|Date||January 16, 2009|
|Speaker||Jay K. Rosengard(Director, Financial Sector Program and Lecturer in Public Policy, John F. Kennedy School of Government, Harvard University)|
|Moderator||KURIHARA Jun(Liaison Officer, RIETI / Senior Fellow, Mossavar-Rahmani Center for Business and Government, John F. Kennedy School of Government, Harvard University)|
The world is now facing the greatest global economic challenge since the Great Depression of the 1930s. The international community is very much interested in understanding how and why this current global economic crisis occurred, and what can be done about it. Although the crisis started in the United States, all nations are going to feel its effects.
The global economic crisis began with the bursting of the U.S. real estate bubble, which was inflated by a dramatic decline in mortgage interest rates that led to a steep and unsustainable rise in home values. People were delusionary and put their faith in false financial alchemy, believing that high-return investments had low risks. Looking at each set of actors - the borrowers, the lenders, the raters and the regulators - it is clear that each one in its own particular way was behaving rationally in response to a bunch of perverse incentives. There was a failure of government, both in the failure of regulation and supervision of the financial sector, and ineffective government intervention to deal with market failures. There was a very strong supply response to incentives to build more houses, and there is now a surplus inventory that cannot be sold.
In four years, mortgage interest rates experienced a great decline from 8.5% for a 30-year fixed mortgage to around 5%-6%. That made homes more affordable, but generally when financing costs go down, prices go up. In 2000, the median home price was about $150,000, but in a matter of a few years it rose to $250,000. Incomes did not rise as quickly, so individuals were overbuying.
One aspect of the false financial alchemy was that a large number of loans were extended that should not have been made. This was due to two factors. The first was the lowering of underwriting standards, which allowed alternative documentation to lead to "ninja" (no income, no job and no assets) loans. Adjustable rate mortgages (ARMs) with refinancing also contributed to affordability problems. Many of these issues were combined with subprime mortgages. Subprime, by definition, means a lower credit rating and a higher risk. The second factor was the belief that escalating home prices combined with securitization mitigated the credit rise, because individuals could always refinance or repackage the debt. What is more, the credit rating agencies regarded the lending as low risk; it looked like a good deal for both the originator and the secondary markets.
Looking at the incentive for subprime mortgages from the perspective of borrowers, the idea was to get into the housing market before being priced out. Financing was really cheap, and borrowers took the attitude that when costs rose, they would just refinance on the grounds that the value of the underlying asset would also continue to go up. From the perspective of the originator and lender, fee income could be made and then the loan sold, so it would not really matter to them if the loan went bad. Lenders were rewarded on volume and paid by transaction; credit risk was shifted elsewhere. Wall Street, with its great excess liquidity, was looking for alternative investment opportunities; so there were both willing buyers and willing sellers. For investors, subprime mortgages appeared to offer higher returns than the alternatives without any more risk. Good ratings from the credit rating agencies and escalating home prices were their insurance.
Part of all this was intentional government policy under the Bush Administration. President Bush wanted to create what he called an "ownership society." He wanted more American families to be homeowners. He also wanted to provide support to two very important political groups: the housing sector (construction and developers) and the financial sector. All in all, this series of incentives made it possible and attractive to make loans, which were risky, to people who should not have been borrowing.
The fault in the logic was that this worked fine only until prices slowed down or began to decline. When monthly payments rose and people found themselves unable to refinance or sell, they defaulted on their loans and, in some cases, their homes went into foreclosure. People had assumed that prices would always go up, and when they did not, everything came tumbling down.
The total dollar value of subprime mortgages was $200 billion in 2001, but it had more than tripled to $650 billion by 2005. In 2001, only 5% of subprime mortgages were securitized, but that figure grew to more than 20% by 2006. The growth in securitization fit the logic of trying to shift credit risk from the bank to somebody else. In 2000, U.S. asset-backed securities totaled roughly $1 trillion, but grew to $2.5 trillion in 2008. Total global derivative contracts had grown from roughly $100 trillion in 2000 to $500 trillion by 2007. These asset- and mortgage-backed securities and the insurance against them (the credit default swaps) are now bringing down many financial institutions.
Turning to perverse incentives, the focus on fee generation over fiduciary responsibility created significant moral hazard in both lending and underwriting practices. So both banks and nonbanks (the home mortgage loan companies, which were basically unregulated) securitized and sold mortgages, after which point they were no longer responsible for loan performance. The problem arose because the most important relationship between the borrower and the investor had been severed.
In traditional banking, a bank makes a loan that remains on its balance sheet. If the loan goes bad the bank is responsible, so it has an incentive to make sure it issues good loans, and that they are repaid on time and in full. But as soon as the loan is sold, the responsibility is severed. In the secondary markets, especially, there were short-term and one-time bonuses that provided powerful incentives to neglect long-term risks and vulnerabilities. Every time a security was packaged and sold a fee was awarded, regardless of whether the security was good or bad. This emphasis on volume was very unhealthy in the long run.
Regulatory failures included the fact that financial innovation outpaced the capacity of private managers and public officials to monitor and control the situation. The financial markets model in Europe requires the passage of a law before a new product or service is permitted; thus, financial innovation is not seen in Europe. The U.S. is the opposite; basically anything can be done until the authorities say otherwise. The result is a lot of creativity, which can sometimes become excessive. In the case of the current global economic crisis, the innovation got well ahead of regulators' capacity to understand, quantify, and attempt to mitigate the risks that were being created. Creative financial engineering produced very complicated loan products, which were packaged into even more complex instruments and sold and resold repeatedly in secondary mortgage markets. In the end, it was unclear who even owned the underlying assets, making it hard for borrowers to know who to talk to when repayment problems arose. Many mortgages were originated by unregulated nonbank financial institutions that were able to avoid a lot of regulations, including "truth in lending" laws. Some borrowers were clearly greedy, but many did not fully comprehend ARMs, resets, or the risks of the loan, and indeed did not understand the contracts they were signing.
Under the Bush Administration, there was aggressive deregulation and faith in the markets. Between 2003 and 2008, Fannie Mae and Freddie Mac spent a combined total of roughly $114 million lobbying for Congressional approval to remain free from regulation. So there are political economic elements that need to be considered, too.
Rising home prices led to a strong supply response. In 2005, roughly 1.3 million new single family homes were sold, compared to an average of around 600,000 per year during the first half of the 1990s. The largest home builders saw their revenues and share prices skyrocket. The housing inventory doubled from roughly 2 million units in 2000 to around 4 million units in January 2006. This excess supply led to a fall in prices. Single family home-starts plummeted after 2005, due to the glut of housing stock.
There were two main triggers for the global financial crisis. The first was the tightening of monetary policy by the Federal Reserve. The federal funds effective rate rose from about 1% in June 2004 to 5.3% in August 2006, a fivefold increase in two years. That destroyed the subprime mortgage model. The second trigger was the deterioration of the U.S. housing market. July 2006 was the peak for risky home loans. In January 2007, home prices began a steep fall. The first big bankruptcy was New Century in April 2007. From July to December of that year there was a great rise in the number of mortgage defaults. June 2008 saw a crash in both Fannie Mae and Freddie Mac share prices.
There are two broad reasons why the subprime mortgage crisis ultimately mushroomed into a full-blown global economic crisis. The macroeconomic context in the U.S. was already under great strain, and there were also ripple effects and negative synergies. Regarding the macroeconomic crisis, in addition to the financial crisis, the U.S. already had growing budget and current account deficits. Real GDP growth was declining. There was also a record amount of personal consumption embedded in the GDP figure. People were living beyond their means, which included taking out home equity loans. In 2007, there was record borrowing against homes to finance spending: $950 billion of consumption was financed by borrowing against homes. The U.S. was waging two wars at the same time as pursuing historically large tax cuts. Commodity price shocks increased the risk of stagflation. The general economic slowdown heightened the fear of a double-dip recession. The U.S. has, in fact, been in recession since December 2007. This is set to be the longest recession in postwar history and will perhaps last into early 2010.
Regarding the ripple effects and negative synergies, there was a "perfect storm" of asset price deflation (the bursting of the property and stock market bubbles), illiquidity (modern bank runs) and insolvency. This has led to global deleveraging, a condition where institutions pull their money out of other markets in order to shore up their institutions at home. The housing deterioration in 2006 created a "credit issue" as investors reassessed the risk of subprime mortgages and the securities based on subprime mortgages, and bid down their prices. The credit issue quickly transformed into a "liquidity issue" as banks stopped lending even to each other, due to fears of counterparty risk. The liquidity issue ultimately became a capital issue as portfolios went bad.
Larry Summers has spoken of a "vortex of five vicious cycles." The first of them is in the stock market: stock prices fall, investors want to sell before they fall further, so prices do fall further. The second vicious cycle is in the banking sector: bank portfolios lose value, leaving banks with less capital to lend, and then lose even more value because of capital adequacy ratio and leveraging requirements. The third is in the real sector, where the economic slowdown leads to a weaker financial system, then less lending, thus less production and employment, and further economic contraction. The fourth is the "Keynesian cycle," where less spending means that less is produced and sold, causing people to be laid off, which results in even less spending. The fifth cycle is the panic cycle in the banking system: depositors rush to withdraw funds from troubled banks, which creates a liquidity problem that distresses the banks even further, leading to more withdrawals.
Despite writing off billions of dollars worth of assets, creditors still do not know the full extent of their losses on complex securities. Each report issued seems to present an even worse assessment. Many homeowners are facing foreclosure and a growing number of renters are facing eviction (because a lot of the real estate was actually investment real estate for rental property), which is causing huge social problems in many communities. There were 233,000 foreclosures in January 2008, up 57% over the year before. Due to "tipping," when a sufficient number of homes in a community become troubled, the value of all homes goes down, creating a foreclosure spiral. Roughly 10% of all mortgages are either in trouble or in default. The rate at which loans are going bad is accelerating.
The current recession is unlikely to bottom out until the third or fourth quarter of this year at best, which is the most optimistic scenario. Median home prices will probably decline at least another 5%-10%, and they will likely overshoot the normal equilibrium of three times the median household income, because in a crisis markets generally overreact. Household consumption will continue to decline by at least another 2%-3% of GDP, which is really bad news for companies exporting to the U.S. market. In 2008, 2.6 million jobs were lost in the U.S.
Global forecasts are uncertain and are changing on a daily basis. Most forecasts predict sluggish or no growth in all major economic zones, and in most developing and transitional economies. European banks purchased a lot of collateralized mortgage obligations issued by U.S. financial institutions, but the extent of their exposure is unknown. Asset markets, consumer confidence, household spending and manufacturing are down almost everywhere.
The key challenges facing developing countries are growing weaknesses in export markets, rising commodity prices, and volatility in global financial markets; all of which exacerbate existing vulnerabilities such as weakening domestic demand, declining relative productivity, infrastructure bottlenecks, and bursting credit-fueled bubbles in housing and stock markets.
European economies are shrinking, as are their manufacturing production and consumer confidence levels. Japan's consumer confidence and manufacturing are also dropping. The Chinese renminbi is no longer appreciating, which is bad news for companies competing with Chinese ones for export market share. There had been a lot of talk about Asian markets being decoupled from the West, but Asian stocks have fallen sharply.
There are four components of the response to the crisis: liquidity, solvency, spending (a stimulus), and trust.
The response to lack of liquidity is an injection of funds. Governments, as lenders of last resort, make low-interest loans to financial institutions. To date, the U.S. has spent about $700 billion, but commitments run to over $4 trillion. Central banks around the world have been coordinating liquidity injections with the Federal Reserve. Governments also serve as insurers of last resort, by providing guarantees to investors and depositors. In terms of guarantees to homeowners, the U.S. government began its "Hope for Homeowners" program on October 1, 2008.
The response to lack of solvency has been an injection of capital. The U.S. Government, as the investor of last resort, is taking stakes in financial institutions, with $738 billion invested so far.
The problem with tax cuts and tax rebates is that people tend to save the funds, rather than spend them. President-elect Obama's proposed stimulus package has three objectives: to maximize speed and magnitude; to assist those who are most vulnerable; and to invest in the U.S.'s capacity to compete in the future through modernization of infrastructure. The stimulus plan will include an extension of unemployment and health insurance benefits, aid to state and local governments, and labor-intensive public works projects focusing on clean energy, education, healthcare and new infrastructure.
The response to economic disequilibrium has been economic stimulus packages, totaling $943 billion in the U.S., $586 billion in China (though only 10% of this is new), and $105 billion in Japan.
If the U.S. stimulus package is too big, it could become inflationary and crowd out the private sector. If it is too small, it might not make an impact. If it is too fast, it will overwhelm the absorptive capacity of the system and lead to waste and corruption. It if is too slow, it is going to be too late and might become inflationary by the time it does kick in. If the stimulus package is not done in the correct form, it will lead to saving rather than consumption and investment. If it is targeted to the wrong people, there will be economic inefficiency, misallocation of resources, and corruption.
Another problem in the U.S. has been trust: the people lost all trust and confidence in their leadership, but that appears to be changing now that new national and subnational leadership is taking office.
Questions and Answers
Q: What scenario do you anticipate for the end of the crisis?
A: For the U.S., it is going to get much worse before it gets better. Markets, property prices, and consumer spending are going to continue to go down and job losses are going to go up. Markets have to reach new equilibriums, and confidence has to be restored. There will be a major stimulus package, but it will take time. There will continue to be bad news.
The scenario is more liquidity, more capital, and more spending. A powerful economic management team will come into place, but recovery will take time. One of Obama's challenges is going to be managing expectations.
Q: What do you think of the Chinese process?
A: The Chinese leadership has been very smart in packaging its stimulus to make it look like $600 billion. China announced the plan right before the G20 meeting in Washington, which gave China the appearance of being proactive and ahead of other nations. The leadership in China is actually being quite prudent because it has to worry about both inflation and overheating, so its strategy of part representation and part new money is the right one for the country. Also, slowing or stopping appreciation of the currency is a good strategy. China is facing tremendous challenges as more factories close, because people cannot return to rural areas as they have lost their land.
Q: If you became Secretary of the Treasury next week, is there anything not already planned that you would do? Or is there anything that is being done that you would not do to try to make things better?
A: I am very skeptical about tax cuts because they create a large structural problem. Tax cuts are not effective because people do not spend the money, they save it. Making tax cuts is a political argument, but a very bad economic argument. Unemployment benefits, health insurance benefits, and state and local governments should indeed be emphasized. The part of the package focused on money that will most quickly lead to consumption is the first round of the stimulus. The investments are important because they will kick in later. You need a time capsule-like release because some stimulus will be needed later. There is room for a lot of bad investment, like bridges and roads to nowhere. The challenge is to make good investments and good use of capital that will rebuild and modernize American infrastructure without creating a lot of white elephants.
Q: How will the U.S. government manage the long-term debt problem?
A: Under President Bush, the entire cumulative U.S. debt doubled. The budget deficit this year is approximately $1.2 trillion and does not include the Obama stimulus package. Interest rates will go up, and the U.S. will have to pay more for debt. So the financing burden is going to grow, and it is a big structural problem. There is very little discretionary expenditure in the U.S. budget, a lot of it is entitlements, which are the fastest-growing part of the budget.
But the good news is that the debt is still manageable, given the size of the U.S. economy. It does, however, create a large structural problem because it becomes nondiscretionary expenditure. It goes back to tax cuts: if they are introduced now it will be very difficult to reverse them later to pay for the stimulus. The long-term debt problem is manageable with prudent fiscal policy, including prudent tax policy. If not, it will constrain what the U.S. can do in other areas.
Q: What kind of re-regulation or new regulation is needed for the U.S. financial sector?
A: The U.S. regulatory model is very fragmented and confusing, because it has evolved over time. At a minimum there will be a consolidation of authority, though authority will not come to be unified. Authority will be broadened to include nonbank and noncapital market financial institutions.
There will likely be tighter regulations on leveraging, especially where size poses a systemic risk. It is also likely that capital requirements will be introduced where risk is determined by the complexity of the financial instrument. It is very hard to price the risk in some of these instruments, so on the basis of complexity alone they are going to require more capital provisioning.
Q: What are your views on new global financial regulations?
A: A lot of suggestions have been put on the table. There are three variations with respect to the role of the International Monetary Fund (IMF). Up to now the IMF has been pretty inconsequential in the crisis, most likely because the magnitude of the crisis is much greater than the resources of the IMF. The first variation calls for the IMF role to remain the same, but see its resources increased. The second variation involves an increase in IMF resources and a broadening of its role and mandate. The third variation leaves the IMF as is, but calls for the creation of new institutions or new financing mechanisms.
The fundamental problem with the IMF is an argument over governance, because emerging markets are greatly underrepresented and extra resources are going to come from some of these countries. Unless these countries are likely to gain more votes, it will be very difficult to convince them to put money into the IMF. It will take a long time to negotiate something new. There will be an acceleration of many IMF and World Bank initiatives, such as the ones to improve reporting, disclosure, accounting standards, surveillance and financial sector assessments.
Looking to alternative complimentary institutions, there may be a role for sovereign wealth funds, perhaps on a regional basis. There may also be some role for petrodollars. There may be ways for excess liquidity to be channeled into appropriate applications.
France would like to see a super-regulator, but it is unclear what body would oversee the super-regulator. Another problem is that national systems are so different that convergence will be hard to find. The UK argues in favor of improved monitoring and surveillance, which is necessary, but the problem is that large economies tend to ignore warnings.
Q: Where does the discussion stand at the moment in respect to mark-to-the-market accounting?
A: The problem is when you move away from rules-based accounting toward discretionary methods, it is an invitation for manipulation. There is a dilemma regarding whether you overstate the problem, or do you make the numbers unreliable and non-comparable? What is needed is conservative and comparable numbers without overstating the situation when the institution really is not insolvent. When there is a move away from standardization and rules-based accounting, it creates a whole lot of other problems concerning the validity and comparability of the data. There is no consensus on this issue.
Q: In which areas will the U.S. tend toward protectionism?
A: There is the fear that similar to the response to the Great Depression, there will be a round of trade protection that will make things much, much worse. There is a great effort underway to avoid heading in that direction. There might not be many reductions in tariffs, but there will be efforts to avoid making economies more protectionist. NAFTA will not be renegotiated. There will be great pressure to show that the lessons of the 1930s have been learned by not overreacting with competitive devaluations and increased tariffs.
There are so many countries involved in the Doha negotiations that the outcome is uncertain. A lot of free trade agreements are being reached, but they leave out the most contentious areas of trade, like agriculture. The regional agreements ignore the areas where the greatest gains would be realized from the liberalization of trade. Right now, however, it is politically difficult for any country to open up its markets.
*This summary was compiled by RIETI Editorial staff.