Money and Banking Robert E Wright Vincenzo Quadrini

Money and Banking Robert E. Wright Vincenzo Quadrini

Chapter 12 The Financial Crisis of 2007 -8 Chapter Objectives • • Define financial crisis and differentiate between systemic and non-systemic crises. Describe a generic asset bubble. Define leverage and explain its role in asset bubble formation. Explain why bubbles burst, causing financial panics. Define and explain the importance of lender of last resort. Define and explain the importance of bailouts. Narrate the causes and consequences of the financial crisis that began in 2007.

1. Financial Crises Chapter Objectives • Define financial crisis and differentiate between systemic and nonsystemic crises. What is a financial crisis?

1. Financial Crises One or more financial markets or intermediaries: • cease functioning • function inefficiently

1. Financial Crises Non-systemic: • One or a few markets Example: Savings and loan crisis

1. Financial Crises Systemic: • Entire financial system Example: The Great Depression

1. Financial Crises Systemic crises in U. S. : 1792 1818 -19 1837 -39 1857 1873 1884 1893 -95 1907 1929 -33 2008

1. Financial Crises Non-systemic crises in U. S. : 1966 Credit markets 1973 -74 Stock markets 1987 Stock markets 1998 Hedge funds 2000 Tech stocks 2001 Post-911 2007 Mortgage market

1. Financial Crises Non-systemic Not contained Contained Become systemic Burn out

1. Financial Crises Both systemic and non-systemic crises damage the real economy by: • preventing the normal flow of credit from savers to entrepreneurs/businesses • making it more difficult or expensive to spread risks.

1. Financial Crises Chapter Objectives • Define financial crisis and differentiate between systemic and nonsystemic crises. Key Takeaways ü Throughout history, systemic (widespread) and non-systemic (contained within a few industries); financial crises have damaged the real economy by disrupting the normal flow of credit and insurance. ü Understanding their causes and consequences is therefore important.

2. Asset Bubbles Chapter Objectives • Describe a generic asset bubble. • Define leverage and explain its role in asset bubble formation. What are asset bubbles and what role does leverage play in their creation?

2. Asset Bubbles Asset bubbles are rapid increases in the value of some asset, like bonds, commodities (cotton, gold, oil, tulips), equities, or real estate. Causes: • • low interest rates, new technology, unprecedented increases in demand, and leverage

2. Asset Bubbles The big ten financial bubbles: • • • - • 1636, the Dutch Tulip Bulb Bubble • 1720, the South Sea Bubble • 1720, the Mississippi Bubble • 1927 -29, the Stock Price Bubble 1970 s, bank loans to developing countries 1985 -89, real estate and stocks (Japan) 1992 -1997, real estate and stocks (Asia) 1990 -1993, foreign investment (Mexico) • 1995 -2000, OTC stocks (U. S. ) 2003 -2007, Real estate and credit (U. S. )? from Charles P. Kindleberger and Robert Aliber, Manias, Panics, and Crashes. New York: John Wiley & Sons, Inc. (2005)

2. Asset Bubbles Causes: • low interest rates PV = FV/(1+i)n As i decreases, PV increases.

2. Asset Bubbles Causes: • low interest rates Example Land as a perpetuity and FV as its expected revenues: • • • PV = FV/i PV = £ 100/. 08 = £ 1, 250 PV = £ 100/. 04 = £ 2, 500 • PV = £ 150/. 04 = £ 3, 750 effect of interest rate decrease + effect of expected asset value increase

2. Asset Bubbles Causes: • new technology The effect of new technology can be thought of as increasing FV, leading to a higher PV.

2. Asset Bubbles Causes: • new technology Example: Equities In the Gordon Growth Model: P = E x (1+g)/(k– g) • low interest rates decrease k (required return) • new inventions increase g (constant growth rate) Price increases

2. Asset Bubbles Causes: • unprecedented increases in demand Demand can be increased merely by investors’ expectations of higher prices in the future: In the One Period Valuation Model: P = E/(1+k) + P 1/(1+k). As P 1 increases, P increases.

2. Asset Bubbles Causes: • unprecedented increases in demand Some scholars verify the existence of an asset bubble when news about the price of an asset affects the economy, rather than the economy affecting the price of the asset.

2. Asset Bubbles Causes: • Leverage To increase their returns, investors often employ leverage, or borrowing: R = (Pt 1 – Pt 0)/Pt 0 decreasing Pt 0 increasing R

2. Asset Bubbles “Irrational Exuberance” Robert J. Schiller (2000, revised 2005) • Economic factors • Cultural components • Psychological factors amplified by feedback loops

2. Asset Bubbles “Irrational Exuberance” Robert J. Schiller (2000, revised 2005) Economic factors • • • The capitalist explosion and the ownership society Cultural and political changes favoring business success New information technology Supportive monetary policy and the Greenspan Put The baby boom and bust and their perceived effects on the markets An expansion of media reporting of business news Analysts’ optimistic forecasts The expansion of defined contribution pension plans The growth of mutual funds The decline of inflation and the effects of money illusion Expansion of the volume of trade: discount brokers, day traders, and 24 -hour trading The rise of gambling opportunities

2. Asset Bubbles “Irrational Exuberance” Robert J. Schiller (2000, revised 2005) Cultural factors • • The news media New era economic thinking Psychological Factors • • • Psychological anchors for the markets Herd behavior and epidemics Rationalizing exuberance: efficient markets and random walks

2. Asset Bubbles Chapter Objectives • Describe a generic asset bubble. Key Takeaways ü Asset bubbles occur when the prices of some asset, like stocks or real estate, increase rapidly due to some combination of low interest rates, high leverage, new technology, and large, often selffulfilling, shifts in demand. ü The expectation of higher prices in the future, combined with high levels of borrowing, allow asset prices to detach from their underlying economic fundamentals.

3. Financial Panics Chapter Objectives • Explain why bubbles burst, causing financial panics. What are financial panics and what cause them?

3. Financial Panics A financial panic occurs when leveraged financial intermediaries and other investors must sell assets quickly in order to meet lenders’ calls.

3. Financial Panics Bubble becomes a negative bubble Shock • Interest rates rise • Asset values fall Credit tightens Sell off/defaults Asset values fall • Interest rates rise • Lending volume falls More sell off/defaults

3. Financial Panics Negative bubble becomes credit crisis Credit freezes Asset values fall • Interest rates rise • Lending stops • Asset value expectations fall

3. Financial Panics Credit crisis becomes contraction Credit freezes Asset values fall • Interest rates rise • Lending stops • Asset value expectations fall Growth stops Employment falls Contraction • Confidence falls • Consumption falls

3. Financial Panics During de-leveraging, the forces that drove asset prices up now conspire to drag them lower. Asset bubble Negative asset bubble Interest rates = low Interest rates = high Value expectations = low

3. Financial Panics Causes: • higher interest rates Example Land as a perpetuity and FV as its expected revenues: • PV = FV/i • PV = £ 100/. 06 = £ 1, 666. 66 • PV = £ 100/. 12 = £ 833. 33 • PV = £ 75/. 12 = £ 625 effect of interest rate increase + effect of expected asset value decrease

3. Financial Panics Chapter Objectives • Explain why bubbles burst, causing financial panics. Key takeaways ü The bursting of an asset bubble, or the rapidly declining prices of an asset class, can lead to a financial panic, reductions in the quantity of available credit, and the de-leveraging of the financial system. ü The most highly leveraged investors suffer most.

4. Lender of Last Resort Chapter Objectives • Define and explain the importance of lender of last resort. What is a lender of last resort and what does it do?

4. Lender of Last Resort Purpose: Stop panics and de-leveraging by: • adding liquidity to the financial system and/or • attempting to restore investor confidence.

4. Lender of Last Resort Methods: • Increase money supply • Reduce interest rates • Loan to open credit markets • Restore confidence

4. Lender of Last Resort Role of: Central Bank IMF Wealthy individuals The most common form of lender of last resort today is the government central bank, like the ECB or the Federal Reserve.

4. Lender of Last Resort Restore confidence and currency “This is preeminently the time to speak the truth, the whole truth, frankly and boldly. Nor need we shrink from honestly facing conditions in our country today. This great Nation will endure as it has endured, will revive and will prosper. So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself—nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance. In every dark hour of our national life a leadership of frankness and vigor has met with that understanding and support of the people themselves which is essential to victory. I am convinced that you will again give that support to leadership in these critical days… …there must be provision for an adequate but sound currency… We do not distrust the future of essential democracy. The people of the United States have not failed. ” - Franklin D. Roosevelt, President of the U. S. 1933 -45 First Inaugural Address, March 4, 1933

4. Lender of Last Resort Benign Neglect: Let the Markets Purge Themselves “The ‘leave-it-alone-liquidationists’ led by Secretary of the Treasury (Andrew) Mellon felt that government should keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: ‘liquidiate labor, liquidate stocks, liquidate the farmers, liquidate real estate. ’ He insisted that when the people get an inflationary brainstorm, the only way to get it out of their blood is to let it collapse. He held that even panic was not altogether a bad thing. He said: ‘ It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people. ’” - Herbert Hoover, President of the U. S. 1929 -33 from The Memoirs of Herbert Hoover, 1952

4. Lender of Last Resort Chapter Objectives • Define and explain the importance of lender of last resort. Key Takeaway ü A lender of last resort is an individual, private institution, or, more commonly, government central bank that attempts to stop a financial panic and/or post-panic de-leveraging by increasing the money supply, decreasing interest rates, making loans, and/or restoring investor confidence.

5. Bailouts Chapter Objectives • Define and explain the importance of bailouts. What is a bailout and how does it differ from the actions of a lender of last resort?

5. Bailouts restore the losses suffered by one or more economic agents, usually with taxpayer money. Politically controversial: • Moral hazard • “Welfare for the rich”

5. Bailouts Chapter Objectives • Define and explain the importance of bailouts. Key Takeaways ü Bailouts usually occur after the actions of a lender of last resort, such as a central bank, have proven inadequate to stop negative impacts on the real economy. ü They usually entail restoring losses to one or more economic agents. ü Although politically controversial, bailouts can stop negative bubbles from leading to excessive de-leveraging, debt deflation, and economic depression.

6. The Crisis of 2007 -8 Chapter Objectives • Narrate the causes and consequences of the financial crisis that began in 2007. What factors led to the present financial crisis?

6. The Crisis of 2007 -8 2007 Nonsystemic (mortgage market) 2008 Systemic

6. The Crisis of 2007 -8 2000 -2006 Housing bubble • Low interest rates • Easy credit o Securitization o Lack of regulation

6. The Crisis of 2007 -8 2007 Negative housing bubble • Values decrease • Mortgage defaults increase • Bankruptcy of leveraged lenders • Nationalization of bankrupt “securitizers” • Nationalization of leveraged intermediaries • Panic Bailout

6. The Crisis of 2007 -8 Chapter Objectives • Narrate the causes and consequences of the financial crisis that began in 2007. Key Takeaways ü Low interest rates, indifferent regulators, unrealistic credit ratings for complex mortgage derivatives, and poor incentives for mortgage originators led to a housing bubble that burst in 2006. ü As housing prices fell, homeowners with dubious credit and negative equity began to default in unexpectedly high numbers. ü Highly leveraged financial institutions could not absorb the losses and had to shut down or be absorbed by stronger institutions. ü Despite the Fed’s efforts as lender of last resort, the non-systemic crisis became systemic in September 2008 following the failure of Lehman Brothers and AIG. ü The government responded with huge bailouts of subprime mortgage holders and major financial institutions.

Chapter 12 The Financial Crisis of 2007 -8 Chapter Summary ü Throughout history, systemic (widespread) and non-systemic (contained to a few industries) financial crises have damaged the real economy by disrupting the normal flow of credit and insurance. ü Understanding their causes and consequences is therefore important. ü Asset bubbles occur when the prices of some asset, like stocks or real estate, increase rapidly due to some combination of low interest rates, high leverage, new technology, and large, often self-fulfilling, shifts in demand. ü The expectation of higher prices in the future, combined with high levels of borrowing, allow asset prices to detach from their underlying economic fundamentals.

Chapter 12 The Financial Crisis of 2007 -8 Chapter Summary ü The bursting of an asset bubble, or the rapidly declining prices of an asset class, can lead to a financial panic, reductions in the quantity of available credit, and the de-leveraging of the financial system. ü The most highly leveraged investors suffer most. ü A lender of last resort is an individual, private institution, or, more commonly, government central bank that attempts to stop a financial panic and/or postpanic de-leveraging by increasing the money supply, decreasing interest rates, making loans, and/or restoring investor confidence. ü Bailouts usually occur after the actions of a lender of last resort, such as a central bank, have proven inadequate to stop negative impacts on the real economy.

Chapter 12 The Financial Crisis of 2007 -8 Chapter Summary ü They usually entail restoring losses to one or more economic agents. ü Although politically controversial, bailouts can stop negative bubbles from leading to excessive de-leveraging, debt deflation, and economic depression. ü Low interest rates, indifferent regulators, unrealistic credit ratings for complex mortgage derivatives, and poor incentives for mortgage originators led to a housing bubble that burst in 2006. ü As housing prices fell, homeowners with dubious credit and negative equity began to default in unexpectedly high numbers. ü Highly leveraged financial institutions could not absorb the losses and had to shut down or be absorbed by stronger institutions.

Chapter 12 The Financial Crisis of 2007 -8 Chapter Summary ü Despite the Fed’s efforts as lender of last resort, the non-systemic crisis became systemic in September 2008 following the failure of Lehman Brothers and AIG. ü The government responded with huge bailouts of subprime mortgage holders and major financial institutions.