1G. Hardouvelis

How bad is the 2007How bad is the 2007--8 8 financial crisis?financial crisis?

GikasGikas A. A. HardouvelisHardouvelis**

Athens, July 16, 2008Athens, July 16, 2008

* * Professor, Department of Banking and Financial Management, UniveProfessor, Department of Banking and Financial Management, University of Piraeus, rsity of Piraeus, & Chief Economist, Eurobank EFG Group& Chief Economist, Eurobank EFG Group

Presentation at the Hellenic Bank Association conference: “The recent international financial turmoil”

2G. Hardouvelis

TABLE OF CONTENTS

Intro: Differing views on the crisisMy view: VERY BAD

I. Causes of the financial crisisII. How serious is the crisis?III. Where does Greece stand now?

How bad is the 2007-8 financial crisis?

My view: Problems ahead

3G. Hardouvelis

Introduction: Is the financial crisis a problem?

A. Calomiris’ view belongs to category A: “Not yet a Minskymoment.” Minsky moment: “A worsening of credit standards culminates in a moment of recognition and recoil”

Crisis was not a surpriseMinor effects on the economy: No negative wealth effects from housing, banks able to raise capitalCrisis not as big as in the 1989-92 period

B. Yet most insiders, like George Soros or Alan Greenspan, think it is a big problem:The largest post-depression financial crisis

Different views:C. Super-bigB. BigA. Small

C. A view is slowly arising that the financial crisis is even worse than previously thought: Fundamentally related to the global inflation shock, with a possible underlying cause for both the global imbalances and the previous low interest rates, which led to the quest for yield

4G. Hardouvelis

The roots of the crisis … are in the simultaneous development of three factors:

1) A big increase (bubble) in house prices in the US2) The rapid expansion of subprime mortgages3) The transfer of risk from the banks’ balance sheets to

third party investors through securitization

Introduction: Causes & consequences

Crisis is problematic becauseit began in the US, which produces 25% of 2007 world GDPit spread in all of the financial sector and across the worldThe financial sector is highly leveredThe financial sector has the most important influence on the economy than any other sector

5G. Hardouvelis

PART I:

CAUSES OF THE FINANCIAL CRISIS

1. Housing prices

2. Subprime mortgages

3. Securitization and financial leverage

6G. Hardouvelis

I.1 The house price “bubble” was large

Categorization of banking crises according to Reinhart-Rogoff:• 5 «big» banking crises: Spain (1977), Norway (1987), Finland (1991), Sweden (1991), Japan (1992).• Smaller banking crises in developing economies: Australia (1989), Canada (1983), Denmark (1987),

France (1994), Germany (1977), Greece (1991), Iceland (1985), Italy (1990), N. Zealand (1987), Un. Kingdom (1974, 1991, 1995) και USA (1984).

Πραγµατικές τιµές ακινήτων και τραπεζικές κρίσεις

Source: Reinhart & Rogoff (2008)

USA, 2007 crisis Average for banking crises in advanced economies

Average for 5 largebanking crises

Real house prices 4 years before until 3 years after the crisist = year of banking crisis

7G. Hardouvelis

The largest fall in the history of the indices, in some areas aslarge as 40%They are expected to fall for a while in the future

I.1 The fall in home prices continues in the US …

8G. Hardouvelis

Ι.1 ... and possibly around the globe

Europe will probably follow the US experience, with most of the effect to come in the future …

House Price Gaps(unexplained increase in house prices)

1997 – 2007

-10-505

101520253035

Irela

ndN

ethe

rland

sU

n.A

ustra

liaFr

ance

Nor

way

Den

mar

kB

elgi

umSp

ain

Swed

enIta

lyJa

pan

USA

Finl

and

Ger

man

yC

anad

aA

ustri

a

Source: ΙΜF

%

9G. Hardouvelis

I.2 Rapid credit expansion

100

150

200

250

2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: Federal Reserve

2000=100

Mortgages 127%

Rest of loans 61%

USA EUROZONE

In Euro Area, no subprime lending

In the US, subprimeloans expanded

100

125

150

175

200

2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: ECB

2000=100

Mortgages 92%

Rest of loans 70%

10G. Hardouvelis

I.2 Expansion in subprime loans in the US with deteriorating credit standards

Subprime: From 9% of total mortgages in 2003 to 24% by mid-2007 (subprime & Alt-A)

Subprime-Prime spreadafter controlling for loan

characteristics

Source: Demyanyk & Van Hemert (2008)

Downward Trend

A “Minsky” apparatus:

0%

1%

2%

3%

4%

5%

6%

7%

Jan-

00A

pr-0

0Ju

l-00

Oct

-00

Jan-

01A

pr-0

1Ju

l-01

Oct

-01

Jan-

02A

pr-0

2Ju

l-02

Oct

-02

Jan-

03A

pr-0

3Ju

l-03

Oct

-03

Jan-

04A

pr-0

4Ju

l-04

Oct

-04

Jan-

05A

pr-0

5Ju

l-05

Oct

-05

Jan-

06A

pr-0

6Ju

l-06

Oct

-06

Jan-

07A

pr-0

7Ju

l-07

Oct

-07

Jan-

08A

pr-0

8Ju

l-08

Fed Funds Target Rate

Period of increase in subprime loans

11G. Hardouvelis

I.3 … due to the cannibalization of a useful market innovation: Securitization

Banks have three options:1) Keep the loans on their

balance sheets2) Sell the loans to state

controlled agencies (FNMA, FHLA, etc.), which in turn securitize them, a practice existing since 1939. So banks acquire the necessary liquidity in order to give new loans.

3) Sell the loans to private agents, especially the jumboloans, which also securitize them.

54%

30%

Share of mortgages securitized by private agents

Source: Mian & Soufi (2008)1999 2006

77% of new subprime loans were securitized

12G. Hardouvelis

I.3 The distribution of risk classes in CDOs

Source: IMF, 10/2007

Subprime exposure in Europe & Asia was small, yet the crisis spread

Banks and Insurance companies own mostly the equity portion

Buyers of ABS CDOs and distribution of risk(Market size: $350 bn)

by type of FIand Rating

by Region and Rating

13G. Hardouvelis

Lack of transparency?Lack of intimate knowledge of risk in subprimeloans?Lack of knowledge on the softness of ratings of securitized products?Lack of understanding of the leverage factor and its consequences?

I.3 Why did FI hold the equity portion?

My view:Excessive short-term profit seeking, as the equity portion provided the highest return

Miscalculation of the probability of a systematic collapse of the market

Unfortunate realization of the “bad state,” although true probability of occurrence was perhaps low, i.e. the inverse of the “peso” problem in financial markets

14G. Hardouvelis

I.3 The crisis spread as …1. Structured products are present everywhere

in portfolios across the entire financial system, in US, European and Asian banks, funds, insurance companies, etc.

2. Counterparty risk increased (lack of transparency & complexity)Interbank market – liquidity problems

3. High leverage of hedge funds, investment banks:Increased the need for liquidity & pressures for selling (Νear) defaults of Investment Banks, Insurers, Hedge funds

4. Supply of credit insurance by single entitiesCredit Default Swaps (a $62 trill. market), Monoline Insurers

5. Securitization had expanded into non-mortgage loansAsset Backed Commercial Paper

6. Rating agencies became more strict Further write-downs

7. International Accounting Standards: Mark-to-MarketBanks are forced to show PV lossesIncreased pressure for selling assets fire sales lower prices

15G. Hardouvelis

PART II:

HOW SERIOUS IS THE FINANCIAL CRISIS?

1. The market was taken by surprise2. Huge write-offs3. Cost of capital up, credit spreads do not shrink4. Housing market and MEW in the US economy5. No decoupling of emerging markets6. Inflation shock poses a dilemma for central banks7. Is the inflation shock really unrelated to the

financial shock?

16G. Hardouvelis

II.1 The market was taken by surprise:Evidence from Mortgage-based Credit Default Swaps

Note: ABX contracts are used by investors to speculate on or hedge against the risk that the underlying mortgage securities are not repaid as expected. A decline in the ABX Index signifies investors’ sentimentthat subprime mortgage holders will suffer increased financial losses from those investments.

Losses since the beginning of the crisis (July2007):

High credit quality loans ΑΑΑ : - 54%Low credit quality loansΒΒΒ: - 91%

Source: Ecowin

0

15

30

45

60

75

90

105

Jan-

07

Mar

-07

Apr

-07

May

-07

Jul-0

7

Aug

-07

Sep-

07

Nov

-07

Dec

-07

Feb-

08

Mar

-08

Apr

-08

Jun-

08

ABX, AAA rated

ABX, BBB rated

29/6/07: 99.5

29/6/07: 54.5

14/7/08: 46.2

14/7/08: 4.9

17G. Hardouvelis

II.2 Huge write-offs50 million households with mortgages, 18% of whom have negative equity, i.e., a mortgage loan higher than the value of the house (mortgages of about $1.9 trillion). This number is likely to increase, as house prices continue to decline. Asset write downs & credit losses, 1/ 2007 – 6/2008:Total write-downs of $416 bn - $326 bn capital increasesEstimated losses (IMF):$945 billion: $225 billion on unsecuritized US loans

$720 billion mark-to-market losses on related securities

Therefore:Additional capital increases necessaryAssets have to shrink (by about $1-2 trillion) credit squeeze significant economic deterioration

The authorities do whatever it takes to contain the crisis:Bernanke: Deeply aware of the Great Depression 1929-1933, innovative and effective interventionsFiscal package for the US recessionFinancial Stability Forum recommendations to G7 countriesCorrigan group, etc.

The credit crisis is deep and widespread, but hopefully will not prove to be like in Japan in 1990, or the Great Depression

18G. Hardouvelis

ΙΙ.3 A rise in the cost of capital for banks

TED spread points to an increase in default premiums (3mEurodollar - 3mTbill)Same is true in the Euro Area (3mEuribor – 3mEuroZoneTbills)This leads to an increase in household and corporate lending rates by around 1%

0

50

100

150

200

2502/

5/20

07

2/6/

2007

2/7/

2007

2/8/

2007

2/9/

2007

2/10

/200

7

2/11

/200

7

2/12

/200

7

2/1/

2008

2/2/

2008

2/3/

2008

2/4/

2008

2/5/

2008

2/6/

2008

2/7/

2008

EUROZONE USA Source: Ecowin

11/7: 117

78

19G. Hardouvelis

ΙΙ.3 Turbulence in money markets signifies increase in counterparty risk

Source: Bloomberg

US: 3m LIBOR-OIS

0

20

40

60

80

100

120

Jan-

07Fe

b-07

Mar

-07

Apr

-07

May

-07

Jun-

07Ju

l-07

Aug

-07

Sep-

07O

ct-0

7N

ov-0

7D

ec-0

7Ja

n-08

Feb-

08M

ar-0

8A

pr-0

8M

ay-0

8Ju

n-08

Jul-0

8

Eurozone: 3m EURIBOR-EONIA, OIS

0102030405060708090

100

Jan-

07Fe

b-07

Mar

-07

Apr

-07

May

-07

Jun-

07Ju

l-07

Aug

-07

Sep-

07O

ct-0

7N

ov-0

7D

ec-0

7Ja

n-08

Feb-

08M

ar-0

8A

pr-0

8M

ay-0

8Ju

n-08

Jul-0

8

Uncovered minus covered 3-month inter bank rates

20G. Hardouvelis

ΙΙ.3 Credit-derivatives: Systemic risk worries continue

CDS spreads in mid-March multi-year highsRebound following FED’s initiative to rescue Bear Sterns and coordinated central bank activity, but new widening shows systemic risk worries continue

CDX Indices: 5yr CDS spreads (bps) - US

0

50

100

150

200

250

Jan-07 May-07 Sep-07 Feb-08 Jun-08050100150200250300350400450500

Sub-investment grade (rhs)

Investment grade (lhs)

iTraxx Indices: 5yr CDS spreads (bps) - Europe

020406080

100120140160180

Jan-07 May-07 Sep-07 Feb-08 Jun-080

100

200

300

400

500

600

700Sub-investment grade (rhs)

Investment grade (lhs)

21G. Hardouvelis

* Net Equity Extraction: Free cash resulting from equity extraction - Closing costs on existing home sales, refinancings, and home equity loans

-2

0

2

4

6

8

10

Mar-91

Mar-92

Mar-93

Mar-94

Mar-95

Mar-96

Mar-97

Mar-98

Mar-99

Mar-00

Mar-01

Mar-02

Mar-03

Mar-04

Mar-05

Mar-06

Mar-07

Mar-08

-50

0

50

100

150

200

250

<< As a % of disposable income Net Equity Extraction* >>

% bn $

Net Home Equity Extraction

II.4 Housing markets pose a threat

22G. Hardouvelis

ΙΙ.4 Output falls after banking crises

Real GDP per capita growtht = year of banking crisis

US subprimecrisis, 2007 Average for banking crises in

advanced economies

Average of the “Big 5”banking crises

Source: Reinhart & Rogoff 2008Years

23G. Hardouvelis

ΙΙ.5 No decoupling: Country risk premiastay high

Source: Bloomberg, JP Morgan EMBIG Index

Sovereign Spreads in New Europe

0

50

100

150

200

250

300

350

400

450

Bulgaria Romania Serbia Turkey EmergingMarkets

Greece

29-06-2007 17-03-2008 14-07-2008

bps

Spread withGermany

24G. Hardouvelis

II.5 No decoupling so far

Real GDP growth 2007 Economist 2008f

Bloomberg 2009f

World (IMF) 4.9 3.7 3.8US 2.2 1.2 2.0

(0.36) (0.61)Eurozone 2.6 1.7 1.5

(0.21) (0.30)Japan 2.1 1.3 1.4

(0.18) (0.30)China 11.9 9.6 9.5

(0.40) (0.46)Brazil 5.4 4.6 4.0

(0.21) (0.33)Russia 8.1 7.1 6.5

(0.33) (0.24)India 9.3 7.6 8.0

(0.15) (0.40)

25G. Hardouvelis

ΙΙ. The Fed does worry

Fed: An aggressive reduction in rates, from 5.25% to 2.00%Substituted good for bad collateralIntervened beyond its jurisdiction to save an investment bank

ΕCB: Puts emphasis on inflation

01234567

4/1/

1999

4/7/

1999

4/1/

2000

4/7/

2000

4/1/

2001

4/7/

2001

4/1/

2002

4/7/

2002

4/1/

2003

4/7/

2003

4/1/

2004

4/7/

2004

4/1/

2005

4/7/

2005

4/1/

2006

4/7/

2006

4/1/

2007

4/7/

2007

4/1/

2008

4/7/

2008

Eurozone USA

Subprimecrisis

26G. Hardouvelis

0

1

2

3

4

5

6

7

2000

:Q1

2000

:Q4

2001

:Q3

2002

:Q2

2003

:Q1

2003

:Q4

2004

:Q3

2005

:Q2

2006

:Q1

2006

:Q4

2007

:Q3

2008

:Q2

Taylor Rule (EFG) Actual

%

Fed funds rate

Taylor rule: Fed funds = 1.87 + 1.09*PCE(-1) + 2.02*LMT(-1) + u, R2 = 63%, sample: 1987Q1 – 2007Q2

PCE = Core Personal Consumption ExpenditureLMT = Inverse of product of the unemployment rate and the median duration of unemployment

II.6 The central bank dilemmaOur Taylor rule with real time data, says Greenspan was correct to bring FF down to 1.0% in 2003, but the same rule now says that the FF should have been at 4.1%

Loose monetary policy

27G. Hardouvelis

II.7 Yet another shock: Global inflation

The fall in global growth reduces the size of the increase in demand, but problems at the production and refining stage remain

80.2

23.84.5

48.1

76.4

2000(mil. blper day)

9.4%

22.7%66.6%

2.1%

12.3%

7-yearGrowth

87.7Global Supply

57.5%29.2Other Developing Economies

32.0%7.5China

10.5%49.1Advanced Economies

100%85.8Global Demand

Share in Total

Growth

2007(mil. blper day)

28G. Hardouvelis

II.7 Food prices on a march forward

Food prices picked up, albeit by less than oil and metals Contributing factors:

Increase in demand from China & developing economiesIncrease in demand for bio-fuel productionEnergy cost increases in production, processing and transportationRestrictions in exports

Basic Agricultural Products

50

70

90

110130

150

170

190

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

507090110130150170190210230

Stocks of basic Agricultural Products (days of consuption) - left axis

Price Index of basic Agricultural Products (2005=100) - rght axis

Meat consumption in China20kg/person in 1980, 50kg in 19971kg of beef requires 7 kg of grains

29G. Hardouvelis

II.7 Is the inflation shock related to the origins of the financial crisis?

Some have argued that the global imbalances and the excess liquidity in emerging economies kept interest rates, especially long rates, too low: Greenspan’s conundrum

The low rates led to an unusual expansion in aggregate demand, in the US and the emerging world

The low rates also led to a quest for yield: Carry trades, securitization

This could be done as long as the world benefited from the GREAT MODERATION, a period with high growth and low inflation

But eventually the expansion in global demand growth was not matched by an equivalent supply growth, leading to the current problems.

Hence, view C: today’s super-big financial problem is due to a single source, the past global macro environment

30G. Hardouvelis

PART III:

THE UNCERTAINFUTURE GROWTH PROSPECTS

IN GREECEGreek Border

FT: “Greeks will again become immigrants …”

31G. Hardouvelis

ΙII. Impact on Greece … higher than perceived

Global shocks are precursors to an inevitable reduction in Greek growthFin. Crisis: Cost of capital up, exports down, tourism down, housing market down, shipping flatInflation: Worse impact on Greece as energy intensity larger

236.5183.42005268.5196.31995

GreeceΕU-13

(1995 real prices, consumption of oil equivalents in kg for the production of 1000€ GDP)

Energy Intensity of the Economy

Inflation: Greece & Eurozone

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Jan-

00M

ar-0

0M

ay-0

0Ju

l-00

Sep-

00N

ov-0

0Ja

n-01

Mar

-01

May

-01

Jul-0

1Se

p-01

Nov

-01

Jan-

02M

ar-0

2M

ay-0

2Ju

l-02

Sep-

02N

ov-0

2Ja

n-03

Mar

-03

May

-03

Jul-0

3Se

p-03

Nov

-03

Jan-

04M

ar-0

4M

ay-0

4Ju

l-04

Sep-

04N

ov-0

4Ja

n-05

Mar

-05

May

-05

Jul-0

5Se

p-05

Nov

-05

Jan-

06M

ar-0

6M

ay-0

6Ju

l-06

Sep-

06N

ov-0

6Ja

n-07

Mar

-07

May

-07

Jul-0

7Se

p-07

Nov

-07

Jan-

08M

ar-0

8M

ay-0

8

Greece Eurozone

%6/2008: 4.9%

Source: ECOWIN

6/2008: 4.0%

32G. Hardouvelis

ΙII. Problematic Competitiveness …… the deepest thorn of the Greek economyVisible at the macro level in the rising current account deficit

-5,8 -7,4-11,1

-6,6

-14,1

-2,8 -7,8 -7,3 -6,8-3,8-3,9

-26

-21

-16

-11

-6

-1

4

9

14

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007-26

-21

-16

-11

-6

-1

4

9

14

Income ServicesGoods TransfersCurrent Account Balance

% GDP % GDP

Source: BoG

33G. Hardouvelis

ΙII. Dismal Competitiveness rankings

World Bank: Greece ranks 100th in 2007 among 178 countries in the ease of doing business

202202121266787814144848Romania616616232366171732324646Bulgaria223223141455..335656665757Turkey

930930161655333317175656CzechRepublic

3283281616663333773737Portugal183183101066252566OECD26426420203344441515100100Greece

Paying Taxes

(hours)

Time for export(days)

Investor Protection

Index(0-10)

Difficulty of Hiring

Index(0-100)

Starting a Business (days)

Rank

34G. Hardouvelis

ΙII. High Public Debt & Aging Population

31 40 4969 77 87

98111 119 127

139152 159 168

195 204216 223

183

72,675,0

100,5 99,2101,6

104,1 102,5 103,8100,8

97,9 98,694,5

91,0

101,898,6

80,1

95,398,0

102,6

0

50

100

150

200

250

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

50

60

70

80

90

100

110

General Goverment Debt in €, (left axis)Debt as % of GDP, (right axis)

€ %

144417681888Number of pupils&students(thousands)

60.428.026.8Old-age Dependency Ratio

17.412.010.9% of older employees(55 – 64)

3.13.13.4Education Expenditures(% GDP)

6.85.45.1Health Expenditures(% GDP)

205020102005

Source: European Commission

35G. Hardouvelis

For more info, please consult the Eurobank website:

http://www.eurobank.gr/research

THANK YOU FOR YOUR ATTENTION!!My thanks to the research department of Eurobank EFG

for able research assistance and support

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