May 27, 2009
More papers on the credit crunch
Links to some interesting papers that I recently read.
The first comes from a conference on financial markets held at the start of this month at the University of Illinois in Chicago. Last fall, V.V. Chari, Larry Christiano, and Pat Kehoe received a lot of attention (e.g., Tabarrok, Avent, Economist, Kwak, Bonddad, and Thoma , , ,) for noting that aggregate lending by banks was in fact increasing during the period in which many analysts were describing it as sharply curtailed. At the Chicago conference, Federal Reserve Bank of Boston economists Ethan Cohen-Cole, Burcu Duygan-Bump, Jose Fillat, and Judit Montoriol-Garriga argued that those aggregate numbers conceal some very significant compositional trends, namely, previously existing lines of credit were being drawn on by borrowers and a sharply increased fraction of lending was consumed by securities originally intended for securitization but which banks were forced to hold on their own books.
Another interesting conference was held two weeks later at the Federal Reserve Bank of Atlanta, from which I found the paper by Gary Gorton quite interesting. (You can also find it discussed by Falkenblog, Cowen, Kling, and Klein). Gorton views the recent problems as an ongoing banking panic. Here are some excerpts:
A banking panic means that the banking system is insolvent. The banking system cannot honor contractual demands; there are no private agents who can buy the amount of assets necessary to recapitalize the banking system, even if they knew the value of the assets, because of the sheer size of the banking system. When the banking system is insolvent, many markets stop functioning and this leads to very significant effects on the real economy....
The current crisis has its roots in the transformation of the banking system, which involved two important changes. First, derivative securities have grown exponentially in the last twenty-five years, and this has created an enormous demand for collateral, i.e., informationally-insensitive debt. Second, there has been the movement of massive amounts of loans originated by banks into the capital markets in the form of securitization and loan sales. Securitization involves the issuance of bonds ("tranches") that came to be used extensively as collateral in sale and repurchase transactions ("repo"), freeing other categories of assets, mostly treasuries, for use as collateral for derivatives transactions and for use in settlement systems.... [R]epo is a form of banking in that it involves the "deposit" of money on call (as repo is short-term, e.g., mostly over night) backed by collateral. The current panic centered on the repo market, which suffered a run when "depositors" required increasing haircuts, due to concerns about the value and liquidity of the collateral should the counterparty "bank" fail....
Securitized asset classes, e.g., mortgages, credit card receivables, auto loans, may be examples of relatively informationally-insensitive debt, created by the private sector without government insurance....
A "systemic shock" to the financial system is an event that causes such debt to become informationally-sensitive, that is, subject to adverse selection because the shock creates sufficient uncertainty as to make speculation profitable. The details of how that happens are discussed below, but in summary, fear of the resulting lemons market can cause the (inefficient) collapse of trading in debt and a stoppage of new credit being issued.
Gorton's paper might offer some support for those who think that we just got stuck on the bad side of a structure with multiple possible equilibria. An alternative and more pessimistic perspective is developed in a recent note by Federal Reserve Bank of San Francisco economists Reuven Glick and Kevin Lansing. Glick and Lansing view the problem as more structural and fundamental, resulting from an unsustainable run-up of household debt. Their analysis was also highlighted by Thoma and Bloomberg.
Posted by James Hamilton at May 27, 2009 06:01 AMdigg this | reddit
Gordon's paper is so comprehensive that I also think I understand why the shadow banking system was created, why it is important. The shadow banking system deals with firms as depositors and loan purchasers. It's problem was that the collateral that they hoped to use to safeguard loans was not strustworthy after Lehman's collapsed. His article should be must reading for anyone attempting to write laws dealing with bank regulation
What I did not learn from Gordon was any criteria for evaluation of the reasonableness of actions of Paulson and Bernenke to try to deal with the crisis.
Nor did I see any effort to understand the role of household debt and mortgage default as a continuing and increasing problem as unemployment increases.
Posted by: ReformerRay at May 27, 2009 08:13 AM
Why can't economists agree on historic facts, even given slightly varying analytical methods?
In contrast to Chiari-Christiano-Kehoe above, "Bank Lending in the Financial Crisis or 2008," by Harvard professors Ivashina and Sharfstein, presented at December's AEA conference concludes that, "new loans to large borrowers fell by 37% during the peak period of the financial crisis (September-November 2008) relative to the prior three-month period and by 68% relative to the peak of the credit boom (Mar-May 2007). New lending for real investment (such as capital expenditures) fell to the same extent as new lending for restructuring (LBOs, M&A, share repurchases)." (Sorry I do not have the link for this paper, but it's on the web.)
Can anyone out there bridge the two? Up, down, or otherwise....
Posted by: Terry at May 27, 2009 08:55 AM
Mr. Gorton's main point is that the shadow banking system is in fact a banking system, therefore, it should be regulated.
I disagee. It is a special kind of banking system, created to serve the interests of the firms involved. And created to excape regulation. Financial firms find they can make more money if they invent a way to escape regulation. The impulse toward a shadow banking system is old. Only recently has the government allowed that impluse free reign.
I say let them roam free. Do not try to regulate all financial activities. Give them their playing space. Only force them to live in it without endangering the regulated system.
Of course, separating the regulated from the unreagulated system is very difficult. Some interchange must be allowed. The trick is to legislate and regulate the maner of interaction - working from the side of what the regulated banking system is allowed to do in terms of funding the unregulated system.
Selling collateral to the unregulated system, as AIG did, must be prohibited.
Posted by: ReformerRay at May 27, 2009 01:51 PM
"The concern that I think we should be having about the current situation arises from the same economic principles as a classic bank run, and potentially applies to any institution whose assets have a longer maturity than its liabilities. The problem arises when the losses on the institution's assets exceed its net equity. Short-term creditors then all have an incentive to be the first one to get their money out. If the creditors are unsure which institutions are solvent and which are not, the result of their collective actions may be to force some otherwise sound institutions to liquidate their assets at unfavorable terms, causing an otherwise solvent institution to become insolvent."
I call this a Calling Run, and agree with you. But my notion of this came from Irving Fisher's classic paper "The Debt-Deflation Theory Of Great Depressions", and Debt-Deflation is what frightened me, not a contained run on some kinds of investments. Was this your worry as well? In other words, the fear was a run that spread outside of its purview.
Posted by: Don the libertarian Democrat at May 27, 2009 02:18 PM
I think the post you link to as Avent's was actually Felix Salmon when he was writing the Market Movers blog.
Posted by: winstongator at May 27, 2009 05:12 PM
There is a need for "channeling", which I prefer to "regulation". Regulation has the connotation of prohibiting activites; channeling suggests frameworks for conducting activities safely. For example, derivatives aren't necessarily bad, but a market participant must be able to honor promises made to counter-parties. AIG, for example, was not able to because it earned fees from assuming risks which it could discharge from its own financial resources. So we want to "channel" those activites into manageable risk venues.
Posted by: Steve Kopits at May 28, 2009 08:30 AM
Thank you for this, by the way. We are finally seeing signs of life from the Fed regarding the deleveraging process. Still no synthesis that I can see, but at least we have some comps from Japan and some sense of where debt/GDP ratios might trend over the next several years.
Posted by: Steve Kopits at May 28, 2009 08:33 AM
Investors always search for the best global diversification. Even in Gold times, investors had to hedge against world wide Gold mining companies.
When constraints in global economies make better investment unobservable, then the investors bide their time by building ladders of hedges, until the real constraint reveals itself.
Posted by: Mattyoung at May 28, 2009 08:50 AM
What I have yet to see is a good handling of the monetary implications of a collapse in the shadow banking system. Gorton's paper alludes to this by arguing correctly that repo is simply a non-deposit monetary liability of the financial system. I am less concerned about default of the asset counterparts to repo - which goes through equity, even if only over time - and more concerned with the demise of the repos themselves. That equates to a destruction of money in a broad sense, i.e. some aggregate M4 or L in which these types of repo are included as monetary liabilities of the financial system.
What seems to me to be crucial about this is that it should be very highly deflationary, in contrast to most of what one reads about the explosion of the Fed's balance sheet. The bulk of what the Fed has done has been to replace the repo financing of financial system assets which were previously liquid, i.e. able to be financed in repo with near zero haircut but now cannot be repoed or come with very large haircuts. What I fear is that over time as the assets on the balance sheets roll off they will not to be replaced with new ABS with the end result being a destruction of money.
I would love to hear what either Professors Hamilton or Chinn think about this or references to good analysis of this issue.
Posted by: rfarris at May 31, 2009 01:12 PM
Maybe we can pretend that non-banks and the "shadow" banking system can somehow be isolated from the entire monetary system.
But that is a charade.
It is primarily the failure of the non-banks that is bringing down the economy and the money system.
I find it amusing when Fed economists lay down the line that the problems are more structural, or more systemic than say sub-prime loans, or SIVs without risk.
And then they leave you hanging.
Here's a clue.
The debt-money is insolvent.
As a result, the banks, the non-banks and the highly-leveraged capital markets appear to be faulty and in need of a fix.
There is no fix.
The debt-money system is broke, broken and insolvent. Read : "How Debt Money Goes Broke".
"Thus, when interest charges...overtake annual debt growth... liquidation will immediately trigger cascading cross-defaults. .... the Fed cannot facilitate the expansion of government debt to fill the breach and simultaneously ..... keep debt growth greater than interest charges, the precondition for the viability of a debt-based monetary system. Once started, cascading cross-defaults consume all debt within an economy. The Fed has only two options: institute a new monetary system with a new currency or return monetary authority to the market and shut down."
So, I vote for Greenbacks !
Posted by: joebhed at May 31, 2009 05:09 PM
I am puzzled about Groton's statement that we do not know for sure how securitization arose (28). Securitization like derivatization was created first within the GSE entities: ie GNMA pass through securities, FHLMC participation certificates, and FNMA mortgage backed securities and the accompanying interest rates swaps to manage duration risk. Freddie Mac also issued in June 1983 a billion dollar landmark CMO. (The Handbook of Mortgage Backed Securities edited by Fabozzi is a great source).
It was the GSE together with the private IB sector that developed these instruments and created secondary markets under the government agency safe-haven where experimentation without interference from traditional public market oversight regulators allowed for extensive innovation. The IBs also developed private label products backed not by GSE guarantees but by private LOC; then much later CDS.
The GSEs provided stability to securitization/derivatization and the secondary markets but at a high cost to taxpayers. Then too the initial shock to the securization system was the concern over GSE failure and the ensuing scandals. Once there was concern over GSE failure it was only a matter of time before private issue securitization would be subjected to greater scrutiny at a time when credit was being extended to the least creditworthy.
If the system is to be re-booted then what is needed is a re-tooled GSE but that will not happen unless until the GSEs are recognized as the lynchpin in the system; much the way demand deposits do not reflect the risk of bank failure because of government guarantees.
Posted by: dd at June 1, 2009 03:06 PM