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