Published on April 10, 2008
The Financial Crisis and its learning's:Theoretical and Policy-oriented: The Financial Crisis and its learning's: Theoretical and Policy-oriented Jacques SAPIR, PhD. Professor of Economics, EHESS-Paris Director CEMI-EHESS -Paris [email protected] I. The creeping financial world crisis: I. The creeping financial world crisis The US “Subprime” crisis. The banking crisis. The Currency crisis I.I. The “Subprime” crisis: I.I. The “Subprime” crisis I. Subprime and Subprime-ARM: Mortgages where the debt to income ratio is over 55% (highly indebted households) or mortgages where the loan to good value is over 85% (high leverage loans). ARM: Adjustable Rates Mortgage. II. Alt “A”: Debt to income ratio or loan to value ratio are under Subprime thresholds but documentation incomplete (so-called “fast track loans”). III. Jumbos: Loans of over 417,000 USD. What’s the Subprime relevance: What’s the Subprime relevance Subprime and Alt “A” have a relatively low share in the US Mortgage market (around 15% each). The traditionally subsidised mortgage brokers Fanny Mae and Freddie Mac where making more than 55% of mortgages. But Subprime and other “specials” developed fast since 1998. Subprime loans were over 1300 billions USD by March 2007. They were at 150 Billions in 2001 and 600 Billions in 2005….. And they were backed by a powerful string of financial derivatives. It is the “collateralization” process which gave Subprime mortgages their relevance. The development of Mortgage Based Securities: The development of Mortgage Based Securities Credit Default Swaps (CDS). Collateralized Debt Obligations (CDO). Collateralized Loan Obligations (CLO). “Selling” risk on financial markets: MBS are actually a kind of insurance system for the emitter and they are attractive bonds for buyers till the default rate is low (usually 0.5%). But MBS have spread the risk throughout the financial system and everybody can become an insurance company if it buy a CDS or a CDO…. MBS: an industry which grew too fast...: MBS: an industry which grew too fast... MBS have developed extremely fast in 8 years. Risk has been spread-out among Banks and Hedge-Funds through “obligations baskets” sold by SPV working from off-shore zones. Weak collateralization could induce a major liquidity crunch. US Household indebtedness in GDP %: US Household indebtedness in GDP % The current crisis compared to 40 years of indebtedness cycles: The current crisis compared to 40 years of indebtedness cycles Mortgaged loans have been made so easy that they had been used as a proxy for an income policy.: Mortgaged loans have been made so easy that they had been used as a proxy for an income policy. The US economy paradox: Fast growth but an impoverished middle-class. From 2000 to 2006 if the average income increased by 3% a year, the median income has been stable. Lower income households have lost ground. From 1997 to 2004 the 2nd lowest decile lost 12% when the 2nd best decile gained 10%. Poverty is gaining ground: in the USA 20% of children are under the poverty line against 16% in GB and 7% in France and Germany. The 0.1% wealthiest part of the population is accumulating 7% of the national income against 2% in France and Germany. As a result indebtedness has been used to maintain consumption. The average household debt ratio is 120% of the yearly income and households saving ratio was 1.5% of GDP in 2006. I.II. The Banking crisis: I.II. The Banking crisis Banks have been the main user of MBS (40% of cumulative total). Strong competition in a deregulated market has made Subprime-ARM based CDS attractive to boost Banks profit rates. The use of SPV and SPV-based Securities-baskets by banks has decreased transparency. New accounting rules (“Mark to Market”) have increased Banks and Insurance companies vulnerability to financial market fluctuations. The Body Count…(early December 2007).: The Body Count…(early December 2007). Total losses in real-estate properties is 107 Billions USD. Total financial losses is around 400 Billions USD. Banks are accounting for at least 50% of losses. But…nobody knows precisely how much has been lost. Confidence has been broken and the inter-bank monetary market has collapsed. Requiescat in Pace. New Century Financial (Subprime lender) American Home Mortgage (Subprime lender). Ameriquest (Subprime lender) Netbank (Internet Bank) NorthernRock (Bank) Who’s next?: Who’s next? Known losses. Citigroup, investment Bank, USD 11.0 Bln. Merry Lynch, investment bank, USD 12.5 Bln (and may be 15.0…) Morgan Stanley, investment bank, USD 3.7 Bln. HSBC, bank, USD 3.4 Bln. Freddie Mac, Mortgage Lender, USD 3.7 Bln. UBS-AG Investment bank, USD 3.6 Bln. Propagation into Europe. The German Banking System is highly vulnerable. Deutsche Bank acknowledge a loss of Euro 2.2 Bln. The Spanish Banking System: dead on Arrival? Insurance Companies: Swiss-Re acknowledge for more than USD 1,1 Bln of losses. I.III. The Currency Crisis: I.III. The Currency Crisis The banking crisis raises the ghost of a generalized “Credit Crunch”. Central Banks are reacting by injecting liquidity. But the US Economy is so much indebted that the value of the USD is in doubt. Currency change rates are now extremely volatile. A major crisis is possible in 2008 when we will reach the peak of the Subprime crisis (March-April 2008). The US Debt is increasing fast.: The US Debt is increasing fast. Is the US Dollar to spin down?: Is the US Dollar to spin down? NO The US Treasury needs to keep the USD attractive to sell T-Bonds. East-Asian countries want to defend their competitiveness and would try to prop-up the USD. The ECB is pouring as much money as it can to prevent a bank crisis. A brutal fall of the USD could have widespread political implications. Yes The US Government can’t afford a recession in an electoral year and any increase of interest rates would have devastating effects. The FED is to bail-out US Banks. Commodity exporters are beginning to use other currencies. The wealth risk on USD denominated Funds is too high. A flight from the USD is to happen. II. Theoretical and Political lessons: II. Theoretical and Political lessons II.I. The current crisis validates some important theoretical findings.: II.I. The current crisis validates some important theoretical findings. (A): Moral Hazard and Adverse Selection have been proeminent in the Subprime crisis. (B) The “Herd Mentality” validates Herbert Simon’s theory of Bounded Rationality. (C) Markets are not spontaneously information-efficient (Stiglitz). (D) Uncertainty and Surprise are shaping decision-makers preferences. (E) Rationality is context-dependent. (F) Institution matters. (G) Market-value is not the value…. II.II. Keynes is back…..(and so are Minsky and Shackle): II.II. Keynes is back….. (and so are Minsky and Shackle) (A) When uncertainty is prevalent credit is crunching: this is the preference for liquidity. (B) Agents are reacting not to what happens but to how they understand other agents reaction to the new situation: this is the “Beauty Pageant” metaphor. (C) When a surprise comes from the “Unexpected” it can have disastrous consequences. (D) Money-managers are not stabilizing but de-stabilizing the economy. (E) A market does not generate institutions it needs. II.III. Policy implications.: II.III. Policy implications. Central Banks need to be reactive and not bounded by a single target. They have to interact with governments. Full independence is not workable. Financial markets need regulations and supervision. Regulation can’t be fully “market based”. Wealth redistribution is to be consistent with the accumulation process. There can’t be good finance where the real sector is not working well. Change rates in a fully liberalised financial environment doesn’t reflect actual economic performances.