The Financial Crisis of 2008: What Went Wrong?

1. The Financial Crisis of 2008: What Went Wrong? David MarshallSenior Vice President Federal Reserve Bank of ChicagoApril 14, 2009

2. Prices and Value • A self-correcting economic system requires • People to respond to price incentives, and • Prices (approximately) to reflect fundamental value. • Leading into the current crisis, people responded to prices • Yields on risky securities fell, so producers of these securities ramped up production. • Prices of residential real estate were high and rising, so homebuilders built more homes. • Real long term interest rates fell, so households reduced savings and increased consumption. • But prices did not reflect fundamental value: • Price of risk too low • Price of residential real estate too high

3. Plan of Talk • Fundamental driver of the crisis • Mispricing # 1: Risk • Mispricing # 2: Housing • Role of financial innovation in the crisis • Tentative policy conclusions

4. The Fundamental Driver • Massive global capital flows into the U.S. from 2002 to 2006 • Demise of socialism vastly increased productivity of East and South Asian workers • Primitive insurance/financial markets induced higher propensity to save • U.S. financial markets seen as most robust place to invest these surplus funds • Anomaly: Poor countries sending capital to rich. • Result: very low real interest rates

5. Flow of Capital into U.S. and Real Interest Rates

6. Price of Risk: VIX + Junk Bond Spread

7. Mispricing of Risk • Market price of risk very low • Market indicators suggested very low risk levels • Extremely lax lending terms in private equity funding • Typical explanation: “The great moderation” • Business cycle variability since 1982 dramatically lower •  Lower fundamental risk in the economy

8. Lower Risk or Higher Risk Tolerance? • Alternative explanation: Not a reduction in risk, but an increase in risk tolerance. • Rajan (2005): strong incentives were present for portfolio managers to seek out risk. • Low real interest rates lead portfolio managers to search for yield. • But the only way to increase yield is to take on risk. • Furthermore, portfolio manager compensation contracts provided incentives to take on more risk.

9. Tail Risk • Managers would preferentially take on tail risk, (risk of low probability but high impact events) • Tail risk is extremely difficult to quantify. • Most risk management approaches measure risk by short-run volatility, which can’t capture tail events. • High yields associated with tail-risk strategies show up as α (high risk-adjusted performance) while it really represents β (compensation for risk). • AIG-Financial Products

10. Mispricing of Housing • Surplus capital from abroad parked in U.S. securities. • Prices of U.S. securities bid up. • American capital markets went into overdrive to create securities, mostly by securitizing residential real estate • MBS originators needed flow of mortgages to satisfy demand • Vast expansion of sub-prime mortgage origination • Major public policy push to extend home-ownership for low income and minority households. • Volume of sub-prime mortgages soared to meet this demand • From 2000-2007, • Outstanding amount of conforming mortgages doubled, • But subprime grew 800%! • By 2006 , Subprime /Alt-A mortgage issuance ≈ 30% of the mortgage market

11. Housing Price Indices 1987-Present

12. Housing Starts: 1960 - Present

13. Housing Bubble • How did housing prices get so far above fundamental value? • It’s hard to detect a bubble when you’re in the middle of it. • Analysis in 2006: increased housing investment could be justified by fundamentals • increased household wealth • financial innovation. • Even if rational agents correctly saw that home prices were in an unsustainable bubble, would that have corrected the bubble? • Usual economic insight: If the price of an asset is too high, arbitrageurs short the asset, thereby pushing the price down. • Problem: No way to short-sell residential housing. • What could an individual do? Sell home and rent! • Problem: homeowners have decided preference for owning residence. • Upshot: Limited capacity for arbitrage.

14. The Role of Financial Innovation in Crises • Caballero and Krishnamurthy (2007): Crises often associated with financial innovation • 1970 Penn Central Crisis • Innovation: Commercial Paper • 1987 Crash • Innovation: Computerized trading, portfolio insurance • Why are financial innovations potentially disruptive? • Innovations change the return distribution in unpredictable ways. • Tail events (under the old distribution) become more likely • Financial markets are unprepared

15. Financial Innovation in the Current Crisis: Subprime Mortgage Securitization • Design of MBSs: equity tranche protects the senior tranches. • Equity tranche only provides protection if defaults within the mortgage pool have low correlation. • When rating agencies rated MBSs, they typically estimated these correlations from past data. • Little effort was made to assess the impact of tail events on these correlations. • Problem: Sub-prime mortgages much more sensitive to house price declines than conventional mortgages • When housing prices fall (as in 2006), all the correlations become extremely high! •  senior tranches unprotected, achieve junk status.

16. Summary and Policy Implications • Massive inflow of capital from abroad  • Low interest rates, reach for yield • Underpricing of tail risk • Overprovision of housing loans to nontraditional borrowers • Overpricing of residential real estate • Policy implications: Serious look at • Managerial incentives • Measurement and containment of tail risk • Disruptive effects of housing mispricing • The dark side of financial innovation