The Credit and The Credit and Sovereign Debt Sovereign Debt

CrisesCrises

Prof. Anne SibertProf. Anne Sibert

MSc Financial EconomicsMSc Financial Economics

May 2012May 2012

Who is to blame for the Who is to blame for the financial crisis?financial crisis?

How is it related to the How is it related to the sovereign debt crisis?sovereign debt crisis?

US presidents and the US US presidents and the US Congress: for following a policy of Congress: for following a policy of

encouraging home ownershipencouraging home ownership Fannie Mae was founded in 1938 and chartered by Fannie Mae was founded in 1938 and chartered by

Congress as a government-sponsored enterprise (GSE) Congress as a government-sponsored enterprise (GSE) in 1968. in 1968.

Fannie Mae puchases and securitises loans from Fannie Mae puchases and securitises loans from approved mortgage sellers. For a fee, Fannie Mae approved mortgage sellers. For a fee, Fannie Mae guarantees the timely payment of interest and principal. guarantees the timely payment of interest and principal.

Freddie Mac is a GSE founded in 1970. It buys Freddie Mac is a GSE founded in 1970. It buys mortgages on the secondary market and securitises mortgages on the secondary market and securitises them.them.

In 2008, Fannie Mae and Freddie Mac owned or In 2008, Fannie Mae and Freddie Mac owned or guaranteed about half of the $12 trillion worth of guaranteed about half of the $12 trillion worth of mortgages outstanding in the United States.mortgages outstanding in the United States.

Not officially backed by the government, but believed to Not officially backed by the government, but believed to be implicitly backed; exempt from state and local taxes. be implicitly backed; exempt from state and local taxes. (An off-shoot of Fannie Mae named Ginnie Mae explicitly (An off-shoot of Fannie Mae named Ginnie Mae explicitly guaranteed some mortgages to veterans and state guaranteed some mortgages to veterans and state employees.)employees.)

What happened nextWhat happened next

In Sept 2008, Fannie Mae and In Sept 2008, Fannie Mae and Freddie Mac were placed in Freddie Mac were placed in receivership. receivership.

The government provided a $187.5 The government provided a $187.5 billion rescue package. Thanks to billion rescue package. Thanks to rising house prices they have since rising house prices they have since paid $185.2 billion in dividends to paid $185.2 billion in dividends to the government.the government.

Increasing risky lending, Increasing risky lending, loans and lending practices loans and lending practices

were tolerated.were tolerated. In 1994, one in twenty new In 1994, one in twenty new

mortgages was subprime; by 2006 it mortgages was subprime; by 2006 it was one in five.was one in five.

Risky loans: no down payment; Risky loans: no down payment; adjustable interest rate; interest adjustable interest rate; interest only for some period.only for some period.

Loans were made without verifying Loans were made without verifying assets and income of borrowers.assets and income of borrowers.

Risky loans to risky Risky loans to risky borrowers were encouragedborrowers were encouraged

The Community Reinvestment Act of 1977 (Carter The Community Reinvestment Act of 1977 (Carter administration): forced banks to open new branches administration): forced banks to open new branches in areas of extreme poverty in inner cities and to in areas of extreme poverty in inner cities and to make home mortgages loans in these areas. make home mortgages loans in these areas.

In 1999 (Clinton administration) Lenders under In 1999 (Clinton administration) Lenders under pressure to increase loans to poor and moderate pressure to increase loans to poor and moderate income borrowers in inner cities. Lenders pressured income borrowers in inner cities. Lenders pressured Fannie Mae to ease its credit requirements on the Fannie Mae to ease its credit requirements on the loans it was willing to purchase. loans it was willing to purchase.

In 2002 (Bush 2 administration) "Renewing the In 2002 (Bush 2 administration) "Renewing the Dream”: tax credits for building affordable housing Dream”: tax credits for building affordable housing in distressed areas. Increased funding for other in distressed areas. Increased funding for other programmes aimed at increasing home ownership for programmes aimed at increasing home ownership for low-income Americans. low-income Americans.

Events abroad were to Events abroad were to blameblame

Current Account Surpluses in the Current Account Surpluses in the Developing World (in $ billion)Developing World (in $ billion)

-100

0

100

200

300

400

500

1980 1985 1990 1995 2000 2005

Developing Asia Mid East China

The counterpart was US The counterpart was US current account deficitscurrent account deficits

(in $ billions)(in $ billions)

-200

0

200

400

600

800

1980 1985 1990 1995 2000 2005

US EU

Saving (as a percentage of Saving (as a percentage of GDP) was too high in ChinaGDP) was too high in China

010203040506070

2005 2006 2007

saving investment

And, in the Middle EastAnd, in the Middle East

0

10

20

30

40

50

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

saving investment

Why?Why?

Distortions in China led to too high Distortions in China led to too high saving.saving.

Rising oil prices led to a windfall Rising oil prices led to a windfall gain in Middle Eastern countries. gain in Middle Eastern countries. They did not have enough absorptive They did not have enough absorptive capacity to invest it at home.capacity to invest it at home.

Saving in the US fellSaving in the US fell

0

5

10

15

20

25

1997 1998 1999 2000 2001 2001 2003 2004 2005 2006 2007

saving investment

Saving in advanced Saving in advanced countriescountries

0

5

10

15

20

25

30

35

Canada

France

Germany

Italy

Japan

UK

US

Factors causing too high saving in Factors causing too high saving in developing countries resulted in developing countries resulted in

too low saving in the United Statestoo low saving in the United States Equity prices rose in the United States Equity prices rose in the United States

as capital flowed in. This cause as capital flowed in. This cause perceived US wealth to rise and perceived US wealth to rise and consumption went up; saving went consumption went up; saving went down.down.

After the dot com bubble burst in 2000, After the dot com bubble burst in 2000, real interest rates declined in the United real interest rates declined in the United States. As the US is a debtor country, States. As the US is a debtor country, both the income and substitution effect both the income and substitution effect went the same way. This probably went the same way. This probably caused saving to go down.caused saving to go down.

House prices went upHouse prices went up

When the real interest rate when When the real interest rate when down the discounted stream of down the discounted stream of future rents went up and house future rents went up and house prices went up.prices went up.

Housing wealth is readily Housing wealth is readily collateralisable in the United States collateralisable in the United States and previously credit-constrained and previously credit-constrained households spent more and saved households spent more and saved less.less.

Saving Glut HypothesisSaving Glut Hypothesis

This is called the savings glut hypothesis; This is called the savings glut hypothesis; it is associated with Bernanke.it is associated with Bernanke.

Flows of foreign capital into the US were Flows of foreign capital into the US were matched by lower US saving through, matched by lower US saving through, first, a rise in equity prices and, later, a first, a rise in equity prices and, later, a fall in the real interest rate.fall in the real interest rate.

The fall in the real interest rate was The fall in the real interest rate was associated with an increase in house associated with an increase in house prices.prices.

Was the Fed to blame for Was the Fed to blame for the house price boom?the house price boom?

The Fed controls a short-term nominal The Fed controls a short-term nominal interest rate.interest rate.

Because of distortions, it can affect the Because of distortions, it can affect the real interest rate in the short run.real interest rate in the short run.

Monetary policy cannot systematically Monetary policy cannot systematically affect real variables such as the real affect real variables such as the real interest rate.interest rate.

The Fed did not cause the house price The Fed did not cause the house price boom.boom.

Was it a bubble? Should the Was it a bubble? Should the Fed have popped it?Fed have popped it?

We don’t know if it was a bubble.We don’t know if it was a bubble. Bubbles are deviations from the Bubbles are deviations from the

price path implied by the price path implied by the fundamentals. Would a small change fundamentals. Would a small change in a fundamental help?in a fundamental help?

Monetary policy is not the right tool Monetary policy is not the right tool for popping bubbles.for popping bubbles.

Why did capital flow into Why did capital flow into the US and not into the US and not into

Europe?Europe?

Table 1. Ease of Doing Business Index, 2007

United States 3

United Kingdom 6

Ireland 10

Finland 14

Belgium 20

Germany 21

Netherlands 22

Austria 30

France 35

Spain 39

Portugal 40

Italy 82

Greece 109

The US may have been The US may have been perceived as a more perceived as a more

attractive place to investattractive place to invest During the period 1997 – 2006, relatively rigid labour During the period 1997 – 2006, relatively rigid labour

and product markets, more poorly functioning credit and product markets, more poorly functioning credit markets, higher costs of starting and closing businesses markets, higher costs of starting and closing businesses and more restrictions on land use and business hours and more restrictions on land use and business hours may have made the EU a less attractive place to invest may have made the EU a less attractive place to invest than the United States. than the United States.

The relatively business-friendly environment of the The relatively business-friendly environment of the United States has been especially important over the United States has been especially important over the last two decades. When technological innovations in last two decades. When technological innovations in semiconductor manufacturing led to the information semiconductor manufacturing led to the information and communications technology (ICT) revolution, the and communications technology (ICT) revolution, the relatively unregulated product markets and flexible relatively unregulated product markets and flexible labour markets in the United States enabled a rapid labour markets in the United States enabled a rapid restructuring of the economy to make the best use of restructuring of the economy to make the best use of ICT in other industriesICT in other industries

The dollar is the world’s The dollar is the world’s premier reserve currencypremier reserve currency

A significant fraction of capital inflows in the United States are A significant fraction of capital inflows in the United States are believed to be official holdings. believed to be official holdings.

Between 1999 and Aug 2007, Chinese foreign exchange reserves Between 1999 and Aug 2007, Chinese foreign exchange reserves increased from about $160 hundred million to $1.4 trillion. increased from about $160 hundred million to $1.4 trillion.

Other Asian countries also increased their reserve holdings Other Asian countries also increased their reserve holdings following the Asian crisis. Most of these increases were probably following the Asian crisis. Most of these increases were probably in dollars.in dollars.

It is estimated that about two-thirds of the world’s reserves are in It is estimated that about two-thirds of the world’s reserves are in dollars.dollars.

Along with high productivity in the United States, relative to the Along with high productivity in the United States, relative to the rest of the world, the dollar is a convenient currency for central rest of the world, the dollar is a convenient currency for central banks to hold. banks to hold.

Size, liquidity and depth of financial markets: At the end of 2005, Size, liquidity and depth of financial markets: At the end of 2005, the outstanding stock of US government securities was $4.2 the outstanding stock of US government securities was $4.2 trillion, compared with $4.7 trillion for the euro area. But, unlike trillion, compared with $4.7 trillion for the euro area. But, unlike the euro area, US government securities were all perceived to be the euro area, US government securities were all perceived to be of high quality (rated AAA by Fitch). Moreover, the markets for of high quality (rated AAA by Fitch). Moreover, the markets for US government securities are more liquid and have greater depth US government securities are more liquid and have greater depth than those in the euro area.than those in the euro area.

Twin Deficits HypothesisTwin Deficits Hypothesis

Current Account Deficit = Private Current Account Deficit = Private financing deficit + Government Budget financing deficit + Government Budget DeficitDeficit

This theory seems particularly ill-suited This theory seems particularly ill-suited to the period under discussion as the US to the period under discussion as the US government budget was in surplus government budget was in surplus between 1996 and 2000 and Germany between 1996 and 2000 and Germany and Japan have run government budget and Japan have run government budget deficits and their current accounts have deficits and their current accounts have been in surplus. been in surplus.

Rising house prices fueled Rising house prices fueled securitisationsecuritisation

Once upon a time, bankers (and other lenders) Once upon a time, bankers (and other lenders) who made loans to a house purchaser, or other who made loans to a house purchaser, or other borrower, retained the default risk. borrower, retained the default risk.

Hence, they had an incentive to collect Hence, they had an incentive to collect information on the borrowers and to monitor their information on the borrowers and to monitor their subsequent behaviour. subsequent behaviour.

Banks did not like holding illiquid assets, however. Banks did not like holding illiquid assets, however. The innovation of securitisation gave bankers the The innovation of securitisation gave bankers the

opportunity to sell their mortgages, passing off the opportunity to sell their mortgages, passing off the risk and obtaining new liquidity with which to risk and obtaining new liquidity with which to make additional loans. make additional loans.

Banks no longer had much of an incentive to Banks no longer had much of an incentive to screen or oversee their borrowers; they made screen or oversee their borrowers; they made riskier types of loans to less credit-worthy riskier types of loans to less credit-worthy borrowers.borrowers.

SecuritisationSecuritisation When the banks sold their mortgages, it was to off-balance-When the banks sold their mortgages, it was to off-balance-

sheet special-purpose vehicles (SPVs). sheet special-purpose vehicles (SPVs). These SPVs combined the mortgages with other assets and These SPVs combined the mortgages with other assets and

issued tranched securities backed by the entire pool. issued tranched securities backed by the entire pool. These securities were then purchased by other SPVs that These securities were then purchased by other SPVs that

combined them with various assets in the next level of combined them with various assets in the next level of securitisation. securitisation.

By the time a conduit of a German Landesbank sold some By the time a conduit of a German Landesbank sold some tranche of a security backed by mortgages, sliced and diced tranche of a security backed by mortgages, sliced and diced and bundled and rebundled with credit card receivables, and bundled and rebundled with credit card receivables, automobile loans and other assets, to a London hedge fund, automobile loans and other assets, to a London hedge fund, neither borrower nor seller had much of a clue about the neither borrower nor seller had much of a clue about the nature of the underlying assets. nature of the underlying assets.

Nor did they appear to be overly concerned. As long as US Nor did they appear to be overly concerned. As long as US house prices would continue to rise, all would be well.house prices would continue to rise, all would be well.

When the boom endedWhen the boom ended

Highly leveraged home owners began Highly leveraged home owners began to default on their mortgages, eroding to default on their mortgages, eroding the value of mortgage-backed the value of mortgage-backed securities. securities.

High degrees of leverage in the High degrees of leverage in the financial sector magnified the effect of financial sector magnified the effect of changes in asset prices on the balance changes in asset prices on the balance sheets of financial institutions and the sheets of financial institutions and the financial crisis began.financial crisis began.

The search for yieldThe search for yield Paulson (2008) has advanced a complimentary Paulson (2008) has advanced a complimentary

reason why the fall in real interest rates helped reason why the fall in real interest rates helped fuel the crisis: low interest rates led to fuel the crisis: low interest rates led to excessive risk taking and a global search for excessive risk taking and a global search for return. Presumably, this is because bankers return. Presumably, this is because bankers and employees of other financial firms have an and employees of other financial firms have an asymmetric loss function which causes them to asymmetric loss function which causes them to search for investments that have the possibility search for investments that have the possibility of high upside returns.of high upside returns.

A related reason for greater risk taking is that A related reason for greater risk taking is that a long period of good monetary policy lowered a long period of good monetary policy lowered volatility in financial markets, triggering a volatility in financial markets, triggering a search for investments with risky returns.search for investments with risky returns.

Where were the supervisors Where were the supervisors

and regulators?and regulators? In the United States, regulators were lax in In the United States, regulators were lax in

permitting unbridled securitisation. permitting unbridled securitisation. Originally seen as a way of pooling risk, it Originally seen as a way of pooling risk, it caused financial institutions to make riskier caused financial institutions to make riskier loans. loans.

Around the world, but especially in Europe, Around the world, but especially in Europe, regulators were to blame for allowing regulators were to blame for allowing financial institutions to become as large and financial institutions to become as large and as leveraged as they were. as leveraged as they were.

Lawmakers in the United States were Lawmakers in the United States were culpable for allowing a patchwork institution-culpable for allowing a patchwork institution-based regulatory system to prevail.based regulatory system to prevail.

Bankers rashly bet that the US house bubble would continue long after economists predicted its demise.

Managers of insurance companies and pension funds did not exercise due diligence when they purchased collateralised debt obligations and mortgage-backed securities that they did not understand.

Bankers were over confident and they took on too much risk.

“We were hitting on all 99 cylinders, so you have to ask yourself, What can we do better? And I just can’t decide what that might be … Everyone says that when the markets turn around, we will suffer. But let me tell you we are going to surprise some people this time around. Bear Stearns is a great place to be.” James E. Cayne, Chairman and CEO of Bear Stearns, 2003.

Odean (1998), Barber and Odean (2001), Biais, Hilton, Mazurier and Pouget (2005) demonstrate that overconfidence can lead to excess trading and lower profits.

Daniel, Hirshleifer and Subrahmanyam (1998), Scheinkman and Xiong (2003) and Burnside, Han, Hershleifer and Wang (2011) show that it can lead to asset price anomalies such as overreactions, excess volatility and bubbles.

An individual has been described by a neighbour as follows: “Steve is very shy and withdrawn, invariably helpful but with little interest in people or the world of reality. A meek and tidy soul, he has a need for order and structure and a passion for detail.” Is Steve more likely to be a librarian or a farmer?

Kahneman, D., Thinking, Fast and Slow, London, Allen Lane, 2011.

Humans have evolved to form impressions, make judgements and invent explanations quickly: Fast and frugal heuristics

A snap judgement: “This is dangerous” may be more apt to keep us alive than a slower and more finely nuanced thought.

But, the heuristics that promote speed may cause systematic biases.

The representativeness heuristic is where we judge something by comparing it to our mental picture of a category.

An example from Myers (2008): “Linda, who is 31, single, outspoken, and very bright. She majored in philosophy in college. As a student she was deeply concerned with discrimination and other social issues, and she participated in anti-nuclear demonstrations. Based on that description, would you say it is more likely that• Linda is a bank teller• Linda is a bank teller and active in the feminist

movement

Most people say that the answer is b. (Mellor et al, 2001) But that cannot possibly be right!

Some other examples: (Myers, 2008)• Do more people live in Iraq or Tanzania? People

usually answer according to how readily Iraqis and Tanzanians come to mind.

• Vivid, easy to imagine events (shark attacks) seem more likely than hard-to-picture events.

• People are quick to infer general conclusions from a single striking event: People switched from air travel to car travel after 11 September 2001.

A person’s mental life can be described by the metaphor of two internal agents. The first produces that fast and frugal heuristics; the second produces slow and deliberative thought. Call these System 1 and System 2, respectively.

System 1 can be very good. A team of fire fighters is trying to douse a fire in a kitchen when the chief, without knowing why, heard himself yell to get out. Immediately after the floor collapsed. Only later did he realise that the fire had been unusually quiet and his ears unusually hot. The heart of the fire was in the basement below.

A bat and a ball cost $1.10. The bat costs one dollar more than

the ball. How much does the ball cost?

Do the math: Let bat := price of the bat ball := price of the ballbat + ball = 1.10bat = ball + 1.00This implies that 2 x ball + 1.00 = 1.10 or

that 2 x ball = 10 cents or that ball = five cents. Thus the bat cost 1.05.

Probably everyone who got this right immediately thought of the answer that the bat cost a dollar and the ball ten cents, but they managed to resist it.

ANNAPPROACHED THE BANK

Another example from Kahneman (2011)

Going back to the introverted Steve. Our System 1 thinking associated Steve’s personality traits with those of a librarian.

Unless our System 2 overrules our System 1 we will say that Steve is more likely to be a librarian.

There are far more farmers than librarians. It is more likely that Steve is a farmer.

A study of the incidence of kidney cancer in 3,141 counties of the United States reveals a remarkable pattern. The counties in which the incidence is lowest are mostly rural, sparsely populated and located in traditionally Republican states in the Midwest, the South and the West. What do you make of this?

The counties in which the incidence of kidney cancer is highest are mostly rural, sparsely populated and located in traditionally Republican states in the Midwest, the South and the West. What do you make of this?

Suppose an urn is filled with marbles. One fifth of the marbles are red and four-fifths are blue.

Suppose we consider a scenario where we draw three marbles. The probability that all are red is 1/125. In a scenario where we draw seven marbles the probability that they are all red is 1/78,125.

Also known as the “Lake Woebegone Effect”.

Overconfidence is pervasive. Fischhoff (1977) found that when people

claimed to be 100 percent confident, they were right 70 – 80 percent of the time.

Most of us are sure that we are better drivers than average. Svenson (1891), for example, found that 80 percent of survey respondents claimed to be in the top 30 percent of all drivers.

Daniel Kahneman and Amos Tversky (1979) asked people to fill in the gaps in statements such as “I fell 98 percent certain that the air distance between New Delhi and Beijing is more than ___ miles but less than ___ miles.”

About 30 percent of the time the answers lay outside the range they felt 98 percent confident about.

Kahneman, D. a nd Tversky, A. (1797), “Intuitive Prediction: Biases and Corrective Procedures,” Managnement Science 12, 313-327.

Overconfidence may lead to a failure to look for disconfirming evidence.

In psychology experiments, the failure of subjects to look for disconfirming evidence has “raised more doubts over human rationality than any other psychological tasks.” Oaksford and Chator (1993)

Wason gave participants in his test a sequence: 2,4,6. He asked participants to guess the rule that generated the sequence.

The rule was: Any three ascending numbers. The subjects were allowed to discover the

rule by generating sequences of three numbers. They were then told whether there sequence conformed to the rule or not.

Participants typically formed a belief about what the rule was: say, counting by twos.

They then tested this by seeking for confirming evidence, rather than attempting to look for evidence that might disprove their theories.

There is a sizable literature documenting that men are more confident of their abilities at activities that are perceived as traditionally male.

Using data on 35,000 households from a large brokerage firm, Barber and Odean (2001) argue that men are substantially more overconfident than women in financial markets.

Overconfidence is not related to ability: it is found even when women perform as well or better than men.

Using undergraduate and graduate students, Lundeberg et al (1994) found that most students were over confident, but women were less overconfident then men, “who tended to show high degrees of confidence when wrong.”

Campbell and Sedikides (1999) document the importance of the self-serving bias: a tendency to attribute success to one’s own ability and failure to external factors.

Beyer (1990) and others, however, find that this effect is stronger in men than in women. Thus, if confidence helps produce successful outcomes, there is more likely to be strong feedback loop in confidence in men than in women.

In a fascinating and innovative study, Coates and Herbert (2008) consider the effect of testosterone on both risk aversion and overconfidence.

They explain that testosterone – a steroid hormone -- rises in athletes preparing for a contest; it rises further in winners and falls in losers.

Because increased testosterone increases confidence and risk taking, this produces a positive feedback loop in the winners as it improves their chances of winning again.

They hypothesised that something similar might happen in financial market participants.

To test this, they took samples of testosterone levels of 17 male traders on a typical London trading floor (which had 260 traders, only four of whom were female) twice a day for eight days.

(They controlled for food, medications and whether the traders had received any important news from outside work.)

They found that testosterone was significantly higher on days when traders made more than their daily one-month average profit.

Furthermore, higher levels of testosterone led to greater profitability – presumably because of greater confidence and risk taking.

The authors hypothesise that if raised testosterone were to persist for several weeks the elevated appetite for risk taking might have important behavioural consequences and there might be cognitive implications as well.

Testosterone, they say, has receptors throughout the areas of the brain that neuroeconomic research has identified as contributing to irrational financial decisions.

They also point to a study where testosterone was administered to a group of subjects playing a gambling task and it led to irrational behaviour: subjects preferred options with high variance and a negative expected return to options with a low variance and a positive expected return.

They speculate that steroid feedback loops may help explain why bankers behave irrationally when caught up in bubbles.