The Micro- and Macroeconomic Causes of the Financial Crisis

Inhalt

List of Abbreviations

1. Introduction

2. Microeconomic Causes of the Financial Crisis
2.1 Credit User Variable
2.2 Financial Intermediate Variable
2.3 Credit Derivative Variable
2.4 Rating Agency Variable

3. Macroeconomic Causes of the Financial Crisis
3.1 Regulator Variable
3.2 Monetary Policy Variable
3.2.1 Monetary Transmissions and the Monetary Policy Variable
3.2.2 International Financial System and the Monetary Policy Variable
3.2.3 Asset Inflation and the Monetary Policy Variable
3.3 Fiscal Policy Variable
3.4 Global Imbalances Variable

4. Safe Asset Imbalances versus Global Imbalances

5. Conclusion

Appendix

References

List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1. Introduction

The US subprime mortgage crisis that broke out in august 2007 was triggered by mortgage delinquencies in the US and has escalated into a global financial crisis.¹ Investor confidence sagged off, and Knightian uncertainty² emerged, consequently risk premia increased and liquidity was withdrawn from interbank and credit markets.³ This financial disturbance and the bankruptcies of some banks and near banks (e.g. insurance companies, hedge funds) triggered contagiously waves of violent collapses in the financial system. The current financial crisis is adjusting the global growth cycle that was still robust over the past few years, plunging the whole world into the greatest economic crisis since 1929/30.⁴ In the following the micro- and macroeconomic causes of this financial crisis will be outlined.

2. Microeconomic Causes of the Financial Crisis

2.1 Credit User Variable

The subprime bubble in the US and other parts of the world was fueled by historically low interest rates, initiated to soften the massive collapse of the dot.com bubble burst, and backed by poor lending standards and in particular a mania for purchasing houses which mirrors the credit user variable.⁵ Mortgage refinancing was applied by some credit user, which used the enlarged real estate value driven by the subprime bubble to refinance their real estates with lower interest rates, and took out additional mortgage against the added value to use the funds for consumption.⁶ Latter is one of the reasons why the USA has been one of the first countries in world history with negative saving rates, financed by foreign investors, e.g. China, Japan and oil and commodity producing Countries.⁷ During the early 21 century recession, which began in 2001 and was boosted by the September 11, 2001 terrorist attacks, the Americans were asked to invest, declaring “consumerism” as an act of patriotism.⁸ The one who linked shopping to patriotism was the former President Bill Clinton, promoting the phrase “get out and shop”.⁹ This slogan was based on the idea to stimulate future growth by encouraging consumption in the present. As well the credit card bubble reflects the credit user dilemma, choosing between present and future consumption. It is believed that a significant percentage of the baby boom generation is not saving adequately enough for their retirement. Typically the baby generation planned to use their increased real estate value as a piggy bank or replacement for a retirement-savings account. “It’s a change from previous generations when people worked to pay off the family house so they could hand it down to their children.”¹⁰ However, below the line consumers acted rationally considering the regulative and incentive market context cheering for and rewarding high consumption, financed by easy and cheap credit lines and backed by increasing property value.¹¹

2.2 Financial Intermediate Variable

Financial intermediates were able to generate loans and transfer the risk to others, a mayor incentive why lenders offered an increasing range of loans to credit users, which exposed a high credit default risk. Latter is known as originate and distribute model and was made possible, because of the securitization processes, investors who were seeking for mortgage-backed securities (MBS) and rating agencies that gave investments grade ratings to MBS.¹² The trend of disintermediation of financial intermediates caused a change from the pursued objective of interest rate towards provision gains.¹³ Indeed, market observes described that each link in the mortgage credit chain profited and tried to pass on the risk to the next link.¹⁴ Consequently mortgages standards became to high risky, and moral hazard augmented, due to the fact that the originate and distribute model diminished the screening and monitoring incentives of the originating banks. However, applying the prisoner’s dilemma it is important to state that every link along the credit chain acted in reference to the given information, regulation and incentive conditions ex-ante rational, despite the bubble burst, the resulted decline in property values and increasing volume of monthly outstanding payments, which left many lenders unable to recover losses, afterwards.¹⁵

2.3 Credit Derivative Variable

Model innovations in financial engineering originated credit derivative contracts in particular CDOs¹⁶ and CDSs which enabled to transform the classical credit intermediation process with its buy and hold strategy to credit securitization, transforming future cash flows into tradable securities backed by its own anticipated cash flows.¹⁷ The classical credit intermediation process can be stated as efficient because financial intermediaries had to audit the current and future solvency of debtors.¹⁸ Financial innovations like CDOs are adding significantly value by enhancing and controlling better asset liability management or portfolio management in general, by (1) transforming risk, term and size, (2) diversifying and (3) allocating credit positions to the respective risk exposure of investors. The result is a market for tradable CDOs tailored to the needs of investors.¹⁹ Disintermediation was not caused by credit derivatives but by financial agents that were focused on receiving provisions and boni by the given incentive schemes, profiting from the information and risk asymmetries during the credit risk allocation process. In relation to the given regulatory and incentive market conditions every part in this credit lending chain acted rationally.²⁰ Rational behavior gives not an excuse for moral hazards, but it shifts more the focus on macroeconomic causes like for example the easy-credit- lending policy since 2001 or the expansionary fiscal policies, both demand-sided economic policy instruments are anticipating future growth to maintain the present level of consumption.²¹ In contrast to that, supply-sided economic policy tackles regulation and incentive market conditions, e.g. the pricing of CDSs, which is based on a notional principal amount, which is estimated by the SEC to be USD 61 trillion or “over four times the publicly traded corporate and mortgage U.S. debt they are supposed to insure, are completely unregulated, and have often been contracted over the phone without documentation.”²² Under this given unregulated and in-transparent market conditions, moral hazard can augment without any constraints. Another major contributor to this adverse selection and mispricing of credit derivatives were the given incentive scheme, which fostered moral hazards or in other words a principal agent bias in reference to subjective judgment, verification and due diligence of the model inputs and ultimately questioning validity of applied pricing models et all.²³ Those pricing models contribute a decisive impact on financial markets nevertheless large forecasting errors of those models could be proven;²⁴ and sometime described as complete “useless”. However, despite uncertainty about this pricing models “blind faith in financial risk models” originated large profits for many financial institutions.²⁵ CDO investors accept as well uncertainties, because MBSs were widely hedged against losses from default by insurers like AIG via CDSs.²⁶ “As a result of such blurring of risks to final investors, many mortgages were made with no money down and no proof of income.”²⁷ This information and risk-asymmetries mirrors the rationality trap of CDO brokers to either sell CDOs to investors worldwide and cash in boni by increased provisions income or re-price and dismantle CDOs as non­investment grade products which ultimately reduced provision income and boni payments. Indeed selling overpriced CDOs is on the one hand, despite the moral hazard, an individual rational behavior, because it maximizes the payoff of the CDO Broker, but diverges heavily with a pareto-optimum criterion within an economy. This Principal Agent bias causes adverse selection and by this mispricing of credit derivatives, which set up a large leverage, linkages of interconnected obligations, system risk exposure and in the end the fragility of the financial system, which triggered after the subprime bubble burst a mayor system instability worldwide.²⁸

2.4 Rating Agency Variable

How could subprime mortgages become such an attractive investment? In General investors in debt securities look only at the credit ratings provided by a few rating agencies such as Moody’s and Standard & Poors (S&P), which evaluate credit default risk largely using only quantitative models.²⁹ Those models, which use complex statistics to uncover past relationships between debt defaults and statistical parameters, can ignore very important factors and probabilities, like for example interest rate spikes in reference to a changing macroeconomic development.³⁰ BBB rated mezzanine tranches³¹ of Mortgage Backed Securities (MBS) referencing to subprime mortgages for example were difficult to sell and were repackaged with other similar mezzanine tranches and turned into high grade AAA rated senior debt tranches (this is known as a MBS CDOs). The AAA rating for the senior tranche of the MBS CDOs are more and more reasonable if the losses experienced by different mezzanine tranches show lower correlations among each other.³² Valuing correlation parameters between mezzanine tranches to low or ignoring parameters means (1) that in case of credit default all mezzanine tranches are likely to experience a high loss rate at the same time, and (2) implements an overvaluation and hence misallocation of CDOs by Rating-Agencies ratings.³³ After the subprime bubble burst the big rating agencies are now meeting criticism for giving investment grade ratings to securitizations transactions. The underlying indigenous quantitative models, which incorporated significant diversification effects, underestimated the credit risk and by that mispriced value CDOs. As a matter of fact this models are focused on c.p. parameters like a stable growing underlying property value and low interest rates. By the experience of the last two financial crises 2001 and 2007 one can state that this concentrated confidence in rating agency effectiveness is not justified. This has three structural reasons: (1) The excessive demand by financial innovations like CDOs, (2) macroeconomic blindness to value systematic credit risk, and following critics, (3) structural conflicts of interest were involved which mirrors a similar rational trap which was already described as moral hazard.³⁴ In the end all market participants, the credit user or consumer variable, the financial intermediate variable and as to some degree the rating agency variable show clear patterns of high liability to moral hazard behavior sustaining the mispricing of credit derivatives and by that ultimately the instability of the financial system.

3. Macroeconomic Causes of the Financial Crisis

The microeconomic variables contributed to the trigger³⁵ to the financial crisis in 07/08 but all parts along the credit lending chain acted in reference to the given regulations, incentive, structural context, the subprime bubble formation and the macroeconomic policy in general completely rational. Hence to criticize effectively one has to focus in particular on the macroeconomic variables as causes of the crisis.

3.1 Regulator Variable

It is argued that the subprime bubble burst was neither caused primarily by credit derivatives nor by the other microeconomic variables, which were focused to accomplish their provisions and incentive schemes and profiting from the given information- and risk-asymmetries during the credit risk allocation process. It is important to make clear that in relation to the given regulatory and incentive market conditions every part in the credit lending chain acted completely rational. Credit user were motivated to consume more as they could effort, mortgage brokers were motivated by loan origination provision, credit lenders by loan distribution provisions, rating agencies by loan rating provisions, which all together maximized the volume of issued mortgages because they were finally to be owned by other investors who took positions in them through plain CDSs or other credit derivatives.³⁶ However latter gives not an excuse for moral hazard triggering the subprime crisis 2007, the financial crisis and by that the world economy crisis 2008, but it shifts more the focus on regularity and incentive market conditions as decisive pathological cause and major systemic responsibility holder.³⁷ Under this given unregulated and in-transparent market condition, mispricing of credit derivatives can be considered as the consequence of ineffective economic system policy, in particular banking and supervision regulation like for example Basel II.

3.2 Monetary Policy Variable

The monetary policy is an important variable, which largely contributed to the financial crisis and is highly linked with other variables such as the fiscal and in particular the global imbalances variable, because banks and central banks are crucial in a functioning international economic system.

3.2.1 Monetary Transmissions and the Monetary Policy Variable

Both, banks and central banks, require sufficient assets in form of bank capital to absorb losses, collateral to back loans of enterprises and adequate levels of interest rates to compensate for the stressing of bank capital in this process.³⁸ The availability of unimpaired property assets determines the creation of excess of money inducing a recent phenomenon called asset inflation.³⁹ Thus interest rates set too low cause (1) severe imbalances and a mismatch of nominal and real values, but also a (2) certain changes in market behavior. For example the credit user variable and the financial intermediary variable are confronted with cheap credit conditions and hence a strong incentive for the credit user extend both mortgage and credit debt and consumer spending and for financial intermediaries to increase lending and facilitate lending conditions.⁴⁰ A second important effect of low interest rates is that present values of assets enlarges which originates in particular a large incentive for the financial intermediary variable to take higher risks in order to obtain higher yields to compensate reduced returns in plain-vanilla fixed income instruments. In addition assets are increasing in its value when interest rates are low because low interest rates change risk valuation models.⁴¹ A third effect of low interest rates is that short term credits contracts give an incentive to scale up the leverage ratio.⁴² In the end both transmission effects of global excess liquidity, caused by expansionary monetary policy, (2) market behavior change and (1) availability of unimpaired property assets were mutually enforcing asset price inflation and the subprime bubble formation.⁴³

3.2.2 International Financial System and the Monetary Policy Variable

The expansionary monetary and fiscal policy contributed to sustain US domestic consumption after the peak of the new economy boom and extending the US external imbalance and compensated by oppositely growing imbalances of mayor emerging economies in particular China. “Low interest rates triggered a search for yield which, by squeezing risk premiums, tended to make financial conditions even more favorable for a broad range of borrowers.

[...]

¹ De Cock (2009).

² Knightian uncertainty, named after the economist Frank Knight, refers to special market situation within risk is unmeasurable. In reference to the crisis Knightian uncertainty emerged as markt participants realized the complexity of securitization products. See Caballero (2009).

³ Cassola (2008); Fagan (2008); Brunnermeier (2009); Caballero (2008).

⁴ Bernanke (2009); Lux (2009). See in Appendix I evolution of a robust cycle in equity prices.

⁵ Murthy and Deb (2008); Sachverstandigenrat (2008), p. 124.

⁶ Brady, Canner, and Maki (2008).

⁷ Steindel (2007).

⁸ Schumann (2008).

⁹ Reginer Pat (2007).

¹⁰ Hoak (2007).

¹¹ Ludger (2009); Akerlof (1970); Fromlet (2001).

¹² Brunnermeier (2009).

¹³ Hurt (2007).

¹⁴ Haldane (2009), p.7; Duarte, Siegel and Young (2009), p.11.

¹⁵ Dymski (2007), p.14; Ludger (2009).

¹⁶ Collateralized Debt Obligation (CDO) is a type of Asset Backed Securities (ABS). The creator of CDOs acquires first a credit portfolio (ABS). These are passed on to an Special Purpose Vehicle. also known as a trust or a conduit, which passes the income generated from mortgages, already securitized securities, automotive credit, loans on credit cards, etc., to a series of tranches. See Hull (2007).

¹⁷ Hull (2009), p.537/538; Purnanandam (2009), p. 2.

¹⁸ Franke and Krahnen (2008), p. 13.

¹⁹ Reid (2008), p. 2.

²⁰ Ludger (2009); Akerlof (1970); Fromlet (2001).

²¹ Mankiw (2004).

²² Murphy (2008).

²³ Glantz and Mun (2008).

²⁴ Rajun, Sera, and Vig (2008).

²⁵ Morgenson (2008).

²⁶ Morgenson (2008); Brunnermeier (2009).

²⁷ Murphy (2008).

²⁸ Jameson (2008); Murphy (2008).

²⁹ Rajun, Sera, and Vig (2008); Murphy (2008).

³⁰ Murphy (2008).

³¹ The income is first used to provide the promised return to the most senior tranche, then to the mezzanine tranche and then to the equity tranche. The ABS mezzanine tranche however is repackaged with other similar mezzanine tranches to form the ABS CDO. The liability structure reflects a cascade starting with the equity tranche. ”See Hull (2007).

³² Brunnermeier (2009); Glen Arnold (2007); Hull (2007), p.538/529. Gunnar Heinsohn (2008).

³³ “Assets rated AAA/AA carry under normal circumstances a very low risk and are therefore attractive assets for pension funds, commercial banks and specially vehicles like conduits and Structured Investment Vehicles (SIVs).” Gunnar Heinsohn (2008).

³⁴ Huffschmid (2008); Ludger (2009).

³⁵ The trigger for the financial crisis was mortgage delinquencies in the US by which house prices dwindled and collaterals of MBS and other complex products diminished. See Brunnermeier (2009).

³⁶ Buchanan (2008).

³⁷ Greenwald and Stiglitz (1996), p.11.

³⁸ Bruni (January 2009), p.4; Dunaway (2009), p.29.

³⁹ Heinsohn, Decker and Heinsohn (2008), p.2/3

⁴⁰ The dramatic fall in US households’ saving rate, from around 7 percent in the early 1990s to close to zero in 2005-2007. See Visco (2009); Bank of International Settlement (2009a); Sachverstandigenrat (2008), p. 124.

⁴¹ Bank for International Settlements (2009b), p.42-45.

⁴² Sachverstandigenrat (2007a), p.97/98; See also figure in Appendix II.

⁴³ Bruni (January 2009), p.4; Dunaway (2009), p.29.