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FINANCIAL & ECONOMIC SITUATION Where We Have Been Where We Are Where We Are Going

Where We Have Been Where We Are Where We Are Going

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Page 1: Where We Have Been Where We Are Where We Are Going

FINANCIAL & ECONOMIC SITUATION

Where We Have BeenWhere We Are

Where We Are Going

Page 2: Where We Have Been Where We Are Where We Are Going

Key Questions How did the current econ/financial

situation arise? What are causes and what are effects?

What are the unfolding of events v. root causes? What are the roles of the public sector and

private sector? What impact of financial innovation, MTM

accounting, foreign investment, …? How does the current financial/econ

situation stack up against past episodes? What indications of where we may be

headed are given by past episodes?

Page 3: Where We Have Been Where We Are Where We Are Going

Financial/Econ Crisis in a Picture

Page 4: Where We Have Been Where We Are Where We Are Going

U.S. Debt Growth

1.0

1.5

2.0

2.5

3.0

3.5

4.0

0

10000

20000

30000

40000

50000

60000

20 30 40 50 60 70 80 90 00

U.S. Debt -- right scale

Debt/GDP - left scale

Page 5: Where We Have Been Where We Are Where We Are Going

European Data

1.1

1.2

1.3

1.4

1.5

1.6

1.7

6000

8000

10000

12000

14000

16000

18000

97 98 99 00 01 02 03 04 05 06 07 08 09

"Domestic Credit"

Credit/GDP

Euro Area "Domestic Credit"

Page 6: Where We Have Been Where We Are Where We Are Going

Debt Growth by Sector

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

50 55 60 65 70 75 80 85 90 95 00 05

Total Debt/GDP

Non-house-govt/gdp

House-debt/gdp

Govt Debt/gdp

Page 7: Where We Have Been Where We Are Where We Are Going

Magnitude of Recent Debt Growth?

2.6

2.8

3.0

3.2

3.4

3.6

3.8

00 01 02 03 04 05 06 07 08

Actual Debt/GDP

Forecast Debt/GDP(Based on 1980-99, AR(4) Model)

Page 8: Where We Have Been Where We Are Where We Are Going

Income & Debt Constraints

Infinite Horizon Economy Budget Constraint:

Income + Debt = Debt Service + Consumption

No Ponzi Scheme (Transversality) Constraint:

PV of debt converges to zero Income (not debt) funds consumption over long run

Page 9: Where We Have Been Where We Are Where We Are Going

How Much is Too Much?Debt-Income Ratios in Simulations

Steady State Debt-Income Ratio

Income Growth - Interest Rate for PV (Y-C-rb)>=0

3.5 0.60%3 -0.40%

2.5 -1.80%Assumptions: 75-year Horizon

APC = 0.80 (NIPA est.)

Variable Actual Post WWII Values Income Growth - Interest RateIncome Growth 6.70%10-year Treasury 6.45% 0.25%

AAA Bond 6.75% -0.50%BBB Bond 7.67% -1.00%

Page 10: Where We Have Been Where We Are Where We Are Going

Causes of Debt/GDP Expansion?

Cheap Credit

Prime AAA BBB Fed Funds ComPaper0

1

2

3

4

5

6

7

8

9

1990-992003-07:7

Page 11: Where We Have Been Where We Are Where We Are Going

Cheap Credit: Fed’s Role?Monetary Aggregates

-4

0

4

8

12

16

95 96 97 98 99 00 01 02 03 04 05 06 07 08

M2 Percent Changes (9/11 at average)

-8

-4

0

4

8

12

16

20

95 96 97 98 99 00 01 02 03 04 05 06 07 08

M-Base % Changes (Y2k & 9-11 at average)

Page 12: Where We Have Been Where We Are Where We Are Going

Inflation Rates From 1982

-8

-4

0

4

8

12

16

20

82 84 86 88 90 92 94 96 98 00 02 04 06 08

Inflation Rate & Smoothed (HP Filter)

Page 13: Where We Have Been Where We Are Where We Are Going

Inflation Statistics: 1982-2001, 1990-97, 1998-05, 2002-05

0

4

8

12

16

20

0 2 4 6 8 10

Series: INFLSample 1990M01 1997M12Observations 96

Mean 3.101818Median 2.636830Maximum 11.40143Minimum 0.000000Std. Dev. 1.947708Skewness 1.629926Kurtosis 7.161351

Jarque-Bera 111.7739Probability 0.000000

0

4

8

12

16

20

24

-5 0 5 10 15

Series: INFLSample 1998M01 2005M12Observations 96

Mean 2.542697Median 2.167596Maximum 15.90214Minimum -5.421687Std. Dev. 2.946918Skewness 0.765576Kurtosis 6.648730

Jarque-Bera 62.63063Probability 0.000000

0

10

20

30

40

50

60

70

-5 0 5 10

Series: INFLSample 1982M01 2001M12Observations 240

Mean 3.176899Median 3.048124Maximum 13.76434Minimum -6.563355Std. Dev. 2.439902Skewness 0.313226Kurtosis 6.120650

Jarque-Bera 101.3090Probability 0.000000

0

2

4

6

8

10

-5 0 5 10 15

Series: INFLSample 2002M01 2005M12Observations 48

Mean 2.779565Median 2.552644Maximum 15.90214Minimum -5.421687Std. Dev. 3.372371Skewness 0.797570Kurtosis 6.850455

Jarque-Bera 34.74095Probability 0.000000

Page 14: Where We Have Been Where We Are Where We Are Going

Cheap Credit: Public Sector Supply-Side

1000

2000

3000

4000

5000

6000

7000

8000

9000

90 92 94 96 98 00 02 04 06 08

GSE Assets + Govt-MBS(in Billions $)

Page 15: Where We Have Been Where We Are Where We Are Going

Cheap Credit: Expansion/Term Reduction in Markets (e.g. Commercial

Paper)

Page 16: Where We Have Been Where We Are Where We Are Going

Cheap Credit: Increasing Leverage

Page 17: Where We Have Been Where We Are Where We Are Going

Cheap Credit: Innovations Risk-Influencing Innovations

Securitization, e.g. CDOs – risk pooling Derivatives (“Insurance”), e.g. CDS – risk

transfer Key Issues/Questions:

Aggregate Risk not influenced by pooling/transfer

Miscalculation of expected flows Probability of Event x Size of Event

How big of an influence on credit growth/crisis?

Page 18: Where We Have Been Where We Are Where We Are Going

Securitization & Credit Growth

Global CDO New Issuance (in billions $)

U.S. Mortgage market increased by $7T from 2000-2008

U.S. & Euro Area Debt increased by $35T from 2000-2008

2004 2005 2006 2007 2004-09$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

Series1

Page 19: Where We Have Been Where We Are Where We Are Going

Credit Market “Insurance” Reported Values of CDS Growth Enormous

“Notional Values” = $2T (2003), $34T (2007), $60T (2008) Key Questions:

What are the real notional values after “netting”? What are the cash flow implications of these values?

Actual v. reported notional values & cash flow implications example:

Lehman Failure: estimated $400B in CDS protection Bond “Recovery Rate” only 8% -- implied CDS liability = $380B Roubini’s Group (RGE) Estimates Cash Flow impact of $270B after

netting October 21, 2008: $6B in actual cash settlements (1.5%) Note: Expected value of “protection” in Lehman Model = 2% of

notional value

In the end, not clear that the cash flow implications of these innovations have been that great

Page 20: Where We Have Been Where We Are Where We Are Going

Foreign Capital & U.S. Debt

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

.000

.004

.008

.012

.016

.020

.024

.028

.032

50 55 60 65 70 75 80 85 90 95 00 05

CAPINYHP DEBTY

Foreign Capital Inflow/GDP

Debt/GDP

Capital Inflows (Smoothed) and Debt Growth

Page 21: Where We Have Been Where We Are Where We Are Going

Role of Foreign Capital?

-.01

.00

.01

.02

.03

.04

.05

.06

97 98 99 00 01 02 03 04 05 06 07 08 09

U.S.

Euro Area

Capital Inflows Relative to GDP

Page 22: Where We Have Been Where We Are Where We Are Going

Role of Marked-to-Market Accounting?

How big of an effect is possible from MTM pricing of banks?

See SEC Dec. 2008 Study www.sec.gov/news/studies/2008/marktomarket123008.pdf

31% of bank assets MTM 22% of these impact income statement Part of this amount in Treasuries

Differences in MTM and “amortized cost” If 20% difference, then 4.4% impact on

income Currently, using “amortized cost” method

Citi assets increase by apx. $3B (out of $1.2T) BoA assets increase by apx. $9B (out of $1.4T)

Page 23: Where We Have Been Where We Are Where We Are Going

Where Are We Now?U.S. Stock Crashes Since 1907

Time Frame DJIA Change (Real) Length

1907-08 -40% 13 months

1919-20 -46% 15 months

1929-33 -83% 43 months

1937-38 -49% 15 months

1946-48 -35% 21 months

1973-75 -51% 25 months

1978-82 -37% 48 months

1987-88 -28% 5 months

2000-01 -18% 16 months

2007- -53% 16 months…

Page 24: Where We Have Been Where We Are Where We Are Going

Stock Crash Similarities (16 months in)

Correlations in 6-month Cumulative Sum of Monthly Changes in DJIA1907 1919 1929 1937 1973 1978 1987 2000 2007

1907 1.00 0.15 -0.20 0.89 0.08 -0.16 -0.13 0.13 -0.331919 0.15 1.00 0.07 0.17 0.07 -0.48 -0.34 0.16 0.431929 -0.20 0.07 1.00 -0.46 0.40 0.47 0.14 0.36 0.571937 0.89 0.17 -0.46 1.00 -0.26 -0.39 -0.34 -0.14 -0.331973 0.08 0.07 0.40 -0.26 1.00 0.23 0.33 0.33 0.121978 -0.16 -0.48 0.47 -0.39 0.23 1.00 0.56 0.65 -0.101987 -0.13 -0.34 0.14 -0.34 0.33 0.56 1.00 0.24 -0.532000 0.13 0.16 0.36 -0.14 0.33 0.65 0.24 1.00 0.052007 -0.33 0.43 0.57 -0.33 0.12 -0.10 -0.53 0.05 1.00

Page 25: Where We Have Been Where We Are Where We Are Going

How Much Like the 1930s?

-50

-40

-30

-20

-10

0

10

20

2 4 6 8 10 12 14 16

Early 30s

Current

Month from Beginning of Downturn

Cumuluative Percent Change in DJI over Prior 6 Months

Page 26: Where We Have Been Where We Are Where We Are Going

Stock Crashes & Real Effects

Time Frame DJIA Change (Real) Length BBB-AAA Peak GDP Change (Real) %ΔDIJA/%ΔGDP

1907-08 -40% 13 months NA -5% 8

1919-20 -46% 15 months 2.25%* -23% 2

1929-33 -83% 43 months 5.60% -29% 3

1937-38 -49% 15 months 3.10% -7% 7

1946-48 -35% 21 months < 1% -5% 7

1973-75 -51% 25 months 2.00% -5% 10

1978-82 -37% 48 months 2.60% -7% 5

1987-88 -28% 5 months 1.20% >0% NA

2000-01 -18% 16 months 0.80% -1% 18

2007- -53% 16 months… 3.50% ? ?

*NBER Series -- Highest Grade v. Lowest Grade Corp. Bond

Page 27: Where We Have Been Where We Are Where We Are Going

GDP What Ifs (From 2007 peak of $11.5T GDP (in 2000$) and U of 4.7%

Decline in Real GDP Real GDP Year Equivalent Unemployment @2% Rate5% $10.9T 2005 7.2%

10% $10.3T 2003 9.70%15% $9.7T 1999 12%20% $9.2T 1998 14.70%30% $8.1T 1994 19.70%