The Financial Crisis: A global perspective

The current financial crisis dominated the news in 2008, especially in September:• March 17, 2008: JP Morgan Chase agreed to buy investment bank

Bear Stearns for $2 per share (eventually raised to $10, compared to its $133 pre-crisis high).

• September 7, 2008: The federal government assumed legal control over Fannie Mae and Freddie Mac, the nation’s largest mortgage-backed securities traders.

• September, 14, 2008: Investment bank Merrill Lynch agreed to sell itself to Bank of America.

• September 15, 2008: Investment bank Lehman Brothers Holdings filed for bankruptcy, the largest in US history.

• September 16, 2008: The Federal Reserve loaned $85 billion loan to the American International Group (AIG) insurance company in exchange for the right to purchase 79.9% of its stock.

• September 21, 2008: The Fed approved requests by Morgan Stanley and Goldman Sachs to convert to bank holding companies regulated by the Fed. They were the last two major investment banks in the United States.

Part 1: Domestic origins to the financial crisis.

Many analysts have traced the roots of the crisis to a variety of domestic factors.

New York Times, Sept. 30, 1999: In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders… Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

Factor 1: Beginning in the late 1990s, the government adopted policies specifically designed to promote homeownership.

The home-ownership effort was bipartisan.

Mortgage Bankers Association Newslink, October 16, 2002: President George W. Bush said his administration would work to close the “homeownership gap” between minority homeowners and white homeowners. And he said the Administration’s goal of adding 5.5 million first-time minority homebuyers over the next 10 years would provide a strong economic benefit to both minorities and the overall economy. Speaking yesterday at the White House Conference on Increasing Minority Homeownership at George Washington University, Bush said that he considered the 5.5 million goal “achievable” and pledged the administration’s support. “We want everyone in America to own their own home. An ownership society is a compassionate society,” Bush said. “All of us in America should believe that we should be a nation of owners. It’s part of a free society. It helps bring stability to neighborhoods. When you own your own home you care more about how your neighborhood looks. It’s an asset-based investment, and it’s an important part of America.”

An increasing proportion of loans took the form of lower-quality (“subprime”) mortgages after 2002

Source: Milken Institute

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1994 1996 1998 2000 2002 2004 2006

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Factor 2: The government scaled back regulation of the financial services industry.

• The Financial Services Modernization Act of 1999 (Gramm–Leach–Bliley Act): repealed part of the Glass–Steagall Act of 1933 and allowed commercial banks, investment banks, securities firms, and insurance companies to consolidate.

• The Commodity Futures Modernization Act of 2000: Deregulated most over-the-counter derivatives transactions between “sophisticated parties.”

• April 28, 2004: The SEC voted unanimously to permit broker-dealers with "tentative net capital" of more than $5 billion to apply for permission to use mathematical models (based on international standards used by commercial banks) instead of traditional security-specific risk characteristics to compute the discounts reported on their securities holdings.

• Lax regulations and accounting standards allowed commercial banks to move mortgages off their books by marketing them through separately established finance companies (“structured investment vehicles”), thereby circumventing ordinary capital requirements.

Factor 3: Complicated and risky financial innovations proliferated within a “shadow banking system” run by unregulated investment banks.

The innovations facilitated an increase in the share of mortgages that were sold off in the secondary market.

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1994 1996 1998 2000 2002 2004 2006

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U.S. inflation-adjusted housing prices surged to 50% above their stable 1990s levels, including a 28% increase from the end of 2001 to 2006.

US real house price index (1991 = 100)

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Inflation-adjusted housing prices in the US rose by 28% from 2001 to 2006.

The crisis hit when low introductory interest-rates on adjustable rate mortgages expired and got reset at higher levels. Overleveraged U.S. consumers couldn’t pay their mortgages, and default rates skyrocketed…

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By 2009, US housing prices had lost virtually all of their gains since 2001, …

US real house price index (1991 = 100)

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1991

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…and the US was in the midst of its worst recession since the Great Depression.

Average annual grwoth rate of real GDP since 1960

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-6.0

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Part 2: A global perspective on the financial crisis

When the U.S. sneezes, the world catches cold.

The recession was global: 2009 was the only year in the past half-century when output for the world as a whole contracted.

Average annual grwoth rate of real GDP since 1960

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But the origins were global too: home prices rose and then fell by even more elsewhere than in the US:

Throughout the 2000s, home price volatility was more pronounced abroad than in the US.

Fed Chairman Ben Bernanke offered an earlier and prescient global perspective in a speech delivered in March 2005, in which he raised and explained his concerns about what he referred to as the “global saving glut.”

The roots of the global saving glut predate the housing crisis and can be explained by basic capital migration theory as reflected in current account balances.

NPR provided a global context for the financial crisis in its May 9, 2008, Peabody-winning broadcast of “The Giant Pool of Money” that sparked the launch of its daily Planet Money program.

Back in 1996, the world’s current account balances corresponded pretty well to basic capital migration theory. The US was the standout exception.

1996 Current Account Balances, % of global total

Savers (CAB surpluses) Borrowers (CAB deficits)

China 4%

OPEC 14% US 50%

High-income DCs, excl. US 82% LDCs excl. OPEC 50%

Total 100% Total 100%

Several significant events altered global finances from 1996 to 2006:

1. Several high-income countries with aging populations increased their savings rates to prepare for future retirement spending.

2. China, a country with fixed exchange rates and restricted capital markets, generated huge national savings through its Export-Led Industrialization backed by an undervalued exchange rate.

3. The inflation-adjusted price of oil more than doubled, resulting in substantial CAB surpluses in OPEC countries with fixed exchange rates and restricted capital mobility.

4. A series of financial crises from 1997-2001 in several emerging-market economies prompted savers to look for investment opportunities in “safe-haven” countries.

The Asian financial crisis hit at the end of 1997. Exchange rate pressures dated back to China’s devaluation in early 1994.

In 1998, “Asian contagion” spread to Russia and Brazil.

And then at the end of 2001, Argentina abandoned the fixed exchange-rate system it had set up a decade before.

Net capital flows increased from less than $200 billion in 1996 to over $1.2 trillion in 2006, with virtually all of it flowing to high-income countries with booming mortgage markets

The $1 trillion shift in Current Account Balances from 1996-2006 (shares of global total)

Shares of CAB increases Shares of CAB decreases

China 21%

OPEC 20% US 67%

High-income, non-housing boom countries

37% Other high-income housing boom countries

29%

1997-2001 debt-crisis LDCs

22% LDCs, excluding OPEC and debt-crisis countries

4%

Total 100% Total 100%

To be continued