Lecture 10

Great Recession after Financial Crisis

Geographic spread through international PF diversification
Initial loss on RMBS quite small: $ 400 bn (2% of stock market cap)
Why such a big impact on real economic activity?
o Models of business cycles so far: no role for asset prices, financial sector, debt

Before the Crisis: Great Moderation

Macroeconomic volatility during 1980-2007 lower
than before
Reasons:
o Independent CB & good MP
o Structural change from manufacturing
(volatile) to services (less)
o More information available (IT revolution)
o Luck

Increase in debt:

1970-2007: huge increase in private sector debt

o all: HH debt, financial sector debt, non-financial sector debt, government debt
Reasons:
o Great Moderation: everything less risky
o Financial liberalisation in 90s
o Shifts in world demographics (save more)
Increased longevity and lower fertility rate = higher retirement savings
Eventually will reverse as they start to dissave (not there yet)
o Bad assets in emerging economies high
demand for savings, but assets not safe
enough buy Western assets
Our view of business cycles so far

Drop in House prices

suppose you own durable asset then price decreases
o negative wealth effect
o asset as collateral can borrow less
remember: model of intertemporal consumption decision:
o max (1 ) + (2 )
o 1 + 1 1
o 2 2 + (1 + )1

Houses as asset
model assumes: HHs can borrow & lend freely at interest rate r
now:
o income in period 1 is 1 + instead of 1
H = stock of houses owned
= price of a house
o housing wealth is illiquid cannot be solid in period 1, only in period 2
housing wealth can be used as collateral
Borrow and dont pay back bank seizes house (collateral)
How much can you borrow?
o If you borrow x pay back (1+r)x next period
o If thats more than the value of collateral default

o Bank anticipates that wont lend more than 1+
Hence:
o Bonds holding must be bigger than amount lent

o 1 1+
The Consumption-Saving Decision with a borrowing constraint

Drop in asset price : wealth effect Drop in asset price : collateral effect

This only works if agents are constrained in their borrowing

agents not constrained, dont even want

to borrow to consume that much in t1
constraint doesnt hold here
collateral effect doesnt matter
only wealth effect

Drop in house prices

real estate = most important type of collateral for households
house prices drop drop in resale value of the house HH worse off
o value of collateral falls HHs can borrow less
If initially constrained in borrowing gets even tighter sharp drop in consumption

For firms need to borrow too

Firms typically need to borrow in order to finance investment
Any asset thats:
 o Tangible & exclusive (so that its seizeable)
o Durable (doesnt go bad)
Applies in particular to production capital: factories, machines, airplanes, patents

The price of capital

What determines price of capital? what you can do with it
o = expected future cash flows from using the capital in production process
Suppose: people expect demand (and sales) will be lower in the future
o Price of capital drops!
o value of firms collateral lower
Investment?
o Investment falls! Firm cannot borrow that much anymore
But:
o Investment is part of demands for goods
o (buy capital goods from someone!)
o if investment decreases demand for good decreases
lower sales for firms
lower price of capital even further
Spiral:
o Lower sales lower price of capital lower value of collateral lower investment
lower sales
Effect is stronger the more leveraged a firm is!
= CREDIT CYCLES, FINANCIAL ACCELERATOR
MECHANISM

Financial Accelerator

this mechanism works

o with any type of shock: productivity, demand
(preferences), monetary, cost-push
o both on HH & firm side
Moral hazard & adverse selection make problem worse
 Even if intertemporal substitution mechanism not there: credit cycle still exists
changes in LT interest rates affect asset prices through discount factor!

Additional amplification of financial accelerator mechanism: Bank capital channel

banks have minimum capital requirements
Basel II:
o Tier I capital (book equity) must be at least 4% of risk-adjusted assets
o Tier II capital (reserves, long-term debt) must be at least 8% of risk-adjust assets

Bank satisfying the Tier I capital requirement of Basel II

Bank capital channel

Suppose: negative shock to value of banks assets
o Loan defaults, MBSs lose value, decrease in firms share prices,
Reduction in value of assets and banks capital!
To maintain leverage ratio consistent with capital requirements (25:1) bank needs to reduce size
of its balance sheet
o = cut down on lending, sell assets to decrease debt
fire sales, firms have to reduce investment
Further decrease of asset prices SPIRAL

An example
new capital ratio: 3.1/(89.1+10) = 3.1%
insufficient!!

bank could issue new equity (new shares): 0.9

in times of crisis, difficult!! (bad sign)
hence: reduce size of BS by sale of assets
o how much? 3.1/(99.1 x) = 4
o x = 21.6
o reserves not enough! Hence: entirely done using loans
 Resulting size of BS: 10 + 67.5 = 77.5 (down from 100!)
o Just because of 0.9 drop in loan values!

Another example
Assets Liabilities
Reserves 10 Deposits 96
Loans 80 Equity capital 4
MBS 10

Assume:
o 100 identical banks
o each have same BS (above) with q=10 MBS
Price of MBS determined on competitive market (banks are price-takers) where supply is:
o = 0.001
o when Q = 100 * q = 100 * 10 = 1000 p = 1

Now
1% of MBS go bad, have to be written off
Banks cannot issue equity, have to first sell off MBS, then loans, then reserves (if necessary)

Initial loss:
Assets Liabilities
Reserves 10 Deposits 96
Loans 80 Equity capital 3.9
MBS 9.9

How much MBS do we need to sell off to satisfy 4%?

o 3.9/(10+80+9.9 x) = 4
o x = 2.4 has to be resold

Assets Liabilities
Reserves 10 Deposits 93.6
Loans 80 Equity capital 3.9
MBS 7.5

if that happens to all 100 banks

o instead of Q = 100 * 10 = 1000
o we have Q = 100 * 7.5 = 750
hence:
o instead of p = 0.001Q = 1
o we have p = 0.001Q = 0.75
value of the 7.5 MBS has decreased
o value = 0.75 * 7.5 = 5.625
Assets Liabilities
Reserves 10 Deposits 93.6
Loans 80 Equity capital 2.025
MBS 5.625
after writing off assets & liabilities: whats the new capital ratio?
o 2.025/(2.025 + 93.6) = 2.1%
o insufficient!
Sell off
o 2.025/(2.025 + 93.6 x) = 4
o x = 45!!!

Assets Liabilities
Reserves 10 Deposits 48.6
Loans 40.625 Equity capital 2.025
MBS 0

Bank has to sell all MBS, cut down loans in half

Size of BS:
o 50.625 (down from 100)
o all those because of a loss of 0.1 in the MBS
now its over because MBS are already at 0 (unless the price of loans decreases through sales)

Margin/haircut spiral
when you borrow against collateral: lender will typically deduct some value from the market value
of the collateral to adjust for riskiness
deduction = haircut
in times of crisis: haircuts increase hence banks need to reduce their leverage ratio
reinforces bank credit channel spiral! (value of collateral = key!)