1. John H. Cochrane University of Chicago Booth School of Business
Financial crisis
John H. Cochrane
University of Chicago
Booth School of Business

2. House prices, investment
House prices rose a lot, then fell.
Residential investment (home building) fell too. It often falls first in recessions
Mortgage defaults start, especially in subprime and other mortgage products that basically invite homeowners to default if house prices go down
Defaults wipe out low tranches fast!

8. Interest Rates

9. In normal times, CP spreads are really low!

10. A chronology of the crisis, and a sense of when things are better/worse

11. The crisis. I’m interested how much is financial, how much “illiquidity,” and how much a simple rise in credit risk and its premium. The fact that non financial AA does well and nonfinancial A2P2 is even worse than financial suggests the latter interpretation to me. The credit risk premium went up – and this is just about how investors feel, not about liquidity, leveraged investors, etc.

12. A closer view. CP rates. It differs a lot by maturity
A closer view. CP rates. It differs a lot by maturity. I found it interesting that overnight financial and nonfinancial are the same. The banks were not having special problems borrowing overnight. Again, the poor A2P2 are the ones really having problems. I think the sharp drop comes when the Fed starts buying commercial paper.

13. Lehman or Tarp?
Did Lehman or the Tarp speeches set off the run? This makes the case it was the TARP speeches. (With inspiration from John Taylor) It also suggests that the function of the TARP asset purchases was just to convince the markets that the government really really was going to bail out citi, not “recapitalization so they could start lending”

14. The bond spread widens to historic proportions
The bond spread widens to historic proportions. Let’s look a bit deeper…

15. We worry about a crisis because “firms can’t borrow
We worry about a crisis because “firms can’t borrow.” But of course most firms do not depend terribly on bank financing, they can issue bonds. Also, bond issues do go straight to investors – you and I can buy the Vanguard corporate bond fund if prices are good. So, what happened to these rates? The credit spread opened to huge amounts, not seen since 1982 and near Depression levels. Interestingly though it’s because government and short rates fell not so much because corporate rates rose, at least until Tarp. There is nothing that “recapitalizing the banks” will do about this.

16. The huge credit spread doesn’t seem that affected by the momentous events moving around short-term rates

17. A bit of an update though without the nice vertical bars

18. The Fed is easing like crazy. (More Fed policy later)
The Fed is easing like crazy. (More Fed policy later). Notice 3 month bills below fed funds, and notice 3 month bills actually hitting zero in Dec I think the “flight to quality” represented here is a big part of the crisis.

19. CDS is the modern way to measure credit spreads
CDS is the modern way to measure credit spreads. This is percent per year you have to pay for bond insurance (-200 = 2%). By summer 09 the crisis is over .

20. “Arbitrage”
Many markets saw “arbitrages” open up. These aren’t true arbitrages; one end is always more illiquid than the other, or has some counterparty risk, etc. But these are prices that usually are very close to each other. In each case, the leg of the arbitrage that needs cash, needs funding, or needs borrowing is underpriced. In each case, the price difference is still small enough that “long only” investors don’t really bother that much.
Why does this matter? It’s certainly a sign of illiquid markets – the usual arbitrageurs are maxed out, can’t borrow, can’t raise equity -- so strategies that try to manage risk by “we’ll sell on the way down’’ rather than buy real put options will fall apart at times like these.

21. Borrow dollars, buy Euros, lend euros, buy dollars forward
Borrow dollars, buy Euros, lend euros, buy dollars forward. 20bp is huge, because you can lever this up arbitrarily. But…”borrow dollars!” 20bp is not enough to attract long-only money.

22. Average Daily (Bond–CDS) Basis: by Rating
Date A
BBB BB
9/12/2008
54bp
105bp
126bp
12/16/2008
282
388
760
10/8/2009 51
100
123
Source: J.P.Morgan
Buy corporate and CDS vs. buy Treasuries. But buying corporate needs cash or repo financing, now hard to do. (Also illiquid, and CDS counterparty risk)

23. A normal treasury yield curve

24. On the run/off the run spread explodes!
Yield vs. duration of all outstanding treasury bonds and bills, crsp mbx database

25. Credit quantities
What matters to the economy of course is whether it’s hard to borrow.
It’s important to distinguish “sand in the gears,” financial dysfunction, from simple shift in the supply curve or greater credit risk. If that’s the case, fixing the banks won’t help, nor is it obvious we should help. Not every fall in quantity is a wedge between demand and supply, not every project should be funded
Which kinds of debt fell, and what can we tell about supply vs. demand vs. wedge between the two opening up?

26. D.2 Borrowing by Sector ($Billion, SAAR)
Flow of funds data—private borrowing collapses
Home
Consumer
Business
S&L
Federal
financial
Date
Total
Mortgage
credit
Corp
Govt
sectors
Foreign
D.2 Borrowing by Sector ($Billion, SAAR)
2007
2536
659
137
1252
783
186
237
1791
170
2008
1870
-58 40
551
347 43
1239
888
-129
2008Q4
2011
-196
-76
113 56
-3.5
2155
554
-429
2009Q4
956
-370
-81
-283 94
115
1485
-1533
-547
Massive decline in private borrowing, massive increase in government!
Which markets and channels show this huge decline?
Why? Is this “supply and demand” or “something’s wrong”?

27. Flow of new lending r r “Something’s wrong” Broken intermediary?
Loan
Loan
“Something’s wrong”
Broken intermediary?
Capital constrained banks?
In banks or securitized debt markets?
“Supply and demand”
Higher risk aversion, greater chance of default
Less demand to borrow, invest in recession?

28. Commerical paper issuance
Commerical paper issuance. Asset-backed falls apart in 2007 with the blowup of SPVs. Financial falls apart post Lehman/TARP. Nonfinancial keeps going! In fact, it increases. Savers want to put money somewere, it was easy for large safe companies to borrow commercial paper in the middle of the crisis. Newspaper hyperbole “credit markets froze” miss this fact.

29. Quantities. Yes, financial declined (and all maturities declined a lot), but you’d expect to see much worse given all the complaining.

30. US Non-Agency MBS Issuance
Falls off a cliff. And in 07 (along with ABS), long before TARP etc. The originate to sell model ended. If you want to see credit quantities affected by the financial crisis this is it. These are mortgage backed securities that don’t go through FannieFreddie, thus don’t get the government guarantee. Jumbos are an example.

35. Scale of Dealer Deleveraging in Corporate Bonds over 2007 and 2008
A sense of how important the run in repo is
Source: Primary Dealer Survey, Federal Reserve Bank of New York

36. What about the Banks?
Do the banks want to lend, can’t because of capital constraints?
Or do the banks not want to lend, (they can’t sell loans anymore), and no amount of capital will change that fact?
Distinguish “banks” (many were surely in trouble) from “banking system” (can competitors come in and take over)
Bottom line: I think the evidence favors #2, and TARP purchases did not spur lending.

37. Fact: Banking system did not “delever” to any great extent

38. Again, we do not see a huge decline in loans at banks

39. Once again, no huge decline in lending
Once again, no huge decline in lending. Actually, given the severity of the recession, it’s surprising how little lending went down.

41. Bank –held debt is a small part of credit markets.
L.1 Credit Market Debt Outstanding
2006
2008
Description
Pct Q2
Total credit market assets held by :
45347
100
51019
Household sector
3865
8.5
4140
8.1
Nonfinancial corporate
329
0.7
169
0.3
noncorporate
109
0.2
129
State and local
1471
3.2
1473
2.9
Federal
281
0.6
294
Rest of world
6198
13.7
7775
15.2
Monetary Authority
779
1.7
538
1.1
Commercial banking
8019
17.7
8950
17.5
Savings institutions
1519
3.3
1607
3.1
Credit unions
623
1.4
686
1.3
Property-casualty insurance
814
1.8
835
1.6
Life insurance
2806
6.2
2937
5.8
Private pension funds
705
757
1.5
State and local retirement
770
812
Federal retirement 84
108
Money market mutual funds
1561
3.4
2233
4.4
Mutual funds
1932
4.3
2314
4.5
Closed end funds
172
0.4
161
Exchange traded funds 21
0.0 43
0.1
GSE
2591
5.7
2995
5.9
Agency and GSE-backed Mortgage pools
3837
4762
9.3
ABS
4069
9.0
4257
8.3
Finance companies
1627
3.6
1639
REITS
295
232
0.5
Broker dealers
583
694
Funding corporations
289
480
0.9
Bank –held debt is a small part of credit markets.
Even if the “banks don’t lend”, does this matter?
Source: FRB Sept 18 Flow of funds

42. This is what all assets and liabilities of commercial banks look like, from which the next slide is drawn

43. Banks did not delever, they actually expanded
Banks did not delever, they actually expanded! Banks also did not conserve captal, paying dividends, bonuses, and making acquisitions.
Controversies: Much expansion came from existing lines of credit, not new lending. Much came by taking on SPV assets from unwinding of shadow system, not new lending. And many borrowers did report trouble getting loans.

44. Banks Can And Do Raise Capital!
Firm
Writedown & Loss
Capital Raised
Citigroup Inc.*
60.8
71.1
Wachovia Corporation*
52.7 11
Merrill Lynch & Co.
52.2
29.9
Washington Mutual Inc.
45.6
12.1
UBS AG
44.2 28
HSBC Holdings Plc
27.4
5.1
Bank of America Corp.
21.2
20.7
JPMorgan Chase & Co.
18.8
19.7
Morgan Stanley*
15.7
14.6
IKB Deutsche Industriebank AG
14.8
12.2
Royal Bank of Scotland Group Plc
14.1
23.1
Lehman Brothers Holdings Inc.
13.8
13.9
Credit Suisse Group AG
10.4 3
Deutsche Bank AG
6.1
Wells Fargo & Company 10
5.8
Credit Agricole S.A.
8.8
8.5
Barclays Plc
7.6
17.9
Canadian Imperial Bank of Commerce
7.2
2.8
Fortis*
7.1
Bayerische Landesbank
6.9
HBOS Plc
6.8
ING Groep N.V.
6.7
4.6
Societe Generale
6.6
9.4
Mizuho Financial Group Inc.
National City Corp.
5.4
8.9
Natixis
5.3
11.8
Indymac Bancorp Inc
4.9
Goldman Sachs Group Inc.
10.6 …… …
TOTAL
590.8
434.2
Banks Can And Do Raise Capital!
The “debt overhang” story is not absolute. When banks lose money they can and do go out and raise more capital. (This being impossible is a central part of the “capital constraint” story)
(source: Bloomberg.com)

45. Banks Can and Do Raise Capital II
Source :Anil Kashyap
Includes Treasury Purchase

46. Banks can and do fail, with operations taken over and continuing under new ownership. A bank failing does not mean it cannot process new loans. In fact, sometimes it can do it better.
Two lists from the internet
#1 Northern Rock #2 Bear Stearns #3 ANB Financial #4 First Integrity Bank #5 Roskilde Bank #6 IndyMac #7 First Heritage Bank #8 First National Bank of Nevada #9 IKB (basically insolvent after gov't intervention) #10 Silver State #11 Fannie Mae #12 Freddie Mac #13 Lehman Brothers #14 AIG #15 Washington Mutual
JPMorgan Chase
Bear Stearns
Bank of America
Merrill Lynch
Washington Mutual
Wells Fargo
Wachovia
5/3 Bank
First Charter Bank
PNC Financial Services
National City Corp.

47. Macroeconomics and finance
Is there anything for our simple models that tie macro to asset pricing to do? Or do we throw everything out and only study frictions?
A: Frictions are frosting, but there is a lot of cake. Many long-only unconstrained investors were “marginal” and tried to sell.
Consumption: Risk aversion rises following recent losses. (“habits”). Investment: Investment falls when stock prices (q) falls.

48. Rising risk aversion
U(C) X C

49. SPC is the Cambell/Cochrane measure of consumption relative to habit.
When SPC falls, prices fall, risk premia rise

50. Q theory says investment falls when stock market falls
Q theory says investment falls when stock market falls. This needs no frictions or constraints

51. The Fed

53. The Fed is no longer just setting the funds rate and letting others adjust. The Fed was trying to influence rates in many markets. A good issue for monetary economics is whether it actually raises rates in individual markets or just ends up supplying more money and treasury debt

54. “Expansion of balance sheet” = printing money, lending it out
“Expansion of balance sheet” = printing money, lending it out. A trillion extra dollars!
Bernanke: “Milton Friedman, we won’t make the same mistake again”

55. More detail on the many new facilities

57. Balance sheet of the Federal Reserve. Millions of dollars
Balance sheet of the Federal Reserve. Millions of dollars. Data source: Federal Reserve Release H.4.1.
Aug 8, 2007
Sep 3, 2008
Oct 22, 2008
Securities
790,820
479,726
490,617
Repos
18,750
109,000
80,000
Loans
255
198,376
698,050
    Discount window
    255
    19,089
    107,561
    TAF
    150,000
    263,092
    PDCF
    102,377
    AMLF
    107,895
    Other credit
    90,323
    Maiden Lane
    29,287
    26,802
Other F.R. assets
41,957
100,524
519,713
Factors supplying reserve funds
902,993
939,307
1,839,042
Currency in circulation
814,626
836,836
856,821
Reverse repos
30,132
41,756
95,987
Treasury general
4,670
5,606
55,625
Treasury supplement
558,987
Reserve balances
6,794
3,831
220,762
Factors absorbing reserve funds
Off balance sheet
Securities lent to dealers
120,790
226,357

58. Stocks
You know the stock market cratered and then recovered.

60. A reminder that lower p/d means a higher risk premium, quite sensible in a huge recession and the same as the higher credit spread. P/D didn’t change that much because D fell like a stone.

61. Earnings may be a better divisor, since price decline anticipates lower dividends next year. This means less of a screaming buy, higher ER

62. Both actual and implied volatility rose sharply. 80%
Both actual and implied volatility rose sharply. 80%! Lots of signs of distress, forced selling, illiquidity (negative serial correlation).
Vol = 20 day backward looking average volatility of daily S&P500 index

63. Vol = 20 day backward looking average volatility of daily S&P500 index

64. People thought volatility was temporary. “Safer in long run”
Source: CBOE.com

65. Does the crash mean that free markets failed
Does the crash mean that free markets failed? New instruments, toxic derivatives, financial innovation gone amok, etc.

67. Unused slides

68. Ideas

69. What is the worry?
Home prices decline → defaults → mortgages worth less → banks insolvent
Who cares?
Great depression story 1: (Friedman)
Banks fail → M1 declines
Great depression story 2: (Bernanke)
Banks fail → No banks to make loans -> savers can’t meet borrowers.

70. A credit crunch: Banking system cannot make new loans.
Interest
rate
Supply (savings)
System
Doesn’t
Work
Demand (investment, mortgages)
Loans

71. View 2:
A crunch, but in
debt markets
not banks.

72. View 3: Investor Fear + Recession
Supply
Of risky debt
Interest
rate
Demand
Loans
A fall in loans need not mean a credit crunch

73. Which is it? Banking system wants to lend, but cannot.
-Secretly undercapitalized, can’t get new capital. “Recapitalizing” banks would fix everything
Banking system doesn’t want to lend because it can’t sell in dysfunctional debt markets.
Nobody wants to lend because investors don’t want to hold risk.

74. Summary: Bank constraint vs. Credit market Or risk premium view
Loan
Loan
Little decline in banking system lending.
Banks can and do raise equity.
Banks can and do fail / get taken over.
Treasury purchase/debt guarantee did not stop it in tracks.
“Recapitalized banks” pay dividends, buy other banks.
High risk premiums in nonfinancial, non-intermediated assets.
Obvious huge problem in credit markets
Nothing without Govt guarantee or direct purchase is selling

75. Summary so far:
Huge risk premium in debt markets = Large demand for Treasury debt
Risk premium: “precautionary savings”, lower “aggregate demand” = more demand for treasury or guaranteed debt.
Policy #1 (basically good) :
Fed and Treasury Accommodate demand for Treasury Debt/money
Together they issue Trillions of Treasury/money to buy assets
Act as missing intermediary
Provide desired Gov’t debt without needing deflation

76. Policy #1 danger Fed is running the world’s biggest hedge fund.
Can we reverse all this without inflation?
Will the Fed be the only intermediary for a generation?
Is the Fed buying good, especially new, debt at market prices?
True blue free-market objections

77. Bad Policy Ideas TARP to buy troubled assets on the open market
TARP to buy assets from banks at artificial prices
Bank “recapitalization” without quick workout.
Forced mortgage renegotiation: a $150,000 unemployment subsidy
Bailout Contagion. S&L Government, Pension Funds, …
Policy uncertainty, changing the rules of the game. Who will buy now?
Government running the banks / credit system for a long time.
Fiscal “stimulus.”
“Do something.” It’s ok to be negative.
The major danger is political, not economic.

78. Policy. Will the Treasury Plan work?
Supply
Price
Treasury Hope:
Small purchase raises price a lot
Finance experience:
Huge purchase to move
prices a little
Demand
Mortgage-backed securities

79. Credit Crunch – “undercapitalized” mechanics
1. Before
2. After
Risk
100 10
Equity
Equity 95 ! 5 90 90
Loan
(Assets) =
Debt =
Debt
3. No new loans!
3. “Deleverage?”
New
loan 5 5 50 95 5
Sell. 50 90
New debt 45 5 = = 45

80. Solutions? 4. “Recapitalize” 4. “Failure” = recapitalization 1. New
Equity 55 10
New
loan 90 5 45 70 70 20 =?
2. New debt
Fail, = = 95 50 90 =
WaMu JPMorgan

81. What went wrong / needs to be fixed?
Amazing amount of overnight / short financing
$100
$100
Joe
Yes
Not
$100
Joe
$1.10 $1
Joe
$99
Sue
$1.10
$99
Sue $1
Joe
$98
Bob
$1.10

82. Swaps, brokerage, etc.
$100
$100
2. Value = 80
3. Value = 80
$100
Joe $1
$99
Sue $1
$99
Sue
Who stops ?
$98
Bob $1
1. Will this last?
2. Abandon Mark to Market?
3. Dynamic capital standards!

83. A credit crunch: banking system cannot make new loans.
Deposits,
CDs, Stock
Mortgage
Demand (investment)
Financial system
(intermediary)
Supply (saving)
The financial system can slice, dice and transfer risk, but cannot bear risk.
People must bear risk.
A credit crunch: banking system cannot make new loans.
Interest
rate
Supply
Banking
System
Demand
Loans