The Credit Crisis

Raghuram Rajan Chicago Booth School of Business

Outline
The Crisis: Origins The Impact Resolving the crisis? Regulatory Lessons

Bad Investments
Child of past crises
Emerging markets => Industrial country corporations => Industrial country household

Sophisticated Financial Sector

Effectively sold mortgages from Phoenix, Arizona to buyers around the world
$ 100 sub-prime mortgages generated $ 80 AAA

Originate to distribute spreads risks but

Quality of originations weakened Depended on house price rising

Bad Investments contd.

Banks held on to poor quality assets
Poor governance and risk management
At the top Through the organization
Tail risk Writing earthquake insurance

Where were the risk managers?

Financed with short term debt

Short term debt cheaper because
Lenders better protected. Rolling over financing is easy in good times. Market requires banks to hold little capital because losses remote.

Aided and abetted by Fed policy

Greenspan put

The Impact: Sequence of events

House price stops rising Mortgage Defaults=> MBS fall in value, become more difficult to price, and price becomes more volatile Market for mortgage backed assets dries up.

Illiquidity
Potential Insolvency More hits on their way
Credit cards Commercial real estate Commercial and industrial loans

Issuance of ABS
300 Student Loans Other Non US RMBS Manufactured Housing Home Eq (subprime) Equipment Credit Cards Autos

250

200

150

100

50

0 Jan-00 Oct-00 Jul-01 Apr-02 Jan-03 Oct-03 Jul-04 Apr-05 Jan-06 Oct-06 Jul-07 Apr-08

Credit markets freeze

Banks unwilling to sell impaired assets Banks unwilling to substitute for shadow financial system

Worries about borrower credit risk. Worries about own liquidity if lenders want money back. Worries about likely fire sales pushing securities prices further down common discount rate for risky assets

Banks unwilling to raise enough equity Stability is not the major focus of the private sector in the midst of a crisis! Institutional overhang not a major problem right now because demand for credit low. But will hamper recovery.

Declining credit asset prices pull equity prices downwards

ABX.07-1 AAA versus BKX* index prices

120 BKX (left) 100 ABX.07-1 AAA (right)

100 90 80 70 60

80

60

50 40

40

30 20 10

20

0 1/1/2007

0 4/1/2007 7/1/2007 10/1/2007 1/1/2008 4/1/2008 7/1/2008 10/1/2008 1/1/2009

source: Bloomberg

When will credit markets find a bottom?

When the risk of large institutions collapsing is small.
Guarantee debt Audit institutions (the Stress Test) Clean up bank balance sheets by isolating/selling problem assets
Good bank/bad bank

Recapitalize banks through a mix of private and public funds Some actions may have to be mandated

This will allow asset prices to recover and credit to flow more freely, thus not impeding recovery. Will require more public money: political support weak

3 Lessons for financial regulation

Regulators and markets are subject to the same euphoria that bankers are. Over the cycle
the market becomes less risk averse, so regulatory arbitrage increases enforcement as well as risk management get weaker. How do you ensure regulations have bite?

Illiquidity is contagious. Problems can emerge from anywhere and hit elsewhere.

Stability is a public good in the midst of a crisis, with limited private incentive to help create it.

Implications
Heavy handed, focused, regulation will most likely to lead to arbitrage, without insulating sensitive areas.
Bright lines? Utilities?

Lighter, across-the-board, regulation with contingent escalation of regulatory powers and actions more useful. No matter what regulators do, disaster can always strike. Create private sector buffers that will not be eroded in good times.

A problem
Large complex entities! Break them up? Slow their growth (higher capital and supervision)? Limit their growth? Force them to become easier to fail.

THANK YOU!
T