The Financial Crisis and its learning's: Theoretical and Policyoriented

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The Financial Crisis and its learning'sTheoretic
al and Policy-oriented

• Jacques SAPIR, PhD.
• Professor of Economics,
• EHESS-Paris
• Director CEMI-EHESS -Paris
• Sapir_at_msh-paris.fr

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I. The creeping financial world crisis

• The US Subprime crisis.
• The banking crisis.
• The Currency crisis

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I.I. The Subprime crisis

• I. Subprime and Subprime-ARM
• Mortgages where the debt to income ratio is over
  55 (highly indebted households) or mortgages
  where the loan to good value is over 85 (high
  leverage loans).
• ARM Adjustable Rates Mortgage.
• II. Alt A
• Debt to income ratio or loan to value ratio are
  under Subprime thresholds but documentation
  incomplete (so-called fast track loans).
• III. Jumbos
• Loans of over 417,000 USD.

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Whats the Subprime relevance

• Subprime and Alt A have a relatively low share
  in the US Mortgage market (around 15 each). The
  traditionally subsidised mortgage brokers Fanny
  Mae and Freddie Mac where making more than 55 of
  mortgages.
• But Subprime and other specials developed fast
  since 1998. Subprime loans were over 1300
  billions USD by March 2007. They were at 150
  Billions in 2001 and 600 Billions in 2005..
• And they were backed by a powerful string of
  financial derivatives. It is the
  collateralization process which gave Subprime
  mortgages their relevance.

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The development of Mortgage Based Securities

• Credit Default Swaps (CDS).
• Collateralized Debt Obligations (CDO).
• Collateralized Loan Obligations (CLO).
• Selling risk on financial markets MBS are
  actually a kind of insurance system for the
  emitter and they are attractive bonds for buyers
  till the default rate is low (usually 0.5).
• But MBS have spread the risk throughout the
  financial system and everybody can become an
  insurance company if it buy a CDS or a CDO.

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MBS an industry which grew too fast...

• MBS have developed extremely fast in 8 years.
• Risk has been spread-out among Banks and
  Hedge-Funds through obligations baskets sold by
  SPV working from off-shore zones.
• Weak collateralization could induce a major
  liquidity crunch.

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US Household indebtedness in GDP
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The current crisis compared to 40 years of
indebtedness cycles
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Mortgaged loans have been made so easy that they
had been used as a proxy for an income policy.

• The US economy paradox Fast growth but an
  impoverished middle-class.
• From 2000 to 2006 if the average income increased
  by 3 a year, the median income has been stable.
• Lower income households have lost ground. From
  1997 to 2004 the 2nd lowest decile lost 12 when
  the 2nd best decile gained 10.
• Poverty is gaining ground in the USA 20 of
  children are under the poverty line against 16
  in GB and 7 in France and Germany.
• The 0.1 wealthiest part of the population is
  accumulating 7 of the national income against 2
  in France and Germany.
• As a result indebtedness has been used to
  maintain consumption. The average household debt
  ratio is 120 of the yearly income and households
  saving ratio was 1.5 of GDP in 2006.

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I.II. The Banking crisis

• Banks have been the main user of MBS (40 of
  cumulative total).
• Strong competition in a deregulated market has
  made Subprime-ARM based CDS attractive to boost
  Banks profit rates.
• The use of SPV and SPV-based Securities-baskets
  by banks has decreased transparency.
• New accounting rules (Mark to Market) have
  increased Banks and Insurance companies
  vulnerability to financial market fluctuations.

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The Body Count(early December 2007).

• Requiescat in Pace.
• New Century Financial (Subprime lender)
• American Home Mortgage (Subprime lender).
• Ameriquest (Subprime lender)
• Netbank (Internet Bank)
• NorthernRock (Bank)

• Total losses in real-estate properties is 107
  Billions USD.
• Total financial losses is around 400 Billions
  USD.
• Banks are accounting for at least 50 of losses.
• Butnobody knows precisely how much has been
  lost. Confidence has been broken and the
  inter-bank monetary market has collapsed.

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Whos next?

• Known losses.
• Citigroup, investment Bank, USD 11.0 Bln.
• Merry Lynch, investment bank, USD 12.5 Bln (and
  may be 15.0)
• Morgan Stanley, investment bank, USD 3.7 Bln.
• HSBC, bank, USD 3.4 Bln.
• Freddie Mac, Mortgage Lender, USD 3.7 Bln.
• UBS-AG Investment bank, USD 3.6 Bln.
• Propagation into Europe.
• The German Banking System is highly vulnerable.
  Deutsche Bank acknowledge a loss of Euro 2.2 Bln.
• The Spanish Banking System dead on Arrival?
• Insurance Companies Swiss-Re acknowledge for
  more than USD 1,1 Bln of losses.

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I.III. The Currency Crisis

• The banking crisis raises the ghost of a
  generalized Credit Crunch.
• Central Banks are reacting by injecting
  liquidity.
• But the US Economy is so much indebted that the
  value of the USD is in doubt.
• Currency change rates are now extremely volatile.
• A major crisis is possible in 2008 when we will
  reach the peak of the Subprime crisis
  (March-April 2008).

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The US Debt is increasing fast.
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Is the US Dollar to spin down?

• NO
• The US Treasury needs to keep the USD attractive
  to sell T-Bonds.
• East-Asian countries want to defend their
  competitiveness and would try to prop-up the USD.
• The ECB is pouring as much money as it can to
  prevent a bank crisis.
• A brutal fall of the USD could have widespread
  political implications.

• Yes
• The US Government cant afford a recession in an
  electoral year and any increase of interest rates
  would have devastating effects.
• The FED is to bail-out US Banks.
• Commodity exporters are beginning to use other
  currencies.
• The wealth risk on USD denominated Funds is too
  high. A flight from the USD is to happen.

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II. Theoretical and Political lessons
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II.I. The current crisis validates some important
theoretical findings.

• (A) Moral Hazard and Adverse Selection have been
  proeminent in the Subprime crisis.
• (B) The Herd Mentality validates Herbert
  Simons theory of Bounded Rationality.
• (C) Markets are not spontaneously
  information-efficient (Stiglitz).
• (D) Uncertainty and Surprise are shaping
  decision-makers preferences.
• (E) Rationality is context-dependent.
• (F) Institution matters.
• (G) Market-value is not the value.

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II.II. Keynes is back..(and so are Minsky and
Shackle)

• (A) When uncertainty is prevalent credit is
  crunching this is the preference for liquidity.
• (B) Agents are reacting not to what happens but
  to how they understand other agents reaction to
  the new situation this is the Beauty Pageant
  metaphor.
• (C) When a surprise comes from the Unexpected
  it can have disastrous consequences.
• (D) Money-managers are not stabilizing but
  de-stabilizing the economy.
• (E) A market does not generate institutions it
  needs.

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II.III. Policy implications.

• Central Banks need to be reactive and not bounded
  by a single target. They have to interact with
  governments. Full independence is not workable.
• Financial markets need regulations and
  supervision. Regulation cant be fully market
  based.
• Wealth redistribution is to be consistent with
  the accumulation process.
• There cant be good finance where the real sector
  is not working well.
• Change rates in a fully liberalised financial
  environment doesnt reflect actual economic
  performances.