INTERNATIONAL LENDING AND THE GREAT RECESSION The recent financial crisis shares some similarities with past crises, but is

INTERNATIONAL LENDING AND THE GREAT RECESSION The recent financial crisis shares some similarities with past crises, but is

also different in some ways. The recent crisis, starting in the end of 2007, has been called the Great Recession, because of its sharp effect on output across the world. Economists are still debating the causes of the crisis, but some general observations can be made. The Great Recession was caused by an overexpansion of credit and a lack of transparency into the riskiness of the investments. This is similar to the Asian financial crisis. However,

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ly 2006 y 2008 il 2009 y 2011 uar n

ugust 2005 Ju June 2007 Ma Apr uar ve

A Ja March 2010 October 1992

ebr F September 1993

A March 1999

December 1990 No

Figure 11.2 House prices in selected cities in the U.S. Source: Standard and Poors’ Shiller-Case Home Price Index, February, 2012.

Systemic risk is the possibility that an event, such as a failure of a single firm, could have a serious effect on the entire economy.

The beginning of the crisis occurred in the housing sectors in five states in the U.S., namely: Arizona, California, Florida, Nevada and Virginia. The housing market crash in these five states caused financial markets across the world to momentarily break down. How could the housing market in a few states cause such a big effect? The answer lies in the way mortgage lending has become an international market. Figure 11.2 shows the home prices in two big U.S. cities. These two cities are typical for the price behavior in the five states, experiencing the housing market crash. Figure 11.2 shows how from 2001 2006 home prices rapidly increased, and then in 2007 the prices fell back down even faster. Note that, in particular, in 2004 2006 the prices in both cities show a remarkable rise.

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2006 2007 2008 2009 2010 2011 Figure 11.3 Delinquency rates for single-family homes in the U.S. Source: Mortgage Bankers Association and author’s calculations, January, 2011.

domestic U.S. financial markets. Instead, financial markets across the world were affected by the U.S. mortgage problems.

The reason for the spread of the losses across the world was the high degree of securitization of the U.S. mortgages. The process of home ownership in the U.S. involves a loan originator, using money from an original lender for the mortgage. The original lender rarely holds the loan, instead bundling mortgages into a Mortgage Backed Security (MBS). This practice enables the loan originator to continue lending, thereby increasing the availability of mortgage funds. The loan originator charges

a fee, but does not end up with the risk of the loan not being repaid. The fact that the loan originator did not end up holding the mortgage resulted in less careful screening of individuals applying for home loans.

Once the original lender has a sufficient number of mortgages, the lender will bundle the mortgages into an MBS. An MBS is a number of different mortgages that are bundled together, and sold in such a way

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a mortgage to an individual in the U.S., because of the monitoring costs of the loan. However, an MBS is a bundle of mortgages with a specific risk. Thus, international investors do not need to worry about what the MBS contains. This made international investment in MBSs particularly attractive. In addition, the MBS could be hedged using the CDS market, which made the international investors feel protected. Therefore, loans to individuals that are seen as risky (subprime or nonprime loans) increased with the introduction of the MBS market. According to DiMartino and Luca (2007) nonprime loans increased from 9 percent of new mortgages in 2001 to 40 percent in 2006.

The MBS and CDS markets grew sharply in 2004 2007. The CDS market was $6.4 trillion in 2004 and grew to $57.9 trillion in 2007. However, the protection had one flaw: there still was a counterparty risk.

A counterparty risk is the risk that a firm that is part of the hedge defaults. Thus, one can set up a perfect hedge against default risk of the MBS, but if one firm that sold you the CDS defaults then your invest- ment is suddenly unhedged. Once your portfolio is unhedged, your chance of default increases. Thus, one firm defaulting can have a spreading effect across financial institutions and individuals across the globe. In general, this systemic risk seems to have been unanticipated by the financial market.

In March 2008, the first major problem appeared with Bear Stearns, an investment bank in the U.S., nearing bankruptcy. Bear Stearns was highly interconnected with both domestic and international financial markets through MBSs and CDSs. To forestall the systemic risk possibility, the Federal Reserve and Treasury decided to intervene. However, when Lehman Brothers ran into the same type of problem in October 2008, it was allowed to go into bankruptcy. At the time of its bankruptcy, Lehman had close to a million CDS contracts, with hundreds of firms all over the world. Therefore, the ripple effects from Lehman Brothers default were felt throughout the world with the cost of risk hedges increasing sharply and many banks and financial firms edging closer to bankruptcy. In the U.S., Countrywide (the largest U.S. mortgage lender) failed and

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the U.K. government, while in Iceland the whole banking system defaulted pushing the entire country into default in October, 2008.

The reason for the multitude of bankruptcies across the world was the high levels of leverage for many financial institutions. Financial institutions need to have equity to back up the loans they make. The more equity they have, the lower the leverage level. Let us assume that you have $1, and lend it to Sam for 10% interest. You now will receive an interest payment of 10 cents when the loan matures. In this example the leverage level is one, because your equity (the cash you invested in the company) is equal to your assets (the loan you made). Now assume that you want to lend $10 more to Joe. You are out of cash to lend Joe so you borrow money from Roger (at 5%) to lend to Joe (at 10%). You now have $1 in equity plus $10 in liabilities (to Roger) and assets of $11. Your leverage level is now 11 to one. Note that the higher the leverage level, the higher your profit will be, unless someone defaults. If Joe defaults on his loan then you do not have any equity to pay back your loan, and consequently have to go bankrupt. The higher the leverage level is, the higher the risk that you will become bankrupt from a bad loan.

Traditional banks have to hold liquid capital to back up their asset portfolios. The riskier the assets are, the higher the capital that is required to hold. To prevent bank insolvency, the Bank for International Settlements, located in Switzerland, sets the international rules for capitalization of banks. The most recent framework is called the Basel III rules. In addi- tion to the Basel III regulation, the Federal Reserve sets additional rules for U.S. banks. In contrast, investment banks and hedge funds have fewer rules. Thus, they may have higher leverage levels than traditional banks. At the start of the Great Recession, many investment banks had leverage ratios of 30 to 1, meaning that 30 dollars of assets had only 1 dollar of equity. Even a small reduction in the value of the assets wiped out the equity, making the financial institution insolvent.

The financial markets became much more cautious following the default of financial institutions in the fall of 2008. The lack of risk appetite by financial firms led to a sharp increase in the cost of hedging

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no choice but to ask the IMF for assistance. In the next section, we look at how the role of the IMF has changed from supervising the Bretton Woods system to a lender of last resort.