The Private-Money View of Financial Crises. Gary Gorton, Yale and NBER

Transcription

1 The Private-Money View of Financial Crises Gary Gorton, Yale and NBER

2 Financial Crises Doug Diamond: Financial crises are everywhere and always due to problems of short-term debt (and to the reasons why short-term debt is needed). Need short-term debt but vulnerable to runs. Challenge for theory: Explain the optimality of debt, even though it is vulnerable to runs.

3 Themes The evolution of money forms and how the information environment evolved. The price system is not supposed to work for bank money. When the price system works financial crisis. A crisis is an information event.

4 Crises are Systemic At the present moment [during the Panic of 1837], all the Banks in the United States are bankrupt; and, not only they, but all the Insurance Companies, all the Railroad Companies, all the Canal Companies, all the City Governments, all the Country Governments, all the State Governments, the General Government, and a great number of people. This is literally true. The only legal tender is gold and silver. Whoever cannot pay, on demand, in the authorized coin of the country, a debt actually due, is, in point of fact, bankrupt: although he may be at the very moment in possession of immense wealth, and although, on the winding up of his affairs, he may be shown to be worth millions. Gouge (1837; italics in original)

5 What is a financial crisis? A financial crisis is not just a bad event. Stock market crashes are not systemic events. A financial crisis is an event in which households or firms no longer believe that bank debt (money) is worth par instead the want cash: A run on the banks. Sudden but not irrational. But, banks do not have the cash, so insolvent. The banking system is insolvent.

6 Geithner: Of the twenty-five largest financial institutions at the start of 2008, thirteen failed (Lehman, WaMu), received government help to avoid failure (Fannie, Freddie, AIG, Citi, BofA), merged to avoid failure (Countryside, Bear, Merrill, Wachovia), or transformed their business structure to avoid failure (Morgan Stanley, Goldman). Bernanke s FCIC testimony--during September and October of the 13 the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two.

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8 Financial Crises are not Rare Financial Crises: Have occurred in all market economies throughout history; Occur in advanced economies; Occur in emerging markets; Occur in economies with or without central banks; Occur with different forms of bank debt.

9 Financial Crises not Rare Since 1970 there have been 147 systemic events around the world. Occur in all market economies. Not just events from an earlier era. And not just in emerging markets. Of the 147 events, about 65% involved bank runs.

10 Crises are Common in Developed Countries Country Financial Crisis (first year) Australia 1893, 1989 Canada 1873, 1906, 1923, 1983 Denmark 1877, 1885, 1902, 1907, 1921, 1931, 1987 France 1882, 1889, 1904, 1930, 2008 Germany 1880, 1891, 1901, 1931, 2008 Italy 1887, 1891, 1901, 1930, 1931, 1935, 1990, 2008 Japan 1882, 1907, 1927, 1992 Netherlands 1897, 1921, 1931, 1988 Norway 1899, 1921, 1931, 1988 Spain 1920, 1924, 1931, 1978, 2008 Sweden 1876, 1897, 1907, 1922, 1931, 1991, 2008 Switzerland 1870, 1910, 1931, 2008, United Kingdom 1890, 1974, 1984, 1991, 2007 United States 1819, 1837, 1857, 1873, 1884, 1893, 1907, 1929, 2007

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15 Percentage Discount from Par 30 Planters Bank of Tennessee Note Discount in Philadelphia Source: Gorton and Weber.

16 In the use of money, everyone is a trader; those whose habits and pursuits are little suited to explore the mechanism of trade are obliged to make use of money, and are no way qualified to ascertain the solidity of different banks whose paper is in circulation; accordingly we find that men living on limited incomes, women, laborers, and mechanics of all descriptions, are often severe sufferers by the failure of country banks... Ricardo (1876, p. 409)

17 Intuition for Dang, Gorton, Holmström (2011) Payoff on Debt At Maturity Contractual Payoff on Debt Face Value of Debt Bankruptcy point Low Value Final Value of the Collateral Backing High Value

18 Likelihood of Different Final Collateral Values Distribution of Different Collateral Values Most likely collateral value Low Value Final Value of the Collateral Backing High Value

19 Debt is the optimal contract Final Value of Collateral Likelihood of Different Collateral Values Distribution of Different Collateral Values Face Value of Debt $10 Most likely collateral value $10 Low Value Final Value of the Collateral Backing High Value

20 Final Value of Collateral Likelihood of Different Collateral Values Financial Crisis Distributions of Different Collateral Values Face Value of Debt $10 $10 Low Value Final Value of the Collateral Backing High Value

21 Payoff on Debt At Maturity Contractual Payoff on Equity Face Value of Debt Bankruptcy point Low Value Final Value of the Collateral Backing High Value

22 Debt and Info Cut cash flows by seniority cuts information! That s the point of debt.

23 Frequency of Loss Loss Distribution for Debt 0 Size of Loss F-X

24 Loss Distribution for Debt Frequency of Loss Size of Loss F-X 0

25 Maximal Info-Insensitivity: Debt-on-Debt Face Value of Debt Loss Distribution for Debt Frequency of Loss Almost riskless Size of Loss F-X 0

26 Debt (cont.) Debt is information-insensitive. Does not mean riskless. Means that it is not profitable to produce private information. Avoids adverse selection. Price does not change much/at all. Price system not work.

27 Compare to Equity The value of equity always depends on the value of the backing assets or collateral. Producing information about equity is always valuable (if you are the only one producing it). Equity is information-sensitive.

28 Debt-on-Debt Debt backed by debt maximizes information-insensitivity. Free bank notes: backed by state bonds. Demand deposits: backed by loans to consumers and small businesses. Money market instruments: backed by debt. Repo: specific bond ABCP: asset-backed securities

29 Debt and Info Cut cash flows by seniority cuts information!! That s the point of debt.

30 Implications Debt Equity Purpose Money-like Risk Sharing Information Info-insensitive Info-sensitive Retain value; NO Price Discovery Price Discovery Market Structure Trades over-the-counter Bilateral Few Traders Central Stock Exchange (NASDAQ; NYSE) Many Traders Backing Collateral Debt Real Assets Adverse Selection No No Liquidity Safe liquidity Risky liquidity Analysts None really Many Ratings Yes No Academics Don t Study Study

31 Implications for Trade Bonds do not trade. And when they do, it is bilateral (OTC). 4.0% Percentage of Total U.S. Bonds that Trade Daily 3.0% 2.0% 1.0% 0.0%

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33 Implications for Bond Prices Since bonds essentially are not traded after they have been sold, how are off-the-run bonds valued? The answer is that the value of a bond is estimated/guessed matrix pricing.

34 NASDAQ Most bonds are priced relative to a benchmark. This is where bond market pricing gets a little tricky. Different bond classifications, as we have defined them above, use different pricing benchmarks.

35 Bond Mutual Funds Look at how bonds held by different funds are marked-to-market. There is significant price dispersion across the exact same bonds (on average). The price dispersion is decreasing in bond credit quality: lower dispersion for higher rated bonds. Dispersion is higher for high yield bonds than for investment-grade bonds.

36 But, short-term debt is money Pre-crisis repo market ~ $10 trillion - Every morning more than $1 trillion rollover of tri-party repo in early Daily trading volume of bilateral repo $5.81 trillion in 2007 (SIFMA (2008)) - Non-rollover of repos caused bankruptcy of Bear Stearns and Lehman Bankruptcy Examiner s report (2010, p.3): - Lehman funded itself through the short term repo markets and had to borrow tens or hundreds of billions of dollars in those markets each day from counterparties to be able to open for business.

37 Back to the Evolution of Bank Money - - -

38 Growth of Demand Deposits 800, , ,000 $ Thousands 500, , ,000 Bank Notes in Circulation Deposits 200, ,000 0 Year Source: Gorton

39 Number Stocks 140 New York Stock Market, Active Stocks Total Number of Stocks in Index Total Number of Bank Stocks in Index 20 0 Source: Goetzmann, Ibbotson and Peng (2001).

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41 Ratio of Notes to Deposits and Treasury Debt to GDP Correlation = 0.96

42 U.S. National Banking Era Panics NBER Cycle Peak-Trough Panic Date % (C/D) % Pig Iron Loss per Deposit $ % and # Nat l Bank Failures Oct Mar Sep (56) Mar May 1885 Jun (10) Mar Apr No Panic (12) Jul May 1891 Nov (14) Jan Jun May (74) Dec Jun Oct (60) Jun Dec.1900 No Panic (12) Sep Aug No Panic (28) May 1907-Jun Oct (20) Jan Jan No Panic (10) Jan Dec Aug (28)

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46 1-Aug 2-Aug 3-Aug 4-Aug 5-Aug 6-Aug 7-Aug 8-Aug 9-Aug 10-Aug 11-Aug 12-Aug 13-Aug 14-Aug 15-Aug 16-Aug 17-Aug 18-Aug 19-Aug 20-Aug 21-Aug 22-Aug 23-Aug 24-Aug 25-Aug 26-Aug 27-Aug 28-Aug 29-Aug 30-Aug 31-Aug 1-Sep 2-Sep Premium of Currency over Certifified Checks (%) 6 Currency Premium for the Panic of High Aug 2- Aug 3- Aug 4- Aug 5- Aug 7- Aug 8- Aug 9- Aug 10- Aug 11- Aug 12- Aug 14- Aug 15- Aug 16- Aug 17- Aug 18- Aug 19- Aug 21- Aug 22- Aug 23- Aug 24- Aug 25- Aug 26- Aug 28- Aug 29- Aug Low Aug 31- Aug 1- Sep 2- Sep Source: Gorton and Tallman.

47 The Quiet Period, A book called The End of History became a runaway best seller. Economists declared The Great Moderation. Bob Lucas announced that macroeconomics... has succeeded. Why no crisis? Moral hazard?

48 The Demand for Safe Assets There has always been a demand for safe assets. Historically, gold coins. Short-term safe debt money-like Long-term safe debt--- certainty of final payoff. Safe assets are debt that is near-riskless. Private sector cannot produce riskless debt. But, can produce substitutes: AAA/Aaa Abs.

49 The Transformation of the Financial System Over the last 30 years prior to the crisis, the architecture of the financial system changed. Immobile collateral bank loans became mobile collateral in the form of MBS and ABS can be traded, posted in derivative positions, collateral for repo and ABCP, rehypothecated.

50 70% Ratio of Total Private Securitization to Total Bank Loans 60% 50% 40% 30% 20% 10% 0% Source: Flow of Funds.

51 Growth of Assets in Four Financial Sectors (March 1954=1) Broker-Dealer Assets Commercial Bank Assets Household Assets Non-financial Corporate Assets Source: Flow of Funds.

52 0.700 Holders of Treasury Securities as a Fraction of Total Outstanding (0.100) US Depository Institutions Rest of the World Insurance Companies Mutual Funds Securities Broker-Dealers

53 Securitization Pooling of Assets Tranching of Assets Securitization Investors Traditional Bank: Creates Loans Sells Cash Flows From Loans Master Trust Pool of Loans AAA 85% Last (equity) Tranche Not Sold Proceeds of Sale of Assets AA A BBB

54 The Safe-Asset Share 45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Government Liabilities Financial Liabilities Source: Gorton, Lewellen, Metrick (2012)

55 Components of Privately-produced Safe Financial Debt 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Shadow Banking Deposits Money-like debt MBS/ABS Debt Corporate Bonds and Loans Other Liabilities Source: Gorton, Lewellen, Metrick (2012) Traditional Banking

56 Broker-Dealer Pledged Assets ($ millions) May 31, 2008 May 31, 2008 May 31, 2008 June 27, 2008 Feb. 29, nd Quarter Total Morgan Stanley Goldman Sachs Lehman Merrill Lynch Bear Stearns Total Financial Instruments Owned --of which pledged (and can be repledged) --of which pledged (and cannot be repledged) --of which not pledged at all % own financial instruments pledged 390, , , , ,104 1,501, ,000 37,383 43,031 27,512 22, ,829 54, ,980 80,000 53,025 54, , , , , ,388 64, ,699 50% 39% 46% 28% 55% 42%

57 $ Millions The Scarcity of Safe Debt 3,000,000 Primary Dealer Treasury Fails 2,500,000 2,000,000 1,500,000 1,000,000 Total Treasury Receive Total Treasury Deliver 500,000 0 Source: Gorton and Muir.

58 Mortgage Originations and Subprime Securitization Total Mortgage Originations (Billions) Subprime Originations (Billions) Subprime Share in Total Originations (% of dollar value) Subprime Mortgage Backed Securities (Billions) Percent Subprime Securitized (% of dollar value) 2001 $2,215 $ % $ % 2002 $2,885 $ % $ % 2003 $3,945 $ % $ % 2004 $2,920 $ % $ % 2005 $3,120 $ % $ % 2006 $2,980 $ % $ %

59 Where did the sub-prime risk go?

60 1/2/2007 2/2/2007 3/2/2007 4/2/2007 5/2/2007 6/2/2007 7/2/2007 8/2/2007 9/2/ /2/ /2/ /2/2007 1/2/2008 2/2/2008 3/2/2008 4/2/2008 5/2/2008 6/2/2008 7/2/2008 8/2/2008 9/2/ /2/ /2/ /2/2008 1/2/2009 2/2/2009 Percentage 50.0% Average Repo Haircut on Structured Debt 45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Source: Gorton and Metrick

61 1999Q4 2000Q2 2000Q4 2001Q2 2001Q4 2002Q2 2002Q4 2003Q2 2003Q4 2004Q2 2004Q4 2005Q2 2005Q4 2006Q2 2006Q4 2007Q2 2007Q4 2008Q2 2008Q4 2009Q2 2009Q4 2010Q2 2010Q4 2011Q2 2011Q4 2,500 BD+Banks NET Funding Received from Repo ($ bil; FoF) 2,000 1,500 1,

62 1999Q4 2000Q2 2000Q4 2001Q2 2001Q4 2002Q2 2002Q4 2003Q2 2003Q4 2004Q2 2004Q4 2005Q2 2005Q4 2006Q2 2006Q4 2007Q2 2007Q4 2008Q2 2008Q4 2009Q2 2009Q4 2010Q2 2010Q4 2011Q2 2011Q4 1,200 Net Repo Lending ($ bils; FoF) 1, MMFs Discrepancy ROW

63 Fire Sales: AAA Spreads Above AA Spreads Aug 2007 Lehman Sept 2008

64 Crises and Macroeconomic Activity Crises preceded by credit boom. Credit boom caused by positive shock to TFP and LP. If technological change is not persistent, the boom ends in a crisis.

65 Those who ignore history are entitled to repeat it.

66 Further Reading