The Financial Crisis of 2007-201? Gerald P. Dwyer Federal Reserve Bank of Atlanta University of Carlos III, Madrid
Disclaimer These views are mine and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System.
How To Interpret Recent Events? Financial Crisis of 2007-2008 Private Banking and Debt Crisis Sovereign Debt Crisis of 2009-201?
LIBOR less OIS - 30 days January 1, 2006 to May 16, 2012 350 300 Run on money market funds 250 200 September 16, 2008 150 End of year 100 50 Northern Rock August 9. 2007 0 1/1/06 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
2500 European CDS Spreads January 2, 2006 to May 16, 2012 Greece agreement Ireland agreement Portugal agreement Greece agreement Greece Basis points 2000 1500 1000 Germany Spain Portugal Italy Ireland United Kingdom Greece (on right-hand axis) 25000 20000 15000 10000 500 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 1/1/2012 0 Source: Datastream, Bloomberg
Summary of Developments Private Debt Crisis of 2007-2008 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?
Housing Price Indices January 2000 to February 2012 220 200 Case Shiller Index 180 160 FHFA Index 140 120 100 80 1/1/00 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
U.S. Delinquencies by Loan Type First Quarter 2002 to First Quarter 2012 35 30 Subprime ARM 25 Subprime FRM 20 15 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
Billions $ US Mortgage Originations by Type 2001 through 2009 4,500 4,000 3,500 3,000 2,500 Home Equity Lines Alt A Subprime Prime Jumbo Conventional FHA/VA 2,000 1,500 1,000 500 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: Inside Mortgage Finance
Size of Global Financial Markets Source: Dwyer and Tkac, JIMF, December 2009
Story A tiny part of securities markets put asset markets around the world in a state of turmoil How can that be?
06-1 vintage ABX Indices by Vintage 06-2 Vintage 100.0 100.0 80.0 80.0 60.0 60.0 40.0 20.0 40.0 20.0 100.0-1/2/06 1/2/08 1/2/10 1/2/12 07-1 Vintage AAA AA A BBB BBB- - 1/2/06 1/2/08 1/2/10 1/2/12 100.0 07-2 Vintage 80.0 80.0 60.0 60.0 40.0 40.0 20.0 20.0-1/2/06 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
Three Securities Instead of One AAA rated RMBS Residential Mortgages BBB- RMBS Equity RMBS
Three Securities Instead of One AAA rated RMBS Subprime Mortgages BBB- RMBS Equity RMBS
CDOs from Tranches AAA rated CDO BBB tranches of RMBS BBB- CDO Equity CDO
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
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
200 Global Issuance of Collateralized Debt Obligations First Quarter 2005 tothird Quarter 2009 180 160 140 Other CDOs CDOs of ABS CLOs 120 100 80 60 40 20 0 Source: SIFMA 2005 2006 2007 2008 2009 Source: SIFMA
Billions $ Global Issuance of Collateralized Debt Obligations First Quarter 2005 to First Quarter 2012 200 180 160 140 120 100 80 Other Tranches High Yield Loans High Yield Bonds Investment Grade Bonds 60 40 20 0 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 Q1 2005 2006 2007 2008 2009 2010 2012 Source: SIFMA
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
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
Global Financial Crisis? Other countries Iceland Ireland United Kingdom Spain
Global Financial Crisis? Other countries Iceland Ireland United Kingdom Spain Not really global Australia Canada Japan Korea
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
Housing Prices 300.0 United States 300.0 Ireland 250.0 250.0 200.0 200.0 150.0 150.0 100.0 1/2000 1/2002 1/2004 1/2006 1/2008 1/2010 100.0 2000 2002 2004 2006 2008 2010 Spain U.K. 300.0 300.0 250.0 250.0 200.0 200.0 150.0 150.0 100.0 2000 2002 2004 2006 2008 2010 100.0 1/2000 1/2002 1/2004 1/2006 1/2008 1/2010
Housing Prices 300.0 250.0 United States 300.0 Canada 250.0 200.0 200.0 150.0 150.0 100.0 1/2000 1/2002 1/2004 1/2006 1/2008 1/2010 100.0 1/2000 1/2002 1/2004 1/2006 1/2008 1/2010 300.0 Australia 250.0 200.0 150.0 100.0 2000 2002 2004 2006 2008 2010
ICEXI Icelandic Stock Price Index December 4, 2001 to November 29, 2011 9,100 8,100 7,100 6,100 5,100 4,100 3,100 2,100 1,100 100 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
Run on Northern Rock Source: http://www.wealthbuildinglessons.com
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
The Great Moderation: U.S. Unemployment Rate January 1948 to April 2012 12 10 8 8.1 6 4 2 0 1/1/48 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
A Quest for Stability Source: http://img2.travelblog.org/photos2/
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
Financial Regulation My Thoughts Make financial system more resilient Don t try to avoid what will happen anyway
LIBOR less OIS - 30 days January 1, 2006 to May 16, 2012 350 300 Run on money market funds 250 200 September 16, 2008 150 End of year 100 50 Northern Rock August 9. 2007 0 1/1/06 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
2500 European CDS Spreads January 2, 2007 to May 16, 2012 Greece agreement Ireland agreement Portugal agreement Greece agreement Greece Basis points 2000 1500 1000 Germany Spain Portugal Italy Ireland United Kingdom Greece (on right-hand axis) 25000 20000 15000 10000 500 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 1/1/2012 0 Source: Datastream, Bloomberg
6000 European Bond Spreads Basis points, 10-year bond spread to German bonds January 2, 2010 to May 16, 2012 Greece 5000 4000 3000 Spain Portugal Ireland Italy UK United States Greece Ireland Portugal Spain Italy 2000 1000 0 1/2/10 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
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 489 530 billion billion LTRO LTRO Negative Euro area PMI report 500 ECB announced reboot of Securities Market Program 400 300 200 100 0 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, 2012 37
Ratio of Debt to Gross Domestic Product 2003 to 2011 180.00 160.00 140.00 120.00 100.00 80.00 60.00 United States Germany France Spain Greece Iceland Ireland portugal Italy 40.00 20.00 0.00 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: CIA World Factbook, estimates 38
180.00 Debt to GDP Ratios and Government Deficits December 31, 2011 160.00 140.00 Public Debt to GDP Deficit to GDP 120.00 100.00 Percent 80.00 60.00 40.00 20.00 0.00 Greece Iceland Italy Ireland Portugal France Germany Spain United States Source: CIA World Factbook, estimates 39
5.0 Debt Relative to Government Revenue 2011 4.5 4.0 Years to Pay off Debt if used 100% of Revenue 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Greece Iceland Italy Ireland Portugal France Germany Spain United States Source: CIA World Factbook, estimates 40
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
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
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
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.
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
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
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
U.S. Debt Held by the Public as a Percentage of U.S. GDP 200 180 160 CBO 2010 Alt % of GDP 140 120 100 80 60 40 20 2012 Budget CBO 2011 Baseline CBO 2010 Baseline 0 1940 1950 1960 1970 1980 1990 2000 2010 2020 2030 Source: Private Enterprise Research Center, Texas A&M University
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
Eurozone Banking Crisis? Banks hold substantial amounts of government debt
Different Monies
United States Different Monies Greece
Inflation
Source: www.wtf.si Eurozone Choices
Good Choice for Greece? Default and leave eurozone Don t default
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
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
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