Financial crisis
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Financial crisis John H. Cochrane University of Chicago Booth School of Business House prices, investment House prices rose a lot, then fell. Residential investment (home building) fell too. It often falls first in recessions

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Financial crisis

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Financial crisis l.jpg
Financial crisis

John H. Cochrane

University of Chicago

Booth School of Business


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House prices, investment

  • House prices rose a lot, then fell.

  • Residential investment (home building) fell too. It often falls first in recessions

  • Mortgage defaults start, especially in subprime and other mortgage products that basically invite homeowners to default if house prices go down

  • Defaults wipe out low tranches fast!





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The crisis. I’m interested how much is financial, how much “illiquidity,” and how much a simple rise in credit risk and its premium. The fact that non financial AA does well and nonfinancial A2P2 is even worse than financial suggests the latter interpretation to me. The credit risk premium went up – and this is just about how investors feel, not about liquidity, leveraged investors, etc.


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A closer view. CP rates. It differs a lot by maturity. I found it interesting that overnight financial and nonfinancial are the same. The banks were not having special problems borrowing overnight. Again, the poor A2P2 are the ones really having problems. I think the sharp drop comes when the Fed starts buying commercial paper.


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Lehman or Tarp? found it interesting that overnight financial and nonfinancial are the same. The banks were not having special problems borrowing overnight. Again, the poor A2P2 are the ones really having problems. I think the sharp drop comes when the Fed starts buying commercial paper.

Did Lehman or the Tarp speeches set off the run? This makes the case it was the TARP speeches. (With inspiration from John Taylor) It also suggests that the function of the TARP asset purchases was just to convince the markets that the government really really was going to bail out citi, not “recapitalization so they could start lending”



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We worry about a crisis because “firms can’t borrow.” But of course most firms do not depend terribly on bank financing, they can issue bonds. Also, bond issues do go straight to investors – you and I can buy the Vanguard corporate bond fund if prices are good. So, what happened to these rates? The credit spread opened to huge amounts, not seen since 1982 and near Depression levels. Interestingly though it’s because government and short rates fell not so much because corporate rates rose, at least until Tarp. There is nothing that “recapitalizing the banks” will do about this.


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The huge credit spread doesn’t seem that affected by the momentous events moving around short-term rates


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A bit of an update though without the nice vertical bars momentous events moving around short-term rates


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The Fed is easing like crazy. (More Fed policy later). Notice 3 month bills below fed funds, and notice 3 month bills actually hitting zero in Dec 2008. I think the “flight to quality” represented here is a big part of the crisis.


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CDS is the modern way to measure credit spreads. This is percent per year you have to pay for bond insurance (-200 = 2%). By summer 09 the crisis is over .


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“Arbitrage” percent per year you have to pay for bond insurance (-200 = 2%). By summer 09 the crisis is over .

Many markets saw “arbitrages” open up. These aren’t true arbitrages; one end is always more illiquid than the other, or has some counterparty risk, etc. But these are prices that usually are very close to each other. In each case, the leg of the arbitrage that needs cash, needs funding, or needs borrowing is underpriced. In each case, the price difference is still small enough that “long only” investors don’t really bother that much.

Why does this matter? It’s certainly a sign of illiquid markets – the usual arbitrageurs are maxed out, can’t borrow, can’t raise equity -- so strategies that try to manage risk by “we’ll sell on the way down’’ rather than buy real put options will fall apart at times like these.


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Borrow dollars, buy Euros, lend euros, buy dollars forward. 20bp is huge, because you can lever this up arbitrarily. But…”borrow dollars!” 20bp is not enough to attract long-only money.


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Average Daily (Bond–CDS) Basis: by Rating 20bp is huge, because you can lever this up arbitrarily. But…”borrow dollars!” 20bp is not enough to attract long-only money.

Source: J.P.Morgan

Buy corporate and CDS vs. buy Treasuries. But buying corporate needs cash or repo financing, now hard to do. (Also illiquid, and CDS counterparty risk)


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A normal treasury yield curve 20bp is huge, because you can lever this up arbitrarily. But…”borrow dollars!” 20bp is not enough to attract long-only money.


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On the run/off the run spread explodes! 20bp is huge, because you can lever this up arbitrarily. But…”borrow dollars!” 20bp is not enough to attract long-only money.

Yield vs. duration of all outstanding treasury bonds and bills, crsp mbx database


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Credit quantities 20bp is huge, because you can lever this up arbitrarily. But…”borrow dollars!” 20bp is not enough to attract long-only money.

What matters to the economy of course is whether it’s hard to borrow.

It’s important to distinguish “sand in the gears,” financial dysfunction, from simple shift in the supply curve or greater credit risk. If that’s the case, fixing the banks won’t help, nor is it obvious we should help. Not every fall in quantity is a wedge between demand and supply, not every project should be funded

Which kinds of debt fell, and what can we tell about supply vs. demand vs. wedge between the two opening up?


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Flow of funds data—private borrowing collapses 20bp is huge, because you can lever this up arbitrarily. But…”borrow dollars!” 20bp is not enough to attract long-only money.

  • Massive decline in private borrowing, massive increase in government!

  • Which markets and channels show this huge decline?

  • Why? Is this “supply and demand” or “something’s wrong”?


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Flow of new lending 20bp is huge, because you can lever this up arbitrarily. But…”borrow dollars!” 20bp is not enough to attract long-only money.

r

r

Loan

Loan

  • “Something’s wrong”

  • Broken intermediary?

  • Capital constrained banks?

  • In banks or securitized debt markets?

  • “Supply and demand”

  • Higher risk aversion, greater chance of default

  • Less demand to borrow, invest in recession?


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Commerical paper issuance. Asset-backed falls apart in 2007 with the blowup of SPVs. Financial falls apart post Lehman/TARP. Nonfinancial keeps going! In fact, it increases. Savers want to put money somewere, it was easy for large safe companies to borrow commercial paper in the middle of the crisis. Newspaper hyperbole “credit markets froze” miss this fact.


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Quantities. Yes, financial declined (and all maturities declined a lot), but you’d expect to see much worse given all the complaining.


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US Non-Agency MBS Issuance declined a lot), but you’d expect to see much worse given all the complaining.

Falls off a cliff. And in 07 (along with ABS), long before TARP etc. The originate to sell model ended. If you want to see credit quantities affected by the financial crisis this is it. These are mortgage backed securities that don’t go through FannieFreddie, thus don’t get the government guarantee. Jumbos are an example.


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Scale of Dealer Deleveraging in Corporate Bonds over 2007 and 2008

  • A sense of how important the run in repo is

Source: Primary Dealer Survey, Federal Reserve Bank of New York


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What about the Banks? and 2008

Do the banks want to lend, can’t because of capital constraints?

Or do the banks not want to lend, (they can’t sell loans anymore), and no amount of capital will change that fact?

Distinguish “banks” (many were surely in trouble) from “banking system” (can competitors come in and take over)

Bottom line: I think the evidence favors #2, and TARP purchases did not spur lending.




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Once again, no huge decline in lending. Actually, given the severity of the recession, it’s surprising how little lending went down.


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Bank –held debt is a small part of credit markets. severity of the recession, it’s surprising how little lending went down.

Even if the “banks don’t lend”, does this matter?

Source: FRB Sept 18 Flow of funds


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  • Banks did not delever, they actually expanded! Banks also did not conserve captal, paying dividends, bonuses, and making acquisitions.

  • Controversies: Much expansion came from existing lines of credit, not new lending. Much came by taking on SPV assets from unwinding of shadow system, not new lending. And many borrowers did report trouble getting loans.


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Banks Can And Do Raise Capital! did not conserve captal, paying dividends, bonuses, and making acquisitions.

The “debt overhang” story is not absolute. When banks lose money they can and do go out and raise more capital. (This being impossible is a central part of the “capital constraint” story)

(source: Bloomberg.com)


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Banks Can and Do Raise Capital II did not conserve captal, paying dividends, bonuses, and making acquisitions.

Source :Anil Kashyap

Includes Treasury Purchase


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#1 Northern Rock#2 Bear Stearns#3 ANB Financial#4 First Integrity Bank#5 Roskilde Bank#6 IndyMac#7 First Heritage Bank#8 First National Bank of Nevada#9 IKB (basically insolvent after gov't intervention)#10 Silver State#11 Fannie Mae#12 Freddie Mac#13 Lehman Brothers#14 AIG#15 Washington Mutual


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Macroeconomics and finance continuing under new ownership. A bank failing does not mean it cannot process new loans. In fact, sometimes it can do it better.

Is there anything for our simple models that tie macro to asset pricing to do? Or do we throw everything out and only study frictions?

A: Frictions are frosting, but there is a lot of cake. Many long-only unconstrained investors were “marginal” and tried to sell.

Consumption: Risk aversion rises following recent losses. (“habits”). Investment: Investment falls when stock prices (q) falls.


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Rising risk aversion continuing under new ownership. A bank failing does not mean it cannot process new loans. In fact, sometimes it can do it better.

U(C)

X

C


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SPC is the Cambell/Cochrane measure of consumption relative to habit.

When SPC falls, prices fall, risk premia rise



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The Fed needs no frictions or constraints


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Stocks it out. A trillion extra dollars!

You know the stock market cratered and then recovered.


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A reminder that lower p/d means a higher risk premium, quite sensible in a huge recession and the same as the higher credit spread. P/D didn’t change that much because D fell like a stone.


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Earnings may be a better divisor, since price decline anticipates lower dividends next year. This means less of a screaming buy, higher ER


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Vol = 20 day backward looking average volatility of daily S&P500 index




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Does the crash mean that free markets failed? New instruments, toxic derivatives, financial innovation gone amok, etc.


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Unused slides instruments,


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Ideas instruments,


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What is the worry? instruments,

  • Home prices decline → defaults → mortgages worth less → banks insolvent

  • Who cares?

  • Great depression story 1: (Friedman)

    • Banks fail → M1 declines

  • Great depression story 2: (Bernanke)

    • Banks fail → No banks to make loans -> savers can’t meet borrowers.


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A credit crunch: Banking instruments, system cannot make new loans.

Interest

rate

Supply (savings)

System

Doesn’t

Work

Demand (investment, mortgages)

Loans


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View 2: instruments,

A crunch, but in

debt markets

not banks.


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View 3: Investor Fear + Recession instruments,

Supply

Of risky debt

Interest

rate

Demand

Loans

A fall in loans need not mean a credit crunch


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  • Which is it? instruments,

  • Banking system wants to lend, but cannot.

    • -Secretly undercapitalized, can’t get new capital. “Recapitalizing” banks would fix everything

  • Banking system doesn’t want to lend because it can’t sell in dysfunctional debt markets.

  • Nobody wants to lend because investors don’t want to hold risk.


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Summary: Bank constraint vs. Credit market instruments,

Or risk premium view

r

r

Loan

Loan

  • Little decline in banking system lending.

  • Banks can and do raise equity.

  • Banks can and do fail / get taken over.

  • Treasury purchase/debt guarantee did not stop it in tracks.

  • “Recapitalized banks” pay dividends, buy other banks.

  • High risk premiums in nonfinancial, non-intermediated assets.

  • Obvious huge problem in credit markets

  • Nothing without Govt guarantee or direct purchase is selling


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  • Summary so far: instruments,

  • Huge risk premium in debt markets = Large demand for Treasury debt

  • Risk premium: “precautionary savings”, lower “aggregate demand” = more demand for treasury or guaranteed debt.

  • Policy #1 (basically good) :

  • Fed and Treasury Accommodate demand for Treasury Debt/money

  • Together they issue Trillions of Treasury/money to buy assets

  • Act as missing intermediary

  • Provide desired Gov’t debt without needing deflation


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Policy #1 danger instruments,

  • Fed is running the world’s biggest hedge fund.

  • Can we reverse all this without inflation?

  • Will the Fed be the only intermediary for a generation?

  • Is the Fed buying good, especially new, debt at market prices?

  • True blue free-market objections


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Bad Policy Ideas instruments,

  • TARP to buy troubled assets on the open market

  • TARP to buy assets from banks at artificial prices

  • Bank “recapitalization” without quick workout.

  • Forced mortgage renegotiation: a $150,000 unemployment subsidy

  • Bailout Contagion. S&L Government, Pension Funds, …

  • Policy uncertainty, changing the rules of the game. Who will buy now?

  • Government running the banks / credit system for a long time.

  • Fiscal “stimulus.”

  • “Do something.” It’s ok to be negative.

  • The major danger is political, not economic.


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Policy. Will the Treasury Plan work? instruments,

Supply

Price

Treasury Hope:

Small purchase raises price a lot

Finance experience:

Huge purchase to move

prices a little

Demand

Mortgage-backed securities


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Credit Crunch – “undercapitalized” mechanics instruments,

1. Before

2. After

Risk

100

10

Equity

Equity

95

5

!

90

90

Loan

(Assets)

=

Debt

=

Debt

3. No new loans!

3. “Deleverage?”

New

loan

5

5

50

Sell.

95

5

50

90

New debt

45

5

=

=

45


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Solutions? instruments,

4. “Recapitalize”

4. “Failure” = recapitalization

1. New

Equity

55

10

New

loan

90

5

45

70

70

20

=?

2. New debt

Fail, =

=

95

50

90

=

WaMu JPMorgan


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What went wrong / needs to be fixed? instruments,

  • Amazing amount of overnight / short financing

$100

$100

Joe

Yes

Not

$100

Joe

$1.10

$1

Joe

$99

Sue

$1

Joe

$1.10

$99

Sue

$98

Bob

$1.10


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Swaps, brokerage, etc. instruments,

$100

$100

2. Value = 80

3. Value = 80

$100

Joe

$1

$99

Sue

$1

$99

Sue

Who stops ?

$98

Bob

$1

1. Will this last?

2. Abandon Mark to Market?

3. Dynamic capital standards!


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Deposits, instruments,

CDs, Stock

Mortgage

Demand (investment)

Financial system

(intermediary)

Supply (saving)

The financial system can slice, dice and transfer risk, but cannot bear risk.

People must bear risk.

A credit crunch: banking system cannot make new loans.

Interest

rate

Supply

Banking

System

Demand

Loans


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