2008 MACROFINANCECRASH

Explanations & Questions

Stock Crashes in 20th and 21rst Centuries

Time Frame DJIA Change (Real) Length

1907-08 -40% 13 months

1919-20 -46% 15 months

1929-33 -83% 43 months

1937-38 -49% 15 months

1946-48 -35% 21 months

1973-75 -51% 25 months

1978-82 -37% 48 months

1987-88 -28% 5 months

2000-01 -18% 16 months

2007-09 -53% 16 months…

U.S. Stock Crashes and Macroeconomic Events

Time FrameStock Market Change (DIJA) Length

GDP Change (Real)

Stock Change/ GDP Change

Highest Unemp. Rate

1907-08 -40% 13 months -5% 8 8.00%

1919-20 -46% 15 months -23% 2 11.30%

1929-33 -83% 43 months -29% 3 25.20%

1937-38 -49% 15 months -7% 7 19.10%

1946-48 -35% 21 months -5% 7 4.00%

1973-75 -51% 25 months -5% 10 9.00%

1978-82 -37% 48 months -7% 5 10.80%

1987-88 -28% 5 months >0% NA 5.80%

2000-01 -18% 16 months -1% 18 6.10%

2007-2009 -53% 16 months -4% 13 10.10%

Can Financial Events CauseMacroeconomic Problems?

“Payments crises” (liquidity crises) Debtors (first level) stop payments Lenders (first level) income drop, reduce

payments on short term loans Short-term (money market) lenders income

drop, reduce payments … Consumption/Investment effects

Wealth (balance sheet) effects: firms, households reduce consumption/investment as wealth decreases

Debt/Income ratios: solvent firms, household reduce consumption/investment to bring debt to income ratios down

Framework for Thinking

about Debt and Macro Outcomes

Infinite Horizon Economy Budget Constraint:

PV Income + PV Debt = Debt Service + PV Consumption

“NPG” Condition: Over the long run income funds

consumption (not debt) Entire economy faces a budget constraint just as households or government

Sustainable Long Run Relationship: Income – Consumption – Debt Service >= 0 Income Growth > Interest Rate on Debt

Example Calculations on Sustainable Debt/Income Ratios

Long Run Debt-Income Ratio

Income Growth - Interest Rate for PV (Y-C-rb)>=0

3.5 0.60%3 -0.40%

2.5 -1.80%Assumptions: 75-year Horizon

APC = 0.80 (NIPA est.)

Post WWII

Variable Actual Post WWII Values Income Growth - Interest RateIncome Growth 6.70%10-year Treasury 6.45% 0.25%

AAA Bond 6.75% -0.50%BBB Bond 7.67% -1.00%

Aggregate U.S. Debt and Debt/GDP Levels

1.0

1.5

2.0

2.5

3.0

3.5

4.0

0

10000

20000

30000

40000

50000

60000

20 30 40 50 60 70 80 90 00

U.S. Debt -- right scale

Debt/GDP - left scale

Mortgage Debt only Part of the Story:Commercial Lending a Bigger Part

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

50 55 60 65 70 75 80 85 90 95 00 05

Total Debt/GDP

Non-house-govt/gdp

House-debt/gdp

Govt Debt/gdp

Debt Growth in 2000s High Relativeto Prior (growing) Trend

2.6

2.8

3.0

3.2

3.4

3.6

3.8

00 01 02 03 04 05 06 07 08

Actual Debt/GDP

Forecast Debt/GDP(Based on 1980-99, AR(4) Model)

Case Study of U.S. Debt

$11 Billion City Center ProjectLas Vegas – MGM MirageBank Loan/Bond Funded

1920s Equity “Bubble & 2000s Debt “Bubble”:Same Story, Different Financial Instruments

Whether Debt-instrument (bond, loan) funded or Equity (stock) funded, ultimate value is net revenue stream from project (Modigliani-Miller Theorem) High Debt or Equity values imply high expected future net revenue

Consider 2 Scenarios for City Center (at $10B nominal value)

Case 1: $9B in Shareholder Equity with $1B in bank debt; Case 2: $1B in Shareholder Equity with $9B in bank debt: Actual PV of future net revenue of project = $5T

With project bankruptcy: Case 1: Bank claims bankruptcy value = $1B

Original shareholders lose $9B New shares issued worth $4B Loss in balance sheets = $5B

Case 2: Bank claims bankruptcy value = $1B Shareholders lose $1B Bank loses $8B in value up front; issues new stock and regains $4B Loss in balance sheets = $5B

In both cases, assets on balance sheets over-valued by $5T; purchases made with this “leverage”

1920s: Stock Valuations Indicating Very High Net Revenues to Make Sustainable

0.4

0.8

1.2

1.6

2.0

5 10 15 20 25 30 35 40 45 50

Oct 1927-Oct 1931

Nov 2005-Nov 2009

Common Explanations

Long Run Problems: Mortgage markets overvalued Fed & other gov’t guarantees (moral hazard)

pushing mortgage markets Fed supplied too much money to markets in early

2000sseparating “systemic” v. non-systemic problems

Poor pricing models separating “systemic” v. non-systemic problems pushing too much money into mortgage markets

Short Run Sparks Uncertainty about Fed reaction Lack of Fed reaction (2007-08) Marked-to-market accounting for mortgages

Evaluating “Policy Uncertainty” Thesis:Financial Stress Appearing Long Before Sept 08

-2

-1

0

1

2

3

4

5

6

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

90 92 94 96 98 00 02 04 06 08

TED (Libor -TB3) KCFSI

-1

0

1

2

3

4

5

6

07M01 07M07 08M01 08M07 09M01 09M07

TED KCFSI

Why So Much Attention on Mortgage Debt?

See mortgage debt as leading indicator, not as only cause Fire analogy: room with fire in it first does not

tell you about the fuel and match

Mortgage debt securitized-tradeable; Quickly reflecting change in valuations

Commercial bank loans non-tradeable; Held at bank estimated values for longer

Causes of Debt/GDP Expansion:Cheap Credit

Prime AAA BBB Fed Funds ComPaper0

1

2

3

4

5

6

7

8

9

1990-992003-07:7

Cheap Credit:Fed Responsible?

-8

-4

0

4

8

12

16

20

82 84 86 88 90 92 94 96 98 00 02 04 06 08

Inflation Rate & Smoothed (HP Filter)

Cheap Credit: Public Sector Supply

1000

2000

3000

4000

5000

6000

7000

8000

9000

90 92 94 96 98 00 02 04 06 08

GSE Assets + Govt-MBS(in Billions $)

Cheap Credit: Private Sector Supply

Cheap Credit: Increasing Leverage

Cheap Credit:Inflow of Foreign Capital

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

.000

.004

.008

.012

.016

.020

.024

.028

.032

50 55 60 65 70 75 80 85 90 95 00 05

CAPINYHP DEBTY

Foreign Capital Inflow/GDP

Debt/GDP

Capital Inflows (Smoothed) and Debt Growth

Role of Foreign Capital?

-.01

.00

.01

.02

.03

.04

.05

.06

97 98 99 00 01 02 03 04 05 06 07 08 09

U.S.

Euro Area

Capital Inflows Relative to GDP

Cheap Credit: Innovations?

Securitization, e.g. CDOs Pooling mortgage (other debt) risk (CDOs,

SPVs) Credit Insurance

Transferring Risk (CDS) Cochrane: can shuffle risk around, but not

change total amount

Evaluation: CDOs, CDS actually relatively small versus

size of overall debt growth

Marked-to-Market Accounting?

How big of an effect is possible from MTM pricing of banks?

See SEC Dec. 2008 Study www.sec.gov/news/studies/2008/marktomarket123008.pdf

31% of bank assets MTM 22% of these impact income statement Part of this amount in Treasuries

Differences in MTM and “amortized cost” If 20% difference, then 4.4% impact on

income Currently, using “amortized cost” method

Citi assets increase by apx. $3B (out of $1.2T) BoA assets increase by apx. $9B (out of $1.4T)

Solutions? Cochrane:

Specify systemic risk for Fed, limiting TBTF Stiglitz, …

Limit financial innovation More stringent oversight

Poole, Bullard, BG, … Raise equity standards Limit financial firm size

Charge insurance fee based on size Explicit size limitations

Higher Equity Standards the answer?Modigliani-Miller Theorem: Capital Structure Irrelevance

No difference of debt v. equity (ownership shares) financing of projects if Asset prices move with statistical independence; Asset prices are information based without

systematic errors; Taxes treatment of both sources is the same Bankruptcy treatment of both is the same No asymmetry of knowledge among borrowers,

lenders, shareholders Implies capital structure matters to the

degree that these conditions matter

Debt-GDP Ratios 20s/30s v. 2000s

1.2

1.6

2.0

2.4

2.8

3.2

3.6

5 10 15 20 25 30 35 40 45 50

Debt-GDP Ratio 2001-09

Debt-GDP Ratio 1923-1931