The financial crisis: Initial conditions, basic

mechanisms, and appropriate policies.

Olivier Blanchard

Munich lecture, November 2008

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1. Introduction

• Much too early to give a definitive assessment.

• Not too early to think about the basic mechanisms, and whether/how
we can prevent similar events in the future.

• A first pass, in the midst of the action. With thanks to the IMF team.

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The basic question: How could such a small trigger have such enormous effects
on world output?

Initial Subprime Losses and Subsequent Declines in World GDP,

US Households Real Estate Wealth, and US Stock Market Capitalization


(in Billions US Dollars)



      
        #      
 -
       1  1          1  1  

             !   " ' "      +  ,    "  ' "     +  

   2  ' "     +      2 




 
 .    
   

 
     3          3    

             $ Ͳ      %    "  & ' (  

) "  / !  "           $ !  "       

     
        #   *  0  0

             ' "   ) "                $      $

Source: IMF Global Financial Stability Report; World Economic Outlook November update and estimates; Federal Reserve Flow of
Funds Accounts; World Federation of Exchanges.

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Organization

• Initial conditions

• Two amplification mechanisms

• Interconnections and dynamics

• Implications for policy now and in the future

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Setting the stage: Initial conditions

• The trigger: The issuance of risky assets, with undervaluation of risk.

Subprime mortgages (but not only).
Causes? Large world demand for safe assets, and bad regulation.

• The determinants of amplification.

– Complexity and opacity of assets on balance sheets of financial

institutions, so low liquidity.
Causes? Better risk allocation, and bad regulation.
– Increased leverage (lower capital relative to assets).
Causes? Bad, and sometimes perverse regulation.

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A visual sense of the complexity. From mortgages to securities

Bought by
Bought by both ABCP
more risk-
low and high risk-
Residuals seeking
seeking investors
investors
Loan
proceeds Lines of Banks provide liquidity ABCP Conduits
credit to lenders
/ SIVs buy ABS
Subprime Subprime Subprime and issue short-
Borrower Servicer Lender Banks provide credit term debt
Loan cash Loan cash Loan cash Securitization Banks lines to conduits / SIVs
flow flow flow Subprime Underwriting
Securitization
Structure Bam ks prov ide
financing to CDOs

Subprime BBB- Provide insurance on

through Single A CDOs, ABS and some Insurers
ABS are bought SIVs
Subprime AAA bonds
by CDOs and
& AA bonds
tranched into
CDO CDO
structured
debt equity
Bought by less products, financed
Bought by Bought by more
risk-seeking by issuing debt
other risk-seeking
investors investors
CDOs

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Amplification mechanism 1. Runs

• Bad (or doubtful) assets on balance sheets

• Runs (not only by depositors, but by other investors)

• Need to sell assets.

• Not enough deep pocket investors to buy (or investors waiting for the
right moment to buy).

• Firesale prices. P < EN P V .

• Worse balance sheets. More incentives to run, etc

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Amplification mechanism 2. Capital

• Bad (or doubtful) assets on balance sheets

• Decrease in capital ratio (Assets minus liabilities, over Assets)

• Need to sell assets (deleverage)

• Not enough deep pocket investors to buy. (id)

• Firesale prices. P < EN P V .

• Lower capital ratio. More incentives to sell assets, etc

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The two mechanisms: Conceptually separate but strongly interacting

• Run on financial institution 1

• Cut credit to financial institution 2

– Sale of assets at depressed prices

Low capital, so further sales
– Or cut credit to financial institution 3

Examples. From US banks to Hungary. From subprimes to other assets.

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The dynamics in real time

• Increase in probability of insolvency.

• Increase in counterparty risk.

• Decrease in volume and maturity of interbank lending.

• Contagion across institutions. From direct exposure to subprime on-
wards.

• Contagion across countries. From the US to Europe, to emerging market

countries.

• Increasing effects on the ultimate borrowers: households and firms.

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Contagion across institutions, assets, and countries

Heat Map: Developments in Systemic Asset Classes

Emerging markets

Corporate credit

Prime RMBS

Commercial MBS

Money markets

Financial institutions

Subprime RMBS
Jan-07 Jul-07 Jan-08 Oct-08
Source: IMF, Global Financial Stability Report, October 2008

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Counterparty risk: Difference between the lending rate between banks and the
riskless rate

5.0
Ted Spreads: 3-month Libor Rate minus T-bill Rate
(in percent)
4.0

Sep 15, 2008

3.0 Lehman Files for Bank ruptcy

2.0

1.0

0.0
01/01/07 08/01/07 03/01/08 10/01/08

US Euro Japan UK

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Emerging market spreads

Emerging Markets Sovereign Srpeads - Composite Index



(1/2/06 - 11/12/08)

06

06

08

08

08
06

07

07

07

08
06

07

/
/

/
2/

2/

2/

2/

2/

2/

2/
2/

2/
/2

/2

/2
1/

4/

7/

1/

4/

1/

4/

7/
7/
10

10

10
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Bank lending standards

100
Bank Lending Standards
80

60

40

20

-20

-40
6/ 5

9/ 5

05

6/ 6

9/ 6

3/ 6

6/ 7

9/ 7

3/ 7

6/ 8

9/ 8

8
0

0
/0

/0

/0

/0

/0

/0

/0

/0

/0

/0

/0

/0
0/

0/

0/
30

30

30

30

30

30

30

30

30

30

30

30
/3

/3

/3
3/

3/
12

12

12
U.S.: C&I loans U.S.: Mortgages
ECB: Large company loans ECB: Mortgages
Change in the Balance of Respondents Between “Tightened Considerably-Tightened Somewhat” and “Eased Somewhat-Eased
Considerably” in Percent of Respondents. Source: Haver Analytics.

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Financial policies for the short run

Need to dampen/eliminate the two amplification mechanisms.

• Runs: Provide liquidity to a broader set of institutions.

Done. Still problem with institutions, countries without access to lender
of last resort (Iceland).

• Capital.

– Buy bad assets. For two reasons: Clarify price. Move price closer
to EPDV.
– Increase capital.
Many institutions may still need recapitalization. So need to add
capital (buy shares).

• Second leg takes time to implement. May need guarantees for deposi-
tors, and for interbank claims. To start interbank lending.

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Basic financial architecture in place in advanced countries

• A crucial weekend in October, but:

• Problems with speed/scope of recapitalization

• Coherence across countries

• Still hidden land mines. for example: CDS positions.

• Problems in emerging market countries.
Sudden stops. Need access to international liquidity provision.

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Counterparty risk since September

Ted Spreads: 3-month Libor Rate

3-month Libor Rate
minus T-bill Rate
8.0 5.0
4.5
7.0
4.0
6.0
3.5
5.0 3.0

4.0 2.5
2.0
3.0
1.5
2.0
1.0
1.0 0.5
0.0 0.0
8/1 8/16 8/31 9/15 9/30 10/15 10/30 8/1 8/16 8/31 9/15 9/30 10/15 10/30
US Euro Japan UK US Euro Japan UK

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Sovereign spreads since September

3500

Sovereign CDS Spreads

3000
(index 7/2/07=100)

2500

2000

1500

1000

500

0
7/2/07 9/2/07 11/2/07 1/2/08 3/2/08 5/2/08 7/2/08 9/2/08 11/2/08

Current account deficit larger than 5% of 2007 GDP

Current account surplus, or small deficit

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From the financial crisis to the economic crisis

• Not a side show.

Direct effects: Credit growth, stock prices, exchange rates
Indirect effects, through confidence, and wait and see

• A Keynesian recession
Worsens the financial crisis
Back to fiscal and monetary policy (in addition to financial policies)

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Decrease in stock prices

120 500
Equity Markets in Advanced Economies Equity Markets in Emerging Economies
110 450
(March 2000 = 100; national currency) (Index 2001=100; national currency)
400
100
350
90
300
80
250
70
200
60
150
50
100
40
50
30
0
Fe 03

Ja 06
Ju 0 5
Ma 01

8
Oc 1

Oc 08
A u 00

A u 07
Ma 00

Ma 07
No 5
D e 02

S e 04
Ju 2

A p 04

t -0
r -0

r-0
0

n-
l-
t-

v-

r-
n-

n-
y-
g-

b-

g-

Fe 3

Ja 6
Ju 5
Ma 01

8
Oc 1

Oc 8
c-

p-

Au 0

Au 7
Ma 0

Ma 7
No 5
D e 02

S e 04
Ju 2

Ap 4
l- 0

0
0

t -0
r -0

r -0
0

0
0

0
r-0
0

0
Ja

n-
t-

v-
n-

n-
y-
g-

b-

g-
c-

p-
Ja

WILSHIRE 5000 DJ EURO STOXX TOPIX ASIA LATIN AMERICA EASTERN EUROPE

Source: Bloomberg and IMF staff estimates.

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Decrease in confidence

65 170 5

60 150
0

130
55 -5
110
50 -10
90
45
-15
Euro area 70
United States
40
Emerging economies
50
EU (right scale) -20
U.S. (left scale)
35
30 -25
M 0

Ju 5

M 7
De 2

Fe 3
M 01

No 5

Ja 6

8
Oc 1

02

Se 4

Ap 4

Oc 8
Au 0

07
0

0
-0

l-0

r-0

t-0
-0

0
0

-0
0
g-

v-

g-
t-

n-
c-

b-
p-
n-

n-

Fe 3
De -02
M -01

Ja 06
No -05

8
O 01

Ju 2

Se 04
Ap 04

O 08
M 00

Ju 05

M 07
Au -00

Au 07
ar

ar
ay

l-0

-0
Ju

0
Au

n-
Ja

c-

b-
p-

-
g-

v-

g-
n-
ct

ct
ar

ar
ay
n
Ja

Manufacturing PMIs Consumer Confidence

(Values greater than 50 indicate expansion) (United States, 1985 = 100; Euro Area, percent balance)

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Growth forecasts

8
Real and Potential GDP Forecasted Growth Rates 7
for 2009; in percent
6
5.2
5
4
3
2
1

0
-0.4 -0.2 -1
-0.7
-2
United States Euro Area Japan Emerging & Developing
Economies

Real GDP Potential GDP

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Looking forward. How to avoid a repeat?

• Back to the trigger and the two mechanisms:

• To limit the build up of systemic risk.

Broader regulation and monitoring systemic risk.
Limit leverage.
More transparent pricing and tracing of assets. Centralized trading
rather than over the counter.

• For runs: Broader liquidity provision.

Across institutions, in exchange for regulation,
Across countries, for runs on claims in foreign currency.
• For capital: Procyclical capital ratios.
A public fund to purchase illiquid assets at EN P V − x?

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The international dimension

• Need to coordinate regulation, national policies. Ireland and unilateral

guarantees.

• Need to monitor risk at a global level.

Exposure of Austria and Belgium to Hungary, of France to Belgium.
Exposure of emerging markets to sudden stops.

• Need to organize multilateral liquidity provision. Swaps, and the new

IMF facility.
• Need for burden sharing rules if recapitalization. National approaches
have large spillovers.

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