ECOS2002 Intermediate Macroeconomics
Week 12:
Christopher Gibbs
University of Sydney
Semester 1, 2021
Agenda
• The Global Financial Crisis
• Adding financial frictions to IS-MP-AS model
The Lesser Depression
• What happened and why was it so severe?
• What are the similarities to the Great Depression?
• What do our models have to say about these events?
The Lesser Depression
• The story in two parts:
– Part 1: The Mortgage Meltdown and the Global Financial
Crisis.
– Part 2: The Euro crisis
The Global Financial Crisis
Part 1: The Mortgage Meltdown and the Global Financial
Crisis
The Global Financial Crisis
• Most popular explanation for the GFC is a the U.S.
housing bubble.
• However, it was much more complicated than just a
housing bubble bursting and a number of factors
contributed.
– The loss of wealth due to the collapse of the housing market
was almost exactly equal to the dot com bubble that
happened 7 years early and which clearly did not cause a
global recession.
The Global Financial Crisis
• Two causes of the GFC:
1. New financial instruments:
– Collaterized Debt Obligations (CDO)
– Credit Default Swaps (CDS)
2. Classic bank run… in shadow banks
– Shadow banks – any institution that engages maturity
transformation.
– Maturity transformation – Borrowing short and lending
long.
The Global Financial Crisis
• Collaterized Debt Obligation
– This is the part where housing came into play.
– The basic idea is to put a number of different loans into a
trust.
– Then sell bonds that give the bond holder a right to the
stream of payments that flow into the trust.
The Global Financial Crisis
• Collaterized Debt Obligation
– The idea is risk sharing through diversification.
– If a bank or an investor holds a single loan, then they hold
the entire risk of default.
– However, if you own a bond from a CDO, then you own
slices of many different loans and the default of any one
loan has less impact on your overall investment.
The Global Financial Crisis
• Collaterized Debt Obligation
– The bonds themselves can also be used to diversify risk.
– Bonds can be sold where some holders agree to accept losses
first in the event of default in exchange for a higher interest
rate.
• CDOs comprised of mortgages are called mortgaged backed
security (MBS).
The Global Financial Crisis
• MBS opened new markets
– People who were once too risky to obtain loans could now
get financing because of the risk sharing through MBS.
– Subprime buyers
– Banks and mortgage finance companies no longer had to
bear the risk of these loans.
– New secondary mortgage market.
– The risk could be shifted to investors globally.
The Global Financial Crisis
• The effect of the new markets
– New access to credit brought many new buyers into the
market and prices rose.
– Important to note that this was not just a U.S. phenomena.
Houses prices rose in many parts of the world.
– Rising prices caused an even further erosion of lending
standards as banks counted on capital gains rather than
down payments.
The Global Financial Crisis
• At the peak of the bubble in the U.S. (2005 – 2006) it was
possible to purchase a home
– without a down payment
– without income verification
– with so called teaser interest rates that were artificially low
for a short period of time, but adjusted up later.
The Global Financial Crisis
• The Credit Default Swap (CDS)
– This is essentially an unregulated insurance contract for
bonds.
– If you have a bond and you are worried about default you
can buy a CDS.
– You pay a premium to the person selling the CDS and the
person promises to pay you the value of the bond if it
defaults.
The Global Financial Crisis
• BUT… CDS are not regulated… Why does this matter?
The Global Financial Crisis
• BUT… CDS are not regulated… Why does this matter?
– Well a key requirement in an insurance market is that you
actually own the thing you are insuring.
– For example:
– If you have a neighbour who is always playing with
fireworks, it may be a good idea to buy fire insurance on
your house.
– What you can’t do, however, is also buy insurance for your
neighbour’s house.
The Global Financial Crisis
• A lot of CDS were taken out on bonds people or firms did
not own.
– By some estimates the total amount of CDS outstanding
leading up to the GFC was 12 x the amount of bonds in
existence.
– Potentially, if one bond defaulted, 12 people would be owed
the full value.
• CDS allowed financial firms to bet on bonds
The Global Financial Crisis
• MBS, CDS, and housing bubble.
1. We have a number of shady mortgages being made mostly
in the U.S. (but also in some parts of Europe).
2. The loans are packaged into bonds and sold to investors all
over the world.
3. Financial institutions all over the world use CDS to take
bets on these bonds.
The Global Financial Crisis
• The magnetar trade:
– A hedge fund would propose the creation of a MBS to a big
bank. Essentially telling a bank what loans to put into an
MBS with the offer of purchasing the most risky bonds
created by the MBS.
– The hedge fund would then take out CDS on the safe”
bonds at the top of the MBS sold to other investors.
– The idea was to basically create an exploding MBS, where
the majority of money was made when default on the more
safe bonds occurred and the CDS payed out.
The Global Financial Crisis
• Systemic Risk
– These instruments that were meant to diffuse risk actually
increased risk in the global financial system.
– Individual banks and investors all felt safer, when in fact
things had become much much riskier.
The Crash
• February 2007
– Freddie Mac announces it will no longer buy the most risky
subprime mortgages and MBS
• April 2007
– New Century Financial Corporation, one of the largest
subprime lenders, goes bankrupt
• August 2007
– BNP Paribas, France’s largest bank, halts redemptions on
three investment funds.
• September 2007
– The Chancellor of the Exchequer authorizes the Bank of
England to provide liquidity support for Northern Rock, the
United Kingdom’s fifth-largest mortgage lender.
• October 2007
– The US economy enters a recession (Statistic agencies only
confirm this nearly 9 months later)
• March 2008
– Investment bank Bear Stearns fails
The Crash
• September 14th, 2008
– Fed and Treasury decide to not rescue Lehman Brothers
• September 15th, 2008
– Lehman Brothers Fails
• September 16th, 2008
– The Reserve Primary Fund Breaks the Buck
– Fed lends $85 billion to AIG
• September 17th, 2008
– Shareholder withdraw $210 Billion from money market
funds in one day.
• October 3rd, 2008
– TARP signed into law by President Bush.
The Euro Crisis
Part 2: The Euro Crisis
The Euro Crisis
Figure: Source: Cecchetti and Schoenholtz (2012)
The Euro Crisis
• The story of the Euro is similar to the story of MBS in the
U.S.
• Bonds from countries like Greece and Portugal looked to be
as safe as bonds from Germany.
• This perceived safety allowed the so called PIGS (Portugal,
Italy, Greece, and Spain) to borrow much more than would
of been possible without the Euro.
– CDS played the same role with these bonds as in the MBS
story.
The Euro Crisis
• The crash in the Euro Crisis
– November 2009: The new government in Greece announces
that is budget deficit is actually twice as large as previously
reported.
– It is reported to be 12.7% of GDP.
– By April 2010, Greece officially requests a bailout.
The Euro Crisis
• Problems in Greece triggered problems in the rest of
Europe
– The problem with debt crisis is that they can become
self-fulling.
– The belief that a country will default causes investor to
demand higher interest rates.
– Higher interest rates make default more likely.
– Default also would trigger CDS contracts and potentially
could cause GFC round 2.
Capturing these events in our models
Financial Frictions
• Our current models do not have a role for financial markets.
• Financial markets are hidden in our models. Therefore,
implicitly we are assuming:
– Financial markets operate perfectly i.e. prices and
quantities always adjust to clear markets.
– Perfect markets allow us to model the central bank as
setting the real rate of interest.
• This is an okay approximation for normal times, but does
not capture the crises we just discussed.
Financial Frictions
• Interest rate spreads
– In normal times all interest rates generally move in the
same direction as the policy rate (i.e. cash rate)
– However, in times of crisis this is not the case.
– Interest rates for the average borrower can move in the
opposite direction.
Financial Frictions
9 8 7 6 5 4 3 2 1 0
10
Jan 2008 Jul 2008 Jan 2009 Jul 2009 Jan 2010 Jul 2010
Shaded areas indicate US recessions – 2014 research.stlouisfed.org
Effective Federal Funds Rate
10-Year Treasury Constant Maturity Rate
Moody’s Seasoned Baa Corporate Bond Yield©
(Percent)
Financial Frictions
• Adding this feature to the model
R = Rff + f¯ (1)
–
f¯ = 0 in normal times
–
f > ¯ 0 in times of distress
Financial Frictions
Financial frictions in IS-MP-AS
Financial Frictions
Financial frictions in IS-LM-AD-AS
Policy Response
• Policy response to the GFC
– Universally the response across the world was expansionary
fiscal and monetary policy.
– Unconventional monetary policy
Policy Response
94
95
96
97
98
99
100
101
2007 2008 2009 2010
2014 research.stlouisfed.org
Gross Domestic Product by Expenditure in Constant Prices: Total
Gross Domestic Product for the Euro Area©, 2007:Q4=100
Real Gross Domestic Product, 2007:Q4=100
(Index)
Policy Response
• Unconventional monetary policy:
1. Quantitative Easing (QE)
2. Forward Guidance
Policy Response
• Quantitative Easing
– Influencing interest rates at longer maturities by buying
assets with longer maturities
– Normally central banks operate in the market for overnight
loans. Under QE policy they operate in markets for loans of
1 year, 3 years, 10 years, or even 30 years.
Policy Response
0
100,000
200,000
300,000
400,000
500,000
600,000
700,000
2004 2006 2008 2010 2012 2014
Shaded areas indicate US recessions – 2014 research.stlouisfed.org
Source: Board of Governors of the Federal Reserve System
U.S. Treasury securities held by the Federal Reserve: Maturing in
over 10 years
(Millions of Dollars)
Policy Response
100,000
200,000
300,000
400,000
500,000
600,000
700,000
800,000
900,000
1,000,000
1,100,000
2004 2006 2008 2010 2012 2014
Shaded areas indicate US recessions – 2014 research.stlouisfed.org
Source: Board of Governors of the Federal Reserve System
U.S. Treasury securities held by the Federal Reserve: Maturing in
over 1 year to 5 years
(Millions of Dollars)
Policy Response
• Operation Twist
– Changing the mix of bonds held by the fed to affect interest
rates at different maturities without increasing the money
supply.
– Sell 5 year bonds, buy 10 year bonds
Policy Response
• Forward Guidance
– Announcing the path of future interest rates
– If the announcement is credible, it can stimulate the
economy today.
Policy Response
• Policy response to the Euro Crisis
– Contractionary fiscal policy
– More unconventional monetary policy
Policy Response
92.5
95.0
97.5
100.0
102.5
105.0
107.5
2007 Q1 2008 Q1 2009 Q1 2010 Q1 2011 Q1 2012 Q1 2013 Q1 2014 Q1
2014 research.stlouisfed.org
Gross Domestic Product by Expenditure in Constant Prices: Total
Gross Domestic Product for the Euro Area©, 2007:Q4=100
Real Gross Domestic Product, 2007:Q4=100
(Index)
Policy Response
70
80
90
100
110
120
2004 2006 2008 2010 2012 2014
2014 research.stlouisfed.org
Gross Domestic Product by Expenditure in Constant Prices: Total
Gross Domestic Product for the United Kingdom©, 2007:Q4=100
Real Gross Domestic Product, 2007:Q4=100
Gross Domestic Product by Expenditure in Constant Prices: Total
Gross Domestic Product for Greece©, 2007:Q4=100
Gross Domestic Product by Expenditure in Constant Prices: Total
Gross Domestic Product for Australia©, 2007:Q4=100
(Index)
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