2012.05.02 - crisis_Cochrane
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2012.05.02 - crisis_Cochrane


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Treasury Purchase 
JPMorgan	
  Chase	
   Bear	
  Stearns	
  
Bank	
  of	
  America	
   Merrill	
  Lynch	
  
JPMorgan	
  Chase	
   Washington	
  Mutual	
  
Wells	
  Fargo	
   Wachovia	
  
5/3	
  Bank	
   First	
  Charter	
  Bank	
  
PNC	
  Financial	
  
Services	
   NaFonal	
  City	
  Corp.	
  
#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 
\u2022\u202fBanks 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 
Macroeconomics	
  and	
  \ufb01nance	
  	
  
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 \u201cmarginal\u201d and tried to sell. 
 
Consumption: Risk aversion rises following recent losses. (\u201chabits\u201d). 
Investment: Investment falls when stock prices (q) falls. 
C 
U(C) 
X 
Rising risk aversion 
1990 1992 1995 1997 2000 2002 2005 2007 2010
Surplus consumption (C-X)/C and stocks
 
 
SPC
S&P
P/D
SPC is the Cambell/Cochrane measure of consumption relative to habit. 
When SPC falls, prices fall, risk premia rise 
1990 1992 1995 1997 2000 2002 2005 2007 2010
1
1.5
2
2.5
3
3.5
4
Nonres. Fixed I/K and Q
 
 
I/K
P/(20*D)
BE/ME
Q theory says investment falls when stock market falls. This needs no frictions 
or constraints 
The	
  Fed	
  
§\uf0a7\u202fThe 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 
\u2022\u202f\u201cExpansion of balance sheet\u201d = printing money, lending it out. A trillion extra dollars! 
\u2022\u202fBernanke: \u201cMilton Friedman, we won\u2019t make the same mistake again\u201d 
\u2022\u202fMore detail on the many new facilities 
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	
  	
  
SecuriFes	
  	
   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	
  circulaFon	
  	
   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	
  	
   902,993	
  	
   939,307	
  	
   1,839,042	
  	
  
	
  	
  	
  
O\ufb00	
  balance	
  sheet	
  	
  
SecuriFes	
  lent	
  to	
  dealers	
  	
   120,790	
  	
   226,357	
  	
  
Stocks	
  
You know the stock market cratered and then recovered. 
1950 1960 1970 1980 1990 2000 2010
-5
0
5
10
15
20
25
30
4 x D/P and Annaulized Following 7-Year Return
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\u2019t change that much because D fell like a stone. 
Earnings may be a better divisor, since price decline anticipates lower 
dividends next year. This means less of a screaming buy, higher ER 
Vol = 20 day backward looking average volatility of daily S&P500 index 
\u2022\u202fBoth 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 
Source: CBOE.com 
\u2022\u202fPeople thought volatility was temporary. \u201cSafer in long run\u201d 
Does	
  the	
  crash	
  mean	
  that	
  free	
  
markets	
  failed?	
  New	
  instruments,	
  	
  
toxic	
  derivaFves,	
  \ufb01nancial	
  
innovaFon	
  gone	
  amok,	
  etc.	
  	
  
Unused	
  slides	
  
Ideas	
  
\u2022\u202fHome	
  prices	
  decline	
  \u2192	
  defaults	
  \u2192	
  mortgages	
  worth	
  
less	
  	
  \u2192	
  	
  banks	
  insolvent	
  
	
  
\u2022\u202fWho	
  cares?	
  
\u2022\u202fGreat	
  depression	
  story	
  1:	
  (Friedman)	
  	
  
\u2022\u202fBanks	
  fail	
  	
  \u2192	
  	
  M1	
  declines	
  
\u2022\u202fGreat	
  depression	
  story	
  2:	
  	
  (Bernanke)	
  	
  
\u2022\u202fBanks	
  fail	
  	
  \u2192	
  No	
  banks	
  to	
  make	
  loans	
  -­\u2010>	
  savers	
  can\u2019t	
  
meet	
  borrowers.	
  	
  	
  
What is the worry? 
Interest	
  
rate	
  
Supply	
  (savings)	
  
Demand	
  (investment,	
  mortgages)	
  
A	
  credit	
  crunch:	
  Banking	
  system	
  cannot	
  make	
  new	
  loans.	
  
System	
  	
  
Doesn\u2019t	
  
Work	
  
Loans	
  
View 2: 
A crunch, but in 
debt markets 
not banks. 
Interest	
  
rate	
  
Loans	
  
Supply	
  
Of	
  risky	
  debt	
  
Demand	
  
 
A fall in loans need not mean a credit crunch 
View 3: Investor Fear + Recession 
Which is it? 
 
1.\u202f Banking system wants to lend, but cannot. 
-Secretly undercapitalized, can\u2019t get new capital. 
\u201cRecapitalizing\u201d banks would fix everything 
2.\u202f Banking system doesn\u2019t want to lend because it can\u2019t sell in 
dysfunctional debt markets. 
3.\u202f Nobody wants to lend because investors don\u2019t want to hold 
risk. 
\u2022\u202fLittle decline in banking system lending. 
\u2022\u202fBanks can and do raise equity. 
\u2022\u202fBanks can and do fail / get taken over. 
\u2022\u202fTreasury purchase/debt guarantee did not stop it in tracks. 
\u2022\u202f\u201cRecapitalized banks\u201d pay dividends, buy other banks. 
\u2022\u202fHigh risk premiums in nonfinancial, non-intermediated assets. 
\u2022\u202fObvious huge problem in credit markets 
\u2022\u202fNothing without Govt guarantee or direct purchase is selling 
Summary: Bank constraint vs. Credit market 
Or risk premium view 
r	
  
Loan 
r	
  
Loan 
Summary so far: 
 
1.\u202fHuge risk premium in debt markets = Large demand for 
Treasury debt 
2.\u202fRisk premium: \u201cprecautionary savings\u201d, lower \u201caggregate 
demand\u201d = 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 
a)\u202fAct as missing intermediary 
b)\u202fProvide desired Gov\u2019t debt without needing deflation 
Policy	
  #1	
  danger	
  
1.\u202f Fed is running the world\u2019s biggest hedge fund. 
2.\u202f Can we reverse all this without inflation? 
3.\u202f Will the Fed be the only intermediary for a generation? 
4.\u202f Is the Fed buying good, especially new, debt at market prices? 
5.\u202f True blue free-market objections 
Bad	
  Policy	
  Ideas	
  
1.\u202f TARP to buy troubled assets on the open market 
2.\u202f TARP to buy assets from banks at artificial prices 
3.\u202f Bank \u201crecapitalization\u201d without quick workout. 
4.\u202f Forced mortgage renegotiation: a $150,000 unemployment 
subsidy 
5.\u202f Bailout Contagion. S&L Government, Pension Funds, \u2026 
6.\u202f Policy uncertainty, changing the rules of the game. Who will