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The Financial Crisis of 2008: What Went Wrong?

David MarshallSenior Vice President Federal Reserve Bank of ChicagoApril 14, 2009

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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

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Plan of Talk Fundamental driver of the crisis

Mispricing # 1: Risk

Mispricing # 2: Housing

Role of financial innovation in the crisis

Tentative policy conclusions

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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

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

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Flow of Capital into U.S. as % of GDP Real 30yr Mort. Rates

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Price of Risk: VIX + Junk Bond Spread

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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

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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.

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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

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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

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Housing Price Indices 1987-Present

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Housing Starts: 1960 - Present

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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.

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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

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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.

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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