The Subprime and the Euro Debt Crises -...

The Subprime and the Euro Debt Crises

Carlo Favero

Dept of Finance, Bocconi University

December, 2015

Favero (Dept of Finance, Bocconi University) Financial Crises December, 2015 1 / 62

The Ingredients

cycle vs trend

monetary policy and �scal policy

Zero Lower Bound, Quantitative Easing, Large Scale Asset PurchasingProgramme, interest rate pathbalance sheet of a central bankLong Term Bonds and policy ratesspreadsausterity

banks

balance sheet of a bankleverage, repos, CDO and CDS


The Big Picture

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3

4

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6

7

15

10

5

0

5

10

15

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30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05 10

BAAAAA spread Annual GDP Growth

NBER contractions shaded


The dimension of the crisis

The worst crisis in the postwar era. Global GDP contraction and risein unemployment

Contraction in Consumption and Investment, drop in Consumers�Con�dence

Global stock market collapse

Huge drop in wealth

Fluctuations in risk premia and euro area sovereign bond spreads


GDP Growth and Unemployment

.050

.025

.000

.025

.050

.075

.100

.125

.150

50 55 60 65 70 75 80 85 90 95 00 05 10

Euro area annual GDP GrowthUS annual GDP Growth


2

4

6

8

10

12

14

50 55 60 65 70 75 80 85 90 95 00 05 10

US Unemployment RateEA Unemployment Rate



Consumption and Investment

.04

.02

.00

.02

.04

.06

.08

.10

.12

50 55 60 65 70 75 80 85 90 95 00 05 10

Euro area annual Consumption GrowthUS annual Consumption Growth


.4

.2

.0

.2

.4

.6

.8

50 55 60 65 70 75 80 85 90 95 00 05 10

Euro area annual INV GrowthUS annual INV Growth



Consumer Con�dence

60

70

80

90

100

110

120

50

60

70

80

90

100

110

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Euro Sentiment Indicator (EU Commission)US Univ of Mich. Consumer Sentiment



Households Wealth

2.8

3.2

3.6

4.0

4.4

4.8

50 55 60 65 70 75 80 85 90 95 00 05 10

US household wealth as a ratio of GDP


The Stock Market and In�ation

0

200

400

600

800

1,000

1,200

1975 1980 1985 1990 1995 2000 2005 2010

US Stock Market IndexEU Stock Market Index


.04

.00

.04

.08

.12

.16

1975 1980 1985 1990 1995 2000 2005 2010

US CPI InflationEU CPI Inflation



Sovereign Bonds

0

2

4

6

8

10

90 92 94 96 98 00 02 04 06 08 10 12 1410Y Bond Yield Germany10Y Bond Yield US

Yields

2

0

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90 92 94 96 98 00 02 04 06 08 10 12 14

ItalySpainFrancePortugalIreland

Spreads between Government Bond and Bund


The Initial Conditions

The great moderation:low volatility of in�ation and growth

monetary policy and the conundrum

low risk aversion and restored con�dence

house price bubble and the "Greenspan put"


The Great Moderation

.050

.025

.000

.025

.050

.075

.100

.125

.150

1975 1980 1985 1990 1995 2000 2005 2010

US GDP Growth US CPI Inflation

The Great Moderation


Monetary Policy and the Conundrum

0

2

4

6

8

10

12

14

16

82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

Fed Funds RateUS Government Bonds 10Y rate

Monetary Policy and the Conundrum


Low Risk Aversion and Restored Con�dence

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

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70

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82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

Spread BaaAaaConsumer Confidence

Low Risk Aversion


The House Price bubble and the "Greenspan put"

0

400

800

1,200

1,600

2,000

2,400

100

120

140

160

180

200

220

82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

S&P stock market index (at 2011 CPI prices)CaseShiller House Prices (at constant prices)

The Stock Market and the House Market


The Initial Shock

In 2006, following the increase in monetary policy rates between 2004and 2006, house prices started to fall.

Between 2006 and 2008 house prices fell 20 per cent

this is not a huge shock. The collapse in houseprices caused losses inthe mortage and especialy in the subprime mortgage market. Theselosses can be estimated in around 650 billions USD, equivalent to adrop of 4 percent in the S&P index.In October 1987 the S&P index fell by 20 per cent in one-month,but this shock has not sparked neither a �nancial crisis nor a recession

the peculiarity of the subprime crisis is not in the initial shock but inthe transmission mechanism


The Initial Shock

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.15

.10

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.00

.05

.10

.15

.20

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Fedfunds rateCaseShiller House Prices Inflation

The Initial shock


The Transmission Mechanism

Liquidity and Leverage. Procyclical leverage as the key in thetransmission mechanism

CDO and CDS. The link between procyclical leverage and the housingmarket

A Black Swan in the money market. The e¤ects of the lack of trust inthe REPO market.


Liquidity and Leverage (Adrian and Shin,2007)

Passive Investor Active Investor

time Assets Liabilities Assets Liabilities

0 House, 10 Mortgage, 9 House, 10 Mortgage, 9Equity, 1 Equity, 1

Leverage 10 10

1 House price goes up 1 per centHouse, 10.1 Mortgage,9 House 10.1 Mortgage,9

Equity 1.1 Trading Ass,1 Debt 1Equity 1.1

Leverage 9.2 10.1


Liquidity and Leverage (Adrian and Shin,2007)


The balance sheet of an investment bank


Procyclical leverage and the transmission mechanism


CDO and CDS

Collateralized debt obligations are the instruments to transformmortgages into securities that are considered safer and can be used ascollateral in repo�s

Credit Default Swap can provide insurance against the worst casescenarios


Collateralized Debt Obligations


The Mechanism

So long as house prices increases CDOs are easy to re�nance andestimation of default risk is unimportant

they can be used as collateral in REPO and allow to expand banksbalance sheet

if a SIV is used to redistribute risky subprime mortgages are notanymore in banks balance sheet (and the incentive to monitordisappears)

but when houseprices start collapsing the whole construction falls anda black swan in the money market appears


A Black Swan in the money market

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

4.0

4.2

4.4

4.6

4.8

5.0

5.2

5.4

5.6

I II III IV I II III IV2006 2007

3month LIBOROIS spreadAverage Expected Fed Fund rate over the next 3 month

The 3month LIBOROIS spread


The explosion of the crisis

Early 2007 Spreading Subprime WorriesSummer 2007 Disruptions in Funding

Late 2007 to Early 2008 Billions in Subprime LossesMarch 2008 The Fall of Bear Stearns

March to August 2008 Systemic Risk ConcernsSeptember 2008 Conservatorship of Fannie Mae and Freddie Mac

Bankruptcy of LehmanBailout of AIG


The Policy Interventions

Expansionary Monetary Policy: Conventional (but policy rates hit thezero bound) and unconventional

Expansionary Fiscal Policy:


Monetary Policy Interventions

Extending Liquidity Provision: Term Auction Facilities,TermSecurities Lending facility (reduce the discount window stigma by makingthe money available to all banks at once through a regular auction)

Asset Repurchases: TARP 1

Recapitalization: TARP Equity Plan

The �rst two meausures create a buyer for bad assets, which is not enoughif banks do not have capital


Monetary Policy Interventions

TAF and TARP 1 do not work, but TARP Equity Plan has an importante¤ect on the market


The Fed Balance Sheet:Assets

Federal Reserve Assets(in billions of dollars)

4 July 07 26 Nov 08

Securities Held Outright Uncommitted Committed to TSLF Repurchase AgreementsLoans Primary Credit Term Auction Credit Primary Dealer Credit Portfolio of Maiden Lane LLC†

Portfolio of Maiden Lane III LLC++

ABCP Money Market Liquidity Facility Credit to American International Group Other credit extensionsCommercial Paper Funding Facility

Foreign Exchange Reserves+

FX Swaps

Gold*

Other assetsTotal Assets

$790.6

$ 30.3

$ 0.19

$ 20.8

$ 11.0$27.5

$880.4

$295.4$193.2$ 80.0

$ 91.7$406.5

$57.9$27.0$21.1$53.3$55.9$0.0

$294.1

$24.8$476.7‡

$ 11.0$ 20.5

$2,109.1


The Fed Balance Sheet:Liabilities

Federal Reserve Liabilities(in billions of dollars)

4 July 07 26 Nov 08

Federal Reserve Notes

Commercial Bank Reserve Balances

Reverse Repos w/ Dealers

U.S. Treasury Supplementary Financing Account

Liabilities related to Foreign Official and US Treasury Deposits

Other Liabilities

Total Liabilities

Capital

$781.4

$ 16.8

$ 42.4

$ 5.7

$846.3

$ 34.1

$835.1

$582.7

$25.0

$479.1

$136.8

$5.8

$2,065.5

$49.4


Expansionary Fiscal Policy in the US

.2

.3

.4

.5

.6

.7

.8

.9

.04

.02

.00

.02

.04

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.08

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50 55 60 65 70 75 80 85 90 95 00 05 10

debt/GDP ratio deficit/GDP ratio

Fiscal Policy in the US


Expansionary Fiscal Policy in Europe

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0

4

8

12

16

2000 2002 2004 2006 2008 2010 2012 2014

Deficit/GDP in Europe

0

40

80

120

160

200

2000 2002 2004 2006 2008 2010 2012 2014

ItalySpainFrancePortugalIrelandGreeceGermany

Debt/GDP in Europe


Spreads:local versus international factors

10

0

10

20

30

40

2000 2002 2004 2006 2008 2010 2012 2014

ItalySpainFrancePortugalIrelandGreece

10Y Bonds Spread on Bund

0.5

1.0

1.5

2.0

2.5

3.0

3.5

2000 2002 2004 2006 2008 2010 2012 2014

BAAAAASpread


Same fundamentals di¤erent yields


Same fundamentals di¤erent yields

�R it ,t+k � R

gert ,t+k

�= ∆et ,t+k + RP it ,t+k


The mechanism(The Euro-nomics group)


Unconventional Monetary Policy in the Euro Zone

Substantial increases in size of central bank balance sheet

Buy medium and long term public debt and private assets

Lower long-term interest rates

Channels of in�uence

Shift markets�stocks of assets of di¤erent maturities and risksFewer long-term assets, more liquidity, bank depositsInduce shift into equities, long-term public and corporate bondsHigher equity stock prices, stimulate investmentLower exchange rateStimulate bank lendingRaise expected future in�ation and create expectations that CBs willhold policy interest rates lower for longer


ECB QE Scheme

Plans to buy e1.1 tn �at a rate of e60 bn per month until sept 2016�e850 bn of public debt plus private sector assets � started March2015

Will not buy if yields fall below -0.2%

ceiling set at current yield paid by ECB on bank reserves


The transmission mechanism of monetary policy

Monetary policy controls directly short-term rates but it a¤ects theeconomy through long-term rates.

Long terms rates are determined by two factors the average (future)short term-rate until maturity of the bond and the term premium

In normal times the expectations channel dominates the termpremium

The crisis has changed this by inducing a negative term premium inthe US and a positive and heterogenous term-premium in Euro area


The negative term premium in the US

LSAPs in�uence interest rates via supply-and-demand e¤ects in thelong-term bond market.

As the Fed buys more long-term bonds, their price goes up, and theiryield falls, even if expectations of future short rates are unchanged.Said di¤erently, the so-called term premium on long-term bondsdeclines.

As a matter of fact LSAP have induced a negative risk premium


The negative term premium in the US

When policy works by moving term premiums, as opposed to movingexpectations about the path of short rates, the transmission to thereal economy may be altered

A risk-neutral �rm faces a rate on its 10-year bonds of 2 percent. Atthe same time, it expects that the sequence of rolled-over short-termrates over the next 10 years will average 3 percent. Hence, there is aterm premium of minus 1 percent.

The �rm should take advantage of the cheap long-term debt byissuing bonds.

It can take the proceeds of the bond issue and use these to pay downshort-term debt, repurchase stock, or buy short-term securities.

These capital-structure adjustments all yield an e¤ective return of 3percent.

the hurdle rate for new investment remains pinned at 3 percent


The term premium in Europe

In Europe the debt crisis has induced positive term premiaheterogenous across countries.

The same monetary policy is associated to very di¤erent long-termrates, these rates are higher in countries with a more di¢ cult �scalsituation, which are countries where the stimulus is most needed

The same monetary policy impacts di¤erently on consumption andinvestment in the euro area because �scal fundamentals a¤ect thetransmission of monetary policy


QE in Europe


Italy and the Euro

Low growth, high unemployment (especially youth unemployment)remarkable asymmetry in the distribution of private wealth and highpublic debt. This is Italy in 2014.

All these problems have not been caused by the euroLet us go back to 1973. The Bretton Woods system (the peg of allexchange rates to the dollar is abandoned because Non-US countriesare tired of �nancing US twin de�cits: a �exible exchange rate systemis introduced)


Two Economic Regimes (up to 1991)

in�ation regime: use in�ation to promote growth

stability regime: use price stability to promote growth


The in�ation regime

In�ation Regime features: strong trade-unions, weak governments andnon-independent central banks

trade unions put pressure, on private and government owned �rms, toincrease wages (strikes are the intruments).Weak Government increases wages and employment in the publicsector increasing the de�cit as taxation is untouched.higher public sector wages put pressure also on private sector �rms,public contracts are used to subsidized them.market might react asking higher interest rates to �nance the debt, thegovernment puts then pressure on the central and to roll the printingpress and buy government bonds. Then we have in�ation and tradede�cit and loss of competitiveness. The solution is competitivedevaluation of exchange rates. But exchange rate devaluation slashesthe value of the initial wage increase, and we are back to square 1.


The stability regime

Stability Regime features: independent trade-unions, governmentsand central banks with diversi�ed competences

trade unions organize strikes for economic and not for political reasonsindependent central banks prevents goverment from in�ating the debtawaywage growth re�ects productivity growth, stable prices. Stabilitystimulates investment and growth


Di¤erences across the two regime

Regime 1: high in�ation, possible same growth with regime 2, but highpublic debt and social security debt, asymmetric increase in private wealth(because the redistributive e¤ect of taxation does not take place)


The Data: Growth


The Data: Government Taxation and Expenditure


The Data: Private Wealth

Private Net (of private and public debt) Wealth GDP ratio is almost6 times GDP. 6 trillions housing, 1.2 trillion cash and deposits, 1.8shares and investment funds

The richest 10 per cent of the population holds 40 per cent of totalwealth


The Data: Nominal E¤ective Exchange Rate


After Bretton Woods collapse Germany Austria and Benelux adoptmodel 2, France Italy Spain Protugal and Greece model 1.

not an equilibrium. Speculative attacks and competitive devaluation(particularly damaging (e¤ective) in the agricultural sectors

single surrency is the solution. Convergence criteria are setu up in1991 and currency starts in 1999.

unfortunately in 1999 the convergence process is still far fromcompletion


Initally no problem because of a convergence enthusiasm sustained by thegreat moderation,instituional reasons help convergence( all thegovernment bonds in the euro area have a zero risk weights to computebanks capital requirements). Capital �ows towards peripheral countriesthat generates higher in�ation and loss of competitiveness (no morecompetitive devaluation)


the US subprime crises puts a sudden stop to capital �ows, the debtcrisis follows, only BCE intervention prevents the system fromcollapsing.

persistent growth di¤erentials between the core and the peripheryemerge


Two alternatives

default and euro exit (no problem solved back to the old regime 1)

mobilize private wealth to promote growth


The Subprime and the Euro Debt Crises -...

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