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The Credit Crisis
Raghuram Rajan
Chicago Booth School of Business
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Outline
The Crisis: Origins
The Impact
Resolving the crisis?
Regulatory Lessons
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Bad Investments
Child of past crises Emerging markets => Industrial country
corporations => Industrial countryhousehold
Sophisticated Financial Sector Effectively sold mortgages from
Phoenix, Arizona to buyers around theworld
$ 100 sub-prime mortgages generated
$ 80 AAA
Originate to distribute spreads risks but
Quality of originations weakened
Depended on house price rising
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Bad Investments contd.
Banks held on to poor quality assets Poor governance and risk
management
At the top
Through the organization Tail risk
Writing earthquake insurance
Where were the risk managers?
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Financed with short termdebt
Short term debt cheaper because Lenders better protected.
Rolling over financing is easy in goodtimes.
Market requires banks to hold littlecapital because losses remote.
Aided and abetted by Fed policy
Greenspan put
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The Impact: Sequence ofevents
House price stops rising
Mortgage Defaults=> MBS fall in value,become more difficult to price, and pricebecomes more volatile
Market for mortgage backed assets driesup.
Illiquidity
Potential Insolvency
More hits on their way Credit cards Commercial real estate Commercial and industrial loans
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Issuance of ABS
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Jan-00 Oct-00 Jul-01 Apr-02 Jan-03 Oct-03 Jul-04 Apr-05 Jan-06 Oct-06 Jul-07 Apr-08
Student Loans
Other
Non US RMBS
Manufactured Housing
Home Eq (subprime)
Equipment
Credit Cards
Autos
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Credit markets freeze
Banks unwilling to sell impaired assets
Banks unwilling to substitute for shadowfinancial system Worries about borrower credit risk. Worries about own liquidity if lenders want
money back.
Worries about likely fire sales pushing securitiesprices further down common discount rate forrisky assets
Banks unwilling to raise enough equity
Stability is not the major focus of the privatesector in the midst of a crisis!
Institutional overhang not a major problemright now because demand for credit low. Butwill hamper recovery.
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Declining credit asset pricespull equity prices downwards
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1/1/2007 4/1/2007 7/1/2007 10/1/2007 1/1/2008 4/1/2008 7/1/2008 10/1/2008 1/1/2009
BKX (left) ABX.07-1 AAA (right)
source: Bloomberg
ABX.07-1 AAA versus BKX* index prices
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When will credit marketsfind a bottom?
When the risk of large institutions collapsingis small. Guarantee debt Audit institutions (the Stress Test) Clean up bank balance sheets by
isolating/selling problem assets
Good bank/bad bank Recapitalize banks through a mix of privateand public funds
Some actions may have to be mandated
This will allow asset prices to recover and
credit to flow more freely, thus notimpeding recovery.
Will require more public money: politicalsupport weak
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3 Lessons for financialregulation
Regulators and markets are subject tothe same euphoria that bankers are.Over the cycle
the market becomes less risk averse, soregulatory arbitrage increases
enforcement as well as risk managementget weaker.
How do you ensure regulations have bite?
Illiquidity is contagious. Problems canemerge from anywhere and hit
elsewhere.
Stability is a public good in the midst ofa crisis, with limited private incentiveto help create it.
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Implications
Heavy handed, focused, regulationwill most likely to lead to arbitrage,without insulating sensitive areas.
Bright lines? Utilities?
Lighter, across-the-board,regulation with contingentescalation of regulatory powers andactions more useful.
No matter what regulators do,disaster can always strike. Createprivate sector buffers that will notbe eroded in good times.
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A problem
Large complex entities!
Break them up?
Slow their growth (higher capitaland supervision)?
Limit their growth?
Force them to become easier to fail.
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THANK YOU!
T
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