Long Term Private Outstanding Debts In Paris

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Cecilia Stevenson
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1 Remembrance of Financial Crises Past Jean-Laurent Rosenthal 1

2 We know a crisis when we see one Long Term Private Outstanding Debts In Paris Mil lions of Silver Francs Outsta anding Banks (CFF) Life Annuities Obligations Perpetual Annuities 0 From Hoffman, Postel-Vinay and Rosenthal, Priceless Markets (2001) 2

3 Our Crisis % of Foreclosre % Mortgages ency and F tstanding M Delinqu Out Delinquency rate Foreclosure rate Home Prices (Real) Mortgage debt outstanding (real) ces and mor rtgages =100 Home Pri It is not over! Sources: Mortgage Bankers Assn., FHA, Federal Reserve 3

4 Tonight Explore this crisis as economic history Ignore Short Term macro-economic management Bernanke vs Greenspan responsibilities Focus on the crisis origins and its long term consequences ces Ask questions like Is this crisis new? Why did we not avoid it? What can we do to prevent recurrence? Lets start with mortgages 4

5 Its all about leverage Give me a place to stand and with a lever I will move the whole world world. Archimedes Debt is the lever of finance Leverage is the ratio of debt to assets. Traditional conforming loans: 0.8/1 Commercial banks: 10/1 Investment banks in 2007: 60/1 Give me enough leverage and I will give you a global financial crisis. 5

6 A big crisis starts with a big market bts outsta anding Sh hare of de 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% The Structure of the US debt Market Consumer credit Mortgages Bank loans Corporate and foreign bonds Open market paper Municipal securities US U.S. Government Bonds 0%

7 Finance and Growth in the United States ollars illions US d Gross Domestic Product Mortgage Debt Outstanding B

8 Mortgages and Home Prices Mortgage debt outstanding (Real) al Debt Billion Dolla ars Home Prices (FHA) Home Prices (Case-Shiller Index; 10 Cities) es 1980= =100 Pric Re

9 From Liberalization to Crisis Liberalization Clinton administration Greenspan-Rubin/Summers Bush administration Greenspan/Bernanke-O Neal/Snow/Paulson Political costs of intervention were high Homeowners Construction industry Real Estate Industry Financial Industry Would be home owners Speculators in real estate We all ate Cake! Now we all eat Crow. 9

10 Crash BETWEEN 2006 AND 2009 Delinquencies and foreclosures triple Three of the largest mortgage lenders collapse Countrywide, WaMu, Wachovia Bank stocks fall by 90% in some cases Stock market fall by 50% Real estate prices fall by 30% or more in many parts of the U.S. Comparisons with the Great Depression begin 10

11 Crises and History Before the Crash, History does not matter Financial Innovation and bank concentration Past crises not relevant Since the Crash Once in a century crisis! Bernanke, Romer derive legitimacy from their expertise in the Great Depression But is that the right history to understand the causes of the crisis? i No goes from equity to banks to mortgages and real estate (almost the reverse chain from 2007) 11

12 Finance and Growth in the United States llars lions 1980 US do Bil Gross Domestic Product Gross Federal Debt Counter factual Mortgage Debt Outstanding Mortgage Debt Outstanding

13 Beyond the Recent Past Two episodes in the 19 th century The 1830s and the 1890s on the frontier Both feature land booms and mortgage credit expansion followed by a crisis In each case the crises began as regional problems. But in several ways they created larger problems in the US and abroad 13

14 Dubai World on the Frontier; Indiana in the 1830s 14

15 A Crisis unfolds Debt Outstanding (million dollars) 10 Value of Taxable Land Per Acre (dollars) Property Tax Revenue ($100,000) Source John Wallis 15

16 Financial Consequences States and the Federal Government not concerned with investors States default (Indiana in 1841) States pass debt moratoria Federal Government will forgive the debt it is owed by settlers Peabody and Co, US U.S. investment banking firm in London Sold U.S. states bonds on the London market After the defaults Peabody yputs a lot of personal effort in negotiating resumption. (Indiana 1847) Earns a reputation of caring for the investor that is transmitted to successor firm: Morgan and Co 16

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18 Mortgages on the Frontier 1880s Opening up of the Plains, farms need credit Savings/Building and Loans Short Term Interest Rates (1893 5) New England 4.85 Mid Atlantic 4.91 South 7.29 Mid West 6.35 Rockies 8.99 Very safe (total losses 0.25% West of capital) EUROPE But only lend within county London 2 and have limited it funds Amsterdam 2.7 Paris 2.7 Interregional capital flows? There is money to be made From Lance E Davis Evolution of a National Market (1965) 18

19 The interregional Loan Market Midwest Mortgage Cos act as brokers Loan Agents hired on commission So they have incentive to max the value of loans made (not the return on loans) Capital comes from East Coast or Europe Investors own mortgages--can screen loans And they routinely refuse to fund some of them Early Profits Entry! 19

20 From Innovation to crisis New companies create competition for Loan agents They work for Co s that do not turn down applications Mortgage co seek new sources of funds they where control acceptance rates Mortgage backed bonds Solve this pb How? Advantages to investor? But then lending standards decline and CRISIS Of 99 Mortgage Cos operating in are still in business in Lesson: You can t trade off information quality and financial sophistication. 20

21 From Crises to Regulation Savings and Loans Nothing until the Great Depression Banks also face crises in 1907 and again in the 1930s Federal reserve (1913), FDIC (1933) Authority over federally chartered commercial banks Lobbies block regulation investment banks (J-P Morgan opposed) State chartered banks or Other financial firms (insurance companies) Lesson: Our complex regulatory system is a product of our political history It produces both good and bad innovation 21

22 Mortgage backed securities done right (Yes we can) standing Millions of Silv ver Francs Out The Credit Foncier Long Term Outstanding Debts In Paris Banks (CFF) Life Annuities Obligations Perpetual Annuities Founded 1852 as the Parisian then French Mortgage Bank, The third in a succession of banks founded d to modernize credit after 1789 other two had failed! 22

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26 The CFF Strategy Stay well away from marginal borrowers: find borrowers who are safe. Require exacting collateral evaluation and strict loan to value ratio Expensive! but cheaper for bigger loans and for larger parcels Then give borrowers something the traditional market can t Long maturities and low interest rates Median Loan in Paris 1850s CFF OTHER RATIO

27 In the end its all about leverage The lesson from the CFF is that it is not whether or not to be leveraged, but how much More leverage, more accelerated growth AND More crises SO? Rules in the mortgage market should be simple: keep Loan (First+Second+Home equity+++) to 85% of home value Easy to enforce, requires no innovation, bank rules more complicated. People may not all have granite countertops, or drive convertibles, but maybe we can all retire when planned. And its ok to be renters, I was one until I was 35 (one had to put 20% down in 1997) and I survived! 27

28 Recovery? In the Long Run! 10, , ,000.0 Billions 1980 US Do ollars 7, , , , , , , Mortgatge Debt at Peak Gross Domestic Product Mortgage Debt Outstanding Counter factual Mortgage Debt Outstanding Axis Title 28

29 Financial markets and Growth The crisis should not move us to think badly about financial markets or even about adjustable rate subprime mortgages Nearly all the large scale challenges we face will be met more easily if we have well functioning financial market. We must decide what markets we need or what markets we want 29

b. Financial innovation and/or financial liberalization (the elimination of restrictions on financial markets) can cause financial firms to go on a

b. Financial innovation and/or financial liberalization (the elimination of restrictions on financial markets) can cause financial firms to go on a Financial Crises This lecture begins by examining the features of a financial crisis. It then describes the causes and consequences of the 2008 financial crisis and the resulting changes in financial regulations.