The Subprime and the Euro Debt Crises
Carlo Favero
Dept of Finance, Bocconi University
December, 2015
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 1 / 62
The Ingredients
cycle vs trend
monetary policy and �scal policy
Zero Lower Bound, Quantitative Easing, Large Scale Asset PurchasingProgramme, interest rate pathbalance sheet of a central bankLong Term Bonds and policy ratesspreadsausterity
banks
balance sheet of a bankleverage, repos, CDO and CDS
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 2 / 62
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 3 / 62
The Big Picture
0
1
2
3
4
5
6
7
15
10
5
0
5
10
15
20
30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05 10
BAAAAA spread Annual GDP Growth
NBER contractions shaded
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 4 / 62
The dimension of the crisis
The worst crisis in the postwar era. Global GDP contraction and risein unemployment
Contraction in Consumption and Investment, drop in Consumers�Con�dence
Global stock market collapse
Huge drop in wealth
Fluctuations in risk premia and euro area sovereign bond spreads
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 5 / 62
GDP Growth and Unemployment
.050
.025
.000
.025
.050
.075
.100
.125
.150
50 55 60 65 70 75 80 85 90 95 00 05 10
Euro area annual GDP GrowthUS annual GDP Growth
NBER contractions shaded
2
4
6
8
10
12
14
50 55 60 65 70 75 80 85 90 95 00 05 10
US Unemployment RateEA Unemployment Rate
NBER contractions shaded
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 6 / 62
Consumption and Investment
.04
.02
.00
.02
.04
.06
.08
.10
.12
50 55 60 65 70 75 80 85 90 95 00 05 10
Euro area annual Consumption GrowthUS annual Consumption Growth
NBER contractions shaded
.4
.2
.0
.2
.4
.6
.8
50 55 60 65 70 75 80 85 90 95 00 05 10
Euro area annual INV GrowthUS annual INV Growth
NBER contractions shaded
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 7 / 62
Consumer Con�dence
60
70
80
90
100
110
120
50
60
70
80
90
100
110
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Euro Sentiment Indicator (EU Commission)US Univ of Mich. Consumer Sentiment
NBER contractions shaded
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 8 / 62
Households Wealth
2.8
3.2
3.6
4.0
4.4
4.8
50 55 60 65 70 75 80 85 90 95 00 05 10
US household wealth as a ratio of GDP
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 9 / 62
The Stock Market and In�ation
0
200
400
600
800
1,000
1,200
1975 1980 1985 1990 1995 2000 2005 2010
US Stock Market IndexEU Stock Market Index
NBER contractions shaded
.04
.00
.04
.08
.12
.16
1975 1980 1985 1990 1995 2000 2005 2010
US CPI InflationEU CPI Inflation
NBER contractions shaded
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 10 / 62
Sovereign Bonds
0
2
4
6
8
10
90 92 94 96 98 00 02 04 06 08 10 12 1410Y Bond Yield Germany10Y Bond Yield US
Yields
2
0
2
4
6
8
10
12
14
90 92 94 96 98 00 02 04 06 08 10 12 14
ItalySpainFrancePortugalIreland
Spreads between Government Bond and Bund
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 11 / 62
The Initial Conditions
The great moderation:low volatility of in�ation and growth
monetary policy and the conundrum
low risk aversion and restored con�dence
house price bubble and the "Greenspan put"
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 12 / 62
The Great Moderation
.050
.025
.000
.025
.050
.075
.100
.125
.150
1975 1980 1985 1990 1995 2000 2005 2010
US GDP Growth US CPI Inflation
The Great Moderation
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 13 / 62
Monetary Policy and the Conundrum
0
2
4
6
8
10
12
14
16
82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14
Fed Funds RateUS Government Bonds 10Y rate
Monetary Policy and the Conundrum
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 14 / 62
Low Risk Aversion and Restored Con�dence
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
50
60
70
80
90
100
110
120
82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14
Spread BaaAaaConsumer Confidence
Low Risk Aversion
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 15 / 62
The House Price bubble and the "Greenspan put"
0
400
800
1,200
1,600
2,000
2,400
100
120
140
160
180
200
220
82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14
S&P stock market index (at 2011 CPI prices)CaseShiller House Prices (at constant prices)
The Stock Market and the House Market
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 16 / 62
The Initial Shock
In 2006, following the increase in monetary policy rates between 2004and 2006, house prices started to fall.
Between 2006 and 2008 house prices fell 20 per cent
this is not a huge shock. The collapse in houseprices caused losses inthe mortage and especialy in the subprime mortgage market. Theselosses can be estimated in around 650 billions USD, equivalent to adrop of 4 percent in the S&P index.In October 1987 the S&P index fell by 20 per cent in one-month,but this shock has not sparked neither a �nancial crisis nor a recession
the peculiarity of the subprime crisis is not in the initial shock but inthe transmission mechanism
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 17 / 62
The Initial Shock
0
1
2
3
4
5
6
7
.15
.10
.05
.00
.05
.10
.15
.20
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Fedfunds rateCaseShiller House Prices Inflation
The Initial shock
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 18 / 62
The Transmission Mechanism
Liquidity and Leverage. Procyclical leverage as the key in thetransmission mechanism
CDO and CDS. The link between procyclical leverage and the housingmarket
A Black Swan in the money market. The e¤ects of the lack of trust inthe REPO market.
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 19 / 62
Liquidity and Leverage (Adrian and Shin,2007)
Passive Investor Active Investor
time Assets Liabilities Assets Liabilities
0 House, 10 Mortgage, 9 House, 10 Mortgage, 9Equity, 1 Equity, 1
Leverage 10 10
1 House price goes up 1 per centHouse, 10.1 Mortgage,9 House 10.1 Mortgage,9
Equity 1.1 Trading Ass,1 Debt 1Equity 1.1
Leverage 9.2 10.1
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 20 / 62
Liquidity and Leverage (Adrian and Shin,2007)
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 21 / 62
The balance sheet of an investment bank
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 22 / 62
Procyclical leverage and the transmission mechanism
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 23 / 62
CDO and CDS
Collateralized debt obligations are the instruments to transformmortgages into securities that are considered safer and can be used ascollateral in repo�s
Credit Default Swap can provide insurance against the worst casescenarios
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 24 / 62
Collateralized Debt Obligations
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 25 / 62
The Mechanism
So long as house prices increases CDOs are easy to re�nance andestimation of default risk is unimportant
they can be used as collateral in REPO and allow to expand banksbalance sheet
if a SIV is used to redistribute risky subprime mortgages are notanymore in banks balance sheet (and the incentive to monitordisappears)
but when houseprices start collapsing the whole construction falls anda black swan in the money market appears
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 26 / 62
A Black Swan in the money market
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
4.0
4.2
4.4
4.6
4.8
5.0
5.2
5.4
5.6
I II III IV I II III IV2006 2007
3month LIBOROIS spreadAverage Expected Fed Fund rate over the next 3 month
The 3month LIBOROIS spread
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 27 / 62
The explosion of the crisis
Early 2007 Spreading Subprime WorriesSummer 2007 Disruptions in Funding
Late 2007 to Early 2008 Billions in Subprime LossesMarch 2008 The Fall of Bear Stearns
March to August 2008 Systemic Risk ConcernsSeptember 2008 Conservatorship of Fannie Mae and Freddie Mac
Bankruptcy of LehmanBailout of AIG
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 28 / 62
The Policy Interventions
Expansionary Monetary Policy: Conventional (but policy rates hit thezero bound) and unconventional
Expansionary Fiscal Policy:
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 29 / 62
Monetary Policy Interventions
Extending Liquidity Provision: Term Auction Facilities,TermSecurities Lending facility (reduce the discount window stigma by makingthe money available to all banks at once through a regular auction)
Asset Repurchases: TARP 1
Recapitalization: TARP Equity Plan
The �rst two meausures create a buyer for bad assets, which is not enoughif banks do not have capital
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 30 / 62
Monetary Policy Interventions
TAF and TARP 1 do not work, but TARP Equity Plan has an importante¤ect on the market
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 31 / 62
The Fed Balance Sheet:Assets
Federal Reserve Assets(in billions of dollars)
4 July 07 26 Nov 08
Securities Held Outright Uncommitted Committed to TSLF Repurchase AgreementsLoans Primary Credit Term Auction Credit Primary Dealer Credit Portfolio of Maiden Lane LLC†
Portfolio of Maiden Lane III LLC++
ABCP Money Market Liquidity Facility Credit to American International Group Other credit extensionsCommercial Paper Funding Facility
Foreign Exchange Reserves+
FX Swaps
Gold*
Other assetsTotal Assets
$790.6
$ 30.3
$ 0.19
$ 20.8
$ 11.0$27.5
$880.4
$295.4$193.2$ 80.0
$ 91.7$406.5
$57.9$27.0$21.1$53.3$55.9$0.0
$294.1
$24.8$476.7‡
$ 11.0$ 20.5
$2,109.1
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 32 / 62
The Fed Balance Sheet:Liabilities
Federal Reserve Liabilities(in billions of dollars)
4 July 07 26 Nov 08
Federal Reserve Notes
Commercial Bank Reserve Balances
Reverse Repos w/ Dealers
U.S. Treasury Supplementary Financing Account
Liabilities related to Foreign Official and US Treasury Deposits
Other Liabilities
Total Liabilities
Capital
$781.4
$ 16.8
$ 42.4
$ 5.7
$846.3
$ 34.1
$835.1
$582.7
$25.0
$479.1
$136.8
$5.8
$2,065.5
$49.4
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 33 / 62
Expansionary Fiscal Policy in the US
.2
.3
.4
.5
.6
.7
.8
.9
.04
.02
.00
.02
.04
.06
.08
.10
50 55 60 65 70 75 80 85 90 95 00 05 10
debt/GDP ratio deficit/GDP ratio
Fiscal Policy in the US
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 34 / 62
Expansionary Fiscal Policy in Europe
4
0
4
8
12
16
2000 2002 2004 2006 2008 2010 2012 2014
Deficit/GDP in Europe
0
40
80
120
160
200
2000 2002 2004 2006 2008 2010 2012 2014
ItalySpainFrancePortugalIrelandGreeceGermany
Debt/GDP in Europe
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 35 / 62
Spreads:local versus international factors
10
0
10
20
30
40
2000 2002 2004 2006 2008 2010 2012 2014
ItalySpainFrancePortugalIrelandGreece
10Y Bonds Spread on Bund
0.5
1.0
1.5
2.0
2.5
3.0
3.5
2000 2002 2004 2006 2008 2010 2012 2014
BAAAAASpread
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 36 / 62
Same fundamentals di¤erent yields
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 37 / 62
Same fundamentals di¤erent yields
�R it ,t+k � R
gert ,t+k
�= ∆et ,t+k + RP it ,t+k
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 38 / 62
The mechanism(The Euro-nomics group)
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 39 / 62
Unconventional Monetary Policy in the Euro Zone
Substantial increases in size of central bank balance sheet
Buy medium and long term public debt and private assets
Lower long-term interest rates
Channels of in�uence
Shift markets�stocks of assets of di¤erent maturities and risksFewer long-term assets, more liquidity, bank depositsInduce shift into equities, long-term public and corporate bondsHigher equity stock prices, stimulate investmentLower exchange rateStimulate bank lendingRaise expected future in�ation and create expectations that CBs willhold policy interest rates lower for longer
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 40 / 62
ECB QE Scheme
Plans to buy e1.1 tn �at a rate of e60 bn per month until sept 2016�e850 bn of public debt plus private sector assets � started March2015
Will not buy if yields fall below -0.2%
ceiling set at current yield paid by ECB on bank reserves
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 41 / 62
The transmission mechanism of monetary policy
Monetary policy controls directly short-term rates but it a¤ects theeconomy through long-term rates.
Long terms rates are determined by two factors the average (future)short term-rate until maturity of the bond and the term premium
In normal times the expectations channel dominates the termpremium
The crisis has changed this by inducing a negative term premium inthe US and a positive and heterogenous term-premium in Euro area
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 42 / 62
The negative term premium in the US
LSAPs in�uence interest rates via supply-and-demand e¤ects in thelong-term bond market.
As the Fed buys more long-term bonds, their price goes up, and theiryield falls, even if expectations of future short rates are unchanged.Said di¤erently, the so-called term premium on long-term bondsdeclines.
As a matter of fact LSAP have induced a negative risk premium
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 43 / 62
The negative term premium in the US
When policy works by moving term premiums, as opposed to movingexpectations about the path of short rates, the transmission to thereal economy may be altered
A risk-neutral �rm faces a rate on its 10-year bonds of 2 percent. Atthe same time, it expects that the sequence of rolled-over short-termrates over the next 10 years will average 3 percent. Hence, there is aterm premium of minus 1 percent.
The �rm should take advantage of the cheap long-term debt byissuing bonds.
It can take the proceeds of the bond issue and use these to pay downshort-term debt, repurchase stock, or buy short-term securities.
These capital-structure adjustments all yield an e¤ective return of 3percent.
the hurdle rate for new investment remains pinned at 3 percent
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 44 / 62
The term premium in Europe
In Europe the debt crisis has induced positive term premiaheterogenous across countries.
The same monetary policy is associated to very di¤erent long-termrates, these rates are higher in countries with a more di¢ cult �scalsituation, which are countries where the stimulus is most needed
The same monetary policy impacts di¤erently on consumption andinvestment in the euro area because �scal fundamentals a¤ect thetransmission of monetary policy
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 45 / 62
QE in Europe
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 46 / 62
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 47 / 62
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 48 / 62
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 49 / 62
Italy and the Euro
Low growth, high unemployment (especially youth unemployment)remarkable asymmetry in the distribution of private wealth and highpublic debt. This is Italy in 2014.
All these problems have not been caused by the euroLet us go back to 1973. The Bretton Woods system (the peg of allexchange rates to the dollar is abandoned because Non-US countriesare tired of �nancing US twin de�cits: a �exible exchange rate systemis introduced)
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 50 / 62
Two Economic Regimes (up to 1991)
in�ation regime: use in�ation to promote growth
stability regime: use price stability to promote growth
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 51 / 62
The in�ation regime
In�ation Regime features: strong trade-unions, weak governments andnon-independent central banks
trade unions put pressure, on private and government owned �rms, toincrease wages (strikes are the intruments).Weak Government increases wages and employment in the publicsector increasing the de�cit as taxation is untouched.higher public sector wages put pressure also on private sector �rms,public contracts are used to subsidized them.market might react asking higher interest rates to �nance the debt, thegovernment puts then pressure on the central and to roll the printingpress and buy government bonds. Then we have in�ation and tradede�cit and loss of competitiveness. The solution is competitivedevaluation of exchange rates. But exchange rate devaluation slashesthe value of the initial wage increase, and we are back to square 1.
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 52 / 62
The stability regime
Stability Regime features: independent trade-unions, governmentsand central banks with diversi�ed competences
trade unions organize strikes for economic and not for political reasonsindependent central banks prevents goverment from in�ating the debtawaywage growth re�ects productivity growth, stable prices. Stabilitystimulates investment and growth
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 53 / 62
Di¤erences across the two regime
Regime 1: high in�ation, possible same growth with regime 2, but highpublic debt and social security debt, asymmetric increase in private wealth(because the redistributive e¤ect of taxation does not take place)
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 54 / 62
The Data: Growth
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 55 / 62
The Data: Government Taxation and Expenditure
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 56 / 62
The Data: Private Wealth
Private Net (of private and public debt) Wealth GDP ratio is almost6 times GDP. 6 trillions housing, 1.2 trillion cash and deposits, 1.8shares and investment funds
The richest 10 per cent of the population holds 40 per cent of totalwealth
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 57 / 62
The Data: Nominal E¤ective Exchange Rate
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 58 / 62
After Bretton Woods collapse Germany Austria and Benelux adoptmodel 2, France Italy Spain Protugal and Greece model 1.
not an equilibrium. Speculative attacks and competitive devaluation(particularly damaging (e¤ective) in the agricultural sectors
single surrency is the solution. Convergence criteria are setu up in1991 and currency starts in 1999.
unfortunately in 1999 the convergence process is still far fromcompletion
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 59 / 62
Initally no problem because of a convergence enthusiasm sustained by thegreat moderation,instituional reasons help convergence( all thegovernment bonds in the euro area have a zero risk weights to computebanks capital requirements). Capital �ows towards peripheral countriesthat generates higher in�ation and loss of competitiveness (no morecompetitive devaluation)
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 60 / 62
the US subprime crises puts a sudden stop to capital �ows, the debtcrisis follows, only BCE intervention prevents the system fromcollapsing.
persistent growth di¤erentials between the core and the peripheryemerge
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 61 / 62
Two alternatives
default and euro exit (no problem solved back to the old regime 1)
mobilize private wealth to promote growth
Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 62 / 62