The current global financial crisis: What was really ‘purely prime’?

Esteban Pérez Caldentey, Daniel Titelman, Ramon Pineda1

April 2009

1 Development Studies Section, ECLAC. Santiago, Chile. This paper has not been subject to editorial revision. The authors are grateful to Cecilia Vera and Pablo Carvallo for their valuable comments and suggestions.

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Abstract

The current crisis follows the boom/bust dynamics of past episodes. It is nonetheless, unique in the disproportion between the relatively small size of the market that originated the crisis and its magnitude and systemic character. The explanation to this disproportion lies in the combination of off balance sheet funding with pro-cyclical leverage management. Off balance sheet funding set the stage for the crisis. On the one hand, it allowed to seemingly separate the risk of the asset issued (financial risk) from its originator (real risk). On the other hand, it permitted to blur the distinction between securities issued against low risk loans, from those issued against high risk loans. As a result assets could move in tandem during the different phases of the crisis. Assets were viewed as ‘prime’ in the boom phase and downgraded to ‘subprime’ in the bust phase. The potential effects of off balance sheet funding were amplified through pro-cyclical management practices. In the bust phase, pro-cyclical management resulted in a generalized cumulative decline in asset prices turning assets, irrespectively of their real risk profile, into ‘sub prime’ assets. The consequent effects on asset base reduction and balance sheet contraction led to a generalized asset deflation and ‘credit crunch.’

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1. Introduction

Even though the current global financial crisis follows the boom/bust dynamics of other episodes, it is atypical in its magnitude, systemic character and especially in the pervasiveness with which, regardless of their risk, assets became ‘prime’ in the boom and ‘sub prime’ in the bust.

The stage for the current crisis was set up by the generalized adoption of off

balance sheet funding practices through out the financial system of the developed world. The off balance sheet funding procedure consists in the creation of a financial asset structure that is remote from the possible bankrupt or insolvency status of the originator. In this way, off balance sheet funding seemingly separated the risk of the portfolio of the originating financial institution from that of its own.

Moreover, off balance sheet funding provided additional protection to the investor through credit enhancing techniques permitting to blur the distinction between securities issued against low risk loans, from those issued against high risk loans. This in turn, allowed risk perceptions to move in tandem in the boom and bust phases. As a result, in the boom phase, as the price of assets tended to increase sharply, all securities would be viewed as prime. Contrarily in the bust phase all securities would tend to bear the ‘sub prime’ label. This particular and unique feature of the crisis is reflected in the difficulty of reforming the financial system by separating the ‘toxic’ from the ‘non-toxic’ assets in the balance sheets of financial institutions.

Off balance sheet funding and its effects on the prices and on risk perceptions and

ratings of securities became widespread by pro-cyclical leverage management. Pro-cyclical management entailed reducing debt in the bust phase which eventually led to a cumulative asset deflation and the generalized categorization of assets and securities as ‘sub prime.’

The consequent loss in the value of assets and contraction in financial institutions

balance sheets reduced their lending capacity and set the stage for a credit crunch.

The above working logic of these financial mechanisms and more precisely the combination of off balance sheet practices with pro-cyclical leverage management can explain, in part, a most fundamental question regarding the current episode, namely how can such a disruption in such a relatively small market as the subprime market cause such a world debacle only comparable in magnitude, virulence, and systemic character to the Great Depression?

This paper addresses this question focusing on off-leverage funding practices and

pro-cyclical management. It is divided into five sections. Following this introduction, the second section argues that while the subprime crisis episode follows the pattern of past crisis it is atypical in the disproportion between the small size of the market which generated the crisis (i.e., the subprime market) and its worldwide effects. The third section explains the specificities of the current crisis on the basis of off leverage funding

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and pro-cyclical management. The fourth and fifth sections focus on each of these financial practices respectively. The sixth sections centers on the ensuing credit crunch and the final reflections are found in the conclusion.

2. The subprime Crisis: Another case of boom/bust dynamics

As postulated in the literature on the subject, the financial crises which have erupted in the past two decades follow a similar sequence of events characterized by boom/bust dynamics2. In spite of its unprecedented magnitude and widespread contagion, the current crisis (2007) which originated in the sub-prime real estate sector of the United States is not an exception to this established crisis pattern 2.a. The boom phase

The general sequence of events depicting a crisis unfolds in the boom stage according to the following process.3 Excess liquidity conditions produce an increase in the effective demand for certain assets increasing their price and fueling a speculative boom (bubble) in that asset. As the market price of that asset increases it induces even greater demand for it mainly for short term capital gains associated to anticipated increases in their prices.4 Also higher asset prices translate into greater wealth providing the basis for increased spending and further credit expansion.

As shown in table 1 all of the main financial crises of the past two decades, are characterized by an increase in liquidity in the immediate years prior to the eruption of the crisis. For these episodes, on average, the increase in the ratio of bank lending to GDP rose from 95% to 124% in the immediate years prior to the eruption of the crisis.

The maximum rise in the ratio of credit to GDP was registered during the Asian

crisis for the cases of Thailand and Malaysia in the five year period preceding the start of the crisis. The ratio of credit to GDP increased from 98% to 147% and from 143% to 187% respectively. Contrarily the smallest increase was registered by Norway (Nordic Crisis) and by the United States during the Savings and loan crisis. Both experienced increases of roughly 8 percentage points in the ratio of private credit to GDP.

2The list of crises that have erupted in the past decade include, among others, Japan (1991), the Nordic Crises (1989); the Latin American debt crisis of the 1980’s; the Asian Crisis (1997); the United States in the Savings and Loan financial debacle (1986), the Long Term Capital Management (LTCM) failure (1998) and the Dot Com crash (2001) 3 This view is traced to Wesley Mitchell (1913) and Fisher, I. (1933) See also, Kindleberger, Ch. And Aliber R.Z. (2005). Kindleberger, Ch. (1984) Minsky, H.P. “The Financial-instability hypothesis: capitalists processes and the behavior of the economy” Bordo, M. (2007);. Mishkin, F. (1991) For other authors mostly in the monetarist tradition, banking panics are an essential element in financial crisis. See, Friedman M. and Schwartz (1963) and Schwartz A. (1986) Real and Pseudo-Financial Crises. 4 This is referred to as ‘speculation.’ See Klindberger et. Al (2005). In this sense it can be argued that as put by J.M. Keynes (1936, p.158) in the General Theory of Employment, Interest and Money (HBJ: New York), speculation is the “activity of forecasting the psychology of the market.”

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Table 1 Past crises episodes

Country/Region (Crisis episode)

Crisis episodes

Increased levels of liquidity Expansionary monetary policy Financial deregulation and institutional change

Sweden (Nordic Crisis)

1991-1994

Ratio of bank lending to GDP rose from 43% to 63% between 1985-1990

The money market rate declined from 17% to 11% between 1984 and 1988. Thereafter these increased to reach 15% in 1991.

Abolition of liquidity ratios for banks (1983). Lifting of official lending guidelines by the Central Bank (1985). Removal of interest rate and lending ceilings for banks (1985)

Finland (Nordic Crisis)

1991-1994

Ratio of bank lending to GDP rose from 64% to 92% between 1985-1990

The money market rate declined from 15% to 10% between 1984 and 1988. Thereafter these increased to reach 15% in 1990.

Removal of interest rate ceilings (1986) and liberalization of corporate lending from abroad (1987)

Norway (Nordic Crisis)

1991-1994

Ratio of bank lending to GDP rose from 71% to 80% between 1985-1990

The money market rate declined from 14.2% to 11.4% between 1986 and 1990. Rates increase to reach 20% in 1993.

Removal of quantitative regulation of banks’ lending and interest rate caps on lending (1984-1985)

Latin America 1982-1983

Net financial flows increased from 3.4% to 7.4% of GDP between 1973 and 1981.

Variable interest rate or rollover loans “designed to protect banks against adverse interest-rate developments on their short-term deposits”

Thailand (Asian Crisis)

1997-1998

Ratio of bank lending to GDP rose from 98% to 147% between 1992 and 1996.

The money market rate declined from 11.2% to 6.5% between 1991 and 1993. Rates increase to reach 16% and 13% in 1997 and 1998.

Deregulation of FDI and liberalization of cross-border financial transactions (1980s and 1990s).

South Korea (Asian Crisis)

1997-1998

Ratio of bank lending to GDP rose from 61% to 72% between 1992 and 1996

The money market rate declined from 17% to 12% between 1991 and 1993. Rates increase to reach 13.2% and 15% in 1997 and 1998.

Lifting of restrictions on the capital account at the beginning of the 1990’s. Inbound foreign investment liberalized. Banks are allowed to borrow from abroad. Increase in limits of external indebtedness for local banks.

Malaysia (Asian Crisis)

1997-1998

Ratio of bank lending to GDP rose from 143% to 187% between 1992 and 1996

The money market rate declined from 7.1% to 4.2% between 1993 and 1994. Rates increase to reach 7.6% and 8.5% in 1997 and 1998.

Deregulation of FDI and liberalization of cross-border financial transactions (1980s and 1990s).

Japan 1991-2001

Ratio of bank lending to GDP rose from 158% to 197% between 1985-1990

Interest rates declined from7.3% to 3.8% between 1985 and 1989. Thereafter rates increased reaching a peak of 7.5% in 1991.

Liberalization of deposit rates and lifting of banks capital controls. Absence of regulatory distinctions among financial institutions. Establishment of offshore market.

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Table 1 Past crises episodes (Continued)

Country/Region (Crisis episode)

Crisis episodes

Increased levels of liquidity Expansionary monetary policy Financial deregulation and institutional change

United States (Savings and Loan)

1986-1995

Ratio of bank lending to GDP rose from 92% to 100% between 1980-1985

The federal funds rate declined from 12.3% in 1982 to 6.7% in 1987 and increased thereafter to levels comprised between 8%-9% in the period 1989-1990.

Depository Institutions Deregulation and Monetary Control Act (the Garn-St Germain Act) (1982).Elimination of regulations initially designed to prevent lending excesses and minimize failures.

United States (Dot Com)

2001 Ratio of bank lending to GDP rose from 135% to 170% between 1994-2000

Financial Services Modernization Act (1999)

United States (Subprime)

2007-2008

Ratio of bank lending to GDP rose from 169% to 209% between 2002 and 2006.

The Federal Funds rate fell from 6% to 1% between 2001 and 2003. There followed a change in the monetary policy stance and the federal funds rate increased to 5% in 2006.

Commodity Futures Modernization Act (2000)

Notes: Sources: The sources used for the Nordic Crisis include Hansen (2003); Barot and Takala (1998); Kennedy and Andersen (1994); Girouard and Blöndal (2001); Von Peter (2004); Herring and Wachter (1999); Vale (1994). The source used for Latin America is Lamfalussy (2000). The sources used for the Japanese case include Kennedy and Andersen (1994); Herring and Wachter (1999); Honda (2003); Osugi (1990); Baba et al. (2005). The sources for the East Asian crisis include: Special Issue on the Asian Crisis (Cambridge Journal of Economics (1998); Kregel (1998); Eichengreen (2004); Klindeberger & Aliber (2005); Park and Bae (2002); Collyns and Senhadji (2002), Quigley (1999). The sources used for the savings and loan crisis include: Kennedy and Andersen (1994); Becketti (1990). The sources for the Long term management capital fund failure include: Stulz (2007); Shoven (2005); Holden (2007); Bernstein (1998).

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The current financial crisis is not an exception to this pattern as the ratio of private sector credit to GDP rose from 169% to 209% in the five years prior to the unfolding of the crisis.

Excess liquidity was facilitated by declining interest rates signaling an expansive

monetary policy stance. In most of the episodes presented in Table 1, including in the case of the subprime crisis, the decline in money market interest rates reached roughly 5 percentage points. Following the sequence described above, in all of these crises episodes excess liquidity fueled a price boom in an asset or a range of assets. These assets, thus became ‘the object(s) of speculation’, as they are traded mainly for short term capital gains resulting from anticipated increases in their prices. The different episodes reported in table 2 show that there may be a variety of assets that can serve as the ‘objects of speculation.’

A prominent ‘object of speculation’ is real estate residential property as illustrated in the Nordic (1989), the Japanese and Asian, the Savings and Loan (1986) and the sub prime (2007) crises episodes.5 On average in the Nordic case and Japan the prices of real houses measured in real terms increased from trough-to-peak by 30% and 100% respectively.

In the case of the Asian Crisis, the price of real estate properties measured by a

property stock index rose above 100% for Malaysia and Thailand and at a rate of 50% for Malaysia. Finally, in the cases of the savings and loan debacle and the subprime crisis, real estate properties witnessed an accumulated increase of 51% and 184% from their trough-to-peak values (Table 2 below). Finally in the case of the current crisis, the accumulated increase in real estate properties from trough-to-peak comprising the period 1997-2006 reached 184%.

However, the ‘objects of speculation’ are not limited to include real estate properties. They have also comprised loans to emerging market economies as shown by the Latin American crisis of the 1980’s; junk bonds as in the case of the savings and loan debacle; the derivative market as in the case of the LTMC; and technology related stocks as in the case of the dotcom bubble. During the boom period, in these episodes, the market for junk bonds and derivates, and the NASDAQ (the National Association of Securities Dealers Automated Quotations) which reflects the performance of technological stocks, recorded an increase of 400%. 5In Nordic country the real prices of houses increased from trough-to-peak by 120%, 34% and 28% for Finland, Sweden and Norway respectively. In the case of Japan, the prices of real houses began to increase in 1977 reaching a peak in 1990. During this period the accumulated rate of increase reached a 100%. In Asian Crisis, the real price of estate properties measured by a property stock index increased by 285% between 1991-1994 for Thailand; 145% between 1991-1997 for Malaysia; and 50% between 1991-1994 for South Korea. Finally, in the cases of the savings and loan debacle and the subprime crisis, real estate properties witnessed an accumulated increase of 51% and 184% from their trough-to-peak values

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Table 2

Crisis episodes in the boom phase Episodes, affected countries, objects of speculation, trough-to-phase years and accumulated

increase Crisis Episode Country Object of speculation Trough-to-

peak in the boom phase a/

Accumulated increase b/

Nordic Crisis (1989) Finland Real estate properties 1980-1990 120% Nordic Crisis (1989) Sweden Real estate properties 1985-1990 34% Nordic Crisis (1989) Norway Real estate properties 1984-1988 28% Japanese Crisis (1990) Japan Real estate properties

Nikkei Shares Index 1977-1990

100% 500%

Latin American Debt Crisis (1980)

Latin American countries

Lending to emerging market economies

1977-1981 30%

Asian Crisis (1997) Thailand Real estate properties Stock shares

1991-1994 285% 156%

Asian Crisis (1997) Malaysia Real estate properties Stock shares

1991-1997 145% 156%

Asian Crisis (1997) South Korea Real estate properties Stock shares

1991-1994 50% 74%

Savings and Loan (1986) United States

Real estate properties Junk bonds

1970-1989 1982-1986

51% 1650%

Dot Com (2001) United States

Stock market 1995-2001 400%

Long Term Capital Management (1998)

United States

Derivatives Hedge funds

1994-1997 163% 400%

Subprime (2007) United States

Real estate properties Stock market

1997-2006 2003-2007

184% 21%

Notes: a/ The year periods included in the column comprise the evolution of the object of speculation from the trough to peak year. b/ In the case of the Nordic crises, the Japanese crisis and the Savings and Loan crisis the figures corresponding to real estate property refer to the rate of increase in real house prices (that is, house prices deflated by consumer prices taking 1980 as the base year). In the case of the Asian countries, the figures refer to the rate of increase of the property stock and composite stock indices. House prices were not used due to the lack of comparable data for Asian countries for the period in question. In the case of the Dotcom bubble the figure refers to the accumulated rate of increase of the NASDAQ (the National Association of Securities Dealers Automated Quotations) which is the largest electronic screen-based equity securities trading market in the United States reflecting the increase in technological stocks. In the case of the Long Term Capital Management failure, the figures refer to the rate of growth of global derivatives and the value of weighted returns of hedge funds. The figure for junk bonds corresponds to the accumulated rate of increase of new issues of junk bonds. In the case of Subprime crisis the figures refer to the rate of change of the Case-Shiller composite index. c/ In the case of Latin America the figure refers to total net debt flows.

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A fundamental aspect of asset speculation is that it allows the boom phase to

continue and become widespread and cumulative over time. These assets are generally related to other trading activities and can also be used as collateral to further expand liquidity. In this way they can become a platform to transform other assets into ‘objects of speculation.’

Emblematic examples of this include the Asian, Nordic, Japanese and Sub-prime

cases where real estate was directly linked to the stock market or securities trading and the increase in the real estate prices fed a boom in stock market and securities prices. As a result, in these cases stocks and securities also became ‘objects of speculation.’

In the case of Asian crisis countries, stock shares increased on average above 100%

In the case of the Japanese crisis, the Nikkei shares index expanded by 500% in the boom phase. Finally in the case of the Subprime Crisis, the Dow Jones entered a bull market phase in their quarter of 2003 reaching a historical milestone high level in the third quarter of 2007 (Table 2). The formation of the asset bubble is facilitated and enhanced by a process of deregulation and in some cases financial innovation in the context of unregulated markets. Even though financial deregulation and innovation can lead to the development of financial markets, they can also stimulate excessive risk taking which results in an inefficient allocation of resources to the extent to which they promote speculative based financial investment.

In the crises episodes here analyzed, this process included mainly the expansion of financial intermediaries’ possibilities to extend loans and to borrow by the removal of restrictions on foreign exchange transactions, and the encouragement of foreign borrowing by the development of offshore financial markets (Asian case) or the increased flexibility granted to bank operations in the Nordic and Japanese cases (see Table 1 above).

In the case of the United States crises episodes, the expansion of financial

intermediaries’ possibilities to extend loans and to borrow was extended through several means. These include the relaxation of geographical and activity limitations on bank holding companies and new regulatory interpretations of existing law. They also comprised the expansion of activities of depository institutions to allow them to act like commercial banks, the repeal of the separation of commercial and investment banking imposed in the Banking Act of 1933, and the creation of new entities within the financial sector such as private equity firms and hedge funds.

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Financial market deregulation and institutional change tend to spur, in some cases, a process of financial innovation. 6 Financial innovations have occurred throughout recorded history, and financial innovation without adequate regulation, were also present in the financial crises episodes here analyzed. Two examples are the Junk Bond and the derivatives and Hedge Funds markets which were at the center of the Savings and Loan Crisis and the Long Term Capital Market failure.7

The process of financial deregulation and innovation without adequate regulation

allowed the boom to continue its course by reducing funding costs, expanding access to capital, and through risk transfer. However, as pointed above it also leads to excessive risk taking as a result of changes in the incentive structure and the relaxation and virtual circumvention of existing financial regulations and prudential provisions.

One important example is the Commodity Futures Modernization Act (2000) which

preceded the 2007 crisis. The Act established a series of provisions affecting the regulatory and supervisory roles of the Commodity Futures Trading Commission and the Securities and Exchange Commission. At a practical level however, the act shielded the market for derivatives from federal regulation and thus inevitably led to riskier financial practices. 2.b. The distress phase

Following the boom period financial crisis episodes are characterized by a phase of

distress. Distress refers to the increasing awareness that asset prices, and in particular the asset that serves as the ‘object of speculation’ are too high and is characterized by sharp declines in their prices.8 These, in turn, lead to substantial losses in the banking and financial sectors as the ‘object of speculation’ serves as collateral and is related to other assets.

The Nordic crisis, Japan and the Dotcom bubble provide illustrative examples of the

distress phase. The first two cases are characterized by significant declines in the value of real estate property. In the case of the former set of countries the decline in inflation adjusted residential real estate reached 45%, 30% and 33% for Finland, Norway and Sweden. Loan losses of the financial system amounted to 4.4%, 2.8% and 3.8% in the cases of Finland, Norway and Sweden respectively (Table 3 below).In the case of Japan residential property lost 33% of its value between 1990 and 2002. Non-performing loans losses are estimated at 7% to 8% of GDP.

6 According to…”financial innovation is the act of creating and then popularizing new financial instruments as well as new financial technologies, institutions and markets. 7 The junk bond market expanded rapidly in the 1980s, primarily as a source of funding for corporate mergers and acquisitions. Before the development of a liquid junk bond market, corporate takeovers were typically financed with loans from banks or other financial institutions. The junk bond market attracted much of this business by providing a less expensive and less restrictive source of funds. The capital markets were better able to absorb these risky loans than were banks. 8 See, Kindleberger et al. (2005), Op.Cit.

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The dotcom bubble illustrates the distress phase by the large decline in the value of stocks as the gains that technological stocks had achieved in the boom phase (400%) were basically wiped out during the distress phase.

Table 3 Crisis episodes in the distress phase

Episodes, affected countries, objects of speculation, trough-to-phase years and accumulated increase

Crisis Episode Country Object of speculation Peak-to-trough in the distress phase a/

Accumulated decline b/

Nordic Crisis (1989) Finland Real estate properties 1990-1995 45% Nordic Crisis (1989) Sweden Real estate properties 1990-1995 34% Nordic Crisis (1989) Norway Real estate properties 1990-1995 30% Japanese Crisis (1990) Japan Real estate properties

Nikkei Shares Index 1990-2002

33%

Latin American Debt Crisis (1980)

Latin American countries

Lending to emerging market economies

1983-1986 30%

Asian Crisis (1997) Thailand Real estate properties Stock shares

1994-1998 90% 99%

Asian Crisis (1997) Malaysia Real estate properties Stock shares

1997-1998 85% 86%

Asian Crisis (1997) South Korea

Real estate properties Stock shares

1994-1998 90% 91%

Savings and Loan (1986) United States

Real estate properties Junk bonds

1989-1991 1986-1989

15% 40%

Dot Com (2001) United States

Stock market 2001-2003 400%

Long Term Capital Management (1998)

United States

Derivatives Hedge funds

Subprime (2007) United States

Real estate properties Stock market

2006-2007 2007-2008

30% 90%

Notes: a/ The year periods included in the column comprise the evolution of the object of speculation from the peak to the trough year. b/ In the case of the Nordic crises, the Japanese crisis and the Savings and Loan crisis the figures corresponding to real estate property refer to the rate of increase in real house prices (that is, house prices deflated by consumer prices taking 1980 as the base year). In the case of the Asian countries, the figures refer to the rate of increase of the property stock and composite stock indices. House prices were not used due to the lack of comparable data for Asian countries for the period in question. In the case of the Dotcom bubble the figure refers to the accumulated rate of increase of the NASDAQ (the National Association of Securities Dealers Automated Quotations) which is the largest electronic screen-based equity securities trading market in the United States reflecting the increase in technological stocks. In the case of the Long Term Capital Management failure, the figures refer to the rate of growth of global derivatives and the value of weighted returns of hedge funds. The figure for junk bonds corresponds to the accumulated rate of increase of new issues of junk bonds. In the case of Subprime crisis the figures refer to the rate of change of the Case-Shiller composite index. c/ c/ In the case of Latin America the figure refers to total net debt flows.

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In the current subprime crisis, distress also began with a sharp decline of the asset that acts as the object of speculation which in this case, as in other cases presented above, was real estate prices. Between 2006 and 2008 property values fell by 30% (See Table 3).9

The initial defaults and losses were mainly limited to sub-prime mortgages loans

and securities. The subprime mortgage sector is a small component of the residential sector, mostly of lower incomes. These represented in 2007 roughly 20% of all mortgage loans and 4% of all United States assets. The losses on subprime loans and securities amounted to only roughly US$ 400 billion.10

However, contrarily to past crises episodes, the consequent effects of the crisis have

by far outstripped the initial losses. Indeed it is estimated that the cumulative declines of United States real estate wealth and the stock market capitalization values that followed the subprime crisis reached roughly US$ 1 and 7 trillion dollars respectively.

In addition, far from remaining focalized within the subprime sector of the United

States, the crisis has widely spread to affect some of the most important financial institutions in the United States and in the developed world. Moreover the contagion effects have also reached the emerging market regions of the world such as the Middle East, the Asia-Pacific region, South Asia and also Latin America. Currently it is estimated that the cumulative decline of World GDP relative to its trend caused by the subprime crisis is equivalent to roughly 3 trillion dollars. 11

9 This estimate is based on the Case Shiller Index. An alternative index is the purchase-only OFHEO index. Hatzius et al. (2008, p.3, n. 1) explain the differences which boil down to the fact that the Case Shiller index shows a greater price decline than the OFHEO index. 10 This estimate is provided by Blanchard (2008) and refers to the losses of subprime loans and securities by October 2007. This is the same estimate as that provided by Greenlaw et al. (2008). The estimate provided by Hatzius (2008) is slightly higher and of the order of US$ 500 billion. 11 These estimates are also found in Blanchard (2008).

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3. Some specificities of sub prime financial crisis

The disproportion between the relatively small size of the sector which generated the crisis (the subprime sector) and the importance of the magnitude of its effects on asset values, stock market capitalization, and systemic worldwide contagion beg an answer to the most fundamental question surrounding the present crisis episode, namely how can a shock to such a small segment of the real estate market in the United States cause such a world debacle?12

The answer to this fundamental question lies in understanding that although the

current crisis displays the anatomy of a ‘typical crisis,’ it also exhibits specificities of its own which make it an ‘atypical crisis.’ These specificities consist mainly in the combination of widespread adoption of off balance sheet funding with pro-cyclical leverage management practices.

Off balance sheet funding practices provided the basis for the gestation of the crisis.

The purpose of off balance sheet practices is ‘asset deconstructing’ through the creation of a financial asset structure, ‘bankrupt remote’, that is, legally independent of the risk, quality or continued existence of the originator of the assets in question. In this way off balance sheet practices were able to seemingly separate the risk of investing in an asset or asset backed security (financial risk) from the risk associated with the originator of the asset or security and even with the risk of the asset or security themselves (real risk).13 In addition, off balance sheet practices provided further protection to the investor against losses on the underlying assets through credit enhancement techniques. This permitted to blur credit rating perceptions across a broad spectrum of assets and the co-movement of risk perceptions on assets to move in tandem with the boom and bust phases of the crisis. In the boom phase, risk perceptions tended to consider assets as ‘prime.’ Contrarily in the bust phase, these were downgraded to the ‘sub prime’ category.

The effects of these practices on balance sheet size and aggregate liquidity were

amplified via pro-cyclical leverage management. Pro-cyclical leverage management entails the propagation of contagion through cumulative asset price inflation and deflation in the boom and distress phases respectively. 14

12 See, Greenlaw et al. (2008); Blanchard (2008); Hatzius (2008); Adrian and Shin (2008 a/, 2008 b/, 2008 c/). Prior to the crisis a similar question was posed by Bernanke et al. (1996) namely how can small impulses provide large aggregate fluctuations in economic activity. These authors named this mechanism the financial accelerator. 13 See, Gorton and Souleles (2005) and Ashcraft and Schuermann (2008) for a pre and post crisis treatment of off balance sheet practices. 14 Adrian and Shin (2008, p.3) define pro-cyclical leverage management in the following way: “…there is a positive relationship between changes in leverage and changes in balance sheet size. Far from being passive, financial intermediaries adjust their balance sheets actively and do so in such a way that leverage is high during booms and low during busts. Leverage is pro-cyclical in this sense.”

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4. Off – Balance Sheet Financing

Off balance sheet funding is a form of funding that enables a firm, financial or otherwise, to obtain finance: i) without at the same time showing debt on its balance sheet and ii) through the issue of high credit rated securities against a collateral pool of risky assets. 15 As such it enables financial institutions to obtain liquidity, improve their debt ratios that analysts use to assess the financial risk of a firm and expand their borrowing capacity.

Off balance sheet operations began to grow substantially in the 1980’s and especially since the beginning of the 1990’s and became widely used by financial intermediaries. The significant growth and widespread adoption of off-balance sheet financing practices respond in part to the universalization of banking and the spread of financial globalization. The universalization of banking,which has blurred the boundary between bank and nonbank financial services, and financial globalization have increased competitive pressure on financial institutions and have reduced margin of operations on on-balance-sheet operations.16 The growth of off-balance sheet financing is seen as a way for banks to achieve compliance with reserve requirements, and bank capital adequacy requirements and undertake lending activities which would not be as profitable if carried out through standard operations. Finally, off-sheet balance practices are also seen as the outgrowth of an increased demand for risk management services by private firms.17

In the case of the federally insured commercial banks in the United States, the

ratio of off-balance sheet derivatives to assets (on-balance) expanded from a multiple of 2.9 to 14.8 between 1992 and 2008. If other off balances bank operations are also taken into account the ratio of off-balances operations to assets (on balance) expanded from a multiple of 5.4 to 18.2 in the same period.18

15 A more general definition is “any form of funding that avoids placing owners' equity, liabilities or assets on a firm's balance sheet.” By contrast using balance sheet funding means making any form of funding whether equity or debt to appear on the balance sheet. See, http://www.riskglossary.com 16 The universalization of banking and is epitomized in the repeal in 1999 of the separation of commercial and investment banking imposed in the Glass-Steagall Banking Act of 1933. On the reasons explaining the adoption of off-sheet-balance practices see, BIS (1986), Chaudry (1989), Greebaum and Thakor (1987), James (1987), Ngassam (1990); Breuer (2000), and Lamfalussy (2000). 17 On this particular issue see, Nachane and Ghosh (2002). Since at least the beginning of the 1990’s the notional amount of off-balance sheet derivative products at commercial banks have exceeded their respective asset (on-balance) levels. These derivative products include interest-rate contracts (as defined as the notional value of interest-rate swap, futures, forward and option contracts), foreign-exchange-rate contracts, commodity contracts and equity contracts (defined similarly to interest-rate contracts) 18 The fact that the value of off-balance sheet derivatives operations exceeds that of assets applies to developed economies such as the United States and European Union and in some cases also to developing economies. See, for example Nachane and Ghosh (2002). The data here presented was computed on the basis of commercial bank reports of the United States Federal Deposit Insurance Corporation (FDIC) and include a sample of 11463 and 7146 depository institutions for 1992 and 2008 respectively. The definition of off balance sheet derivative products given above is that of the FDIC. In the middle of 2008, commercial banks had at least an equivalent of US$ 5 trillion assets in off-balance sheet operations.

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Off-balance sheet operations also formed the bulk of investment banks activities.19 For the period 1997-2008, an analysis of the balance sheets of the five major investment banks of the United States shows that a greater share of their total assets and liabilities consists of off balance sheet operations. 20

In the sub prime crisis episode, off balance financing, was instrumented through the creation of a new and independent legal entity termed a special purpose vehicle (SPV), and the sale to the SPV of a designated portfolio of assets. This designated portfolio of assets comprised residential mortgage loans.

Against this designated portfolio of assets (i.e., collaterals), the SPV issued liabilities (i.e., debt) in the form of fixed income securities to be sold to investors. The fixed income securities are known as asset backed securities (or more precisely in the subprime episode mortgage backed securities). Collateralized debt obligations (CDOs) are a special type of asset backed security. 21

The SPV transferred the proceeds received from the sale of securities to the

originating institution. Thus, the originating institution increased the value of its assets without showing on its balance a concomitant increase in its liabilities (debt).

The value of the principal and the interest yielded by these securities issued by the

SPV, depended on the cash flow produced by the designated portfolio of assets, that is, by residential mortgage loans. The SPV guaranteed in a first stage that it was in a position to make the payments on its debt commitments by de-linking the credit quality of the securities it issued, from the solvency status of the originating financial institution

19 Investment banks are banks engaging mainly in raising funds for corporations or governments through the issue and selling of securities in the capital market. Investment banks also provide advice on mergers and acquisitions. Investment banks differ from commercial banks as they do not take or lend deposits. Up until the eruption of the 2007-2008 sub-prime crisis the major investment banks of the United States included Bear Sterns, Merrill Lynch, Lehman Brothers and Goldman Sachs and Morgan Stanley. Bear Sterns collapsed in 2008 and was sold to JP Morgan Chase. In spite of having weathered the Great Depression, Merrill Lynch also collapsed during the 2007 crisis and was sold in 2008 to Bank of America. Lehman Brothers filed for bankruptcy in 2008 and was bought by Barclays plc. Finally, Morgan Stanley and Goldman Sachs survived the crisis but converted to commercial banking institutions in 2008. 20 On the basis of Adrian and Shin (2008), the stylized balance sheet of an investment bank includes on the asset side, collateralized lending and reverse repos, other trading assets. The liability side comprises, collateralized borrowing, repos, and other borrowing. Collateralized borrowing and lending and repo (reverse repo) operations are considered off balance sheet activities for the computations here presented which are based on Adrian and Shin. Needless to say, investment bank operations are of a short term nature and thus are valued at spot market prices (their balance sheet is marked to market). As will be explained below the importance of investment banks increased significantly since the late 1980s. Between 1988 and 2006 the assets of the major investment banks in proportion to those of commercial banks increased from roughly 5% to 27%. 21 This is referred to in the literature as securitization. It is defined as process of pooling assets of differing quality and risk to be repackaged into different tranches of securities differing in liquidity, maturity, contingency, and risk, each of which appealed to a particular clientele of investors. Securitization started in the 1970’s as a way for financial institutions and corporations to find new sources of funding—either by moving assets off their balance sheets or by borrowing against them to refinance their origination at a fair market rate.

16

(that is the SPV is bankrupt remote). As put by the ECB (2008,p.2): “…the key underlying concept is that if the originator goes bankrupt, the collateral held by the SPV is still good and the servicer ensures that payments on the collateral continue to be made so that investors still receive their interest and principal.”

The SPV provided further protection to investors against possible losses on the

underlying assets by dividing the securities issued into slices (i.e, tranches) of different seniority, including senior, mezzanine and junior. In the case of sub prime mortgages, the most junior tranche was overcollateralized.22 The SPV tranching process implied that payments on the securities were to be first made to the senior tranches, then to the mezzanine tranches then to the junior ones. Losses were first absorbed by the junior tranches, then by the mezzanine tranches and then ultimately by the senior tranches.

This process of subordination acted as a form of credit protection and

enhancement as it protected senior asset tranches against loss of payments stemming from defaults and guaranteed the promised payments with a very high probability. Subordination ensured that as put by Nadauld and Sherlund (2008 p.9): “loans that default first will destroy the principal balance of the over collateralization before touching any tranche more senior. Only after the over-collateralization principal has been fully exhausted will defaults accrue to the next most junior tranche. Thus senior tranches benefit from ‘thick’ junior tranches, and in this way, subordination acts as a form of credit protection.”

Following the logic of this prioritization and subordination scheme here described,

the most senior tranches were also the ones that received the highest credit ratings followed by the mezzanine and junior tranches.

The construct of the SPV implied that even if the senior security tranches, were

issued against risky collateral (such as subprime mortgage loans), these securities would still receive a high credit rating, that is they would be considered ‘prime securities.’ This is due, in the first stage, to the fact that the credit rating of the securities issued by the SPV are, by virtue of its creation, independent or again ‘delinked’ from the credit quality of the originator or issuer of the asset (or collateral) in question.23 In a second stage, the SPV provided further protection to the senior tranches against losses on the underlying assets by guaranteeing the respective payments on principal and interest.

In the case of the sub prime crisis episode, the representative sub-prime mortgage

securitization structure concentrated the bulk of the investment in the senior asset tranches. Empirical evidence for the period 1997-2007 shows that the total principal balance of senior tranches represented on average 81% of the total principal deals. 24

22 A tranche is said to be overcollaterilized when ‘the principal balance of the mortgage loans exceeded the principal balance of all the securities (debt) issued by the SPV.’See, Aschcraft and Shuermann (2008, p. 29). 23 That is the SPV is bankrupt remote. 24 See, Gorton (2008).

17

In summary, the off balance practice allowed the transformation of risky assets (such as subprime mortgages) into ‘safe and high credit rated securities.’ At the same time, the deconstruction of a financial institution into an on-balance (the institution itself) and an off balance institutions (the SPV), allowed the former, (through the transfer of income receipts from the off balance institution) to have access to an untapped access to finance and liquidity, without showing at the same time, the corresponding debt on their balances.

The process of off-balance and securitization was successfully applied over time to subprime mortgage loan based originations in the United States as long as the spot and future price (value) of the underlying asset (collateral) showed an upward trend which happened to be the case during the boom phase. Table 4 below shows that between 2001 and 2006, the percentage of subprime mortgage loans securitized increased from 50% to 81% of total subprime loans.

Table 4 Mortgage Originations and Subprime Securitization

Year Total Mortgage

Originations US$ Billion

Subprime Originations US$ Billion

Subprime Share in

total originations (% of dollar

value)

Subprime Mortgage Backed

Securities US$ Billions

Percent Subprime

Securitized (% of dollar

value)

2001 2,215 190 8.6 95 50.4 2002 2,885 231 8.0 121 52.7 2003 3,945 335 8.5 202 60.5 2004 2,920 540 18.5 401 74.3 2005 3,120 625 20.0 507 81.2 2006 2,980 600 20.1 483 80.5

Gorton (2008) However, in the ‘distress phase’, when real estate prices collapsed, the off-balance sheet model, through its separation of real from financial risk and investor protection of through the ‘tranching’ of securities, revealed to have encouraged excessive risk taking increasing the vulnerability and fragility of financial institutions balance sheets. More to the point, it showed that in the same way that securities could rapidly become ‘prime’ in the boom, they could also be downgraded to ‘subprime’ securities.

18

5. Pro-cyclical leverage as the amplifying mechanism

The losses that resulted from the decline in real estate sector values were not limited to the subprime mortgage sector but expanded to include some of the most important financial institutions in the United States and the world. This can be explained by the widespread adoption of the combination of leverage ratios, showing extensive reliance on debt financing, with pro-cyclical leverage management practices.25

The leverage ratio reflects the extent to which financial intermediaries use debt to

finance the acquisition of its assets. The greater is the leverage ratio of a financial intermediary the greater is its level of indebtedness. Relying heavily on debt financing may impact negatively on the credit rating of a financial intermediary and makes it difficult for funds to be raised in the future.

In addition, since equity is a cushion against insolvency, the greater is the

dependency on debt financing, the smaller is the buffer of the financial intermediary in question against any unforeseen change in the value of assets. In short, relying heavily on debt financing implies that a financial intermediary assumes a higher risk by becoming more exposed and vulnerable to illiquidity and more importantly to insolvency.

However at the same time that, leverage ratios showing extensive reliance on debt

financing, entail greater risks, they also create significant profit opportunities since the higher is the leverage ratio the higher is the rate of return over equity. 26 In this sense, the expectation of higher profitability provides a significant incentive to over leverage.

25 Obviously as shown below the leverage ratios are higher for financial institutions such as the investment banks that are not subject to the regulation applied to commercial banks. 26 If an investment bank has a 30:1 leverage ratio as was the case prior to their virtual extinction, the bank can borrow 3,000 US$ per 100 US$ in capital. If it is assumed that the rate of interest on the loan is 5% and the bank earns 6% on its total new capital (3,000 + 100 = 3,100), it can earn a profit of 129 US$ (or 29% rate of return on the original capital of US$ 100).At a more formal level this can be seen through a simple banking profit identity, also known as the Du Pont de Nemours and Company return over equity (ROE) decomposition stating that the ratio of earnings to equity equals the product of the ratio of earnings to assets and assets to equity. That is,

( )*( )

where and thus,

*

Earnings Earnings AssetsEquity Assets Equity

Assets LeverageEquity

Earnings Earnings LeverageEquity Asets

=

=

=

As a result for a given assets to equity ratio the greater is the leverage the greater are profit opportunities captured by the ratio of earnings over equity. However, high leverage ratios also lead to very high losses. If for any reason there is a decline of 10% in the value of the total investment 3,100 US$, the total value of the investment after taxes will be equal to US$ 2,940. However the debt is equal to 3,000 US$ and as a result the bank has a loss of 60 US$ In this case the investment of the bank in this example is based on more than 100% debt. To some extent this approximates the case of some of the investment banks such as

19

In congruence with this, the available empirical evidence on the leverage ratios for financial institutions across regions and countries indicates that these rely extensively on debt financing. In 2007, the commercial banks of the United States exhibited average leverage ratios of 10-12 Those recorded by investment banks were higher reaching ratios of 20-30. In the case of Japan the average leverage ratio stands at 18 and in Europe it reached 34 (See figure 1 below).27

Figure 1: Leverage ratios for selected financial institutions (2007)

0 10 20 30 40 50 60

US

SGP R

US

US

US

US

JP N

JP N

US

JP N

JP N

EU

EU

EU

US

EU

EU

EU

EU

Leverage

Country/Region Average St. Dev.United States 15.5 7.2Japan 18.0 3.6Europe 34.3 10.9

Source: On the basis of Bloomberg (November, 2008)

Moreover, available empirical evidence also indicates that, the correlation coefficient for the period 1990-2007 between the average leverage ratio of the most important banks in the United States and that of earnings over equity is equal to 0.69 and that it is statistically significant at the 95% level of confidence.

Lehman whose investment portfolio was based on 3% equity capital and 97% of borrowed funds. See, Haughey, J. (2008). 27 To put things in perspective If the leverage ratio is equal to 10, then debt and equity finance represent 90% and 10% of the financial intermediary’s acquisition of assets respectively. With a leverage ratio of 34, the respective debt and equity ratios are 97% and 3% respectively.Figure 1 includes 37 financial institutions out of which 14 are European, 5 are Japanese and 16 are for the United States. The two remaining institutions are from the Middle East and Asia respectively. The financial institutions for the United States, comprise commercial banks, savings institutions, credit unions, government sponsored enterprises and brokers/hedge funds.

20

Financial institutions not only exhibit high leverage ratios but in addition their leverage management is pro-cyclical. That is, banks adjust their leverage in reaction to a rise or fall in the value of their balance sheet assets. More precisely they tend to adjust upwards the leverage ratio when the economy experiences a boom and asset prices increase. Contrarily, banks tend to adjust downwards the leverage ratio (deleverage) when the economy experiences a recession and asset prices decline 28

Pro-cyclical leverage management is explained by risk considerations. Financial institutions and other firms adjust their balance sheet according to the expected risk of loss on their asset portfolios. During boom conditions, the expected risk of loss on financial institutions and other firms is low and as result they tend to increase their leverage by acquiring assets through debt financing. Contrarily during bust conditions the expected risk of loss on financial institutions and other firms is high and as result they tend to deleverage by selling assets with the aim of reducing debt.

The available empirical evidence for the United States investment banks shows that these financial institutions increased their leverage upwards during the last expansionary phase of the cycle which comprised the period November 2001-November 2007) and decreased their leverage (or that they deleveraged) during the current recession phase of the cycle which started in November 2007 (Table 6 and Figure 2). A simple correlation exercise between the trend in leverage and that of GDP per capita between 2001 and 2008 indicate that the correlation coefficient is equal to 0.73 and significant at the 5% confidence level.

Table 6 Average values of investment bank leverage during business cycle phases

1990-2008 (Quarterly Data) Dates of business cycles Phase of the

business cycle Leverage

Beginning of business cycle

phase

End of cycle phase

Maximum

Average

July 1990-March 1991 Recession 21.6 22.8 22.8 21.8 March 1991 –March

2001 Expansion 22.8 21.7 30.7 27.8

March 2001-November 2001

Recession 21.7 21.1 21.8 21.5

November 2001-November 2007

Expansion 21.1 29.6 29.6 23.4

Note: The average leverage of investment banks is a simple average of the leverage of Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs. Source: On the basis of Bloomberg (2008) and NBER (2008).

28 Adrian and Shin (2008, p.3) define pro-cyclical leverage management in the following way: “…there is a positive relationship between changes in leverage and changes in balance sheet size. Far from being passive, financial intermediaries adjust their balance sheets actively and do so in such a way that leverage is high during booms and low during busts. Leverage is pro-cyclical in this sense.” Pro-cyclical leverage entails downward sloping demand curves and upward sloping supply curves. As a result the equilibrium is unstable.

21

Figure 2: Average leverage of investment banks in the last phase of expansion and recession of the United States Economy. November 2001-March 2008

18

20

22

24

26

28

30

32

2001

:4

2002

:1

2003

:1

2004

:1

2005

:1

2006

:1

2007

:1

2008

:1

2008

:3

Phase of expansionCorrelation coefficient between the trend in leverage and GDP per capita =0.73

Source: On the basis of Bloomberg (2008) and NIPA (2008)

In the last expansionary phase of the cycle (November 2001-November 2007), the average leverage ratio rose from 21 to 30. This means that investment banks began to rely more on debt financing. That is, during this period, investment banks, on average, increased the proportion of assets financed by debt from 95% to 98%.29 By increasing the proportion of debt financing, banks became riskier. However, at the same time they became more profitable. The empirical evidence shows that during this time the net earnings of most investment banks more than doubled.30

In the same way that high leverage ratios can yield high profits in the upward phase of the cycle, the shift to lower leverage ratios in the downward phase of the cycle can entail significant losses. This is due to the fact that the growth of balance sheets sustained mainly by over borrowing and debt imply that in the downturn financial institutions will struggle to pay down their debts by selling assets. The losses can become systemic when the struggle to pay down debt through the selling of assets becomes a widely adopted practice.

The sole action of one institution may succeed in reducing debt and not produce systemic effects. However, the same action by many or the most important financial institutions and other firms can produce systemic effects by igniting a cumulative process

29 See footnote 21 above. 30 Own computations based on Bloomberg (2008).

22

of asset debt deflation as changes in debt financing (or the adjustment of leverage) and in asset prices ‘reinforce each other in an amplification of the financial cycle’.31 In this way, pro-cyclical leverage management practices entails the propagation of contagion through cumulative asset price deflation in the distress phase.

This perverse cumulative process provides a working mechanism for financial contagion in the present current crisis episode. Indeed, in the case of the subprime crisis episode contagion worked through asset price declines and balance sheet contraction. These were caused by sharp falls in the asset backed collateral which in this case was real estate mortgages held in large quantities by financial institutions. 32 The working dynamics of this mechanism involved declines in the value of mortgage backed asset securities matched by commensurate falls in the price of equity followed by adjustments in the leverage ratio through debt reduction via the selling of assets.

The empirical evidence shows that since the last recession began in November 2007 in the United States, as the values of assets fell due to the sharp decline in house prices, the financial sector began a process of deleveraging. Available evidence (November 2007 to April 2008) for investment banks in the United States shows that, the average leverage ratio declined from 30 to 24. The deleveraging process was accompanied by a contraction in the value of assets of 20% on average for investment banks. 33

In this sense, contrary to other financial crises episodes, the contagion mechanisms in the sub prime financial crisis did not work only through defaults igniting a domino effect. 34 As put by Adrian and Shin (2008 b/ p.2): “If the domino effect of financial contagion is the relevant one…then defaults on subprime mortgages would have had limited impact.35 This is because the exposure to the subprime sector is small relative to the total size of the balance sheet, and to the capital held by the financial institutions themselves. Any defaults by subprime borrowers could easily be absorbed by the total capital of the financial sector.”

31 Greenlaw et al. (2008) p. 30. 32 As put, by Greenlaw et al. (2008, p.31): “…mortgages and asset-backed securities built on mortgage assets are held in large quantities by leveraged institutions –by the broker dealer themselves at the warehousing stage of the securitization process, by hedge funds specializing in mortgage securities and by the off-balance sheet vehicles that the banks had set up specifically with the purpose of carrying the mortgage securities and the collateralized debt obligations that have been written on them.” Federal Reserve data shows that these financial institutions held 37% of the mortgage debt at the end of the third quarter of 2007. 33 Own computations based of Bloomberg (2008). 34 See for example Adrian and Shin (2008a/ b/); Blanchard (2008); Greenlaw et al. (2008); Hatzius (2008). For a supportive but critical view of this balance sheet contagion mechanism see, Mishkin (2008). 35 The domino effect of financial contagion refers to a situation where “Bank A has borrowed from bank B, and bank B has borrowed from bank C, etc. Then, if A takes a hit and defaults, then bank B will suffer a loss. If the loss is large enough to wipe out B’s capital, then B defaults. Bank C then takes a hit. In turn, if the loss is big enough, bank C defaults, etc. We could dub this the “domino” model of financial contagion.” (Adrian and Shin, 2008 b/p.2).

23

To summarize, generalized pro-cyclical leverage management can lead to the wide practice of reducing debt resulting in excess supply of assets and put downward pressures in their price. In turn, a further fall in the price of assets leads to further adjustments in the leverage ratio which can then depress the price of assets even further.

Asset price deflation can have significant effects on liquidity as the reductions in

equity and contractions in balance sheets undermine the capacity of banks to lend. Hence, the stage is set for a ‘credit crunch’ since as argued by Greenlaw et al. (2008, p.30) aggregate liquidity refers to the rate of growth of balance sheets.

An analytical exercise undertaken by Greenlaw et al. (2007) show that for the current subprime crisis a 200 US$ billion loss (such as that suffered by the leveraged sector in the United States) can result in an aggregate asset contraction equivalent to 2 US$ trillion under the assumption of a 5% decline in leverage. In a similar vein, a 10% decline in leverage can result in a contraction of the financial system aggregate balance sheet of 3 US$ trillion. In other words, a 5% decline in leverage multiplies initial balance sheet losses by 10. A 10% decline in leverage has an amplification effect of 15 times the initial losses. 36

The subprime crisis has led to significant contractions in asset prices and financial institutions balance sheets. The crisis has affected more than 63 of the most important financial institutions in the world. More recently it is estimated that the subprime crisis led to a loss of capital valuation of financial assets worldwide reaching US$ 50 trillion for 2008 that is roughly the equivalent of the world’s GDP for that year.37

The contraction in the value of assets and balance sheets of financial institutions led to an important reduction in credit availability (i.e. to a credit crunch). The Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices which is a standard barometer of credit market conditions showed for October 2008 and January

36 These amplification effects are calculated according to the following formula:

(1 )* 1

, aggregate assets post balance sheet adjustment. aggregate assets pre balance sheet adjustment. ratio of the new to the old leverage. total credit losses. pr

a

i

a

i

A L kA E

WhereAA

Lk

μ

μ

−= −

=

=

=

=

=

⎛ ⎞⎜ ⎟⎝ ⎠

oportion of credit losses made up by raising of new capital. total initial assets.E =

The greater is the ration of the new to the old leverage the greater will be the difference between the aggregate assets per and post balance sheet adjustment. See also, Hatzius (2008). 37 See, Loser (2009).

24

2009, that 84% and 66% of the large firms and 83% and 63% of the largest surveyed banks reported a tightening of credit conditions.38 Conclusions and policy implications

The staggering effects of the current global financial can be explained by the combination of off-balance sheet funding with pro-cyclical leverage management.

Off balance sheet funding practices provided the basis for the gestation of the crisis. Off balance sheet practices seemingly separated the risk of investing in an asset or asset backed security (financial risk) from the risk associated with the originator of the asset or security and even with the risk of the asset or security themselves (real risk). Moreover, off balance sheet practices permitted to blur the distinction between the relative risks of a broad spectrum of assets through credit enhancement techniques. As a result, risk perceptions on assets tended to move in tandem with the boom and bust phases of the crisis. In the boom phase, risk perceptions tended to consider assets as ‘prime.’ Contrarily in the bust phase, these were downgraded to the ‘sub prime’ category.

The effects of off-balance sheet funding were amplified by pro-cyclical leverage

management practices. Pro-cyclical leverage management meant that financial institutions aimed at expanding their asset base by relying on debt finance in the boom phase. Contrarily, in the bust phase, financial institutions aimed at reducing their debt. The generalized practice of pro-cyclical management resulted in cumulative increases in asset prices in the boom phase and cumulative declines in the bust phase.

Generalized and continued asset price deflation in the bust phase contracted financial institutions balance sheets and their capacity to lend setting the stage for a credit crunch.

The current crisis has brought to the forefront the fact that the current model of finance prevalent in the United States and Europe is inadequate to fulfill the basic functions of a financial system. It has moreover shown that the current financial architecture is unfit to prevent and manage systemic crises, and also that it encompasses incomplete and fragmented regulation. Financial regulation is fundamental to minimize the occurrence of future financial crises and dampen their contagion effects.

The analysis here presented for the subprime crisis, highlights the fact that the

process of a crisis takes place both at a macro and micro levels. Crises involve issues related to the stability of the financial system in the aggregate (macro) as well as specific themes dealing with particular financial practices (micro). Off balance sheet financing belongs to the micro realm whereas the systemic effects of off balance sheet financing transmitted to the system via pro-cyclical management practices is a macro issue.

38 See, Federal Reserve Bank (2009) and Udell (2009).

25

As a result, regulatory reform should follow a two tier strategy focusing at the same time on macro and micro regulatory issues. Macro regulation focuses on the stability of the financial system in the aggregate. It focuses on the systemic and possible sources of contagion of the financial system. Micro regulation should instead focus on the financial practices of institutions. Outlining and designing the basic principles for a two tier financial regulation system is one of the most pressing tasks ahead for the financial system.39

39 See, Brunnermeier et. Al (2009) for a recent attempt to propose principles of financial regulation along these lines.

26

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