The Credit Crisis Raghuram Rajan Chicago Booth School of Business Outline The Crisis: Origins The Impact Resolving the crisis? Regulatory Lessons.
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Transcript The Credit Crisis Raghuram Rajan Chicago Booth School of Business Outline The Crisis: Origins The Impact Resolving the crisis? Regulatory Lessons.
The Credit Crisis
Raghuram Rajan
Chicago Booth School of Business
Outline
The Crisis: Origins
The Impact
Resolving the crisis?
Regulatory Lessons
Bad Investments
Child of past crises
− Emerging markets => Industrial country
corporations => Industrial country
household
Sophisticated Financial Sector
− Effectively sold mortgages from
Phoenix, Arizona to buyers around the
world
$ 100 sub-prime mortgages generated
$ 80 AAA
− Originate to distribute spreads risks but
Quality of originations weakened
Depended on house price rising
Bad Investments contd.
Banks held on to poor quality assets
− Poor governance and risk
management
At the top
Through the organization
− Tail risk
− Writing earthquake insurance
Where were the risk managers?
Financed with short term
debt
Short term debt cheaper because
− Lenders better protected.
− Rolling over financing is easy in good
times.
− Market requires banks to hold little
capital because losses remote.
Aided and abetted by Fed policy
− Greenspan “put”
The Impact: Sequence of
events
House price stops rising
Mortgage Defaults=> MBS fall in value,
become more difficult to price, and price
becomes more volatile
Market for mortgage backed assets dries
up.
Illiquidity
Potential Insolvency
More hits on their way
− Credit cards
− Commercial real estate
− Commercial and industrial loans
Issuance of ABS
300
250
200
Student Loans
Other
Non US RMBS
Manufactured Housing
Home Eq (subprime)
Equipment
Credit Cards
Autos
150
100
50
0
Jan-00
Oct-00
Jul-01
Apr-02
Jan-03
Oct-03
Jul-04
Apr-05
Jan-06
Oct-06
Jul-07
Apr-08
Credit markets freeze
Banks unwilling to sell impaired assets
Banks unwilling to substitute for shadow
financial system
− Worries about borrower credit risk.
− Worries about own liquidity if lenders want
money back.
− Worries about likely fire sales pushing securities
prices further down – common discount rate for
risky assets
Banks unwilling to raise enough equity
Stability is not the major focus of the private
sector in the midst of a crisis!
Institutional overhang not a major problem
right now because demand for credit low. But
will hamper recovery.
Declining credit asset prices
pull equity prices downwards
ABX.07-1 AAA versus BKX* index prices
120
100
BKX (left)
ABX.07-1 AAA (right)
90
100
80
70
80
60
60
50
40
40
30
20
20
10
0
1/1/2007
0
4/1/2007
7/1/2007
10/1/2007
1/1/2008
4/1/2008
7/1/2008
10/1/2008
1/1/2009
source: Bloomberg
When will credit markets
find a bottom?
When the risk of large institutions collapsing
is small.
− Guarantee debt
− Audit institutions (the Stress Test)
− Clean up bank balance sheets by
isolating/selling problem assets
Good bank/bad bank
− Recapitalize banks through a mix of private
and public funds
− Some actions may have to be mandated
This will allow asset prices to recover and
credit to flow more freely, thus not
impeding recovery.
Will require more public money: political
support weak
3 Lessons for financial
regulation
Regulators and markets are subject to
the same euphoria that bankers are.
Over the cycle
− the market becomes less risk averse, so
regulatory arbitrage increases
− enforcement as well as risk management
get weaker.
− How do you ensure regulations have bite?
Illiquidity is contagious. Problems can
emerge from anywhere and hit
elsewhere.
Stability is a public good in the midst of
a crisis, with limited private incentive
to help create it.
Implications
Heavy handed, focused, regulation
will most likely to lead to arbitrage,
without insulating sensitive areas.
− Bright lines? Utilities?
Lighter, across-the-board,
regulation with contingent
escalation of regulatory powers and
actions more useful.
No matter what regulators do,
disaster can always strike. Create
private sector buffers that will not
be eroded in good times.
A problem
Large complex entities!
Break them up?
Slow their growth (higher capital
and supervision)?
Limit their growth?
Force them to become easier to fail.
THANK YOU!
T