2012.05.02 - crisis_Cochrane

Prévia do material em texto

Financial	
  crisis	
  
	
  
John	
  H.	
  Cochrane	
  
University	
  of	
  Chicago	
  	
  
Booth	
  School	
  of	
  Business	
  
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! 
 
 Interest Rates 
In normal times, CP spreads are really low! 
A chronology of the crisis, and a sense of when things are better/worse 
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. 
 
Aug Sep Oct Nov Dec Jan Feb
0
1
2
3
4
5
6
7
Overnight Commercial Paper Rates
 
 
AA Financial
A2P2 Non-Financial
AA Non-Financial
Aug Sep Oct Nov Dec Jan Feb
0
1
2
3
4
5
6
7
30 Day Commercial Paper Rates
 
 
AA Financial
A2P2 Non-Financial
AA Non-Financial
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. 
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” 
1920 1940 1960 1980 2000
0
1
2
3
4
5
6
BAA-AAA
The bond spread widens to historic proportions. Let’s look a bit deeper… 
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. 
The huge credit spread doesn’t seem that affected by the momentous events moving around short-term 
rates 
2007 2008 2009
0
1
2
3
4
5
6
7
8
9
10
BAA
AAA
20 Yr
5 Yr
1 Yr
baa,aaa
A bit of an update though without the nice vertical bars 
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 2008. I 
think the “flight to quality” represented here is a big part of the crisis. 
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 . 
“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. 
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. 
Average	
  Daily	
  (Bond–CDS)	
  Basis:	
  by	
  RaFng	
  
-200
-100
0
100
200
300
400
500
600
700
800
900
1/2/2007 7/2/2007 1/2/2008 7/2/2008 1/2/2009 7/2/2009
bp
/y
ea
r
A-Rated BBB-Rated BB-Rated
(Bond-CDS) Basis 
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) 
0 2 4 6 8 10 12 14 16 18 20
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
5.5
Duration
Yi
eld
Treasury and Fama Bliss yield curve Dec 29 2006
A normal treasury yield curve 
0 2 4 6 8 10 12 14 16 18 20
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
Duration
Yi
eld
Treasury and Fama Bliss yield curve Dec 30 2008
On the run/off the run spread explodes! 
Yield vs. duration of all outstanding treasury bonds and bills, crsp mbx database 
Credit	
  quanFFes	
  
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? 
Flow of funds data—private borrowing collapses 
Home	
   Consumer	
   Business	
   Business	
   S&L	
   Federal	
   financial	
  
Date	
   Total	
   Mortgage	
   credit	
   Total	
   Corp	
   Govt	
   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”? 
r	
  
Loan 
r	
  
Loan 
Flow of new lending 
• “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? 
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. 
Quantities. Yes, financial declined (and all maturities declined a lot), but you’d 
expect to see much worse given all the complaining. 
0,0	
  
10,0	
  
20,0	
  
30,0	
  
40,0	
  
50,0	
  
60,0	
  
70,0	
  
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08
	
  
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. 
Scale	
  of	
  Dealer	
  Deleveraging	
  in	
  Corporate	
  Bonds	
  over	
  2007	
  and	
  2008	
  
0
100
200
300
400
500
600
01/05 05/05 09/05 01/06 05/06 09/06 01/07 05/07 09/07 01/08 05/08 09/08 01/09 05/09 09/09
Date
$ 
B
ill
io
ns
Repo for Clients Dealer Positions
Just prior to Lehman Bankruptcy (9/10/09)
Total Dealer Inventory: $340BN
for Clients: $180BN
Peak (1/18/09)
Total Inventory: $524BN
for Clients: $243BN
(9/16/09)
Total Inventory: $215BN
for Clients: $91BN
Source: Primary Dealer Survey, Federal Reserve Bank of New York 
• A sense of how important the run in repo is 
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. 
Fact: Banking system did not “delever” to any great extent 
Again, we do not see a huge decline in loans at banks 
Once again, no huge decline in lending. Actually, given the severity of the 
recession, it’s surprising how little lending went down. 
L.1	
  Credit	
  Market	
  Debt	
  Outstanding	
  	
   2006	
   2008	
  
DescripFon	
   	
  	
   Pct	
   Q2	
   Pct	
  
Total	
  credit	
  market	
  assets	
  held	
  by	
  :	
   45347	
   100	
   51019	
   100	
  
Household	
  sector	
   3865	
   8.5	
   4140	
   8.1	
  
Nonfinancial	
  corporate	
   329	
   0.7	
   169	
   0.3	
  
noncorporate	
   109	
   0.2	
   129	
   0.3	
  
State	
  and	
  local	
  	
   1471	
   3.2	
   1473	
   2.9	
  
Federal	
  	
   281	
   0.6	
   294	
   0.6	
  
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	
  insFtuFons	
   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	
   1.6	
   757	
   1.5	
  
State	
  and	
  local	
  reFrement	
   770	
   1.7	
   812	
   1.6	
  
Federal	
  reFrement	
   84	
   0.2	
   108	
   0.2	
  
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	
   0.3	
  
Exchange	
  traded	
  funds	
   21	
   0.0	
   43	
   0.1	
  
GSE	
   2591	
   5.7	
   2995	
   5.9	
  
Agency	
  and	
  GSE-­‐backed	
  Mortgage	
  pools	
   3837	
   8.5	
   4762	
   9.3	
  
ABS	
   4069	
   9.0	
   4257	
   8.3	
  
Finance	
  companies	
   1627	
   3.6	
   1639	
   3.2	
  
REITS	
   295	
   0.7	
   232	
   0.5	
  
Broker	
  dealers	
   583	
   1.3	
   694	
   1.4	
  
Funding	
  corporaFons	
   289	
   0.6	
   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 
• This is what all assets and liabilities of commercial banks look like, from which the 
next slide is drawn 
• 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. 
Firm	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
   	
  	
  Writedown	
  &	
  Loss	
   	
  	
  Capital	
  Raised	
  	
  
CiFgroup	
  Inc.*	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
   60.8	
   71.1	
  
Wachovia	
  CorporaFon*	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
   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	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
   10.4	
   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	
  
ForFs*	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
   7.1	
   23.1	
  
Bayerische	
  Landesbank	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
   6.9	
   0	
  
HBOS	
  Plc	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
   6.8	
   7.2	
  
ING	
  Groep	
  N.V.	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
   6.7	
   4.6	
  
Societe	
  Generale	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
   6.6	
   9.4	
  
Mizuho	
  Financial	
  Group	
  Inc.	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
   6.1	
   0	
  
NaFonal	
  City	
  Corp.	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
   5.4	
   8.9	
  
NaFxis	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
   5.3	
   11.8	
  
Indymac	
  Bancorp	
  Inc	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
   4.9	
   0	
  
Goldman	
  Sachs	
  Group	
  Inc.	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
  	
   4.9	
   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) 
Banks Can and Do Raise Capital II 
Source :Anil Kashyap 
IncludesTreasury 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 
• 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 
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. 
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	
  
§ 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 
• “Expansion of balance sheet” = printing money, lending it out. A trillion extra dollars! 
• Bernanke: “Milton Friedman, we won’t make the same mistake again” 
• More 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	
  	
  
	
  	
  	
  
Off	
  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’t 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 
• 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 
Source: CBOE.com 
• People thought volatility was temporary. “Safer in long run” 
Does	
  the	
  crash	
  mean	
  that	
  free	
  
markets	
  failed?	
  New	
  instruments,	
  	
  
toxic	
  derivaFves,	
  financial	
  
innovaFon	
  gone	
  amok,	
  etc.	
  	
  
Unused	
  slides	
  
Ideas	
  
• 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.	
  	
  	
  
What is the worry? 
Interest	
  
rate	
  
Supply	
  (savings)	
  
Demand	
  (investment,	
  mortgages)	
  
A	
  credit	
  crunch:	
  Banking	
  system	
  cannot	
  make	
  new	
  loans.	
  
System	
  	
  
Doesn’t	
  
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.  Banking system wants to lend, but cannot. 
-Secretly undercapitalized, can’t get new capital. 
“Recapitalizing” banks would fix everything 
2.  Banking system doesn’t want to lend because it can’t sell in 
dysfunctional debt markets. 
3.  Nobody wants to lend because investors don’t want to hold 
risk. 
• 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 
Summary: Bank constraint vs. Credit market 
Or risk premium view 
r	
  
Loan 
r	
  
Loan 
Summary so far: 
 
1. Huge risk premium in debt markets = Large demand for 
Treasury debt 
2. 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 
a) Act as missing intermediary 
b) Provide desired Gov’t debt without needing deflation 
Policy	
  #1	
  danger	
  
1.  Fed is running the world’s biggest hedge fund. 
2.  Can we reverse all this without inflation? 
3.  Will the Fed be the only intermediary for a generation? 
4.  Is the Fed buying good, especially new, debt at market prices? 
5.  True blue free-market objections 
Bad	
  Policy	
  Ideas	
  
1.  TARP to buy troubled assets on the open market 
2.  TARP to buy assets from banks at artificial prices 
3.  Bank “recapitalization” without quick workout. 
4.  Forced mortgage renegotiation: a $150,000 unemployment 
subsidy 
5.  Bailout Contagion. S&L Government, Pension Funds, … 
6.  Policy uncertainty, changing the rules of the game. Who willbuy now? 
7.  Government running the banks / credit system for a long time. 
8.  Fiscal “stimulus.” 
9.  “Do something.” It’s ok to be negative. 
10. The major danger is political, not economic. 
Supply	
  
Price	
  
Demand	
  
Treasury	
  Hope:	
  	
  
Small	
  purchase	
  raises	
  price	
  a	
  lot	
  
Finance	
  experience:	
  	
  
Huge	
  purchase	
  to	
  move	
  	
  
prices	
  a	
  lirle	
  
Mortgage-­‐backed	
  securiFes	
  
Policy. Will the Treasury Plan work? 
100	
  
90	
  
10	
   Equity	
  
Debt	
  =	
  
1.	
  Before	
  
95	
   90	
  
5	
   Equity	
  
Debt	
  =	
  
2.	
  Ater	
  
95	
   90	
  
5	
  
=	
  
3.	
  No	
  new	
  loans!	
  
5	
  
5	
  
New	
  debt	
  
New	
  
loan	
  
Loan	
  
(Assets)	
  
45	
   45	
  
5	
  
=	
  
3.	
  “Deleverage?”	
  
50	
  
Sell. 
! 
50	
  
Credit Crunch – “undercapitalized” mechanics 
Risk 
95	
   90	
  
5	
  
1.	
  New	
  
Equity	
  
=	
  
55	
  
10	
  
45	
  
2.	
  New	
  
debt	
  
New	
  
loan	
  
4. “Recapitalize” 
70	
  
90	
  
=?	
  
4. “Failure” = recapitalization 
70	
  
	
  Fail,	
  =	
  
50	
  
20	
  
	
  =	
  
Solutions? 
WaMu JPMorgan 
$100	
  
$1.10	
  
$1.10	
  
$1.10	
  
$100	
  
Joe	
  
Joe	
  $100	
  
$99	
   Sue	
  
$98	
  
Sue	
  $99	
  
Bob	
  
What went wrong / needs to be fixed? 
1.  Amazing amount of overnight / short financing 
Yes Not 
$1	
   Joe	
  
$1	
   Joe	
  
$100	
  
$1	
  
$1	
  
$1	
  
$100	
  
Joe	
  $100	
  
$99	
   Sue	
  
$98	
  
Sue	
  $99	
  
Bob	
  
2.	
  Value	
  =	
  80	
   3.	
  Value	
  =	
  80	
  
1.	
  Will	
  this	
  last?	
  
Who	
  stops	
  ?	
  
2. Abandon Mark to Market? 
3. Dynamic capital standards! 
Swaps, brokerage, etc. 
Supply	
  (saving)	
  Financial	
  system	
  
(intermediary)	
  
Demand	
  (investment)	
  
Deposits, 
CDs, Stock 
Mortgage 
Interest	
  
rate	
  
Supply	
  
Demand	
  
A	
  credit	
  crunch:	
  banking	
  system	
  cannot	
  make	
  new	
  loans.	
  
Banking	
  
System	
  	
  
Loans	
  
The financial system can slice, dice and transfer risk, but cannot bear risk. 
People must bear risk.