Date posted: October 11, 2008

The Credit Crisis: Some Preliminary Analyses

For many years to come the current financial crisis will provide material for PhD theses, academic papers and special issues of scholarly journals. Since history is still being written, it’s too early for firm conclusions, but some interesting analyses are already starting to appear. If only people would read these papers before forming an opinion or making some policy decisions. As I pointed out earlier there are no simple answers.

Historically this is not the first financial crisis and it won’t be the last either. Carmen Reinhardt and Kenneth Rogoff give a panoramic view of eight centuries of financial crises, and no, viewed from a distance, this time is NOT different. I quote “Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically.”

Luc Laeven and Fabian Valencia provide another historical comparison of systemic banking crises based on a new database spanning the period 1970 – 2007. I’m afraid most people will have forgotten about the recent banking crises in Turkey (2000/01) and Argentina (2001) to name but a few.

One of the root causes is the U.S. government intervention in the housing market through Fannie Mae and Freddie Mac. A history of Fannie Mae and Freddie Mac.

A combination of fiscal, legal and regulatory factors may have increased the likelihood of the U.S. housing boom ending badly.

Another root cause is excess leverage in the financial system at large made possible by a low interest rate environment in the wake of September 11 and the deflating of the internet bubble and exascerbated by the rise of off-balance investment vehicles (SIV’s, conduits etc.).

Another root cause are more lenient capital requirements for U.S. investment banks (I’ve made this point before).

Anil Kashyap, Raghuram Rajan of the University of Chicago and Jeremy Stein of Harvard University have also written an interesting paper. I quote: “The proximate cause of the credit crisis (as distinct from the housing crisis) was the interplay between two choices made by banks. First, substantial amounts of mortgage-backed securities with exposure to subprime risk were kept on bank balance sheets even though the ‘originate and distribute’ model of securitization that many banks ostensibly followed was supposed to transfer risk to those institutions better able to bear it, such as unleveraged pension funds. Second, across the board, banks financed these and other risky assets with short-term market borrowing.”

Yuliya Demyanyk of the Federal Reserve Bank of St Louis and Otto Van Hemert of New York University “provide evidence that the rise and fall of the subprime mortgage market follows a classic lending boom-bust scenario, in which unsustainable growth leads to the collapse of the market. Problems could have been detected long before the crisis, but they were masked by high house price appreciation between 2003 and 2005.”

Another root cause is the over-reliance on ratings and quantitative methods and a lack of transparancy in the market for structured products.

Is financial innovation, securitization and the boom in credit derivatives to blame? No, the benefits and potential risks associated with credit derivatives have been known for a long time. To form an informed opinion it's good to read a primer on structured finance.

This paper by Günter Franke and Jan Pieter Krahnen of the Center for Financial Studies at the Goethe University Frankfurt "analyzes possible reasons for the breakdown of primary and secondary securitization markets, and argues that misaligned incentives along the value chain are the primary cause of the problems".

In a working paper on The Economics of Structured Finance Joshua Coval and Erik Stafford of Harvard Business School and Jakub Jurek of Princeton University conclude that "at the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised." Of course it's the analysis that leads them to this conclusion that is of interest and not the conclusion in itself.