Published on September 6, 2009
A Analytical Framework for Understanding Global Financial Crisis : A Analytical Framework for Understanding Global Financial Crisis K.V. Bhanu Murthy Dr. Ashis Taru Deb Professor Sir Ratan Tata Senior Post-Doctorate Fellow Department of Commerce, Institute of Economic Growth, Delhi School of Economics University Enclave, North Campus, Delhi-7 JEL Code: E22, E32, E44, L58, G11, G12. Keywords: Mortgage, Housing bubble, Sub-prime Crisis. The bubble has burst! : The bubble has burst! Analyzing the crisis : Analyzing the crisis How did the sub-prime crisis happen? Why did it happen? What are the implications? Theory Macro economic Finance theory Policy Incentives Markets Lessons for Current Crisis Housing Prices in USA - Trend : Housing Prices in USA - Trend Growth rate of Housing Prices in USA : Growth rate of Housing Prices in USA Housing Prices in USA- Final collapse : Housing Prices in USA- Final collapse Housing Crash : Housing Crash Dramatic rise in default on sub-prime loans consequent on rise in the interest rate led to increase in supply of mortgaged houses coupled with reduced demand for them led to plummeting of price in real estate sector. This trend was visible in the period May2006 to April 2007. The most dramatic fall in price was just in one month, from March 2007 to April 2007 when the prices declined by over $ 25000 in just one month. Prior to this in the preceding 87 months the growth in prices was an alarming 0.56 percent per month! It is about 13 percent annually. In the last month the fall equals the rise in one year! Volatility in the last phase - speculation : Volatility in the last phase - speculation Mortgage securitization : Mortgage securitization Bank: mortgage securitization =one middleman: several middleman. : Bank: mortgage securitization =one middleman: several middleman. Securitization is broad distribution of risk held by bank and is viewed as bank “disintermediation”. But actually it replaces one middleman by several. In the traditional model, there is only middleman between the lender and the borrower, the bank. Two implications: democratization of risk: eulogized by the financial system emergence of a principal-agent problem at multiple levels. Multiple principal agent problems : Multiple principal agent problems In a mortgage securitization the simple process is supplanted by: The mortgage broker The loan originator The servicer The arranger Mortgage bond issuers. Rating agencies The investor mortgage standards became lax because securitization gave rise to a form of moral hazard, whereby each link in the mortgage chain made a profit while passing any associated credit risk to the next link in the chain Responsibility : Responsibility (1) home buyers who took on mortgages they couldn't repay (sub-prime); (2) mortgage originators, for issuing same (due diligence); (3) bank regulators, who didn't have the inclination or authority to monitor this closely enough; (4) the investors who ultimately provided the funds for the mortgages (high return with high risk); (5) securitization, which led to assets that are "too complex for anyone's good” (direct link is lost); and (6) ratings agencies which underestimated the risk (or were outright unethical). By design and not accidental : By design and not accidental The design was such that it could not have been hatched in isolation. It was therefore the resultant of the design of a syndicate consisting of the following. There were stakes on each party in the design. Real estate agents. Mortgage lenders. Wall Street firms Rating agencies Investors. They were indented to enable short term capital gains by forcing delinquency. This was done with a view to enable repossession of property created out of sub-prime lending. Strategy of syndicate : Strategy of syndicate The strategy consisted of creating a bubble through creation of excess demand. ‘Cheap money policy’ and coupled with lax lending policies. The purposive lending envisaged a distinct possibility of default. This would enable repossession for second and third sales. The buying decision was ex-ante and decision to sell is ex-post. The high interest rate made the possibility of default & re-sale almost a certainty. This leads an abnormal gain to the realtor. The mortgagee bank stands to gain because the debt has been converted into a debt instrument and is takeover by a third party. Who would then ‘slice and dice’ the asset for further sale in the capital market. The investment banks leverage their assets with the help of this instrument so that they gain even in spite of default of a certain proportion of the debt. Hence, there is a win-win strategy for the syndicate. Turnover in speculation : Turnover in speculation The strategy was successful in providing short term capital gain while the market was being skimmed of rising asset prices. It continued so long as there was a trickle of sale in the country wide housing market because the supply of repossessed houses was controlled. The gains from the housing speculation fuelled the rising housing price. This sustained the bubble. The strategy only backfired when there was a glut in the market. However, the point at which the downturn was to come was: Either not anticipated Was anticipated by some but came sooner than expected Anticipated by some and not by others Was anticipated and was meant to fall upon the shoulder of public financial institutions. Therefore, there were differential losses with the possibility that some had a substantial net gain while being responsible for the downturn, in the sense that they offloaded en-mass at a point of imminent downturn, after transferring their gains to greener pastures. The real losers were those house owners, investor, and others who were saddled with houses in the last cycle of speculative buying and selling. Multiple inter-connected causal origins : Multiple inter-connected causal origins Crisis Ethics Government Failure Financial Innovation Market Failure Macro-economic Corporate Governance Multiple Principal Agent Problem Multiple causal origins : Multiple causal origins Macroeconomics Financial innovation Multiple Principal Agent Problem Corporate Governance Government Failure Market failure Ethical dimensions These dimensions interacted amongst each other and with the endogenous instabilities of the credit economy which was built layer by layer upon an unstable base. Macroeconomics : Macroeconomics Monetary policy - Decline in rate of interest followed by rise (RBC) Consumption function - Later Cyclical behavior & Cascading Crises –boom ‘n bust + transmission => domestic or international: Asian Crisis 1997-98 Dot Com Crisis 2000-01 Sub-prime crisis & General Housing Crisis 2007 Securitization crisis Banking crisis, Liquidity crisis, Solvency crisis & Stock market crisis New international financial architecture: Exporting crisis (Open Macro) - Financial innovation – separating risk from lending - Financial technologies – slicing and dicing Globalization of crisis: (Open Macro) Easing out of restrictions on global financial flows: Globalization of interest rate Globalization of return Globalization of risk Consumption function : Consumption function Inadequacy of Keynesian consumption function. The easy availability of credit for consumer durables and housing provided the opportunity for spending beyond current incomes, a possibility that was conceived in Keynesian theory. Relevance of Dussenberry’s relative income hypothesis and Freidman’s wealth effect on consumption. Consumption increased due to the wealth effect and relative income effect resulting in excess spending. This explains the phenomenon of an extremely low savings (China 50% and India 34%). Thus consumerism is a necessary but not a sufficient condition for occurrence of sub-prime crisis. Lack of buffer savings reduced leverage for controlling the bubble : Lack of buffer savings reduced leverage for controlling the bubble If there is a sufficient buffer of normal savings, the interest rates (mortgage rates) may be raised and the increased burden would be absorbed. Such a policy would have the effect of stemming the bubble by curtailing housing demand which was being fuelled by unnatural demand created due to sub-prime lending coupled with speculative investments in housing. Market Failure : Market Failure Asymmetric information: incomplete market-“unknown-unknown” Risk return relationship: separation of risk from return Speculation: perverse relationship between price and demand Competition: efficiency vs. instability Housing bubble: gap between asset value and asset price. Rating agencies: failure to simulate regulation unknown unknown”.: The result of “democratization of risk : unknown unknown”.: The result of “democratization of risk The net result is two fold. One does not have an idea what he owns. No one knows which firms have exposure to sub-prime debts or the amounts involved in a situation in which one does not know, who is affected and by how much, the efficacy of the monetary policy pursued by Fed becomes questionable. Risk-return relationship : Risk-return relationship Allocation of risk Competition De-linking risk from return Democratization vs. Universalization of risk Hedge funds - Leverage Credit Default Swap – Counter party risk Systematic risk Contingency table Slide 25: Allocation of risk: A financial market is supposed to allocate funds and since funds earn return, and return is proportional to risk - markets are supposed to allocate risk as well. What rational price does to a goods market rational return and risk does to a financial market. Competition In a goods market competition leads to efficiency. In a financial market it leads to greater risk. De-linking risk from return – Systematic and Unsystematic risk : De-linking risk from return – Systematic and Unsystematic risk Democratization vs. Universalization of risk Democratization of risk (as per risk appetite - choice) actually lead to Universalization of risk (indiscriminate risk exposure – no choice) – Bank and Pension funds Hedge funds Follow a high risk high return strategy Hedge by leveraging and not diversification (Contingency) Credit Default Swap Shifting risk to third party Not traded – Hence price is not market determined and does not reflect risk Systematic risk When there is generalized failure no structured product can help because they can only protect against diversifying unsystematic risk. Contingency table : Contingency table Return Risk Speculative behavior on the side of the home buyer : Speculative behavior on the side of the home buyer Lowering of interest rates to smoothen the impact of collapse of the ‘dotcom bubble’ and a regime of high liquidity, due to inflows from Asia and other economies Led US banks started lending liberally for housing. A long-term trend of rising housing prices , which created an expectation of further rise in prices Had encouraged borrowers to assume difficult mortgages Excepting that they would be able to quickly refinance at more favorable terms. Due to competition among lenders to make quick and high profit Economies of scale and competitive pressures on the supply side : Economies of scale and competitive pressures on the supply side Excessive amounts of money thrown into the mortgage arena by investors who were very eager for high-yielding investments. However, they did not have appreciation for high risk which goes along a high rate of return. High fixed costs of the loan originator platform motivated the mortgages lenders to generate as many loans as they could and then sell them quick. In order to compete with other mortgage lenders, they relaxed lending standards easy initial terms Lack of appropriate documentations Low treasury rates on adjustable rate mortgages. Competition and speculation led to a housing bubble : Competition and speculation led to a housing bubble A housing bubble is characterized by rapid increases in the valuations of real property such as housing until unsustainable levels are reached relative to incomes, price-to-rent ratios, and other economic indicators of affordability Perverse relationship between price and demand Both demand and supply are upward sloping leading to unstable market equilibrium Housing bubble: gap between asset value and asset price. 1. House price as index of wealth; 2 As value of security. Dual market failure Rating Agencies – Double Failure : Rating Agencies – Double Failure Self-regulation: without the intervention of the government Agencies providing credit scores:Equifax, Experian & TransUnion. Different agencies have different scores (FICO) for the same individual because they have different information and use different models Agencies rating complex derivatives An agency problem: Paid by those whom they rate Capability problem: Faulty models Incomplete sub-prime market. Financial innovation : Financial innovation Securitization: loan sale Structured products: slicing and dicing Credit default swaps: financial instruments used as a hedge and protection for debt holders, in particular MBS investors, from the risk of default. Off-balance sheet activities of banks Hedge funds Early warning on derivatives : Early warning on derivatives “Derivatives are financial weapons of mass destruction”, Warren Buffet, warned as early as 2003 and that they could harm not only their buyers and sellers, but the whole economic system (BBC NEWS Tuesday, 4 March, 2003). Warren Buffet continues… : “Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years”. “Large amounts of risk have become concentrated in the hands of relatively few derivatives dealers ... which can trigger serious systemic problems”. Warren Buffet continues… Regulation : Regulation Two types of regulations Positive regulation Community Re-investment Act lending to weaker sections Negative regulation Commodity Futures Modernization Act of 2000 Exclusion of Credit Default Swaps from regulatory control In the last few years, SEC in US (counterpart of SEBI) removed the ceiling of 12 times capital placed on the borrowing limits of investment banks. Absence of legislation a stricter legislation on derivative: Greenspan admits that it was a mistake. Regulatory failure : Regulatory failure An estoppels created by the liberal lending policies enforced by the Community Re-investment Act which prevented a reversal of the policy towards restrictive and rational lending in the event of a failure of the liberal policy, since there was a social implication of doing so. This lead to a ‘ratchet effect’. This strikes at the root of market planning which should allow for incremental as well as decremental policies so as to adjust market forces. Furthermore, the regulator was forced to follow an alternation of low and high interest rates. In such a situation it was not possible to de-link rising mortgage rate from rising general interest rates. This precipitated the default on account of sub-prime lending. The regulators could either not foresee the impending crisis or the above ‘ratchet effect’ made it inevitable. Supervisory failure : Supervisory failure The normal regulatory checks like those capital adequacy were not regularly imposed. Supervisors of the financial system did not comprehend and control the inherent risk in CDS. They did not take note of the phenomenal growth of theses derivates. Corporate governance : Corporate governance The moral restraint of reverting back to ‘controls’ by the regulators, once the Nation State had adopted the philosophy of economic management through the ‘market’. “I made a mistake in presuming that the self interest of organizations, specifically banks and others, was such that they best capable of protecting their own shareholders”, Greenspan (ex-Fed Chief) to the Congress (Financial Times, 24 October, 2008). Tendency toward taking short-term risks while ignoring long-term obligations. Investment banker incentive compensation focused on fees generated from assembling financial products, rather than the performance of those products and profits generated over time. Poor understanding of people at the top of the banks about complex derivatives However, public financial institution should not have been brought under such an umbrella since they leverage public funds for private gain. Ethical dimensions : Ethical dimensions Citibank CEO – “Sold our souls to the devil”. Credit rating agencies – Paid by clients whom they rate. Role of brokers –misguided the buyers and steered them into loans they could not afford Banks – Main function – judgment of credit-worthiness -sub prime lending. UBS Report – incentives leading to unethical practices Unethical link between Wall Street firms and the regulators Conclusions : Conclusions Finance theory - Securitization Risk return Universalization Systematic risk Not covered Total gain Exceeds loss during last cycle Accounting Of balance sheet activities – contingent liabilities Corporate Governance Public funds Lack of information to those whose funds are used in risky assets Market failure – risk : Market failure – risk Asset market failure: Asset market may fail to recover the dues in case of failed lending. This is true even when the asset is a real estate which appears to be a reliable asset. Alternative: The alternative of de-linking the risk from lending is more risky that the original risk. It is more spread out. Asymmetric information problem: most unique problem is “unknown unknown”, where both sides do not know. Informational link: breakdown of the link between lender and bearer of risk. Structured products: often not priced by market. Therefore, not based on efficiency. Private and public risk: financial markets do not distinguish between private funds and funds leveraged from public financial institutions. Macro-economics : Macro-economics Old banking model: Unwillingness of the mortgage banks to asses the risk profiles of the borrowers since ultimately they can shift the risk Therefore, the old banking model is better Consumption function: It must be understood in terms of a wealth effect not income effect Banks create money: This is the original maxim. This double edge – Now banks spread bad assets Open macroeconomics: Based on world rate of interest. Rate of interest is an indicator of return. This ignores the risk aspect. There is no parallel theory of world risks. Micro-foundationsof macro-economics : Micro-foundationsof macro-economics Perverse incentives The housing bubble as well as the derivative bubble has created perverse incentives with four features Enjoys the return and shifts the risk. Can earn virtually without investment of own funds Enjoys abnormally high returns Do so without waiting No postponement of consumption High return coupled with extremely low interest cost There is a cascading effect through competition on the entire financial system. Policy Challenge : Policy Challenge A sectoral problem spreads to through the banking system How to prevent such a problem from engulfing the whole economy and global economy High risk – high return strategies Are not leveraged by public financial institutions Like the stock markets we could have ‘circuit breakers’ We have to re-think about uninhibited markets If crises are the cost paid for growth and openness restrictions may prove to be a smaller cost The policy issue is not about transparency of structured products but the reason for which transparency is being sought: They need not be encouraged on a mass-scale, involving banks and pension funds Slide 45: THANK YOU!