Where We Have Been
Where We Are
Where We Are Going

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?
4.0
60000
3.5
50000
3.0
40000
2.5
30000
Debt/GDP - left scale
2.0
20000
1.5
10000
U.S. Debt -- right scale
1.0
0
20
30
40
50
60
70
80
90
00
1.7
18000
Euro Area "Domestic Credit"
1.6
1.5
16000
Credit/GDP
1.4
1.3
14000
12000
"Domestic Credit"
10000
1.2
8000
1.1
6000
97 98 99 00 01 02 03 04 05 06 07 08 09
4.0
3.5
Total Debt/GDP
3.0
2.5
2.0
Non-house-govt/gdp
1.5
1.0
0.5
House-debt/gdp
Govt Debt/gdp
0.0
50 55 60 65 70 75 80 85 90 95 00 05
3.8
Actual Debt/GDP
3.6
3.4
3.2
3.0
Forecast Debt/GDP
(Based on 1980-99, AR(4) Model)
2.8
2.6
00
01
02
03
04
05
06
07
08

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

Steady State
Debt-Income Ratio
Income Growth - Interest Rate
for PV (Y-C-rb)>=0
3.5
3
2.5
Assumptions: 75-year Horizon
APC = 0.80 (NIPA est.)
0.60%
-0.40%
-1.80%
Variable
Income Growth
10-year Treasury
AAA Bond
BBB Bond
Actual Post WWII Values
6.70%
6.45%
6.75%
7.67%
Income Growth - Interest Rate
0.25%
-0.50%
-1.00%

Cheap Credit
9
8
7
6
5
1990-99
2003-07:7
4
3
2
1
0
Prime
AAA
BBB
Fed Funds
ComPaper
M-Base % Changes (Y2k & 9-11 at average)
20
M2 Percent Changes (9/11 at average)
16
16
12
12
8
8
4
4
0
0
-4
-8
-4
95 96 97 98 99 00 01 02 03 04 05 06 07 08
95 96 97 98 99 00 01 02 03 04 05 06 07 08
20
16
Inflation Rate & Smoothed (HP Filter)
12
8
4
0
-4
-8
82 84 86 88 90 92 94 96 98 00 02 04 06 08
70
20
Series: INFL
Sample 1982M01 2001M12
Observations 240
60
50
40
30
20
Mean
Median
Maximum
Minimum
Std. Dev.
Skewness
Kurtosis
3.176899
3.048124
13.76434
-6.563355
2.439902
0.313226
6.120650
Jarque-Bera
Probability
101.3090
0.000000
Series: INFL
Sample 1990M01 1997M12
Observations 96
16
12
8
Mean
Median
Maximum
Minimum
Std. Dev.
Skewness
Kurtosis
3.101818
2.636830
11.40143
0.000000
1.947708
1.629926
7.161351
Jarque-Bera
Probability
111.7739
0.000000
4
10
0
-5
0
5
0
10
0
24
2
4
6
8
10
10
Series: INFL
Sample 1998M01 2005M12
Observations 96
20
16
12
8
Mean
Median
Maximum
Minimum
Std. Dev.
Skewness
Kurtosis
2.542697
2.167596
15.90214
-5.421687
2.946918
0.765576
6.648730
Jarque-Bera
Probability
62.63063
0.000000
Series: INFL
Sample 2002M01 2005M12
Observations 48
8
6
4
Mean
Median
Maximum
Minimum
Std. Dev.
Skewness
Kurtosis
2.779565
2.552644
15.90214
-5.421687
3.372371
0.797570
6.850455
Jarque-Bera
Probability
34.74095
0.000000
2
4
0
-5
0
5
10
15
0
-5
0
5
10
15
9000
GSE Assets + Govt-MBS
(in Billions $)
8000
7000
6000
5000
4000
3000
2000
1000
90
92
94
96
98
00
02
04
06
08

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?

Global CDO New Issuance (in billions $)
$1,600
$1,400
$1,200
$1,000
$800
Series1
$600
$400
$200
$0
2004


2005
2006
2007
2004-09
U.S. Mortgage market increased by $7T from 20002008
U.S. & Euro Area Debt increased by $35T from 20002008

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
4.5
.032
Capital Inflows (Smoothed) and Debt Growth
4.0
.028
3.5
.024
3.0
.020
2.5
.016
Debt/GDP
2.0
.012
1.5
.008
1.0
.004
Foreign Capital Inflow/GDP
0.5
.000
50
55
60
65
70
75
80
CAPINYHP
85
90
95
DEBTY
00
05
.06
Capital Inflows Relative to GDP
.05
.04
U.S.
.03
.02
.01
.00
Euro Area
-.01
97 98 99 00 01 02 03 04 05 06 07 08 09


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)
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…
Correlations in 6-month Cumulative Sum of Monthly Changes in DJIA
1907
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
-0.33
1919
0.15
1.00
0.07
0.17
0.07
-0.48
-0.34
0.16
0.43
1929
-0.20
0.07
1.00
-0.46
0.40
0.47
0.14
0.36
0.57
1937
0.89
0.17
-0.46
1.00
-0.26
-0.39
-0.34
-0.14
-0.33
1973
0.08
0.07
0.40
-0.26
1.00
0.23
0.33
0.33
0.12
1978
-0.16
-0.48
0.47
-0.39
0.23
1.00
0.56
0.65
-0.10
1987
-0.13
-0.34
0.14
-0.34
0.33
0.56
1.00
0.24
-0.53
2000
0.13
0.16
0.36
-0.14
0.33
0.65
0.24
1.00
0.05
2007
-0.33
0.43
0.57
-0.33
0.12
-0.10
-0.53
0.05
1.00
Cumuluative Percent Change in DJI over Prior 6 Months
20
10
Current
0
-10
-20
-30
Early 30s
-40
-50
2
4
6
8
10
12
Month from Beginning of Downturn
14
16
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
Decline in Real GDP Real GDP
5%
$10.9T
10%
$10.3T
15%
$9.7T
20%
$9.2T
30%
$8.1T
Year Equivalent Unemployment @2% Rate
2005
7.2%
2003
9.70%
1999
12%
1998
14.70%
1994
19.70%