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International Economics Presentation

The Financial Crisis of 2007-2008 was caused by a combination of global imbalances, low interest rates, and the rise in securitized products. Excess savings from countries like China and oil exporters lowered global interest rates and increased the flow of money into the US, fueling a housing boom. Securitization of subprime mortgages became popular and obscured risks, while low rates encouraged borrowing. When housing prices declined, widespread losses occurred, drying up liquidity and causing bank failures that spread globally. Proposed solutions focused on regulation, coordinated policies, and ensuring financial stability.

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Topic 10: The Financial Crisis of 2007 - 2008 Huang Jirong| Glen Chan| Lim Wei| Heng Xiangle | Tan Kwan Hong
2 Imbalance Low Interest Rates Securitization Solutions
Characters in focus Kenneth Rogoff Markus K. Alan Brunnermeier Greenspan 3 Imbalance Low Interest Rates Securitization Solutions
Global Imbalances 4 Imbalance Low Interest Rates Securitization Solutions
Savings Glut Main Sources Oil-exporting countries Increase in oil prices (2004) Emerging economies Strong Economic Growth Excess Savings Source: CEIC; RBA 5 Imbalance Low Interest Rates Securitization Solutions
Excess Savings Excess Savings Insurance against Buying USD, weaken sudden capital flight own currencies E X CA 6 Imbalance Low Interest Rates Securitization Solutions
Inflow of Money into America Causes • Insufficient trustworthy saving vehicles in emerging economies Source: IMF • Seeking reliable stores of value that can be sold easily 7 Imbalance Low Interest Rates Securitization Solutions
How Inflow of Money affects US Impact of Money Inflows into US Increases in government-bond price Lowering interest rates Increase in house prices 8 Imbalance Low Interest Rates Securitization Solutions
USA vs. Emerging economies Emerging Economies • Encourage exports, depress spending United States of America • Saving reductions , Spending increments • Yearly CA deficit since 1992 9 Imbalance Low Interest Rates Securitization Solutions
Does Global Imbalances Leads to the Global Financial Meltdown? Stand 1: External Imbalances had little or nothing to do with the crisis. •The crisis was the result of financial regulatory failures and and policy errors. •Mainly on the part of the U.S. Stand 2: Global Imbalances and the financial crisis are intimately connected. •Former U.S. Treasury Secretary Henry Paulson: High savings rate of China, oil exporters and other surplus countries depressed global real interest rates. •Investors scramble for yield and under price risk. Stand 3 (Authors’ view): Agreed with Stand 2, but adopted in a more nuanced stance in the nature of the connections. •Originated from Kenneth Rogoff •Economic policies followed in a number of countries including the U.S. •Distortions that influenced the transmission of these policies through U.S. and ultimately the global financial Markets 10 Imbalance Low Interest Rates Securitization Solutions
The Financial Crisis of 2007 - 2008 Cheap Low real Low Global Credit and U.S. interest mortgage imbalance Housing rates rates Boom Economic Recession Legend Causation links Crisis links 11 Imbalance Low Interest Rates Securitization Solutions
Falling Interest Rates from 2000 to 2005 “We track Shiller Composite Index against other funding rates and see a divergence which might suggest that low funding rates lead to higher home prices” Benchmark of rates against Shiller Composite Index Correlation of lagged rates with 250% House Prices Shiller Composite 200% Inverse Correlation of Rates House Prices With Lagged Rates 150% Fed Funds -0.15 Rate 100% 10 Year -0.36 Treasury Rate 50% Adjustable Rate -0.64 0% Mortgages June 2003 June 2008 July 2000 July 2005 March 2002 November 2003 March 2007 April 2004 November 2008 April 2009 August 2002 August 2007 May 2001 May 2006 September 2004 September 2009 February 2000 February 2005 December 2000 December 2005 October 2001 January 2003 October 2006 January 2008 Fixed Rate -0.55 Mortgages Shiller Composite Fed Funds Rate Fixed Rate Mortgages Adjustable Rate Mortgages 10 Year Treasury Constant Maturity Rate Source: Standard and Poor’s www.newyorkfed.org 12 Imbalance Low Interest Rates Securitization Solutions
Lowering of Federal Funds Rate “We see little signs of inflation slowing down (2000 to 2003) which suggests that Greenspan claim might be potentially invalid” What Greenspan claims Empirical Evidence Fed Funds Rate % Price Change 7 1.00% 6 0.80% 5 0.60% 0.40% Act of insurance against falling 4 3 0.20% rate of inflation in 2003? 2 0.00% -0.20% 1 -0.40% 0 -0.60% November 2000 November 2001 November 2002 November 2003 May 2000 May 2001 May 2002 May 2003 February 2000 August 2000 February 2001 August 2001 February 2002 August 2002 February 2003 August 2003 Source: www.bls.gov & www.newyorkfed.org Year Yearly Inflation rate The fed funds rate was lowered 2000 3.73% from 6.5% (early 2001) to 1 ¾% 2001 1.14% (2001) and 1% (mid 2003) 2002 2.60% 2003 2.48% 13 Imbalance Low Interest Rates Securitization Solutions
Debate between cause of housing prices (Alan Greenspan and John Taylor) “John Taylor argues that the correct Fed Funds Rate should have been higher. Alan Greenspan kept it to low for too long leading to rise in CPI and housing prices” Taylor Rule John Taylor During period 2002 to 2005, FFR too low! Significant inverse correlation with a lag from mid 1959 to mid 2007 between Federal Funds Rate and housing starts i t=2+ t +0.5( t - )+0.5 xt : FOMC inflation target t : Prior 4 quarters inflation rate xt : % deviation from trend of real GDP 14 Imbalance Low Interest Rates Securitization Solutions
Debate between cause of housing prices (Alan Greenspan and John Taylor) “Alan Greenspan argues however that home prices are not included in Taylor’s regression model” Home Prices and Housing Starts, Alan Greenspan 1976-2009 Not starts that drive prices but the other way around Home price changes with a 6 month lead has significant explanatory power for housing starts from 1976 to 2009 with adjusted R2 of 0.36 and t statistics of 15.0 Home prices are not included in Taylor’s regression model, only CPI is included which is insufficient given that CPI and homes price have low correlation 15 Imbalance Low Interest Rates Securitization Solutions
Statistical Analysis by Alan Greenspan ^ ^ ^ Home prices = βo - β1 Fixed rate mortgaget+11 - β2 Fed Funds ratet+8 *Data from 2005 to 2007 Variable Coefficients Significant? Fixed rate -5.20 Yes mortgaget+11 Fed Funds ratet+8 -0.51 No Serial correlation? Small Sample? Cherry-picking? •Feels that federal funds rate don’t affect capitalization rate of real estate •Correlation between fed funds rate and fixed rate mortgage is 0.10 during 2002-2005 16 Imbalance Low Interest Rates Securitization Solutions
The Financial Crisis of 2007 - 2008 Cheap Low real Low Global Credit and U.S. interest mortgage imbalance Housing rates rates Boom Economic Recession Rise in popularity of securitized products Legend Causation links Crisis links 17 Imbalance Low Interest Rates Securitization Solutions
The role of banks in the crisis Movement Rise in popularity Cheap Credit toward of securitized and Housing origination and products Boom distribute model Regulatory and ratings arbitrage 18 Imbalance Low Interest Rates Securitization Solutions
Insert video on CDO (green video here) 19 Imbalance Low Interest Rates Securitization Solutions
Why did securitization become so popular Market Asset pool Generous credit rating Investors demand Banks demand Structured financial Move assets into off- Rating agencies such as products can cater to balance sheet vehicles Moody’s and S&P rated the needs of different and grant credit lines to them triple A due to investor groups. them reducing exposure conflict of interest and Furthermore interest and amount of capital wrong statistical inputs rates were low needed 20 Imbalance Low Interest Rates Securitization Solutions
Deciphering the liquidity and credit crunch Liquidity dries up Shortening What happens if the maturity of housing market turn funding downwards? Movement Rise in popularity Cheap Credit toward of securitized and Housing Bank failure: origination and Widespread loss products Boom distribute model of confidence throughout breaks the business model of banks Regulatory and ratings arbitrage 21 Imbalance Low Interest Rates Securitization Solutions
Shortening maturity of funding Off-balance-sheet vehicles invest in long-term Use of overnight repos greatly increase assets with short-term financing Off- balance- sheet vehicle Market Short-term Provide liquidity backstop: A guarantee Repo: Sell collateral asset today and to provide liquidity promising to repurchase at a later date Banks still bear liquidity risk from holding Banks roll over a large part of their dal long-term assets even though its not on funding on a daily basis bank’s balance sheet Any reduction in funding liquidity could thus lead to significant stress for the financial system 22 Imbalance Low Interest Rates Securitization Solutions
The two liquidity spirals: loss spiral and margin spiral Reduced Positions Prices move Initial Losses Funding away from e.g. credit Problems fundamentals Margin spiral Higher margins Loss spiral Losses on existing positions Banks face funding problems leading to bank failures and bank runs 23 Imbalance Low Interest Rates Securitization Solutions
The Financial Crisis of 2007 - 2008 Cheap Low real Low Global Credit and U.S. interest mortgage imbalance Housing rates rates Boom Economic Recession Rise in popularity of securitized Bank failure: Widespread loss of confidence products throughout breaks the business model of banks Banks lose Bank Failure/ Bank money from Run investments What happens if the Legend Liquidity dries up housing market turn Causation links downwards? Crisis links 24 Imbalance Low Interest Rates Securitization Solutions
Proposed Solutions Internal Measures External Measures Regulation (Greenspan) Coordinated action (Economist) - FIs issue convertible debt - surplus and deficit countries. US Government - Create “living wills” Tighten Macroeconomic Policies Central Clearinghouse (Markus) (Economist) - reduce info asymmetry - When setting Monetary and Fiscal Policies Domestic Financial Development in Measured and Coordinated Global poorer countries (Rogoff) Regulation (Greenspan) - Well functioning financial markets will - to avoid regulatory arbitrage instill domestic confidence in Others investment instruments. Liquidity Lifeline for emerging economies(Economist) - IMF could offer funds more quickly with fewer strings - Emerging economies could pool reserves 25 Imbalance Low Interest Rates Securitizations Solutions
Proposed Solutions Convertible debt Internal Measures External: Current Account External Measures Debt Debt Regulation (Greenspan) Coordinated action (Economist) Conv. Equity - FIs issue convertible debt - Asset surplus and deficit countries. Equity Asset Equity US Government - Create “living wills” Living Wills Credit Flows (Rogoff) Countering Central Clearinghouse (Markus) Orderly liquidation of Financial the - Richer countries can employ - reduce info asymmetry same countercyclical intensive Intermediaries -> Reduces uncertainty for response to regulatory oversight in depositors andbig financial inflows. creditors. Central Clearinghouse Domestic Financial Development in Measured and Coordinated Global poorer countries (Rogoff) Regulation (Greenspan) - Well functioning financial markets will - to avoid regulatory arbitrage instill domestic confidence in Complex Centralise/Transparent Others investment instruments. Liquidity Lifeline for emerging Counterparty Risks Counterparty Risks economies(Economist) - IMF could offer funds more quickly with fewer strings - Emerging economies could pool reserves 26 Imbalance Low Interest Rates Securitizations Solutions
Dealing with Banks that are “Too Big To Fail” Whole Process Administered By Financial Institutes that are “Too Big To Fail” Panel of Judges Financial Expert in Finance Banks Intermediaries Explanation Debt that is automatically Banks to issue Contingent Capital converted to equity when equity capital falls below Bonds a certain threshold. No viable exit Allow Banks Too Inter-Connected to from the Can Liquidate Quickly Liquidate Quickly to Fail bankruptcy appears When Equity is Wholly Wiped Out available, the Creditors Special Bankrupting financial Facility intermediary  Subjected to statutorily defined Taxpayers Funds should be  Regulator would be granted principles of discounts from par liquidated as (“haircuts”) access to taxpayer funds for expeditiously as “debtor-in-possession financing” of the failed institution. feasible. Institutions  Split up into separate units Survive  None are “too big to fail” Imbalance Low Interest Rates Securitizations Solutions
Proposed Solutions Internal Measures External Measures Regulation Achieve Difficult to (Greenspan) Coordinated action (Economist) -Countries have incentive to stick to the FIs issue convertible debt - surplus and deficit countries. US Government -status quo “living wills” Create Tighten Macroeconomic Policies Central Clearinghouse (Markus) (Economist) - reduce info asymmetry - When setting Monetary and Fiscal Policies Wants China to keep Wants to promote buying its public debt her exports Past failures of co-ordination activities Domestic Financial Development in Measured and Coordinated Global poorer countries (Rogoff) Policies Tighten Macroeconomic Regulation (Greenspan) -Benefits: Well functioning financial markets will - to avoid regulatory arbitrage instill domestic confidencespending - Dampened consumer in Others investment instruments. - Curb imports Liquidity Lifeline for emerging Risks: economies(Economist) - Recessions in America and - IMF could offer funds more quickly emerging markets could occur with fewer strings - Emerging economies could pool Business Case: Hard to justify policy tightening reserves when inflation is low 28 Imbalance Low Interest Rates Securitizations Solutions
Proposed Solutions Internal Measures External Measures Regulation (Greenspan) Coordinated action (Economist) - FIs issue convertible debt - surplus and deficit countries. US Government - Create “living wills” Tighten Macroeconomic Policies Central Clearinghouse (Markus) (Economist) - reduce info asymmetry - When setting Monetary and Fiscal Policies Income effect > substitution effect Domestic Financial Development in Measured and Coordinated Global poorer countries (Rogoff) Regulation (Greenspan)Reduce surplus Increased domestic - to avoid regulatory arbitrage - Well functioning financial markets will (eg. China) consumption instill domestic confidence in Others investment instruments. Liquidity Lifeline for emerging economies(Economist) Reduces Amount of Capital Flows to US - IMF could offer funds more quickly Ease downward with fewer strings - pressure on interest could pool Emerging economies reservesrates. 29 Imbalance Low Interest Rates Securitizations Solutions
Proposed Solutions Internal Measures External Measures Regulation (Greenspan) Coordinated action (Economist) - FIs issue convertible debt - surplus and deficit countries. US Government - Create “living wills” Monitor CA Balance (Rogoff) Central Clearinghouse (Markus) - When setting Monetary and Fiscal - reduce info asymmetry Policies Tightening International Bank Liquidity Regulation - Avoid co-mingling of client money Domestic Financial Development in Measured and Coordinated Global poorer countries (Rogoff)fund runs. - Prevents episodes of Regulation (Greenspan) - Well functioning financial markets will - to avoid regulatory arbitrage instill domestic confidence in Others investment instruments. Liquidity Lifeline for Emerging Liquidity Lifeline for emerging Economies economies(Economist) - IMF could offer funds more quickly - Assure Emerging-Market Countries with fewer strings that they will not be caught out if - Emerging economies could pool they run short on Liquidity reserves 30 Imbalance Low Interest Rates Securitizations Solutions
An Overview of Proposed Solutions Tighten Macro Policies Cheap Low real Low Global Credit and U.S. interest mortgage imbalance Housing Coordinated rates rates Boom Effort Domestic Economic Financial Recession Int’l Development Regulatory Rise in popularity Framework of securitized Bank failure: Widespread loss of confidence Convertible products throughout breaks the Debt business model of banks Central Clearing Banks lose Bank Failure/ Bank House money from Run Liquidity investments Lifeline What happens if the Living Will Legend Liquidity dries up housing market turn Causation links downwards? Crisis links 31 Imbalance Low Interest Rates Securitization Solutions
Concluding remark Cheap Low real Low Global Credit and U.S. interest mortgage imbalance Housing rates rates Boom Economic Recession Rise in popularity Bank failure: Widespread loss of confidence What’s Yours? of securitized products throughout breaks the business model of banks Banks lose Bank Failure/ Bank money from Run investments What happens if the Legend Liquidity dries up housing market turn Causation links downwards? Crisis links 32 Imbalance Low Interest Rates Securitization Solutions
Q&A Imbalance Low Interest Rates Securitizations Solutions 33
Back-up Slides Imbalance Low Interest Rates Securitizations Solutions 34
Federal Funds Rate and Housing Prices SPCS20R-SA Fed Funds Rate Fed funds rate lagged by a year 250.00 7 200.00 6 Correlation of 5 Home Price 150.00 Index With: S&P composite 20- 4 City Home price Fed Funds rate index 3 Fed Funds Rate 100.00 2 0.15 50.00 1 Lagged Fed 0.00 0 Funds Rate May 2001 May 2003 May 2005 May 2007 May 2009 September 2000 September 2002 September 2004 September 2006 September 2008 January 2000 January 2002 January 2004 January 2006 January 2008 January 2010 -0.15 Source: Standard & Poor’s and newyorkfed.org 35 Imbalance Low Interest Rates Securitization Solutions
10 Year Treasury Rate and Housing Prices Correlation of 10 Year Treasury Constant Maturity Rate Home Price 10 Year Treasury Constant Maturity Rate (Lagged 1 Year) Index With: Shiller Composite (20 City) 7.00 250.00 10 Year 6.00 5.00 200.00 Treasury Rate 4.00 150.00 3.00 2.00 100.00 0.25 50.00 1.00 0.00 0.00 Lagged 10 Year February 2000 August 2000 February 2001 August 2001 February 2002 August 2002 February 2003 August 2003 February 2004 August 2004 February 2005 August 2005 February 2006 August 2006 February 2007 August 2007 February 2008 August 2008 February 2009 August 2009 Treasury Rate -0.36 Source: Standard & Poor’s and newyorkfed.org 36 Imbalance Low Interest Rates Securitization Solutions
Fixed Rate Mortgages and Housing Prices Correlation of Fixed Rate Mortgages Home Price Fixed Rate Mortgages (Lagged by a year) Index With: 9.00 Shiller Composite (20 City) 250.00 8.00 Fixed Rate 7.00 200.00 Mortgages 6.00 5.00 4.00 150.00 -0.40 100.00 3.00 2.00 50.00 1.00 Lagged Fixed 0.00 0.00 Rate February 2000 February 2001 February 2002 February 2003 February 2004 February 2005 February 2006 February 2007 February 2008 February 2009 August 2000 August 2001 August 2002 August 2003 August 2004 August 2005 August 2006 August 2007 August 2008 August 2009 Mortgages -0.64 Source: Standard & Poor’s and newyorkfed.org 37 Imbalance Low Interest Rates Securitization Solutions
Adjustable Rate Mortgages and Housing Prices Adjustable Rate Mortgages Correlation of Adjustable Rate Mortgages (Lagged 1 year) Home Price Shiller Composite (20 City) 8.00 250.00 Index With: 7.00 6.00 200.00 Fixed Rate 5.00 150.00 Mortgages 4.00 3.00 100.00 -0.22 2.00 50.00 1.00 Lagged Fixed 0.00 0.00 Rate February 2000 February 2001 February 2002 February 2003 February 2004 February 2005 February 2006 February 2007 February 2008 February 2009 August 2000 August 2001 August 2002 August 2003 August 2004 August 2005 August 2006 August 2007 August 2008 August 2009 Mortgages -0.55 Source: Standard & Poor’s and newyorkfed.org 38 Imbalance Low Interest Rates Securitization Solutions
Issue Contingent Capital Bonds • Has at least a reasonable chance of reversing the extraordinarily large “moral hazard” that has arisen over the past year and more. • To require banks and possibly all financial intermediaries to issue contingent capital bonds, that is, debt that is automatically converted to equity when equity capital falls below a certain threshold. • Such debt will, of course, be more costly on issuance than simple debentures. Imbalance Low Interest Rates Securitization Solutions
Debtor-in-possession financing • However, should contingent capital bonds prove insufficient, we should allow large institutions to fail and, if assessed by regulators as too inter-connected to liquidate quickly, be taken into a special bankruptcy facility, whereupon the regulator would be granted access to taxpayer funds for “debtor-in-possession financing” of the failed institution. • Its creditors (when equity is wholly wiped out) would be subject to statutorily defined principles of discounts from par (“haircuts”), and the institution would then be required to split up into separate units, none of which should be of a size that is too big to fail. • The whole process would be administered by a panel of judges expert in finance. Imbalance Low Interest Rates Securitization Solutions
Allow Banks to be Liquidated as Expeditiously as Feasible • Greenspan assumed that some of the newly created firms would survive, and others fail. • If, after a fixed short period of time, no viable exit from the bankruptcy appears available, the financial intermediary should be liquidated as expeditiously as feasible. Imbalance Low Interest Rates Securitization Solutions
What Regulation Can Do Supervision Strong Capital Counterparty and Regulatory Requirements Surveillance Examination System Supervision and examination, as a back-up to capital requirements and counterparty surveillance is promulgate rules that are preventative and do not require anticipating an uncertain future. Supervision • can audit and enforce capital and liquidity requirements • can require that financial institutions issue some debt that will become equity should equity capital become impaired • can, and has, put limits or prohibitions on certain types of concentrated bank lending • can prohibit complex affiliate and subsidiary structures whose sole purpose is tax avoidance or regulatory arbitrage • can inhibit the reconsolidation of affiliates previously sold to investors, especially structured investment vehicles (SIVs) • can require “living wills” in which financial intermediaries indicate, on an ongoing basis, how they can be liquidated expeditiously with mini- mum impact on counterparties and markets. Imbalance Low Interest Rates Securitization Solutions
New Set of Regulatory Requirements and Standards • Fix the level of regulatory risk-adjusted capital, liquidity, and collateral standards required by counterparties. • Private market participants are now requiring economic capital and balance sheet liquidity well in excess of the yet-to-be-amended Basel II requirements. • The shadow banks that survived the crisis are now having to meet significantly tighter market standards, with respect to capital, liquidity, and collateral, than existed before the crisis. Imbalance Low Interest Rates Securitization Solutions
Increase Collateral that Cannot Be Commingled with Own Assets • To ensure that financial intermediaries have adequate cash to meet ongoing commitments in the event of a shutdown in external funding, international bank liquidity regulation should match the tightening already evident in private risk management paradigms (Basel Committee on Banking Supervision 2009). • In the United States, to lower the risk of a “run on the broker,” the amount of customer assets (collateral) held by broker-dealers that cannot be commingled with their own assets needs to be increased. That would decrease the amount of funds that can “run.” • However, such action must be measured and coordinated with other global regulators to avoid regulatory arbitrage. Imbalance Low Interest Rates Securitization Solutions
“Capital, liquidity, and collateral, in my experience, address almost all of the financial regulatory structure shortcomings exposed by the onset of the crisis.” ~ Alan Greenspan The Crisis Imbalance Low Interest Rates Securitization Solutions

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International Economics Presentation

  • 1.
    Topic 10: The FinancialCrisis of 2007 - 2008 Huang Jirong| Glen Chan| Lim Wei| Heng Xiangle | Tan Kwan Hong
  • 2.
    2 Imbalance Low Interest Rates Securitization Solutions
  • 3.
    Characters in focus Kenneth Rogoff Markus K. Alan Brunnermeier Greenspan 3 Imbalance Low Interest Rates Securitization Solutions
  • 4.
    Global Imbalances 4 Imbalance Low Interest Rates Securitization Solutions
  • 5.
    Savings Glut Main Sources Oil-exportingcountries Increase in oil prices (2004) Emerging economies Strong Economic Growth Excess Savings Source: CEIC; RBA 5 Imbalance Low Interest Rates Securitization Solutions
  • 6.
    Excess Savings Excess Savings Insurance against Buying USD, weaken sudden capital flight own currencies E X CA 6 Imbalance Low Interest Rates Securitization Solutions
  • 7.
    Inflow of Moneyinto America Causes • Insufficient trustworthy saving vehicles in emerging economies Source: IMF • Seeking reliable stores of value that can be sold easily 7 Imbalance Low Interest Rates Securitization Solutions
  • 8.
    How Inflow ofMoney affects US Impact of Money Inflows into US Increases in government-bond price Lowering interest rates Increase in house prices 8 Imbalance Low Interest Rates Securitization Solutions
  • 9.
    USA vs. Emergingeconomies Emerging Economies • Encourage exports, depress spending United States of America • Saving reductions , Spending increments • Yearly CA deficit since 1992 9 Imbalance Low Interest Rates Securitization Solutions
  • 10.
    Does Global ImbalancesLeads to the Global Financial Meltdown? Stand 1: External Imbalances had little or nothing to do with the crisis. •The crisis was the result of financial regulatory failures and and policy errors. •Mainly on the part of the U.S. Stand 2: Global Imbalances and the financial crisis are intimately connected. •Former U.S. Treasury Secretary Henry Paulson: High savings rate of China, oil exporters and other surplus countries depressed global real interest rates. •Investors scramble for yield and under price risk. Stand 3 (Authors’ view): Agreed with Stand 2, but adopted in a more nuanced stance in the nature of the connections. •Originated from Kenneth Rogoff •Economic policies followed in a number of countries including the U.S. •Distortions that influenced the transmission of these policies through U.S. and ultimately the global financial Markets 10 Imbalance Low Interest Rates Securitization Solutions
  • 11.
    The Financial Crisisof 2007 - 2008 Cheap Low real Low Global Credit and U.S. interest mortgage imbalance Housing rates rates Boom Economic Recession Legend Causation links Crisis links 11 Imbalance Low Interest Rates Securitization Solutions
  • 12.
    Falling Interest Ratesfrom 2000 to 2005 “We track Shiller Composite Index against other funding rates and see a divergence which might suggest that low funding rates lead to higher home prices” Benchmark of rates against Shiller Composite Index Correlation of lagged rates with 250% House Prices Shiller Composite 200% Inverse Correlation of Rates House Prices With Lagged Rates 150% Fed Funds -0.15 Rate 100% 10 Year -0.36 Treasury Rate 50% Adjustable Rate -0.64 0% Mortgages June 2003 June 2008 July 2000 July 2005 March 2002 November 2003 March 2007 April 2004 November 2008 April 2009 August 2002 August 2007 May 2001 May 2006 September 2004 September 2009 February 2000 February 2005 December 2000 December 2005 October 2001 January 2003 October 2006 January 2008 Fixed Rate -0.55 Mortgages Shiller Composite Fed Funds Rate Fixed Rate Mortgages Adjustable Rate Mortgages 10 Year Treasury Constant Maturity Rate Source: Standard and Poor’s www.newyorkfed.org 12 Imbalance Low Interest Rates Securitization Solutions
  • 13.
    Lowering of FederalFunds Rate “We see little signs of inflation slowing down (2000 to 2003) which suggests that Greenspan claim might be potentially invalid” What Greenspan claims Empirical Evidence Fed Funds Rate % Price Change 7 1.00% 6 0.80% 5 0.60% 0.40% Act of insurance against falling 4 3 0.20% rate of inflation in 2003? 2 0.00% -0.20% 1 -0.40% 0 -0.60% November 2000 November 2001 November 2002 November 2003 May 2000 May 2001 May 2002 May 2003 February 2000 August 2000 February 2001 August 2001 February 2002 August 2002 February 2003 August 2003 Source: www.bls.gov & www.newyorkfed.org Year Yearly Inflation rate The fed funds rate was lowered 2000 3.73% from 6.5% (early 2001) to 1 ¾% 2001 1.14% (2001) and 1% (mid 2003) 2002 2.60% 2003 2.48% 13 Imbalance Low Interest Rates Securitization Solutions
  • 14.
    Debate between causeof housing prices (Alan Greenspan and John Taylor) “John Taylor argues that the correct Fed Funds Rate should have been higher. Alan Greenspan kept it to low for too long leading to rise in CPI and housing prices” Taylor Rule John Taylor During period 2002 to 2005, FFR too low! Significant inverse correlation with a lag from mid 1959 to mid 2007 between Federal Funds Rate and housing starts i t=2+ t +0.5( t - )+0.5 xt : FOMC inflation target t : Prior 4 quarters inflation rate xt : % deviation from trend of real GDP 14 Imbalance Low Interest Rates Securitization Solutions
  • 15.
    Debate between causeof housing prices (Alan Greenspan and John Taylor) “Alan Greenspan argues however that home prices are not included in Taylor’s regression model” Home Prices and Housing Starts, Alan Greenspan 1976-2009 Not starts that drive prices but the other way around Home price changes with a 6 month lead has significant explanatory power for housing starts from 1976 to 2009 with adjusted R2 of 0.36 and t statistics of 15.0 Home prices are not included in Taylor’s regression model, only CPI is included which is insufficient given that CPI and homes price have low correlation 15 Imbalance Low Interest Rates Securitization Solutions
  • 16.
    Statistical Analysis byAlan Greenspan ^ ^ ^ Home prices = βo - β1 Fixed rate mortgaget+11 - β2 Fed Funds ratet+8 *Data from 2005 to 2007 Variable Coefficients Significant? Fixed rate -5.20 Yes mortgaget+11 Fed Funds ratet+8 -0.51 No Serial correlation? Small Sample? Cherry-picking? •Feels that federal funds rate don’t affect capitalization rate of real estate •Correlation between fed funds rate and fixed rate mortgage is 0.10 during 2002-2005 16 Imbalance Low Interest Rates Securitization Solutions
  • 17.
    The Financial Crisisof 2007 - 2008 Cheap Low real Low Global Credit and U.S. interest mortgage imbalance Housing rates rates Boom Economic Recession Rise in popularity of securitized products Legend Causation links Crisis links 17 Imbalance Low Interest Rates Securitization Solutions
  • 18.
    The role ofbanks in the crisis Movement Rise in popularity Cheap Credit toward of securitized and Housing origination and products Boom distribute model Regulatory and ratings arbitrage 18 Imbalance Low Interest Rates Securitization Solutions
  • 19.
    Insert video onCDO (green video here) 19 Imbalance Low Interest Rates Securitization Solutions
  • 20.
    Why did securitizationbecome so popular Market Asset pool Generous credit rating Investors demand Banks demand Structured financial Move assets into off- Rating agencies such as products can cater to balance sheet vehicles Moody’s and S&P rated the needs of different and grant credit lines to them triple A due to investor groups. them reducing exposure conflict of interest and Furthermore interest and amount of capital wrong statistical inputs rates were low needed 20 Imbalance Low Interest Rates Securitization Solutions
  • 21.
    Deciphering the liquidityand credit crunch Liquidity dries up Shortening What happens if the maturity of housing market turn funding downwards? Movement Rise in popularity Cheap Credit toward of securitized and Housing Bank failure: origination and Widespread loss products Boom distribute model of confidence throughout breaks the business model of banks Regulatory and ratings arbitrage 21 Imbalance Low Interest Rates Securitization Solutions
  • 22.
    Shortening maturity offunding Off-balance-sheet vehicles invest in long-term Use of overnight repos greatly increase assets with short-term financing Off- balance- sheet vehicle Market Short-term Provide liquidity backstop: A guarantee Repo: Sell collateral asset today and to provide liquidity promising to repurchase at a later date Banks still bear liquidity risk from holding Banks roll over a large part of their dal long-term assets even though its not on funding on a daily basis bank’s balance sheet Any reduction in funding liquidity could thus lead to significant stress for the financial system 22 Imbalance Low Interest Rates Securitization Solutions
  • 23.
    The two liquidityspirals: loss spiral and margin spiral Reduced Positions Prices move Initial Losses Funding away from e.g. credit Problems fundamentals Margin spiral Higher margins Loss spiral Losses on existing positions Banks face funding problems leading to bank failures and bank runs 23 Imbalance Low Interest Rates Securitization Solutions
  • 24.
    The Financial Crisisof 2007 - 2008 Cheap Low real Low Global Credit and U.S. interest mortgage imbalance Housing rates rates Boom Economic Recession Rise in popularity of securitized Bank failure: Widespread loss of confidence products throughout breaks the business model of banks Banks lose Bank Failure/ Bank money from Run investments What happens if the Legend Liquidity dries up housing market turn Causation links downwards? Crisis links 24 Imbalance Low Interest Rates Securitization Solutions
  • 25.
    Proposed Solutions Internal Measures External Measures Regulation (Greenspan) Coordinated action (Economist) - FIs issue convertible debt - surplus and deficit countries. US Government - Create “living wills” Tighten Macroeconomic Policies Central Clearinghouse (Markus) (Economist) - reduce info asymmetry - When setting Monetary and Fiscal Policies Domestic Financial Development in Measured and Coordinated Global poorer countries (Rogoff) Regulation (Greenspan) - Well functioning financial markets will - to avoid regulatory arbitrage instill domestic confidence in Others investment instruments. Liquidity Lifeline for emerging economies(Economist) - IMF could offer funds more quickly with fewer strings - Emerging economies could pool reserves 25 Imbalance Low Interest Rates Securitizations Solutions
  • 26.
    Proposed Solutions Convertible debt Internal Measures External: Current Account External Measures Debt Debt Regulation (Greenspan) Coordinated action (Economist) Conv. Equity - FIs issue convertible debt - Asset surplus and deficit countries. Equity Asset Equity US Government - Create “living wills” Living Wills Credit Flows (Rogoff) Countering Central Clearinghouse (Markus) Orderly liquidation of Financial the - Richer countries can employ - reduce info asymmetry same countercyclical intensive Intermediaries -> Reduces uncertainty for response to regulatory oversight in depositors andbig financial inflows. creditors. Central Clearinghouse Domestic Financial Development in Measured and Coordinated Global poorer countries (Rogoff) Regulation (Greenspan) - Well functioning financial markets will - to avoid regulatory arbitrage instill domestic confidence in Complex Centralise/Transparent Others investment instruments. Liquidity Lifeline for emerging Counterparty Risks Counterparty Risks economies(Economist) - IMF could offer funds more quickly with fewer strings - Emerging economies could pool reserves 26 Imbalance Low Interest Rates Securitizations Solutions
  • 27.
    Dealing with Banksthat are “Too Big To Fail” Whole Process Administered By Financial Institutes that are “Too Big To Fail” Panel of Judges Financial Expert in Finance Banks Intermediaries Explanation Debt that is automatically Banks to issue Contingent Capital converted to equity when equity capital falls below Bonds a certain threshold. No viable exit Allow Banks Too Inter-Connected to from the Can Liquidate Quickly Liquidate Quickly to Fail bankruptcy appears When Equity is Wholly Wiped Out available, the Creditors Special Bankrupting financial Facility intermediary  Subjected to statutorily defined Taxpayers Funds should be  Regulator would be granted principles of discounts from par liquidated as (“haircuts”) access to taxpayer funds for expeditiously as “debtor-in-possession financing” of the failed institution. feasible. Institutions  Split up into separate units Survive  None are “too big to fail” Imbalance Low Interest Rates Securitizations Solutions
  • 28.
    Proposed Solutions Internal Measures External Measures Regulation Achieve Difficult to (Greenspan) Coordinated action (Economist) -Countries have incentive to stick to the FIs issue convertible debt - surplus and deficit countries. US Government -status quo “living wills” Create Tighten Macroeconomic Policies Central Clearinghouse (Markus) (Economist) - reduce info asymmetry - When setting Monetary and Fiscal Policies Wants China to keep Wants to promote buying its public debt her exports Past failures of co-ordination activities Domestic Financial Development in Measured and Coordinated Global poorer countries (Rogoff) Policies Tighten Macroeconomic Regulation (Greenspan) -Benefits: Well functioning financial markets will - to avoid regulatory arbitrage instill domestic confidencespending - Dampened consumer in Others investment instruments. - Curb imports Liquidity Lifeline for emerging Risks: economies(Economist) - Recessions in America and - IMF could offer funds more quickly emerging markets could occur with fewer strings - Emerging economies could pool Business Case: Hard to justify policy tightening reserves when inflation is low 28 Imbalance Low Interest Rates Securitizations Solutions
  • 29.
    Proposed Solutions Internal Measures External Measures Regulation (Greenspan) Coordinated action (Economist) - FIs issue convertible debt - surplus and deficit countries. US Government - Create “living wills” Tighten Macroeconomic Policies Central Clearinghouse (Markus) (Economist) - reduce info asymmetry - When setting Monetary and Fiscal Policies Income effect > substitution effect Domestic Financial Development in Measured and Coordinated Global poorer countries (Rogoff) Regulation (Greenspan)Reduce surplus Increased domestic - to avoid regulatory arbitrage - Well functioning financial markets will (eg. China) consumption instill domestic confidence in Others investment instruments. Liquidity Lifeline for emerging economies(Economist) Reduces Amount of Capital Flows to US - IMF could offer funds more quickly Ease downward with fewer strings - pressure on interest could pool Emerging economies reservesrates. 29 Imbalance Low Interest Rates Securitizations Solutions
  • 30.
    Proposed Solutions Internal Measures External Measures Regulation (Greenspan) Coordinated action (Economist) - FIs issue convertible debt - surplus and deficit countries. US Government - Create “living wills” Monitor CA Balance (Rogoff) Central Clearinghouse (Markus) - When setting Monetary and Fiscal - reduce info asymmetry Policies Tightening International Bank Liquidity Regulation - Avoid co-mingling of client money Domestic Financial Development in Measured and Coordinated Global poorer countries (Rogoff)fund runs. - Prevents episodes of Regulation (Greenspan) - Well functioning financial markets will - to avoid regulatory arbitrage instill domestic confidence in Others investment instruments. Liquidity Lifeline for Emerging Liquidity Lifeline for emerging Economies economies(Economist) - IMF could offer funds more quickly - Assure Emerging-Market Countries with fewer strings that they will not be caught out if - Emerging economies could pool they run short on Liquidity reserves 30 Imbalance Low Interest Rates Securitizations Solutions
  • 31.
    An Overview ofProposed Solutions Tighten Macro Policies Cheap Low real Low Global Credit and U.S. interest mortgage imbalance Housing Coordinated rates rates Boom Effort Domestic Economic Financial Recession Int’l Development Regulatory Rise in popularity Framework of securitized Bank failure: Widespread loss of confidence Convertible products throughout breaks the Debt business model of banks Central Clearing Banks lose Bank Failure/ Bank House money from Run Liquidity investments Lifeline What happens if the Living Will Legend Liquidity dries up housing market turn Causation links downwards? Crisis links 31 Imbalance Low Interest Rates Securitization Solutions
  • 32.
    Concluding remark Cheap Low real Low Global Credit and U.S. interest mortgage imbalance Housing rates rates Boom Economic Recession Rise in popularity Bank failure: Widespread loss of confidence What’s Yours? of securitized products throughout breaks the business model of banks Banks lose Bank Failure/ Bank money from Run investments What happens if the Legend Liquidity dries up housing market turn Causation links downwards? Crisis links 32 Imbalance Low Interest Rates Securitization Solutions
  • 33.
    Q&A Imbalance Low Interest Rates Securitizations Solutions 33
  • 34.
    Back-up Slides Imbalance Low Interest Rates Securitizations Solutions 34
  • 35.
    Federal Funds Rateand Housing Prices SPCS20R-SA Fed Funds Rate Fed funds rate lagged by a year 250.00 7 200.00 6 Correlation of 5 Home Price 150.00 Index With: S&P composite 20- 4 City Home price Fed Funds rate index 3 Fed Funds Rate 100.00 2 0.15 50.00 1 Lagged Fed 0.00 0 Funds Rate May 2001 May 2003 May 2005 May 2007 May 2009 September 2000 September 2002 September 2004 September 2006 September 2008 January 2000 January 2002 January 2004 January 2006 January 2008 January 2010 -0.15 Source: Standard & Poor’s and newyorkfed.org 35 Imbalance Low Interest Rates Securitization Solutions
  • 36.
    10 Year TreasuryRate and Housing Prices Correlation of 10 Year Treasury Constant Maturity Rate Home Price 10 Year Treasury Constant Maturity Rate (Lagged 1 Year) Index With: Shiller Composite (20 City) 7.00 250.00 10 Year 6.00 5.00 200.00 Treasury Rate 4.00 150.00 3.00 2.00 100.00 0.25 50.00 1.00 0.00 0.00 Lagged 10 Year February 2000 August 2000 February 2001 August 2001 February 2002 August 2002 February 2003 August 2003 February 2004 August 2004 February 2005 August 2005 February 2006 August 2006 February 2007 August 2007 February 2008 August 2008 February 2009 August 2009 Treasury Rate -0.36 Source: Standard & Poor’s and newyorkfed.org 36 Imbalance Low Interest Rates Securitization Solutions
  • 37.
    Fixed Rate Mortgagesand Housing Prices Correlation of Fixed Rate Mortgages Home Price Fixed Rate Mortgages (Lagged by a year) Index With: 9.00 Shiller Composite (20 City) 250.00 8.00 Fixed Rate 7.00 200.00 Mortgages 6.00 5.00 4.00 150.00 -0.40 100.00 3.00 2.00 50.00 1.00 Lagged Fixed 0.00 0.00 Rate February 2000 February 2001 February 2002 February 2003 February 2004 February 2005 February 2006 February 2007 February 2008 February 2009 August 2000 August 2001 August 2002 August 2003 August 2004 August 2005 August 2006 August 2007 August 2008 August 2009 Mortgages -0.64 Source: Standard & Poor’s and newyorkfed.org 37 Imbalance Low Interest Rates Securitization Solutions
  • 38.
    Adjustable Rate Mortgagesand Housing Prices Adjustable Rate Mortgages Correlation of Adjustable Rate Mortgages (Lagged 1 year) Home Price Shiller Composite (20 City) 8.00 250.00 Index With: 7.00 6.00 200.00 Fixed Rate 5.00 150.00 Mortgages 4.00 3.00 100.00 -0.22 2.00 50.00 1.00 Lagged Fixed 0.00 0.00 Rate February 2000 February 2001 February 2002 February 2003 February 2004 February 2005 February 2006 February 2007 February 2008 February 2009 August 2000 August 2001 August 2002 August 2003 August 2004 August 2005 August 2006 August 2007 August 2008 August 2009 Mortgages -0.55 Source: Standard & Poor’s and newyorkfed.org 38 Imbalance Low Interest Rates Securitization Solutions
  • 39.
    Issue Contingent CapitalBonds • Has at least a reasonable chance of reversing the extraordinarily large “moral hazard” that has arisen over the past year and more. • To require banks and possibly all financial intermediaries to issue contingent capital bonds, that is, debt that is automatically converted to equity when equity capital falls below a certain threshold. • Such debt will, of course, be more costly on issuance than simple debentures. Imbalance Low Interest Rates Securitization Solutions
  • 40.
    Debtor-in-possession financing • However,should contingent capital bonds prove insufficient, we should allow large institutions to fail and, if assessed by regulators as too inter-connected to liquidate quickly, be taken into a special bankruptcy facility, whereupon the regulator would be granted access to taxpayer funds for “debtor-in-possession financing” of the failed institution. • Its creditors (when equity is wholly wiped out) would be subject to statutorily defined principles of discounts from par (“haircuts”), and the institution would then be required to split up into separate units, none of which should be of a size that is too big to fail. • The whole process would be administered by a panel of judges expert in finance. Imbalance Low Interest Rates Securitization Solutions
  • 41.
    Allow Banks tobe Liquidated as Expeditiously as Feasible • Greenspan assumed that some of the newly created firms would survive, and others fail. • If, after a fixed short period of time, no viable exit from the bankruptcy appears available, the financial intermediary should be liquidated as expeditiously as feasible. Imbalance Low Interest Rates Securitization Solutions
  • 42.
    What Regulation CanDo Supervision Strong Capital Counterparty and Regulatory Requirements Surveillance Examination System Supervision and examination, as a back-up to capital requirements and counterparty surveillance is promulgate rules that are preventative and do not require anticipating an uncertain future. Supervision • can audit and enforce capital and liquidity requirements • can require that financial institutions issue some debt that will become equity should equity capital become impaired • can, and has, put limits or prohibitions on certain types of concentrated bank lending • can prohibit complex affiliate and subsidiary structures whose sole purpose is tax avoidance or regulatory arbitrage • can inhibit the reconsolidation of affiliates previously sold to investors, especially structured investment vehicles (SIVs) • can require “living wills” in which financial intermediaries indicate, on an ongoing basis, how they can be liquidated expeditiously with mini- mum impact on counterparties and markets. Imbalance Low Interest Rates Securitization Solutions
  • 43.
    New Set ofRegulatory Requirements and Standards • Fix the level of regulatory risk-adjusted capital, liquidity, and collateral standards required by counterparties. • Private market participants are now requiring economic capital and balance sheet liquidity well in excess of the yet-to-be-amended Basel II requirements. • The shadow banks that survived the crisis are now having to meet significantly tighter market standards, with respect to capital, liquidity, and collateral, than existed before the crisis. Imbalance Low Interest Rates Securitization Solutions
  • 44.
    Increase Collateral thatCannot Be Commingled with Own Assets • To ensure that financial intermediaries have adequate cash to meet ongoing commitments in the event of a shutdown in external funding, international bank liquidity regulation should match the tightening already evident in private risk management paradigms (Basel Committee on Banking Supervision 2009). • In the United States, to lower the risk of a “run on the broker,” the amount of customer assets (collateral) held by broker-dealers that cannot be commingled with their own assets needs to be increased. That would decrease the amount of funds that can “run.” • However, such action must be measured and coordinated with other global regulators to avoid regulatory arbitrage. Imbalance Low Interest Rates Securitization Solutions
  • 45.
    “Capital, liquidity, andcollateral, in my experience, address almost all of the financial regulatory structure shortcomings exposed by the onset of the crisis.” ~ Alan Greenspan The Crisis Imbalance Low Interest Rates Securitization Solutions

Editor's Notes

  • #2 LW
  • #5 According to The Economists, the problem of imbalances lay at the root of the financial crisis.Imbalance stems from the savings glut.
  • #6 This is the first time that capital flows go mostly from emerging market economies (mainly Asia and the Oil exporting economies), to advanced economies. Also, the foreign asset positions have become much larger in both gross and net terms, and the degree of capital mobility is the highest in decades.
  • #7 Lessons learnt from AFCExchange rate policy in China: Further helped to improve their exports and hence their CA as their exports became cheaper
  • #8 financial development has not been followed at the same pace as the financial openness.Investors were searching for a safe haven for their money. They were seek reliable stores of value which could be sold easily.For this reason, many countries have decided to invest those assets abroad, in the more financially developed countries, such as the United States
  • #9 The Savings Glut helped push down the yields on Treasury bonds, through the foreign purchases. This reduction in interest rate, in addition to other policy measures adopted by central banks
  • #10 On one hand, Emerging economiesIncrease CA through increase in net exportsHence, we can see the imbalance formingWith the rise in cheap available credit, saving reductions, spending increments,In fact US has seen a yearly CA deficit since 1992