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1G. Hardouvelis
How bad is the 2007How bad is the 2007--8 8 financial crisis?financial crisis?
GikasGikas A. A. HardouvelisHardouvelis**
Athens, July 16, 2008Athens, July 16, 2008
* * Professor, Department of Banking and Financial Management, UniveProfessor, Department of Banking and Financial Management, University of Piraeus, rsity of Piraeus, & Chief Economist, Eurobank EFG Group& Chief Economist, Eurobank EFG Group
Presentation at the Hellenic Bank Association conference: “The recent international financial turmoil”
2G. Hardouvelis
TABLE OF CONTENTS
Intro: Differing views on the crisisMy view: VERY BAD
I. Causes of the financial crisisII. How serious is the crisis?III. Where does Greece stand now?
How bad is the 2007-8 financial crisis?
My view: Problems ahead
3G. Hardouvelis
Introduction: Is the financial crisis a problem?
A. Calomiris’ view belongs to category A: “Not yet a Minskymoment.” Minsky moment: “A worsening of credit standards culminates in a moment of recognition and recoil”
Crisis was not a surpriseMinor effects on the economy: No negative wealth effects from housing, banks able to raise capitalCrisis not as big as in the 1989-92 period
B. Yet most insiders, like George Soros or Alan Greenspan, think it is a big problem:The largest post-depression financial crisis
Different views:C. Super-bigB. BigA. Small
C. A view is slowly arising that the financial crisis is even worse than previously thought: Fundamentally related to the global inflation shock, with a possible underlying cause for both the global imbalances and the previous low interest rates, which led to the quest for yield
4G. Hardouvelis
The roots of the crisis … are in the simultaneous development of three factors:
1) A big increase (bubble) in house prices in the US2) The rapid expansion of subprime mortgages3) The transfer of risk from the banks’ balance sheets to
third party investors through securitization
Introduction: Causes & consequences
Crisis is problematic becauseit began in the US, which produces 25% of 2007 world GDPit spread in all of the financial sector and across the worldThe financial sector is highly leveredThe financial sector has the most important influence on the economy than any other sector
5G. Hardouvelis
PART I:
CAUSES OF THE FINANCIAL CRISIS
1. Housing prices
2. Subprime mortgages
3. Securitization and financial leverage
6G. Hardouvelis
I.1 The house price “bubble” was large
Categorization of banking crises according to Reinhart-Rogoff:• 5 «big» banking crises: Spain (1977), Norway (1987), Finland (1991), Sweden (1991), Japan (1992).• Smaller banking crises in developing economies: Australia (1989), Canada (1983), Denmark (1987),
France (1994), Germany (1977), Greece (1991), Iceland (1985), Italy (1990), N. Zealand (1987), Un. Kingdom (1974, 1991, 1995) και USA (1984).
Πραγµατικές τιµές ακινήτων και τραπεζικές κρίσεις
Source: Reinhart & Rogoff (2008)
USA, 2007 crisis Average for banking crises in advanced economies
Average for 5 largebanking crises
Real house prices 4 years before until 3 years after the crisist = year of banking crisis
7G. Hardouvelis
The largest fall in the history of the indices, in some areas aslarge as 40%They are expected to fall for a while in the future
I.1 The fall in home prices continues in the US …
8G. Hardouvelis
Ι.1 ... and possibly around the globe
Europe will probably follow the US experience, with most of the effect to come in the future …
House Price Gaps(unexplained increase in house prices)
1997 – 2007
-10-505
101520253035
Irela
ndN
ethe
rland
sU
n.A
ustra
liaFr
ance
Nor
way
Den
mar
kB
elgi
umSp
ain
Swed
enIta
lyJa
pan
USA
Finl
and
Ger
man
yC
anad
aA
ustri
a
Source: ΙΜF
%
9G. Hardouvelis
I.2 Rapid credit expansion
100
150
200
250
2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: Federal Reserve
2000=100
Mortgages 127%
Rest of loans 61%
USA EUROZONE
In Euro Area, no subprime lending
In the US, subprimeloans expanded
100
125
150
175
200
2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: ECB
2000=100
Mortgages 92%
Rest of loans 70%
10G. Hardouvelis
I.2 Expansion in subprime loans in the US with deteriorating credit standards
Subprime: From 9% of total mortgages in 2003 to 24% by mid-2007 (subprime & Alt-A)
Subprime-Prime spreadafter controlling for loan
characteristics
Source: Demyanyk & Van Hemert (2008)
Downward Trend
A “Minsky” apparatus:
0%
1%
2%
3%
4%
5%
6%
7%
Jan-
00A
pr-0
0Ju
l-00
Oct
-00
Jan-
01A
pr-0
1Ju
l-01
Oct
-01
Jan-
02A
pr-0
2Ju
l-02
Oct
-02
Jan-
03A
pr-0
3Ju
l-03
Oct
-03
Jan-
04A
pr-0
4Ju
l-04
Oct
-04
Jan-
05A
pr-0
5Ju
l-05
Oct
-05
Jan-
06A
pr-0
6Ju
l-06
Oct
-06
Jan-
07A
pr-0
7Ju
l-07
Oct
-07
Jan-
08A
pr-0
8Ju
l-08
Fed Funds Target Rate
Period of increase in subprime loans
11G. Hardouvelis
I.3 … due to the cannibalization of a useful market innovation: Securitization
Banks have three options:1) Keep the loans on their
balance sheets2) Sell the loans to state
controlled agencies (FNMA, FHLA, etc.), which in turn securitize them, a practice existing since 1939. So banks acquire the necessary liquidity in order to give new loans.
3) Sell the loans to private agents, especially the jumboloans, which also securitize them.
54%
30%
Share of mortgages securitized by private agents
Source: Mian & Soufi (2008)1999 2006
77% of new subprime loans were securitized
12G. Hardouvelis
I.3 The distribution of risk classes in CDOs
Source: IMF, 10/2007
Subprime exposure in Europe & Asia was small, yet the crisis spread
Banks and Insurance companies own mostly the equity portion
Buyers of ABS CDOs and distribution of risk(Market size: $350 bn)
by type of FIand Rating
by Region and Rating
13G. Hardouvelis
Lack of transparency?Lack of intimate knowledge of risk in subprimeloans?Lack of knowledge on the softness of ratings of securitized products?Lack of understanding of the leverage factor and its consequences?
I.3 Why did FI hold the equity portion?
My view:Excessive short-term profit seeking, as the equity portion provided the highest return
Miscalculation of the probability of a systematic collapse of the market
Unfortunate realization of the “bad state,” although true probability of occurrence was perhaps low, i.e. the inverse of the “peso” problem in financial markets
14G. Hardouvelis
I.3 The crisis spread as …1. Structured products are present everywhere
in portfolios across the entire financial system, in US, European and Asian banks, funds, insurance companies, etc.
2. Counterparty risk increased (lack of transparency & complexity)Interbank market – liquidity problems
3. High leverage of hedge funds, investment banks:Increased the need for liquidity & pressures for selling (Νear) defaults of Investment Banks, Insurers, Hedge funds
4. Supply of credit insurance by single entitiesCredit Default Swaps (a $62 trill. market), Monoline Insurers
5. Securitization had expanded into non-mortgage loansAsset Backed Commercial Paper
6. Rating agencies became more strict Further write-downs
7. International Accounting Standards: Mark-to-MarketBanks are forced to show PV lossesIncreased pressure for selling assets fire sales lower prices
15G. Hardouvelis
PART II:
HOW SERIOUS IS THE FINANCIAL CRISIS?
1. The market was taken by surprise2. Huge write-offs3. Cost of capital up, credit spreads do not shrink4. Housing market and MEW in the US economy5. No decoupling of emerging markets6. Inflation shock poses a dilemma for central banks7. Is the inflation shock really unrelated to the
financial shock?
16G. Hardouvelis
II.1 The market was taken by surprise:Evidence from Mortgage-based Credit Default Swaps
Note: ABX contracts are used by investors to speculate on or hedge against the risk that the underlying mortgage securities are not repaid as expected. A decline in the ABX Index signifies investors’ sentimentthat subprime mortgage holders will suffer increased financial losses from those investments.
Losses since the beginning of the crisis (July2007):
High credit quality loans ΑΑΑ : - 54%Low credit quality loansΒΒΒ: - 91%
Source: Ecowin
0
15
30
45
60
75
90
105
Jan-
07
Mar
-07
Apr
-07
May
-07
Jul-0
7
Aug
-07
Sep-
07
Nov
-07
Dec
-07
Feb-
08
Mar
-08
Apr
-08
Jun-
08
ABX, AAA rated
ABX, BBB rated
29/6/07: 99.5
29/6/07: 54.5
14/7/08: 46.2
14/7/08: 4.9
17G. Hardouvelis
II.2 Huge write-offs50 million households with mortgages, 18% of whom have negative equity, i.e., a mortgage loan higher than the value of the house (mortgages of about $1.9 trillion). This number is likely to increase, as house prices continue to decline. Asset write downs & credit losses, 1/ 2007 – 6/2008:Total write-downs of $416 bn - $326 bn capital increasesEstimated losses (IMF):$945 billion: $225 billion on unsecuritized US loans
$720 billion mark-to-market losses on related securities
Therefore:Additional capital increases necessaryAssets have to shrink (by about $1-2 trillion) credit squeeze significant economic deterioration
The authorities do whatever it takes to contain the crisis:Bernanke: Deeply aware of the Great Depression 1929-1933, innovative and effective interventionsFiscal package for the US recessionFinancial Stability Forum recommendations to G7 countriesCorrigan group, etc.
The credit crisis is deep and widespread, but hopefully will not prove to be like in Japan in 1990, or the Great Depression
18G. Hardouvelis
ΙΙ.3 A rise in the cost of capital for banks
TED spread points to an increase in default premiums (3mEurodollar - 3mTbill)Same is true in the Euro Area (3mEuribor – 3mEuroZoneTbills)This leads to an increase in household and corporate lending rates by around 1%
0
50
100
150
200
2502/
5/20
07
2/6/
2007
2/7/
2007
2/8/
2007
2/9/
2007
2/10
/200
7
2/11
/200
7
2/12
/200
7
2/1/
2008
2/2/
2008
2/3/
2008
2/4/
2008
2/5/
2008
2/6/
2008
2/7/
2008
EUROZONE USA Source: Ecowin
11/7: 117
78
19G. Hardouvelis
ΙΙ.3 Turbulence in money markets signifies increase in counterparty risk
Source: Bloomberg
US: 3m LIBOR-OIS
0
20
40
60
80
100
120
Jan-
07Fe
b-07
Mar
-07
Apr
-07
May
-07
Jun-
07Ju
l-07
Aug
-07
Sep-
07O
ct-0
7N
ov-0
7D
ec-0
7Ja
n-08
Feb-
08M
ar-0
8A
pr-0
8M
ay-0
8Ju
n-08
Jul-0
8
Eurozone: 3m EURIBOR-EONIA, OIS
0102030405060708090
100
Jan-
07Fe
b-07
Mar
-07
Apr
-07
May
-07
Jun-
07Ju
l-07
Aug
-07
Sep-
07O
ct-0
7N
ov-0
7D
ec-0
7Ja
n-08
Feb-
08M
ar-0
8A
pr-0
8M
ay-0
8Ju
n-08
Jul-0
8
Uncovered minus covered 3-month inter bank rates
20G. Hardouvelis
ΙΙ.3 Credit-derivatives: Systemic risk worries continue
CDS spreads in mid-March multi-year highsRebound following FED’s initiative to rescue Bear Sterns and coordinated central bank activity, but new widening shows systemic risk worries continue
CDX Indices: 5yr CDS spreads (bps) - US
0
50
100
150
200
250
Jan-07 May-07 Sep-07 Feb-08 Jun-08050100150200250300350400450500
Sub-investment grade (rhs)
Investment grade (lhs)
iTraxx Indices: 5yr CDS spreads (bps) - Europe
020406080
100120140160180
Jan-07 May-07 Sep-07 Feb-08 Jun-080
100
200
300
400
500
600
700Sub-investment grade (rhs)
Investment grade (lhs)
21G. Hardouvelis
* Net Equity Extraction: Free cash resulting from equity extraction - Closing costs on existing home sales, refinancings, and home equity loans
-2
0
2
4
6
8
10
Mar-91
Mar-92
Mar-93
Mar-94
Mar-95
Mar-96
Mar-97
Mar-98
Mar-99
Mar-00
Mar-01
Mar-02
Mar-03
Mar-04
Mar-05
Mar-06
Mar-07
Mar-08
-50
0
50
100
150
200
250
<< As a % of disposable income Net Equity Extraction* >>
% bn $
Net Home Equity Extraction
II.4 Housing markets pose a threat
22G. Hardouvelis
ΙΙ.4 Output falls after banking crises
Real GDP per capita growtht = year of banking crisis
US subprimecrisis, 2007 Average for banking crises in
advanced economies
Average of the “Big 5”banking crises
Source: Reinhart & Rogoff 2008Years
23G. Hardouvelis
ΙΙ.5 No decoupling: Country risk premiastay high
Source: Bloomberg, JP Morgan EMBIG Index
Sovereign Spreads in New Europe
0
50
100
150
200
250
300
350
400
450
Bulgaria Romania Serbia Turkey EmergingMarkets
Greece
29-06-2007 17-03-2008 14-07-2008
bps
Spread withGermany
24G. Hardouvelis
II.5 No decoupling so far
Real GDP growth 2007 Economist 2008f
Bloomberg 2009f
World (IMF) 4.9 3.7 3.8US 2.2 1.2 2.0
(0.36) (0.61)Eurozone 2.6 1.7 1.5
(0.21) (0.30)Japan 2.1 1.3 1.4
(0.18) (0.30)China 11.9 9.6 9.5
(0.40) (0.46)Brazil 5.4 4.6 4.0
(0.21) (0.33)Russia 8.1 7.1 6.5
(0.33) (0.24)India 9.3 7.6 8.0
(0.15) (0.40)
25G. Hardouvelis
ΙΙ. The Fed does worry
Fed: An aggressive reduction in rates, from 5.25% to 2.00%Substituted good for bad collateralIntervened beyond its jurisdiction to save an investment bank
ΕCB: Puts emphasis on inflation
01234567
4/1/
1999
4/7/
1999
4/1/
2000
4/7/
2000
4/1/
2001
4/7/
2001
4/1/
2002
4/7/
2002
4/1/
2003
4/7/
2003
4/1/
2004
4/7/
2004
4/1/
2005
4/7/
2005
4/1/
2006
4/7/
2006
4/1/
2007
4/7/
2007
4/1/
2008
4/7/
2008
Eurozone USA
Subprimecrisis
26G. Hardouvelis
0
1
2
3
4
5
6
7
2000
:Q1
2000
:Q4
2001
:Q3
2002
:Q2
2003
:Q1
2003
:Q4
2004
:Q3
2005
:Q2
2006
:Q1
2006
:Q4
2007
:Q3
2008
:Q2
Taylor Rule (EFG) Actual
%
Fed funds rate
Taylor rule: Fed funds = 1.87 + 1.09*PCE(-1) + 2.02*LMT(-1) + u, R2 = 63%, sample: 1987Q1 – 2007Q2
PCE = Core Personal Consumption ExpenditureLMT = Inverse of product of the unemployment rate and the median duration of unemployment
II.6 The central bank dilemmaOur Taylor rule with real time data, says Greenspan was correct to bring FF down to 1.0% in 2003, but the same rule now says that the FF should have been at 4.1%
Loose monetary policy
27G. Hardouvelis
II.7 Yet another shock: Global inflation
The fall in global growth reduces the size of the increase in demand, but problems at the production and refining stage remain
80.2
23.84.5
48.1
76.4
2000(mil. blper day)
9.4%
22.7%66.6%
2.1%
12.3%
7-yearGrowth
87.7Global Supply
57.5%29.2Other Developing Economies
32.0%7.5China
10.5%49.1Advanced Economies
100%85.8Global Demand
Share in Total
Growth
2007(mil. blper day)
28G. Hardouvelis
II.7 Food prices on a march forward
Food prices picked up, albeit by less than oil and metals Contributing factors:
Increase in demand from China & developing economiesIncrease in demand for bio-fuel productionEnergy cost increases in production, processing and transportationRestrictions in exports
Basic Agricultural Products
50
70
90
110130
150
170
190
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
507090110130150170190210230
Stocks of basic Agricultural Products (days of consuption) - left axis
Price Index of basic Agricultural Products (2005=100) - rght axis
Meat consumption in China20kg/person in 1980, 50kg in 19971kg of beef requires 7 kg of grains
29G. Hardouvelis
II.7 Is the inflation shock related to the origins of the financial crisis?
Some have argued that the global imbalances and the excess liquidity in emerging economies kept interest rates, especially long rates, too low: Greenspan’s conundrum
The low rates led to an unusual expansion in aggregate demand, in the US and the emerging world
The low rates also led to a quest for yield: Carry trades, securitization
This could be done as long as the world benefited from the GREAT MODERATION, a period with high growth and low inflation
But eventually the expansion in global demand growth was not matched by an equivalent supply growth, leading to the current problems.
Hence, view C: today’s super-big financial problem is due to a single source, the past global macro environment
30G. Hardouvelis
PART III:
THE UNCERTAINFUTURE GROWTH PROSPECTS
IN GREECEGreek Border
FT: “Greeks will again become immigrants …”
31G. Hardouvelis
ΙII. Impact on Greece … higher than perceived
Global shocks are precursors to an inevitable reduction in Greek growthFin. Crisis: Cost of capital up, exports down, tourism down, housing market down, shipping flatInflation: Worse impact on Greece as energy intensity larger
236.5183.42005268.5196.31995
GreeceΕU-13
(1995 real prices, consumption of oil equivalents in kg for the production of 1000€ GDP)
Energy Intensity of the Economy
Inflation: Greece & Eurozone
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Jan-
00M
ar-0
0M
ay-0
0Ju
l-00
Sep-
00N
ov-0
0Ja
n-01
Mar
-01
May
-01
Jul-0
1Se
p-01
Nov
-01
Jan-
02M
ar-0
2M
ay-0
2Ju
l-02
Sep-
02N
ov-0
2Ja
n-03
Mar
-03
May
-03
Jul-0
3Se
p-03
Nov
-03
Jan-
04M
ar-0
4M
ay-0
4Ju
l-04
Sep-
04N
ov-0
4Ja
n-05
Mar
-05
May
-05
Jul-0
5Se
p-05
Nov
-05
Jan-
06M
ar-0
6M
ay-0
6Ju
l-06
Sep-
06N
ov-0
6Ja
n-07
Mar
-07
May
-07
Jul-0
7Se
p-07
Nov
-07
Jan-
08M
ar-0
8M
ay-0
8
Greece Eurozone
%6/2008: 4.9%
Source: ECOWIN
6/2008: 4.0%
32G. Hardouvelis
ΙII. Problematic Competitiveness …… the deepest thorn of the Greek economyVisible at the macro level in the rising current account deficit
-5,8 -7,4-11,1
-6,6
-14,1
-2,8 -7,8 -7,3 -6,8-3,8-3,9
-26
-21
-16
-11
-6
-1
4
9
14
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007-26
-21
-16
-11
-6
-1
4
9
14
Income ServicesGoods TransfersCurrent Account Balance
% GDP % GDP
Source: BoG
33G. Hardouvelis
ΙII. Dismal Competitiveness rankings
World Bank: Greece ranks 100th in 2007 among 178 countries in the ease of doing business
202202121266787814144848Romania616616232366171732324646Bulgaria223223141455..335656665757Turkey
930930161655333317175656CzechRepublic
3283281616663333773737Portugal183183101066252566OECD26426420203344441515100100Greece
Paying Taxes
(hours)
Time for export(days)
Investor Protection
Index(0-10)
Difficulty of Hiring
Index(0-100)
Starting a Business (days)
Rank
34G. Hardouvelis
ΙII. High Public Debt & Aging Population
31 40 4969 77 87
98111 119 127
139152 159 168
195 204216 223
183
72,675,0
100,5 99,2101,6
104,1 102,5 103,8100,8
97,9 98,694,5
91,0
101,898,6
80,1
95,398,0
102,6
0
50
100
150
200
250
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
50
60
70
80
90
100
110
General Goverment Debt in €, (left axis)Debt as % of GDP, (right axis)
€ %
144417681888Number of pupils&students(thousands)
60.428.026.8Old-age Dependency Ratio
17.412.010.9% of older employees(55 – 64)
3.13.13.4Education Expenditures(% GDP)
6.85.45.1Health Expenditures(% GDP)
205020102005
Source: European Commission
35G. Hardouvelis
For more info, please consult the Eurobank website:
http://www.eurobank.gr/research
THANK YOU FOR YOUR ATTENTION!!My thanks to the research department of Eurobank EFG
for able research assistance and support
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