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

 PAY DEFAULT
junior 0:92 = 0:81 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

 PAY DEFAULT
junior 0:729 0:271
mezzanine 0:972 0:028 could combine in a CDO
squared
senior 0:999 0:001

!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 as-

set 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 avail-
able?

- 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

Assets Liabilities
traditional banks long-term loans deposits
investm. banks MBS 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 inter-

mediaries 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?