Richard Clarida's retrospective on the financial crisis

October 24, 2010

I earlier discussed several of the presentations at the monetary policy conference at the Federal Reserve Bank of Boston last week. But missed in the popular coverage of the conference was an insightful discussion by Columbia Professor Richard Clarida that expressed very nicely the conclusions that I have come to as well on the events that led us into these problems.

Clarida wrote:

The subtitle of this paper is not 'I Told You So' and for a good reason. I didn't, and it wasn't because I was shy. Rather, as will be discussed later, I, like the vast majority of economists and policymakers, suffered-- in retrospect-- from Warren Buffet's 'lifeguard at the beach' problem: "you don't know who is swimming naked until the tide goes out"....
The efficient markets paradigm was seen as a working approximation to the functioning of real world equity and especially credit markets. The growing role of securitization in credit markets, especially in the US, was seen as a stabilizing innovation that reduced systemic risk by distributing and dispersing credit risk away from bank balance sheets and toward a global pool of sophisticated investors. While asset prices might well drift away from fundamental value and for long periods of time, 'bubbles' were difficult enough to identify ex ante so that the role for monetary policy was to limit collateral damage to inflation and economic activity when they burst....
It is startling to note in the US the chasm that emerged during the 'great moderation' between credit extended to the household and non-financial business sectors-- much of it through the 'shadow banking' system to be discussed below-- as compared against nominal GDP. This was the 'great leveraging' that accompanied the 'great moderation'....

Source: Clarida (2010; presentation slides)

Shadow bank liabilities versus traditional bank liabilities, in trillions of dollars. Source: Clarida (2010)

Clarida continued:

...greater and greater use of leverage which in turn supports asset prices which in turn support more leverage. And importantly, this channel is missing in the justly celebrated and influential Bernanke-Gertler model (1999) presented at Jackson Hole in 1999. In that model, the bubble affects real activity in two ways. First, there is a wealth effect on consumption, although that effect is presumed to be rather modest. Second, because the quality [of] firms' balance sheets depends on the market values of their assets rather than the fundamental values, a bubble in asset prices affects firms' financial positions and, thus, the premium for external finance. Although bubbles in valuations affect balance sheets and, thus, the cost of capital, B and G assume that—conditional on the cost of capital—firms make investments based on fundamental considerations, such as net present value, rather than on valuations of capital including the bubble. This assumption rules out the arbitrage of building new capital and selling it at the market price cum bubble-- the Ponzi finance stage of a bubble in the Minsky nomenclature.... "This time it was supposed to be different" because securitization and the expertise of the ratings agencies in assessing default risk correlations across various tranches of structured products was in theory supposed to make the financial system more stable and reduce systemic risk....
With the benefit of hindsight ... it seems clear-- at least to this author-- that the financial crisis and the credit and securitization bubble that preceded it resulted not only from spectacular failures in securities markets-- to allocate capital and price default risk-- but serious failures also as well by policymakers to adequately understand, regulate, and supervise these markets. Policymakers, academics, and market participants simply didn't know what they didn't know. They assumed that either it couldn't happen (after all, AAA securities 'never' default), or if it did, it would be systemically unimportant. Until the tide went out. But by then it was too late.

econbrowser.com

The more the murkier

Oct 5th 2010, 13:30 by A.P. | LONDON 

COMPETITION is generally a good thing, but is it beneficial in finance? If banks expect a lower stream of profits in the future because of rising competition, then their incentives to take risks grow. There is a well-established line of thinking among bank regulators in places like Canada and Australia that reckons a less competitive industry leads to a more stable financial system.
A new NBER paper looks at the same question from the perspective of the credit-rating agencies. The paper, by Bo Becker of Harvard Business School and Todd Milbourn of Washington University in St. Louis, examines a natural experiment in competition­—the rise of Fitch between the mid-1990s and the mid-2000s to stand alongside Moody’s and Standard & Poor’s (S&P) as the predominant ratings agencies. That rise was steep: in the median industry that the researchers looked at, Fitch issued less than a tenth of American corporate-bond ratings in 1997 but close to a third ten years later.
The authors find that this increased competition from Fitch coincided with a deterioration in the quality of ratings issued by Moody’s and S&P. First, there was ratings inflation, with more ratings rising towards the top of the scale as competition increased. Second, the correlations between issuers’ ratings levels and bond yields weakened. And third, the power of ratings to predict default went down as competition went up.
The paper assesses two theories to explain this “econometrically robust” negative relationship between competition and quality. One is ratings shopping: with more providers of ratings to choose from, issuers chose the firm that issued the highest marks. That explanation looks more plausible for structured products; in corporate bonds, the focus of the paper, it is less persuasive. That’s because agencies have a habit of rating publicly issued corporate bonds whether they are paid for it or not: shopping around does not eliminate other, less favourable ratings from the market.
The authors think the second explanation for the relationship between competition and quality more compelling. This says that by reducing expected future profits, competition reduces the reputational incentives to keep quality high. Those incentives may fade particularly quickly in an industry where it takes many years for ratings to be proven correct or wrong. Whether a ratings market with just two participants would have done any better during the boom is another question, of course. And there should be some offsetting benefits to investors from the availability of more information. But the argument that greater competition in finance itself requires more stringent regulation has got stronger.

economist.com/blogs/freeexchange

How has the crisis changed the teaching of economics?

How have the financial crisis and recession affected the way economics is taught? How should economic instruction change?

Take a look here