Raghuram Rajan, Does Financial Development Make the World Riskier?2005 Presentation at Jackson Hole Conference

•Financial innovations•Driven by technology, deregulation, new institutions•Banks spin off liquid assets

•Increasingly specialize in illiquid assets•keep high risk pieces that can’t be sold off signal confidence

•New intermediaries manage financial investments•Perverse incentives: principal – agent problem

•Incentive for high return: look good increase assets under management•Economies of scale in asset management: WIN BIG / lose small

•Take hidden “long tail” risks … Rajan cites CDSs•Incentive for herding: don’t look bad

•Deviations from fundamental values persist the herd is validated•Information “beauty contest” muted incentive information acquisition deviations from fundamental values persist the herd is validated

•Financial fragility grows … the longer a market structure proves reliable, the more reliance is placed on it

Raghuram Rajan, Does Financial Development Make the World Riskier?• Incentive for high return: Look good Take hidden “long tail” risks

Banks have incentive to feed investment manager appetite for risk» Feed the frenzy to the limit leave little cushion of liquidity» Banks bear small, volatile tip of the “iceberg of risk they have created”

Will banks be able to provide liquidity when tail risk crisis hits?» Liquidity is needed to unwind positions – to allocate loses» But bank balance sheets and off-balance sheet guarantees bode ill» If banks themselves are perceived as credit risks in a crisis, their ability to

reallocate liquidity is compromised» Banks become a problem, not a solution

• The real economy is vulnerable when liquidity is scarce» Rush to liquidity fire sale of assets credit crunch

• Policy responseBefore crisis

» Supervisory vigilance: “macro-prudential supervision”When crisis hits

» Liquidity vigilance: be ready to respond to demands for liquidityLong – run: REALIGN INCENTIVES!!!

Ferguson & JohnsonToo Big to Bail: The “Paulson Put,” Presidential Politics and the Global Financial

Meltdown

• The “Paulson Put” I: put off high-profile bailouts until after election• The “Paulson Put” II: avoid diluting financial firm shareholders

The Great Recession – The Long SlumpVillain: Market Fundamentalism• Deregulation – Self-regulation – Non-regulation

Glass – Steagle Squashing Born

• The Greenspan “Put”» Fuel a bubble – Clean up later

• Securitization and its discontentsEfficient market dogma rocket science complex over-the-counter derivativesBank’s Shadow Banks: Conduits – SIVs

• A shadow bailout: Paulson enlists FHLB, the Fed’s “facilities”

Financial Crisis of 2007 - 2009 (cont’d)• Banks’ balance sheets deteriorate

– Write downs– Sale of assets and credit restriction

• High-profile firms fail– Bear Stearns (March 2008)– Fannie Mae and Freddie Mac (July 2008)– Lehman Brothers, Merrill Lynch, AIG, Reserve Primary Fund (MMMF) and

Washington Mutual (September 2008).

• Fed pumps up bank reserves: TARP/TALF,etc.– Lend and lend freely

• Bailout package enacted– House votes down the $700 billion bailout package (9/29/08) Stock market slumps Bailout passes on October 3. – Congress approves a $787 billion economic stimulus plan on February 13, 2009.

• Recession deepens

Atif Mian and Amir SufiThe Great Recession: Lessons from Microeconomic Data

• Economic Crises provide unique opportunities to test and further understand economic theory.

• From the Great Depression we get:– John Maynard Keynes fiscal theory– Milton Friedman Monetarist tradition– Irving Fisher Debt Deflation

• Goal: Incorporate Micro data and advancements in computational data to understand origin of the recession

What Were the Origins of the Credit Crisis: Credit Demand or Supply?

• Financial crises are almost always preceded by a sharp rise in leverage or debt-based financing and there are two competing explanations for this:– Demand side or Supply side driven.

• Demand side would be associated with positive productivity and/or technology shocks, increasing demand for credit.

• Supply side would be associated with financial innovation (e.g., securitization).

• Kindleberger: “in many cases the expansion of credit resulted from the development of substitutes for what previously had been the traditional monies.”

Supply or Demand Driven?

• Zip code level data on household borrowing points to supply driven buildup of credit.– Zip Codes that saw the largest increase in home

purchases from ’02-’05 experienced declines in income.• Correlation between mortgage growth and income

growth is negative from 02-05, while positive in all other periods since 1990.– In these zip codes mortgage denial rates dropped

dramatically and debt to income ratios skyrocketed.

Does the Supply of Credit Influence Asset Prices?

• Traditionally you price an asset by discounting future cash flows. The availability of credit plays no role in determination of asset prices. – A view which is now considered to be too narrow.

• Geanakoplos “variations in leverage cause fluctuations in asset prices.” aka financial innovation or shifts in supply of credit directly impact asset prices, creating an important feedback mechanism.

• Data suggests a credit-induced housing price Boom.• Bernanke: “the availability of these alternative mortgage

products proved to be quite important and, as many have recognized, is likely a key explanation of the housing bubble.”

Do House Prices Have an Accelerator Effect?

• The growth in the mortgage credit and house prices impacted economy through more than just the construction sector.

• The major accelerator effect was driven by the impact of rising home equity on household spending.

• Existing homeowners borrowed 25-30 cents against the rising value of their homes.

Do House Prices Have an Accelerator Effect?

• This home equity based borrowing was not used to pay down debt or purchase new properties, but consumption and home improvement.

• The home equity based borrowing channel was much stronger among households with low credit scores and high credit card utilization rates.

• The most credit constrained homeowners were most aggressive in their home equity extraction response to housing price growth.

• Accounts for $1.5 trillion increase in household debt.

The Household Leverage-Driven Recession• An expansion in the supply of credit, coupled with

the feedback effect of borrowing against rising house values by existing homeowners, created an unprecedented growth in US household leverage between 02-06. – An outward shift in the supply of credit from 02-06 was

primary driver of the macroeconomic cycle of 02-09. • What caused the shift?– Financial innovation– Subsidies for mortgage credit in the form of govt.

homeownership initiatives and implicit govt. guarantees and expected bailouts.