the great crisis and the prospects for globalization · giovanni ferri università di bari (may...

Giovanni Ferri Università di Bari (May 2011)

The Great Crisis and the Prospects for Globalization

Giovanni Ferri

Lezione 9 Corso di Economia delle scelte di portafolgio

This presentation is based on D’Apice V., Ferri G., (2010), “Financial Instability: Toolkit for Interpreting Boom and Bust Cycles”, Palgrave Macmillan Studies in Banking and Financial Institutions, London.

© Vincenzo D’Apice and Giovanni Ferri 2010. All rights reserved.

1. Outline

2. The Political Economy Cycle of Finance

3. The Great Financial Crisis of 2007-2009 - Chronology

4. The Great Financial Crisis of 2007-2009 - Causes: Global Imbalances

5. The Great Financial Crisis of 2007-2009 - Causes: The Fed

6. The Great Financial Crisis of 2007-2009 - Causes: Securitization

7. The Great Financial Crisis of 2007-2009 - Causes: Financial Regulation

8. The Great Financial Crisis of 2007-2009 - Causes: Rating Agencies

9. The Great Financial Crisis of 2007-2009 - Causes: Shadow Banking System

10. The Great Financial Crisis of 2007-2009 - Effects: High Debt/GDP Ratios

11. The Emerging Economies Rebound

12. Where Do We Go From Here?

Fin.Ac. Moscow Study visit Giovanni Ferri Università di Bari (May 2011)

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●  The Great Financial Crisis of ’07-09 may possibly conclude a political-economy cycle of finance started after the G. Crash.

●  During the ‘30s, we had an heavy re-regulation process that delivered a long period of financial stability, based on gold standard exchange.

●  H/e, from ‘70s, liberalization, deregulation and the end of the gold exchange standard paved the way to a series of financial crises.

●  The initial signals of instability appeared in the ‘80s with the crises in Lat. America.

●  Then, during the ’90s, financial instability hit Mexico, Asia and Japan.

●  The mega-bankruptcies of LTCM, Enron, Worldcom and Parmalat, moved the instability from developing to developed economies.

●  The burst of the “dotcom” bubble lead to a severe recession in US, but the financial damages seemed apparently low.

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●  Just few years later, the bigger burst of the house bubble triggered an epochal crisis that shaken the financial systems worldwide.

●  The severity of this crisis is comparable just to the Great Depression of ’30.

●  Thus, it may be possible that another heavy re-regulation process is needed to bring back the international financial system on solid base.

●  Alternatively, another (bigger) crisis may be possible (e.g. this week’s Economist titles” The new tech bubble”).



●  The roots of the Great Crisis are to be found in the US financial deregulation waves, whose harmful effects had been exacerbated by the improvident monetary policies undertaken by the Fed after the collapse of the ‘new economy’.

●  Between January 2001 and June 2003, the decrease in the policy rate, which dropped from 6 to 1 per cent, encouraged American households to buy real estate properties.

●  As a result, real estate prices skyrocketed triggering two feedback processes which amplified the effects of the monetary policy and fed the speculative bubble .

●  The growing real estate value and the increased ratio between issuance of mortgage-backed securities and origination of mortgage loans led to a significant lowering of credit standards.



●  Hence, a growing share of new loans was granted to subjects with very low repayment capacity, the so-called subprime clients.

●  However, between June 2004 and June 2006, the US policy rate increased from 1 to 5.25 per cent, affecting the sustainability of mortgage debts. Thus, insolvencies started to increase, especially for subprime mortgages. Consequently, the demand for houses slowed down, curbing house-price appreciation.

●  In spring 2007, the insolvency rate on the subprime mortgages exceeded 16 per cent thus speeding up the property price drop (see figure 1).

●  The default of the subprime segment soon affected the financial markets because many insolvent loans were the cash flow of many structured bonds (ABS & CDO) in the hands of a multitude of international investors.



●  In addition, between June and July the market lost its confidence in the ability of rating to estimate the structured bond default probability.

●  The financial markets worldwide panicked.

●  The international financial crisis that erupted in August 2007 went through five stages.

●  For a detailed timeline of the crisis, check this out:

http://www.ny.frb.org/research/global_economy/policyresponses.html

●  To know all forms of lending implemented by the Fed during the crisis:

http://www.newyorkfed.org/markets/Forms_of_Fed_Lending.pdf

●  These five phases are clearly evident in Figure 2, which also shows the international stock market index and the Ted spread (the latter, calculated as the difference between the three months’ Libor rate and three months’ government bonds, is used to gauge the credit risk on the interbank market).



Figure 3: GDP Growth



●  Global imbalances are the first macroeconomic cause of the crisis. This problem was generated by the high and long-lasting current account deficit in the main industrialized countries, particularly the USA, which was funded by the massive capital inflow from the emerging economies.

Figure 6: Global imbalances



●  Besides fuelling a strong increase in real estate prices, the inflow of foreign capital also weakened the relation between short-term interest rates and long-term rates.

●  The first signs of this weakness and its perils emerged a few years before the beginning of the crisis.

●  The Greenspan conundrum:


5. The Great Financial Crisis of 2007-2009 - Causes: The Fed ●  The overly easy monetary policy by the Fed is the second macroeconomic cause

of the financial crisis. The policy rate was kept too low for too long by Alan Greenspan’s Fed to ease the recessionary consequences following the burst of the ‘dotcom’ bubble.

●  But two feedback mechanisms amplified the negative effect of the overly easy monetary policy.

●  The first circular mechanism - the balance-sheet channel - is at work in the real estate market, where the supply of loans is closely related to the value of the collateral asset.

●  The second circular mechanism - the bank-lending channel - is strictly linked to the spreading out of securitizations and is at work in the financial market.


6. The Great Financial Crisis of 2007-2009 - Causes: Securitization ●  Securitization has drastically changed the banking industry. Many financial intermediaries

shifted from the ‘originate to hold’ (OTH) to the ‘originate to distribute’ (OTD) business model.

●  In the first model, the loan origination is a simple operation that involves just two subjects: the bank and the borrower.

●  On the contrary, in the second model the loan origination is a more complex operation, similar to a production process, which involves several subjects.


6. The Great Financial Crisis of 2007-2009 - Causes: Securitization

●  The main advantages OTD business model are specialization and risk distribution.

●  But the increase in efficiency has a cost, which sometimes can be very high. ●  Moreover, due to their complexity, the risk of the financial instruments resulting

from the securitizations is often very difficult to evaluate. ●  In this framework, the US financial deregulation has not only favored the

development of new loan types but also complicated the estimate of the potential credit losses and the identification of the most exposed subjects.

●  Therefore, it is not surprising that the defaults of the last link in the complex US financial chain (subprime clients) have rapidly affected the whole sector.

●  The securitization processes greatly exacerbated the effects of the US real estate bubble burst.

●  Securitization can be divided into three phases: ●  a) identification of a group of homogeneous credits in the portfolio of the

financial institution that originated them (originator); ●  b) sale of credits to an ad hoc vehicle (conduit, SIV or SPV); ●  c) placement, by this vehicle, of asset-backed securities (ABS), whose interest-

rate payment and repayment when due depend on the cash flow generated by the underlying credits.

7. The Great Financial Crisis of 2007-2009 - Causes: Financial Regulation


●  Basel I contributed to the growth of securitization by assigning lower capital charges to securitized assets.

●  Hence, to reduce the regulatory capital in the years before the crisis, many banks established some special-purpose entities to which they could sell the originated loans through securitization.

●  The special-purpose entities funded the procurement of the loans by using the ABCP (Asset Backed Commercial Paper) guaranteed by the sponsoring bank.

●  The issues in the ABCP market peaked in the second quarter of 2007 but, when the crisis started, the special purpose entities could not find any investors who were ready to underwrite these instruments.

●  The financial regulation reliance on ratings has given a significant contribution to the development of securitization and, as a consequence, to the activity of the rating agencies.

●  The demand for high-rated and high-yield instruments has encouraged the growth of structured bonds, because by creating different types of tranches it is possible to issue many bonds with a rating higher than that of the average pool of securitized assets.

●  However, since July 2007, the quality of structured bonds rapidly decreased.

●  As a consequence, the demand for structured bonds, which was highly dependent on the rating, collapsed.


8. The Great Financial Crisis of 2007-2009 - Causes: Rating Agencies

● The main rating agencies were harshly criticized for declaring some bonds nearly risk-free (triple-A), which then defaulted a few months later.

● The main cause of the debacle may be conflicts of interest in the rating industry. ● Moreover, some agencies also provide consulting services on how to organize the

issues and structure the tranches to get the highest possible rating. ● The rating agencies have also been bitterly criticized for the methods they used in

evaluating structured bonds.


- 9. The Great Financial Crisis of 2007-2009 - Causes: Shadow Banking System

●  The shadow banking system: definition

Figure 20: The SBS


- 9. The Great Financial Crisis of 2007-2009 - Causes: Shadow Banking System

Figure 23 ($trillion)

●  The growing importance of SBS


- 10. The Great Financial Crisis of 2007-2009 - Effects: High Debt/GDP Ratios

● Slower growth, global imbalances and financial liberalization brought about unsustainable debt/GDP levels in various advanced countries, while the situation was much better in emerging economies (e.g. the BRICS).

16/05/11 17.57Indebtedness after the financial crisis: World debt | The Economist

Pagina 1 di 5http://www.economist.com/blogs/buttonwood/2010/06/indebtedness_after_financial_crisis

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134 636Mi piaceJun 24th 2010, 16:45 by Buttonwood

Indebtedness after the financial crisis

World debt

THE headlines are all about sovereign debt at the moment. But that is only part of the problem. Debthas risen across the economy, from consumers on credit cards, though industrial companies borrowingfor expansion and financial companies using debt to buy risky assets.

The interactive graphic above shows the overall debt levels for a wide range of countries, based on datasupplied by the McKinsey Global Institute. In theory there is no maximum level for debt relative to GDP,but Ireland and Iceland (not on this map) found the limit in practice when they hit eight-to-ten timesGDP.

The debt is also broken down by sector. Note the huge size of Britain’s banks relative to its economy,and the high level of Spanish corporate debt. These figures will worry owners of government bonds sincethe 2008 crisis showed that governments may be forced to stand behind private sector debt.

We have also updated a sovereign debt table we published in February, ranking countries in terms oftheir primary budget balance, debt-to-GDP ratios plus the relationship between the yield on their debtand economic growth (if the former is larger than the latter, the debt burden is getting steadily worse).Spain has now taken over from Greece as the country in the worst position. Here’s the table:

Period:

About Buttonwood's notebook

In this blog, our Buttonwood columnist grapples withthe ever-changing financial markets and the motleycrew who earn their living by attempting to masterthem.

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Buttonwood's notebook

134 636Mi piaceJun 24th 2010, 16:45 by Buttonwood

Indebtedness after the financial crisis

World debt

THE headlines are all about sovereign debt at the moment. But that is only part of the problem. Debthas risen across the economy, from consumers on credit cards, though industrial companies borrowingfor expansion and financial companies using debt to buy risky assets.

The interactive graphic above shows the overall debt levels for a wide range of countries, based on datasupplied by the McKinsey Global Institute. In theory there is no maximum level for debt relative to GDP,but Ireland and Iceland (not on this map) found the limit in practice when they hit eight-to-ten timesGDP.

The debt is also broken down by sector. Note the huge size of Britain’s banks relative to its economy,and the high level of Spanish corporate debt. These figures will worry owners of government bonds sincethe 2008 crisis showed that governments may be forced to stand behind private sector debt.

We have also updated a sovereign debt table we published in February, ranking countries in terms oftheir primary budget balance, debt-to-GDP ratios plus the relationship between the yield on their debtand economic growth (if the former is larger than the latter, the debt burden is getting steadily worse).Spain has now taken over from Greece as the country in the worst position. Here’s the table:

Period:

About Buttonwood's notebook

In this blog, our Buttonwood columnist grapples withthe ever-changing financial markets and the motleycrew who earn their living by attempting to masterthem.

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For more detail, see our special report on debt, which explains how the burden has built up over the last50 years, and has affected economies from Florida to Iceland.

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Debt, so this is how the West falls.

So why don't we just do a reverse debt split and we'll all have half the debt.

Few theories for West (East is prudent and doesn't need these)-1. John Maynard Keynes' theory is to save in good times, to spend in bad times. (But West never didthat)2. Milton Friedman's theory is to keep cutting interest rates. But you can't cut interest rates below zero.(In West they are nearly there)3. Another Solution: just print money (like Zimbabwe). They now have 100 Trillion Zimbabwe dollarnotes, worth less than 40 US $. So if Western countries continue borrowing, i.e. keep on printing dollars,Euros & Pounds in their backyard, they go the Zimbabwe way.

So which one will west choose?

The USA isn't anywhere near as bad off as some would have us believe. That's not to say that weshouldn't aim to balance budgets, but it certainly implies that we have time. Slowly reducing

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- 10. The Great Financial Crisis of 2007-2009 - Effects: High Debt/GDP Ratios

● The situation in the USA

16/05/11 18.31The crisis explained in one chart: Debt-to-GDP - Blogs at Chris Martenson

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Home » Blogs » cmartenson's Blog

The crisis explained in one chart: Debt-to-GDPTuesday, January 13, 2009, 9:41 am, by cmartenson

If I was ever given just one chart, just one piece of data, to make the case that we were on an unsustainablepath that had a date with a long period of contraction and economic hardship, it would be this one.

Figure 1: This chart compares total debt (or “credit”) in the U.S. to GDP (or Gross Domestic Product) on a percentage basis. Currenttotal credit-market debt stands at more than 340 percent of total GDP.

As we can see on this chart, the last time debts got even remotely close to current levels was back in the early 1930s, and that bearsa bit of explanation. The debt-to-GDP ratio back then didn’t start to climb until after 1929 (blue arrow), because debts remainedrelatively fixed in size, while it was the GDP that fell away from under the debts. With the exception of the Great Depression anomaly,our country always held less than 200 percent of our GDP in debt (green circle). In 1985 we violated that barrier and have neverlooked back.

What does this chart tell me? It says that what each of us knows to be “just how the economy works” is really a historically unusualexperiment with debt that is barely 25 years old. In the sweep of economic history, this barely qualifies as a blink.

It says, if you listen carefully enough, that all of our global economic growth has been fictitious. An illusion of debt.

Consider that debt had most recently been growing at a rate six times faster than the underlying GDP and you’ll begin to appreciatejust how bogus the recent “growth” really was.

Here's an example. Consider two families living side by side. Each is earning $50,000/year. At our first “GDP snapshot” of these twofamilies, we find that each has a GDP of $50k. But the next year one of the families goes out and buys an additional $50k of goodsand services for itself, using a combination of auto loans, credit cards, student loans, and a home equity line of credit (HELOC).

At our second “GDP snapshot” one family is still mired in a $50k GDP but the other has undergone an exciting 100% growth in theireconomy and is now sporting a GDP of $100k.

But the underlying reality is that each family still has $50k of earning power. The measurement itself introduced a fallacy by neglectingto factor out the use of credit when measuring “growth.” That is exactly analogous to the US GDP situation and explains why the US,

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11. The emerging economies rebound : the trends in the four recent decades


Over world GDP the BRICs grow while US, Europe decrease

●  In the latest four decades (since the 1st oil shock) world GDP largely shifted from Western countries to emerging economies, here represented by the 4 largest ones, the BRICs (Brazil, India, China & Russia).

11. The emerging economies rebound: secular trends


0%

20%

40%

60%

80%

100%

1 1000 1500 1820 1870 1913 1950 1973 2006

China Japan

India Other Asia

Western Europe Eastern Europe+Former USSR

Latin America USA

Other Western Offshoots (Australia, Canada, New Zealand) Africa www.ggdc.net/maddison/

●  The center of the world economy changes over the centuries. Asia dominated for almost 2 millennia: in particular, India & China were the main economic powerhouses until the early 1800 (Angus Maddison).

11. The emerging economies rebound: the future


●  The future looks grim for the rich countries and rosy for (most of) the emerging economies.

Distribution (%) of world GDP in 1990, 2008 & 2030 (forecast) SHARE (%) 1990 2008 2030 Western Europe 22.2 16.9 11.0 USA 21.4 18.6 14.2 Other Western countries 3.2 2.8 2.2 Japan 8.6 5.7 3.3 Rich countries 55.3 44.0 30.6 Eastern Europe 2.4 2.0 1.2 Russia 4.2 2.5 1.8 Other former URSS countries 3.1 1.9 1.1 Latin America 8.3 7.9 7.1 China 7.8 17.5 28.2 India 4.0 6.7 11.3 Other Asian countries 11.4 13.9 15.3 Africa 3.3 3.4 3.5 Rest of the world 44.7 56.0 69.4 World 100.0 100.0 100.0

Source: author’s calculations on data by Mold (2010).

12. Where Do We Go From Here?


●  How to solve the global imbalances and secure the future of globalization?

●  Need to adjust the gap between the larger growth of credit (inside money) and the smaller growth of money:

1) Inflation (e.g. Quantitative Easing in the US etc.):

-  Pros: lower cost of adjustment;

-  Cons: USD losing ground as vehicle currency; multipolar globalization; higher prices of staple goods (e.g. food) drive instability (e.g. MENA); possible new asset bubbles.

2) Deflation (e.g. cutting public debt in the EU etc.):

-  Pros: avoiding asset bubbles;

-  Cons: debt-deflation spiral possibly driving to depression; further instability of the financial institutions

the great crisis and the prospects for globalization · giovanni ferri università di bari (may...

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