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Getting to the Root of the Cause
MACROFINANCE CRASH OF 2008
Landmark Events in Crisis
Winter 2006-07
 Real Estate Prices Fall
Summer 2007
 Countrywide Mortgage fails
 Fannie Mae, Freddie Mac in
distress
Summer-Fall 2007
 Northern Rock (British
lender) fails
 Spread between T-Bill and
LIBOR grows large
 Recession begins
Spring 2008
 Bear Stearns fails
Summer 2008
 Oil & other commodity prices
spike
September 2008
 Lehman Bros. fails
 AIG near failure
 Stock market plunges
 LIBOR; Commercial Paper
markets freeze (“wholesale
money markets”
 Wachovia (bank) fails
 Fed begins/expands unusual
interventions
Financial Stress Leading up to Sept 08
TED = T-Bill Rate – LIBOR (usually equal)
KCFSI = Kansas City Fed Financial Stress
Index
6
5
4
3
6
3.5
5
3.0
1
4
2.5
0
3
2.0
2
1.5
1
1.0
0
0.5
-1
0.0
-2
-0.5
2
-1
07M01
07M07
08M01
08M07
TED
09M01
09M07
KCFSI
90
92
94
96
98
00
TED (Libor -TB3)
02
04
06
KCFSI
08
Relative Size of Financial &
Macroeconomic Losses
Time Frame
Stock Market
Change (DIJA)
1907-08
Length
GDP Change
(Real)
Stock Change/
GDP Change
Highest
Unemp. Rate
-40%
13 months
-5%
8
8.00%
1919-20
-46%
15 months
-23%
2
11.30%
1929-33
-83%
43 months
-29%
3
25.20%
1937-38
-49%
15 months
-7%
7
19.10%
1946-48
-35%
21 months
-5%
7
4.00%
1973-75
-51%
25 months
-5%
10
9.00%
1978-82
-37%
48 months
-7%
5
10.80%
1987-88
-28%
5 months
>0%
NA
5.80%
2000-01
-18%
16 months
-1%
18
6.10%
2007-2009
-53%
16 months
-4%
13
10.10%
Key Questions
 Cause/Effect
 What was the gasoline, what was the match?
 Responses
 Get rid of gasoline?
 Get rid of matches?
 Store in safer places?
Fuel for the Crash
 Home Mortgage Debt = 1/3
 Commercial Loans
 Amplified by implied or explicit guarantees to
banking/financial system (“moral hazard”)
 Fed/Fannie-Freddie
 Amplified by competition for loans
 Amplified by gov’t push for loans to non-qualifiers
DEBT, DEBT, DEBT
4.0
60000
3.5
50000
3.0
40000
2.5
30000
Debt/GDP - left scale
2.0
20000
1.5
10000
U.S. Debt -- right scale
1.0
0
20
30
40
50
60
70
80
90
00
Mortgage Debt Part of the Story,
Commercial Lending a Bigger Part
4.0
3.5
Total Debt/GDP
3.0
2.5
2.0
Non-house-govt/gdp
1.5
1.0
House-debt/gdp
0.5
Govt Debt/gdp
0.0
50
55
60
65
70
75
80
85
90
95
00
05
“Poster” Project for Commercial (nonmortgage) Debt (Artist Image)
$11 Billion City Center Project
Las Vegas – MGM Mirage
Bank Loan/Bond Funded
The Real Thing
Limits of Debt Constraints
 Economy-wide Budget Constraint:
Income + Debt Value = Debt Payments + Consumption
Over the long run:
 Debt Value = Debt Payment or else “Ponzi Scheme”
 Implies Consumption must be based on Income (not
debt)
Why So Much Attention on
Mortgage Debt?
 Mortgage market was the first “on fire”
 Many interpreted as “the cause”
 Mortgage debt traded daily in markets
 Quickly reflecting change in valuations
 Info on this appearing by 2007
 Commercial bank loans not traded in markets
 Change in value reported slowly by banks over
time
 Info on this not really appearing until into 2009
MATCH FOR THE FUEL
 Falling real estate prices & mortgage defaults
beginning in 2006-2007
 Lenders not receiving expected payments
 Begins chain of financial firms in trouble because not
receiving payments from other firms
 Oil Price (and many other basic commodities)
Price Spikes of 2008
 Oil from $70/barrel to $145/barrel
 Oil price spikes leading all but 1 post WWII recession
Limiting Future Problems?
 LIMIT “SYSTEMIC RISK”
 MANY IDEAS:
 Stricter regulation including more owner “capital” per
loan
 Limit financial firm size
 Insurance fees tied to risks of lending
 Eliminate subsidies to housing lending like Fannie/Freddie
 Bottom Line: whatever the specifics, systemic risk
only reduced through substantially less lending
 Tradeoff: Benefits of lending-Risks of lending
Causes of Debt/GDP Expansion:
Cheap Credit
9
8
7
6
5
1990-99
2003-07:7
4
3
2
1
0
Prime
AAA
BBB
Fed Funds
ComPaper
Causes of Cheap Credit:
Public Sector Backing of Debt
(Fannie Mae, Freddie Mac, and others)
9000
GSE Assets + Govt-MBS
(in Billions $)
8000
7000
6000
5000
4000
3000
2000
1000
90
92
94
96
98
00
02
04
06
08
Cheap Credit:
Foreign Investors Liked U.S.
.06
Capital Inflows Relative to GDP
.05
.04
U.S.
.03
.02
.01
.00
Euro Area
-.01
97 98 99 00 01 02 03 04 05 06 07 08 09
Causes of Cheap Credit:
Expansion of “Wholesale” Money Markets
Cheap Credit:
Wholesale Market Expansion
Cheap Credit:
Wholesale Market Expansion
 Securitization, e.g. CDOs
 Pooling mortgage (other debt) risk (CDOs, SPVs)
 Credit Insurance
 Transferring Risk (CDS)
Cheap Credit:
Fed Responsible?
20
16
Inflation Rate & Smoothed (HP Filter)
12
8
4
0
-4
-8
82 84 86 88 90 92 94 96 98 00 02 04 06 08