The Subprime Crisis: Lessons about Market Discipline

Transcription

1 The Subprime Crisis: Lessons about Market Discipline Mark J. Flannery University of Florida Eleventh International Banking Conference, The Credit Market Turmoil of : Implications for Public Policy, sponsored by the European Central Bank and the Federal Reserve Bank of Chicago. September 25-26, 2008.

2 Outline 1. What happened? 2. Market Discipline defined 3. Lessons a. For market monitoring b. For market influence 4. Reforms 5. Is the concept of market discipline dead? 2

3 What happened? Growing volume of subprime loans Many securitized and tranched: better than Aaa returns little recourse to underwriters Default risks highly correlated with housing prices 3

4 An economist sees something work in practice and wonders if it can work in theory. Were these underwriting and securitization arrangements fundamentally flawed?

5 To assess market discipline, we need to decide: 1. Were these loans reasonable investments, ex ante? Or should influence have prevented them? 2. Why did investors purchase securitizations when arrangers had so little skin in the game? 3. Did market prices reflect risks? Value? 4. How did the rating agencies affect other market participants actions? 5

6 Market Discipline Defined What is it? Use market information and investor pressure to help control risk-taking in financial firms. 1. Monitoring a) prices of stock, bonds b) quantities of debt available 2. Influence a) Direct b) Indirect 6

7 Pros and Cons of Market Discipline Market monitoring reflects firm condition own money forward looking, use more creating methods Market influence can occur quickly Legal/administrative restrictions But, is transparency enhanced by supervisors private information? Use market information to induce speedier problem resolutions. (E.g. Bliss (2001)). 7

8 An Ideal Market Discipline Scorecard Monitoring Influence Loan originations Loan sales to other investors Ratings Reaction to losses 8

9 Monitoring : did market prices provide advance warning? Represent financial sector equity with four Fidelity sector funds Brokers Financial Services Insurance Banking Not a true return series 9

10 Monthly Sub-Index Values, rel. to Apr Brokers Fin Svcs Insurance Banks 10 Apr-88 Apr-90 Apr-92 Apr-94 Apr-96 Apr-98 Apr-00 Apr-02 Apr-04 Apr-06 Apr-08

11 Financial Index, SP500, rel. to Apr Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Fin Index SP500 11

12 Financial Index, SP500, rel. to Apr Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Fin Index SP500 12

13 1/3/ /3/1998 1/3/1999 1/3/2000 1/3/2001 1/3/2002 1/3/2003 1/3/2004 1/3/2005 CDM3 - TBM3 (% points) 1/3/2006 1/3/2007 1/3/

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15 Market Discipline Scorecard Monitoring Influence Loan originations Loan sales to other investors Ratings Reaction to losses 15

16 What went wrong with security Unusual(!) opaqueness prices? Before the crisis started Since Prominent role of asymmetric information and risk aversion Akerlof doesn t talk about the people who don t buy/sell a used car. 16

17 Influencing Originations and Sales Effective free markets require that Employees can be induced to function for the good of the firm. Firms earn reputations that affect future business. But these things did not always occur in subprime Poor incentives for underwriters Bonuses based on getting deals done Investment managers bought pools without sufficient due diligence 17

18 Market Discipline Scorecard Monitoring Influence Loan originations Loan sales to other investors Ratings Reaction to losses 18

19 Rating Agencies (NRSROs) (#1 of 3) Acting as monitors: report quality to investors. Acting as influencers: change nature of the security (or bank s asset portfolio risk) to attain the issuer s desired rating. SEC Report (7/8/08): issuer pays conflict may be exacerbated for RMBS, CDOs The volume of new business may have trampled the PV of reputational rents. 19

20 Rating Agencies (#2 of 3) Did the rating agencies make An honest mistake in their models? A self-serving attempt to maximize market share? failure of market influence. Slow revisions to their models, as new data arrived? failure of market influence. 20

21 Rating Agencies (#3 of 3) Moody s EVP and director of Corporate Department: by using securities ratings as a tool of regulation, governments fundamentally change the nature of the product agencies sell. Issuers pay ratings fees to purchase... a license from the government.. if present trends of regulatory use of ratings are not arrested, the credibility and integrity of the ratings system itself will inevitably be eroded. (McGuire (1995), italics added for emphasis). 21

22 Market Discipline Scorecard Monitoring Influence Loan originations Loan sales to other investors Ratings Reaction to losses 22

23 Through May 2008 Re-Capitalization World: US: Losses $ 381 bill. $ 162 bill. New Capital $ 266 bill. $ 138 bill. This week: $8 billion to Morgan Stanley, $5 billion to Goldman Sachs.

24 Next Steps 1. Remove some of the opacity from OTC settlements 2. Set the rules: Federal Reserve revisions to Reg Z (July 2008) 3. Strengthen Pillar II 24

25 The verdict on market discipline seems pretty negative But who did better? Good information perfect foresight Different expectations: in the midst of a bubble, who s expectations should influence prices? The arguments for market information remain but the moral hazard will reduce bond info. Rely more on stockprices. 25

26 A statesman addressing the House of Commons in 1947 said: No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of government except all those other forms that have been tried from time to time. 26

27 No one pretends that democracy is perfect or allwise. Indeed, it has been said that democracy is the worst form of government except all those other forms that have been tried from time to time. 27