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Narrative: From the East AsianFinancial Crisis of 1997-1998 tothe Credit Crisis of 2007-2009

J. Bradford DeLong

University of California at Berkeley and NBERbrad.delong@gmail.com

http://delong.typepad.com/+1 925 708 0467

April 28, 2009-May 5, 2009

April 28:

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• If g is greater than or equal to r bubbles are not just “rational” andpossible—they are required.

• If r > g than prices must be equal to fundamentals—if we identify“expectation” with orthogonal projection.

• So we must find some way to drive r less than g—dynamically-inefficient economy.

• Or deprive “rational” investors of capital.• For we do see things we pretty much have to call “bubbles”—both

the most recent one in the real estate market, but also and morefrequently in the bond and stock markets as well.

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• Short look-backs.• Adopting recently-successful portfolio strategies.• An initial displacement.• And it is easy to generate bubbles and manias and overshooting.• Panics and crashes are harder to generate.

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Let us change gears now and look back at the last big financial crisis—theEast Asian crisis of 1997-1998:

From Morris Goldstein:

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- In the first period investors bid for land, setting itsprice.

- In the second period they receive rents, which areuncertain at the time of bidding.

- Suppose that the rent on a unit of land could beeither 25, with a probability of 2/3, or 100, with aprobability of 1/3.

- Risk-neutral investors would then be willing tospend (2/3)25 + (1/3)100 = 50 for the rights to thatland.

- But now suppose that there are financialintermediaries… able to borrow at the worldinterest rate… the Pangloss value: 100.

What if this regime may not last?- Liabilities carried over from period 2 to period 3

might not be guaranteed.- The price of land will reflect only its expected return

of 50.- On the other hand, if intermediaries are guaranteed,

the price will still be 100…

What about the price of land in the first period?- Investors now face two sources of uncertainty:

o they do not know whether the rent in thesecond period will be high or low,

o they do not know whether the price of landin the second period will reflected expectedvalues or Pangloss values.

Propose that creditors of financial intermediaries will bebailed out precisely once…

- Suppose that in period 2 rents are disappointing - 25,not 100.

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- A less-than-Panglossian rent in period 2 means thatcreditors of intermediaries need to be bailed out inthat period,

- Future creditors can no longer expect a bailout.- So the intermediaries collapse, and the price of land

drops from 100 to the expected rent 50.- Magnification effect. The "real" news about the

economy is that rents in period 2 were 25, not thehoped-for 100. But land bought for 200 will nowyield only 25 in rents plus 50 in resale value, a lossof 125 rather than merely 75.

- The magnification effect is caused, of course, by thecircular logic of disintermediation: the prospectiveend to intermediation, driven by the losses of theexisting institutions, reduces asset prices andtherefore magnifies those losses.

- Multiple equilibria.- Second period rent of 100.- Land price at the end of the second period will also

be 100 if guarantee is credible.- In that case no bailout will be needed; and so the

government guarantee for intermediation will in factcontinue.

- But suppose that despite the high rents in the secondperiod potential creditors become convinced thatthere will be no guarantee: Then price of land in thesecond period will be only 50.

- That means that intermediaries that borrowed moneyin the first period based on Pangloss require abailout--and since the government's willingness toprovide for bailouts is now exhausted, investors'pessimism is justified.

- Plunging asset prices undermine banks, and thecollapse of the banks in turn ratifies the drop inasset prices.

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The East Asian crises seemed baffling because of: 

• The absence of the usual sources of currency stress, whether in theform of fiscal deficits or macroeconomic difficulties;

• The pronounced boom-bust cycle in asset prices prior to thecurrency crisis;

• The severity of the crisis given a lack of strong adverse shocks,and the spread of the initial crisis to countries that seemed to havefew economic links with the initial victims.

We now have an admittedly primitive but still illuminating way to makesense of these paradoxes. The reason that traditional measures ofvulnerability did not signal a crisis is that the problem was off thegovernment's balance sheet: the underlying policy mistake was, like theguarantees that created the S&L fiasco, not part of the government'svisible liabilities until after the fact. The boom-bust cycle created byfinancial excess preceded the currency crises because the financial crisiswas the real driver of the whole process, with the currency fluctuationsmore a symptom than a cause. And the ability of the crisis to spreadwithout big exogenous shocks or strong economic linkages can beexplained by the fact that the afflicted Asian economies were in a sort of"metastable" state in any case - highly vulnerable to self-fulfillingpessimism, which could and did generate a downward spiral of assetdeflation and disintermediation.

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Lessons not drawn from the East Asian financial crisis…

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April 30:

Now let’s go on to the present, a decade later…

Martin Baily, Robert Litan and Matthew Johnson (2008), "The Origins ofthe Financial Crisis"Claudio Borio (2008), "The Financial Turmoil of 2007-?"Markus Brunnermeier (2009), "Deciphering the Liquidity and CreditCrunch 2007-2008," Journal of Economic Perspectives

Brunnermeier:

• The shift to “originate and distribute” banking…• Regulatory and ratings arbitrage…• Housing boom• February 2007 increase in subprime mortgage defaults• On May 4, 2007, UBS shut down its internal hedge fund, Dillon• Read, after suffering about $125 million of subprime-related losses• Late May: Moody’s put 62 tranches across 21 U.S. subprime deals

on “downgrade review• Rating downgrades of other tranches by Moody’s, Standard &

Poor’s, and Fitch unnerved the credit markets in June and July2007.

• Mid-June: two hedge funds run by Bear Stearns had troublemeeting margin calls, leading Bear Stearns to inject $3.2 billion inorder to protect its reputation.

• Countrywide Financial Corp. earnings drop on July 24.• July 2007: market for short-term asset-backed commercial paper

began to dry up.• July 2007: IKB, a small German bank, unable to roll over asset-

backed commercial paper. A €3.5 billion rescue packageinvolving public and private banks was announced.

• July 31: American Home Mortgage Investment Corp. announcedits inability to fund lending obligations: declared bankruptcy onAugust 6.

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• August 9, 2007, BNP Paribas froze redemptions for threeinvestment funds.

Each ABX index is based on a basket of 20 credit default swapsreferencing asset-backed securities containing subprime mortgages ofdifferent ratings. An investor seeking to insure against the default of theunderlying securities pays a periodic fee (spread) which—at initiation ofthe series—is set to guarantee an index price of 100. This is the reasonwhy the ABX 7-1 series, initiated in January 2007, starts at a price of 100.In addition, when purchasing the default insurance after initiation, theprotection buyer has to pay an upfront fee of (100 – ABX price). As theprice of the ABX drops, the upfront fee rises and previous sellers of creditdefault swaps suffer losses.

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An interest rate spread measures the difference in interest rates betweentwo bonds of different risk. These credit spreads had shrunk to historicallylow levels during the “liquidity bubble” but they began to surge upward inthe summer of 2007. Historically, many market observers focused on theTED spread, the difference between the risky LIBOR rate and the risk-freeU.S. Treasury bill rate. In times of uncertainty, banks charge higherinterest for unsecured loans, which increases the LIBOR rate. Further,banks want to get first-rate collateral, which makes holding Treasurybonds more attractive and pushes down the Treasury bond rate. For bothreasons, the TED spread widens in times of crises. The TED spreadprovides a useful basis for gauging the severity of the current liquiditycrisis.

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• August 1–9, 2007, many quantitative hedge funds, which usetrading strategies based on statistical models, suffered large losses,triggering margin calls and fire sales. Crowded trades caused highcorrelation across quant trading strategies (for details, seeBrunnermeier, 2008a; Khandani and Lo, 2007).

• The first “illiquidity wave” on the interbank market started onAugust 9. At that time, the perceived default and liquidity risks ofbanks rose significantly, driving up the LIBOR.

• In response to the freezing up of the interbank market on August 9,the European Central Bank injected €95 billion in overnight creditinto the interbank market.

• The U.S. Federal Reserve followed suit, injecting $24 billion.• To alleviate the liquidity crunch, the Federal Reserve reduced the

discount rate by half a percentage point to 5.75 percent on August

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17, 2007, broadened the type of collateral that banks could post,and lengthened the lending horizon to 30 days.

• September 18, the Fed lowered the federal funds rate by half apercentage point (50 basis points) to 4.75 percent.

• The U.K. bank Northern Rock was subsequently unable to financeits operations through the interbank market and received atemporary liquidity support facility from the Bank of England.

• October 2007 was characterized by a series of write-downs. For atime, major international banks seemed to have cleaned theirbooks. The Fed’s liquidity injections appeared effective. Also,various sovereign wealth funds invested a total of more than $38billion in equity from November 2007 until mid-January 2008 inmajor U.S. banks (IMF, 2008).

• Matters worsened again starting in November 2007 when itbecame clear that an earlier estimate of the total loss in themortgage markets, around $200 billion, had to be revised upward.

• The TED spread widened again as the LIBOR peaked in mid-December of 2007. This change convinced the Fed to cut thefederal funds rate by 0.25 percentage point on December 11, 2007.

• On December 12, 2007, the Fed announced the creation of theTerm Auction Facility (TAF), through which commercial bankscould bid anonymously for 28-day loans against a broad set ofcollateral, including various mortgage-backed securities.

• Monoline insurers focused completely on one product, insuringmunicipal bonds against default (in order to guarantee a AAA-rating). More recently, however, the thinly capitalized monolineinsurers had also extended guarantees to mortgage backedsecurities and other structured finance products.

• This change would have led to a loss of AAA-insurance forhundreds of municipal bonds, corporate bonds, and structuredproducts, resulting in a sweeping rating downgrade across financialinstruments with a face value of $2.4 trillion and a subsequentsevere sell-off of these securities.

• On January 19, 2008, the rating agency Fitch downgraded one ofthe monoline insurers, Ambac, unnerving worldwide financialmarkets. Emerging markets in Asia lost about 15 percent, and

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Japanese and European markets were down around 5 percent. DowJones and Nasdaq futures were down 5 to 6 percent

• Given this environment, the Fed decided to cut the federal fundsrate by 0.75 percentage point to 3.5 percent—the Fed’s first“emergency cut” since 1982. At its regular meeting on January 30,the Federal Open Market Committee cut the federal funds rateanother 0.5 percentage point.

• Collapse of Bear Stearns:150 million trades spread across variouscounterparties. It was therefore considered “too interconnected.”Officials from the Federal Reserve Bank of New York helpedbroker a deal, through which JPMorgan Chase would acquire BearStearns for $236 million, or $2 per share (ultimately increased to$10 per share). By comparison, Bear Stearns’s shares had traded ataround $150 less than a year before. The New York Fed alsoagreed to grant a $30 billion loan to JPMorgan Chase.

• On Sunday night, the Fed cut the discount rate from 3.5 percent to3.25 percent and for the first time opened the discount window toinvestment banks, via the new Primary Dealer Credit Facility(PDCF), an overnight funding facility for investment banks.

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May 5:

• Fannie Mae and Freddie Mac: July 2008-September 2008• The Witching Hour:

• AIG• Merrill Lynch• Lehman Brothers

• The collapse of Lehman: why?

• In the aftermath of Lehman…• The end of financial-real “decoupling”• More Fed vehicles• The TARP• The Stimulus• The new administration• The “stress tests

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• The bonuses• The Republicans• The Europeans• Fear of deflation/inflation• Thinking about the tails…

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Chicago: Robert Lucas:

[T]hr additional reserves the Fed has put into the systemhave induced double-digit growth in M1 and M2 domainmonetary aggregates… rates which… if they weresustained would soon yield inflation at 1970s levels orhigher…. [A]s confidence returns, which it will, velocity isgoing to return to pre-crisis levels and people are going tostart spending more out of their cash balances.  So… thattoo is going to add to the inflationary pressures…. [I]t'sabsolutely necessary for the Fed to be able and willing toreverse course and sell off the assets its acquired over theseyears…. [I]t’ssomething you might as well think about it,because we're going to get there.  

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There's nothing technically hard about unwinding these Fedpositions fast…. But, it's going to take political courage, orsome kind of consensus….  I don't think it's an argumentagainst the policy that's being followed, and I hope whenthe crunch comes we'll do the right thing, but it's aconcern….

[W]ould a fiscal stimulus somehow… add another weaponthat would help…. I just don't see [how]...  If thegovernment builds a bridge, and then the Fed prints upsome money to pay the bridge builders, that's just amonetary policy….  We can print up the same amount ofmoney and buy anything with it…. [T]here are… differentways of getting the cash out there.  Maybe some of thethings Bernanke's doing right now to get the cash out thereare properly called fiscal policy….But if we do build thebridge by taking tax money away from somebody else, andusing that to pay the bridge builder… then it's just awash… there's nothing to apply a multiplier to.  (Laughs.) You apply a multiplier to the bridge builders, then you'vegot to apply the same multiplier with a minus sign to thepeople you taxed to build the bridge.  And taxing them laterisn't going to help, we know that….

[T]his monetary response that we're in the middle of… is aresponse to the lessons of the 1930s…. I think the currentpolicy we're doing is the right one, and I just hope that wehave the nerve to terminate it when it's done its job….

The Moody's model that Christina Romer -- here's what Ithink happened.  It's her first day on the job and somebodysays, you've got to come up with a solution to this -- indefense of this fiscal stimulus, which no one told her whatit was going to be, and have it by Monday morning.  

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So she scrambled and came up with these multipliers andnow they're kind of -- I don't know.  So I don't think anyonereally believes.  These models have never been discussed ordebated in a way that that say -- Ellen McGrattan wastalking about the way economists use models this morning. These are kind of schlock economics.  

Maybe there is some multiplier out there that we couldmeasure well but that's not what that paper does.  I think it'sa very naked rationalization for policies that were already,you know, decided on for other reasons.  I don't -- I'd liketo talk about the Lucas critique but I don't -- I don't thinkwe can -- (chuckles) -- deal with that issue….

The zero interest rate thing is -- there no -- look whatBernanke's done already.  After interest rates hit zero he'sputt $1 trillion-plus into the economy.  So no one's evergoing to -- whatever happens in this -- whatever Ben's does-- done for us he's completely removed this zero interestbound as something we have to think of as a limit on whatmonetary policy can do.  

I think if you had to do something -- I mean, you're sayinga slump is probably a pretty good time to build stuff withgovernment programs.  I mean, the construction industry isslumping, wages aren't going to be going up fast, so wecould take advantage of that and build some roads.  That'strue in the private sector too.  It's a great time to buy a newcar.  I mean, it's a great time to do a lot of things.  Butpeople aren't -- so I think these incentives are not -- they'rea force that's going to bring a private response.  You'redescribing if the interest structure thing is analogous to a --I agree with that.  

I certainly don't think, you know, it would be a bad idea tobuild some new bridges.  But that's got to be justified not

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on stimulus or multipliers, just on the fact that we'd likebetter bridges and we're willing to pay for it if we are. Now, right now maybe is not -- I don't think thegovernment's exactly flush but, you know, I think those arethe issues to talk about and I certainly don't think --obviously, the role for government in providinginfrastructure is really central to the whole process….

I avoided this bank bailout issue in my 15 minutes andthere's a reason for it.  I don't really get it.  Some of theproblems you're talking about about deciding who gets paidand who doesn't, that's the whole function of bankruptcylaw is to deal with that in an effective way.  Now, it may bethat the kind of neighborhood effects of the bankrupt banksare sufficiently different from the neighborhood effects of abankrupt auto company -- that they need some kind ofspecial treatment.  

But then it seems like the right public policy is somethingthat -- maybe some kind of accelerated bankruptcyproceedings.  Just to say make them well on all the moneythey've lost over this thing, I just -- I do not get it and Iknow of -- I don't know whether we're headed that way ornot.  I hope not.  Now, what was the first part of that?  (Offmike exchange.)  Oh, the differences with -- I did want tosay something.  

I think Friedman and Schwartz have got a lot to tell usabout the current situation.  There's certainly plenty ofdifferences between the '29 to '33 period and the presentperiod besides magnitude, the whole role of who providesliquidity which was then more or less completely confinedto cash and commercial bank deposits as, you know, partlybecause of the '70s inflation spilled out into the shadowbanking system, which is, you know, unregulated and

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which the Fed has no special responsibility for.  And sothere's been a lot of improvising in that dimension.

I said I was going to not deal with moral hazard.  This isnot the right time to worry about too big to fail, you know? What I'd say now is the failure of the bank is going to causespill over effects that deepen this recession and so on, it'snow -- keep them alive.  We're going to come out of thiswith a new regulatory structure, a new set of incentives andwe're going to have to kind of start from scratch anyway. So in terms of you bailing out a bank and setting upincentives for the next 30 years for bank behavior, that's notwhat's going on right now I don't think…