Journey over the next 3 weeks

Financial crisis and European Debt Crisis The South African economy The goods market (IS) The financial market (LM) The IS-LM model European debt crisis and the liquidity trap

The Financial Crisis and the European Debt Crisis

A Depressed World Economy

Financial Crisis & European Debt Crisis

Why are we looking at this?
Relevant to current macroeconomic environment SA exists within a global economy Most significant economic slowdown since Great Depression (event from which the discipline of macroeconomics emerged). So there must be some significance. The IS-LM model is great for understanding the policy response to the depression Relevant to your essay (incentive) Hopefully interesting

GDP growth (PPP US$) 10.00% 15.00% 20.00% 5.00%

-5.00% 0.00%

-10.00% 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 EU 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 WRLD CHN ZAF USA

08/09 Financial Crisis World recession

Increased unemployment
12.00 10.00

8.00 Unemployment rate

6.00

4.00

2.00

0.00 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

USA

EU

OECD

What happened?
It started in the US with the collapse of the US housing bubble Who to blame? Greedy banks or government? So, the story begins...

In wake of dot-com bubble and recession, declining and very low US interest rates
US Lending and Real interest rates
20 18 16 14 Interest rate (%) 12 10 8 6 4 2 0

Cheap money

1995

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Lending interest rate (%)

Real interest rate (%)

2011

Growing housing bubble - highly debt leveraged economy Heading for a Minsky moment...

Low i (cheap money)

Debt and leverage

lending by banks

P houses

Creation of mortgages

DD houses

Securitisation process

Once this massive credit crunch hit, it didnt take long before we were in recession. The recession in turn, deepened the credit crunch as demand and employment fell, and credit losses of financial institutions surged. Indeed, we have been in the grips of precisely this adverse feedback loop for more than a year. A process of balance sheet deleveraging has spread to nearly every corner of the economy. Consumers are pulling back on purchases, especially on durable goods, to build their savings. Businesses are cancelling planned investments and laying off workers to preserve cash. And, financial institutions are shrinking assets to bolster capital and improve their chances of weathering the current storm. Once again, Minsky understood this dynamic. He spoke of the paradox of deleveraging, in which precautions that may be smart for individuals and firms and indeed essential to return the economy to a normal state nevertheless magnify the distress of the economy as a whole.
Janet Yellen, vice chair of the FED from a speech entitled A Minsky Meltdown: Lessons for Central Bankers. April 16, 2009

What is this Minsky moment?

Financial instability hypothesis Focus of hypothesis = leverage (build up of debt relative to assets and income Leverage feels good until it feels terrible
Period of economic stability with low debt

Borrowing

Debt

Overall level of leverage

Sets stage for Minsky moment

Economic stability/expansion and rising prices leads to complacency, perception that debt is safe, borrowing as a habit and lessons of past forgotten (relaxation of lending standards) As long as nothing bad happens in the economy, lending doesnt seem very risky

Interest rate (%) 10 12 14 16 18 20 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 2 4 6 8

US Lending and Real interest rates

Lending interest rate (%) 1995

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

The trigger

Real interest rate (%)

The catalyst - i

Minsky moment and the debtdeflation spiral

Debt levels and leverage high enough Trigger rising interest rate Collapse of housing bubble

Minsky moment

Lenders rediscover risks of debt and debtors are forced to start deleveraging

Debt-deflation spiral

Recession

The debt-deflation spiral

fi
Borrowers cant make repayments and under threat of default

Borrowers underwater

Sell houses to pay off mortgage

P houses

SS houses

At the same time...

The debt-deflation spiral

Deleveraging consumers slash spending Burden of consumer debt becomes worse

DD

Debtors cant spend, creditors wont spend Slump in demand Recession in US

Deflation

Production & Investment

Ue

At the same time...

Banking sector collapses

Increasing number of defaults
Banks realise balance sheets are not healthy Realise other Banks balance sheets arent healthy

Stop lending to one another

Credit markets dry up

Threat of a bank run

Banking system collapses

End result
Worst recession since the Great Depression Bailouts of some of the biggest and most successful banks and investment banks in the world Recession spreads to rest of world SA has first recession since dawn of democracy Current world economy still feeling effects (e.g. European debt crisis)

How did this happen?

The low interest rate cheap money environment enabled excessive lending in the economy A financial system marked by deregulation since the 1980s allowed for increasingly risky lending practices Together, low interest rates and deregulation fed the housing bubble Perverse incentives evident in the financial sector One of the most notable sources of risk within the financial system was the securitisation process (mortgage backed securities)

Recent regulatory reform, coupled with innovative technologies, has stimulated the development of financial products, such as asset backed securities, collateral loan obligations, and credit default swaps, that facilitate the dispersion of risk... These increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter century ago.
Alan Greenspan, October 12, 2005

Banking back in the day

Stream of payments R10k each year and R1m in tenth year bank gets R1.1m

2 core functions Hold deposits and facilitate transactions Assess and manage risk and create loans Lubricant to the economy match those with excess savings to those who need finance Efficient allocation of financial resources to more productive use

$
1000 loans R1m loan (10 yr) at 10%
1000 x R1m loans at 10% Means R1.1bn stream of income Banks made money from differential between lending rate and deposit rate

Banking gone bad

Stream of payments R10k each year and R1m in tenth year bank gets R1.1m x 1000 loans = R1.1bn

$
1000 loans
R1m loan x 1000 = R1bn worth of loans Bank bundles loans and sells future stream of income to investment bank

I$
Investment bank pays bank R1bn (plus some fees) for rights to future stream of income from loans

Banking gone bad

Creates company (SPE)

1000 loans

Stream of payments R10k each year and R1m in tenth year bank gets R1.1m x 1000 loans = R1.1bn

I$

Transfers rights to future stream of payments to Company Divides company up into shares an sells shares (profit) 1 000 000 shares at R1100 per share (at least)

Owners of shares entitled to 1/1000000th of future stream of income These are mortgage (loan) backed securities

SH

A volatile system created by deregulation and perverse incentives

Mortgage Originator Ratings Agencies

SPE Stream of future payments

$
Loans

I$

Shareholders of MBSs

Stream of future payments

A volatile system created by deregulation and perverse incentives

Mortgage originators incentivised to make more mortgages (fees) Quantity over quality Trusted bosses to check risk of mortgages Banks did not check riskiness of mortgages because selling them off in bundles to investment banks (no incentive to be cautious because no longer their loan)

A volatile system created by deregulation and perverse incentives

Post Great Depression era regulations (to protect borrower and society as a whole from excessive risk taking and exploitation from banks) removed in 80s and 90s Deposit insurance and moral hazard necessitated regulation - lessons forgotten Banks used to make profit from interest differential change in banking culture its all about the fees Because banks sold off bundles of mortgages, they designed products that simply maximised fees (Perverse incentive once mortgage sold, not their problem)

A volatile system created by deregulation and perverse incentives

Bad products: 100% non-recourse loans (moral hazard)no equity of the debtor involved. Could just up and move. Lose lose situation for both bank and debtor though Mortgages that allowed borrowers to decide on value of payments (negative amortisation) Liar loans Greenspan encouraged flexible interest rate loans Constant refinancing E.g. Doris Canales refinanced home 13 times in 6 years with no-doc mortgages Many others... All based on incentive to max fees

Perverse incentive of borrower (moral hazard) and lender (did not bear risk of bad loans) aligned to get biggest house possible

A volatile system created by deregulation and perverse incentives

Deregulation GlassSteagal Act repealed in 1999 (too big to fail moral hazard i.e commercial banks were under the same umbrella as investment banks and so were not expected to fail with such resources)

A volatile system created by deregulation and perverse incentives

Should have recognised the risk of products whose safety they were asked to certify Incentive to give AAA rating to client whose paying them Race to the bottom Flawed investment models Pension funds in jeopardy

A volatile system created by deregulation and perverse incentives

No link to communities loss of incentive for bank to be a reliable lender to the communities it services (loss of channel for renegotiation

Summary
Housing bubble pops US economy in recession Spreads to global economy Ultimately sets the scene for the Euro Debt Crisis US response to recession (more about this is week 3)