM
Rest of the company filed for bankruptcy

No one lost money: neither FDIC nor depositors
o Even unsecured depositors (> 205k$)
But: other unsecured creditors had to go to the bankruptcy court queue
Contrast to creditors of Bear, F&F, AIG
o All protected
o Bailed out
Why?
o FDIC tried to reduce moral hazard
o Restore some semblance of market discipline
Possible?
o Because WaMu was FDIC insured (unlike other institutions)
o Creditors take haircuts
36
o haircuts created panic among creditors among other banks (e.g. Wachovia)
Debate:
o Other regulators not happy with FDICs decision
o Moral hazard has to be avoided, yes
o But imprudent in the middle of a financial panic
o Philosophical question: which investors should be protected, which shouldnt?
Wachovia
Nations 4th largest bank

o 2x the size of WaMu
contagion from WaMus bankruptcy
Origin: subprime mortgages on Wachovias BS
o run
Regulators:
o Avoid WaMu
o Dont impose any losses on Wachovias creditors
o even at governments budget
o to avoid further panic
Wachovia sold to Wells Fargo
Further measures
Well-Wachovia didnt end the panic or the bailouts

FDIC: new programme to guarantee newly issued debt (any kind) of major financial institutions
o TLGP: Temporary Liquidity Guarantee Program
New:
o Applied to non-bank institutions
o Insured other liabilities than deposits

Citigroup
Faced difficulties: stock prices dropped from 60 4$
Biggest US financial conglomerate!
Regulators guarantee >300b$ of its assets (size of WaMu)
Citi absorbs first 29b$ of losses
Treasury + FDIC absorb next 15b$
Fed the Rest

3 Remaining large institutions
JPM (acquired Bear + WaMu)
Wells Well-Wachovia (megabank!)
BoA BoA Merrill Lynch

o First 2 turned out well
o Regulators had to vouch for BoAs losses (Merrill Lynch too bad for BoA)

37
International panic
Post-Lehman panic spread beyond US borders

o Rest of the world spared from panics before Lehman!
o 80 insolvency proceedings in 18 countries quickly followed
Benelux:
o Fortis nationalised
o Belgium injected capital in & guaranteed Dexias debt
Germany:
o Finance minister & BuBa arrange credit line to Hypo Real Estate Bank
o Avert liquidity runs
Ireland:
o Guaranteed all liabilities of its 6 largest banks
Private debt became public debt!
Ireland put in difficult fiscal position

Iceland:
o Transformed itself into a huge leveraged Hedge fund
o Lehman failed Iceland nationalised 3 biggest banks
Economic consequences
Post-Lehman: financial crisis economic crisis

Employment + GDP decline
Until Lehman: problems in financial sectors wont have large economic consequences
Fed & other CBs: cut interest rates on October 8
o Usually done through OMOs: Fed buys bonds off secondary market with printed money provide
money supply, stimulates demand, give more funds to bank (lend more easily, interest rate down)

Figure 1 Lehman & Employment
38
XI TARP

Introduction

TARP = Troubled Assets Relief Program

Basic idea: government buys low quality assets of banks in difficulty
one of the most successful programs to avert the crisis
o But politically controversial
o Poorly understood by the public
2012 poll: only 39% of Americans thought that TARP was right, 52% thought it was wrong
Poll asked how much money had been paid back
Only 15% answered all/most of it (correctly)
72% only some of it
Sometimes, politics can get in the way
Origins
After Bear rescue (2008): Treasury concluded that they should work on contingency plans in case things got
worse
Treasury put up a team to outline drastic policy options in case of financial meltdown
4 options
o Buy toxic assets
o Guarantee the assets rather than buying them
o Inject capital directly into banks by buying shares
o Refinance home mortgages into loans guaranteed by the government
Guess estimation: 500b$ fund from government would be enough to cover banks losses on mortgagerelated securities
o After AIG: Paulson decided that such a fund might be desirable
Provide liquidity to undercapitalised banks outside the Feds mandate
Using taxpayers money to save insolvent banks should be subject to democratic process thus
responsibility of government

Agreement on necessity, disagreement on how to use it
Bernanke favoured recapitalising banks
o Implies: government buys bank shares partly owns them
o = socialism! (Republicans)
o = gift to bankers! (Democrats)
Paulson favoured buying toxic assets
Bernanke & Paulson conscious of gravity of financial crisis Congress wasnt!
o Their perception: Wall Street problem only! why should we solve it?
o Thus: Paulson had to convince a sceptical audience to get fund!
How to convince them?

scare them!
Paulson presented apocalyptic vision of what might happen then present TARP option
in the meantime: things had gotten worse since April: fund had to be extended to 700b$
September 20: first draft of Paulsons TARP posted online

39

Gave Treasure complete discretion on how to use these 700b
Not reviewed by any court or administrative agency!
Could buy anything they wanted!
o People were shocked against constitution?!
Paulson: just a draft, wait for revision by Congress
Paulson portrayed as King Henry on Newsweek
Congress rejected draft
o controversial point: executive pay
o in eyes of regulators secondary issues compared to saving banks
o primary issue to Congress!
Transfer money from taxpayer to executive = unfair
Final TARP legislation: minor restrictions on executive pay
o disallowed golden parachutes
o capped severance payments at 3x base salary
o banned giving top executives pay incentives (that encouraged excessive risks)
left that determination to corporate boards, not to Treasury
Despite all: TARP still viewed as giveaway to greedy bankers
judicial & administrative review restored
Treasury could still buy any assets they wanted

September 29: TARP first rejected by Congress
o Opposition from Democrats + Republicans
o
Next day: Stock market fell by 9% destruction of 1.25t$ wealth

o = 2x TARP request!
hence: bill passed 4 days later!
Also: Paulson now convinced that injecting capital into banks works better than buying troubled assets
o J Flexibility of the TARP: TARP would allow this specific policy options
wouldve rejected if outside the TARP
Implementation
buy troubled assets vs. inject capital

design a workable mechanism to buy troubled assets during the crisis NOT EASY

BS of troubled bank

Assets
Liabilities
Good assets: 50b$
Deposits: 90b$
Bad assets: 50b$
Equity: 10b$

looks well capitalized
o not for the market though: are assets really worth it?
o Suppose: bad assets actually worth only 35b$ ( 50b$) 30% discount to face value

banks true mark-to-market BS:

Assets
Liabilities
Good assets: 50b$
Deposits: 90b$
Bad assets: 35b$
Equity: -5b$

40

Bank looks now insolvent

If govt. buys asserts at their true value:

Assets
Liabilities
Good assets: 50b$
Deposits: 90b$
Cash (TARP): 35b$
Equity: -5b$

whats the point?

Alternative: overpay for troubled assets

Assets
Liabilities
Good assets: 50b$
Deposits: 90b$
Cash (TARP): 50b$
Equity: 10b$

Bank now looks solvent
received a 15b$ gift from taxpayer acceptable?

Pricing problem
In reality: nobody knew what these assets were worth
o Markets for toxic assets barely functioning
o No reliable market quotes
hard to guess let alone to really assess the market value of mortgage-related assets
Imagine:
o Highest bid for asset: 20$
o Lowest asking price: 60$
o no transaction
o no market value
If Fed pays 40$: overpay or underpay?! Nobody knows

Bid-ask spread

Market clearing at supply = demand

In practice? Gap between
o highest price any demander is willing to pay (bid)
o lowest price any supplier is willing to accept (ask)
= bid-ask spread
In thick markets (that are functioning): small spread
In thin/disruptive markets: spread can get very large
! Spread = measure of market liquidity !
o large spread impossible to determine value ( = market is shut down)
41
Implementation (continued)

Capital injection
argument for capital injection over asset purchases leverage
o add capital to bank = greater leverage
o Example:
Bank holds 10$ assets for each 1$ capital = leverage 10 to 1
Each additional 1$ injected would finance 10$ of additional lending
Impact of each dollar injected multiplied!
Nave argument!
o Bankers require (by law) to maintain minimum ratio of capital to assets, e.g. 10%
o Most banks presumable undercapitalised:
Use mark-to-market basis
But BS (using book value) said otherwise
So: needed capital desperately, most of them couldnt raise it!
If government made equity injections lower leverage banks happy to take it
o
Not clear though: banks could just see that as an invitation to borrow to keep their leverage at the same level
Nobody wanted to lend in post-Lehman era either

Buy troubled assets
By buying assets govt. revives market increases its value
Helps to increase bank capital
But: indirect effect (compared to injection)
In the beginning:
o Treasury used fund to inject capital later reversed to buy assets

How do you inject capital in a bank?
Paulson invited bankers from top 9 US bank CEOS to come to Treasury

Offer: take-it-or-leave-it offer banks all had to accept injection
o All! avoid stigma!
o as a regulator: could even threaten a reluctant bank
terms were nice, all accepted J
equity injection = nonvoting preferred stock

o government had no interest in managing the companies
o imposed 5% dividends
dividend payments to common stockholders not banned but could not be increased
no requirements to increase lending volumes or to mitigate foreclosures
Criticism
large bailout was heavily criticised
dividends too low
o Warren Buffett asked Goldman for 2x dividends on his preferred stock
Banks had to do nothing in exchange for this gift
o Couldve been asked to reduce foreclosures, increase lending, stop paying dividends
Looked like direct transfer from taxpayer to shareholders without any benefit to the taxpayer

42
Figures: TARP
TARP got further used for

o More capital injections into banks
o Asset guarantees to save Citi & BoA
o Auto industry bailout
Only 430b$ used out of 700b$
Estimate: net cost to taxpayer = 32b$
According to model estimates: thanks to TARP
o GDP 6% higher
o Unemployment 3% lower
XII Stimulus
Introduction
When economies around the world contracted in late 2008, governments remembered Keynes
o Increase money supply
o Cut taxes
o Raise public spending
Idea: give total spending a stimulus
US: Keynesian policies always very controversial (especially Republicans)
Keynesian economics
When AD low goods hard to sell, jobs hard to find

Keynes 1930: governments can boost employment by
o Cut interest rates (looser MP)
o Raise their own spending
When AD too high
o Decrease spending
o Tighten MP
Governments = equilibrating force
o Stimulate AD when too weak
o Restrain AD when too high
(Keynes wrote in the context of the Great Depression, hence emphasised the former)

America
American economists took for granted that most of that job should be done by MP
fiscal policy is too slow and too political
Afer Lehman: Fed was indeed the most active FP did nothing
But what if Fed runs out of tools (hit ZLB) and economy is still sinking?
o Fiscal policy necessary
o Or unconventional MP

43
Political transition
Obama elected president in Nov 2008, inaugurated in Jan 2009

o Terribly timed transition
o During this period: economy lost > 2m jobs
5 days sfter election:
o GM (100k+ employees!) announces it runs out of cash in 6 months
o Unless it receives government assistance, sold assets, merged into another company
Auto industry already faced difficulties, crisis made it worse
o Why: increased foreign competition, increased oil prices
November 19, 2008:
o CEOs of GM, Ford, Chrysler solicited for federal aid but were unsuccessful
Bankruptcy for Detroits big 3 possible!
o Disastrous consequences for dealers, suppliers, workers, general economy!
December 19: Bush used TARP to lend several b$ to GM & Chrysler (Ford was alright)
o During transition period Bush was mostly absent
o Obama more present but couldnt do anything until January

Obama
Obama set up dream team of economic advisors:
o Tim Geithner: secretary of Treasury
o Larry Summers: director of the National Economic Council
o Peter Orszag: budget director
o Christina Romer: chair of the Council of Economic Advisers

All talented economists, but none are politicians!
Who should explain economic matters to people?
o Geithner: no oratory skills
o Summers: too arrogant
o Romer: got the job had no political experience, never worked with Obama
In the end: Obama himself & his political advisors delivered the economic-related speeches
o Delivered very few of them though
o Economics not his core interest
During his presidency: Obama did not focus on fighting the crisis
o attention on other policies, such as health care
explains why public didnt understand/support economic policies adopted
o no one tried to educate or convince them

The Fed
Dec 16, 2008: FOMC meeting

Which option should Fed choose?
o More conventional open-market policy
but rate was already at 1%... still al little scope for lowering
o Reduce LT interest rates by committing to holding its overnight rate low for a long time
Interesting for houses, industry,
o Fed keeps on extending its BS
Already soared from 1t$ to > 2t$

Fed adopted all 3 options
ST: Fed funds rate decreased from 1% to 0-0.25%
o Biggest cut in 26 years (more than market had expected!)
o Over the next year: funds rate averages around 16 basis point
LT:

44

Fed committed to keep rates low for some time and then for an extended period
How to form expectations?
o Bought LT Treasuries to directly affect LT interest rates
Directly bought private assets under TALF (Term Asset-Backed Loan Facility)
The S&P 500 rose 5% that day
o

sounds like good news!
problem: Fed had exhausted all its options!
only FP remained!

The expectations theory of the yield curve
LT interest rates depend on beliefs/expectations about what overnight interest rate will be there in the
future
= basis for Fed policies that make implicit/explicit commitments about future interest rates

Example
annualised overnight rate is 2%
expected to be 3% tomorrow
How much should a two night rate be?
o Take two consecutive overnight loans average cost of funding is 2.5%
o Two-day loan should cost 2.5% without arbitrage
General:
o 1-year interest rate should be the average of all the overnight rates expected over the next 365 days
o Thus: expectation of future ST interest rates are crucial to determine current LT interest rates
Fed determined in Dec 2008: hold funds rate near 0 for some time try to influence expectations of
investors
o for some time rather vague
o Investors interpretation: 3-6 months
August 2011: similar statement commit to keep rates at 0 for 2 years
Usually: LT rates > average ST rates

o other considerations in pricing
o e.g. compensation for risk, compensation for time (discount factor)
Fiscal stimulus
under Bush: Congress passed modest Economic Stimulus Act in February 2008
o mostly consisted of tax rebates
o 300 - 600$ rebate for singles
o 600 1200$ for couples
o some business tax breaks
o total cost: 150b$ (1% of GDP)

before his new job: Summers said that stimulus should follow 3 Ts-principle
45

Timely
Stimulus should be fast: building roades, takes too long to plan & construct
o Targeted
Each dollar should try to maximize its effect on AD
o Temporary
Inherent of the idea of stimulus
Not designed to enlarge the public sector in general or shrink revenue base

After Lehman:
o Bush stimulus turned out to not be enough
o

Obamas stimulus

During transition: Obama started to plan larger stimulus
o Range 700-800b$ (5% of GDP)
o Republicans against
o Krugman & Romer: too little
o hence Obama thought it was rather right
Tax cuts, more progressive
o Make work pay: tax rebates to workers earning too little to pay income tax (still paid payroll tax)
o rest:
goes to infrastructure spending
aid to state & local governments

Stimulus did not entirely satisfy the 3 Ts

administration argues: recession likely to last for long time! Stimulus would not be temporary (3rd T?!)
o infrastructure a good candidate J

Feb 17, 2009: Democratic majority in Congress bill easily bassed (244 pro vs 188 contra)
o 4 weeks into Obamas term
all Republicans voted against
complications in the Senate
o Republicans used threat of filibuster to force huge concessions from Obama
tactic to delay, prevent a vote by extending the debate over this vote
o obtained a variety of business tax cuts!

The public
Republicans fought hard managed to give the word stimulus a bad connotation
TARP & Stimulus about 700b$ public starts to confuse the two
People & some politicians believed:
o Stimulus helped bankers & investors rather than middle class
o Poll 2010: majority of Americans thought so

Cost effective policies?
Ex-post cost of stimulus: 170k$ per job created
o More than what each job produces on average!
One way the money was used: education grants to states did not create any jobs
exclude them: cost of each job created at 100k$

Other arguments again stimulus
unemployment kept rising above 8% up to 10%
o evidence often used against stimulus

46

but look at counterfactual: estimates suggest that unemployment wouldve gone up to 12% without
stimulus
also: larger budged deficit created
o ARRA raised fiscal deficit by 183b$ in 20009
o 405b$ in 2010
o 145b$ in 2011
o Programme ended in Sept 2011
o Rough estimates though
o

Note! Counteracting forces!
If stimulus increases GDP higher tax receipts, less spending!
Actual deficit impacts probably smaller

Budget deficit
Deficit spiked from 3.2% (2008) to 10.1% of GDP (2009)
o Largest deficit relative to GDP since WWII
Largest share in deficit: losses of revenue, increase in income security payments
o Attributed to shrinking economy! Not to the stimulus!
Large deficits felt wrong
Republicans immediately wanted to balance the budget
o Cutting spending by 1.3t$
But: High deficit only temporary!!! (unlike Greece or Argentina)
o Debt paid back later during better times J

kk
47

The Economic Crisis

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ECOC:

Economics of Crises (Massenot) SS16

Introduction: Economics of Crises

Around 2008: took everyone by surprise

Crisis led to anger

A very brief history of the crisis

Preliminary history (crisis not over yet!)

ECOC: Economics of Crises (Massenot) SS16

Before: too much credit

job losses: employment kept falling for

ECOC: Economics of Crises (Massenot) SS16

2008/Q1,2 2009: declined for 4 consecutive quarters (5 in total)

Comparing with other financial crises

ECOC: Economics of Crises (Massenot) SS16

Banking crises share striking similarities:

emerging economies: lower

ECOC: Economics of Crises (Massenot) SS16

Asset price bubbles

I Asset price bubbles

2 burst bubbles in the last decade:

main culprit of the crisis

interest rate = time value of money

ECOC: Economics of Crises (Massenot) SS16

The housing bubble

US bubble 2000 2009 (quite unique)

ECOC: Economics of Crises (Massenot) SS16

Bubbles leave mark on economies

Origins of the bubble

ECOC: Economics of Crises (Massenot) SS16

= 100% return in 5 yrs

(Germans reluctant to buy stocks: trauma of dot-com bubble)

Bubbles always eventually burst

The Bond Bubble

Bond = fixed income security

ECOC: Economics of Crises (Massenot) SS16

Fundamental value of a bond: easy to compute if there is no default risk

US government bond: no default risk

Mortgage backed securities

Financial security backed by mortgage or pool of mortgages

In the 1990s: banks lost only 0.15% on mortgages

ECOC: Economics of Crises (Massenot) SS16

Many forecasting models used by banks relied on 3 yrs of historical data

ECOC: Economics of Crises (Massenot) SS16

III Excessive leverage

A bit of leverage good, a lot bad

Leverage and financial returns

Leverage = use borrowed funds to purchase assets

Jane invests 1m$ in one-year corporate bonds, 6% interest rate

ECOC: Economics of Crises (Massenot) SS16

Mortgage debt exploded 2000-2008

Leverage at the bank

Banks also levered up

ECOC: Economics of Crises (Massenot) SS16

Leverage on Wall Street

Difference with banks

Leverage not enough risk, want more

ECOC: Economics of Crises (Massenot) SS16

runs killed Big 5

create synthetic leverage

stock only increased by 16%

Leverage everywhere prior to crisis: households, banks, investment banks

ECOC: Economics of Crises (Massenot) SS16

Most important: Federal Reserve

regulators were too permissive