University of Chicago on Credit crisis

Initiative on Global markets have a surprisingly good 4 part lecture on Credit crisis each dwelling on one aspect of credit crisis - the origins, the liquidity crisis, incentives and the policy responses- lessons from Japan. While the conclusions reached are fairly conventional wisdom, the rigor of the research is something of note.

Mortgage crisis
Amir Sufi divides the areas into Prime and Subprime Zip codes (those areas where more than 60% of the loans originated by subprime borrowers are Subprime zip code areas while those with more than 60% prime are prime zip code areas. The growth in loans in subprime zip codes are about three times the growth in Prime areas between 2002 and 2005. There is a precedent in this even between 1999 and 2001, so he chose to see if there is any difference between then and now.

The factors why the loan growth exploded can be a) income growth in subprime is greater than prime areas; b) House price expectations were relatively higher in subprime and c) securitization was higher in subprime, with the associated incentives (as suggested by conventional wisdom)

If a) was indeed true, there seems to be a fair case for the growth in subprime loans. In fact between 1999 and 2001, that was indeed the case. Between 2002 and 2005, the growth in income was about 4% for subprime while for prime borrowers was 8%. Even then, if there is a possibility that the subprime borrowers crossed a threshold to qualify for a homeloan so the home loans exploded (its a similar case with demand for cars in India- a once an income threshold is crossed, the market explodes) So Amir takes only the zip codes where there is a negative growth in nominal income and sees the relation between loan origination growth between subprime and prime growth. Even there, the loan growth is starkly higher.

So the second explantion for the loan growth, higher house price appreciation for subprime borrowers does have some evidence. But it may be the case that the price appreciation happened precisely because of loan origination growth. It is difficult to disentangle the effects between the two variables when causality is the case. Which makes it all the more curious that rating agencies put the house prices on the RHS of the equation for giving the ratings for securitized debt.

There is also strong evidence for the third relationship but it is taken up in the third part. The moot point is micro trends are important for predicting a crisis- how did loan origination grow faster in a segment which has seen slower or even negative growth in income compared to prime borrowers, as was seen as early as 2004? The other conclusion is its important to not treat house prices as exogenous.

Liquidity crisis
Doug Diamond says Banks, investment banks and hedge funds are by nature, highly levered institutions. It is impossible for investors to check the quality of assets of a bank as compared to say, a car company. Which is why both Equity and long term debt is in short supply for a bank and they rely on deposits or wholesale funding.

The more difficult it is to judge the quality of assets, the more levered the institution. That is why Bear Sterns or Lehman have leverage of about 30-35 while even Goldman Sachs had to be satisfied with a modest 20 times leverage. And the funding for the investment banks is almost entirely overnight, because they cannot monitor what the banks do with their money even less than a commercial bank. The investment banks can rapidly alter the risk profiles on a daily basis since they have a trading portfolio as compared to a loan portfolio of a commerical bank whose risk profile is sticky. In this scenario, the only bargaining chip the investors have is that they can stop rolling over short term money. It keeps the investment banks in check, but it also increases the risk of run, which is costly for both the borrower and the lender. If it is costly, why does the investor do it? In times of uncertainity, the investor knows if he doesnt pull out, someone else will and they would get the 100 cents on dollar while he potentially loses some because he was patient.

This is what happened with Northern Rock, a fundamentally solvent bank with no exposure to US subprime but got its funding mostly from ABCP market. With that market crashing because investors stopping to rollover funds for anyone with any exposure to Mortgage assets (Northern Rock assets were mostly in UK prime segment). The fear of solvency was enough to start a run on the bank which became a self fulfilling prophecy.

When the bank fears a run because the capital has become low, it can either raise capital or dump assets to bring down the leverage. Banks usually opt for the second because the first may take time or prove difficult. But there was no market for these assets because of two reasons. First, if the investors think if they dont buy assets today worth $5 today they can get it even cheaper tomorrow (perhaps $2) they would stop buying it. Two, if other instituions think if they buy these assets cheap, they have to mark their similar investments down which results in their capital levels getting low, they wouldn't buy it. This is what TARP 1 wanted to correct; Paulson thought if the government becomes the buyer of dodgy investments of the last resort, the lower bound can be made $5 or even the hold to maturity value of the asset, so that the actual payout by the government may not happen at all, and the instituions may appear solvent. But the more direct approach is to direct equity into the troubled banks so that they need not firesale the assets at all. TARP 1 went into rough weather.

The lecture discusses the effect of short term debt remains the same for every crisis, right from Bank runs of 1930s to current one. The solution proposed then was to insure all short term debt for 90 days, conduct audits for all banks, differentiate good banks from bad, inject equity into good banks, merge the average ones, and let the bank banks go through resturcturing through the FDIC route. Now that the liquidity crisis have largely eased as the Fed is lending to everyone, we may not know how that would've worked.

The other two aspects we can see later.