The Financial Crisis of ? Gerald P. Dwyer Federal Reserve Bank of Atlanta University of Carlos III, Madrid

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1 The Financial Crisis of ? Gerald P. Dwyer Federal Reserve Bank of Atlanta University of Carlos III, Madrid

2 Disclaimer These views are mine and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System.

3 How To Interpret Recent Events? Financial Crisis of Private Banking and Debt Crisis Sovereign Debt Crisis of ?

4 LIBOR less OIS - 30 days January 1, 2006 to May 16, Run on money market funds September 16, End of year Northern Rock August /1/06 7/1/06 1/1/07 7/1/07 1/1/08 7/1/08 1/1/09 7/1/09 1/1/10 7/1/10 1/1/11 7/1/11 1/1/12 Sources: Financial Times, Bloomberg, Haver Analytics

5 2500 European CDS Spreads January 2, 2006 to May 16, 2012 Greece agreement Ireland agreement Portugal agreement Greece agreement Greece Basis points Germany Spain Portugal Italy Ireland United Kingdom Greece (on right-hand axis) Portugal 5000 Ireland Spain Italy 0 1/1/2006 7/1/2006 1/1/2007 7/1/2007 1/1/2008 7/1/2008 1/1/2009 7/1/2009 1/1/2010 7/1/2010 1/1/2011 7/1/2011 1/1/ Source: Datastream, Bloomberg

6 Summary of Developments Private Debt Crisis of Prelude until August 9, 2007 Main Act from August 9, 2007 to September 16, 2008 Climax from September 16, 2008 to early 2009 Sovereign Debt Crisis of 2009 to 201?

7 Housing Price Indices January 2000 to February Case Shiller Index FHFA Index /1/00 1/1/01 1/1/02 1/1/03 1/1/04 1/1/05 1/1/06 1/1/07 1/1/08 1/1/09 1/1/10 1/1/11 1/1/12 Sources: S&P, FHFA, Haver Analytics

8 U.S. Delinquencies by Loan Type First Quarter 2002 to First Quarter Subprime ARM 25 Subprime FRM Prime ARM 10 Prime FRM 5 0 1/1/02 10/1/02 7/1/03 4/1/04 1/1/05 10/1/05 7/1/06 4/1/07 1/1/08 10/1/08 7/1/09 4/1/10 1/1/11 10/1/11 Sources: Mortgage Bankers Association, Haver

9 Billions $ US Mortgage Originations by Type 2001 through ,500 4,000 3,500 3,000 2,500 Home Equity Lines Alt A Subprime Prime Jumbo Conventional FHA/VA 2,000 1,500 1, Source: Inside Mortgage Finance

10 Size of Global Financial Markets Source: Dwyer and Tkac, JIMF, December 2009

11 Story A tiny part of securities markets put asset markets around the world in a state of turmoil How can that be?

12 06-1 vintage ABX Indices by Vintage 06-2 Vintage /2/06 1/2/08 1/2/10 1/2/ Vintage AAA AA A BBB BBB- - 1/2/06 1/2/08 1/2/10 1/2/ Vintage /2/06 1/2/08 1/2/10 1/2/12 Sources: Markit Group Limited/Haver Analytics - 1/2/06 1/2/08 1/2/10 1/2/12

13 Three Securities Instead of One AAA rated RMBS Residential Mortgages BBB- RMBS Equity RMBS

14 Three Securities Instead of One AAA rated RMBS Subprime Mortgages BBB- RMBS Equity RMBS

15 CDOs from Tranches AAA rated CDO BBB tranches of RMBS BBB- CDO Equity CDO

16 Mortgages to CDOs Portfolio of subprime mortgages BBB tranche of RMBS AAA tranche of CDO Portfolio of subprime mortgages BBB tranche of RMBS CDO BBB tranche of CDO Portfolio of subprime mortgages BBB tranche of RMBS Equity tranche of CDO

17 CDO Deals Idiosyncratic and Traded over the Counter A trust, generally in the Cayman Islands, owns the assets backing the CDOs and distributes payments Not standardized contracts Over-collateralization and triggers Can build up a reserve account for possible losses Can be contingent on delinquencies and losses Payment order can change over time Principal may be paid initially to AAA holders Proportionately to all after a couple of years Manager can be passive or active Traded over the counter

18 200 Global Issuance of Collateralized Debt Obligations First Quarter 2005 tothird Quarter Other CDOs CDOs of ABS CLOs Source: SIFMA Source: SIFMA

19 Billions $ Global Issuance of Collateralized Debt Obligations First Quarter 2005 to First Quarter Other Tranches High Yield Loans High Yield Bonds Investment Grade Bonds Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q2 Q3 Q4 Q Source: SIFMA

20 Securities and Risk Sharing CDOs were purchased by entities all over the world AAA rating made them seem like a fine purchase AAA CDO is not a AAA corporate bond CDO is based on a portfolio of loans Behavior of cash flows in default is different Ratings were conditioned on rising house prices Very hard to value if mortgagees start to default

21 Synthetic CDOs Can create a CDO without owning any of the underlying securities Sell protection on the underlying securities using credit default swaps Can replicate cash flows from owning the securities Done using ABX or custom synthetic CDO

22 Global Financial Crisis? Other countries Iceland Ireland United Kingdom Spain

23 Global Financial Crisis? Other countries Iceland Ireland United Kingdom Spain Not really global Australia Canada Japan Korea

24 U.S. Not Only Country with Housing Problems House prices rose in many countries besides U.S. Widespread increases of leverage Widespread increases of maturity transformation

25 Housing Prices United States Ireland /2000 1/2002 1/2004 1/2006 1/2008 1/ Spain U.K /2000 1/2002 1/2004 1/2006 1/2008 1/2010

26 Housing Prices United States Canada /2000 1/2002 1/2004 1/2006 1/2008 1/ /2000 1/2002 1/2004 1/2006 1/2008 1/ Australia

27 ICEXI Icelandic Stock Price Index December 4, 2001 to November 29, ,100 8,100 7,100 6,100 5,100 4,100 3,100 2,100 1, /2001 1/2002 1/2003 1/2004 1/2005 1/2006 1/2007 1/2008 1/2009 1/2010 1/2011 Source: Bloomberg 27

28 Run on Northern Rock Source:

29 An Hypothesis Common elements are Increases in leverage Increases in maturity transformation Funding long-term assets by short-term borrowing Best response World is riskier than many thought Reduce leverage Reduce maturity transformation

30 The Great Moderation: U.S. Unemployment Rate January 1948 to April /1/48 1/1/53 1/1/58 1/1/63 1/1/68 1/1/73 1/1/78 1/1/83 1/1/88 1/1/93 1/1/98 1/1/03 1/1/08 Sources: BLS, NBER, Haver Analytics

31 A Quest for Stability Source:

32 Financial Regulation What have we learned? I would suggest that more capital is desirable What about systemic risk regulator? Depends on someone s ability to See problems coming See when problems are not coming Actually be able to do something about problems seen coming Issue is what behavior consistent with equilibrium

33 Financial Regulation My Thoughts Make financial system more resilient Don t try to avoid what will happen anyway

34 LIBOR less OIS - 30 days January 1, 2006 to May 16, Run on money market funds September 16, End of year Northern Rock August /1/06 7/1/06 1/1/07 7/1/07 1/1/08 7/1/08 1/1/09 7/1/09 1/1/10 7/1/10 1/1/11 7/1/11 1/1/12 Sources: Financial Times, Bloomberg, Haver Analytics

35 2500 European CDS Spreads January 2, 2007 to May 16, 2012 Greece agreement Ireland agreement Portugal agreement Greece agreement Greece Basis points Germany Spain Portugal Italy Ireland United Kingdom Greece (on right-hand axis) Portugal 5000 Ireland Spain Italy 0 1/1/2006 7/1/2006 1/1/2007 7/1/2007 1/1/2008 7/1/2008 1/1/2009 7/1/2009 1/1/2010 7/1/2010 1/1/2011 7/1/2011 1/1/ Source: Datastream, Bloomberg

36 6000 European Bond Spreads Basis points, 10-year bond spread to German bonds January 2, 2010 to May 16, 2012 Greece Spain Portugal Ireland Italy UK United States Greece Ireland Portugal Spain Italy /2/10 4/2/10 7/2/10 10/2/10 1/2/11 4/2/11 7/2/11 10/2/11 1/2/12 4/2/12 Source: Bloomberg 36

37 European Bond Spreads Basis points, 10-year bond spread to German bonds 600 EU agrees on Greek support package Fed, ECB, and other central banks provide liquidity billion billion LTRO LTRO Negative Euro area PMI report 500 ECB announced reboot of Securities Market Program Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 Source: Bloomberg Italy Spain France through April 25,

38 Ratio of Debt to Gross Domestic Product 2003 to United States Germany France Spain Greece Iceland Ireland portugal Italy Source: CIA World Factbook, estimates 38

39 Debt to GDP Ratios and Government Deficits December 31, Public Debt to GDP Deficit to GDP Percent Greece Iceland Italy Ireland Portugal France Germany Spain United States Source: CIA World Factbook, estimates 39

40 5.0 Debt Relative to Government Revenue Years to Pay off Debt if used 100% of Revenue Greece Iceland Italy Ireland Portugal France Germany Spain United States Source: CIA World Factbook, estimates 40

41 Rankings on These Measures Debt/GDP Deficit/GDP Debt/Revenue Greece Ireland United States Iceland Spain Greece Italy France Iceland Ireland United States Ireland France Greece Italy Portugal Iceland Portugal Germany Portugal Spain Spain Italy Germany United States Germany France

42 Rankings on These Measures Debt/GDP Deficit/GDP Debt/Revenue Greece Ireland United States Iceland Spain Greece Italy France Iceland Ireland United States Ireland France Greece Italy Portugal Iceland Portugal Germany Portugal Spain Spain Italy Germany United States Germany France

43 Current Euro Area Arrangement European Financial Stability Facility EFSF can lend up to 440 billion This is an increase in lending ability Can lend less than securities issued Currently limited because of a reserve fund Securities issued backed by governments guarantees Have to issue more securities than lend Some of funds are used to buy AAA-rated securities to help get and keep AAA rating

44 New Euro Area Arrangement European Stabilization Mechanism Euro area states to be members Initially can lend up to 500 billion 700 billion pledged funds 80 billion of funds paid in 620 billion pledged and callable Language interpreted as indicating bondholders will take losses In accordance with IMF practice, in exceptional cases an adequate and proportionate form of private sector involvement shall be considered in cases where stability support is provided accompanied by conditionality in the form of a macro-economic adjustment programme.

45 Fiscal Compact Signed January 2012 Possibly come into force by January 2013 and affect eligibility for funds from ESM Government restrictions at constitutional level Structural deficit <= 0.5% of GDP <= 1% of GDP if debt/gdp low enough Reduce debt/gdp by 1/20 if debt/ GDP > 60% Fine up to 0.1% of GDP

46 How Deal with Sovereign Debt Problems? Problem before: Relatively high leverage Problem now: Relatively high leverage Solution is the same: decrease leverage At least stop future increases

47 What? No Stimulus? Stimulus temporary Increase spending Reduce taxes Long-run fiscal problems if run deficits for a long time Obvious to voters and people in country Creates concern about future taxes and reduces private spending

48 U.S. Debt Held by the Public as a Percentage of U.S. GDP CBO 2010 Alt % of GDP Budget CBO 2011 Baseline CBO 2010 Baseline Source: Private Enterprise Research Center, Texas A&M University

49 Eurozone Distinguish between eurozone and European Union Monetary union need not involve any other sort of entanglement Greece s current situation is not likely to last Raise tax rates to increase tax revenue GDP falls, which decreases tax revenue Perhaps other countries

50 Eurozone Banking Crisis? Banks hold substantial amounts of government debt

51 Different Monies

52 United States Different Monies Greece

53 Inflation

54 Source: Eurozone Choices

55 Good Choice for Greece? Default and leave eurozone Don t default

56 Good Choice for Greece? Default and leave eurozone Don t default Debt / GDP of 120 percent in 2020 Have to lower debt or raise GDP

57 Good Choice for Greece? Default and leave eurozone Don t default Debt / GDP 120 percent in 2020 Have to lower debt or raise GDP Think of it like the collapse of the Soviet Union Drastic measures

58 Good Choice for Greece? Default and leave eurozone Don t default Debt / GDP 120 percent in 2020 Have to lower debt or raise GDP Think of it like the collapse of the Soviet Union Drastic measures Lower tax rates and enforce payment Privatization: give shares to taxpayers

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