How the US financial system arrived at the current crisis:
The Crisis on Wall Street at Princeton conference
By Jon Fernquest |
Yesterday, Paul Krugman and several other prominent economists gave presentations at a Crisis on Wall Street conference at Princeton University near New York (See presentation slides and blog announcement).
Paul Krugman's presentation repeats his call for a government equity stake and closer supervision and accountability over the Treasury plan to purchase toxic assets from bank balance sheets.
What follows are the presentation slides fleshed out a little bit with background history on the crisis from websites such as: Wharton business school, Wikipedia, and the BBC (Also check out the mini-history of the crisis by President Bush in his speech to the American public last night).
Housing bubble inflates then deflates
The crisis developed as follows. First, there was a housing bubble. For several years "an increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms."
Second, there was a "housing bust" when large numbers of borrowers began defaulting on their mortgages:
"...housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically, as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008."
This housing bust led to mortgage loan losses at banks. In a depressed housing market home prices are lower than the amount of money borrowed to buy them and these houses were not worth what people paid for them. Some people even chose to stop making payments on their mortgage and abandon their home.
Mortgage loan losses at banks led to inadequate financial capital at banks, according to Krugman's presentation, but why? The answer lies in one of the other presentations, by Markus Brunnermeier on The New Financial Architecture.
Banks caught with a maturity mismatch: Just like Asia 1997
A maturity mismatch on US bank balance sheets, with long-term assets funded by short-term liabilities, makes the 2008 US Financial Crisis similar to the 1997 Asian Financial Crisis.
The home mortgage loans held by banks are long-term assets. The liabilities and funding behind these long-term assets consisted of mostly cheap short-term money market funds such as Commercial Paper (CP) and Repurchase Agreements (Repos).
Before the crisis there was more and more short-term funding. When the subprime crisis hit short-term financing became harder and harder to obtain until it didn't exist at all.
Deleveraging
Banks had to to sell off their mortgage loan assets because they no longer had the short-term funding to back them.
As banks began to sell these mortgages they found that all the other banks were selling at the same time. When all the banks tried to sell their mortgages at the same time, supply greatly exceeded demand and prices plunged to firesale levels. This left the banks with even more debt relative to their assets than they had before (Paradox of Deleveraging).
The problem is that banking regulation focuses on the capital/leverage ratio of banks. Regulation should have focused on maturity mismatch and market liquidity of assets on bank balance sheets.
Impossible to reinflate the housing bubble
Just like the 1997 Asian Crisis, it will be impossible to reinflate the housing bubble in the short-term.
How much are mortgage loan assets worth? Not much after the housing bubble burst. The graph shows how big the housing bubble got over the last decade. (Note: This can also be seen in the Case-Shiller Index of real estate shown in Krugman's presentation slides):
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Home prices have declined from their peak. If they remain at their current level, mortgage losses will amount to about $473 billion, if they fall another 10% the estimate is $636 billion, and if they fall another 20% the estimate is $868 billion in mortage losses. So you can see where the proposed $700 billion bailout plan amount comes from.
If the US government is going to shell out $700 billion of the taxpayer's money for a bailout, it needs a long-term equity stake in the banks it buys the toxic assets from and also oversight powers, both of which are missing from the Paulson Treasury bailout proposal. Krugman has repeated this over and over again and it has become one of the main issues in the bailout debate.
Vocabulary:
equity stake - owning part of a business
accountability - being responsible for and explaining one's actions
fleshed out - adding details to an outline
a bubble - when asset prices rise far above their actual worth
housing bubble, housing price bubble - when the prices rise to a level much higher than they are worth (often from specualtion because everyone expects to make money from higher home prices in the future)
the bubble bursts, a housing bust - asset prices suddenly fall from unrealistic levels down to their actual worth
incentives - rewards to encourage certain behaviour
easy initial terms - easy to make payments at the beginning
assume difficult mortgages - buy a house with a mortgage that is difficult to pay back
refinance at more favourable terms - get a new loan that is easier to pay back
a default, in default - fail to pay back a loan, as promised
a foreclosure - when the bank takes away the real estate from a borrower that the bank loaned money to
as anticipated - as they expected would happen (but didn't)
an ARM (Adjustable Rate Mortgage) - a mortgage loan with an interest rate that is adjusted up and down to follow interest rates (See Wikipedia)
ARM interest rates reset higher - initially the interest rate was low to attract borrowers but after some time the rate jumps up making the mortgage difficult to pay back
inadequate financial capital - not enough owner's equity in the balance sheet (the amount of financial capital or owner's equity on bank balance sheets is regulated by the government because it provides stability to banks unlike short-term liabilities)
Case-Shiller Index - measures measure the value of the residential real estate market in the United State (See Wikipedia).
maturity mismatch - when long-term assets on a bank balance sheet are not matched by short-term liabilities
money markets - financial markets for short-term borrowing and lending, markets where short-term liquid assets such as money and government treasury bills are traded, the opposite of long-term capital markets, the core money market consists of banks borrowing and lending money to each other using commercial paper or repurchase agreements (See The Economist)
Commercial Paper (CP) - a money-market security issued by large banks and corporations (See Wikipedia)
Repurchase Agreements (Repos) - a borrower sells securities for cash to a lender and agrees to repurchase those securities at a later date for more cash (See Wikipedia)
market liquidity - how much buying and selling is going on in a market, how easy it is to sell your asset and get cash without taking a loss
shell out - give
