Financialization and the crisis

Marc LavoieUniversity of Ottawa

Some background

A couple of years ago hardly any economist knew about these terms

• ABS, MBS, RMBS, CMBS, ABCP, CDO, CDO2, CMO, CLO, CDS, EDS, SPE, SPV, SIV

• asset-backed securities, mortgage-backed securities, residential mortgage-backed securities, commercial mortgage-backed securities, asset-backed commercial paper, collaterized debt obligation, collaterized debt obligation squared, collaterized mortgage obligation, collaterized loan obligation, credit default swaps, equity default swaps, special purpose entity, special purpose vehicle, structured investment vehicle

Some warning signs

• 2005: High share of new mortgage loans that were subprime;

• 2006: Risky mortgage formula (interest only, 2/28, negative amortization)

• Mid 2006: US Real estate prices stop rising• Early 2007: the cost of insuring BBB mortgage-

backed securities against default losses rose briskly (MBX or ABX indices take a plunge)

Falling values of MBX, the reverse of the cost of default insurance on MBS

A change of policy paradigm

A second Keynesian pragmatic revolution

• In contrast to previous financial crises, the IMF advocates low interest rates and government stimulus packages with budget deficits;

• G20 leaders move away from unfettered markets and uncontrolled capitalism;

• Gordon Brown (UK): “The Washington consensus is out”;

• Financial Times: “The credit crunch has destroyed faith in the free market ideology”.

Two opposite views back in favour in the media

• Neo-Austrian theory (Hayek, von Mises) at the forefront of the second counter-revolution;

• Post-Keynesian monetary theory (Galbraith, Minsky) at the forefront of the second Keynesian revolution;

The neo-Austrian view (not mine!) of the crisis in a nutshell

• The US government (CRA) forced banks to grant subprime loans.

• The Fed set short-term rates at too low a level (from 2002 to 2004).

• The Chinese rigged the exchange rate and flooded long-term bond markets, also leading to overly low long-term rates.

• There would be no crises if government was small and interest rates were always set at their natural levels.

• The fiscal stimulus will make things worse!

The post-Keynesian view of the crisis in a nutshell

• Western economies have moved towards a financialization process over the last decades, with deregulation of the regulated financial system and growth of the unregulated financial system.

• The current regime of accumulation (based on low real wages and consumer debt) was unsustainable.

• Financial crises are an endogenous feature of unregulated capitalism.

• As a result, financial crises are more frequent and more severe.

Financialization

Finance capitalism, Stock market capitalism

Money manager capitalism Rentier capitalism

Financialization: definition

• “Financialization means the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies” (Epstein 2006)

Financial institutions – stylized facts

• The GDP share of the finance, insurance and real estate sectors has nearly doubled

• The profits of financial corporations relative to those of non-financial corporations have doubled or tripled.

• The profits of banks as a percentage of their total assets have nearly doubled.

• Compensation of employees in the financial sector as a percentage of total compensation in the economy has doubled.

• The turnover rate of shares on stock markets has doubled.

Non-Financial corporations – stylized facts• The percentage of financial assets held by non-financial

corporations relative to tangible assets has tripled, now on par.

• Non-financial corporations, that used to issue new equity to finance their investments, now often buy back their shares instead.

• Non-financial corporations now raise a larger proportion of their funds through bond issues.

• The interest and dividend income of non-financial corporations as a percentage of their gross value added has tripled.

• The interest payments of non-financial corporations as a percentage of their gross value added has quadrupled.

• The dividend payout ratio (as a percentage of their cash-flow) has doubled.

Distributional issues – stylized facts

• The wage share of income has gone down.• The share of income going to rentiers has risen.• Labour hourly productivity has grown much faster than

hourly earnings or even hourly total compensation of production and non-supervisory workers.

• The income share of the lowest quintile has fallen.• The income share of the highest quintile has risen.• There has been an incredible rise in the income share of

the top centile.

Flow-of-funds – stylized facts• The net accumulation of financial assets of corporations

is positive, meaning that they lend their surpluses to households, with about half of these funds coming from financial corporations.

• The net accumulation of financial assets of households is negative, meaning that they borrow from corporations to pay for their consumption, financial and real estate investments.

• This has been made possible in particular by the use of margin debt – the borrowing of money, collaterized by equity in the stock market or equity in homes.

Some specificics of financialization

Securitization and credit default swaps

The advantages of securitization and its derivatives, according to finance

• It reduces risk in the banking system• It makes the payment system immune to

insolvency• It spreads risk to those best able to handle

it• It is a stabilizing factor• It diversifies the supply of assets• It reduces the cost of mortgages

The dangers of securitization

• Disconnects the risk of the defaulting borrower from the bank granting the loan.

• Creates a chain of self-serving agents getting bonuses (short-termism again):– Mortgage broker, property appraiser, loan officer,

securitizer, bond rater, lawyer, underwriter, CDS issuer, investment manager.

• With deregulation, more fraud incentives (lender-induced liar loans)

Securitization according to Minsky 1987

• Securitization helps financial globalization• Securitization will lead to credit-enhancing

mathematical techniques (AAA rated securities at BBB yields)

• There will be “a thin market if price and quality of the securities deteriorate”

• “Securitization implies that there is no limit in creating credits for there is no recourse to bank capital”

Credit default swaps according to Wojnilower 1984

• “The recent entry of major insurance companies into the business of insuring banks and bond investors against loan defaults represents another effort to stretch the safety net. Now it can be presumed, the authorities will have to intervene to interdict a cascading of defaults only if to save the insurance industry” (Wojnilower 1985, p. 356).

Is this a Minsky crisis?

Financial markets blew up on their own

• This is not a true Minsky crisis.• In the Minsky crisis, the problem starts with over-

indebtedness of non-financial firms, and explodes because of rising interest rates.

• This was not really the case in 2007, and neither was it in 1929.

• Both in 1929 and 2007, problems arose from over-indebtedness of households, and, as in Japan, a meltdown of the real estate market and then the equity market.

US non-financial corporation debt to equity ratio

Source: Wachovia Bank

Household debt to disposable income ratio, US and Canada

0

20

40

60

80

100

120

140

160

180

200

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Canada United States

debt / PDI

Source:

Effect of a one-time increase in the flow of gross household loans to personal income (Godley-Lavoie 2007 model)

Time

Effect of a one-time increase in the flow of gross household loans to personal income

Time

Conclusion: 2009, the worse of two worlds

• The real estate market crashed before these negative effects could really take effect.

• But now we have two negative effects operating at once on consumption:– The long-run negative effects of a higher flow

of household borrowing relative to income– The short-run negative effects of high saving

rates, directly from higher propensities to save, and indirectly from a lower propensity to take new debt