Joseph Stiglitz on the GFC

Joseph Stiglitz is a Nobel Laureate in Economics, and currently a professor at Columbia University. In 2001, Stiglitz was awarded the Nobel Memorial Prize, along with Michael Spence and George Akerlof for their contribution to the theory of asymmetric information. Stiglitz also served as an economic advisor in the Clinton Administration.

This lecture "Who Sank the Global Economy" was presented at the University of Queensland and has been aired on Big Ideas on the ABC. Stiglitz highlights the failure of market forces in this financial crisis, the failure of government policy to prevent the GFC and the ineffectiveness of the US policy response to the GFC.

"Toxic assets were sold all over the world", and has contributed to making the financial crisis global. "40 percent of toxic assets or bad mortgages were sold to Europe; Australia did not buy many toxic assets due to good regulators" - One of the reasons why Australia was relatively sheltered from the GFC compared to the US and Europe. 

"Without the Keynesian stimulus, the world would have faced a global depression. In the US, without the stimulus the unemployment rate, instead of going up to 10 percent, would have gone up to 12 percent. But the unemployment rate still went up to 10 percent so the stimulus package was insufficient. The reason for this is the stimulus package was too small and poorly designed. Too much was spent on ineffective tax cuts...people were burdened with high levels of debt and were not spending (the tax cuts were insufficient to encourage spending)...whilst the government was spending more, states were contracting and laying off workers (contradicting policies on a federal and state level led to ineffective stimulus policy)....The Australian stimulus was not only timely but also well designed...as Australia had the shortest and shallowest downturn.

Interesting question in the Q&A session on Australia's resource boom - Stiglitz suggests that a significant portion of the resource boom profits should be put in stabilisation fund that should be kept abroad, as this would help avoid the appreciation of the dollar. He also points out that when Australia extracts and exports resources, the resources are being depleted and Australia's assets are depreciating. Hence, an adequate mining tax is necessary as an additional revenue stream to fund government investments in order to secure the future of Australia. 

History Lesson No. 1: Global Financial Crisis 2007-2009, Part 2

In the previous post, I have described the sequence of events when the Global Financial Crisis happened and how it affects us all. Now I shall explain how the sub-prime mortgage crisis led to the banking crisis and the role of securitization in laying out the foundations causing the GFC. There are important lessons to be learnt from the causes of the GFC.

Mortgage-Backed Securities
The roots of the GFC track back to 2002 and 2003, when Alan Greenspan, the Chairman of US Federal Reserve lowered cash rates 11 times to around 1 percent. Normally, investors buy treasury bills, which are viewed as the safest investment, but 1 percent is a very low return. Hence investors started looking for other investments to increase return on their capital.

On the other hand, at the low cash rate, financial institutions can obtain cheap credit from the Federal Reserve. This makes housing more affordable as interest payments on mortgage loans were lower. Thus, increasing number of borrowers approached mortgage lenders to obtain loans. Investment banks would purchase the mortgage loans off the mortgage lenders’ balance sheets, funding this through cheap credit. The mortgage lenders benefit from this as they receive more cash flow to provide more mortgage loans to borrowers.

What the investment banks did with the mortgage loans is that they bundle the mortgage loans and sell them to investors. This process of grouping loans and selling them is called securitization. The investors that purchased the mortgage-backed securities (MBS) would receive cash flows when the borrowers make repayments on their mortgages. These investors include hedge funds, insurance companies and also pension funds. The investment banks made a lot of money by selling MBS, receiving a much higher return than holding treasury bills at 1 percent.

When most creditworthy borrowers already own homes, the financial institutions started providing loans to less creditworthy people. Financial institutions were less concerned with the ability of borrowers to repay their loans as it was believed that housing prices can only go up. If the homeowner defaults, the financial institution can then sell the house for compensation. Furthermore, in the process of securitization, the financial institutions eliminated their exposure to credit risk by selling MBS to investors, shifting the risk to the investors who bought the MBS. The financial institutions had no incentive to properly assess the credibility of the borrowers, requiring no down payment, nor proof of income. This is called moral hazard. Furthermore, the problem here is that investors have no way of knowing the creditworthiness of the sub-prime mortgage holders. In fact, the MBS was packaged in such a way that sub-prime mortgages were bundled together with other mortgages so the ratings did not reflect their risk. This gap in information is called asymmetric information.

Sub-Prime Mortgage Crisis
The sub-prime mortgage crisis arose when interest rates hiked 17 times in years 2004 to 2006. The sub-prime mortgages were on variable rates so the borrowers had to pay more interest on their loans, which they could not afford. Hence, homeowners defaulted on their mortgages. This is not too bad if the mortgage lenders are able to sell the house and provide cash flow to the investors.

However, as more and more homeowners defaulted, the increase in the supply of houses puts downward pressure on house prices. Other homeowners who could afford to repay their loans also stopped making payments as they refuse to pay for a home that is worth less than they are paying for. Home foreclosures were up by 93 percent in 2007 compared to a year ago. The escalation in defaults dried up the cash flow to the investors, meaning the investors were not receiving returns on their security holdings. Investors started abandoning their holdings, selling them at lower prices. New purchases of the securities also stopped and the value of MBS on the financial institutions’ balance sheets plummet. The financial institutions were in trouble as they had borrowed to purchase mortgages. Without investors purchasing the MBS they could not pay back what they had borrowed.

In the first half of 2007, two hedge funds held by Bear Stearns fell by 28 per cent in 6 months. In August 2007, investors holding MBS with BNP Paribas were barred from redeeming cash in US$ 2.2billion worth of managed funds. In September 2008, Fannie Mae and Freddie Mac, two of the largest mortgage providers that relied on issuance of MBS to raise money, revealed large losses and were nationalized. On 15th September, Lehman Brothers filed for bankruptcy,

This video provides a more detailed explanation of the sub-prime mortgage crisis and the securitization process.

The Problem of Asymmetric Information and Moral Hazard
The lack of regulation on the securitization process in the financial system had led to two major problems: asymmetric information and moral hazard. Asymmetric information is a situation when one party has more information than the other in a transaction; in this scenario, the financial institutions had more information about the creditworthiness of the borrowers than the investors do. Investors who were buying MBS were unaware of the risks involved in the investments, especially when a portion of the MBS was given AAA rating (explained in the video). The financial institutions were making lots of money from selling MBS and had no incentive to provide investors with information on the risk they were taking.

Furthermore, by selling securitized loans to investors, the financial institutions had shifted the credit risk off their balance sheets to the investors. The financial institutions had little incentive to monitor the creditworthiness of borrowers since they do not bear the burden of the credit risk. This led to the problem of moral hazard, where the financial institutions are engaging in higher-risked activities by lending to borrowers with no ability to pay back, and imposing this risk on the investors. The financial institutions perceived themselves to be “too big to fail”, so when they ran into trouble, they expected the government to bail them out, as did Bear Stearns, Fannie Mae and Freddie Mac. Hank Paulson attempted to teach a lesson on moral hazard when he let Lehman fail, trying to proving a point that the financial institutions should take responsibility for their own actions. However, this turned out to be one of the biggest economic policy mistakes, resulting in the onset of the GFC.

The process of securitization itself is not a problem, but asymmetric information and moral hazard that arises from securitization can cause problems and have caused problems, as we have seen in the sub-prime mortgage crisis. In the sub-prime mortgage crisis, the financial institutions were borrowing to purchase the mortgage loans. The problem of asymmetric information and moral hazard can be minimized by requiring the financial institutions to hold a portion of MBS on their balance sheet. If the financial institutions are also exposed to the credit risk, they will have more incentive to properly assess the creditworthiness of borrowers. The financial institutions were also highly leveraged, borrowing to purchase mortgage loans from mortgage lenders, thus imposing a capital adequacy ratio would also reduce the risk taken. The sub-prime mortgage crisis could be prevented with these necessary measures, however once the defaults began, with the downwards spiral of the house prices, it is difficult to tell if the credit crisis could have been avoided.

As far as repercussions go, Goldman Sachs was charged US$ 500mln in 2010 and The Guardian recently reported that JP Morgan Chase and Credit Suisse have been fined US$416.9mln for “alleged negligence and other wrongdoing in the packaging and sale of risky MBS”, which is still a far cry from the billions of dollars in investment fund losses, the families and homeowners that were eradicated and the effects of the GFC that ensued.

History Lesson No. 1: Global Financial Crisis 2007-2009, Part 1

I thought I’d start off by discussing the Global Financial Crisis (GFC), which is arguably the most catastrophic economic event since the Great Depression. It is important for us to understand the implications of the GFC and how it affects us. Five years after the GFC, the global economy is still suffering from the aftermath of the GFC; the fiscal cliff in the US, the debt crisis in Europe and slow growth in developing countries. Evidently, the health of the financial system is crucial to the economy, which is intimately linked to our daily lives.

In the event of Lehman Brothers bankruptcy, there was widespread panic and the stability of the financial system was threatened, triggering the GFC, in which financial market problems soon spread into the real economy. The collapse of Lehman Brothers saw public trust in banks and in the financial system plummet, inciting a run on banks. The banking crisis spreads into the real economy as other businesses (non- financial institutions) are unable to obtain a line of credit to fund their daily operations. This is when the crisis affects you and me. The banking crisis freezes credit lines to businesses that cannot fund their operations and pay their employees. Businesses start laying off their employees, increasing uncertainty in job security. Consumer sentiment falls as people increase savings and decrease consumption spending, resulting in lower profits for businesses. Businesses lay off more people and put a freeze on hiring. The average person like you and me struggle to keep our jobs or find jobs.

In 2007, the sub-prime mortgage crisis and securitization built the foundations of the global financial crisis, contributing to the collapse of Lehman Brothers, also threatened the collapse of other financial institutions such as Bear Stearns, Merrill Lynch, Fannie Mae and Freddie Mac, which were effectively bailed out. Detailed discussion on the subprime mortgage crisis and the role of securitization leading up to the GFC will be discussed in the next post. However, the event that triggered the financial crisis was the collapse of Lehman Brothers. On 15th September 2008, the failure of Hank Paulson, the US Treasury Secretary at the time to rescue Lehman Brothers (based on the reason of moral hazard) sent ripple effects through the financial system, posing systemic risk and triggering the GFC.

The stability of the financial system is built on public trust in the financial institutions. When Lehman filed for bankruptcy, it came as a shock. It was expected that Lehman Brothers would be bailed out, as Bear Stearns was in March earlier that year. Lehman Brothers was one of the oldest (over 100 years old) and one of the four biggest investment banks in the US. The public operates under the assumption that all banks are safe or “too big to fail”, hence when Lehman was allowed to fail, there was widespread fear that other banks were also unsafe. The collapse of Lehman saw sharp deterioration in confidence in financial institutions and widespread panic that induced bank runs, posing systemic risk that led to the onset of the GFC.

The bank runs during the GFC were unlike the traditional bank runs, where depositors lined up to withdraw their funds. The panic during the GFC was a run on the sale and repurchase market (the repo market). In traditional bank runs, people line up to withdraw their funds, but since banks only hold a proportion of their deposits, whilst the rest were loaned out, mass withdrawals will lead to the bank’s collapse. The repo market provides short term financing, and a run would imply the withdrawal of repurchase agreements.

During the sub-prime mortgage crisis, investors started doubting the safety of the MBS, thus they began withdrawing from the repurchase market, selling their securities at a lower price. The downwards pressure on prices cause the assets on the financial institutions’ balance sheet fall in value. The falling asset values raised fears that banks would not be able to meet their obligations, hence banks could not renew their borrowings from the capital markets to fund their operations. Without funding, the banks could not get enough cash to continue their day to day business. This is what is called a liquidity crisis in the financial system. In 2007, Bear Stearns hedge funds fell 28 percent in value and in March 2008, the investment bank faced insolvency problems due to the decline in value of its mortgage backed securities holdings. They were bailed out by JP Morgan in a fire sale with government backing. However, when Lehman collapsed, investors panicked, pulling funds from all forms of investments, as we can see a massive plummet in the S&P 500 Index Chart around the end of September into October 2008.

(S&P 500 Index Chart from Yahoo Finance)

Problems in the financial system spread into the real economy following the failure of Lehman Brothers. A credit crisis arose when banks were reluctant to provide loans after having had billions of dollars written off their balance sheets. Healthy companies such as General Electric that manufacture light bulbs and engines could not obtain lines of credit to fund their daily operations. Economic growth declined and unemployment rose following the drying up of credit. Bail-out packages were organized for some industries (ie automobile industry) in addition to the financial sector. When unemployment rises, the average person would reduce consumption spending due to the uncertainty in job security. As consumer sentiment fell, business profits declined, slashing even more jobs. The government realized the severity of the Lehman collapse in time, and attempted to remedy their actions by purchasing assets and equity worth up to US$700 billion from financial institutions under the Troubled Asset Relief Program (TARP) on 3rd October 2008. This is an attempt to solve the credit crisis by providing cheap credit to banks in hope that banks will lend the money out.

Evidently, the financial crisis has severe implications and affects all of us. The GFC has demonstrated that the flow of credit is so crucial to the economy; and if the financial system fails, the economy cannot function. Not only do the investors lose investment funds, when the crisis spreads into the real economy, the increased economic uncertainty leads to businesses laying off workers and putting on a hiring freeze, people like you and I will struggle to keep our jobs or to find jobs.

I am a Halfie

Dear Reader,

My name is Zhi and I am a halfie - half economist, half engineer. I am in my fifth year of completing a Double Degree in Chemical Engineering and Economics. In this blog, I hope to relate important economics events in laymen terms so engineering students and other non-economists have a better understanding of these crucial events and why they are important. When I was studying for my International Economic History exam two nights ago, I realised that my knowledge and understanding of economic theory and historical economic events have shaped my perspective of the world differently. That was when the idea hit me that I could share my economics thoughts with everyone through this blog. I hope to inspire interest in economics for engineers and other non-economists

Happy Reading :)