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7/30/2019 Financial Crises Lecture 1
http://slidepdf.com/reader/full/financial-crises-lecture-1 1/21
FinancialCrises
JoseScheinkman
Introduction
Financial Crises
Jose A. ScheinkmanColumbia University
Spring 2013
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7/30/2019 Financial Crises Lecture 1
http://slidepdf.com/reader/full/financial-crises-lecture-1 2/21
FinancialCrises
JoseScheinkman
Introduction Program
(I) Introduction
(II) Classical crises• Bank runs• Currency crises
(III) Speculation•
Limits to arbitrage• Bubbles• Short-termism
(IV) The crisis of 2007...
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FinancialCrises
JoseScheinkman
Introduction Tools
(I) Economic models
(II) Case studies
(III) Formal empirical analyses
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7/30/2019 Financial Crises Lecture 1
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FinancialCrises
JoseScheinkman
Introduction From Reinhart-Rogoff 12/08
Prop or t ion of Count r i es with Banking Cr i s es , 1900 -2008
Weighted by Their Share of World Income
0
5
10
15
20
25
30
35
40
45
1 9 0 0
1 9 0 3
1 9 0 6
1 9 0 9
1 9 1 2
1 9 1 5
1 9 1 8
1 9 2 1
1 9 2 4
1 9 2 7
1 9 3 0
1 9 3 3
1 9 3 6
1 9 3 9
1 9 4 2
1 9 4 5
1 9 4 8
1 9 5 1
1 9 5 4
1 9 5 7
1 9 6 0
1 9 6 3
1 9 6 6
1 9 6 9
1 9 7 2
1 9 7 5
1 9 7 8
1 9 8 1
1 9 8 4
1 9 8 7
1 9 9 0
1 9 9 3
1 9 9 6
1 9 9 9
2 0 0 2
2 0 0 5
2 0 0 8
P e r c e n t o f c o u n t i e s
The GreatDepression
Emerging Markets, Japan the
Nordic Countries, and US(S&L)
World War I
The Panicof 1907
The First Global Financial Crisis of 21stCentury
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FinancialCrises
JoseScheinkman
Introduction Financial Market Episodes in US - 80’s and 90’s1. Failure of Continental Illinois in 1984
• 7th largest bank in US in 1984. Largest bank failure in UShistory until Washington Mutual in 2008
• Losses exceeding $1billion in participations on loans madeby Penn Square, an Oklahoma bank that failed in 1981.
• Exposure to Lat Am
• Bank Run by large depositors, who are not insured byFDIC
• Solution: Bailout by FDIC and reorganization of bank.
• A change in the FDI Act in 1950 allowed the FDIC, if itsBoard of Directors deemed a bank “essential” to itscommunity, to keep a failing bank open through direct
infusion of funds.5/21
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FinancialCrises
JoseScheinkman
Introduction Financial Market Episodes in US - 80’s and 90’s1. Failure of Continental Illinois in 1984
• Holding company bank holders were protected.
• Too big to fail - popularized by Representative McKinneyin hearings on Continental.
• Moral hazard
• Contemporary discussion of failure of supervision.
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FinancialCrises
JoseScheinkman
Introduction Financial Market Episodes in US - 80’s and 90’s2.Crash of 1987
• Financial engineering and portfolio insurance
• A put gives the owner the right (but not the obligation) tosell an asset to the seller of the put at a fixed price
• Black-Scholes formula shows that under some stringentassumptions, a put can be “synthesized” by a trading
strategy.• Assumption includes continuous pricing• Strategy requires selling an asset if the asset price goes
down
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FinancialCrises
JoseScheinkman
Introduction Financial Market Episodes in US - 80’s and 90’s2.Crash of 1987
• 1982 - creation of futures market on S&P 500 index
(CME)• Portfolio insurance by Leland, O’Brien, Rubinstein
Associates (LOR): A dynamic strategy implemented onbehalf of clients
• To protect large portfolios with a predetermined maximum
loss (e.g. 5%)
• Licensees included Wells Fargo, Chase, J.P. Morgan...
• $60 billion of portfolio insurance on the S&P sold topension funds, money managers...
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FinancialCrises
JoseScheinkman
Introduction Financial Market Episodes in US - 80’s and 90’s2.Crash of 1987
• Friday, October 16th, Dow drops 4.6%. Monday, Oct.
19th Dow drops 22.6%. Breakdown of trading + drop of 29% of 2 months S&P 500 index futures. Breakdown inindex arbitrage and put replication.
• Chicago Mercantile Exchange clearinghouse near collapse.
• Solution: FED told (ordered?) banks to extend credit to
investment banks.
• Initial fall in prices probably caused by other factors
• Brady commission blamed portfolio insurance foraccentuating the loss
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FinancialCrises
JoseScheinkman
Introduction Financial Market Episodes in US - 80’s and 90’s...3.Savings & Loans Crisis
•
Regulation• Failure of nearly 750 S&Ls. Cost to taxpayers exceed $300
billion.
• Asset-Liability mismatch. Long-term fixed interest loans(on average longer than 15 years) as assets and short-termvariable interest deposit liabilities
• inflation + competition from money market mutual funds(with unregulated interest rates) make it harder for S&Lsto retain and attract deposits
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FinancialCrises
JoseScheinkman
Introduction Financial Market Episodes in US - 80’s and 90’s...
3.Savings & Loans Crisis
• Garn-St Germain Act of 1982• mandates interest rates on deposit accounts equal to rates
of money market funds. Solves liquidity crisis but createsan insolvency crisis.
• Allows S&Ls to diversify their asset base (up to 40% of
commercial real estate and up to 30% consumer loans).Facilitates moral hazard in lending and gambling forresurrection.
• Regulatory response delayed by forbearance
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FinancialCrises
JoseScheinkman
Introduction Financial Market Episodes in US - 80’s and 90’s...
3.Savings & Loans Crisis
• Solution:• Regulators FHLBB and FSLIC abolished in 1989 and
creation of the Office of Thrift Supervision (OTS). OTSlater was regulator of American International Group (AIG),Washington Mutual, and IndyMac.
• The Resolution Trust Corporation (RTC) is established in1989 to liquidate failed thrifts
• Federal Deposit Insurance Corporation Improvement Act of
1991 (FDICIA) tightens bank and S&L closure rules,establishes risk-based deposit insurance and raises capitalrequirements,
• Greater role for Freddie Mac and Fannie Mae and takeoff of mortgage backed securities (MBS)
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FinancialCrises
JoseScheinkman
Introduction Financial Market Episodes in US - 80’s and 90’s...
4.LTCM failure
• Limits of arbitrage
• A hedge fund betting on “convergence” of similar assets
• High leverage
•
Initially very profitable, return to investors of more than40%/year.
• Lost $ 4.6 billion following Russian crisis
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FinancialCrises
JoseScheinkman
Introduction Some Financial Market Episodes in US - 2000’s
• Dot.com bubble.• Enron, Worldcom
• Corporate governance
• Subprime crisis.
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FinancialCrises
JoseScheinkman
Introduction Major Financial Crises Abroad Since 1980
• Latin American debt crisis in the 80’s• US hikes interest rates to fight inflation. At the same time
(consequence?) commodity prices plunge.• Widespread emerging markets sovereign debt crisis
• Sovereign debt held by banks (syndicated loans)• Debt overhang. Restructuring of sovereign debt required
agreement of banks• Solution: Brady Bonds, converting bank debts into
collateralized tradable bonds
•
Scandinavian banking crisis.• Japanese asset price bubble and crash.• Mexican crisis of 1995.• 1997 Asian financial crises.• 1998 Russian financial crisis.
• Sovereign debt crisis in Eurozone.15/21
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FinancialCrises
JoseScheinkman
Introduction The credit crisis of 2007...
• Proximate causes• The US financial sector allocated substantial resources to
real estate.• Investments financed through new financial instruments.
• Originate and distribute model.
• Financial intermediaries kept a portion of the instrumentsthey were supposed to distribute and sold another sizable
portion to investment and commercial banks.• Buyers included financial institutions in countries that did
not experience a real estate bubble e.g. Germany
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FinancialCrises
JoseScheinkman
Introduction Real Estate and Crises (Reinhart-Rogoff 12/08)
Table 8. Real Housing Price Cycles and Banking CrisesCountry Crisis date Peak Trough Duration of
downturn
Magnitude of
decline(in percent)
Advanced economies: The Big 5Finland 1991 1989:Q2 1995:Q4 6 years –50.4
Japan 1992 1991:Q1 Ongoing Ongoing –40.2 Norway 1987 1987:Q2 1993:Q1 5 years –41.5Spain 1977 1978 1982 4 years –33.3Sweden 1991 1990:Q2 1994:Q4 4 years –31.7
Asian Crisis: The Big 6Hong Kong 1997 1997:Q2 2003:Q2 6 years –58.9
Indonesia 1997 1994:Q1 1999:Q1 5 years –49.9Malaysia 1997 1996 1999 3 years –19.0Philippines 1997 1997:Q1 2004:Q3 7 years –53.0South Korea 1997 2001:Q2 4 years –20.4Thailand 1997 1995:Q3 1999:Q4 4 years –19.9
Other emergingArgentina 2001 1999 2003 4 years –25.5Colombia 1998 1997:Q1 2003:Q2 6 years –51.2
Historical episodes Norway 1898 1899 1905 6 years –25.5US 1929 1925 1932 7 years –12.6
Current casesHungary 2008 2006 Ongoing Ongoing –11.3Iceland 2007 November
2007
Ongoing Ongoing –9.2
Ireland 2007 October 2006 Ongoing Ongoing –18.9Spain 2007 2007:Q1 Ongoing Ongoing –3.1UK 2007 October 2007 Ongoing Ongoing –12.1US 2007 December
2005 –16.6
Sources: Bank of International Settlements and the individual country sources described in the Data Appendix.
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FinancialCrises
JoseScheinkman
Introduction The credit crisis of 2007...
• Financial engineering promised the creation of safesecurity from pool of less safe assets.
• Example: Two mortgages each with a face value of $1million with a probability of 10% of non-payment.
Probabilities of default are assumed to be independent.• In the post WWII period a substantial US-wide fall in
housing prices had not occurred.
• Create pool of the two mortgages and create 2 securities.The first one pays to the owner the first million paid to
the pool. The other security has the right to the rest(equity portion).
• Probability of first security not receiving full payment isonly 1%.
•
What if independence assumption not true?18/21
Financial
7/30/2019 Financial Crises Lecture 1
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FinancialCrises
JoseScheinkman
Introduction The credit crisis of 2007...
• In the past banks had no option but to hold mortgage risk.
• In this episode financial intermediaries had a chance tohold a much smaller portion of the risk
• typically had to hold a piece of equity portion• ended up holding substantial amounts of AAA tranches,
viewed as less risky.• Why did they do it?
• Greed versus ignorance
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FinancialCrises
JoseScheinkman
Introduction The credit crisis of 2007...
(1) Crisis resulted from a realization that these exotic financial
instruments were worth less than previously anticipated?(2) Crisis was simply the result of a random “bank-run”
(liquidity shock)?• Financial intermediaries financed these investments with
short term debt.
• (2) is much more kind to financial intermediaries’management and regulators.
• Data on prices and default rates favors (1).
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FinancialCrises
JoseScheinkman
Introduction The credit crisis of 2007...
• Some observations• In run-up to crisis US ran a large current account deficit
• Current Account = Savings - Investment• Reinhart-Rogoff document that many banking crises in
1960-2007 were preceded by large current account deficits(“capital flow bonanzas”).
• Also true of many other countries in current crises(United Kingdom, Spain, Iceland, Ireland...)
• Why were foreigners willing to finance the US CA deficit atsuch low interest rates?
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