Crisi - Monacelli
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Financial Crisis: Credit Booms, AssetPrices and Externalities
Tommaso Monacelli
Università Bocconi and IGIER
NfA Days - June 2009
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� 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
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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?
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Causes of crisis
1. Global imbalance ! capital from asian countries pour into assets inWestern countries ! low risk spreads
2. Monetary policy! Kept interest rates too low
3. Structured �nance ! the role of securitization
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� What is securitization?
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� Securitization: good idea ! allows to transform illiquid asset (royalties)into liquid asset
� How does it work with structured �nance?
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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!
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� 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
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PAY DEFAULTjunior 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
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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
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PAY DEFAULTjunior 0:729 0:271mezzanine 0:972 0:028senior 0:999 0:001
!Result: credit enhancement for both senior and mezzanine tranches (2/3of the capital)
!Easy to get AAA rating
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Fraction of AAA ratedstructured products 60%
corporate bonds 1%(source Fitch, 07)
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� But to assign rating need an assessment on the joint default correlations
� The higher the default correlation ! the more likely it is that all assetsdefault simultaneously ! the more risky the senior tranches
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The role of rating agencies
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� They tell us that this "AA General Electric bond" is more likely to defaultthan that "A+ General Motors bond"
� No information on whether that bond is particularly likely to default atthe same time that there is a large decline in the stock market or arecession
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Implications
� Pooling of mortgages reduces the default risk of individual tranches but itincreases the correlation to general economic conditions.
� Why? Because tranches become correlated even if underlying assets arenot
� Result: "AAA CDO" more subject to systemic risk than a single "AAAcorporate bond"
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� Paradox of securitization
1. Increase diversi�cation of idiosyncratic risk, but..
2. Increase sensitivity to aggregate risk
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� 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...
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AND INDEED IT DID HIT..!
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� Securitization has been around for a long time
� Why housing market collapse generated a much more severe and systemiccrisis relative to the dot-com burst of 2000?
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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 riskin the hands of banks
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� Why did securitization work in such a perverse way?
1. Banks temporarily placed assets o¤ balance sheets! Get around capitalrequirements
2. Regulation allowed banks to hold less capital if assets on balance sheetswere AAA rated
!In a nutshell: securitization lost its soul ! Especially btw. 2002 and 2007worked more as a way to circumvent regulation than to diversify risk
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� Paradox: things went badly not because of too much but because of toolittle securitization!
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� Still open: why did banks take such a huge bet on the real estate market?
1. Governance: compensation of bankers and wrong incentives! Large shareof cash bonuses linked to short-term pro�ts
2. Government guarantess ! Moral hazard
3. Externality
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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
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"Fire- sale" externality
� Private valuation of liquidity too high in good times and too low in badtimes
� Trade-o¤ between high investment ex-ante and high-volatility ex-post
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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
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- Why? Take asset prices as given !Do not internalize that in bad states willhave to �re-sale assets !depress prices !adverse balance-sheet e¤ects
3. Why �nancial frictions necessary (but not su¢ cient)? Need balance sheete¤ects
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Useful constrast (I)
1. Externality vs. bubble
- Not a bubble story
- Bubble could complement the story !Endogenize bad state = realization ofaggregate shock = fall in asset prices
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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
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� What is this capturing of the crisis?
Key element in the crisis: liquidity problem for new �nancial intermediaries
Assets Liabilitiestraditional banks long-term loans depositsinvestm. banks MBS short-term debt
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� Inv. banks held long-term assets (e.g., MBS) �nanced via short-termdebt (e.g., commercial paper) !Maturity mismatch
� When things deteriorate it is the liquidity problem that matters
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� Bad state
!Financial .conditions deteriorate
!Lenders reduce exposure !Ask to service debt
! Banks try to �re sale long-term illiquid assets
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Hence two problems
1. Excess leverage (due to externality)
2. Market liquidity
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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
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Optimal policy (continued)
2. Ex-ante: need to align the valuation of liquidity between individual inter-mediaries and social planner
!Pigou-tax argument
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� 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
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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 exchangeof money ! increase rate of return on equities
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But what about normal times?
� Should MP worry about crisis states in normal times?
� Could we design a systematic MP that prevent borrowing constraints tobecome binding?
� Should optimal systematic monetary policy target asset prices? (Mostprobably not)
� Has more predictable monetary policy contributed in any way to excessiverisk taking?