The Growth of Finance, Financial Innovation, and Systemic Risk Lecture 3

1. The Growth of Finance, Financial Innovation, and Systemic RiskLecture 3 BGSE Summer School in Macroeconomics, July 2013 Nicola Gennaioli, Universita’ Bocconi, IGIER and CREI

2. Risk Taking, Leverage and Financial Innovations • We saw previously how macroeconomic developments were linked to the growth in risk taking by certain financial sector players • We now consider the corresponding growth in leverage. • Two key points: • It was inextricably lined to the creation of new financial instruments • These new instruments were critical in the recent crisis

3. Shadow banking and the 2007-2008 crisis • Shadow (/securitized) banking: • Provision of short-term safe debt to intermediaries • Debt is collateralized through securitization: • Intermediaries: originate, acquire, and pool loans • Tranching of loan pools to create safe pieces • In 2007-8, as loan pools lost value, the system unraveled: • External financing stopped, intermediaries lost from retained risks

4. The Shadow Banking Sector • Origination: finance companies, financed through commercial paper • Loan warehousing, pooling, and tranching into ABS and their intermediation: broker dealers, structured investment vehicles (SIVs), etc. • Funding of above activities: money market funds, securities lenders

5. Shadow Banking and Leverage

6. Shadow Banking and Innovation • Traditional banking: banks raise deposits, originate loans, and keep these loans in their balance sheets. • Originate and distribute banking: banks raise deposits, originate loans, but sell these loans to the markets. • Loans are pooled by shadow banks, and used to crated ABS to raise collateralized financing. • The originate and distribute model was taught to bring stability: it would allow banks to reduce the risk in their balance sheets. Not quite what happened.

7. Build a “neglected risks” model of Shadow Banking and Securitization • Demand for safety: Outside investors only want riskless debt. • Securitization: Intermediaries use funds to originate safe and risky loans. Risky loans are subject to institution-specific idiosyncratic risk (and to aggregate risk). Trading and pooling of risky loans eliminates idiosyncratic risk. • Neglected Risks: investors and intermediaries neglect low probability aggregate risks (GS 2010, GSV 2011).

8. Neglected Risks • This assumption captures: • Uncertainty of model-economy: overweighting of historical trends • Difficulty in measuring risk in complex, interconnected financial institutions • These problems exacerbated by financial innovations. New securities are difficult to understand for the price and to price for intermediaries • Wrong models (CovalJurek and Stafford, 2010) • How robust is the financial system to these problems?

9. Main results I • Investors’ wealth drives securitization/shadow banking: • As investors’wealth becomes large, intermediaries make marginal, riskyloans. Tocreatesafecollateral, they securitize and pool them. • Intermediaries’ assets (loan portfolios) and liabilities (riskless debt) grow together. Aggregate risk yields a carry trade. • Pooling of risks endogenously renders intermediaries interconnected. Under RE, stability and welfare go up.

10. Mainresults II • With neglected risks, securitization creates a “diversification myth”: each single intermediary now looks safer. • Yet, pooling of idiosyncratic risks also raises the exposure of all intermediaries to any neglected aggregate tail risks. • Ex-ante pooling creates ex-post fragility and illiquidity • Securitization: expand ex-ante financing but creates fragility ex-post by capitalizing on investors’ misperception of risks

11. Some Related literature • Link shadow banking to growing investor wealth (Caballero et al. 2008). Account for link between risk-taking and low interest rates (Maddaloni and Peydro 2011, Jimenez et al. 2011). Show that with, neglected risks, insurance creates catastrophe bonds (Coval, Jurek, and Stafford 2009b). • Explain comovement of assets and leverage (Adrian and Shin, 2010) and intermediaries’ risk retention (Acharya, Schnabl, and Suarez 2010). • Endogenize bank interconnectedness and systematic risk. Shin (2009a) and Allen and Gale (2000). We focus on neglect of aggregate tail risks. • Explain how banks lose a fortune holding other banks’ risks in a crisis. See Benmelech and Dlugosz on CDO’s. • Ex-post illiquidity. Geanakoplos (2009), SV (2010), Gorton and Metrick (2010), etc. We focus on ex-ante insurance, not on short term debt. • Model pooling and tranching, but not as a result of asymmetric information (De Marzo and Duffie 1999) or ring-fencing.

12. Organization of Presentation • The model with rational expectations • The model with local thinking and results • Extensions (briefly)

13. Two dates t = 0, 1 • There is a measure 1 of infinitely risk averse investors Eω[C0 + minωC1,ω] • they receive wealth w at t = 0 • There is a measure 1 of risk neutral intermediaries Eω[C0 + C1,ω ] • they receive wealth wint < 1 at t = 0 • Intermediaries invest by using their own wealth wint and by issuing riskless debt to investors: • Issue debt D at t = 0, promise to repay rD at t = 1.

14. Intermediaries have access to projects that pay in t=1: • Safe (H): invest IH,j and obtain RIH,j at t = 1 • Limited aggregate supply of 1. • Risky (L). Invest IL,j and obtain: • There are three aggregate states ω = g, d, r, with πg> πd> πrandPr(πω) = φω - there is both idiosyncratic and aggregate risk - a pool of projects yields AIL πωin aggregatestateω

15. Intermediaries’ return to investment Marginal Return R A E(πω)A 0 1 Total Investment 15 Technology features decreasing returns + increasing risk

16. Timing • At t = 0 each intermediary borrows Dj , invests IH,jandIL,j, sells SL,junits of risky investment, buys TL,junits of diversified pools of other intermediaries’ investments. • Interest rate r, price of loans pL: competitively set at t=0. • At t = 1 state ω and intermediaries’ returns are revealed. • Investment pays off and debt is repaid. • Investors lend all of their wealth w if r >1, they are indifferent between lending or not at r = 1.

17. Intermediaries’ expected profits I • At t = 0 each intermediary j has expected profits: R∙IH,j + + [Eω(πω)∙A∙(IL,j–SL,j) + Eω(πω)∙A∙TL,j + pL(SL,j–TL,j)] + + Dj – IH,j – IL,j + wint – rDj. • Return from idiosyncratic risk kept (IL,j–SL,j) is 0 or A. • Return from securitized pool TL,j is πω∙Ain ω. • The pool is only subject to aggregate risk about πω.

18. Intermediaries’ expected profits II • Intermediary j holds two types of risky investments. • Risky investments originated and kept: (IL,j–SL,j) → • Risky securitized pools purchased in the market: TL,j→

19. The constraints faced by the intermediary are: • Feasibility: at t = 0 cannot invest more than resources raised • Riskless debt constraint: rDj ≤ R∙IH,j+ πr∙A∙TL,j. • Pledge safe return and securitized pool in worst stateπr. • Intermediaries’ “carry trade” is [ Eω(πω)A – r ]∙TL,j • Feasibility of Securitization: SL,j ≤ IL,j • Cannot sell more investments than those undertaken

20. Preliminaries • Risky asset is securitized only if debt constraint is binding • Pooling of risks relaxes investors’ demand for safe collateral • Securitization pools are bought by intermediaries: they are the high value buyers. Thus, TL,j=SL,j. Use pools to back debt. • Securitization supports growth in leverage and… • Allows intermediaries to earn a return above safe debt

21. Interest rate R Risky investment and securitization wint Total wealth low w : no risky investment, no debt, no securitization

22. Interest rate R > R(1- wint) R Risky investment and securitization 1 wint Total wealth higher w: no risky investment, some debt, no securitization

23. Interest rate R R > E(πω)Aw E(πω)A Risky investment and securitization IL = w + wint – 1 1 R / E(πω)A wint Total wealth Intermediate w: some risky investment, debt, no securitization

24. Interest rate R R + πrASL > E(πω)Aw E(πω)A Risky investment and securitization IL = w + wint – 1 SL = [E(πω)/πr]w – R/Aπr R/E(πω)A wint + w* 1 wint high w : risky investment, debt, securitization

25. Interest rate R E(πω)A R + πrAIL > r(w)w 1 Risky investment and securitization wint + w** R/E(πω)A wint + w* 1 wint Very high w : risky investment, debt, maximal securitization

26. Securitization under RE I 26 • Securitization endogenously arises to meet the demand “w” for riskless debt. Driven by marginal, risky, projects. • By lowering idiosyncratic risk, pooling boosts safe collateral and debt capacity. Growth of assets and leverage • Pools allow intermediaries to earn a yield (“carry trade”) • When at t = 1 returns are revealed, not much happens • Some intermediaries do better than others (if securitization is partial), but all debt is truly safe. • Securitization is welfare improving.

27. Securitization under RE II 27 • In worst case scenario πr : • A fraction 1 –πr of intermediaries get 0 on their projects: [R + πr∙A∙SL + 0∙(IL–SL)] – [R + πr∙A∙SL] = 0 • A fraction πr of intermediaries get A on their projects: [R + πr∙A∙SL + A∙(IL–SL)] – [R + πr∙A∙SL] = A∙(IL–SL) > 0

28. Securitization and Local Thinking • Local thinking (GS 2010, GSV 2011): neglect unlikely (tail) risk. Here is “recession”, because φr = min φω. • At t = 0, agents think only of “growth” and “downturn” • Two things change with respect to RE at t = 0 • Assess higher average return ELT(πω)A > E(πω)A • Relax debt constraint: rDj ≤ R + πd∙A∙TL,j.

29. Interest rate R ELT(πω)A E(πω)A 1 wint + w** wint + w**,LT wint+w* Equilibrium under Local Thinking at t = 0 • Securitization and leverage expand. At low w this raises interest rates, at higher w this also boosts investment higherr higherr, D

30. Securitization and Local Thinking at t=1 30 • If at t = 1 the state is g or d, debt is sustainable, as with RE • In worst case scenario πr : • Share 1 –πr of unsuccessful intermediaries fail: [R + πr∙A∙SL + 0∙(IL–SL)] – [R + πd∙A∙SL] = – (πd– πr)∙A∙SL < 0 • Share πr of successful intermediaries also failiff: [R + πr∙A∙SL + A∙(IL–SL)] – [R + πd∙A∙SL] = = A∙(IL–SL) – (πd– πr)∙A∙SL < 0

31. Default and repayment in recession • All intermediaries fail if: <1+ (πd – πr) • A “successful” intermediary is more likely to fail if more investment is securitized! • Pooling creates correlation in intermediaries’ assets • Small mistakes create massive fragility when w is large

32. Securitization and Market Liquidity at t = 1 • At t = 1, state ω is learned only partially. Observe s in {l, h} • Here h is informative of {g, d}, while l is informative of {d, r} • In s, a share qs of risky projects pays off A at t = 1. qh >ql • Two implications from imperfect learning and “early” projects: • We can study retrading and market liquidity at t = 1 • Early intermediaries may have liquidity to buy claims at t = 1. • Due to “early” projects, some debt repayment occurs at t = 1 • Still focus on long term debt, but promising two coupons • For simplicity, return R is ring fenced by most senior debt class

33. Event tree nesting the previous setup

34. Event tree under local thinking • As ql is revealed, the agent realizes to be in the lower branch, which did not come to mind at t = 0.

35. Basic results with partial information • Not much changes at t=0. If at t=1 neglected state ql realizes, investors learn that debt may default at t = 2 if state is πr. • In qlinvestors value each securitized asset πrA, intermediaries value the same asset at E(πω|ql)A > πrA.Can a trade arise? • The total liquidity of “early” intermediaries is equal to: ql∙[A∙(IL,j–SL,j) – (πd – πr)A∙SL,j] • Which increases in the unsecured portion of projects and decreases in the unexpected drop in collateral (πd – πr)A

36. Market Fragility at t = 1 • In neglected state ql the price of securitized projects drops to investors’ reservation value πrA when: IL,j/SL,j < 1 + (πd – πr) + πd/ql • High securitization reduces the liquidity of successful intermediaries • Securitization creates fragility also by draining out market liquidity after neglected risks realize. Limited securitization leaves “spare liquidity” ex-post. • Correlation in balance sheet costly when neglect risk occurs • This goes beyond idea that intermediaries commit all of their wealth at t = 0 (see SV 2010 and GSV 2011)

37. Ex-ante and ex-post liquidity • Due to market liquidity, investors might be willing to lend against risky collateral (and debt) based on resale value. • Or, equivalently, to directly buy securitized assets. Markets do the “pooling,” regardless of who holds the risky assets • If early intermediaries buy back risky assets at t = 1 at p1> πdA, investors may lend more than reservation value at t = 0 Market trading at price p1

38. Failure of market insurance at t = 1 • Liquidity in good times is consistent with illiquidity in bad times if • “Normal times” market liquidity at t = 1 can coexist with illiquidity when neglected risks materialize. • Investors lend more than reservation value πdA because they expect the t = 1 market to be liquid. If securitization is large, as ql realizes the market becomes illiquid and price drops to πrA • Securitization creates both liquidity in normal times and illiquidity when neglected risks materialize. • This boosts fragility and creates spikes in risk premia

39. Some Facts (I) Mortgage Origination and Subprime Securitization

40. Some Facts (II) Securitization and decline in lending standards

41. Some Facts (III) Centrality of the collapse of AAA securities

42. Some Facts (IV) Collapse of commercial paper market

43. Some Facts (V) Securitization, subprimes and the collapse of ABS

44. Some Facts (VI) Unusual securities

45. Some Facts (VII) Collapse in the issuance of ABS

46. Conclusions I • We offered the following theory for the positive correlation between assets and leverage, and the resulting financial fragility: • Large wealth of risk averse investors creates enormous pressure/opportunities for banks to manufacture safe assets • This induces banks to securitize and expand their balance sheets by holding “safer” pooled risks • Banks make enormous profits out of the resulting carry trade • The system becomes highly interconnected. As some regional housing markets cool off and delinquencies rise, the system collapses

47. Conclusions I • Neglected risks are subtle and changing • Cannot expect regulators to stay ahead • Capital requirements are a crude but appropriate instrument for reducing bets • Problems with market-based risk weighting • Extreme concentration of exposures to a given asset class should raise a red flag • Deeper skepticism about innovations that capitalize on neglect of risk, such as prime MMF.