Munich Lecture Nov 8 2008

8/8/2019 Munich Lecture Nov 8 2008

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The financial crisis: Initial conditions, basic

mechanisms, and appropriate policies.

Olivier Blanchard

Munich lecture, November 2008

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1. Introduction

Much too early to give a definitive assessment.

Not too early to think about the basic mechanisms, and whether/howwe can prevent similar events in the future.

A first pass, in the midst of the action. With thanks to the IMF team.

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The basic question: How could such a small trigger have such enormous effectson world output?

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Initial Subprime Losses and Subsequent Declines in World GDP,

US Households Real Estate Wealth, and US Stock Market Capitalization

(in Billions US Dollars)

Source: IMF Global Financial Stability Report; World Economic Outlook November update and estimates; Federal Reserve Flow ofFunds Accounts; World Federation of Exchanges.

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Organization

Initial conditions

Two amplification mechanisms

Interconnections and dynamics

Implications for policy now and in the future

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Setting the stage: Initial conditions

The trigger: The issuance of risky assets, with undervaluation of risk.Subprime mortgages (but not only).

Causes? Large world demand for safe assets, and bad regulation.

The determinants of amplification.

Complexity and opacity of assets on balance sheets of financialinstitutions, so low liquidity.

Causes? Better risk allocation, and bad regulation.

Increased leverage (lower capital relative to assets).

Causes? Bad, and sometimes perverse regulation.

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A visual sense of the complexity. From mortgages to securities

Subprime

Borrower

Subprime

Servicer

Subprime

Lender

SubprimeSecuritization

Structure

Loan

proceeds

Loan cash

flow

Lines of

credit

Bought by less

risk-seeking

investors

Subprime AAA

& AA bonds

Subprime BBB-

through Single A

bondsABS are bought

by CDOs and

tranched into

structured

products, financed

by issuing debt

Residuals

Bought by

more risk-

seeking

investors

BanksSecuritization

Underwriting

Banks provide liquidity

to lenders

Bamks provide

financing to CDOs

CDO

equity

Bought by more

risk-seeking

investors

CDO

debt

Bought by

other

CDOs

InsurersProvide insurance on

CDOs, ABS and some

SIVs

Banks provide credit

lines to conduits / SIVs

ABCP Conduits

/ SIVs buy ABS

and issue short-

term debt

Bought by both

low and high risk-

seeking investors

Loan cash

flow

Loan cash

flow

ABCP

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Amplification mechanism 1. Runs

Bad (or doubtful) assets on balance sheets

Runs (not only by depositors, but by other investors)

Need to sell assets.

Not enough deep pocket investors to buy (or investors waiting for theright moment to buy).

Firesale prices. P < E N P V .

Worse balance sheets. More incentives to run, etc

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Amplification mechanism 2. Capital

Bad (or doubtful) assets on balance sheets

Decrease in capital ratio (Assets minus liabilities, over Assets)

Need to sell assets (deleverage)

Not enough deep pocket investors to buy. (id)

Firesale prices. P < E N P V .

Lower capital ratio. More incentives to sell assets, etc

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The two mechanisms: Conceptually separate but strongly interacting

Run on financial institution 1

Cut credit to financial institution 2

Sale of assets at depressed prices

Low capital, so further sales

Or cut credit to financial institution 3

Examples. From US banks to Hungary. From subprimes to other assets.

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The dynamics in real time

Increase in probability of insolvency.

Increase in counterparty risk.

Decrease in volume and maturity of interbank lending.

Contagion across institutions. From direct exposure to subprime on-wards.

Contagion across countries. From the US to Europe, to emerging marketcountries.

Increasing effects on the ultimate borrowers: households and firms.

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Contagion across institutions, assets, and countries

Emerging markets

Corporate credit

Prime RMBS

Commercial MBS

Money markets

Financial institutions

Subprime RMBS

Jan- 0 7 Jul- 0 7 Jan- 0 8 Oct - 08

Heat Map: Developments in Systemic Asset Classes

Source: IMF, Global Financial Stability Report, October 2008

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Counterparty risk: Difference between the lending rate between banks and theriskless rate

0.0

1.0

2.0

3.0

4.0

5.0

01/01/07 08/01/07 03/01/08 10/01/08

US Euro Japan UK

Sep 15, 2008

Lehman Files for Bankruptcy

Ted Spreads: 3-month Libor Rate minus T-bill Rate

(in percent)

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Emerging market spreads

Emerging Markets Sovereign Srpeads - Composite Index

(1/2/06 - 11/12/08)

1/2/06

4/2/06

7/2/06

10/2/06

1/2/07

4/2/07

7/2/07

10/2/07

1/2/08

4/2/08

7/2/08

10/2/08

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Bank lending standards

-40

-20

0

20

40

60

80

100

3/30

/05

6/30

/05

9/30

/05

12/30/05

3/30

/06

6/30

/06

9/30

/06

12/30/06

3/30

/07

6/30

/07

9/30

/07

12/30/07

3/30

/08

6/30

/08

9/30

/08

U.S.: C&I loans U.S.: Mortgages

ECB: Large company loans ECB: Mortgages

Bank Lending Standards

Change in the Balance of Respondents Between Tightened Considerably-Tightened Somewhat and Eased Somewhat-EasedConsiderably in Percent of Respondents. Source: Haver Analytics.

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Financial policies for the short run

Need to dampen/eliminate the two amplification mechanisms.

Runs: Provide liquidity to a broader set of institutions.

Done. Still problem with institutions, countries without access to lenderof last resort (Iceland).

Capital.

Buy bad assets. For two reasons: Clarify price. Move price closerto EPDV.

Increase capital.

Many institutions may still need recapitalization. So need to add

capital (buy shares).

Second leg takes time to implement. May need guarantees for deposi-tors, and for interbank claims. To start interbank lending.

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Basic financial architecture in place in advanced countries

A crucial weekend in October, but:

Problems with speed/scope of recapitalization

Coherence across countries

Still hidden land mines. for example: CDS positions.

Problems in emerging market countries.

Sudden stops. Need access to international liquidity provision.

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Counterparty risk since September

3-month Libor Rate

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

8/1 8/16 8/31 9/15 9/30 10/15 10/30

US Euro Japan UK

Ted Spreads: 3-month Libor Rate

minus T-bill Rate

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

8/1 8/16 8/31 9/15 9/30 10/15 10/30

US Euro Japan UK

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Sovereign spreads since September

0

500

1000

1500

2000

2500

3000

3500

7/2/07 9/2/07 11/2/07 1/2/08 3/2/08 5/2/08 7/2/08 9/2/08 11/2/08

Current account deficit larger than 5% of 2007 GDP

Current account surplus, or small deficit

Sovereign CDS Spreads

(index 7/2/07=100)

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From the financial crisis to the economic crisis

Not a side show.

Direct effects: Credit growth, stock prices, exchange rates

Indirect effects, through confidence, and wait and see

A Keynesian recession

Worsens the financial crisis

Back to fiscal and monetary policy (in addition to financial policies)

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Decrease in stock prices

30

40

50

60

70

80

90

100

110

120

J

an-00

A

ug-00

M

ar-01

Oct-0

1

M

ay-02

Dec

-02Jul-0

3

Feb

-04

Sep

-04

A

pr-05

N

ov-0Ju

n-0

J

an-07

A

ug-07

M

ar-0Oc

t-08

WILSHIRE 5000 DJ EURO STOXX TOPIX

Equity Markets in Advanced Economies

(March 2000 = 100; national currency)

0

50

100

150

200

250

300

350

400

450

500

Jan-00

Aug-00

Mar-01

Oct-0

1

May-0

Dec-02

Jul-0

3

Feb-04

Sep-04

Apr-05

Nov-0

Jun-06

Jan-07

Aug-07

Mar-08

Oct-0

8

ASIA LATIN AMERICA EASTERN EUROPE

Equity Markets in Emerging Economies

(Index 2001=100; national currency)

Source: Bloomberg and IMF staff estimates.

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Decrease in confidence

-25

-20

-15

-10

-5

0

5

30

50

70

90

110

130

150

170

Jan-00

Aug-00

Mar-01

Oct-01

May-02

Dec-02

Jul-03

Feb-04

Sep-04

Apr-05

Nov-05

Jun-06

Jan-07

Aug

-07

Mar-08

Oct-08

EU (right scale)

U.S. (left scale)

Consumer Confidence(United States, 1985 = 100; Euro Area, percent balance)

35

40

45

50

55

60

65

Jan-00

Aug

-00

Mar-01

Oct-01

May

-02

Dec

-02

Jul-03

Feb-04

Sep-04

Apr-05

Nov

-05

Jun-06

Jan-07

Aug

-07

Mar-08

Oct-08

Euro area

United States

Emerging economies

Manufacturing PMIs(Values greater than 50 indicate expansion)

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Growth forecasts

-0.7-0.4 -0.2

5.2

-2

-1

0

1

2

3

4

5

6

7

8

United States Euro Area Japan Emerging & DevelopingEconomies

Real GDP Potential GDP

Real and Potential GDP Forecasted Growth Rates

for 2009; in percent

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Looking forward. How to avoid a repeat?

Back to the trigger and the two mechanisms: To limit the build up of systemic risk.

Broader regulation and monitoring systemic risk.

Limit leverage.

More transparent pricing and tracing of assets. Centralized trading

rather than over the counter.

For runs: Broader liquidity provision.

Across institutions, in exchange for regulation,

Across countries, for runs on claims in foreign currency.

For capital: Procyclical capital ratios.

A public fund to purchase illiquid assets at E N P V x?

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The international dimension

Need to coordinate regulation, national policies. Ireland and unilateralguarantees.

Need to monitor risk at a global level.

Exposure of Austria and Belgium to Hungary, of France to Belgium.

Exposure of emerging markets to sudden stops.

Need to organize multilateral liquidity provision. Swaps, and the newIMF facility.

Need for burden sharing rules if recapitalization. National approaches

have large spillovers.

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Munich Lecture Nov 8 2008

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