BALANCE SHEET ECONOMICS OF THE SUBPRIME MORTGAGE CRISIS

Abstract

As Copeland (1947; 1952) demonstrated with his money-flows accounts more than half a century ago, the balance sheets of economic entities are closely interrelated through a lender–borrower relationship. This paper is an attempt to describe the US subprime mortgage crisis in the framework of ‘balance sheet economics’, which was originally proposed by Stone (1966) and Klein (1977; 1983). Since it is almost impossible to collect all the balance sheets of economic entities, we use flow-of-funds accounts instead to simulate the negative consequences resulting from home mortgage delinquencies. We show that the pass-through sequence converges when the original delinquency is made up by loss of net worth in any of the economic entities. Most of the eventual loss is incurred by ‘Households and Nonprofit Organizations’ and ‘Rest of the World’. A portion of pass-through loss is eventually incurred by foreign countries with excess external assets, such as Japan, Ireland, etc.

Keywords:

• Flow-of-funds accounts
• Leontief inverse
• Lender-borrower relationship

Acknowledgements

The authors wish to thank the anonymous referee and the editor Bart Los for their constructive comments and helpful suggestions.

Notes

¹ Mark-to-market accounting (or fair value accounting) refers to accounting, which is based on the prices that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. See US Statements of Financial Accounting Standards No. 157 for details.

² The theme is repeated in Klein (1983; 2003). His idea has much resemblance to Stone (1966).

³ If the economic sector is defined by similarity in the asset/liability portfolio composition, the aggregated balance sheets provided in the flow-of-funds accounts give a good approximation for the simulation results in the formula outlined in this paper. See the Appendix for details.

⁴ The sequel to Leontief and Bródy (1993) is Bródy (2000).

⁵ The assumption is purely hypothetical, which sets aside some of the realities of US and other countries' practices; we will relax the assumption in Section 3.2.

⁶ This is a sufficient condition for Solow's Theorem 1 below.

⁷ C is the coefficient matrix of asset-liability matrix. See Tsujimura and Mizoshita (2003).

⁸ The accounts also include information on flows, i.e. financial transactions. The level is generally the sum of net purchases over time. However, for some instruments – particularly equities and other instruments whose value largely reflects equities – the value outstanding is affected by change in the prices of assets. For these instruments, the level at the end of a period for a sector is the accumulation of net purchases plus any appreciation or depreciation resulting from the change in prices. For further details, see Board of Governors of the Federal Reserve System (2000) and Teplin (2001).

⁹ In Case 2, Equation 7 is written as and , where G is a set of equity and non-guaranteed asset-backed securities.

¹⁰ The Government National Mortgage Association (GNMA; Ginnie Mae), which is a government corporation, provides guarantees on MBS issued by the Federal Housing Administration and other government agencies. Ginnie Mae securities are the only MBS that are guaranteed by the United States government. Other government-sponsored enterprises including the Federal National Mortgage Association (FNMA; Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC; Freddie Mac), which are stockholder-owned corporations chartered by the Congress, buys loans on the secondary mortgage market in exchange for MBS that comprises those loans and that, for a fee, carries their guarantee of timely payment of interest and principal. On 7 September 2008, Fannie Mae and Freddie Mac were placed into conservatorship of the Federal Housing Finance Agency (FHFA).

¹¹ We also assume that the custodial accounts for reinvested ‘Collateral of Securities Lending Operations’ pass the loss onto other sectors solely through ‘Securities Borrowed’.

¹² Some examples of economic literature using CBS are Van Rijckeghema and Weder (2003), Buch (2005), Tsujimura and Tsujimura (2009), etc.

¹³ Some examples of economic literature using CPIS are Warnock (2002), Imbs (2006), Lane and Milesi-Ferretti (2007, 2008), etc.

¹⁴ ‘Rest of the World’ includes not only the countries other than the 73 investor/investee countries but also international organizations and the official reserve assets held by governments or central banks, which is not reported for each country.