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FINANCIAL & ECONOMIC SITUATION
Where We Have BeenWhere We Are
Where We Are Going
Key Questions How did the current econ/financial
situation arise? What are causes and what are effects?
What are the unfolding of events v. root causes? What are the roles of the public sector and
private sector? What impact of financial innovation, MTM
accounting, foreign investment, …? How does the current financial/econ
situation stack up against past episodes? What indications of where we may be
headed are given by past episodes?
Financial/Econ Crisis in a Picture
U.S. Debt Growth
1.0
1.5
2.0
2.5
3.0
3.5
4.0
0
10000
20000
30000
40000
50000
60000
20 30 40 50 60 70 80 90 00
U.S. Debt -- right scale
Debt/GDP - left scale
European Data
1.1
1.2
1.3
1.4
1.5
1.6
1.7
6000
8000
10000
12000
14000
16000
18000
97 98 99 00 01 02 03 04 05 06 07 08 09
"Domestic Credit"
Credit/GDP
Euro Area "Domestic Credit"
Debt Growth by Sector
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
50 55 60 65 70 75 80 85 90 95 00 05
Total Debt/GDP
Non-house-govt/gdp
House-debt/gdp
Govt Debt/gdp
Magnitude of Recent Debt Growth?
2.6
2.8
3.0
3.2
3.4
3.6
3.8
00 01 02 03 04 05 06 07 08
Actual Debt/GDP
Forecast Debt/GDP(Based on 1980-99, AR(4) Model)
Income & Debt Constraints
Infinite Horizon Economy Budget Constraint:
Income + Debt = Debt Service + Consumption
No Ponzi Scheme (Transversality) Constraint:
PV of debt converges to zero Income (not debt) funds consumption over long run
How Much is Too Much?Debt-Income Ratios in Simulations
Steady State Debt-Income Ratio
Income Growth - Interest Rate for PV (Y-C-rb)>=0
3.5 0.60%3 -0.40%
2.5 -1.80%Assumptions: 75-year Horizon
APC = 0.80 (NIPA est.)
Variable Actual Post WWII Values Income Growth - Interest RateIncome Growth 6.70%10-year Treasury 6.45% 0.25%
AAA Bond 6.75% -0.50%BBB Bond 7.67% -1.00%
Causes of Debt/GDP Expansion?
Cheap Credit
Prime AAA BBB Fed Funds ComPaper0
1
2
3
4
5
6
7
8
9
1990-992003-07:7
Cheap Credit: Fed’s Role?Monetary Aggregates
-4
0
4
8
12
16
95 96 97 98 99 00 01 02 03 04 05 06 07 08
M2 Percent Changes (9/11 at average)
-8
-4
0
4
8
12
16
20
95 96 97 98 99 00 01 02 03 04 05 06 07 08
M-Base % Changes (Y2k & 9-11 at average)
Inflation Rates From 1982
-8
-4
0
4
8
12
16
20
82 84 86 88 90 92 94 96 98 00 02 04 06 08
Inflation Rate & Smoothed (HP Filter)
Inflation Statistics: 1982-2001, 1990-97, 1998-05, 2002-05
0
4
8
12
16
20
0 2 4 6 8 10
Series: INFLSample 1990M01 1997M12Observations 96
Mean 3.101818Median 2.636830Maximum 11.40143Minimum 0.000000Std. Dev. 1.947708Skewness 1.629926Kurtosis 7.161351
Jarque-Bera 111.7739Probability 0.000000
0
4
8
12
16
20
24
-5 0 5 10 15
Series: INFLSample 1998M01 2005M12Observations 96
Mean 2.542697Median 2.167596Maximum 15.90214Minimum -5.421687Std. Dev. 2.946918Skewness 0.765576Kurtosis 6.648730
Jarque-Bera 62.63063Probability 0.000000
0
10
20
30
40
50
60
70
-5 0 5 10
Series: INFLSample 1982M01 2001M12Observations 240
Mean 3.176899Median 3.048124Maximum 13.76434Minimum -6.563355Std. Dev. 2.439902Skewness 0.313226Kurtosis 6.120650
Jarque-Bera 101.3090Probability 0.000000
0
2
4
6
8
10
-5 0 5 10 15
Series: INFLSample 2002M01 2005M12Observations 48
Mean 2.779565Median 2.552644Maximum 15.90214Minimum -5.421687Std. Dev. 3.372371Skewness 0.797570Kurtosis 6.850455
Jarque-Bera 34.74095Probability 0.000000
Cheap Credit: Public Sector Supply-Side
1000
2000
3000
4000
5000
6000
7000
8000
9000
90 92 94 96 98 00 02 04 06 08
GSE Assets + Govt-MBS(in Billions $)
Cheap Credit: Expansion/Term Reduction in Markets (e.g. Commercial
Paper)
Cheap Credit: Increasing Leverage
Cheap Credit: Innovations Risk-Influencing Innovations
Securitization, e.g. CDOs – risk pooling Derivatives (“Insurance”), e.g. CDS – risk
transfer Key Issues/Questions:
Aggregate Risk not influenced by pooling/transfer
Miscalculation of expected flows Probability of Event x Size of Event
How big of an influence on credit growth/crisis?
Securitization & Credit Growth
Global CDO New Issuance (in billions $)
U.S. Mortgage market increased by $7T from 2000-2008
U.S. & Euro Area Debt increased by $35T from 2000-2008
2004 2005 2006 2007 2004-09$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
$1,600
Series1
Credit Market “Insurance” Reported Values of CDS Growth Enormous
“Notional Values” = $2T (2003), $34T (2007), $60T (2008) Key Questions:
What are the real notional values after “netting”? What are the cash flow implications of these values?
Actual v. reported notional values & cash flow implications example:
Lehman Failure: estimated $400B in CDS protection Bond “Recovery Rate” only 8% -- implied CDS liability = $380B Roubini’s Group (RGE) Estimates Cash Flow impact of $270B after
netting October 21, 2008: $6B in actual cash settlements (1.5%) Note: Expected value of “protection” in Lehman Model = 2% of
notional value
In the end, not clear that the cash flow implications of these innovations have been that great
Foreign Capital & U.S. Debt
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
.000
.004
.008
.012
.016
.020
.024
.028
.032
50 55 60 65 70 75 80 85 90 95 00 05
CAPINYHP DEBTY
Foreign Capital Inflow/GDP
Debt/GDP
Capital Inflows (Smoothed) and Debt Growth
Role of Foreign Capital?
-.01
.00
.01
.02
.03
.04
.05
.06
97 98 99 00 01 02 03 04 05 06 07 08 09
U.S.
Euro Area
Capital Inflows Relative to GDP
Role of Marked-to-Market Accounting?
How big of an effect is possible from MTM pricing of banks?
See SEC Dec. 2008 Study www.sec.gov/news/studies/2008/marktomarket123008.pdf
31% of bank assets MTM 22% of these impact income statement Part of this amount in Treasuries
Differences in MTM and “amortized cost” If 20% difference, then 4.4% impact on
income Currently, using “amortized cost” method
Citi assets increase by apx. $3B (out of $1.2T) BoA assets increase by apx. $9B (out of $1.4T)
Where Are We Now?U.S. Stock Crashes Since 1907
Time Frame DJIA Change (Real) Length
1907-08 -40% 13 months
1919-20 -46% 15 months
1929-33 -83% 43 months
1937-38 -49% 15 months
1946-48 -35% 21 months
1973-75 -51% 25 months
1978-82 -37% 48 months
1987-88 -28% 5 months
2000-01 -18% 16 months
2007- -53% 16 months…
Stock Crash Similarities (16 months in)
Correlations in 6-month Cumulative Sum of Monthly Changes in DJIA1907 1919 1929 1937 1973 1978 1987 2000 2007
1907 1.00 0.15 -0.20 0.89 0.08 -0.16 -0.13 0.13 -0.331919 0.15 1.00 0.07 0.17 0.07 -0.48 -0.34 0.16 0.431929 -0.20 0.07 1.00 -0.46 0.40 0.47 0.14 0.36 0.571937 0.89 0.17 -0.46 1.00 -0.26 -0.39 -0.34 -0.14 -0.331973 0.08 0.07 0.40 -0.26 1.00 0.23 0.33 0.33 0.121978 -0.16 -0.48 0.47 -0.39 0.23 1.00 0.56 0.65 -0.101987 -0.13 -0.34 0.14 -0.34 0.33 0.56 1.00 0.24 -0.532000 0.13 0.16 0.36 -0.14 0.33 0.65 0.24 1.00 0.052007 -0.33 0.43 0.57 -0.33 0.12 -0.10 -0.53 0.05 1.00
How Much Like the 1930s?
-50
-40
-30
-20
-10
0
10
20
2 4 6 8 10 12 14 16
Early 30s
Current
Month from Beginning of Downturn
Cumuluative Percent Change in DJI over Prior 6 Months
Stock Crashes & Real Effects
Time Frame DJIA Change (Real) Length BBB-AAA Peak GDP Change (Real) %ΔDIJA/%ΔGDP
1907-08 -40% 13 months NA -5% 8
1919-20 -46% 15 months 2.25%* -23% 2
1929-33 -83% 43 months 5.60% -29% 3
1937-38 -49% 15 months 3.10% -7% 7
1946-48 -35% 21 months < 1% -5% 7
1973-75 -51% 25 months 2.00% -5% 10
1978-82 -37% 48 months 2.60% -7% 5
1987-88 -28% 5 months 1.20% >0% NA
2000-01 -18% 16 months 0.80% -1% 18
2007- -53% 16 months… 3.50% ? ?
*NBER Series -- Highest Grade v. Lowest Grade Corp. Bond
GDP What Ifs (From 2007 peak of $11.5T GDP (in 2000$) and U of 4.7%
Decline in Real GDP Real GDP Year Equivalent Unemployment @2% Rate5% $10.9T 2005 7.2%
10% $10.3T 2003 9.70%15% $9.7T 1999 12%20% $9.2T 1998 14.70%30% $8.1T 1994 19.70%