The subprime crisis exposed the vulnerabilities of modern financial markets that rely on wholesale funding and complicated chains of derivatives and structured instruments. Investment banks failed, repo markets froze, and monocline insurers that were supposed to protect against subprime portfolio losses defaulted much as many triple-AAA securitizations did, especially in the US. The crisis has revealed that the determinants of liquidity (collateral) remain poorly understood and henceforth regulated. All this said, our understanding of the causes, and more importantly of the consequences of the subprime crisis, is still limited. The first part of my presentation/intervention will focus on the initial conditions of a new global financial order, and these will refer to main macroeconomic determinants of the subprime crisis and its global spillover. Only with a good diagnosis of such circumstances, we can be able to think about the main drivers of the new international financial order.
While it is relatively easy to enumerate a variety of factors that must have played a role in the collapse, there is some agreement on the major drivers of the past Global Great Recession. In my view, four are the main major factors playing a core or coherent view of the crisis. First, the global imbalances and the savings glut; second, the growth of the U.S. shadow banking system in response to the previous 'excess savings' problem or its reversal: the "assets scarcity" problem; third, the collapse of the wholesale funding market that supported the shadow banking, and fourth, the existence of some regulatory and supervisory deficiencies. Let me briefly turn into these causes in more detail.
The Savings Glut and the Global Imbalances
During the decade of the 2000s the U.S. experience sustained and steady current account deficits (4.4% of GDP in 2000 to 6-7% by the end of the decade). Why did deficits grow so large and steady? An important ingredient of this fact is related to the excess savings coming from emerging markets, such that foreign investors were looking for a safe-place to park their excess funding. The view that money was pushing its way to the U.S., rather than being pulled by a demand for capital, is supported by the fact that long run interest rates kept falling as the U.S. current account deficit grew. Of course, other factors such as the stance of U.S. monetary policy cannot be disregarded. Is this excess savings flying toward the U.S. what contribute to the emergence of the housing bubble and the increasing demand of triple-A securities that the shadow banking system was willing to supply. According to some scholars and market participants, the much discussed 'global savings glut' could be seen as a manifestation of a twin problem: poorly developed financial markets and a booming economy in emerging markets, with a central role played by China, that led to high savings chasing an inadequate supply of domestic (EMEs) financial assets.
These simple facts rise a number of questions that need to deserve further analysis and will shape the evolution of the international capital flows, exchange rates, and where the evolution of the global financial system will certainly play a key role going forward. In particular, how does financial integration between emerging and developed economies affect the global distribution of output volatility, exchange rates and financial crises? Why are shocks to external funding an important source of crises in emerging markets, but typically irrelevant in the developed world? What was the role (if any) of financial integration with emerging markets in setting the stage for the subprime crisis?
The evidence of the past three years suggests an important role for financial integration and specially financial development in 'excess savings' economies. This distortion in the financial system between developed and emerging markets will induce misallocation of resources and will require efforts toward implement structural changes. Otherwise, capital flows to the developed world, and exchange rate volatility, remained high and increasing as the financial system underwent these structural changes.
Thus, international capital markets and international financial institutions might provide adequate insurance if there is sufficient international collateral. Nevertheless, for emerging market economies, as the crisis has proven to be true, having access to international markets does not alleviate or obviate the need for domestic creation of value and collateral, and this can only be done in efficient domestically well developed financial systems. The amount of insurance that can be bought is limited by the amount of international collateral that can be produced, and this is linked to the tradable assets and exporting sectors (but also to the quality of political and economic institutions). This requires enough flexibility of exchange rates as a mechanism of adjustment but definitely it will be precluded from excess volatility of international financial flows and exchange rate volatility.
[A word on exchange rates. Maybe we can have a paragraph on the issue here.]
Let me now turn to the second factor of the crisis. The explosion and the key role played by the so-called shadow banking system.
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The Rise of the Shadow Banking
Global imbalances, as such, do not explain why the bulk f excess savings flowed into the U.S. rather than into Europe, for instance-the European private sector invested substantial amounts in the U.S. during the same period. One reason could be the U.S. consumer's willingness to go deep into debt, given the lax monetary policy followed by the Fed at the time Ok, the ECB policy was also very loose at that time………….. Another ingredient is that the U.S. was specially well positioned to absorb the global savings because its financial sector (and financial markets) were one of the most advanced in the world---this sounds better. Hence, the financial system in the U.S. did come up with enough financial innovation that enabled it to absorb the demand for triple A- securities. The shadow banking system (i.e., the fraction of the financial system that performs assets and liabilities maturities transformation but that is not explicitly insured by the government comprising investment banks, hedge funds, money market mutual funds MMMF, SPV, and government sponsored entities GSE like Fannie Mae and Freddie Mac) has been widely implicated in the crisis. The liabilities of the shadow banking system grew rapidly from less than 10 percent of total bank liabilities in 1980 to about 60 percent in 2008 (with the growth rate specially strong after 1995). This growth of gross liabilities was of the same order of magnitude as the yearly trade deficits suggesting the importance that shadow banks must have played a central role in intermediating the vast amounts of money flowing into the U.S.
To satisfy the international demand for safe opportunities, the repo market, which is at the core of the shadow banking, offered a form of secured lending that emulated many features of demand deposits in commercial banking. Yet, unlike the traditional banking, the repo market was designed to secure hugely bigger deposits-typically millions or even hundreds of millions of dollars in a single trade. Hence, no standard deposit insurance mechanism can provide minimal protection for investment of this size. Interestingly, the working of the repo market was a private sector solution to lack of deposit insurance. Hence, by selling a security in exchange for a deposit, the repo market provided insurance on the appropriate scale. There is a legal aspect in the repo contract that makes it so effective (at least ex-ante and in theory): if a party B (the borrower) cannot repurchase a security when the party A (the lender or investor) demands it (i.e., pay back A's deposit), party A owns the security and it's immediately free to sell it or use it as collateral in another repo transaction. Supongo que todo esto lo habrás copiado de Krishnamurty (JEP 2010)
Unlike the traditional banking, repo markets enjoy the benefits of the scale without much apparent risk. Under such a benign set of circumstances then, the only pitfall was the need for supply or produce securities and safe assets underlying the repo-market transactions. This will put the banking system in search for collateral, and hence the easiest escape was to use the housing sector as the raw material for the production of new securities. The securitization process thus becomes the technology underlying the transformation of collateral into triple AAA safe assets. The enormous growth in home equity loans during the last two decades unleashed some of the potential of this new technology. Securitization, specially of mortgages but later on of just about any other kind of assets (car loans, students loans, credit card loans, etc..), made the most of this opportunity. Securitization could deliver highly rated triple AAA bonds out of relatively marginal assets using tranching. Hence, the combination of the repo market with asset-backed (structured products and vehicles), highly rated securities created an important intermediation technology.
An important lesson going forward will be for the financial system to use such a technology provided that the private sector is willing to supply enough collateral and of high quality so that it does not suffer from the sudden collapse that the world has experienced in the recent years. On the one hand, regulatory arbitrage practices cannot constitute any engine of growth, i.e. by moving capital off the balance-sheet the banking system should not evade onerous capital constraints. On the other hand, financial innovations that have been so decried lately should, in principle, have raised the welfare but it does not seem to be the case. What are the potential causes for such an outcome? In principle, by securitizing loans, the banking system was transforming 'un-used capital' into 'collateral' or liquidity. These should open possibilities in emerging markets economies, but it would require to further develop financial markets and institutions in such an economies. This is not an easy task and it should be subject to analysis and scrutiny so that we avoid that facts turn up-side-down. In particular, that requires building a resilient financial system that is not subject to the vulnerabilities behind the panic of 2007. Let me elaborate a bit more on this later issue, that is, on the causes that create 'the panic' out of the previously described financial innovation machinery.
Three years ago, many of those mortgage-backed securities (MBS) were rated AAA, very likely to yield a steady stream of payments with minimal risk of default. This made the assets liquid. If a financial institution needed cash, it could quickly sell these securities at a fair market price, the present value of the stream of payments. A buyer did not have to worry about the exact composition of the assets it purchased, because the stream of payments was deemed as safe.
When house prices started to decline, this had a bigger impact on some MBS than others, depending on the exact composition of mortgages that backed the security. Although MBS are complex financial instruments, their owners had a strong incentive to estimate how much those securities are worth. This is the crux of the problem. Now anyone who considers purchasing a MBS fears the classic lemons problem: A buyer hopes that the seller is selling the security because it needs cash, but the buyer worries that the seller may simply be trying to unload its worst-performing assets. This asymmetric information this makes the market illiquid. To buy a MBS in the current environment, you first need an independent assessment of the value of the security, which is time-consuming and costly. Put differently, the market price of MBS reflects buyers' belief that most securities that are offered for sale are low quality. This low price has been called the fire-sale price. The true value of the average MBS may in fact be much higher. This is the hold-to-maturity price.
The adverse selection problem then aggregates from individual securities to financial service institutions. Because of losses on their real estate investments, these firms are undercapitalized, some more so than others. Investors rightly fear that any firm that would like to issue new equity or debt is currently overvalued. Thus firms that attempt to recapitalize push down their market price. Likewise banks fear that any bank that wants to borrow from them is on the verge of bankruptcy and they refuse to lend. This is the same lemons problem, just at a larger scale. No firm that is tainted by mortgage holdings, even those that are fundamentally sound, can raise new capital. A full-blown panic ensued, that is adverse selection driven by uncertainty about counterparty risk froze global financial markets.
Underlying these imperfections is the key to implement a proper regulatory framework. Such a framework should trade-off cost and benefits without distorting the incentives and the allocation of capital across regions and productive sectors. Let me briefly turn to this aspect that probably would require another talk, but that I cannot limit myself devoting a few paragraphs on such a challenging matter.
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Regulatory Challenges
Any regulatory policy should rest on the presumption that the government or the policymaker more generally can do certain things that, existing frictions, limit the efficient market outcomes????no se e ntiende. Foremost among these is the guarantee of sound and resilient financial institutions as well as the provision of liquidity.
It is clear that the subprime crisis revealed significant weaknesses in the regulatory system that were meant to keep in check moral hazards, excessive risk taking, adverse selection, and others dysfunctional actions.
A final remark
Let me emphasize, to conclude, my firm conviction that recent events have not shed doubt on the importance of innovation, all innovation, including financial innovation. On the contrary, we have enjoyed prosperity over the past two decades because of rapid innovations quite independent from financial bubbles and troubles. We witnessed a breakneck pace of new innovations in software, hardware, telecommunications, pharmaceuticals, biotechnology, entertainment, and retail and wholesale trade. These innovations are responsible for the bulk of the increases in aggregate productivity we enjoyed over the past two decades. The role of the financial system in financing these innovations to create value and collateral remains a key engine of growth. Even the financial innovations which are somewhat tainted in the recent crisis are in most cases socially valuable and have contributed to growth. Complex securities were misused to take risks with the downside being borne by unsuspecting parties. But when properly regulated, without an implosion or an implausible overhaul of regulation, they also enable more sophisticated strategies for risk sharing and diversification. They have enabled and will ultimately again enable firms to reduce the cost of capital.
As the Nobel Laureate Merton Miller argued, "[the idea] that financial markets contribute to economic growth is a proposition too obvious for serious discussion." Drawing a more restrained conclusion, Bagehot and Schumpeter reject the idea that the finance-growth nexus can be safely ignored without substantially limiting our understanding of economic growth and welfare prosperity for our society.
