In search of stability the economics and politics of the global financial crisis

What Went Wrong?Three Faulty Assumptions About 21 st Century Finance Securitization • Capital markets are so advanced that banks can lend more aggressively while off-loading risk throug

In Search of Stability:

The Economics and Politics of the Global Financial Crisis

Mark Copelovitch

Assistant Professor of Political Science & Public Affairs

University of Wisconsin – Madison

March 16, 2009

What Went Wrong?

Three Faulty Assumptions About 21 st Century Finance

Securitization

• Capital markets are so advanced that banks can lend more

aggressively while off-loading risk through debt securities

Credit agencies

• Credit ratings agencies offer an easy and cheap “compass” for

investors to assess the risk of these complex securities

Risk and financial stability

• The “slicing and dicing” of risk has made the financial system more stable and less crisis-prone

The Initial Problem: Subprime Mortgage Lending

SOURCE: BBC

Subprime Borrowers

“Subprime” borrowers

• Borrowers with “bad” credit (<620 on 300-850 scale)

• NINJAs (~20% of borrowers)

What kind of loans do subprime borrowers get?

• ARMs: Adjustable Rate Mortgages

• “Teaser” rates to start…higher rates later on

Mortgage-Backed Securities (CDOs)

SOURCE: NERA

Ratings agencies play a key role

Subprime Mortgage Lending: Boom and Bust

SOURCE: IMF, BBC

From Housing Crisis to Financial Crisis

Problems of uncertainty

• No one knows how many “bad” mortgages are in the CDOs

• No one wants to lend to banks and other institutions with heavy exposure to these securities

Results

• “Flight to quality” (US Treasuries)

• Spikes in market lending rates

• Stock market crash

• Frozen credit markets

SOURCE: Bloomberg

The Big Freeze

Case Study: Northern Rock (UK)

UK’s 8th largest bank in 2007 (£113 billion in assets)

Northern Rock’s Collapse

Bank of England - steps in to bail out (£55 billion in loans/guarantees)

and ultimately nationalize NR (2/22/08) once the “run” starts

After Northern Rock, 2008-2009

SOURCE: BBC

…the Financial Losses Mount…

March 2009: $5.1 trillion in family net worth losses (9%) in Q4 2008

…and the Real Economic Impact is Severe

SOURCE: BBC/IMF

GDP growth rates (%), 2008-2009

Policy Responses to Financial Crises: Two Phases

Short-term (management/resolution)

• Crisis lending, rate cuts, etc.

• Preventing bank runs/collapses (“bailouts”)

• Unfreezing credit markets (“toxic debt”)

Short-Term Policy Responses: Crisis Management

Liquidity (bailouts)

• To money markets & directly to troubled banks (TARP)

Bank deposit guarantees

• Extension of safety net to prevent bank runs

Dealing with toxic debt

• A government-sponsored “bad bank”

• Partial nationalization of banks

• The “insurance” model (UK, January 2009)

Short-Term Policies: Key Questions

• Why not let troubled financial institutions fail?

• Why not bail out all firms? Who should be saved?

• What should the government get in return?

• Should non-financial firms get bailouts, too?

How to Choose Policies? Difficult Tradeoffs

• Liquidity vs moral hazard

• Financial crisis vs other goals

• Aggregate welfare (“taxpayers”) vs special interests

• National policies vs international cooperation

“Bailouts” – Liquidity vs Moral Hazard

• Government/central bank credit (liquidity) helps banks pay their debts and may “unfreeze” credit markets

• But, bailouts create moral hazard for borrowers and creditors

How to choose?

• A liquidity or solvency problem?

• No clear economic answer  ultimately, a political question

More money,

fewer “strings”

Less money, more “strings”

Greater moral hazard costs

Financial Stability & Stimulus vs Other Goals

SOURCE: New York Times

• Economic stimulus package estimated to cost ~$800 billion

• Full scale of toxic assets may be $3-4 billion

Thus Far: Global Crisis, National Responses

SOURCE: BBC

• Unilateral efforts unlikely to be successful

• Threat of “beggar thy neighbor” policies

The Global Reform Agenda: Consensus on Broad Goals…

Strengthen international supervision and regulation

• Bridge the gap between global markets and national regulation

Reform existing institutions

• International Monetary Fund (IMF)

…But Not on Specific Policies & Institutions

Strengthen international supervision and regulation

• Which financial institutions and regulations?

• What institutional form?

Reform existing global institutions

• The IMF debate: resources, conditionality, votes

• New “G” groups: who should be in/out?

International policy coordination

• How much? For how long?

• Sharp disagreements on trade and exchange rates

Why No Agreement? Difficult Tradeoffs

Tradeoffs: The Primacy of Politics

No optimal economic solutions

• Many possible policies, institutions, and regulations

• Conflicts between “good economics” and “good politics”

Key political factors

• Domestic politics (interests, institutions)

• Power and geopolitics

• Collective action and bargaining problems

• Ideology

Example: Reforming the IMF

SOURCE: Financial Times

• IMF needs ~ $750 billion - $1.75 trillion to be effective

• Will new resources lead to governance reform?

The Next Stage: Are the Bailouts Working?

TED Spread, March 2009

The Next Stage: Crises in Emerging Markets

9/-08 – 3/09:

~$50 billion in new IMF loans to Iceland, Pakistan, Ukraine, Belarus, Georgia, Serbia, Latvia, and

Hungary

SOURCE: Financial Times, IMF World Economic Outlook

The Next Stage: World Trade Collapsing?

Some Perspective: We’ve Been Here Before

SOURCE: IMF, World Bank

Some Perspective: The Great Depression, 1929-1933

The Depression’s Effect on the US Economy

SOURCE: Historical Statistics of the United States, pp 235, 263, 1001, and 1007

Some Perspective: Markets

Some Perspective: Recession vs Depression