This program is brought to you by Emory University I'm going to talk about the financial crisis not a pleasant topic uh and also a topic that I was kind of hoping after five or six years of talking about the financial crisis I wouldn't have to talk about it anymore but it doesn't seem to be the case so um it's not only not a pleasant topic but I'm going to end rather pessimistically so anybody who want Doesn't want to get depressed is free to leave now I mean it's unfortunate that that's the case but I'll explain
why that's the case at the end so I want to start with uh what happened I'm going to talk about what happened and uh I'm going to explain why it's very was very hard uh for anyone to understand what happened unless you had several pieces of apparatus you've been studying financial crisis for 30 years Like me and then you happen to be on a trading floor uh in these markets when it happened so uh and I'm going to uh in a few minutes I'm going to uh try to raise the level of the discussion about
the financial crisis above uh what I see as the conversation out there which is uh not very good I'll also talk about what is a financial crisis and I'm going to spend some time quite a bit of time on talking about uh whether crises have a Common underlying structural feature or whether each one is uh some kind of series of special unfortunate coincidences um okay so let's start so a financial crisis is not just a bad event okay it's not a a stock market crash is not a financial crisis uh um SNL crisis is not
a financial crisis a financial crisis is a situation where households or in the recent one firms uh don't believe that short-term Bank debt is really backed with enough stuff and they Want all their money back so everybody goes to the bank at the same time and the banks don't have the money Franklin Roosevelt explained this very very clearly in his first radio address in March 1933 you can hear it on the Internet it's fantastic what he basically he said what he said was look when you put your money in a bank they don't just put
it in the vault they lend it out so if everybody goes to the bank and asks for their money they're not Going to have it that's exactly what happened in 20072 2008 so this this as I'll explain is a sudden but it's not an irrational event when the whole banking system just doesn't have the cash they can't they can't come up with the cash so they can't honor their debt contracts and consequently the whole banking system is insolvent Okay so we've seen this uh uh many many many times so this is what it looks like
in the old days so before uh Deposit Insurance Americans Were very familiar with this uh the 19th century uh this is an event that occurred repeatedly everybody's at their Bank uh trying to get their money out and 1934 uh the American people just got sick of this and they demanded Deposit Insurance so economists were all opposed to deposit insurance right uh and so was FDR originally economists said oh there'll be moral hazard moral hazard and it passed anyway and we got this Long period uh of quiet so let me let me now start with what
you have to explain if you want to explain the financial crisis the first thing is uh you have to explain how a small shock generated a giant event so the realized losses uh which of as of six months ago are 20 basis points 100 basis points is 1% so 20 basis points is 20% of that uh 1.9 trillion of AAA subprime securities issued in these years that's that's how much money has Been lost in a typical securitization and I'll explain what that is in a few minutes 85% of it is AAA the amount of aleaa
that was lost is just minuscule it's minuscule right so it's not the impression you would get from Reading you know the business press so somehow you have to get from that to Bernan statement that of the 13 largest financial institutions 12 were bankrupt going to go bankrupt this just after Leman so you can't you can't uh uh you You somehow have to link these two things okay another thing you have to do you have to explain why the spr sprs on all assets Rose so spreads rise mean prices fall so prices plummeted on everything not
not just subprime so if it's if it's all to do with subprime or some kind of toxic asset story you need to explain whether everything out there was somehow a toxic asset so so let me be a little more specific about that so here's a Picture uh we don't need a lot of the details on this going up is bad going up is bad right spreads are going up means prices are going down so just one the thing you want to have in your mind is going up is bad so the red line is uh
something link to subprime it's a derivative link to subprime that's all we need to know for today so you can see that uh in starting in January 2007 you can't see it because of the scale the figure but this line just starts going Up right subprime starts deteriorating we all knew that was going to happen and indeed it it happened the blue line is a measure of interbank risk that's all you need to know it's a measure of interbank risk now you can you can see you can see here that right here uh is when
I had a heart attack basically and this was just kind of unheard of and then it flattened out and we get to Leman Brothers okay now the thing the thing to Notice about this picture is that this line just goes up but this line stays flat for a long period of time so the these if if the whole story was about subprime it seems like those those two lines should be uh correlated or close to each other and indeed they are here so this picture has the same measure of interbank risk but it has three
other spreads and these are spreads on AAA securitized bonds backed by student loans credit cards and auto loans so These are these are asset classes have never had a loss in the entire history of the universe uh and they they didn't they haven't had a loss now and yet they're tracking that that interbank measure of risk very very closely so it's a bit of a problem right this thing subprime is supposed to have something to do with interbank risk and that's supposed to be the whole story but there wasn't there wasn't that many uh losses
on subprime so we have we have this Strange situation where you have this tracking interbank risk but not that okay now you know there's another problem here which is that you know people who try to explain the crisis was whether they're academics or Regulators or the press or whoever they are they don't have this data they don't they didn't see this data right because they weren't they weren't in a position to see the data and that's going to be that's going to Be quite uh Insidious okay so we have to explain that there's one third
thing you have to explain you have to say whether the crisis was this special event right it was immoral greedy Bankers created toxic assets uh which they got inflated ratings and sold to stupid investors right so so the question is is that that's not an explanation for every financial crisis it's not even an explanation for this financial crisis But you have to you have to have a view about whether there's something some structural reason why Bank debt is particularly vulnerable to bank runs or whether every financial crisis is some kind of special event so in
fact crises are not that rare right I especially compared to what economists thought before this crisis so since 1970 there have been 147 systemic events around the world events where the banking systems were about to go bankrupt were it not For government intervention and these are these uh events are not just in an earlier ERA this is since 1970 of these events 147 involved Bank runs and in the rest of them the government took some big step like nationalizing the banking system or issuing a blanket guarantee so here's here's a here's a uh just a
list just to convince you that uh developed countries uh haven't been immune from this this is uh from some other researchers so the idea the idea That Financial crises are uh rare is not true the real question about the financial crisis is why didn't we have a financial crisis between 1934 and 2007 that's a question we should all ask right why didn't we have one would have Bankers suddenly become greedy but rating agency suddenly got it wrong so there's some sort of puzzle here to be answered here's the here it is around the world it's
the same uh 147 banking crises and you can see that the Experience uh internationally um is quite uh is quite heterogeneous you have some countries uh that haven't had a financial crisis since since 1970 you know uh Sudan is one they don't have any banks that's a policy some politicians have recommended here uh and you can see the all-time king of banking crises the country that has a banking crisis like every seven years which is Argentina so there's a huge a huge range of of outcomes so they all look like this so If if if
we had lived in uh the 19th century in the US uh we would be lined up at the bank with our friends and we would all know what had happened we wouldn't understand necessarily how this happened or why this was happening or what the effects were but at least we would have seen this we would have seen this happen so what I want to do is start with some banking history and I want to start with some banking history just to alert you to some basic facts About these previous crises uh and um uh and
to to get you to start thinking about this in a certain way so banking panics have been the norm I'm just going to talk about the US so as we've talked in this conference the past few days before the Civil War in the US Banks issued their own money Banks issued their own money so I would have arrived in Atlanta with money printed by a bank in New Haven Connecticut and I would come here and I would try to buy lunch And they would I'd have to stand there for 20 minutes while they were trying
to figure out whether it was real and what it was really worth and it was very difficult to actually transact but in this era at least for the states that had Free banking laws the collateral the collateral backing those notes was State bonds the whole story here is going to be about collateral what backs money private money so it turned out that uh those many banks failed uh not because Of Wildcat banking but because uh of bond prices went down and this is a very important paper it's by Art rolnick and Warren Weber who's right
here it's paper I always talk about paper I teach and it's it's it's the first uh paper that shows you that has to do with collateral okay then we move to the national banking era now the national banking era uh the government takes over business the government takes over this business and and now I come to Atlanta and I Offer $10 and it's accepted for $10 so that was a huge step however it was not uh done so that we'd have a more efficient means of of buying stuff it wasn't that at all it was
that the North had no way of of financing the Civil War so they decided to have this this piece of legislation that would say you have to issue our stuff now and back it by US Treasury bonds so there were these banking panics occurred in the Free banking era but when the national Banking era came into being uh most people at that time thought that the whole problem with banking panics had been solved right why because the money is backed by us treasuries so in 1873 there's a banking there's a banking panic and this is
this alerts people Regulators uh and academics to the fact that demand deposits checking accounts now have this problem right and it took economists about almost a hundred years to understand that checks were money Academics were writing papers like our checks money right they didn't they did they thought it was like a savings account they didn't realize uh how this was used as a medium of exchange and sort of surprising as you look at how the clearing system you see millions and millions of dollars so we're we're going to uh talk about uh a new form
of bank money uh with a slightly different clientele uh and it's called sale and repurchase agreements repo for short and I'll explain how repo Works in a few minutes and the point I want to make to you is that the idea that the form of bank money changes should not be an alien idea right in capitalism things change that's the whole point of capitalism right so things change and if you don't keep up uh you know you're going to be still using a landline instead of an iPhone right so that kind of change happens in
the financial sector as well so so let's look at the Uh national banking era so this is the na this is a per this is from uh 1865 to 1914 the the the rows in red are banking panics so the the column on the on the on the left gives you the National Bureau of economic research business cycle chronology which has never been revised so it's not exactly right and then comes the date the date the Panic started uh and then uh is the percentage change in the currency deposit ratio Every everybody's running to their
Banks they don't want their checks they want cash so this thing should rise until the banks all just suspend convertibility the banks just said we're not giving you any more money that was always illegal but that was never enforced so you can see that even before they had INSP suspension there was pretty big uh increases in this currency deposit ratio now during this period the national banking era we don't have uh national Income accounting we don't have unemployment statistics um and today uh you know we can talk about this at the end of you want
we're sort of in the same world of not having the right set of measures and trying to pretend that we do we're we're we're back in this world before you had all this information so economic historians uh look at pig iron production which was very important for railroads and you can see uh from Peak To trough that these these panics were horrible right Peak to trough this thing went down 51% and so this was the first Great Depression in 1893 there's another Great Depression then there's other great depressions until we get the other Great Depression
now we call it the Great Recession so these events these events were occurring regularly now now notice a few things about this if you look at this these last two columns this column Uh is the losses per deposit dollar as calculated by the com controller of the currency so you have this horrible outcome and yet when the dust settles on average two cents per dollar was lost in 1873 and and the rest of these are just tiny they're like the 17 basis points right so what what's happening is these banks are not bad Banks right
they're not bad Bankers FDR talked about this in his radio address he said look Bankers are not all bad there's a few bad ones We're going to find them don't worry about it so in this era uh there weren't a lot of losses and there weren't very many failures right so this is is sort of a a hint a hint that this event while not irrational is not driven by some massive problem with fundamentals that's not what's going to happen so this is what the banking uh system had looked like uh during that period these
are the institutions which Are regulated uh and so here here's the here's the bank so the bank uh the depositor deposits money in the bank the bank says I'll pay you 3% interest the bank takes the money and lends it out to somebody who wants a mortgage and this person's going to pay 6% interest so the bank earns 6% pays 3% and and and earns the spread right it was a very sleepy business for a long time because this form of banking didn't hadn't hadn't changed its basic form for about a Hundred years it had
been different earlier so so this traditional banking system as we're going to see is is uh is going to is going to morph it's going to morph now to understand that we need to understand uh a bit about Bank debt and what it is is that Banks do okay so what you know what you can't understand this you understand banking at some reasonable level so the output of banks is debt right you know General Motors makes cars McKenzie has advice Banks Make debt right so your checking accounts are debt free Bank notes are debt their
their output is debt right then they do something on the other side with the money other any kind lots of firms can do what they do on the on the Li on the asset side so this debt has this very particular feature the problem is that you when I come to Atlanta with my New Haven money I I don't really know what its true value is right I go to the store and the the person in the store Gets out this newspaper and they look at the newspaper and the newspaper reports a price from some
secondary Market where some sharp person is like picking us all off uh because the discount on this it's only worth 950 in Atlanta uh is something I don't know anything anything about so the whole point about Banks is that they want to produce something that always trades at par but earns interest right we don't want this stuff right it doesn't earn interest you don't want it Nobody wants it right that's why the biggest Market in the world is the Foreign Exchange Market nobody wants it's like a hot potato so Banks Banks want their debt to
always trade at par that means $10 buys $10 so I'm going to describe that as bank that is designed to be information insensitive so what is does that mean that means I don't have to when I when I trade when I buy lunch with my $10 I don't want to have to worry about Whether the other person knows more about the value of this note than I do I just want to know that neither of us know anything and so it's worth $10 and that's what Deposit Insurance assures you deposit Insurance says to you don't
even worry about what it's worth right just just go use it use your checks the government is going to take care of the banks right so so I'm going to call that information in sensitive and then the problem is that this debt can become Information sensitive so let me show you let me show you a quick picture of that so here's here's uh uh the payoff uh function for debt right so over here we have payoff on debt at maturity so this is the the face value of your debt so it's say $100 never mind
about the interest at maturity you're supposed to get a $100 you can never get more than $100 with debt right however uh how much you get back depends on the value of the collateral backing this Debt right so if the collateral is to the left of this line then you can't get back your debt your full amount of 100 you get back whatever the collateral is worth this is a 45 degree line okay so the idea the idea of of private money is to convince you that the value of the collateral is always over here
right and with Deposit Insurance it says don't even think think about the collateral you can just use checks so the the problem with a crisis is that if you get Close to this point right if you get close to this point maybe it's just here then people start to worry about what the value of this collateral is and when they want when they're worried about the collateral the best thing to do is just go get your cash right so if something happens to get us to this point uh and people start to think about the
dead and maybe produce information about the collateral then this debt has become information Sensitive so so let's talk about the collateral right so the collateral in the Free banking era was the state bonds uh for the states with Free banking with checking accounts uh you have Diversified portfolio of of uh loans uh with repo as I'll explain you're going to have a specific Bond and with asset back commercial paper you're going to have a portfolio of highgrade uh secuti bonds okay so there different kinds of collateral which are behind Different kinds of money okay and
what's interesting and we don't have time to talk about it but when the bank creates money it's always debt but the backing collateral is always debt right the same so you you really make the the the money information insensitive by also making the collateral information insensitive to the best to the best of your ability so okay so let's skip this so This loss of confidence right so so loss of you know there's a lot of terms that um People use like they say people lost confidence that causes banking panics people lose confidence like saying inflation
is caused by prices going up um people die because they stop breathing right these are not real statements so here here what a loss of confidence means is the debt moves from information insensitive to sensitive and that's going to be something which happens to to all bank money at the same time right that's not a domino effect All bank money right so when Bernan was saying 12 of 13 financial institutions were about to go down the tubes that that wasn't a contagion story that was there something happened which caused that to be the case okay
so um so let's let's let's move on and talk about uh the demand for safe assets so I'm going to take a little a little sideline here so behind these forms of money there's something some kind of collateral okay and there's A global demand for safe debt as collateral so what is the state Authority for financial Exchange in China buy they buy trillions of dollars of US Government debt right why is that because it holds its value right we we're selling them insurance basically so there's an interest some interesting things about this uh collateral so
here's a picture of uh safe debt as a percentage of total uh uh Financial total assets in the United States so total assets in the United States grew exponentially in the last 30 years more wealth was created in the last 30 years and all of human history put together prior to that and there's two there's two shaded areas this is this is uh government liability So This Is Us treasuries minus whatever the government's holding like in a Social Security fund and this is privately produced safe debt and I'll show you what that is in a
Minute okay so this has been about 32% roughly since 1952 so now so total assets goes up and the economy wants 32% of that to be safe assets okay so that's a kind of demand for money it's not the money you usually think of but it's a demand for money so there's a couple other things to notice about this that are very important one is when the government debt goes down the private sector fills in fills in right so you can see that in the picture You can confirm this econometrically but uh the private sector
is wants to make safe debt if the government doesn't provide enough of it so the private sector can't make safe debt but they they try their best to make safe debt so this this safe debt uh before the financial crisis there was a shortage of of safe debt and so the private sector started creating lots of things um that are later going to get us in trouble now what is what is the the uh privately Produced safe debt so I'm just going to look at I'm going to look at this stuff and I'm going to
show you the percent of each kind of uh debt uh divided by just this stuff okay so here so here it is so here's traditional banking this is checking account you can see that this banking system has really declined right it's not it's not as important as it once was right and notice this happens over a fairly long Period of time right this is not a sudden change these other categories are the interesting ones this category is basically money like short-term debt that companies use sale and repurchase agreements asset back commercial paper uh and then
you have the collateral so this is private label mortgage back Securities and non-mortgage back Securities so this this red bar is the shadow banking system and this blue bar Is the traditional banking system okay so the shadow banking system was at least as large as the traditional banking system right Shadow banking is the real banking system you know we need this banking system so you know in retrospect it's kind of interesting that all this is happening um while economists are writing those mathematic papers that the dean was talking about right I mean it's all happened
like under our noses okay now the the main The main the main point here is that um we're going to we're going to need this collateral uh and we're going to use it to back this new this new form of money so let's talk about sale and repurchase agreements so a sale and repurchase agreement is like a checking account basically you deposit cash overnight you earn interest and you get a piece of Catal so let's let's go through an example Fidelity one of the largest Mutual fund companies on Earth people send money in it goes
into a cash account which is going to be managed Fidelity doesn't want this to just sit around and not earn interest so they're gonna they're going to go to a bank they go to Goldman Sachs they say I want to deposit a $100 million with you overnight what's the rate and Goldman says 3% annualized and then Goldman says your collateral is a bond worth $100 million Which you're are going to have possession of not that they literally give it to you but at the clearing Bank it changes accounts okay so the next morning uh every
morning in the US the repo Traders call up the counterparties and they say do you want to roll your position that is do you want us to just renew the loan at some new interest rate and we'll check the the value of the collateral so the market value of the collateral equals your deposit okay and And you make a decision your Fidelity you say well I need my cash or I don't need my cash okay now notice that this is we're talking about trillions and trillions of dollars right before the crisis you know about eight
trillion dollars worth of repo would roll so just think about that you know I call you up I say do you want to roll your position if you say to me I need my credit team to study this bond for a week well you don't earn an interest right the system Doesn't work that way it's like a free bank note we have to argue over the value of the bond so we need collateral where that doesn't happen so I I have a lot of former students thousands and one of them is a head of uh
repo trading at a very large institution and he he Likens uh repo uh uh to speed chess speed chess right I mean in the stock market you spend a lot of time analyzing stocks and you know you you go to a central Exchange In fixed income markets that doesn't work that way and in repo it all happens very fast and by the way it's not stupid the collateral is going to be stuff we agree upon okay now so how can this work well repo is carved out of the bankruptcy code so if Goldman Sachs defaults
Fidelity just keeps the bonds and we're done we don't go into chapter 11 right so that's why it works as money because if we had to go into chapter 11 our money would be tied up with lawyers And all that so it doesn't you don't do that you you unilaterally terminate and just keep the bond so this this collateral also uh can be re hypothecated which is a word all economists know now um you know they learned these words you know 19 2009 uh collateralized debt obligation these things uh so what does that mean so
go back to my example Fidelity has aund million Bond uh it's overnight but um uh they they they're a global firm so they Might use that bond for some other purpose for example they have a derivative position that's a liability for them and their contract says they have to post $100 million to a counterparty they can do that so Deutsche Bank has it now and then Deutsche Bank can use that bond to borrow in the repo market and you know the next morning uh if I want my cash back I have to give them a
bond I'm Fidelity I that doesn't necessarily have To be the exact same bomb it would have to be say a US Treasury so the collateral moves around it's like the it's like the money multiplier in simple money in banking okay so we by the way we have absolutely no idea the extent of this no idea no no data no nothing okay now now here's here's an important Point let's go back to my example I Fidelity deposit $100 uh in Goldman I'm promised 3% Interest now the first thing to notice is the return on the bond
that I have as collateral goes to Goldman so what is Goldman doing Goldman is is promising me 3% and earning 6% it's banking right just like the other bank right and what is the bond the bond is something backed by bank loans from the other system from the traditional system so the traditional systems grinding out these bank loans we put it in portfolios to make collateral And then it's finan against in this other banking system so Goldman's earning the 6% that the bond returns and paying me 3% so I lent them $100 the next morning
I might say uh look I'm a little nervous I want you to give me back $2 but I'm keeping the $100 Bond okay so now uh let's just go let's just go through this from the beginning again this is very important let's start in the beginning I Deposit $100 imagine the following this doesn't really happen this way but imagine the following Goldman takes $100 they rush out they buy a bond worth $100 and they give it to me for collateral and they're going to earn 6% on that Bond so my loan to them financed that
Bond they borrowed $100 uh they bought a bond they're going to earn 6% and they're going to pay me 3% now if the next day I say I want to keep the $100 Bond but I want $2 back That's like I withdrew $2 because now they have I'm only financing 98% of the bond so they have to come up with $2 somewhere okay you see that see the problem so normally that's not a problem but that's like a withdrawal from the banking system I withdrew $2 from my deposit of $100 okay okay so there's there's
some we know some about this repo Market um the depositors uh tend to be uh Institutional investors uh and and and a lot of them are from around the world um and so these uh these these banks these Banks need to have uh collateral right they need to they need to have collateral so Goldman Sachs Leman Brothers all these people the reason that their uh balance sheets grew is because they had to have collateral to hand out to all these people who wanted checking accounts right Sovereign wealth funds and so on so they they they
these Institutional investors uh have grown enormously in the last 30 years right I mean no we don't invest in the stock market no individual household invest in the stock market we all put our money into mutual funds and and your pension fund and the whole you know trillions and trillions of dollars of financial markets are basically run by institutional investors right whether it's the California State Pension Fund or um black rock or um TASC and Singapore these are you know trillions and trillions of dollars of money uh that have are now managed by institutional investors
this wasn't true 30 years ago okay so while all this wealth grew we had along with it a number of uh important changes um in in the world another change which is uh which has happened which is a pure regulatory Arbitrage is another banking system grew up so the regular banking system had interest rate ceilings for a Long time they couldn't pay they pay they only PID zero on their checking accounts and later a little bit so another banking system arose money market mutual funds where you can write checks and deposit and so on and
they don't have to hold any Capital uh and so they grew exponentially right so this is this is going to this is taking taking money away from the traditional the traditional banking system now if the if the uh if The I don't know what to call them the the the old investment Banks the old investment Banks if they're growing to supply this new kind of money and Commercial banks are supplying less and less money then the total assets of dealer Banks the old investment Banks divided by total assets of commercial Banks should also be growing
okay remember the economy is Shifting demand deposits are becoming less important all Our money's run by institutional investors they want repo so now we have to supply repo for them and so those institutions that do that have to grow so I'm going to look I'm going to show you a plot of the ratio of total assets in dealer Banks divided by total assets of commercial Banks okay so take JP Morgan JP Morgan has a commercial bank that's going to be in the denominator and they have a dealer bank that's going to be in the numerator
okay Okay so here's what it looks like so you can see in 1990 uh this ratio was about 6% and then it just keeps growing it just it just keeps growing until uh at the time of the crisis it's 30% and remember this is around the period that uh these firms change from being Partnerships to publicly owned corporations right which is means completely different system of risk management when you're not a partnership anymore so you know uninsured commercial Banks uh would be finan uh be financed by 75% demand deposits roughly right so they had they
had a lot of demand deposits even though they were uninsured and they were subject to to bank runs so you know it's not so surprising that the dealer Banks uh were about 50% repo finan and this is this is true since uh this is just you know one date 2008 this they started putting this information in their ual reports in 2000 and until the crisis it was always around these Numbers so here's you know total financial instruments owned percent of that pledged as collateral so this gives you a sense of the size of this other
this this repo market now remember this is just a subset of the firms involved in this right we don't have any foreign firms uh for example uh so we have this little this little snapshot so this this is this is exactly this kind of product that they're applying now um The the size of the repo Market well we have no idea we have no we have we have no idea so uh at one point in the crisis I I uh I did a back of the envelope calculation and I said it was 10 trillion the
same size as the commercial banking system everybody sneered at me uh and then some bis economists did a different back of the envelope calculation and they got 11 trillion and then IMF economists did a different back envelope calculation they Also got 10 trillion so I think we can conclude it was pretty big it was pretty big uh and it's kind of shocking that we have no other data really about it I mean the FED has the repo done by the dealer the primary dealers which are the banks that the FED is willing to trade with
that's the old days now they trade with money market mutual funds so uh and also ironically this repo was counted in this monetary aggregate M3 but M3 was discontinued in the mid in the uh mid2 2006 because it was highly correlated with M2 right because they you know they didn't they mismeasured it so um so this collateral is what I want to focus on I want to focus on now so let's let's ask what could this collateral be what's the available collateral so this is the this is the amounts outstanding in uh the US um
uh treasuries uh mortgage related this is all private label uh but would include Home equity loans uh Corp Us corporate debt agency bonds Fanny and Freddy bonds and non-mortgage asset back Securities so this is this is what you could use as collateral right now uh so that that tells you what's issued right one one one of the problems is that uh a lot of this is held abroad it's held abroad so that that's you know that's kind of a plus and a minus you know if you know anything about international trade you know we Buy
teddy bears from China we give them money they don't buy goods from us they buy treasury bills right that's a product so our our Capital account uh looks way out of whack we have a lot more liabilities and assets right we owe a lot of money to China and the oil producing countries because they buy Securities not goods and so but we make 200 basis points more on our assets 2% more than on our liabilities which tells you that we're we're selling a product We're selling a product which was safe debt so before the crisis
the US had three industries that mattered tech rap and movies and entertainment and safe debt that was it those three now we have two right so we better hope that rap evolves um so a lot of this a lot of the collateral is is is off the table uh for purposes of use in in the US system although uh it's not as if we don't want to have this business we we do want to have this business so again a back of The envelope calculation um says that uh the If I subtract out the amount
held by foreigners I get 16 trillion and what do I want to use that for well we need we need collateral in derivatives so when I uh trade a derivative with you its market value typically is zero at the start and then if it becomes a liability for me I owe you money two years later I have to post collateral to you so the this this organization has done a survey and that's about four trillion and we Don't you know we don't really know about repo but we know it's a big number and then there's
clearing and settlement clearing and settlement so clearing and settlement refers to the whole plumbing system uh that's behind all the financial markets so if I buy a bond from you I don't you know hold out my $6 million dollars and you hold out your bonds and we switch that's not how it works it all goes through this big complicated plumbing system that that no Nobody cares about until it doesn't work anymore right it's like when the sewage is backing up in your house suddenly you want suddenly you want to know what's happening so that's a
huge black hole and no we have no idea how much collateral is is sopped up in that but part of Dodd Frank is we're putting all this stuff on exchanges and you're going be forced to have margin so that's going to suck up a lot of collateral the bank for international settlements new bank Regulations are going to suck out about $2 trillion of treasuries so they're pulling collateral out of the system right it's sort of the name of uh stability okay so what was the response to this what was the response to this well us
commercial Banks became unprofitable in the mid 80s in the mid 80s money market mutual funds had taken off junk bonds had taken off uh you know traditional banking was not profitable so a lot of things happened I just want To focus on one thing securitization was the happy meeting of banks needing better financing and the rest of the world needing collateral so a bank can Finance on balance sheet or off balance sheet the the beautiful thing about securitization is that it can't go bankrupt so so let me show you how it works so in securitization
you have a legal entity called a master trust a master trust and this entity uh issues Securities in the Capital markets and takes the money and buys a portfolio of assets from this firm which is can be it can be a bank but it could also be uh Visa or um General Motors you know auto loans uh all manner of firms so this what we've done is we've taken the loans that this firm has made and we've turned it into collateral that can move around to to whoever needs it remember in traditional Banks it's just
sitting there right they're they add value by making the Credit decision right once the credit decision is made they sit there and wait for the checks to come in and if they don't they have this division that goes and repossesses the Motorcycle or whatever it is so it's not it's like a waste of resources we could be using this stuff for collateral but to use it as collateral we got to get it from here over here okay so this guy this guy is a big fat set of rules right nobody works There it has no
physical location it doesn't do anything else uh it's a robot firm okay and there's millions of these robot firms so you there's a whole world of these robot firms I mean when Enron collapsed there was this kind of glimpse of how how much of this stuff was going on they weren't securitizing so that was a whole different ball game but this this is a way to move passive loans that are not really being used from here to here right and this this entity has the Uh nice attribute that it can't go bankrupt so there's a
lot of complications here which I'm not going to go into but but basically there was this way of creating collateral and we needed to create collateral remember because we had a shortage of collateral right because China's buying all the treasury bonds so um so the banking system before the crisis looked like this so over here is what The Regulators knew About right here's the bank and here's the borrowers this bank is making mortgage loans and then the bank is shipping these mortgage loans to a wholesale Bank Goldman Sachs that secures ades them sells them into
the capital markets to investors and then investors might want to do uh repo so they keep some of it so these guys can do repo and then they reh hypothecate the collateral so everything to the left of that Line uh no one knew about unless you were in these markets then you knew all about it but if you if you were a regulator or an academic you didn't know anything about this so uh this process of backing repo and I have I haven't talked much about asset back commercial paper but backing these instruments with mostly
privately produced collateral from securitization was kind of a weakness we we shipped all the good stuff to the rest of the world Treasuries and then we started we started uh using this private stuff for to back our money okay there's a lot there's a lot more to the story but that that's basically what was what was happening okay so that's all background so what does this have to do with uh the crisis we're supposed to be talking about the financial crisis not teaching all of money in banking um so so here here's the here's the
financial crisis so this is the amounts of uh subprime Mortgages originated in 2005 and 2006 that's 1.2 trillion were originated 80% of that was securitized okay so these mortgages were financed by investors buying bonds and if you bought the AAA Bonds on average you would have lost the 20 basis point I talked about in the beginning now the fact is you know that if all of subprime defaulted and there was no recoveries at all that that wouldn't be a global financial crisis that would be one hell Of a problem for our country and we still
have the problem right because we haven't done anything about mortgage uh relief so but that can't be the story right remember the first thing I said you had to expl the second thing I said you had to explain the first thing you had to explain is how do you get from the loss on subprime to the entire Financial system being bankrupt and the answer is the answer is you don't need a lot of a lot of uh Problems right you need some problems so I'll tell you what this is in a minute how many people
in here have ever been to a slaughterous one you a veget are you a vegetarian so I I grew up I grew up in Arizona uh out in the desert kind of and my the neighbor was this huge uh cattle um feed lot and slaughterous the TOA family I went to school with their kids and so you know one time the father took us into the slaughter house and the way It works is they get all the cattle in a line and uh they go through this shoot and they come to this point where they
shoot a bolt through their head and then they're picked up by the feet and they're carried into this refrigerated room where all these guys with bloody aprons proceed to butcher this thing and then if they're making Hamburger they grind up the meat and then they have to mix the meat right because Americans want a certain Fat content if the McDonald's hamburger doesn't taste the same every place on Earth there's something wrong so you have to get exactly that fat content which means you have to mix the meat now when the number of cattle that comes
in is called a lot of cattle a lot it's not a lot it's a lot so it's it's about 30 30 head of cattle come in so you make the Hamburger the next lot comes in you do the same thing now the problem is is that later um somebody can come down With eoli eoli and when that happens the you know the FDA can go to the exact slaughterhouse and the exact lot because of that barcode if you save the barcode on your hamburger they know exactly which 30 cows it may have come from but
they're not sure because they mixed they mixed it and then maybe they didn't clean their Grinders right so they suddenly recall Like 10 million pounds of hamburger because they're not sure when this all happened because we're supposed to inspect them but they don't have enough inspectors they don't have enough resources and so maybe they didn't clean the Grinders and so we recall everything right so I you know I say to my students you know suppose I offer you a choice of 10 glasses of fantastic burgundies each one different and you can pick one and drink
it but one of them's poisoned and You might die right so they say oh we don't want to do that I say okay what about a 100 what about a thousand like how many do I have to offer for you so it's it's this it's a small risk it's a small risk but uh it can it can it can generate a big response right so the the small thing that happened was the news the news was was big for news which was that there were problems in subprime I mean we didn't know at the time
that the losses were going to be so minuscule and We didn't know where this subprime was because we didn't have little barcodes so you know you thought it was your counterparties so for for high quality dealer Banks Goldman JP Morgan the haircuts on repo before August 2007 were zero so remember the example we went through I finan a $100 bond for Goldman Sachs and the next day I want a 20% haircut so I want $20 back right so so now Goldman has to come up with $20 to finance 20% of the bond I'm financing 80%
they have to finance 20% now so I withdrew $20 so the question is you know where are they going to get the $20 in the middle of a financial crisis you can't issue Equity uh and you can't sell debt uh so we'll come to that but here's the picture of the financial crisis and this is not government data I had to give this data to the government it tells you the kind of state they were in this is a equally weighted average of the haircuts on 10 categories of asset Back Securities and mortgage back Securities
and collateralized debt obligations and some other stuff so you can see it was Zero until this little thing where I had the heart attack not knowing what was coming right and then it just it just Rises so so here's a back of the envelope calculation so the FED uh let's start it this way suppose the repo Market is10 trillion and suppose looking at this Picture that haircuts went up to 30% on average so that that means $3 trillion is withdrawn from the banking system so you know where do you get the money money well the
FED bought two trillion and interestingly a trillion of it basically went to hedge funds and the regular banking system right so that was the very very painful process that that I'll say a little bit more about um so that that is related to one of the puzzles I was talking about right so we Know now that a small shock can be a big shock in terms of news and cause this response and let's go back to one of the pictures I showed you earlier so what does this picture have to do with it people are
withdrawing from their repo these banks have to come up with the money so they sell assets they need to raise as much money as possible so what do they sell they sell their best stuff their best stuff and they all sell Their best stuff and their best stuff is this stuff so every time they get a little bit riskier haircuts go up a little bit they dump their best stuff but all of them dump their best stuff at the same time time they all reason the same way so that's why that's why uh uh the
original picture wasn't the story The in Bank the inbank uh risk picture tracks the haircuts and as those are going up the banks have to sell assets and they sell their they sell their best Stuff now so who withdrew from the banking system again we don't have very good data but this is from the government fed's flow of funds data so this is net funding received from repo so net means I net out all the financial firms right so you can see that in their data uh the amount flowing in based on what we do
have is a little over 2 trillion we you know this is like crummy data but the best we have so you can say well what happened you know you see you See this big here's the bank run right now who who ran who ran who was it who ran well uh green ran that's rest of world rest of world ran and also red ran and red is statistical discrepancy so in the FED funds you know it doesn't all add up and so you have this thing called the statistical discrepancy and it's kind of suggests we
we better go find out what the hell it is because they really ran right I mean They went from about a trillion positive to you know withdrawing everything so so we you know we don't exactly know the identity of these of these people so I want show you another another picture and then I'm going to make some concluding some concluding remarks so I want I just want to stress this point about the uh dumping the good assets I'm going to show you a picture of double A minus AAA spreads on fiveyear Industrial bonds so let
me just Say that again double A minus AAA spreads should be a positive number because able a is worse than AAA so it should be 50 basis points minus 10 basis points something like that so we should see a positive number over time and it's five years so we're holding maturity constant and these are on the run so these are all recently issued bonds again this is data from a dealer bank so this thing should always be positive but nope not always positive look at This again what's happening what's happening is the dealer banks are
dumping their best assets and since they they don't coordinate on this they all do it and it just crushes it just crushes the price I mean there was literally money lying around on the floor and streets and you could go pick it up this is like a huge Arbitrage opportunity right but nobody nobody wanted to do it and why was that that's because when you when you have things as Collateral to have them work as collateral privately produced they have to have a number of properties one thing that really helps you is very complicated if
it's very complicated you don't have to worry about somebody producing secret information about it right we all know what it's worth because it doesn't pay anybody to produce information about it so complexity is great until you're in a crisis and then you have this and nobody Wants to buy the stuff because it's too complicated and they can't understand it so in a crisis you're really crushed but before the crisis you need it to be complicated so you know throughout history um no banking system has been intentionally liquidated during a crisis the euphemism now is resolved
which means liquidated um and and Banks societies and governments have always come up with a way to save the banking system right they they allow suspension Of convertibility they allow state governments to pass laws saying you don't have to pay your mortgage for three years uh Supreme Court declared that constitutional on the basis of nothing um uh but they said it was a systemic event um so saving the banking system uh is something that societies have you know always chosen uh in the brink in the brink of thing but the problem problem is that saving
the banking system means saving the Bankers and throughout American history after every crisis there's a huge anti- Banker backlash and a huge you know kind of narrative that doesn't make any sense that motivat some legislation which then doesn't work and we have another crisis and the problem is the problem is that that when you have this this this unfortunate feature that you want to save the banking system but that means saving Bankers you put the whole now we're all in this position where you Know everybody wants to Lynch bankers and that that doesn't lead to
good outcomes that's why I mentioned you know Deposit Insurance uh was a populous mandate so so you know Bank B the big pieces of Bank legislation in the US which I would count as the national Banking Act and Deposit Insurance were not by intelligent design right it wasn't like people said oh this would be a great thing to have it was Finance of Civil War and the American public are Just demanding it so politics basically just prevents prevents reform and so you know we're we're we're we're basically uh we basically reproduced history very well and
unfortunately you know the last the last crisis was you know my grandmother being sent by her parents to the bank to withdraw from the account and she got there and there was no money and the guard gave her a painting Off the Wall which I wish I still had but that that memory lasted through uh Jimmy Stewart and it's a wonderful life so that was in the early 50s and people still had memories of the Great Depression and now um you know it's like uh a family guy had a brief reference to It's a Wonderful
Life so the whole the whole memory and understanding of this has been lost and on top of that you didn't see the Panic so what did you see you saw firms get into trouble right you know a AIG didn't cause Financial prices to go down we stood there and watched Them plummet right they just went down right and then the accountants ah let me get started uh so so it's we're we're in a we're in a um an unfortunate unfortunate situation that's what I meant by a pessimistic ending let me stop there at at one
point at what point should uh some of these complexities uh be legal or at one at what point should things um be prevented from getting more complex on the basis that they cause These sort of I mean like I I don't think your talk like necessarily said that like complexity is a bad thing or a good thing but do you think that like the fact that uh I mean you talk about um how at the very at the very end of all these crisises like the American people go against Bankers like do you think that
has something to do with the fact that they're sort of uh seen as these people in these high Towers uh being able to understand these things That no other people can possibly they didn't understand it either I mean so so so so it the complexity is not the problem the problem is that the government had no oversight of securitization zero so if you have some oversight and I have a proposal about exactly what to do which I won't go into uh I think I think you could see what you want you you need to have
private collateral made the treasury is issuing bonds to fight Wars and so on not to Provide collateral so we're going to have private collateral made what we'd like to do is make make sure it's safe but not in the sense that it's less complex but in the sense that somebody makes some decisions about what you can use like you know so is if you had the system and you went to the regulators and say can I use subprime mortgages for securitization the answer would have been of course because we have a national policy everybody should
have a House subprime before the crisis was this huge thing that was great but if you have these institutions in a framework where they have access to a discount window and so on then you can then you can make make this system work so I I just want to point out that you know you know this is this this is a free enterprise system right you can't make Banks do things because they can always exit they can go make widgets so you can't you you have to have a carrot And a stick you can't just
have a stick because the shadow banking system that we see 20 or 30 years from now uh is going to be something they didn't notice either and they didn't know why it happened and you know so it's very important to bring this stuff into the umbrella rather than push it out so let me give you another example the vulker rule had nothing to do with the crisis even vulker says that has nothing to do with crisis so you know think about the Vulker rule would you rather have the risk being taken in an institution that
you oversee or do you want to push the risk somewhere where you don't even know where it is right I mean it it it's that sense in which you need more oversight but that doesn't mean you prevent things or you know know these kind of policies no I mean it it wasn't it wasn't I mean remember that there's two kinds of markets right there's very Information sensitive markets called stock markets those trade in central locations where everybody can see the prices there's zillions of Equity analysts and University of Chicago has been studying it forever okay
then there's another sort of Market that's much much bigger but it doesn't trade in a centralized way it trades over the counter and why does it trade over the counter because there's no information to produce anyway it doesn't even matter Right I mean most of these bonds are sold and you never they never see the light of day again they mature and so on so it's a market that that uh functions because it's information insensitive so that that that world we need we need right so if again think about Deposit Insurance Deposit Insurance didn't say
we don't want any information it said we want the government to get the information and examination reports of the government Are confidential even now they're not even released like you know 50 years later right Mark Mark's trying to get them uh so you know this this this this is this is the better solution I mean let me give it to you let me put it to you another way suppose you lost electricity power in Atlanta okay so there's two things you could do you could respond by saying we need transparency we want All These Blueprints
put on the web so I can Understand the electrical system or you can say I don't want I never want to know anything about electricity I don't even know what electricity is I just want to have somebody who doesn't let this happen and I'm going to worry about that right that's the way that's the way these s these system should work now you know why why didn't we know about it well you know I I think this goes back to this question of how where we get our information right so in the Great Depression Rosevelt
sent people out to count Freight cses to try to figure out whether the economy growth was going up or down or so in a world like this world where you have derivatives and off balance sheet stuff you need a measurement system that can uh measure risk measure risk so in the Great Depression Roosevelt realized this was a big problem and put a lot of resources behind national income accounting and Simon kzit who got the Nobel Prize for This in the US another another person got in the UK for it you know worked with the government
it was part of the government and it wouldn't have really succeeded finally until but but by good luck we had World War II and then the government wanted to know they wanted questions they had questions like if I stop the auto factories from producing cars and I make them produce tanks what's going to happen right so that that push got us uh National income accounting which is probably the biggest achievement of Economics actually measure economic activity now everything all our measurement systems are cash-based accounting fed funds national income accounting but this world doesn't work that
way right so you know I have a proposal about measurement but but you know the momentum on this has been lost already it's not going to it's not going to happen we need six more Crises that'd be good for research too but I'll tell you you know in in in for for academic economists I mean you know I spent 30 years on financial crisis even though the rest of the profession said I was an idiot and told me I was working on irrelevant stuff right and you know why did I plug away well you know
it's not that I knew there was going to be a financial crisis I just knew the the financial system was important right the rest of the world You know doesn't think that you know most you know macro models or asset pricing models they don't have banking systems in the model they think it's all irrelevant right so they're you know they're you know they've been exposed as frauds when when you see global growth occurring really in kind of the peripheral countries regions yeah do you see that growth as as they start to grow up need financing
needs to do so that that growth is tied to systemic events In the US and so that correlation effect or the kind of crisises occurring in the US will start to really affect these Global countries more especially like Frontier markets merging markets so that's a really complicated question I don't know the answer I mean let me just tell you one fact that I think is kind of interesting I was talking before about you know we buy a teddy bear from China and they buy they buy you know a treasury bond so the These accounts these
trade foreign trade accounts net so you know you net your assets and liabilities and you see whether it's zero or not and you know they that was done because it it was always you know pretty close to zero and if it wasn't close it was going to you know become close over time but what what people have noticed some people small number of people have noticed that if you look at the gross flow fls in the capital account so this is financial Transactions the US with the rest of the world the gross flows are unbelievably
large like orders of magnitude you know bigger than they used to be and they're they're disconnected from the current account which is the goods so it used to be you got International financing when you did exporting and importing and that would drive the capital account if they didn't buy Goods I sold Goods they didn't buy Goods you know it went into the cap Capital account but now the Capital flows are so enormous that they're like they're disconnected from the the you know the the the current account and that that's an important hint I think that's
a very important hint that the financial system is is just it's Global it's Global and you know it's very very difficult to coordinate with other regulators and you know other central banks I mean a lot of that was done during the crisis but you can imagine Uh this stuff moving somewhere we don't know where I mean like again take the vulker rule there's a there's a demand for risk there's lots of investors who want risk it's not irresponsible risk they want High expected returns and they're willing to take you know High volatility so that's a
product how do you supply risk to people to firms so you know somebody is going to view that as a profit opportunity hedge funds can't do it hedge funds are small Rel Speaking so somewhere on Earth Earth somebody's going to come up with a way to sell risk so we're not going to know where that is and I suspect that you know it may not even be in the United States we'll find out in the next one Speaking you had some you had some uh connection or affiliation with AIG back at the time of the
crisis and and they were U widely reported to be U involved with huge amounts of CDs is credit default swaps On these on these subprime mortgage uh tranches and so forth uh the people at AIG were were very intelligent very um uh very careful people did anybody see the freight train coming that was going to hit them so um let me first point out that uh the government the FED made made $30 billion profit off our positions right so you know the fire sale prices caused us to have to put out collateral but once the
dust settled and The prices came back the FED made 30 billion so AIG was the world's largest insurance company and the asset management arm um you know we were a kind of a separate subsidiary AIG financial products the asset management arm lost real money um so when they when they they appointed a person a vice chairman of Morgan Stanley to come into AIG financial products and um to run it and he told me later he thought he was going to come in and there was a bunch Of cowboys and they didn't know what they were
doing and he was totally shocked right and I can tell you I've never been around a smarter set of people in my life they're they're smarter than people at Yale right they're smart they're goddamn smart you know they don't they don't have time to really think about stuff like we do in Academia but they're smart and the thing the thing about AIG is that you know again there was a whole combination of Problems right remember Elliot Spitzer kicked out Hank Greenberg who's a kind of business genius right and so Greenberg was gone and we got
this guy who just didn't know what he was doing and he did all the wrong things and you know so it was it was uh you when I look back the two biggest risks when I was there the two I never would have dreamed of it's management and accounting like those were the risks and you know you can't control Elliot Spitzer kicking out the CEO and you can't control the accountants and they do Insane things so you know um I mean I you know people said why don't you write something about AIG financial products and
the answer is I think it's a sideshow uh it's not Central to anything that happen in the crisis and the Press you know they're never going to get it right because the people who know aren't going to talk and the people who talk Don't know and you know it's just it's just not it's not I mean the Press is a really interesting you know phenomenon I mean you know the press is a you know didn't really do a very good job but it's fairly hard to blame them right they call up economists and economists had
no idea if you call the experts and the experts don't know how are you supposed to know right and Congress you know these people have nine million things they have to be experts on they Can't be experts on everything so you know in a lot of ways it really was a failure of the economics profession to kind of explain things coherently uh in a way that the public could understand and would lead to good policy that's why you know Rosevelt came into office inauguration was in March in those days first thing he did was give
this a radio address about Banking and the next day people lined up to put their money back in the bank right Rosevelt explained What what had happened and what the government was going to do about it and you know this crisis wasn't like that I I don't know how many times I yelled at Ben Banky that he had to articulate a narrative you have to say you have to tell people what's happening you we can't get Obama to do it Obama should have done it right right like on the first anniversary of lhan or something
like that he should have explained to people what what was going on right but He he had to run out in front of the Pitchfork crowd so it's you know and that's that's what I mean about when you save the banking system you save the bankers and you you know you don't get you don't get anything right now Roosevelt didn't have the luxury of really doing that because the public uh wanted Deposit Insurance right that was you know they weren't they weren't after Bankers they wanted Deposit Insurance and uh and that's how we got Deposit
Insurance one more question um so you're you're kind of talking about the moral crisis of saving the bankers um first do do you have a uh uh solution uh uh for a bailout plan that doesn't have that moral crisis and the second one maybe more at home for all of us is uh where do you have your re retirement uh money it's in Tia CRA uh so so let me let me answer the first question and and It's that's a really good question because it hasn't been the focus of legislation it seems to me the
best thing to do is to not have a crisis right that's what we should do we should not have a crisis we shouldn't be worrying about how we're going to liquidate all the banks when the next Crisis happens we shouldn't even have a crisis and we know that's possible because from 1934 to 2007 we didn't have crises Canada doesn't have crises so why Can't we have a policy where you don't have crises but you're right the whole Focus has been on what are we going to do when there's the next Crisis right so they're kind
of trying to prepare for the next Crisis and crises if you really know how they're going to happen they're not going to happen right they happen you never know what's going to happen right so they're going to plan for all this stuff and I can tell you it's it's not none of it's going to work crises Happen so fast they're so Chao otic you know if you read the minutes of 2008 of the you know fomc they had no idea what was going on they literally you know and wasn't only them but they're in these
meetings and you know it was clueless they were clueless you know so it'd be better not to have a crisis but the problem is you know so gner Tim gner told me told me two interesting things one was he said my job during the crisis was to do One thing and one thing only I had to wait till the crisis got bad enough that I could get a consensus to get a lot of money out of Congress but not so bad that when they gave me a lot of money it was too late right you
know okay that's that's conditional on having a crisis right so you know you you can see the problem now the other thing was that Dodd Frank was rushed through uh before the financial crisis Inquiry commission had even finished anything and you know it was kind of a hodgepodge of people's private agendas and some kind of stuff that you know various constituencies wanted right I mean there's people down there who are like running for office I W name all their you know their names and so it was a sort of grab bag of things and that's
that's pretty much like every financial crisis in the US um and that's why I think this point about um you know you Save the bankers the blowback from that is is why we only got the national banking act because of the Civil War and only got Deposit Insurance because the American people rose up but but the but your other question I mean you know Bankers may be greedy and the rating agencies you know all this stuff you can make a big list of stuff right and you can tell from if you think these crises all
have something in common then we know it really doesn't have anything to Do with the rating agencies if Banker greed causes crisis we'd have one every week I mean you know I mean it's not these things these things are are the kind of populous stuff that gets us driving off the road right that's not to say that there's not problems with all this stuff I think you can make a list of 25 things and maybe there's problems with all 25 but at the top of the list should be stop crises well thank you so much
you the Proceeding program is copyrighted by Emory University
