CURRENT FINANCIAL CRISIS, IMPACT OF RESCUE MEASURES AND POLICY CHOICES FOR CHINA

GFC Working Paper 200806 CURRENT FINANCIAL CRISIS, IMPACT OF RESCUE MEASURES AND POLICY CHOICES FOR CHINA Qing Ping Ma Copyright Centre for Global Finance October 2008 Centre for Global Finance 199 Taikang East Road University of Nottingham Ningbo, China Ningbo 315100 China Tel: +86 (0)574 8818 0031 Fax: +86 (0)574 8818 0031 Email: gfc@nottingham.edu.cn Website: www.nottingham.edu.cn/gfc The Centre for Global Finance based at the University of Nottingham Ningbo brings together academics from diverse disciplines with a research interest in finance and financial services. Its focus is research that explores how the financial system mediates the economic and social transformation of China in the context of a global financial system. Its aim is to inform and influence the academic, business and policy-making communities. 1

Current financial crisis, impact of rescue measures and policy choices for China Qing-Ping Ma International Business Division and Global Finance Centre, The University of Nottingham Ningbo China, 199 Taikang East Road, Ningbo, Zhejiang 315100, China Date: November 8, 2008 Abstract This paper briefly reviews the events in the evolution of the current financial crisis and the underlying factors that caused this financial crisis; analyzes the impact of the crisis and the rescue measures by central banks and governments on the real economy; and discusses the policy choices for China in the face of the financial crisis and likely recession in the global economy. The rescue measures have averted a meltdown of the financial system if it was going to have one, but a recession in developed economies and some emerging economies seems inevitable. How severe the recession will be is still unclear. The rescue measures may not be sufficient for a severe recession, and fiscal measures may be needed to alleviate the downturn. The slow down and recession in world economy will decrease the growth rate of China s economy. Although the large foreign exchange reserve, current account surplus and budget surplus will shield China from the worst effects of the financial crisis, a prudent use of its financial strength is highly desirable. China s sovereign fund should have an investment strategy similar to pension funds in the developed economies. Overseas acquisitions should be based on value to the acquiring institutions. Shoring up house prices seems not the best approach for increasing domestic demand in China. Putting a social welfare safety net in place is more likely to stimulate the domestic demand. Keywords: CDO, CDS, credit crunch, domestic demand, liquidity, subprime mortgage 2

1. Introduction The turmoil in the global financial markets is still raging, and there is no definite answer to these two important questions: 1) when will the turmoil in global financial markets end, and 2) whether the financial crisis will have a big impact on the real economy? After a series of dramatic interventions from US and European governments by pumping liquidity into the banking system and guaranteeing deposits and new bank debt, a collapse in the banking system has been averted at least for the time being. There were signs of improvement in terms of interbank lending. The three Month LIBOR rate was 3.51% as of 28 October 2008, whereas it was 4.05% a month ago and 4.91% a year ago. The stock markets are still very volatile, with heavy losses because of the worries on the real economy and some rebounding following interventions from governments. A recession is expected for all major developed economies. To fully understand the current financial crisis, it is worthwhile to look back at what has happened in the financial sector in the past two years. In our view, the current crisis can be roughly divided into three periods: period one (Autumn 2006 August 2007), germination, falling house prices led to credit crunch and intervention from central banks; period two (September 2007-August 2008), development, credit crunch led to collapse of banks, the US Federal Reserve had to arrange a bailout of the investment bank Bear Stearns; period three (September 2008 present), maturity, the collapse of mortgage giants Fannie Mae and Freddie Mac, the bankruptcy of the investment bank Lehman Brothers and the failure of the insurer American International Group initiated a chain of events of central bank intervention and government rescue operations. The first period began when prices started to decline in the US real-estate market in the autumn of 2006. By early 2007, many financial institutions reported losses due to investments in subprime mortgage related assets. On May 4, 2007, the Swiss bank UBS shut down its internal hedge fund Dillon Read, after a subprime-related loss of about US$ 125 million. In June, Bear Stearns injected US$ 3.2 billion to its two hedge funds which were having trouble meeting margin calls. In July a German bank IKB had to be rescued because its conduit for asset-backed commercial paper (ABCP) suffered losses and was unable to roll over its ABCP. All three major credit-ratings agencies announced a review of subprime bonds. American Home Mortgage Investment Corp announced its 3

inability to fund lending obligations and declared Chapter 11 bankruptcy on August 6, 2007. On August 9, the French bank BNP Paribas suspended three investment funds hit by the subprime crisis. The insurance company, American International Group (AIG), warned that mortgage defaults were spreading beyond the subprime sector. Following these events, banks were reluctant to lend to each other, which led to a substantial increase in the interbank LIBOR rate. To provide liquidity to the interbank market, the European Central Bank injected Euro 95 billion in overnight credit into the interbank market on August 9. The US Federal Reserve also injected US$ 24 billion to supply liquidity to the market. The Federal Reserve cut the discount rate to 5.75% on August 17. Another German bank Sachsen Landesbank could not shoulder its liquidity commitment towards its conduit Ormond Quay, and was taken over by Landesbank Baden-Wuerttemberg in an orchestrated bailout. With the intervention from central banks, there was a feeling that the worst might have been averted. The beginning of the second period is marked by the first bank run in Britain in more than a century (Milne and Wood 2008). The British central bank, Bank of England, was initially reluctant to intervene. On September 14, a run on the deposits of the British bank Northern Rock began. The UK government was forced to guarantee all the savings in Northern Rock to stop the bank run spreading and the Bank of England had to pump in emergency money. On 18 September 2007, the Federal Reserve cut the discount rate by 50 basis points to 4.75% and the discount rate to 5.25%. In October 2007, major international banks announced big losses, which were interpreted as those banks cleaning their books.. With more write-downs by the major banks in November and December, the earlier estimates of the total losses in the mortgage market of US$ 200 billion were revised upward. The Federal Reserve announced the creation of the term auction facility (TAF), which would auction a fixed amount of funds to the banking system, initially set at US$20 billion. The ECB lent European commercial banks $500 billion. The Bank of England made 10 billion available to UK banks. Large Write-downs by major banks continued in January and February 2008. On 22 January 2008, the Federal Reserve cut the federal funds rate by 75 basis points to 3.50%. On 14 March 2008, the investment 4

firm Carlyle Capital, which invested heavily in agency papers, defaulted on US$ 17 billion of debt, The investors started to worry about the health of investment banks, and clients fled from Bear Stearns, which was the smallest and most leveraged investment with large mortgage exposure. Bear Stearns liquidity situation worsened and it was taken over by JP Morgan Chase in a rescue package arranged by the Federal Reserve Bank of New York. The Federal Reserve Bank of New York agreed to guarantee $30 billion of Bear Stearns assets, mostly mortgage-related. The Federal Reserve cut the federal funds rate by a further 75 basis points to 2.25% on 18 March 2008 and to 2.0% on 30 April 2008. More losses were announced by major banks and insurers. The California mortgage lender IndyMac collapsed in July. After the Fed arranged bailout of Bear Stearns, many analysts were cautiously positive. Larry Summers, the former Treasury secretary, gave a speech at the Harvard Club in New York on 9 April, and his view was that the worst may be over for financial markets because some debt market instruments may have declined to the point they were great bargains. Events turned out to be quite different. The beginning of the third period may be marked by the bankruptcy of Lehman Brothers, but it is the collapse of AIG that really forced the US government to take action. Troubles for U.S. mortgage giants Fannie Mae and Freddie Mac had been growing since the credit crunch started and the U.S. government had to take over Fannie Mae and Freddie Mac in a US$ 200 billion bailout in September. Troubles had also been growing for the investment banks. Lehman Brothers filed for bankruptcy on 15 September; Merrill Lynch agreed to be acquired by the Bank of America. The US government bailed out AIG for US$ 85 billion. On September 19, the White House requested a $700-billion bailout plan from Congress for all financial firms with bad mortgage securities to free up tightening credit flow. On September 22, the last two investment banks, Morgan Stanley and Goldman Sachs, converted to bank holding companies. America's biggest savings and loan company, Washington Mutual, was seized by federal regulators overnight and sold to JP Morgan for US$ 1.9 billion on September 26. The UK government nationalized the troubled bank Bradford & Bingley on September 28, and Santander bought its deposits and branches. The Belgian, Dutch and Luxemburg governments bailed out the troubled bank Fortis with a Euro 11.2 billion package. The Francobelgian bank Dexia has to be bailed out by Belgian, French and Luxemburg governments with a 5

cash injection of Euro 6.4 billion on September 29. The Citigroup announced that it would buy Wachovia. The Irish government took the unprecedented step of guaranteeing retail deposits for the next two years on September 30. The three biggest banks in Iceland had to be bailed out by the Icelandic government. On October 3, the US congress passed the bill authorizing the US$ 700 billion rescue plan.on October 8, the Treasury of UK announced a rescue plan amounting 500 billion for the ailing banking sector. The 15 members of the Eurozone also provided their banks with capital funding along the British line on October 13. UBS received capital injection from the government. On October 14, the US Treasury announced that US$ 250 billion would be injected into nine major banks in the next few weeks. On October 19, the Dutch bank ING received a capital injection of Euro 10 billion. Through September and October, global stock markets tumbled due to fears firstly of financial system meltdown and then of recession. We have briefly gone through the evolution of the current financial crisis up to the present time. Whether the financial markets will stabilize after the concerted efforts of governments of the major economies, and how badly the real economy will be affected are still unclear. The problem in the financial market before August 2008 has been called the Credit Crunch of 2007-2008 (Brunnermeier 2008; Mizen 2008), when the shortage of liquidity appeared to be relieved by the action of central banks. There have been studies on this first global crisis of the 21 st century (Boeri and Guiso 2008; Brunnermeier 2008; Buiter 2008; Mizen 2008), analysing the background of the crisis, policy responses and lessons to be learned from the early stages of the current crisis. So much has happened in terms of bank collapses and government interventions since those studies, some investigation on these events is needed. With the benefit of hindsight, people may also have a clearer view of the events than in the middle of this year. Although the situation is far from settled, some investigation into the cause of the current crisis, the short and long term impacts of the rescue measures on the economy and policy choices can be still be useful. The aim of this paper is to examine the causes of the current financial crisis, its impact on the global economy, the short-term and long term effects of the rescue measures and policy choices especially for policy makers in China. The paper is organized as follows. 6

Section 2 analyzes why and how the subprime mortgage triggered the financial crisis. Section 3 examines the impact of the current crisis on the real economy and the short-term and long-term effects of rescue measures by governments around the world. Section 4 looks into how the crisis will affect the Chinese economy and the policy choices for the policy makers in China. Section 5 will summarize and conclude. 2. Understanding the current crisis To understand the current crisis, we need to look at three different aspects: firstly, the general economic environment; secondly, the financial innovations and risk pricing; and thirdly, the monetary policy of central banks, especially the US Federal Reserve. It is the combination of these three factors that eventually led to the current financial crisis. 2.1 The economic environment since 80s The 1980s witnessed a break from the high inflation and stagnant growth prevalent in the 1970s in the major Western economies. In the early 1980s, anti-inflation became the priority of the Federal Reserve led by then chairman Paul Volker. With the pro-growth economic policy of the Reagan Administration and strict control of money supply by the Federal Reserve, the long -brewing inflation was subdued and the US economy returned to steady growth again. The anti-inflation policy of Federal Reserve also exacted a heavy price, a severe recession in 1982-83. From then on, the major Western economies have followed the so-called monetarist economic policy. With deregulation, privatization of state-owned industries, free market economic policy, the major western economies appeared to become healthy again. Before the current crisis, economists generally agreed that monetary policy was performed poorly in the 1970s, a period of highest volatility in both output and inflation (Romer and Romer 2002). There has been a substantial decline in macroeconomic volatility in the US economy since 1984. The variability of quarterly growth in real output (as measured by its standard deviation) has declined by half since the mid-1980s, and the variability of quarterly inflation has declined by about two thirds (Olivier Blanchard and John Simon 2001). This remarkable decline in the variability of both output and inflation has been dubbed "the Great Moderation." Similar declines in the volatility of output and inflation also occurred in other major industrial countries (except in Japan). In a speech in 2004 by 7

GDP Index the current Fed chairman Ben Bernanke (2004), this Great Moderation has been mainly attributed to the improved monetary policy. And there are studies supporting this view (Summers 2005). In the UK, the reduced volatility in inflation and output is called the Great Stability. There are also studies pointing to good luck as the cause of this Great Stability (Benati and Mumtaz 2006). Low inflation, low nominal interest rate and steady economic growth encouraged credit expansion. 1600 1400 1200 1000 800 600 400 200 0 China's Real GDP Growth (1978=100) 8 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Fig.1 Real GDP growth in China. The GDP in 1978 is used as baseline (=100). Source: State Statistical Burean of China. The 80s also witnessed a rapid development of East Asian Economies. The most notable is the growth of Chinese economy with an annual growth rate of around 10 percent in the past three decades (State Statistical Bureau 2006; World Bank 2008) (Fig.1). The export led economic growth in East Asia, played an important role in reducing the inflationary pressure in the Western economy. In the 1980s and early 1990s before the East Asian financial crisis, many East Asian countries were net capital importers. In 1995-1996, ASEAN countries and Korea ran a collective current account deficit of US$33 billion. After the Asian crisis of 1997, the East Asian countries started to accumulate official foreign exchange reserve and became net capital exporters (Grenville 2007). The net outflow of capital from East Asia went to finance deficits in the

US$ Billion rest of the world, especially the United States, which was running a substantial current account deficit even before the 1997 Asian crisis. China had a large current account surplus before the 1997 Asian crisis and its official foreign exchange reserve kept growing. Savings from China, Japan, Germany and the oil exporting countries created a global savings glut. Those official reserves were mainly invested in the US Treasuries and bonds (Fig.2). Strong demand for US Treasuries and bonds raised their prices and drove down the long-term interest rate. 700 600 500 400 300 200 100 0 Major Foreign Holders of US Treasury Securities Japan China UK Oil Exporters Brasil Luxembour Russia Hongkong Switzerland Germany Norway Taiwan Korea Fig. 2 Major foreign holders of US Treasury securities (August 2008, the US Treasury Department). Japan and China are the largest and second largest holder of US Treasury securities, respectively. Other East Asian countries (including Thailand and Singapore which are shown here) also hold large amount of US Treasury securities. Oil exporters include Ecuador, Venezuela, Indonesia, Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, the United Arab Emirates, Algeria, Gabon, Libya, and Nigeria. The capital flow from countries with large current account surpluses to those with huge current account deficits led to a strong growth in credit on one hand, and a low investment return on the usual financial assets on the other hand. The efforts to achieve a 9

higher return resulted in various financial innovations. These financial innovations are the other factor which contributed to the formation of this current crisis. 2.2 Risk, financial innovations and subprime mortgages Financial innovations played an important role in the current crisis. In this section we will look at the role they have played. 2.2.1 Risk hedging and insurance Uncertainty or risk exists in most financial assets, with risk taking being rewarded with extra expected returns. Riskless assets can only earn the lower riskless return. Pricing an asset is essentially an assessment of its risk. The development of various financial derivatives is primarily intended to spread and control risk. The need to hedge exchange rate risk arose with the end of the Bretton Woods system of fixed exchange rates in 1971. To hedge against adverse change in the exchange rate, a company with costs and revenues in different currencies can buy a future contract which locks the participants to buy or sell currency at the agreed rate. Another instrument is the option, which gives the holder the right rather than obligation to buy or sell. The buyer pays a premium for the right to exercise his option should prices move in a set direction. Another important development in risk management was the swap, in which two counterparties agree to exchange one stream of cash flows against another stream. Prominent in the current crisis is the credit-default swap (CDS), which allows investors to separate the risk of interest-rate movements from the risk that a borrower will not repay. CDSs emerged in the past decade and grew rapidly up to now (Fig.3). When a bank makes a loan or buy a corporate bond, it can insure itself by buying a CDS. The CDS buyer pays a premium (a periodic fixed insurance fee) to the CDS seller in exchange for a payment if the borrower defaults. With CDSs, the default risk is transferred from the lenders to the CDS sellers. Instead of keeping the loans or corporate bonds on the bank s own book and buying CDSs against default risks, the bank can sell them to other investors. Alan Greenspan, the chairman of the Fed from 1987 to 2006, welcomed the growth of CDSs. In his book, The Age of Turbulence (2007), he argued: Being able to profit from the loan transaction but transfer credit risk is a boon to banks and other financial intermediaries which, in order to make an adequate rate of return on equity, 10

US$ Billion have to heavily leverage their balance sheets by accepting deposit obligations and/or incurring debt. A market vehicle for transferring risk away from these highly leveraged loan originators can be critical for economic stability, especially in a global environment. 80,000.00 Growth of the Credit Default Swap (CDS) Amount outstanding 60,000.00 40,000.00 20,000.00-1H01 2H01 1H02 2H02 1H03 2H03 1H04 2H04 1H05 2H05 1H06 2H06 1H07 2H07 1H08 Fig.3 The growth of the credit default swaps (CDSs). Source: ISDA. 2.2.2 Structured financial products and off balance-sheet entities An important feature of the current financial crisis is the prevalence of structured financial products. These structured products are created by forming portfolios of mortgages, loans, corporate bond, and other assets like credit card receivables and then slicing them into different tranches before selling them in the market, a process called securitization. Securitization was undertaken by commercial and investment banks through special purpose vehicles (SPVs), financial entities which were created by banks to collect principal and interest cash flows from the underlying assets and pass them on to the owners of the various tranches. Securitization started in 1970s and its first big market was for American mortgages. Homeowners make their monthly payments, which are collected by the servicing agents and passed on to investors as interest payments on their bonds. Such securitization enables the banks to earn more fees by making more loans to home buyers 11

because the new securities backed by the loans will be sold to investors as bonds and off the banks balance-sheets. The investors buy bonds backed by mortgage payments from a diversified group of homeowners, so that the default risk is spread and reduced. Investors can earn a yield higher than the government bonds. This apparent win-win outcome led to the fast growth of securitization and the emergence of collateralized debt obligations (CDOs), which are the most common form of structured products and asset-backed securities (ABSs). Each CDO consists of a collection of tranches and of an underlying portfolio of debt, such as corporate bonds. The tranches are separated according to their risk level (senior, mezzanine, and junior or equity levels). The safest tranche (often known as the super senior tranche) offers a relatively low interest rate, but is first to be paid out of the cash flows to the SPV. The junior tranches receive higher interest rates, but will be paid after the senior and mezzanine tranches. The owners of the most junior tranche (often referred to as toxic waste ) will be paid only after all other tranches have been paid. In the event of default by a proportion of the borrowers, the junior or equity tranches would be first to incur losses, followed by mezzanine and finally by senior tranches. The super tranches have AAA rating, equivalent to government bonds, and they are protected by third-party insurance (CDS), which improves their ratings. The tranches are separated in such a way that a specific rating is ensured for each tranche. The CDOs can be pooled and resold as CDOs of CDOs, the so-called the CDOs-squared. The CDOssquared can be further repackaged as CDOs-cubed. With interest rates and ample liquidity, demand for structured credit products carrying the AAA rating and earning higher-than-normal yields continued unimpeded until mid-2007 (Kodres 2008). The rating agencies played an important role in the development of structured products. Their ratings tended to underestimate the risk, because those ratings were based a) on historical data of mortgage default and delinquency rates when credit standards were tight; b) on the fact that past housing downturns were regional phenomena, which gives a cross-regional diversification benefit. The assumed low mortgage default rate and low cross-regional correlation of house prices boosted the AAA-rating tranches. The rating agencies collect the highest fees for structured product up front, which may also contribute the favorable ratings received by structured products. 12

The Basel accord (the first version in 1988) established minimum capital standards for banks to address the issue of the mismatch between their assets and liabilities. The assets are usually long-term loans to companies and consumers, which are very illiquid and cannot be called back when the banks need cash. The liabilities are deposits by consumers and investors that can be withdrawn overnight. When depositors worry about the health of a bank, a bank run may cause failure of the bank. The bank run may then spread and lead to a collapse of the financial system. The Basel accord required banks to set aside capital against contingencies such as default of bigger borrowers. The capital required is based on the overall risk of assets. Setting aside capital instead of lending it reduces banks profitability, so that banks try to find ways around the rules. This leads to the popularity of three financial innovations in the current crisis: a) securitization which shifts assets off banks balance-sheets; b) the SPVs and the structured investment vehicles (SIVs) to hold high risk assets; and c) CDSs to reduce the risk of borrowers defaulting. Securitization and SPVs provide several advantages for banks (Gorton and Souleles 2005). Forming portfolios from different types of asset exploits the power of diversification, which reduces risk at least in theory. Tranches with an AAA rating can be created from underlying assets which may be considered too risky for some institutional investors. Slicing the portfolio into different tranches enables the SPV to market different parts of the product to investors with different risk appetites. The tranches are then sold to pension funds, hedge funds, structured investment vehicles (SIVs), and conduits, etc. The SPVs are not under the direct control of their parent banks, and their off balance-sheet status allows them to make use of assets for investment purposes without incurring risks of bankruptcy to the parent organization. SIVs and conduits are off balance-sheet entities created by banks to purchase and hold long-term assets, such as CDOs and mortgage-backed securities (MBSs). They finance their illiquid long-maturity assets by issuing short-maturity paper in the form of asset-backed commercial paper (ABCP). The SIVs are not under direct control of their parent banks, their off balance-sheet status enables them to evade capital control requirements that apply to banks under Basel I capital adequacy rules. Conduits are similar to SIVs, and they are owned by banks. Since the commercial paper market might 13

suddenly dry up, the SIVs and conduits are usually granted a credit line by their parent banks to ensure funding liquidity. 2.2.3 Subprime mortgages The current crisis was triggered by problems in subprime mortgages. In the United States mortgages comprise four categories: 1) Prime (A-paper) mortgages that conform to the industry standards and enable the originator to sell them to government-sponsored enterprises (GSEs). 2) Jumbo mortgages that are standard except they exceed the loan limits set by Fannie Mae and Freddie Mac. The average interest rates on jumbo mortgages are typically greater than the prime mortgages, and vary depending on property types and mortgage amount. 3) Alternative A-paper (Alt-A) mortgages, that do not conform to the standards set by Fannie Mae and Freddie Mac for prime mortgae, but are considered less risky than the subprime mortgages. 4) Subprime mortgages that are considered riskier than the Alt-A mortgages because the borrowers have high perceived risk of default. The low interest rate and low volatility economy provides an ideal environment for the growth of credit. Prime mortgages soon dry up and the financial institutions lending to home buyers need to expand into markets with more risky mortgages. The financial innovations with CDOs and CDSs supply those institutions with the tools for liquidity and risk protection. In the traditional model of mortgage financing, banks and building societies receive deposits from savers and make loans to home buyers. The mortgage payments from borrowers are used for paying the interests on the deposits. If the lenders do not buy insurance for their loans against default, they have to shoulder the default risk. In this originate and hold business model, where the risk lies and who is responsible are clearly defined. The banks and building societies have every incentive to monitor the credit-worthiness of borrowers and the risk involved. The insurance companies selling protection policies also have the incentive to monitor risks in this type of business. Since mortgages are long maturity assets, in the originate and hold business model only 14

institutions with a large depositor base or the GSEs can act as mortgage originators. The amount of loans which they can make is limited by the deposits and their own capital. Securitization enhances the capacity for financial institutions to invest in long maturity assets, which allows almost everyone to become a mortgage broker. CDOs enable banks to transfer the credit risk to the buyers of CDOs. Instead of originate and hold, the new business model becomes originate and distribute, where banks make loans and then sell the structured products to other financial institutions (Brunnermeier 2008). The transfer of credit risk in this business model distances the borrower from the (end) lenders, and leads to two disadvantages in terms of risk control and management. First, it is difficult to know who holds what risk. By selling the structured products to other financial institutions, banks may think that they have got rid of the credit risk. However, the risk may well come back to the issuing bank because the buyers also bought CDSs from the same issuing bank. Banks businesses have become much broader and more complex since the 1986 Big Bang in the UK (the US had introduced a similar reform in 1975 and Japan in 1998). Second, the banks incentives to carefully examine the loan applications and to monitor (and even to collect) the approved loans are drastically reduced because the risk is now mainly borne by other financial institutions (Brunnermeier 2008; Keys et al 2008). Low interest rates and relatively steady economic growth (the Great Moderation) since mid 80s drove up property prices as well as stock prices. Because of cheap credit the demand for properties increased, which drove up house prices. Increasing house prices stimulated further the demand for properties, since potential home buyers worried about further price increases in future and wanted to buy before any further price increases. Such a positive feedback in house price expectations led to a housing boom Fig.4). When prime mortgages dried up, mortgage brokers offered no-documentation mortgages, piggyback mortgages (a combination of two mortgages in order to reduce the down payment in terms of total loans by not making a down payment for the second mortgage), NINJA ( no income, no job or assets ) loans, and adjustable rate mortgages with a low teaser rate to attract borrowers. With increasing house prices, default was not a particular worry for the lenders since they could refinance using the value of the house (which would be higher than the value of the original loan). Between 2003 and 2006, for 15

US$ Billion example, the share of subprime loans made with little or no documentation of income approximately doubled and the share of piggyback loans quadrupled (Anderson 2007). However, house prices could go down as well as up. These subprime mortgages had been granted under the premise that house prices could only rise, making any background check unnecessary. Mortgage Originations for New Home in the US 1600 1400 1200 1000 800 600 400 200 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Fig.4 The growth of mortgage origination for new homes in the US. The volume dramatically increased in 1997 and since. Source: Mortgage Bankers Association. The boom of subprime mortgages is only part of the story with low interest rates and steady economic growth. Because the costs of funding leveraged buyouts are very low, there had been an acquisition spree by private equity funds. The leveraged buyouts targeted value firms, which boosted value stocks. Cheap credit also provided easy finance to the hedge funds. Probably it is worthwhile to point out here that greed is not a specific cause for the current financial crisis. Many people thought that, 1) had banks not been so greedy, they would not have made the subprime loans to vulnerable customers; 2) had individual investors not been so greedy, they would not have suffered the financial losses. Although blaming greediness is popular and resonates with the general public, it lacks a sound 16

logic and economic foundation. Greed, defined in economics as prefer more to less, is the driving force in all economic activities, from the successful wealth creation to the crash of stock markets. The cause of the current crisis is miscalculating and mis-pricing the risks. 2.3 Loose monetary policy The monetary policy of the Federal Reserve led by Alan Greenspan was to prevent a downward swing in stock markets as long as inflation was under control. A term Greenspan put was coined in 1998, which was the perceived attempt of thenchairman of the Federal Reserve Board, Greenspan, of ensuring liquidity in capital markets by lowering interest rates if necessary. In 1998 the Fed lowered interest rates following the collapse of the hedge fund Long Term Capital Management (LTCM). The effect of this rate reduction was that investors borrowed funds more cheaply to invest in the securities market, thereby averting a potential downswing in the markets. A put option written on the underlying asset you hold will protect the downward price change risk. Since1997 the Fed has shown a great willingness to cut interest rate in order to avert the downward pressure in the stock market. Boeri and Guiso (2008) argued that, without the monetary policy of low interest rates of the Federal Reserve led by Greenspan, the crisis probably would have never occurred. The Fed introduced low interest rates in response to the post-9/11 recession and the collapse of the internet bubble in 2001. Greenspan s monetary policy injected an enormous amount of liquidity into the global monetary system. This reduced short-term interest rates to 1%, their lowest level in 50 years. Interest rates were maintained at levels significantly below equilibrium for the next two years. Low interest rates for a long time leads to low returns on traditional investments, which pushed investors and lenders to take bigger risks to get better returns. The monetary policy of low interest rates by Greenspan and the Fed depended on the savings from countries with large current account surpluses. The official reserves of those countries are mainly invested in US Treasuries and bonds, which created the conditions for the Fed to follow a low interest rate policy. Had there not been the global savings glut, the capacity for the Fed to maintain a low interest rate policy would have been constrained. The current financial crisis is the combined consequence of several 17

factors: a global savings glut, financial innovation and the loose monetary policy of the US Federal Reserve. Boeri and Guiso (2008) also identified the low financial literacy of consumers and investors as one factor. The bubble in the housing market may not be blamed solely on the financial sector. Home ownership has been encouraged by the US and UK governments, whereas countries in the continental Europe such as Germany and France have much lower proportions of households owning their home. In the US, the Community Reinvestment Act of 1977 and other government measures required banks to meet the credit needs of the entire community, which in essence meant more lending to poor people. Fannie Mae and Freddie Mac were also encouraged to guarantee a wider range of loans in the 1990s. More buyers meant higher prices, making loans even less affordable to the poor in a conventional way. Innovative mortgages which depend on continuing increase of house prices provide the solution for lending to the poor, boosting the demand for properties further. Before the 90s, property prices sometimes misaligned with the general price level of commodities, but rarely anything like in the past 10 years. In countries like UK and US, house prices doubled in a few years, the consumer price index increased only a little. In the 1970s and 1980s, central banks would use the interest rate brake when property prices increased together with commodity prices to prevent inflation. Technological change in the 1990s, and the imports from Asian countries kept headline inflation down, which made deflating the property bubble politically unpopular. It may have been easier for Paul Volker to increase the interest rate and induce a severe recession to fight inflation after a long period of high inflation than for Alan Greenspan to increase the interest rate and induce a severe recession to deflate a property bubble when inflation was low and everyone seemed to be benefiting from the bubble. 3. Impact on the economy We can consider the impact of the current crisis on the global economy from two aspects: the impact of the crisis per se on the economy and the impact of the rescue measures on the economy. Since these aspects are closely interconnected, the impact of the crisis per se may be more hypothetical. 3.1 Impact of the current crisis 18

The manifestation of the current financial crisis so far comprises the following phenomena: a) losses of financial institutions due to default of subprime mortgages, b) liquidity crunch due to lack of trust between banks (information asymmetry between borrowers and lenders), c) reluctance of banks to make loans to manufacturers and consumers due to liquidity crunch, and d) consumers lack of confidence in the economy. These phenomena have different implications for the economy. The default of subprime mortgages should be viewed as the natural consequence of the excess previously in the financial sector. A booming global economy will inevitably lead to higher prices of commodities and higher inflationary pressure. To avoid an increasing inflation spiral, interest rates need to be increased eventually. An increasing interest rate will inhibit the upward trend in house prices. Since the viability of subprime mortgages depends on increasing house prices, default is inevitable when house prices stop increasing. The choices before central bankers are between the eventual deflation of the property bubble and an increasing inflation spiral. The interest rate tool can be used to maintain a property bubble at most up to zero nominal interest rate. The price of real estate in longer term has to be in line with the price level of goods and services. The longer and larger the misalignment is, the more adjustment (a drop in house prices) will be needed. This is what has happened in the current crisis. The default of subprime mortgages brought about losses and sometimes defaults of financial institutions that invest in the subprime mortgages. Banks with money to lend worried that the borrowing banks may not repay their debts and became reluctant to lend to other banks. The interbank money market froze up. This is what the term credit crunch means: banks cut the loan supply due to the shortage of financial capital and declining quality of borrowers financial health (Bernanke and Lown 1991; Clair and Tucker 1993). This credit crunch has led to failures of some banks which financed their illiquid long maturity investment with short-maturity. Financial institutions, especially hedge funds and investment banks, have felt the impact of the crisis most conspicuously so far. Concerns about potential huge losses of banks led to a sharp drop in the price of bank shares, making it difficult for banks to raise capital by selling new equity. Concerns about the solvency of banks made it difficult for the banks to raise capital by selling bonds or 19

asset-backed commercial papers. The market for structured products disappeared, since most institutions want to relieve themselves of these toxic assets and there is no buyer. Once an institution is viewed as weak, customers will withdraw their money and flee, and then the failure of the perceived weak bank will become almost self-fulfilling. Bear Stearns and Lehman Brothers were viewed as weak before their failure, so that they could not raise capital and speculators shorted their shares. Whether the credit crunch would really lead to a meltdown of the financial system is a question with no definite answer, because the credit crunch was not left to run its own course. The intervention by central banks and governments may have averted a meltdown if there was really going to be one. We do not know this for certain. The fear that the bankruptcy of AIG would lead to the meltdown of the entire financial system spurred the US government into action with first a US$ 85 billion rescue package for AIG, and then US$ 700 billion for the financial system. Even before the government intervention after the bankruptcy of Lehman Brothers, the central banks had pumped liquidity into the market. With the intervention of central banks and governments, the impact of the current crisis on the economy is no longer the effect of the crisis per se. Rather, it is the combined effects of the crisis and the intervention measures. The reluctance or inability of banks to make loans to business affects the real economy. Since many businesses rely on bank credit for cash flow in their operations, the scarcity of credit will cause difficulties in running their business. Aware that credit is drying up, firms strive to raise cash by reducing inventories, trimming investment and jobs. Because of the decrease in house prices, many households have homes worth less than their mortgages. Such households must save hard to reduce their debts, leading to lower consumption. Even households, whose homes are worth more than their mortgages, may also increase their savings due to concerns about their jobs and incomes. All saving efforts will reduce consumption and production, which in turn may cause recession. OECD s composite leading indicators released in October 2008 suggest a strong slowdown in Europe and the US, and a downturn in East Asia (OECD 2008). 3.2 Impact of the Rescue measures The rescue measures implemented by governments might have averted the perceived immediate breakdown of the financial system. Its impact, especially its long- 20

term impact, on the economy is not immediately clear. One hypothetical question is, what would really happen if the central banks did not provide the liquidity and the government did not come to the rescue of the banks. Would there really be a complete meltdown of the entire financial system? Since the central banks and governments came to the rescue of the banks, there cannot be a definite answer to this hypothetical question. Huge amounts of money were promised by governments, which will keep banks afloat for the time being. Britain announced a rescue plan amounting 500 billion for the ailing banking sector and committed 37 billion (US$64 billion) to buy a stake in banks on 13 October to recapitalize them. Euro-area leaders committed themselves to the same potent mix of debt guarantees and recapitalisation that Britain had unveiled. Germany has set up a 500 billion ($680 billion) stabilisation fund; France has pledged 360 billion; the Netherlands 200 billion. Initially the US government intended to only buy the toxic assets at fair prices instead of market prices from the banks with the US$ 700 billion rescue plan. Following the move of the European countries, the American government announced plans to invest $250 billion of taxpayers money into its banks, half of that into the nine large banks and the other half for smaller banks. It also extended a sovereign guarantee for new bank debt and once again expanded the terms of its deposit guarantees. Central banks are more ready to make loans to banks than ever before. On October 15th the Federal Reserve, the European Central Bank and the Swiss National Bank made available unlimited dollar loans. The Bank of Japan plans to offer unlimited dollar funds from October 21st. Other Asian governments also put measures in place to shore up confidence. With all those rescue packages, the risk that banks will be unable to roll over their short-term funding has receded, since governments are, in effect, acting as counterparties now. Credit-default swap (CDS) spreads on banks, a measure of their risk of bankruptcy, decreased substantially. However, the banking sector may not be ready to return to normal yet. First, banks in the US and the UK still have the toxic assets; how those toxic assets in the US will be bought by the government is still unclear. Setting the fair price too low may not help the banks. Second, governments debt guarantees are not free for the banks and many of them are expensive. There are good reasons for the charges: the banks might take on too many debts if the guarantees had been free, and the taxpayers 21

had to foot the bill should the banks default. Third, capital ratios in American and British banks with money injected by government may become a new benchmark for banks elsewhere, which they have to raise new capital to match. The guarantee for new bank debt and savings offered by governments cannot be maintained forever. The guarantee will encourage risk taking by banks and savers, providing an environment for moral hazard. Knowing that government will foot the bill for defaulted loans, the banks have less incentive to be prudent in making loans. Similarly, savers will have less incentive to search for a prudent bank when governments guarantees for unlimited savings. Therefore, the government guarantees for unlimited amount of savings and new bank debt might induce more risk taking behaviours by both banks and consumers due to moral hazard. Such an emergence or increases in the government guarantee would lead to another bubble in financial market. It seems unlikely that the measures taken by the central banks and government will prevent a recession. The US economy, which has been slowing down since 2006, shrank 0.3% in the third quarter (July September). The British economy shrank 0.5% in the third quarter. Across the globe, falling asset prices, tighter credit and declining confidence will make firms and consumers unable or unwilling to consume or invest. A decrease in consumption will inevitably lead to a recession. Therefore, the measures taken by central banks and governments so far are, in the short term, probably just sufficient to keep the financial sector afloat, and not enough to prevent a recession. It is always difficult to judge whether rescue measures are really necessary, because decisions have to be made before the crisis has run its course and every crisis can be different from all others. The long term effect of the rescue measures, however, depends on whether the rescue measures were really necessary. The current crisis has been partly blamed on the Federal Reserve cutting the interest rate and maintaining it at low levels for too long in 2001 after the burst of the internet bubble and the 9/11 event. The current crisis seems more severe and warrants a drastic cut in interest rates. Low interest rates may boost consumption and investment, but is unlikely to be sufficient. After the collapse of Japanese stock and property markets, the Bank of Japan cut the interest rate to near zero, which did not restore the confidence of consumers or firms. 22

Arguably, the Bank of Japan did not act as promptly as the Federal Reserve, European Central Bank and Bank of England. The rescue measures by governments are different from those by the central banks. The central banks lend the more liquid government bonds to the banks, with less liquid asset-backed securities from the banks as collateral, which do not increase government debt. The rescue measures by governments need to be financed by the government debt. Raising government rescue funds by debt may reduce the capital available for nongovernment borrowing, crowding out private investment. The rescue plans announced are substantial amounts, if they cannot be raised in the money market, government bonds will have to be underwritten by the central banks, which will increase money supply. If the current crisis is as severe as people perceived, an increase in money supply and an extremely low interest rate will not cause inflation. If the current crisis is not as severe as people feared, it bodes another bubble in the financial market or higher inflation in future. If what happened after the collapse of the Japanese stock and property markets is any guide for the current crisis, the current crisis might last a very long time. With low consumer confidence, low interest rates are unable to increase consumption demand. Fiscal stimulus is likely to be used by governments. Cutting taxes puts extra cash straight into people s pockets. Increasing government spending directly can directly boost demand and employment. Fiscal stimulus increases short-term government deficits, but the fiscal damage from a prolonged slump would be greater, and the risk of crowding out private investment would be small because investors are unwilling to buy anything other than government bonds in this uncertain time. However, the fiscal stimulus by the Japanese government (yen 120 trillion in several times) also failed to turn the economy around. It is easier for major western countries, especially the US, to raise money for a fiscal stimulus. That is because dollars and Treasuries are considered safe havens by international investors Even if government bonds have to be underwritten by the Federal Reserve, the consequent increase in money supply and possible inflation will reduce foreign claims on American assets. Many governments in emerging markets, especially those with big external deficits will have difficulties in raising funds by government debts 23