2007 2008 The first World financial crisis

Michael R. Krtke Kr University of Amsterdam

Chronology of a world event

      

2006 the first warnings Summer 2007 the first hedge funds fall August 2007 collapse of the market for mbas - the credit crunch begins From september 2007 to august 2008 banks tumbling down all over the world September 2008 the black september of financial markets October 2008 fighting the Big Bang The world economic crisis the next Great Depression coming closer

Not the first (probably not the last) international financial crisis
        

The US stock market crash of 1987 The US savings and loans crisis of 1986 -96 The Japanese real estate and banking crisis 1990 2000 The EMS crisis in Europe 1992 The Mexico crisis of 1994-95 1994The Asian crisis 1997 1998 The Russian crisis 1998 The dot.com crisis 2000 2002 The Argentina crisis 2001

The new pattern of cycles and crises since the 1980s

   

The business cycle is still there, but The short term erratic cycle of financial bubbles and crises prevails On average: one major international financial crisis every three years From one bubble to the next the flight of international capital from one object of speculation to the next (from ITC to real estate, from real estate to world trade commodities like oil) Booms are driven by bubbles / bursting bubbles trigger off major crises

What is new today?

      

All previous financial crises were regional /local crises In all previous financial crises the effects could be contained The present financial crisis is the first truly world crisis of financial markets / financial capitalism It hits all the stock markets in the world / all financial centres of the world (more or less at the same time)? It hits all internationally operating banks /financial concerns / institutional investors There are no safe havens (not even Zwitserland) A real world crisis starts in the USA (like it did before)

Has Capitalism changed recently?

     

Capitalism with derivatives the explosion of finance in general and of the trade in derivatives in particular Stock markets as multinationals International banks- present on all the major financial markets (as bankscapital markets perform the traditional function of banks) Institutional investors (mutual funds, pension funds, insurance companies) Shift from Commercial Banking to Investmentbanks and their structured investment vehicles and conduits Rise of the Hedge Funds and Private Equity Funds (completely different from traditional long-only mutual funds / investment longfunds) The waning divide between banks and non-banks non-

Financialization
 

   

What financialization means: The predominance of finance the relative rise of the FIRE (finance, insurance, real estate) sector which becomes more important than manufacturing (22,6 % of GDP in the US to 14,9% in 2005) households are urged to behave like businesses businesses are urged to behave like banks banks are urged to behave like hedge funds basic rationale: creating profits without creating new value (thriving on mere price differentials)

Securitization


  

basic logic: transforming illiquid loans in banks portfolios into marketable / tradeable / negotiable assets expanding the secondary markets for derivatives / creating new derivative markets inventing / creating compound (structured) financial derivatives inventing / creating off-balance sheet conduits offSIVs (structured investment vehicles) to hold such assets

For instance: creating a MBS (mortgage backed security)

first step: a new mortgage is issued second: the mortgage bank /company sells it to a firm specialized in buying and reselling mortgages (like Fannie or Freddie)  third: the buyer aggregates many such loans into a pool and issues a new bond based upon this pool (a right to a profit arising from payments for the original loans)  fourth: the buyer (Fannie or Freddie) sells this new paper the MBS to others typically institutional investors and /or hedge funds  Fifth: the hedge funds (or other buyers) start trading these papers on the secondary markets (making profits from rising prices / price differentials arising on those markets
 

The explosion of the trade in derivatives

Since the 1970s the volume of international trade in derivatives has exploded  The real news: the rise of financial derivatives to the forefront  Among them: structured products like mbs / the most important class of new structured financial assets being the CDOs (collaterized debt obligations) and CMOs (collaterized mortgage obligations) rapidly growing between 2000 and 2006  For instance: volume of outstanding interest swaps, currency swaps and interest options was 3450bn $ in 1990 286000 bn $ end 2006 (six times global gross product)


The explosion of the trade in structured financial products



different types: the alphabet soup

The brave new world of international finance: Deregulation

  

 

The race to reduce / abolish capital controls and foreign exchange controls started in the 1970s It continued throughout the 1980s and 1990s Two US examples: the repeal of the Glass Steagall Act of 1933 (in 1999) and the passing of the Futures Modernization Act in 2000 (both still under Clinton) By mid 20th century the financial sector was everywhere highly regulated Today, the global financial sector is as liberalized as it was before 1914

  

  

Shift towards non-regulated area s nonThe rise of shadow-banking shadowNonNon-banks becoming banks (like GM, Chrysler f.i. making more profits with their financial activities than by producing cars) Intermediaries abound The explosion of OTC transactions The rise and multiplication of offshore-markets offshoreand offshore-finance (offshore-markets and tax offshore(offshorehavens throughout the world more than half of them in good old Europe)

The brave new world of international finance: Beyond regulation

The rise of financial engineers

 

   

the new science of finance in economics In the 1960s Fischer Black with associates (among them Nobel prize winnars Scholes and Merton) developed new models to describe / analyze asset pricing in financial markets Their major finding was quickly forgotten: no empirical evidence whatsoever that the activity of funds managers added anything to the value of the funds assets (more embarrassing findings) However, the new generation of funds managers claimed to be scientifically trained experts Fischer Black rethinking the efficient market hypothesis referring to values and very wide margins Fischers science of finance is not exact at all Fischer was a market radical, but clear-sighted enough to see the clearfutures exchanges as gambling houses (if people wanted to gamble there, the state should tax their gains heavily as he does with other forms of gambling)

The peculiar riddle of today s world financial crisis

It started in one relatively small segment of the US real estate and mortgage market (the socalled subprime segment)  and it ended up as a world financial crisis affecting all international financial markets and all capitalist countries in the world  How was this possible?


Subprime and prime the USUShousing market

  

  

What is peculiar about the subprime segment Selling properties to the ninjas (no income, no job, no assets) Teaser rates and other tricks apparently very low costs (at the beginning) but renewal of the loan due at variable conditions variable interest rates to begin with Credit default no problem as long as the bubble thrives Credit default swaps decoupling the loan from the default risk subprime mortgages 160 billion $ in 2001 to more than 600 billion $ in 2006

Subprime and prime the US housing market

    

simple mortgages homeowners and (local) banks the ever extending system of financial intermediation an ever wider range of highly specialized institutions mortgage finance, refinance (public concerns like Fannie and Freddie) and insurance the thriving secondary markets for the mortgage based assets

Selling US-mortgages (subprimes) USworldwide

 

 

 

Basic technique of financial capitalism securitization Secondary markets for mbas are local but the market actors (hedge funds / banks) are operating on a global level Volume of mbas shot up from 56 bn$ to 528 bn$ in five years US structured financial products are sold, repackaged and resold to investors all over the world (Europe, the America s, Asia) on an ever larger scale: the US real estate bubble provides more and more of these assets A hyperspeculation arises the Minsky moment occurs

The brave new world of structured financial products

  

 

From the simple IOY (I owe you) to the alphabet soup Investment banks buying and reselling structured financial products all over the world packaging and repackaging debts (poor and good, of very different origins) into cdo s (collaterized debt obligations) and other products selling and reselling / trading cdo s all over the world Hence: the risk of bad loans (subprimes) and / or the default insurance risk is everywhere

The housing bubble rising mountains of debt

    

Bubble driven by rising house prices (at double digit rate) House prices driven by increasing demand Increasing demand driven by the permanent expansion of mortgage finance from prime to subprime expansion of the market stagnant labour incomes explosive growth of private debt, but also growth of pirvate wealth (making money by selling a house / by refinancing the mortgage based upon ever higher real estate / house prices) the US consumption levels based upon rising mountains of debt (with stagnant wages for the large majority of workers)

The making of an international speculation bubble



Securitization the chance to sell any sort of debt and loans immediately at a good price is the base for the expansion of mortgage finance Huge amounts of capital flow into the secondary markets all over the world (mostly OTC transactions) Investment banks playing the game pass the parcel (with mba s, cdo s etc.) among themselves, the financial markets follow their example not one housing bubble, but several (Spain, UK, Ireland, Belgium and so on)

The importance of high leverage

All these transactions are financed by credit basic rule: you don t risk your own money, you risk other people s money  Speculators (hedge funds in particular) use very high leverage (up to 1 : 26) to finance their transactions  Hence: if the asset purchased is losing its market value or becoming worthless, all that remains is a huge amount of debt!  Intermediaries flock to the markets as long as the markets are on the rise helping to establish high leverage for more and more participants


The dubious role of rating agencies

  

  

The structure of the market for ratings The big three Standard & Poor s, Moody s and Fitch (together, they control nearly 90% of the market for ratings world wide) How they make their money creating structured financial products and evaluating them while the issuing agent who wants to bring these products on the markets pays them a fee for their double service Impressive ratings were a prerequesite for the rising demand for such products At the height of the cdo s /cds s boom, rating agencies received more than half their income from such fees Such papers were rated as high as state / treasury bonds, but yielded much higher returns hence the frenzy of institutional investors

The bubble bursts

     

Credit defaults happen first and foremost in the subprime sector Rising interest rates rising levels of foreclosures - a faltering market (rapid decline of new mortgages) More and more subprime mortgage loans get foul Declining house prices make refinance ever more difficult Credit rationing by the banks (flight from mortgage finance) And flight from trash and into quality, rapid selling off of mba s, cmo s and other structured products the market for these derivatives crashes

Fear spreads
Everybody in the financial world is involved  The mortgage backed securities have been traded world wide  Mortgage backed securities have been bought by banks all over the world  But where are the foul credits  They can be everywhere, everyone is probably at risk


The first banks fall the case of Northern Rock

The fifth largest mortgage financier in the UK  One of the major actors in the British housing bubble  Credit defaults falling price of NR shares  The reaction: A classical run on the bank in october 2007  followed by a bail out (later nationalization in early 2008)


The big credit crunch a crisis of the money market

 

  

Interbank lending the central part of the money market From september 2007 onwards: banks restrict or refuse interbank lending (sharp rise of interbank interest rates like the LIBOR and/or credit rationing) There is no liquidity crisis - banks are not lacking liquidity but hoarding it because they don t trust each other s solvency in the longer run Institutional investors rush to state papers (and commodity exchanges) There is an insolvency crisis hidden bankruptcies because of the losses still undisclosed Since october 2007 central banks have stepped in several times sometimes in joint actions - as money market lenders of the last resort

The giants fall

    

The big Wall Street five in crisis From Bear Stearns to Lehman Brothers Fannie Mae and Freddie Mac in crisis AIC - the second largest insurance corporation Dozens of larger banks have fallen - hundreds of larger and smaller banks (in the US and elsewhere) are presumably in trouble The fearsome domino effect (some banks are just to big to fall)

The big Bail-out begins: Banks first, Bailwomen and children last!
Bailing out an old and common practice  An ever increasing volume of bail outs  First stage (september 2007 august 2008) selective bail outs for individual banks in distress (ad hoc rescues)  Second stage (from september/october 2008 onwards): bailing out the whole banking sector


The return of state socialism

     

Nationalizing the banks, socializing the losses UK leads the move: First nationalizing single banks (at least temporarily) now: nationalizing the junk papers of all the banks US plan following the same pattern: helping the banks to get rid of the junk papers no rescue for the shareholders, rescues for the managers are restricted tens of thousands of bank employees have already lost their jobs, much more to come

The return of central banking



  

A series of individual and collective actions taken by central banks of the major capitalist countries (Fed, BoE, ECB, BoJ, Swiss National Bank) to provide liquidity (short term credits) for the banking system A few days ago: the first concerted action to pump liquidity into the markets and to reduce the bank rate Lowering the standards: More and lower rated papers are accepted as collaterals for central bank credits To no avail actually, the central banks are now substituting the private banks as providers of interbank loans How long can the central banks go on?

The meaning of this crisis: The end of the Wall Street Regime
   

A month ago, only two of the big Five investmentbanks at Wall Street were left Today none The last two giants have chosen to transform themselves into commercial banks! The stock markets crash worldwide but Wall Street even more (last week a series of unprecedented stock market crashs all over the world)

The meaning of the crisis: The end of the dollar hegemony?



 

 

Due to the decline of the USA as the leading financial power of the world, the dollar will loose further The rescue actions of the US government drive the US public debt to unprecedented levels Depending upon the succes of the rescue actions in Europe and Asia, other currencies will further gain in relation to the dollar A major dollar crisis remains possible Anyway, the fate of the dollar will be decided in Beijing

The meaning of this crisis: The end of Neoliberalism?

Certainly the end of the myth of the selfselfregulating markets  Probably the end of the myth of financial market efficiency under minimal or no regulation at all  Rising doubts and second thoughts about freedom for speculators  The myth of the superiority of the USUSmodel of capitalism is shaken


When will the financial crisis tear down the real economy?
In March 2008 the world economy seemed still growing  Except in the USA (where a severe recession had already begun / the US consumer is broke)  But now it s completely different: - four major and several smaller EU-economies are in EUcrisis - Germany s export industry (the leading export economy of the world) is slowing down - Japan s banks are profiting an buying the spoils of the financial crisis in the US and elsewhere, while the Japanese real economy is stagnant - the crisis will continue during 2009!


Will the financial crisis affect the NICs and NACs of today?
   

The financial crisis has already hit the Chinese banks and big insurance concerns Asia s stock markets are hit by a series of crashes as well The slow down of world trade in raw materials has already begun (as several indicators show) The BRIC countries will be affected (how much, depends on the relative size of their domestic markets)

Long term effects

     

A new architecture of world finance in the making A World Financial Authority A new role for the IMF? The shift between financial markets / financial centres of the world An end to offshore financial centra? The end of banking as private business as we knew it?

When and where will the next bubbles rise?

   

Financial market capitalism Anglosaxon style has only one chance to survive: Finding new objects for worldwide speculation, creating the next bubble Candidats: Alternative energies, biotechnology But new bubbles will not solve the underlying problem: a bifurcation between a stagnant real economy (with huge overcapacities all over the world) and a hyperactive financial economy (with still huge surplus capital all over the world)