Financial Crisis: Credit Booms, AssetPrices and Externalities

Tommaso Monacelli

Università Bocconi and IGIER

NfA Days - June 2009

� Things that typify a �nancial crisis

1. Credit boom ! Leveraging of �nancial institutions

2. Asset price boom/bubble

3. Asset price bust ! De-leveraging of banks

Questions

1. What causes the credit boom?

2. Is the credit boom a good thing?

3. What causes asset prices to go bust and the crisis thereafter?

4. Why is the crisis of 2008 so much worse than the dotcom bust of 2001?

Causes of crisis

1. Global imbalance ! capital from asian countries pour into assets inWestern countries ! low risk spreads

2. Monetary policy! Kept interest rates too low

3. Structured �nance ! the role of securitization

Monacelli

Text Box

Housing boom in many countries with different monetary policies

� What is securitization?

� Securitization: good idea ! allows to transform illiquid asset (royalties)into liquid asset

� How does it work with structured �nance?

The magic of securitization

� Suppose two identical bonds, each with probability of NOT default = 0:9! prob. default = 1� 0:9 = 0:1

� NB: prob. default uncorrelated!

� Combine them in a CDO (collateralized debt obligation)

1. Junior tranche: pay if both tranches do not default

2. Senior tranche: defaults only if both default

PAY DEFAULTjunior 0:92 = 0:81 1� 0:81 = 0:19

senior 0:99 (1� 0:9)2 = 0:01

!Result: credit enhancement for the senior tranche

!"Side e¤ect": tranches become correlated even if underlying assets are not

The trick: can expand to three bonds

1. "Junior": pay if NO tranches default

2. "Mezzanine": defaults if at least two default

3. "Senior": defaults if all default

PAY DEFAULTjunior 0:729 0:271mezzanine 0:972 0:028senior 0:999 0:001

!Result: credit enhancement for both senior and mezzanine tranches (2/3of the capital)

!Easy to get AAA rating

Fraction of AAA ratedstructured products 60%

corporate bonds 1%(source Fitch, 07)

� But to assign rating need an assessment on the joint default correlations

� The higher the default correlation ! the more likely it is that all assetsdefault simultaneously ! the more risky the senior tranches

The role of rating agencies

� They tell us that this "AA General Electric bond" is more likely to defaultthan that "A+ General Motors bond"

� No information on whether that bond is particularly likely to default atthe same time that there is a large decline in the stock market or arecession

Implications

� Pooling of mortgages reduces the default risk of individual tranches but itincreases the correlation to general economic conditions.

� Why? Because tranches become correlated even if underlying assets arenot

� Result: "AAA CDO" more subject to systemic risk than a single "AAAcorporate bond"

� Paradox of securitization

1. Increase diversi�cation of idiosyncratic risk, but..

2. Increase sensitivity to aggregate risk

� Risk diversi�cation: earn a premium most of the time and face (catastrophic)losses only in the rare event that the AAA rated tranche gets hit

� AAA tranches hit when aggregate ("systemic") shocks hit...

AND INDEED IT DID HIT..!

� Securitization has been around for a long time

� Why housing market collapse generated a much more severe and systemiccrisis relative to the dot-com burst of 2000?

1. Housing wealth more signi�cant portion of household�s wealth

2. From 2002 to 2007 a deterioration of loan quality

3. Securitization had perverse e¤ect: concentrated rather than diversify riskin the hands of banks

� Why did securitization work in such a perverse way?

1. Banks temporarily placed assets o¤ balance sheets! Get around capitalrequirements

2. Regulation allowed banks to hold less capital if assets on balance sheetswere AAA rated

!In a nutshell: securitization lost its soul ! Especially btw. 2002 and 2007worked more as a way to circumvent regulation than to diversify risk

� Paradox: things went badly not because of too much but because of toolittle securitization!

� Still open: why did banks take such a huge bet on the real estate market?

1. Governance: compensation of bankers and wrong incentives! Large shareof cash bonuses linked to short-term pro�ts

2. Government guarantess ! Moral hazard

3. Externality

What do we mean by externality?

� Bank does not internalize aggregate ("general equilibrium") e¤ects on as-set prices of individual �nancial decisions

� In their leverage policy bank takes asset prices as given

� Does not internalize that when things go bad! will have to �re sale assets! depress prices ! adverse balance sheet e¤ects for all banks

"Fire- sale" externality

� Private valuation of liquidity too high in good times and too low in badtimes

� Trade-o¤ between high investment ex-ante and high-volatility ex-post

For nerds..

1. Why are credit booms ine¢ cient even when �ancial frictions are in place?

(i) too much borrowing relative to constrained e¢ cient.

(ii) too little relative to 1st best (due to credit frictions)

2. Why doesn�t economy replicate 1-st best even though full insurance avail-able?

- Individually optimal to take on (socially) excessive risk taking

- Why? Take asset prices as given !Do not internalize that in bad states willhave to �re-sale assets !depress prices !adverse balance-sheet e¤ects

3. Why �nancial frictions necessary (but not su¢ cient)? Need balance sheete¤ects

Useful constrast (I)

1. Externality vs. bubble

- Not a bubble story

- Bubble could complement the story !Endogenize bad state = realization ofaggregate shock = fall in asset prices

Useful constrast (II)

2. Externality vs. moral hazard

(i) Literature on anticipated bailouts in EM countries (Ranciere-Tornell 2008)

!"Too much insurance" source of �nancial crisis

(ii) Here anticipated bailouts irrelevant

� What is this capturing of the crisis?

Key element in the crisis: liquidity problem for new �nancial intermediaries

Assets Liabilitiestraditional banks long-term loans depositsinvestm. banks MBS short-term debt

� Inv. banks held long-term assets (e.g., MBS) �nanced via short-termdebt (e.g., commercial paper) !Maturity mismatch

� When things deteriorate it is the liquidity problem that matters

� Bad state

!Financial .conditions deteriorate

!Lenders reduce exposure !Ask to service debt

! Banks try to �re sale long-term illiquid assets

Hence two problems

1. Excess leverage (due to externality)

2. Market liquidity

Optimal policy

1. Ex post: during a �nancial crises prevent �re sale (capitalize banks,stabilize asset prices)

But this would not prevent overborrowing in the �rst place

Optimal policy (continued)

2. Ex-ante: need to align the valuation of liquidity between individual inter-mediaries and social planner

!Pigou-tax argument

� Can capital requirements do it?

(i) Yes: but need to be targeted to aggregate/systemic risk ! Very di¢ cult(probably need close to 100%)

(ii) Problem with Basle II: target individual risk ! incentive VaR

!Argument for mandatory "systemic VaR" practices

Optimal policy (continued)

3. What about monetary policy?

� Improve on constrained e¢ ciency: intervene in asset markets

� Optimal open market operations

bad state ! market liquidity deteriorates ! CB purchases equity in exchangeof money ! increase rate of return on equities

But what about normal times?

� Should MP worry about crisis states in normal times?

� Could we design a systematic MP that prevent borrowing constraints tobecome binding?

� Should optimal systematic monetary policy target asset prices? (Mostprobably not)

� Has more predictable monetary policy contributed in any way to excessiverisk taking?