Causes of Global Financial Crisis

Oliver Blanchard (April 2009)

SOURCE
o Chief economist of the IMF
o Analysis of basic economic mechanisms leading to crisis
o Contrast between limited direct losses in subprime US
mortgage market & larger economic losses resulting from crisis
Contrasts highlights initial conditions (subprime) +
amplification mechanisms (magnified consequences)

How could such a limited + localised event have effects of such magnitude on
world economy
Estimated losses on US subprime loans + securities (IMF. Oct 2007)
$250 billion
Expected cumulative loss in world output associated with crisis $4700
billion (x20)
o Sum of expected cumulative deviation of output from trend =
forecasted (Nov 08-15)
Decrease in value of stock markets (fall in stock market capitalization)
$26400 billion (x100) (July 07-Nov 08)
4 Steps of initial to amplification
1. Identify initial conditions
i.
Underestimation of risk newly issued assets
ii.
Opacity of derived securities on balance sheets of financial
institutions
iii.
Connectedness between financial institutions (domestic +
international)
iv.
High leverage of financial system
2. Identify amplification mechanisms
i.
Sale of assets to satisfy liquidity runs by investors
ii.
Sale of assets to re-establish capital rations
Large effect of small trigger
3. How amplified mechanisms are played out in real time
i.
From subprime to other assets filtering to other institutions +
other countries (emerging)
i Assets created + sold + bought more risky than appeared
Subprime mortgages appeared riskless
o High value relative to price = but would decline as prices
increased
BUT prices fell led to defaults + foreclosures (mortgages >
value)
Risk was underestimated due to
o Large saving by Chinese households = low world interest rate =
investors looked elsewhere for yield (disappointed with return on
safe assets)

BUT why did they search

o Large private + public capital inflows into US demand was
satisfied by what looked like safe assets
o Too expansionary a monetary policy in US = low long term I/R
BUT why set higher I/R if low world rates + inflation
o Insufficient monitoring of mortgages
BUT why were mortgages bought by investors if regulation
was insufficient
Side note
o CDS firms could insure themselves against some risks (e.g.
defaults) for low premiums = issuers thought probability of pay our
was negligible

ii Securitisation = complex + hard-to-value assets on balance sheets

Mortgages were pooled forming MBS (mortgage based securities) +
income streams were separated
o Initial mortgages were securitised then separated = and then held
by multiple investors with different degrees of risk aversion
The idea was that should house prices falls = the shock
would have been absorbed by a large set of investors not just
a few institutions BUT
OPACITY was an issue = hard to assess value of
derived securities (initial assets were repackaged and
sold on)
increased uncertainty = affecting large no. of
institutions
iii securitisation + globalisation = increasing connectedness
Securitization = financial institutions connected
Globalisation = countries connected
o International banks exposed to US subprime loans
o Emerging market counties = claims of $4 trillion by 08
iv increased leverage
Institutions financed portfolios with less capital to increase rate of return
on that capital
o Due to optimism + underestimation of risk + insufficient regulation
If = value of assets became lower + uncertain
o Higher the leverage
Higher probability of loss of capital
Higher probability of insolvency
1st amplification = modern bank run
N.B Capital = difference between assets & liabilities
o Negative capital = insolvent institution
Probability of default of asset increases expected loss + uncertainty
increases
o Level of capital decreases (less capital relative to assets) + more
uncertain
Increases probability of insolvency

Depositors + investors withdraw funds out of institutions = IF likely to

become insolvent doesnt really happen now
Modern = institutions seen as being at risk
o Can no longer finance themselves decreasing ability to borrow =
have to sell assets
o Macroeconomic phenomenon = many institutions affected
simultaneously
Often assets are sold at fire-sale prices as outside
investors cannot assess
Assets opaque difficult to value = larger uncertainty
Higher risk of insolvency = bank run more
likely
Higher supply of assets pushes prices lower = reduces
capital = more assets have to be sold

2nd amplification = maintaining adequate capital ratio

Investors needed to improve capital ratio (after fall in value of assets)
o To fulfil regulation + reassure investors
Have to either get additional funds
Hard to find
OR deleverage (decrease assets/lower lending)
Have to sell assets = never-ending cycle
o If cut credit to other institution = that one has to
sell = led to international scale of GFC

Raghuram Rajan (July 2010)

SOURCE
o Governor of Reserve Bank of India + formerly worked for IMF
o Underlying causes of GFC = short-term policies taken by US to deal
with inequality
Encouraged unsustainable consumption + home ownership

How inequality fuelled GFC

Since 1970s wages for workers at 90th %tile (of wage distribution) =
grown faster than wages for 50th %tile
o Probably due to technological progress requiring labour force to
have greater skills + education system cannot provide necessary
education to the lower income households
o AND (nutrition + socialisation + schools etc.)
o Middle class = stagnant pay check + growing job insecurity
Government hard to improve education + more root causes of
inequality = taking years to take effect
o Politicians went for the quick fix expand lending to lowerincome households
This would grow consumption + more jobs = immediate
changes
Credit became more easily available

Start of crisis?

Danny Quah

SOURCE
o Professor of Economics & International development
o Economic causes of GFC within advanced-economy financial
markets + general global economy

Anatomy of financial crisis

GFC destroyed $26 trillion of world stock market value (50% world GDP)
34 million people in unemployment (up by 20%)
5% reduced income in developed economies

Subprime mortgage losses (end of US housing boom)

o BUT only 1% of losses
Financial assets riskier than they appeared + increasingly complex
securitisation + greater interconnectedness across institutions & countries
+ heightened leverage (more borrowing + larger likelihood of insolvency)
Financial assets being traded were built on subprime loans
o Therefore riskier than they appeared and these risks are spread
Large persistent current account deficits in US
o Matching surpluses in emerging economies
Rush of cheap financial capital into US = credit was more
widely available
Surplus economies in Asia grow only because the US buys