Crisi - Monacelli

Financial Crisis: Credit Booms, Asset Prices 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 in Western countries ! low risk spreads 2. Monetary policy! Kept interest rates too low 3. Structured …nance ! the role of securitization

shock recente

rates go up during subprime shock

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

junior

PAY 0:92 = 0:81

DEFAULT 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

junior mezzanine senior

PAY 0:729 0:972 0:999

DEFAULT 0:271 0:028 0:001

could combine in a CDO squared

!Result: credit enhancement for both senior and mezzanine tranches (2/3 of the capital) !Easy to get AAA rating

Fraction of AAA rated structured 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 assets default 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 default than that "A+ General Motors bond"

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

Implications

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

Why? Because tranches become correlated even if underlying assets are not

Result: "AAA CDO" more subject to systemic risk than a single "AAA corporate 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 systemic crisis 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 risk in the hands of banks

Why did securitization work in such a perverse way?

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

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

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

Paradox: things went badly not because of too much but because of too little 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 share of 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 asset 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 bad times

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 available?

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

- Why? Take asset prices as given !Do not internalize that in bad states will have to …re-sale assets !depress prices !adverse balance-sheet e¤ects 3. Why …nancial frictions necessary (but not su¢ cient)? Need balance sheet e¤ects

Useful constrast (I)

1. Externality vs. bubble

- Not a bubble story - Bubble could complement the story !Endogenize bad state = realization of aggregate 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

traditional banks investm. banks

Assets long-term loans MBS

Liabilities deposits short-term debt

Inv. banks held long-term assets (e.g., MBS) …nanced via short-term debt (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 intermediaries 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 exchange of 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 to become binding?

Should optimal systematic monetary policy target asset prices? (Most probably not)

Has more predictable monetary policy contributed in any way to excessive risk taking?