Definitions and history
Global financial crisis
Australia and the GFC
Property and financial crises
“The shapers of the American mortgage finance system hoped to achieve the security of government ownership, the integrity of local banking and the ingenuity of Wall Street. Instead they got the ingenuity of government, the security of local banking and the integrity of Wall Street.”
David Frum(speechwriter for President George W. Bush), National Post, July 11, 2008.
What is a Crisis?
The Palgrave Dictionary of Economicsdefinition: the rush out of real or financial assets into cash money that causes:
“a sharp, brief ultra-cyclical deterioration of all or most of a group of financial indicators –short-term interest rates, asset (stock, real estate, land) prices, commercial insolvencies and failures of financial institutions”
Published in 1841, included the Dutch tulip mania and the UK South Sea Bubble. Also relics, alchemy and haunted houses.
Bubbles and Booms
• A bubble is a sharp rise in the price of an asset, often described as a mania, followed by a crash and crisis:
Dutch tulip mania in 1635-36;
Mississippi bubble in Paris and the South Sea bubble in England 1719-20;
Railway boom in England 1846-7;
US stocks and holding companies 1925-27;
Japanese real estate 1988-90.
• A boom is a slower, more extended rise, that may or may not end in a crisis:
Melbourne land boom in the 1890s;
Gold in the 1970s;
Dot com stocks in the 1990s;
Australia’s mining boom Mark I (to 2007) and II (to 2014).
Kindleberger1978 (5th Ed. 2011)
Manias, Panics and Crashes: A History of Financial Crises by Charles Kindlebergeris a comprehensive history. He argued that several common threads linked these different disasters over the centuries.
Manias typically occur during economic expansions as “New opportunities for profit are seized, and overdone”.
When reality eventually dawns on investors they start to dump risky assets for cash.
The panic phase is characterized by a stampede, a race to change physical or financial assets into money.
The demand for liquidity and safe assets causes excessive changes in pricing of the risky asset/s.
The crash comes when the market becomes a one way bet against the asset.
Reinhardt and Rogoff 2008
This Time is Different: Eight Centuries of Financial Folly.
Study of international debt and banking crises, inflation, currency crashes and debasements in 66 countries.
Found that high inflation, currency crashes and debasements often go together with default.
Historically, significant waves of increased capital mobility are often followed by domestic banking crises.
“… shocks emanating from the centre countries can lead to financial crises worldwide. In this respect, the 2007–2008 US sub-prime financial crisis is hardly exceptional”.
Recovery from a financial crisis takes longer than recovery from a business cycle contraction.
“That men do not learn very much from the lessons of history is the most important of all the lessons that history has to teach”.
1986 U.S. banking crisis, 1,400 savings and loans associations failed.
1987 Black Monday, equity markets dropped by 50% or more.
1990 Japanese bubble economy collapses, property and shares lose 50%.
1991 Swedish banking crisis. Becomes model for splitting and recapitalising banks.
1997 Asian financial crisis, currencies drop, IMF support of Thailand, Indonesia etc.
1998 Long Term Capital Management collapses. Rouble crisis, Russia defaults.
1999 Argentina defaults on debt (and again in 2010, and in 2018).
2000 Dot com bust on Nasdaq in U.S. (the Tech Wreck). In 2001 Enron collapses.
2007 Subprime mortgage market implodes, financial crisis begins as Bear Sterns fails.
2008 Lehman Bros, AIG, Washington Mutual, Merrill Lynch, RBS, Lloyds, UBS, etc.
2009 Iceland defaults.
2010 Greece triggers sovereign debt crisis for Euro. First bailout by ECB and IMF.
2010-12 Bailouts of Ireland, Portugal and Spain follow Greece.
2015 Greece negotiates third bailout. Spain splits banks into ‘good’ and ‘bad’ banks.
2017 Greece negotiates fourth bailout. Spain and Iceland complete bank restructure.
In the 1970s and 1980s financial markets were deregulated:
• Currencies became floating, not fixed;
• Capital controls and international transfers were ended.
International trade and investment took off, global supply chains developed.
Rapid growth of private pools of capital, including pension funds, private equity, sovereign wealth funds and hedge funds.
Financial innovations were viewed as fundamentally good, adding to the liquidity and efficiency of capital markets.
Securitisation increased and spread across asset classes in the US.
• Residential and commercial mortgages, credit cards, auto and student loans.
Asset-backed securities (ABS) are pools (collections) of assets, such as mortgages, car loans or credit cards.
A securitisation makes these assets available to a broad range of investors, as the pooling of assets makes the ABS large enough to be economic and to diversify the quality (i.e. risk) of the underlying assets.
A special purpose trust or entity is set up to take title to the assets and the cash flows are "passed through" to investors in the ABS.
A trustee is responsible for the conduct of the special purpose entity.
Before the crisis, asset-backed securities provided between 20% and 60% of funding for new residential mortgage loans in the US, Western Europe, Japan and Australia.
One reason securitisation grew so quickly, and became such a large market, was the willingness of credit rating agencies to give their highest ratings (AAA or Aaa) to mortgage-backed securities.
A wave of investment funds was searching for higher-yielding, safe-rated, fixed-income investments. Global private issuance soared from almost nothing in the early 1990s to peak at almost USD$5 trillion in 2006.
This was a very profitable business for the Wall Street banks that had a large share of the market, providing finance for sub-prime loans and packaging them into ABSs.
Great Financial Crisis
“From 1978 to 2007, the amount of debt held by the financial sector soared from 3 trillion to 36 trillion, more than doubling as a share of gross domestic product. By 2005, the 10 largest U.S. commercial banks held 55% of the industry’s assets, more than double the level held in 1990. On the eve of the crisis in 2006, financial sector profits constituted 27% of all corporate profits in the United States, up from 15% in 1980.”
Report of the Inquiry Commission.
• In early 2007 the GFC started in the US sub-prime mortgage market.
Centred in California, Nevada and Florida.
Default rates for loans originated 2005-07 were very high, over 20%.
• By late 2007 the UK was in trouble.
Northern Rock Sept. 2007, Halifax, RBS.
• Over 2008 the crisis spread and in Sept
the financial system imploded.
US Government took control of mortgage lenders Fannie Mae and Freddie Mac.
Goldman Sachs and Morgan Stanley, the two surviving US investment banks, became bank holding companies.
Iceland defaulted as its three banks collapse.
Credit expansion fuels a boom, but lower loan requirements builds up risk in the system.
Causes of the GFC
While the vulnerabilities that created the potential for crisis were years in the making, it was the collapse of the housing bubble -fuelled by low interest rates, easy and available credit, scant regulation, and toxic mortgages -that was the spark that … led to a full-blown crisis in the fall of 2008.
Conclusions of the Financial Crisis Inquiry Commission, Feb. 2011.
The financial crisis was avoidable:
• The prime example is the Federal Reserve’s pivotal failure to stem the flow of
toxic mortgages, which it could have done by setting prudent mortgage-lending
Widespread failures in financial regulation and supervision proved devastating to the stability of financial markets:
• The financial industry itself played a key role in weakening regulatory constraints
on institutions, markets, and products.
Dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause:
• Institutions acted recklessly, taking on too much risk, with too little capital, and
with too much dependence on short-term (overnight) funding and trading profits.
A combination of excessive borrowing, risky investments, and lack of transparency put the financial system on a collision course with crisis:
• In 2007 the five major investment banks (Bear Stearns, Goldman Sachs,
Lehman Brothers, Merrill Lynch, and Morgan Stanley) were operating with
extraordinarily thin capital.
• By one measure leverage ratios were as high as 40 to 1, meaning for every $40
in assets there was only $1 in capital to cover losses.
The government was ill prepared for the crisis, and its inconsistent response added to the uncertainty and panic in the financial markets:
• The US Government rescued Bear Stearns, then placed Fannie Mae and
Freddie Mac into conservatorship, followed by the decision not to save Lehman
Brothers but bailout AIG.
Over-the-counter derivatives contributed significantly.
• US legislation in 2000 to ban regulation by federal and state governments of
over-the-counter derivatives was a key turning point.
• There was a systemic breakdown in accountability and ethics:
Lenders made loans they knew borrowers could not afford and could cause massive losses to investors in mortgage securities;
Borrowers took out mortgages that they never had the capacity or intention to pay, and mortgage fraud was rife;
Some banks were shorting the MBS market while selling these securities to investors like local councils and charities.
• The failures of credit rating agencies were essential cogs in the wheel of financial destruction:
Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms around the world.
Euro Crisis 2010
Aging population, low productivity and low economic growth rates. Compounded by differences in growth rates between countries.
Running an export surplus in one EU economy complicates life for less competitive members with trade deficits, creating policy spillovers in a currency union lacking institutional capacity to manage them.
Fiscal and financial trouble in small, southern euro-zone states, as international finance dried up with the GFC, destabilised the much larger northern economies.
Large and overleveraged EU banks had many investments and loans go bad in the GFC. Especially Italy and Spain, with German and Swiss banks also needing recapitalisation.
Countries with high debt became insolvent when GDP growth dropped during the GFC (Greece, Portugal). Also an issue for Italy.
Countries with very large financial sectors became insolvent when their banks collapsed as property prices fell (Spain, Ireland, Iceland).
Debt and Deficits
After numerous bank failures, regulatory reforms were undertaken to make the financial system safer. International agreement was reached in late 2010 on the main elements of international bank capital and liquidity reforms.
The Basel Committee on Banking Supervision (BCBS) developed the Basel III capital and liquidity framework. The core element was a significant increase in the amount of capital held by banks.
The aims are to make markets and institutions more transparent and less complex by increasing bank capital requirements and restricting leverage levels.
New ‘capital conservation’ and ‘counter-cyclical capital’ buffers phased in over 2016-2019, the required minimum total capital ratio plus conservation buffer will be 10.5% of risk-weighted assets.
The emphasis is on how to detect and mitigate systemic risks through better regulation. Reducing the moral hazard posed by the largest systemically important financial institutions, known as the ‘too big to fail’ problem, to avoid a repeat of the government support that rescued many financial institutions in the US and UK during the crisis.
Implementation of these reforms in individual countries has differed, with EU banks lagging US and Asian banks in increasing capital.
Basel III was agreed in 2010 and had a target of 2019, however the BCBS found significant variation in the value of risk weights calculated by banks on their loans, which affected their capital ratios.
So the 2017 final set of post-GFC reforms reduce variability in risk weights, and increase the risk sensitivity of the Basel III capital framework, with a target date of 2022. There is no further increase in capital requirements.
Specifies approaches for calculating credit risk, operational risk and the leverage ratio.
The new banking standards of Basel III are sending some trading and lending to the nonbank sector, known as shadow banking, where those standards do not apply.
Australia and the GFC
Sort of Lucky
• Australia escaped the worst of the GFC for three main reasons:
Bank regulation was effective, and the Commonwealth Government guaranteed bank debt;
Mortgage quality was better, and local investors had not bought a lot of toxic US assets; and
Stimulus spending here and in China supported aggregate demand.
• Nevertheless, there were casualties. Bank West and St. George had funding issues and were absorbed by CBA and Westpac respectively. Many AREITs failed. Some European and US lenders closed their local operations, although there was an increase in loans from Japanese and Chinese banks.
AREIT assets under management grew from around $80bn in 2003 to over $200bn 2009, and are now around $130bn. Leverage was around 40% in 2003 and 50 % by 2009.
In 2008 only one of 61 AREITs earned a positive return to December, 14 suspended distributions and 90 percent recorded falls in value of their properties.
The GFC forced AREITs to raise new equity and reduce leverage levels, which in turn reduced assets under management.
• Capital raisings were used to repay debt.
• Westfield raised over $3bn before the GFC.
• GPT and Stockland had to raise $2.8bn and $1.8bn respectively during 2008 and
• Two reasons the GFC was so severe were:
Its global nature, unlike typical business cycle recessions which mainly affect one country.
It was really two crises in succession. The US sub-prime banking crisis hit first in 2007-08, and prompted a flight to safety by investors. Small, highly indebted countries running large deficits found it increasingly difficult to borrow from global capital markets. By 2010 several European countries were in deep trouble.
• The ‘Great Recession’ that followed the GFC saw widespread unemployment during a prolonged, slow recovery, and it is still high in southern EU countries.
• The global build-up of debt since the GFC is now the focus of concern. Broadly, in the EU it is government debt, in Australia and Canada household debt, and in Turkey, the US and China corporate debt. In emerging economies it is US dollar debt.
During the global financial crisis most governments used countercyclical fiscal policy to support demand and employment, through increasing spending. For China, the IMF estimated the total size of new stimulatory measures was almost 6% of GDP in 2009 and 2010. In Australia it was nearly 5% of GDP.
After inflation was finally beaten in the late 1980s, interest rates fell and debt increased.
Government debt in advanced economies rose sharply during the post-GFC ‘Great Recession’.
Rapid rises in debt have historically been associated with financial crises
Property and Financial Crises
Charles Kindleberger’s Manias, Panics and Crashes is the classic history of crises in the financial, real estate and commodity markets. The sixth edition (2011) has 47 financial crises between 1618 and 2008, covering 20 different asset classes.
In Kindleberger, commercial real estate and office buildings are named for the first time in 1874. However, “in the 20th century most of the manias and bubbles have centred on real estate and stocks” (Kindleberger and Aliber2011: 30).
Shiller in Irrational Exuberance also did not find evidence for residential real estate booms in the past: “We have found relatively little talk about anything that could be considered national bubbles in home prices until the last decades of the twentieth century.” (2005: 25).
Housing and Credit Cycles
Cerutti, E., Dagher, J. and Dell’Ariccia, G. 2015. Housing finance and real estate booms: A cross-country perspective, IMF Staff Discussion Paper.<