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.
The real estate sector and related financing are often at the centre of a financial crisis. Commercial real estate bubbles played an important role in the 1980s savings and loans crisis in the US, the 1990s Nordic banking crisis, the 1998 Asian crisis, and Japan’s lost decade after the bubble economy popped in 1990. In IMF research into the 46 systemic banking crises for which house price data were available, more than two-thirds were preceded by boom–bust patterns in house prices. Also, the IMF paper showed that house price booms have become increasing synchronised over the last few decades. Their sample is over 50 countries.
House Prices and Building
Housing and property booms and bubbles drive building approvals and the volume of work done. Supply responds to price increases. Conversion of approvals to completions rises and falls with house prices.
At the end of the mining boom the RBA lowered interest rates. The strategy succeeded, as residential investment replaced business investment by significantly increasing prices in the secondary market for existing houses), and by pushing prices well above replacement costs.
Morgan Stanley’s Australian housing model, known as MSHAUS, is a leading indicator heavily weighted by completions.
The graphs clearly show the alignment of peaks in annual growth rates of approvals and house prices in 1998, 2002, 2010 and 2014.
Forecasts for 2018 are continuing falls in approvals and prices.
Real Estate Cycles
The drivers of real estate boom–bust cycles, and the crises that often follow, have been different across countries. It was commercial property in East Asia, Scandinavia, Japan, and Australia during the 1990s, but households in the 2008 crisis in the US and UK. Then both commercial and residential real estate developers in Ireland and Spain were responsible for their crises in 2010.
Two common factors found in these real estate booms and busts are tax systems that encourage leverage and increased borrowing, and regulatory regimes that do not effectively restrain lending. In the build-up phase of a cycle, low lending standards fuel a speculative boom in asset markets, particularly property. The stance of prudential supervision is important here, as ‘light touch’ regulatory regimes have frequently failed to prevent excessive risk taking by financial institutions and their customers. That in turn fuels an unsustainable build-up of real estate prices.
Historically, economic downturns following real estate booms and busts are deeper and last longer than other downturns, which are typically associated with business cycle factors like demand and supply side shocks that are usually fairly short-term.
The growth of indebtedness in the financial system raises overall systemic risks, especially if banks’ balance sheet growth is funded by short-term liabilities. When prices fall, the banking system has to write off losses on nonperforming loans and recapitalise balance sheets while reducing assets. This restrains new lending, and the lack of finance further undermines demand.
The strong link between property bubbles, the failure of over-exposed financial institutions, and recessions that are longer and deeper than the average, is well-established across many countries and periods.
Supply and Stock Cycles
• The costs associated with real estate cycles are particularly high because:
Real estate markets have multiple linkages with many sectors of the economy, through financial exposures, banking credit, and household balance sheets, and because new construction leads to spending on furnishings and fittings and so on.
Real estate assets typically involve large upfront fixed costs and long-term financial commitments, and have high information and transaction costs, implying that a significant misallocation of resources will be costly and slow to reverse.
• Commercial real estate, especially office property, is historically more prone to a bust than residential real estate. This is because projects take longer to complete and periods of oversupply are more common. Commercial real estate markets are driven by these physical asset stock cycles, cycles are therefore long.
Housing Cycles and Recessions
The good years before the GFC skewed bank risk models, and securitisation was thought to disperse risk. With low risk and high liquidity the obvious strategy for banks was to expand assets on their balance sheet to increase profits and bonuses. Pushing mortgages into holding companies freed up their balance sheets and allowed banks to write new loans.
Post GFC the focus is on liabilities, the amount of capital required under Basel III, and the duration and sources of funding as debt. Banks are rebuilding their balance sheets through restricting new loans and lending, longer maturity securities, more reliance on deposits from branch networks and lower loan to deposit ratios.
New explanations for asset market cycles have come from the rapid growth of research in behavioural economics.
Although there is no agreement on a single cause, underlying mechanisms such as self-reinforcing feedback loops and groupthink or herding dynamics lead to prices well above a level based on market fundamentals.
Theories on information asymmetry address the lack of transparency in real estate and credit markets, and agency problems explain why incentive structures can lead rational decision-makers to produce suboptimal outcomes for their clients.
• Is concerned with the relationship between two parties, where one party (the agent) contracts with another (the principal) to act on its behalf in defined circumstances:
Managers are agents for shareholders;
Employees are agents of employers;
Fund managers are agents of investors.
• Principals want agents to work in their (the principals’) best interests, but agents typically have their own interests and, potentially, different goals than principals. This is called incentive conflict.
• Employing an agent is a cost, monitoring to ensure compliance or performance is also a cost, and it is often difficulty for a principal to observe the actual effort made by an agent. Costs can be reduced if the principal gathers information on:
The agent’s type (adverse selection);
The agent’s actions (moral hazard).
Herding theories emphasize the role of group behaviour under a range of different assumptions.
Shiller suggests investment managers do not investigate all available opportunities because they are constrained by time and resources. They might observe other managers, subscribe to research, or seek private information.
• It is a well-known phenomena that
decisions by leading investment
managers often bring followers in their
Including individual and group psychological dynamics helps describe how credit cycles and asset bubbles are caused by investor biases, irrational decision-making, and the herd-like behaviour of lenders and borrowers.
Price versus Value
During asset bubbles, irrational investors confuse an asset’s current market price with its value, which is based on fundamentals such as cash and income flows. Instead of valuations based on a reasonable multiple of the asset’s annual income, a feedback loop forms between prices and accelerating credit growth.
A groundswell of irrational exuberance and frenzied speculation develops, and a delusional ‘This time is different’ syndrome reinforces the widespread belief that prices have reached a new, permanently high level. This is despite the fact that, both recently and in historical times, a boom-bust pattern has repeated with great regularity in international financial markets.
From a behavioural perspective, asset bubbles are caused by investor herding behaviour and faulty cognitive biases.
Shiller and Akerlof in their 2009 book Animal Spirits argued the stories people tell each other are important, which they call ‘narratives’.
If booms are driven by irrational exuberance, busts can also ultimately be ascribed to “contagious stories of wide significance”. These will begin when newly popular narratives reduce individuals’ inclination hold assets or to invest.
Psychology matters a great deal.
The GFC and the Great Recession had a long-term effect on global growth and unemployment. Recapitalising banks and recovering from a financial crisis can take 10 years or more.
Growth is well below pre-GFC levels, and increasingly depends on China and the US, both countries have debt issues.
In the EU, and elsewhere, youth unemployment is still a major problem. This is one of the long-run costs of the GFC.
John Maynard Keynes described optimism and pessimism as animal spirits. Businesses need confidence in the future for the economy to invest. Business confidence is also affected by confidence in the financial system, and we know financial markets reflect social mood and behavioural bias.
Behavioural finance focuses on loss aversion, herding, anchoring and probability mistakes. The psychological carriers of value are gains and losses, rather than anticipated wealth and, for many people, attitudes towards risk shift from risk-aversion in the face of gains to risk-seeking after losses. This increases volatility in financial markets through herding.
A financial crisis needs both an economic or financial trigger, like interest rates, energy prices or a default, and a market tipping point, where sellers outnumber buyers and asset prices fall.