From the financial crisis to the euro area debt sovereign crisis

From the financial crisis to the euro area debt sovereign
crisis: facts, interpretations and policy actions
4 Lectures
1. The financial crisis of 2007-09
2. How banking regulation is changing
3. The euro area crisis and the Italian economy
4. The new European governance, the ECB monetary policy
and theBanking Union
Facoltà di Economia, Sapienza Università di Roma, 2013
Riccardo De Bonis
The crisis of 2007-09
It has been the worst financial crisis since
the Great Depression
Outline of the lecture
i) Facts
ii) Interpretations
iii) Final remarks
The chronology of the 2007/09 crisis
• The story of the crisis may be divided into two periods
a) the financial turmoil started in the summer of 2007;
b) the eruption of the crisis in September 2008 when
Lehman Brothers collapsed
• After large actions by governments and central banks,
there were signs of stabilization from March 2009
The Stock Market in the US and Italy
Most of industrial countries recorded credit booms, and house
and share prices increases, until 2007
The start of the crisis: the subprime market
•In the US signals of increase in subprime
mortgage defaults were first noted in February
•June-July 2007: the mortgage subprime market
shows a more severe stress and new home
sales and house prices started to decline
The first measures taken by the Central banks
•July-August 2007: subprime exposure drags
down two German banks, IKB and Sachsen
Landesbanken, a State owned bank
•August 2007: strong turmoil in the
interbank market, where rates increased
•August 2007: in response to the freezing up
of the interbank market the ECB injected 95
billions of euro in overnight credit to banks.
The FED injected 24 billions of dollars
The Northern Rock crisis
• September 2007: a bank run hits the English bank
Northern Rock
• In the nine years from 1998 to 2007, NR’s lending
increased 6.5 times and was mainly financed by
wholesale funding, not by retail deposits
• The run on retail deposits after the Bank of England
announced the intention to provide emergency
liquidity support to NR
• In the last quarter of 2007, to alleviate the liquidity
crunch, central banks reduced their rates, broadened
the type of collateral that banks could post and
lengthened the lending horizon
The Bearn Stearns’ bail-out
• March 2008: bail out of the US investment bank Bearn
• BS was highly leveraged and had a large mortgage
exposure. It was unable to secure funding on the repo
• BS was too entangled to fail, having 150 million trades
spread across various counterparts
• The FED decided to bail-out BS to minimize
counterparty credit risk
• The bail-out was financed by the FED, through a loan of
$30 billion to JP Morgan Chase
The summer of 2008: the bail-out of Fannie Mae and
Freddie Mac
• In 2008 mortgage delinquency rates continued to
• Fannie Mae e Freddie Mac were two publicly traded
but government chartered institutions that securitized a
large part of US mortgages and had about $1.5 trillion
of bonds outstanding
• July 2008: the US Treasury made its implicit
government guarantee explicit
The AIG’s collapse
•AIG - a global insurance company – had a
large derivative business
•September 2008: AIG’s stock price fell more
than 90 per cent
•Owing to AIG’s links in the credit derivatives
market, the FED organized a bail-out of $85
The Lehman Brothers’ crisis
•15 September 2008: bankruptcy
investment bank Lehman Brothers
•The stock price of LB in January 2008 was
about $65: on September 12 it was under $4
•The bank was highly leveraged, having about
700 billion of assets against a capital of
approximately $25 billions
The Lehman Brothers’ crisis
• LB is a story of excessive risk taking, excessive
leverage, bad corporate governance and
• LB had long term illiquid assets – commercial
real estate and private equity-like investments mainly financed through short term repos
• LB ensured the public that it had sufficient
liquidity to overcome any foreseeable economic
Why was Lehman Brothers not bailed-out?
•Some intermediaries did not want to buy LB or
refused to take over LB without a government
•Eventually, the Fed and the Treasury decided
not to offer a guarantee funded by taxpayers
•The previous bail-outs of Bearn Stearns, Fannie
Mae, Freddie Mac and AIG created a cultural
bias against further State aid
The reactions of Central banks
• October 2008: financial crisis spreads to Europe
• 3 October: US Congress approved the Troubled Asset
Relief Program (TARP), authorizing expenditures of
700 billions of dollars
• October 8: there was a coordinated reduction in
policy rates by six major central banks
• Governments of OECD countries decide to back
banks, providing State aid, extending the coverage of
deposit insurance and enlarging the insurance to bank
The end of the financial crisis
• Conditions of financial markets improved since
March 2009. However the real effects of the financial
crisis persisted for many months: 2009 was a
recession year for many economies. Real GDP
contracted by 5,5% per cent in Italy
• The reaction of governments and central banks to the
crisis was very different from what we observed in
the Thirties. Both fiscal and monetary stances were
very expansive
• There was a Great Recession, not a Great Depression
Now we turn to the interpretations of the crisis
•We will first look at the macro scenario and
then at the microeconomic explanations of the
The macro scenario showed global imbalances
Global imbalances
•From traditional net absorbers of financial capital
from the rest of the world many emerging
countries – notably China – became net exporters
of financial capital
•The US run a current deficit of the balance of
payments and had a large net debtor position with
the rest of the world, becoming the main absorber
of international capital flows
Monetary policy in the US before the crisis
• In 2000 the US underwent the burst of the internet
economy started in 1995 (the bubble)
• Monetary policy became expansionary: the Greenspan’s
put. Low interest rates favoured loan demand
• American politicians looked with favour at a larger
homeownership and at mortgage equity withdrawal.
House prices started increasing
• The increase of house prices increased the value of
collateral for banks, boosting a new rise of mortgages
• Household leverage increased, while saving was negative
Which were the causes of the crisis?
•Around mid 2007 the insolvencies on
subprime lending hit the US economy
but to assign the responsibility of the crisis to
the subprime defaults is like to assign the
responsibility of the I World War to the
assassination of Archduke Franz Ferdinand of
Austria in Sarajevo on 28 June 1914 …
The key question
How the original loss of some hundred
billion dollars in the mortgage market was
sufficient to trigger an extraordinary series
of global financial and economic
consequences (Blanchard 2009)?
The crisis amplification mechanisms
There were global unbalances in the world
economy but amplification mechanisms
transformed a relatively small trigger – the
subprime market collapse - in the Great
Recession (Brunnermeier, 2009)
First amplification mechanism: the interbank
• From August 2007 to February 2009 banks
reduced drastically loans granted to other
intermediaries and raised their cost
• But interbank markets
indispensable for banks
• Since the 1990s the growth of loans was
higher than the growth of deposits
• Therefore
indispensable to cover the “funding gap”
The interbank market
The block of the interbank market contributed to
the “credit crunch” of 2008-09
• Two explanations of why interbank markets
did not work
a) A perception of high counterpart crisis
b) Banks wanted to remain liquid because they
were afraid that liquidity could be
indispensable in the future
A run took place on the interbank market
• It was similar to the Diamond – Dybvig story but it
was not a run of small depositors that want to
withdraw their funds from banks
On the contrary intermediaries run the repo market
and the commercial paper market
Central banks reacted increasing the supply of
liquidity and introducing innovation in monetary
policy instruments (Cecioni, Ferrero and Secchi,
The interbank market
The run on the repo market explains why investment
banks suffered more than commercial banks
• Bearn Stearns was bought by JP Morgan Chase
• Lehman Brothers was liquidated
• Merril Lynch was bailed-out by Bank of America
• Only Morgan Stanley and Goldman Sachs survived
but asked the FED to receive the commercial bank
license, in order to be able to receive liquidity from the
central bank
The interbank market
A large part of investment banks funding derived from
repos and commercial paper
• On the asset side their portfolios were full of securities
linked to the mortgage market. Therefore the liquidity of
their assets decreased since the summer of 2007
• Regulation of investment banks was light
• The idea was that regulation must put the emphasis on
commercial banks, especially on the defense of small
depositors’ saving
• But investment banks do not collect deposits from the
public …
The interbank market
The presumption was that investment banks’
assets could be always liquidated and that their
liabilities – repos and commercial paper –
cannot be object of a run
•Leverage of investment banks was very high,
also because capital requirements applied only
to commercial banks
Second amplifications mechanism: securitizations
Since the Nineties commercial banks increased their
securitization business to get new liquidity and
therefore to increase their supply of loans
From “originate to hold” to “originate to distribute”
Mortgages were the first object of securitizations.
Special purpose vehicles bought the loans from banks
issuing asset backed securities (ABS).
Then also ABS have been securitized. Other vehicles
invested in ABS issuing for instance collateralized
debt obligations (CDOs), multiplying securities with a
AAA rating
Second amplifications mechanism: securitizations
Since 2007 markets lost trust in financial
instruments linked to securitizations
securitization products became impossible to
Diversification of risk theoretically ensured
by securitizations was illusory (Rajan 2005):
the risk was always held by banks or other
Third amplification mechanism: excessive
Investment banks and non-bank financial
intermediaries were excessively leveraged
Low leverage implied that banks and other
intermediaries were not able to bear the first
losses and were forced to sell assets, then
contributing to a general decrease of asset
Fourth amplification mechanism: regulatory and
supervisory mistakes
In the US regulation and supervision of non bank
intermediaries was poor
What is the shadow bank system?
Prudential rules were insufficient for vehicles that
invested into securitization products, for moneymarket mutual funds, and for investment banks
In the US and the UK there was a “competition in
laxity”, often inspired by an ideological bias against
State regulation and in favor of self-regulation
From the web site of the Nobel Prize Paul Krugman
(photo taken on 3/6/2003)
Final remarks
Some elements of the 2007-09 crisis are recurrent in all the
crises (Reinhart and Rogoff 2009):
- excessive leverage: today not of industrial firms, but especially
of households and intermediaries
- crash of share prices (in Italy -49 per cent in 2008), after a
bubble (with herd behavior and“irrational exuberance”,
according to Shiller)
- decrease of house prices, after a bubble in many countries
- defaults and subsequent State bail-outs of banks, leading to a
worsening of public finance
Final remarks
But there were are also new characteristics of the
crisis and new causes of instability
1) The systemic impact was analogous only to that of
the Great Depression in the Thirties
2) Interbank markets did not work properly
3) Securitizations – and rating agencies - created
wrong incentives
4) High leverage of intermediaries
Final remarks
5) Liquidity risk was more important than credit risk
6) There where mainly market failures but also
supervisory mistakes, in an intellectual environment
that was sceptical versus State intervention in
Like the Great Depression, no single account of the
2007-09 financial crisis is sufficient to describe it
(Rephrasing Tolstoj: every financial crisis takes place
in its own way)
Blanchard O. (2009), “The Crisis: Basic Mechanisms, and Appropriate
Policies”, IMF Working paper, April, n. 80
Brunnermeier M. K. (2009), “Deciphering the Liquidity and Credit Crunch
2007-2008”, Journal of Economic Perspectives, n. 1, 77-100
Cecioni M., Ferrero G. and Secchi A. (2011), “Unconventional monetary
policy in theory and in practice”, Bank of Italy Occasional papers, 102
Gorton G. B. and A. Metrick (2012), “Getting-up to speed on the financial
crisis: a one-week-end-reader’s guide”, NBER working paper n. 17778.
Lo A. L. (2012), “Reading About the Financial Crisis: A Twenty-OneBook Review”, Journal of Economic Literature, n. 1, 151-178
Rajan R. (2005), “Has Financial Development Made the World Riskier?,
NBER WP n. 11728, October
Reinhart, C. M. and K. S. Rogoff (2009), “This Time is Different: Eight
Centuries of Financial Folly”, Princeton, NJ: Princeton University Press

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