Table of Contents

Table of  Contents  i

List  of Figures and Tables  iv

List  of Abbreviations.  v

1.  Introduction  1

2.  The current financial crisis in the US  2

2.1  The .US. real estate bubble  2

2.1.1  Low interest rates.  3

2.1.2  Global savings glut  4

2.1.3  Legislative and regulatory support  6

2.1.4  Credit boom  7

2.1.5  Speculative fever and real estate mania.  8

2.1.6  Subprime mortgage market and lax lending standards.  9

2.2  The background to the current financial crisis.  12

2.2.1  Securitization and new financial instruments  12

2.2.2  Rating agencies  15

2.2.3  Poor regulation and the shadow banking system.  16

2.2.4  Greed, wrong incentives and conflicts of interest  19

2.2.5  The Great Moderation and the Greenspan Put  20

2.2.6  The end of the Ponzi scheme: a Minsky moment.  20

2.2.7  Forbearance during the bubble inflation.  21

2.3  The current crisis in the .US.  22

2.3.1  Effects on financial markets  22

2.3.2  From Wall Street to Main Street.  26

2.3.3  From the .US. around the globe.  27

3.  The Japanese experience in the 1990s and 2000s  28

3.1  The bubble economy from 1987 to 1990  28

3.1.1  Monetary easing.  29

3.1.2  The Japanese economic miracle and over-confidence.  30

3.1.3  Regulation and tax incentives.  30

3.1.4  Financial deregulation and aggressive bank behavior  31

3.2  Japan in the 1990s: a lost decade.  33

3.2.1  The bubble deflates: 1991 - 1995  35

3.2.2  Adjustment processes after the bubble burst  36

3.2.3  How the government responded to the bursting asset bubble  37

3.2.4  The background to regulatory forbearance and wait-and-see politics.  38

3.2.5  The banking crisis of 1995/1996  42

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3.2.6  The birth of zombie firms and declining productivity.  45

3.3  Japan’s emergency response to the banking crisis: 1997 - 1999  46

3.3.1  Fiscal policy.  47

3.3.2  Banking crisis of 1997-1999.  47

3.3.3  Measures to restore the financial sector.  47

3.4  Japan’s way to recovery: 2000 - 2004  52

3.4.1  Introduction of a crisis framework and tighter supervision.  53

3.4.2  Restructuring of NPLs  53

3.4.3  Back to growth.  54

4.  America now and Japan then: a comparison.  55

4.1  Are Japan and the .US. comparable?  55

4.1.1  Similarities.  55

4.1.2  Differences.  57

4.2  How the .US. responded to the crisis.  59

4.2.1  Monetary easing.  59

4.2.2  Credit easing  61

4.2.3  Deposit Insurance  61

4.2.4  Emergency Economic Stabilization Act and TARP.  62

4.2.5  Economic Stimulus Act of 2008.  63

4.2.6  American Recovery and Reinvestment Act of 2009  63

5.  What lessons can the .US. learn from Japan’s experience?  64

5.1  Do not wait any longer and act.  64

5.2  Evaluate assets and write-off losses.  65

5.3  Monetary policy is not the sole solution.  67

5.3.1  Monetary policy in Japan.  67

5.3.2  The liquidity trap in Japan and America.  70

5.4  Inflation or deflation?  73

5.4.1  The mechanisms of a balance sheet recession and deflation  76

5.4.2  The danger of deflation.  77

5.5  Expansionary fiscal policy to fill the gap.  78

5.6  Recapitalize the banking sector despite its unpopularity  80

5.7  Establish a framework for bank failures.  82

5.8  Establish a framework for capital injections  83

5.9  Nationalize banks if necessary.  85

5.10  Clean banks’ balance sheets from toxic assets  86

5.10.1  The failure of TARP in the .US.  87

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5.10.2  Lessons from Japan’s asset management companies  91

5.10.3  Support the debtor side of banks’ balance sheets  92

5.10.4  Why it is so difficult to value toxic assets in America  94

5.11  Prepare for the second wave of the crisis  95

5.12  Consider the long-term consequences of piling up debt.  95

5.13  Pay attention to banks’ size  98

5.14  Do not create zombie firms  98

5.15  Change the mindset  99

6.  Conclusion  100

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List  of Figures and Tables  

Figure  1. Sharp increase in real estate prices until 2006.  

Figure  2. Effective Federal Funds Rate (shaded areas indicate .US. recessions)  

Figure  3. Global Imbalances (current account balances as percentage of GDP)  

Figure  4. Development of homeownership rates and subprime mortgage originations.  

Figure  5. Evolution of Equity and Borrowing in Residential Real Estate  

Figure  6. Evolution of Subprime and Alt-A Mortgage Originations  

Figure  7. Market Capitalization of Major Banks (in billion USD)  

Figure  8. TED Spread between the 3-month LIBOR rate and the 3-month .US. T-bill yield.  

Figure  9: Japan’s lost decade.  

Figure  10. Land Price Index for Six Metropolitan Areas.  

Figure  11. Japanese GDP growth 1956 - 2001.  

Figure  12. The Japan Premium.  

Figure  13. The .US. and the Japanese real estate bubble.  

Figure  14. Adjusted Monetary Base (shaded areas indicate .US. recessions)  

Figure  15. Japanese money and prices (1997 100)  

Figure  16. Rising debt of the Japanese government.  

iv

List of Abbreviations

ABS Asset backed securities

ARM

BOJ

CCPC

CDO

CDS

CPP

DTI

FDIC

Fed

FSA

GDP

IMF

IRCJ

LTV

MBS

MOF

NPL

OECD

PCA

PPIP

RCC

SEC

SME

SPV

TAF

TARP

TIRAL

TSLF

QEP

ZIRP

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Diploma Thesis Katrin Meier

1. Introduction

The current financial crisis, which started in the Unites States, has dominated the headlines all around the world since summer 2007 and especially after Lehman Brothers’ breakdown in September 2008. Wall Street legends like Bear Stearns, Merrill Lynch or Citigroup as well as insurance and mortgage giants like AIG, Fannie Mae or Freddie Mac had to either go out of business or were bailed out by the U.S. government. What started as a subprime crisis in the beginning soon turned to a global financial crisis and then changed to a worldwide recession. Governments around the world try to fix their financial system and to restore economic health.

According to The Economist, there have been “124 systemic banking crises since 1970” (2009c). While most of them took place in developing countries, there have also been banking crises in the developed world. No crisis is identical to another crisis. Still, it is “important to draw lessons from past experience to guide policymakers struggling to stabilize” financial markets (Shimizutani 2008). The current crisis in the U.S. has parallels with a range of other crisis such as the Great Depression or the U.S. Savings and Loans crisis. Rogoff and Reinhart, for instance, compared the current crisis with a wide range of other crises (2008) However, The Economist (2009d), Posen (2009), Kobayashi (2008b), Koo (2008), Krugman (2009d) and Nakamae (2008) are just few of many well-known authors who state that Japan’s experience in the 1990s is the most suitable for serving as a reference to the United States. Despite many differences between both crises, I agree with Koo who points out that the U.S. is “extremely fortunate” to have the opportunity to learn from Japan’s experiences, a country which “went through something very similar just fifteen years ago” (2008, 69). Both, Japan then and the U.S. now, experienced the bursting of an asset price bubble, declining collateral values that served for loans, shrinking bank capital and less bank lending. There are indeed many similarities in the post bubble period as well as in the aftermath of the deflated assets bubbles in both countries. According to Koo, “the Japanese lessons provide the nearest thing to a roadmap of a post-bubble economy” (2008, 70). The objective of this paper is to explain what the U.S. can learn from Japan’s experience and to give a road map of how to respond to the unfolding events in financial markets. Japan has responded too late and implemented many half-measures that did not restore confidence in the banking industry. As a result, Japan suffered more than a decade from stagnation and deflation - a lost decade. The current head of the Federal Reserve Ben Bernanke studied Japan’s crisis in depth during the 1990s and 2000s and hopefully, U.S. policymakers will make good use of those lessons in order to minimize the pains of the U.S. economy.

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This paper is divided into four sections. The first section provides an overview of the events that led to what the International Monetary Fund (IMF) then called the “largest financial shock since the Great Depression“ (Stewart 2008). The second part explains how the crisis in Japan unfolded and why it took so long until policy measures had a significant positive impact. The third part shortly summarizes America’s response to the crisis so far. The final part tries to answer the question what America can learn from Japan when it comes to handling its crisis.

2. The current financial crisis in the US

Many different factors contributed to the current financial crisis in the United States. I have to agree with Goodhart who states that “it is difficult for a single person to put together a completely coherent story of everything that has happened [and] it may take quite a long time before a comprehensive history of this crisis can be written” (Goodhart 2008, 331). As the crisis is still going on, it is too early to completely assess what has happened. My intention therefore is to give a rather descriptive overview over often-cited ingredients to the U.S. real estate bubble as well as over the basic background mechanisms like securitization that are now unfolding and impact economies around the world.

2.1 The U.S. real estate bubble

The current global turmoil had its roots in the U.S. real estate market. During the late 1980s and 1990s, prices for homes started to increase slowly and accelerated especially after 2000 and 2001, when interest rates were lowered in order to avoid a recession after the dotcom boom.

As can be seen in figure 1, real estate prices in the U.S. went up massively due to increased real estate acquisitions. Comparing home prices in January 1987 to those during the peak in June 2006, values grew by a factor of 3.6. Between January 2000 and June 2006 alone, real estate prices went up by 126 percent as can be seen in figure 1 (Standard & Poor’s 2009).

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250

230 210 (January 2000 = 100, ratio scale) 190 Housing Price Index 170 150 130 110 90 70 50

Source: Case-Shiller Home Price Indices, 10-city monthly nominal index US (author’s own illustration)

There are several factors that contributed to the creation of this massive bubble, which will be described below.

2.1.1 Low interest rates

One driver in the ballooning of the housing bubble were historically low interest rates that gave access to cheap credit.

After the bust of the dotcom bubble in 2000 and especially after 9/11 in 2001, prime rates were decreased by the Federal Reserve in order to stimulate investments and consumption. The Fed justified low nominal interest rates of around 1 percent and negative real interest rates like in June 2003 with the fact that higher rates could lead to deflation and hinder economic growth. In retrospective, it can be said that the Federal Reserve created excess liquidity between 2001 and 2005 “which in turn became a strong contributing factor to indiscriminate proliferation of credit” (Tong and Wei 2008, 5). Taylor empirically showed that “monetary policy was too easy” and deviated unusually much from the Taylor rule so that the housing boom expanded more than it otherwise would have (Taylor 2009, 2). Please refer to figure 2 for the development of the federal funds rate.

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In 2004, the economic situation in the U.S. was supposed to be strong enough and did not need further low interest rates as incentives for consumption and investments. The Federal Reserve decided to increase prime rates starting in 2004. By 2006 “the Fed raised interest rates 17 times, increasing them from 1 to 5.25 percent“ (Guha and Hughes 2006). In the beginning, higher interest rates did not prevent the real estate bubble from growing.

2.1.2 Global savings glut

In addition to low-targeted policy rates, importers to the U.S. like China or Middle East countries invested their trade revenues in the US capital market which lowered interest rates even more as more money was available for investments.

Ben Bernanke, in his effort to explain the huge current account deficit of the US during a speech in March 2005, argued that there is a “global savings glut” (2005), a term which is now often linked to the inflation of the real estate bubble in the US (see for instance Brunnermeier 2009, Krugman 2009a or Goodhart 2008). In 1996, the US current account deficit and thus the surplus of investments over savings stood at 1.5 percent of GDP, then rose and peaked at over 6 percent in 2006. Bernanke’s explanation for this increase was the “emergence of a global savings glut” in the 1990s, which he contributed partly to “the strong saving motive of rich countries with aging populations” (2005). Even more important was the developing countries’ reversal of current account positions who used to be capital net

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importers during the 1990s. Asian and Latin American countries experienced huge capital inflows at that time but experienced “painful financial crises including those in Mexico in 1994, in a number of East Asian countries in 1997-98, in Russia in 1998, in Brazil in 1999, and in Argentina in 2002” as they did not use those funds productively (Bernanke 2005). Bernanke argues that these countries became then net capital exporters by accumulating large foreign exchange reserves in order to mitigate the risk of repeated capital outflows and to avoid exchange rate appreciations. China, for instance had a current account surplus of 7.2 billion USD in 1996, which grew to 371.8 billion USD by 2007. In addition to that, the rising oil price made the current account surpluses of oil exporting countries such as the Middle East or Russia swell. Bernanke further argues that America was especially attractive for those investors due to the technology boom in the 1990s, the strength of its financial markets and the special position of the dollar as reserve currency. In 2007, “the US, UK, Spain and Australia—four countries with housing bubbles—absorbed 63 per cent of the world’s current account surpluses” which resulted in huge global imbalances which are illustrated in figure 3 (Wolf 2008).

Unfortunately, the U.S. did not make productive use of the world’s surplus funds either. Instead, the increasing investments from developing countries financed a real estate and credit bubble through sustained low interest rates. But the housing market was “comprised of the poorest and least credit worth borrowers within the United States” and did burst with

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painful results (Rogoff and Reinhart 2008, 12). Even Bernanke admits that “the key assetprice effects of the global saving glut appear to have occurred in the market for residential investment, as low mortgage rates have supported “record levels of home construction and strong gains in housing prices” (2005). According to Krugman, the current global crisis is simply “the revenge of the glut” (2009a).

2.1.3 Legislative and regulatory support

Low interest rates allowed also people with smaller incomes to afford houses, further promoted by Congress and the U.S. government. Ideally, poorer citizens would have had a unique opportunity to possess their own houses, which must seem ethical and good to everyone. But this turned out to be the trigger for the crisis, in which millions of people in all income groups lost their homes, assets, pensions and jobs.

Affordable home ownership for all ethnic groups was a key policy goal of Clinton and Bush promoted the idea of the “ownership society” by equating home ownership with wealth and security for everyone (Wood 2009 and Shiller 2008). Starting in 1992, Fannie Mae and Freddie Mac where pushed by Congress “to increase their purchases of mortgages going to low and moderate income borrowers” and by 2005 the U.S. department of Housing and Urban Development required that 50 percent of the portfolio of those government chartered mortgage firms shall consist of mortgages to borrowers with income below the median in their area (Roberts 2008 and Holmes 1999). Also traditional banks were encouraged to hand out more loans to low income groups through the Community Reinvestment Act which was strengthened in 1995. According to Miron, the act pressured banks into subprime lending resulting in an 80 percent increase in the value of these loans (2008). The Wall Street Journal calls the political pressure for increased homeownership without fiscal expenses “another political free lunch” (Roberts 2008). It can be said that lenders received support from the very top to sell houses to borrowers who would usually not qualify for mortgages, thereby expanding the real estate market to a whole new clientele. By 2006, the U.S. homeownership rate reached 69 percent compared to 64 percent in 1994 while the share of subprime mortgage originations sharply increased as can be seen in figure 4.

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2.1.4 Credit boom

The IMF identified the Tax Reform Act as another facilitator for the development of the subprime mortgage market and thus the housing boom. The law which was passed in 1986 provided tax deductibility for home mortgages as opposed to other loan types which made home equity withdrawal “a preferred means of financing home improvements and personal consumption, relative to other forms of consumer loans” (Kiff and Mills 2007, 4). Stiglitz criticized that “the Bush administration was providing an open invitation to excessive borrowing and lending” (2009b). As a result, real-estate-financed borrowing through second mortgages and home equity grew much faster than credit card or personal loans (Mahon 2006). As house prices increased steadily, between 2002 and 2007 at a rate of 11 percent per year, consumer spending based on loans on rising home wealth surged as can be seen in figure 5. Homeowners were more and more leveraging their household equity.

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Rising household debt levels were offset by rapid growth in consumer wealth based on home value appreciation keeping debt-to-wealth ratios stable. The Federal Reserve Bank of Minneapolis therefore argued in 2003 that the debt to wealth ratio may be sustainable because “new financial products allow people to tap into that wealth [which was] largely inaccessible in the past” (Mahon 2006). The Federal Reserve Bank of San Francisco even compared the refinancing boom to a “structural change in the economy” as cash-out refinancing on home equity allows for smooth consumption in case of adverse economic shocks to household wealth (Krainer and Marquis 2003). These lines of argumentation demonstrate quite clearly that not only private persons overoptimistically believed in the paradigm of ever increasing home prices. Nevertheless, real incomes were actually decreasing so that consumption heavily depended on real estate price increases.

2.1.5 Speculative fever and real estate mania

Real estate was not only bought for actually living there, but also for speculation. Investors moved their funds into houses, partly because they experienced big losses after the dotcom boom and believed that real estate was a safer investment. Shiller sees the roots of the increase in investment driven purchases of houses even earlier, in smaller home price bubbles in the 1970s and 1980s and in the stock market boom of the 1990s (2008). “We began to think of ourselves as investors. We started buying Money magazine. (...) We simply

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moved out of stocks [in 2000], and deeper into property ownership” (Shiller 2008). According to the Fortune magazine referring to the housing speculation in 2006, "America was awash in a stark, raving frenzy that looked every bit as crazy as dotcom stocks“ (Levenson 2006). The National Organization of Realtors’ second home study analyzed that in 2005, 27.7 percent of all houses were purchased for investment purposes (2006).

The media together with the real estate industry jumped on the bandwagon by promoting real estate acquisitions as save wealth creator. Most Americans “were busy wondering how much their neighbors had made selling their apartment” (Cassidy 2008). Flipping houses, i.e. buying a house, renovating it and selling it against huge profits, became very popular. It seems as if everyone felt save that the collaterals’ prices will keep increasing. Shiller warned already in 2005 that America is caught by an ‘irrational exuberance’ (2005) Soaring demand led to ever increasing prices, which resulted in further expectations about price rises The steady uptrend over years became a self-fulfilling prophecy. And this real estate boom also had positive consequences on the real economy. The construction industry built new houses to satisfy demand. With steadily rising prices, homeowners could take further mortgages on their homes and used the money for consumption. Still, the US boom was mainly financed by debt.

2.1.6 Subprime mortgage market and lax lending standards

Huge capital inflows and low interest rates would have offered a favorable chance to the U.S. but as Bernanke declared in his 2008 speech at the International Monetary Conference, the invested inflows were not always used wisely „as an increased appetite for risk-taking [...] stimulated some financial innovations and lending practices that proved imprudent or otherwise questionable” (Bernanke 2008).

Mortgage lenders felt encouraged to sell as many loans as possible by making it as easy as possible for borrowers to finance their houses. This was especially true for loans to subprime and Alt-A borrowers. Subprime borrowers generally have low credit scores, high debt service to income (DTI) ratios and/ or high mortgage loan-to-value (LTV) ratios. Alt-A borrowers are characterized as people who meet prime loans criteria but provide only little income documentation (Kiff and Mills 2007,). Those borrowers do not qualify for conventional prime loans but instead for mortgages with higher interest rates, including a subprime mark-up in order to compensate the lender for increased default risks (Demyanyk and Van Hemert 2008a). The IMF confirms that subprime lending, which was developed in the mid 90s substantially, supported an expansion in homeownership (Kiff and Mills 2007). The subprime mortgage market expanded from 160 to 540 billion USD between 2001 and 2004 (Duhigg 2008). By 2006, subprime loans accounted for 20 percent of the mortgage market compared

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to only 4.5 percent in 2004 (Arnold 2007 and Bernanke 2008). Please refer to figure 6 for the subprime mortgage market evolution.

1400

1200

Mortgage Origination in billion USD

1000

800

600

400

200

0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Year Subprime Alt-A

Figure 6. Evolution of Subprime and Alt-A Mortgage Originations

Source: Source: Kiff and Mills 2007, 4 and 6 (author’s own illustration)

Problematic in this respect was that the overall riskiness of the subprime market rose over time while the subprime markup declined which means that risk has not been properly accounted for. Demyanyk and Van Hemert show empirically, that lending standards deteriorated substantially between 2001 and 2007 while at the same time loan-to-value ratios increased and that more and more loans with low documentation were handed out. According to their research, the “subprime mortgage market [followed] a classic lending boom-bust scenario, in which unsustainable growth leads to the collapse of the market” (2008b, 5).

Risk increased because everyone wanted to make money in this blooming, profitable market. The purchase of houses was therefore often facilitated by predatory lending practices. Predatory lending means not just deceiving borrowers about loan terms, but also manipulating them through “aggressive sales tactics, or taking unfair advantage of a borrower’s lack of understanding about loan terms.“ (Department for Housing and Urban Development 2008, 3). “‘Low doc’ loans (less documentation required) evolved to ‘no docs’ and to ‘liar loans’ (borrowers were allowed and even encouraged to lie about income and other information relevant to the application process), and finally to ‘Ninja loans’ (no income,

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no job, no assets)” (Wray 2007, 11). Predatory lending practices included abated down payment requirements, seller-funded down payment assistance, interest-only mortgages and/ or adjustable rate mortgages (ARMs) with very low initial teaser rates. This latter mortgage type includes resets of interest rates, which lead to far higher payments later on (Federal Deposit Insurance Corporation 2006). The new rates are usually adjusted each month and are calculated by adding a certain margin “to some established floating rate, like the yield on one-year U.S. Treasury bills” (Knowledge@Wharton 2008). When the teaser rate period ends and the adjustable period starts, borrowers are likely to face a severe reset shock. In 2006, up to 80 percent of all ARM borrowers only paid the minimum sum each month whereas the remaining debt was added to the balance of the mortgage, “a situation known as negative amortization“ as the outstanding debt increases instead of getting smaller (Hovanesian 2006). According to the IMF, “a significant proportion of borrowers were financially overstretching via risky ‘affordability products’ [such as ARMs] with many apparently lying about their financial resources to get loans” (Kiff and Mills 2007, 7). Hovanesian warned already in 2006 that the ARM with its flexibly adjusting interest rates “might be the riskiest and most complicated home loan product ever created [and] brought a whole new group of buyers into the housing market, extending the boom longer than it could have otherwise lasted“ (Hovanesian 2006).

In 2004, the Federal Reserve started to increase prime rates as the US economy was supposed to be strong enough. In June 2006, prime rates reached 5.2 percent and subprime borrowers faced much larger monthly payments. Many homeowners were unable to pay off their rising rates leading to home foreclosures, higher real estate supply and bankruptcies of mortgage lenders. By end 2007, foreclosures “nearly doubled to almost one million with the most rapid and dramatic increase (...) among riskier subprime loans” (Harvard University 2008, 3). Foreclosure rates of subprime ARMs were five times higher than prime ARM loans. Higher interest rates also lowered the demand for new mortgages so that home prices started to decline which in turn made mortgage lenders adjust the rates even further in order to compensate the higher risk of default payments.

As stated above, real estate prices were higher than their fundamental value, i.e. the price that people would pay if they invested with their own money (Allen and Gale 2009). A real estate bubble inflated. Krugman warned already in 2005 that “if housing prices actually started falling, we'd be looking at a very nasty scene, in which both construction and consumer spending would plunge, pushing the economy right back into recession“ (2005). And he was right: when houses lost their value, loans were no longer backed up by their collaterals leading to a chain reaction in the financial market. In the following part, I would like

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to explain how subprime loan defaults, which affect directly only a small part of the U.S. real estate markets, could evolve to a crisis that spread to the complete global banking system.

2.2 The background to the current financial crisis

2.2.1 Securitization and new financial instruments

The underlying reason why the explosion of the US housing bubble affected not only the American real estate industry but also financial markets around the world is that banks switched to an originate-and-distribute model. In the past, mortgage lenders and banks used to hand out loans to people, who were likely to pay them back because they had to keep these loans in their accounts for a long period of time. But as loans are illiquid assets that cannot be traded or converted into cash easily, banks changed to the originate-and-distribute model by creating new financial instruments, such as securities backed up by mortgages, so that enough funds can be generated to hand out more loans and to earn more profit (Goodhart 2008 and Brunnermeier 2009). Banks’ focus shifted towards stock price growth and profit expansion achieved by trading income and receiving fees through securitization (Blundell-Wignall et al. 2009).

Securities are “claims on the principal and interest payments made by borrowers on the loans in the pool” (U.S. Securities and Exchange Commission 2007). According to the IMF, subprime mortgages were mainly securitized in the form of mortgage backed securities (MBS) in which mortgages of different quality are pooled together (Kiff and Mills 2007). Subprime loan securitization peaked at 81.2 percent in 2005 (Marshall 2009). In order to raise fresh capital for new loans, more and more credit claims were securitized, then evaluated by rating agencies and sold to other banks or investors. Over 55 percent of the 10 trillion USD residential mortgage market in the U.S. have been securitized and 64 percent of these securities have been backed by Fannie Mae and Freddie Mac (Acharya and Richardson 2009, 6).

Asset-backed securities like MBSs or collateralized debt obligations (CDOs) allowed on the one hand a reduction in funding costs and a diversification of risk because underlying assets are of different quality and default risk so that “under normal circumstances, the probabilities are independent of each other” (Goodhart 2008, 341). But on the other hand it is quite difficult for investors to assess the risk in detail so that investors could never really know what exactly they were paying for. Let me illustrate this with collateralized debt obligations (CDOs), one type of structured financial products that was first created in 1987 by the investment banking industry as well as with credit default swaps (CDSs).

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Diploma Thesis Katrin Meier 2.2.1.1. Collateralized Debt Obligations

In order to understand why and how the subprime market meltdown hit the global financial markets, it is necessary to understand the principal mechanisms of CDOs more detailed. Whereas in 2004, CDOs worth ‘only’ 157.4 billion USD were issued, new issued dramatically rose to 520.6 billion USD by 2006 (Securities Industry and Financial Markets Association 2009).

In CDOs, home loans are pooled together with car credits, consumer loans as well as with credit card claims (Spiegel Online, 2008). The diverse portfolios of underlying assets are usually acquired by a special purpose vehicle (SPV) which then divides the pool into different tranches that are then sold to a wide range of investors with a varying willingness to take risks. The equity tranche is the riskiest tranche and most commonly held by hedge funds. Compared to other tranches, it pays the highest interest but if underlying assets default, losses are first borne by this most junior tranche and only once it “is completely exhausted will defaults impair the next tranche” which is the mezzanine tranche (Kiff and Mills 2007, 5). The equity tranche was the first part which was later described as ‘toxic waste’ (Goodhart 2008, 341). The subordination principle means that the highest tranches, i.e. the senior tranches, were supposed to be “extremely secure against credit risk, [they] were rated AAA, and traded at lower spreads” (Kiff and Mills 2007, 5). As stated above, these different tranches were supposed to have a different risk-profile and that the probability of default on single underlying loans were therefore independent of each other so that credit risks could be “tranched out” (Hull 2008). Still, this is only true when overall house prices are rising or remain at least stable. When overall real estate prices fall and interest rates are rising, the “correlations rise as well as the probability of defaults themselves” which means that the probability of significant credit losses on the tranches “will rise in a non-linear, indeed possibly an exponential way” (Goodhart 2008, 342).

This is what happened in the United States in 2007 when relatively small changes in average default rates had severe impacts on the value of the different tranches. When interest rates rose and house prices deteriorated, investors finally had to realize that “securitization did not (and cannot) insulate (...) from aggregate risk” (Jones 2009, 7). Lower CDO tranches lost in value and hedge funds were the first to get hit. Two of Bear Sterns’ hedge funds which invested heavily in subprime backed securities collapsed in late June 2007. As a result, there was “growing uncertainty about how further defaults might eat into higher tranches” (Goodhart 208, 342). Wray therefore criticizes that securitization allowed the transformation of “trash into highly rated securities” that even insurance or pension funds were allowed to buy (2007, 25).

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Diploma Thesis Katrin Meier 2.2.1.2. Credit Default Swaps

Another type of securities, which were mainly issued by insurance companies like AIG, were credit default swaps (CDS). CDSs are financial instruments initially used to ensure against default risks of debtors but they also enjoyed great popularity among speculators later, for instance as betting instruments on expectations about the future creditworthiness of single firms or whole industries. CDSs intended to provide security for all sorts of credits like loans to firms, subprime mortgages, CDOs or credit card loans. By buying these CDSs, the lender passes on the risk of default payments or a loss in value to the insurance companies or investment bank, which issued the CDS. The buyer pays a fixed premium per quarter to the CDS issuer in order to compensate for the transferred risk while the issuer in return pays the buyer a certain amount of the loan if default actually occurs. If no default occurs, the buyer of the CDS receives no additional money - just like a car insurance, which pays only in case of an accident. Default events might be insolvency, bankruptcy but also rating downgrades. AIG alone insured commercial papers amounting to 400 billion USD. (Mollenkamp et al. 2008). Unfortunately, AIG “rarely set aside the reserves they would need if the obligation ever had to be paid“ (Kelleher 2008). According to the International Swaps and Derivatives Association, the outstanding credit default swaps in the first half-year 2008 equaled tremendous 54.6 trillion USD compared to a total world GDP of ‘only’ around 54 trillion USD (International Swaps and Derivatives Association 2008). This amount exceeds “over 4 times the publicly traded corporate and mortgage U.S. debt they are supposed to insure” (Murphy 2008, 2). Roubini calls this the “biggest asset and credit bubble in human history” (2009a). This is maybe the reason why Warren Buffett described CDS as ‘financial weapons of mass destruction’ (Kelleher 2008).

Credit default swaps brought AIG and investment banks like Lehman Brothers huge losses as they could not pay off the buyers of their CDS when default occurred on grand scale after those securities were downgraded by rating agencies.

2.2.1.3. Moral hazard

Before the U.S. real estate bubble burst, banks could unload their most toxic securities unto other players in the market. As loans leave the originating banks’ balance sheets in a securitized format, also the default risk of the underlying mortgages could be passed on to investors. That means that the originate-and-distribute model made the originating banks more risk-prone and “less concerned about the quality of credit assessment and monitoring of the borrowers’ conditions during the course of the outstanding loan” (Goodhart 2008, 334). Dell’Ariccia et al. empirically show that lending standards became lax as each link in the mortgage chain could collect profits, which were based on high trade volumes, while passing

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on the risk for losses so that securitization provided “lenders with incentives to extend riskier loans” (Dell’Ariccia et al. 2008, 17). This phenomenon can be best described by moral hazard. Moral hazard means that a party, who is isolated from risk may act differently than it would act if it was fully exposed to the risk. As the full consequences of its behavior are to be borne by someone else, the party has an incentive to behave riskier than it otherwise would (Wikipedia 2009a). Moral hazard in the financial crisis occurred all along the mortgage chain. First, mortgage brokers handed out loans without asking for documentation or proof of the borrowers’ ability to repay because they could push the default risk on to investors. Investment banks bought mortgages, sold them as mortgage-backed securities or sliced up different kinds of debt and repackaged them into complex securities like CDOs. Investors bought these securities and hedged against the risk of default by buying CDSs while pushing the risks further along to insurance companies like AIG. At the end of the chain, banks could feel sure that governments or central banks would bailout their losses that resulted from risk undertaken by them. In the end, central banks had to act as ‘lenders-of-last-resort’ by assuming the ultimate risk.

According to Blundell-Wignall et al., the objective of securitization is therefore not to spread risks as often mentioned but rather a way to boost revenue, the return on capital and share prices (2009). Stiglitz also sharply criticizes securitization by stating that in the resulting “capital gains based pyramid scheme, some were cashing in on the gains, leaving the future losses to others” (2008).

2.2.2 Rating agencies

Rating agencies should have been neutral advisors and safeguarded transparency even though there is asymmetric information inherently in the system as described above. Their task was to rate the credit worthiness of securities in order to help buyers in assessing the associated risk.

Standard&Poor’s, Moody's, Fitch and other agencies are heavily blamed in the current discussion about the background to the crisis “for putting the entire financial system at risk and betraying the public trust“ (Mortgage News Daily 2008). They are strongly criticized for having relied on ever-increasing house prices and for having rated highly risky securities with triple A, which means that credit risk is very unlikely. The Securities and Exchange Commission (SEC) is investigating this topic as they detected improperly managed conflicts of interest (Woellert and Kopecki 2008).

Conflicts of interest arise as rating agencies are being paid by those banks, whose products they are rating (Goodhart 2008). The better the ratings, the more sales to investors are possible. Furthermore, the banks themselves provided agencies with information about the

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financial instruments that had to be rated. This obviously created immense adverseincentives. Stiglitz argues, that even without incentive problems rating agencies would not have assessed risk correctly as competition “had a perverse effect: it was a race to the bottom—a race to provide ratings that were most favorable to those being rated” (Stiglitz 2009a, 5).

In an e-mail released by lawmakers, a Standard & Poor's employee stated “Let's hope we are all wealthy and retired by the time this house of cards falters“ which demonstrates quite clearly that they knew about the ‘toxic waste’ they were praising (Woellert and Kopecki 2008). The ‘house of cards faltered’ when the agencies finally had to downgrade their ratings after foreclosure and delinquency rates increased. Triple A rated securities “halved between July 2007 and March 2008, which created a major credit crisis” as new borrowers could not afford the resulting higher interest rate and investors rushed to sell their securities causing liquidity in markets for mortgage backed securities to dry up (Australian National University 2009). Consequently, investment banks and other investors had to write down their assets, which reduced their capital.

2.2.3 Poor regulation and the shadow banking system

It is important to know that most mistakes that were made prior to the bubble deflation were well within existing laws and regulations. Blaming the real estate bubble for the current crisis is, according to Wray, therefore like “blaming the car for an accident” as regulators and governments should have stepped in earlier (2007, 5).

For Stiglitz, “most of the individual mistakes boil down to just one: a belief that markets are self-adjusting and that the role of government should be minimal” (2009b). The paradigm of self-regulating markets obviously dominated public perception. The U.S. authorities designed a framework, that instead of giving guidelines, allowed financial market enormous freedoms. Spehar even states that the lack of governance over the financial institutions was not just “laissez-faire” it was lawless” (2008, 14). In the following, I would like to give a short overview over the legislative environment that enabled the excesses on Wall Street. 2.2.3.1. Repeal of the Glass-Steagall Act

An often cited legislative change with regard to the financial crisis is the repeal of the Glass-Steagall Act of 1933, which Stiglitz labels as “the culmination of a 300 million USD lobbying effort” by the financial industry (2009b). The Glass-Steagall Act used to separate activities of commercial banks, which take deposits from savers, from investment banks, which invest money. In 1999, the Glass-Steagall Act was repealed and replaced by the Gramm-Leach-Bliley Act. This new law enabled commercial banks to become active in fields which used to

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be reserved for investment banks in the past, thereby enabling “commercial lenders, like Citigroup, to trade instruments” like MBSs and CDOs (Wood 2009). According to Stiglitz, this transmitted the risk-taking culture of investments banks to ordinary banks “which should have acted in a far more prudential manner” (2009a, 7). The Gramm-Leach-Bliley Act also increased the competition in the market for securities and forced investment banks “into ever more risky reliance” on trades for their own accounts by using high leverage levels to increase their return (Arner 2009, 125).

2.2.3.2. Commodity Futures Modernization Act

Another regulation is the Commodity Futures Modernization Act of 2000 which left “any products offered by banking institutions [unregulated] if they were sold as future contracts” like for instance CDSs (Spehar 2008, 15). Although those new financial products became so complex that even traders could not understand them fully, the trade boomed as contracts were negotiated privately over-the-counter without a central clearing house in between which oversees transactions or makes sure that losses are covered if securities default (Morrissey 2008). Especially naked CDS, i.e. “CDS contracts where neither party (...) held the underlying asset created fertile ground for speculation” and insurance companies like AIG could issue as many CDSs as they wished (Marshall 2009, 18).

2.2.3.3. Regulatory arbitrage

Conventional banks are required to hold liquid reserves, to maintain a certain percentage of capital and to contribute to the deposit insurance system. They are part of the Federal Reserve System and are subject to many regulations (Krugman 2009d). However, there were not only ordinary, highly regulated banks. Over time, a shadow banking system evolved, consisting of investment banks, hedge funds, private equity groups, commercial paper markets, special purpose vehicles (SPVs), money market funds, auction rate securities and non-bank mortgage lenders, that “played a major role in excessive credit creation” (Tong and Wei 2008, 16). These non-bank conduits that act like banks “expanded to rival or even surpass conventional banking in importance” but neither regulation nor the deposit insurance system were extended to these new market players (Krugman 2000d, 163). Krugman argues that “anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank (2009d, 163). Nevertheless, this did not happen. Non-banks profited as they could pay higher returns due to more risky and more leveraged investments to their investors.

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Many banks used for instance SPVs to invest in U.S. mortgages and related securities that seemed to keep the risky assets off the banks' balance sheets. As part of the unregulated non-bank system, these off-balance sheet conduits were not subject to capital requirements under the Basel accord as opposed to commercial banks. That means, that regulatory arbitrage was possible as banks could establish non-bank conduits, which held the unregulated securitized assets with a long maturity and financed them by selling assetbacked commercial papers with a short maturity of around one to three months (Goodhart 2008 and Blundell-Wignall et al. 2009). According to Acharya and Richardson, regulatory arbitrage “became the primary business of the financial sector because of the short-term profits it was generating” (2009, 13). But the resulting maturity mismatch - as long term assets were funded with short term debt - bears liquidity funding risks because “investors might suddenly stop buying asset-backed commercial paper, preventing these vehicles from rolling over their short-term debt” (Brunnermeier 2009, 80). Even though those long-term assets are not on the banks’ balance sheets, they still bear the liquidity risk as they would have to grant a credit line to their vehicles in case of trouble. According to Goodhart, banks’ liquidity declined dramatically because their assets increasingly consisted of private sector loans like residential mortgages with high credit ratings but very low liquidity, as there is no strong secondary market (2008). They were literally “putting the management of liquidity to the central bank” (Goodhart 2008, 339). Another factor that contributed to the current financial sector problems is that the Basel accord capital requirements gave banks the opportunity to reduce the amount of capital reserves that has to be held against assets that they kept in their balance sheets by 50 percent “if these assets took the form of AAA-rated nonprime or Fannie Mae/ Freddie Mac securities, as opposed to individual mortgages” (Acharya and Richardson 2009, 1). That means that through securitization, whether held off or on a bank’s balance sheet, capital buffers could be minimized and more loans could be handed out.

2.2.3.4. High leverage and wrong risk assessment

The Securities and Exchange Commission created special exemptions regarding capital requirements for investment banks with assets greater than 5 billion USD in 2004. Five banks, namely Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanley, met those requirements and did not have to adhere any longer to the maximum debt-to-net-capital ratios of 12 to 1 (Casey Research 2008). Instead, those banks were allowed to “employ internal models to assess credit risk and corresponding capital charges” (Acharya and Richardson 2009, 10). Leverage ratios of up to 40 to 1 became common which allowed them to invest even more into risky securities as they were not required to back them

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up thus keeping the cost of capital low. However, when having a high leverage, relatively small changes in assets values can deplete a bank’s equity sharply. For instance, “at a 30-to-1 leverage ratio, a mere 3 percent change in asset values wipes out one’s net worth” (Stiglitz 2009a, 4). These changes from 2004 can therefore be seen as a major reason for the size of the losses that have occurred for investment banks, of which only a few remained on the market. The same applies to commercial banks with large investment banking arms, also part of the shadow banking system, that absorbed the capital of the whole group quickly (Labaton 2008 and Blundell-Wignall et al. 2009).

The five former large U.S. investment banks had a hard landing in 2008: Bear Stearns merged with JPMorgan Chase, Merrill Lynch was taken over by the Bank of America, Lehman Brothers went bankrupt and Goldman Sachs as well as Morgan Stanley became commercial banks.

2.2.4 Greed, wrong incentives and conflicts of interest

One might argue that even though regulations were lax, bankers could have conducted more prudently and more ethically as they have the fiduciary duty to act in the best interest of their clients. However, conflicts of interest arose because large bonus payments, averaging 180,420 USD per Wall Street banker in 2007, depended on revenue generated and supported highly leveraged but risky transactions (Dickler 2008). ‘Greed’ induced by shortterm oriented, volume-driven “perverse incentives” as well as the fact that bankers did not have to bear the consequences of their actions as they were not investing their own money have therefore been often cited by popular media but also by renowned economists as main reasons for the current mess (see for instance Stiglitz 2009a, Acharya and Richardson 2009 and Calomiris 2008).

According to the OECD, a me-too mentality emerged among investment banks for which “beating the key competition is the topic of every morning meeting at all levels” and leveraged transactions became part of the “growth at any cost mentality” (Blundell-Wignall et al. 2009, 10). ‘Jumping on the bandwagon’ became more profitable than leaning against the wave because working with high leverage means higher returns on equity, too. Even Stiglitz admits that “banks that didn’t engage in excessive leverage, and so had lower returns, were ‘punished’ by having their stock values beaten down” (2009a, 5). Nevertheless, it would be wrong to blame only bankers. Also U.S. home owners and conventional banks leveraged their equity even though they do not necessarily receive bonus payments or need to grow at any cost.

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