Getting up to Speed on the Financial Crisis : A one-Weekend-Reader’s Guide --------- Gary Gorton...

Getting up to Speed on the Financial Crisis :

A one-Weekend-Reader’s Guide ---------Gary Gorton and Andrew Metrick

Jingyu WangSep. 12th

Objective

• speed on the literature of the crisis without having to go into a cave and read for a whole year.

• select and summarize sixteen documents, including academic papers and reports from regulatory and international agencies.

• Covers the key facts and mechanisms in the build –up of risk, the panics in short-term debt markets, the policies reactions, and the real effects of the financial crisis.

Outline

• Section 2: Overview and Timeline of the Crisis① 2010 testimony: Bernanke in front of the Financial Inquiry Crisis

Commission ② Report Chapter from International Monetary Fund(IMF 2010)③ Bank for International Settlements(BIS 2009)

• Section 3: Historical perspective on financial crisis ① Reinhart and Rogoff(2011)

② Schularick and Taylor

Accelerations in economy wide leverage and subsequent banking crises

Outline

• Section 4: The Crisis Build-up① Pozar(2011): Institutional Cash Pools grew ② Bernanke(2005): sovereign-wealth grew ③ Reinhart and Rogoff(2008): sharp increase in house price before crisis④ Case and Shiller(2003): housing bubble before crisis

• Section 5: The panics ① Covits, Liang, and Suarez: asset-backed commercial paper② McCabe(2010): money-market mutual funds③ Gorton and Metrick: repurchase agreements and securitization

Demand of short-

termdebt

Provide a narrative of contagion where each step drains the banking system of hundreds of

billions dollars and induces higher risk

Structure

• Section 6: Policy response① IMF’s Financial Stability Report (Oct, 2009): taxonomy and analyses policy

actions across 13 countries from 2007-2009

• Section 7: Real effects of the financial crisis① Ivashina and Scharfstein (2010) : decrease in lending related to bank’s

reliance in short-term funding② Puri, Rocholl, and Steffen(2011): shock to credit supply reduced consumer

loan ③ Campello, graham, and Havey (2010):credit constraints pulled back on

investment

• Section 8: Conclusion

Section 2: Overview and Timeline of the Crisis• Bernanke testimony(2010): • Two vulnerabilities in financial sector:

① short-term debt(main): repurchase agreement and commercial paper

② shadowed bank :serve as intermediaries to channel savings into investment

Section 2: Overview and Timeline of the Crisis

• IMF Document:① Details how repo market work② Large but unregulated③ Total outstanding repo:Between 20 and 30 percent of US

GDP in each year from 2002-2007④ Disruption in US short-term debt creates shortage of US

dollars

Section 2: Overview and Timeline of the Crisis

• Bank for International Settlements(BIS) Document① Bankruptcy filling of Lehman Brother exacerbated whole

situation② Financial institutions facing the risk of default③ Run on money market mutual fund④ far more damage then subprime losses

Section 3: Historical Background

• understand the recent crisis from the phenomenon before the financial crisis

• Reinhart and Rogoff Results:

① external debt increases sharply, in advance of banking crisis② banking crises tend to lead sovereign debt crises

• Schularick and Taylor

① analyze financial crises with overall credit growth② build a 140-year panel data set for 14 developed countries

Results:③ changes in credit supply(bank loans) are a strong predictor

of financial crisis, particular when these change are accelerate

Section 3: Historical Background

Provide a consistent picture :an acceleration of debt from both governments and financial intermediaries are the

most important antecedents

Section 4: The Crisis Build-up

• Try to understand how the Crisis build- up • Previous Section: Credit booms often precede crises • Credit booms:

① asset-baked securities② mortgage-backed securities

Shadow banking system

Securitization

Section 4: The Crisis Build-up

Explosive growth in the six or seven year before the

crisis, which consistent with credit boom

• Pozsar(2011)”Institutional Cash Pools and the Triffin Dilemma of the U.S banking System”

① institutional cash pools: important Securitization② growth of institutional cash pools have a associated

demand for liquidity demand for insured deposit alternatives

③ Not enough safe asset from US treasury for US to hold.④ institutional cash pools demand for insured deposit

alternatives exceeded the outstanding amount of short-term government guaranteed instruments.

Section 4: The Crisis Build-up

Section 4: The Crisis Build-up

• Bernanke(2005)”The Global Savings Glut and the U.S Current Account Deflict”

① foreign official investors hold large amounts of US Treasuries institutional cash pool had to find substitutes

1) short-term bank debt-like products(repurchase agreements and asset-backed commercial paper)

2) indirect holdings of unsecured private money market instruments through money market mutual fund

② Asset-backed securities mortgage’s preferred collateral credit boom borrow money(buy houses) house price increase Bubble?

• Case and Shiller(2003)”Is there a bubble in the housing market”

① House price increasing is not a conclusive evidence of a bubble

② Bubble: a situation in which excessive public expectations of future price increases causes price to be temporarily elevated

Section 4: The Crisis Build-up

Section 4: The Crisis Build-up

• House price run-ups prior to crises are common

• Reinhart and Rogoff(2008)”Is the 2007 U.S Sub-Prime Financial Crisis so Different ? An international Historical Comparison. “

Section 4: The Crisis Build-up

run-up in housing prices in U.S.before

crisis

Section 5: The Panics

• Two main panic period of the financial crisis : Aug. 2007, and Sep-Oct 2008.

• Three paper: Each focus on a different component of the short-term debt market major causes of financial crisis

Section 5: The Panics

• Covitz, Liang, and Suarez(forthcoming) • Analyze runs on the asset-backed commercial paper

market began in Aug. 2007 ① Commercial paper is important security for the financing

of industrial firms minimize transaction cost ② Demand of CP is high increase use of long-term

financial asset(Asset-baked commercial paper) Can bundle mortgages(securitization) transparent, lower funding cost, save on regulatory capital 1.2 trillion ABCP outstanding by July 2007

Section 5: The Panics

• Covitz, Liang, and Suarez(forthcoming)③ Meaning of a run on ABCP program : if lender(depositor)

in bank are unwilling to refinance CP when it come to due. Mechanically, in any week a program does not issue any new paper despite having at least ten percent of its CP maturing

Backup support from the program

sponsor

Force to sell asset

Section 5: The PanicsBeginning in the week of Aug. 7th, the frequency of runs increased dramatically.

By the end of 2007, 40% of program in a run, unable to finance themselves

• Covitz, Liang, and Suarez(forthcoming)④ Program more likely experience a run: high credit risk(exposure to subprime-related securities) high liquidity risk

Section 5: The Panics

Section 5: The Panics

• ABCP market fell a lot in 2007 significant impact on the balance sheet of those sponsor focus on money market mutual fund(MMFs), a major holder of ABCP

• McCabe(2010)

① Shirking ABCP downward pressure on asset classes held by many MMF’

Section 5: The Panics

• Comprehensively analyses short-term debt market and the linking between ABCP and MMF’s help to know how contagion in these market can spread.

• Did not figure out ABCP panic was drive by a weakness in subprime mortgage

• Repo markets play an important role in the contagion• Gorton and Metrick(forthcoming)

Section 5: The Panics

• Gorton and Metrick(forthcoming) ① Repo is the shadow banking equivalent of a deposit

market. ② When cash holdings far exceed insured deposit limits,

large institutional money pools can lend short-term to a financial institution and receive collateral as protection

③ For every $100 of collateral , an institution can receive $(100-x) in loans, with x% represent the haircut.

Section 5: The PanicsBeginning of 2007, average haircut were near 0.

First shock at the time of ABCP panic

Steady rise each year

Lehman failure, large drain

Section 5: The Panics

• Gorton and Metrick(forthcoming) ④ subprime securities (small) Financial Crisis⑤ Subprime failure(ABCP 40% market) Price drop,

unprecedented problems on MMF’s(43 funds required support from their sponsors) Initial panic on Aug. 2007 Pressure on repo market Lehman collapse interbank market near collapse government intervention

Section 6: Policy Response

• IMF Report① Look short-term reaction of both “economic stress

index”(ESI) and “financial stress index”(FSI)② Interest rate cut: no short-run impact on the ESI, only

limited evidence of a positive effect on the FSI③ Liquidity support was effect at calming interbank credit

market in the early stages of the crisis, but not after the fall of Lehman

④ Later stage, capital injection were the most effective policy

Section 7: Real Effect of the financial Crisis

• Crisis is global in nature• Ivshina and Scharfsterin(2010) ① study the supply of credit during the crisis in order to

understand the real effects of the panic on the corporate sector

② lending volume in the fourth quarter of 2008 was 47% lower than it was in the previous quarter, and 79% lower than at the peak of credit boom(2007:Q2)

③ main conclusion: the decline in lending was in large part an effect of reduced bank loan supply

Section 7: Real Effect of the financial Crisis

• Puri, Rocholl, and Steffen(2011) ① focus on the issue of the supply of credit ② examine the effects of the U.S financial crisis on lending

to retail customers in Germany ③ Landesbanken(the regional banks , each in a province)

suffer different extents due to their exposures to US subprime mortgages

④ Overall decrease in demand for consumer loans, result of bank reduced the supply of credit

Section 7: Real Effect of the financial Crisis

• Effect of a reduced bank loan supply have on the real economy, on the activities of nonfinancial firms

• Campello, Graham, and Harvey(2010)

① 1,050 CFOs in thirty-nine countries in North America, Europe and Asia in Dec. 2008:whether they were financially constrained during the crisis.

Section 7: Real Effect of the financial Crisis

81% of the very affected firms reported that they experience less to credit,

20% has problems with lines credit

Reduction in credit supply had significant impact on credit-constrained firm

Conclusion

• Financial crisis of 2007-09 was the most important economic event since the Great Depression.

• Similarity: the acceleration of system-wide leverage just before the crisis

• The crisis was exacerbated by panics in the banking system where various types of short-term debt suddenly became subject to runs.

• Novelty: location of runs, which took place mostly newly evolving “shadow banking” system, including money-market funds, commercial paper, securitized bonds, and repurchase agreements

My opinion

• CDS

• Short-term interest rate, government intervention

Thanks!