Category Archives: Macroeconomics

Financial Crisis Reading Lists

The Journal of Economic Literature is really a great service to economists. It is a journal that publishes up-to-date literature reviews and ideas for future research in many small subfields that would otherwise be impenetrable. A recent issue published two articles trying to help us non-macro and finance guys catch up on the “facts” of the 2007 financial crisis. The first is Gorton and Metrick, “Getting up to Speed on the Global Financial Crisis: A One Weekend Reader’s Guide,” and the second is Andrew Lo’s “Reading About the Financial Crisis: A Twenty-One Book Review.”

There is a lot of popular confusion about what caused the financial crisis, what amplified it, and what the responses have been. Roughly, we can all agree that first there was a massive rise in house prices, not only in the US; second, there was new, enormous pools of institutional investments looking for safe returns, with many of these pools being operated by risk-averse Asian governments; third, house prices peaked in the US and elsewhere in 2006; fourth, in August 2007, problems with mortgage-related bonds led to interbank repo funding problems, requiring massive liquidity help from central banks; fifth, in September 2008, Lehman Brothers filed for bankruptcy, leading a money market fund to “break the buck” and causing massive flight away from assets related to investment banks or assets not explicitly backed by strong governments; sixth, a sovereign debt problem has arisen in a number of periphery countries since, particularly in Europe.

Looking through the summaries provided in these two reading lists, I only see four really firm additional facts. First, as Andrew Lo has pointed out many times, leverage at investment banks was not terribly high by global standards. Second, arguments that the crisis was caused by investment banks packaging worthless securities and then fooling buyers, while containing a grain of truth, does not explain the crisis: indeed, the bigger problem was how many of these worthless securities were still on bank’s own balance sheets in 2008, explicitly or implicitly through CDOs and other instruments. Third, rising total leverage across an economy as a whole is strongly related to banking crises, a point made best in Reinhart and Rogoff’s work, but also in a new AER by Schularick and Taylor. Fourth, the crisis in the financial sector transmitted to the real economy principally via restrictions on credit to real economy firms. Campello, Graham and Harvey, in a 2010 JFE, used a large-scale 2008 survey of global CFOs to show how firms who were credit constrained before the financial crisis were much more likely to have to cut back on hiring and investment spending, regardless of their profitability or the usefulness of their investment opportunities. That is, savings fled to safety because of the uncertain health of banking intermediaries, which led banks to cut back commercial lending, which led to a recession in the real economy.

What’s interesting is how little the mortgage market, per se, had to do with the crisis. I was at the Fed before the crisis, and remember coauthoring in early 2007 an internal memo about the economic effects of a downturn in the housing sector. The bubble in housing prices was obvious to (almost) everyone at the Fed. But the size of the mortgage market (in terms of wealth) and the construction and home-improvement sector (in terms of employment) was simply not that big; certainly, the massive stock losses after the dot-com bubble had more real effects because of declines in total wealth. I can only imagine that everyone on Wall Street also knew this. What was unexpected was the way in which these particular losses in wealth harmed the financial health of banks; in particular, the location of losses because of the huge number of novel derivatives was really opaque. And we know, both then because of the very-popular-at-the-Fed theoretical work of Diamond and Dybvig, and now because of the empirical work of Reinhart and Rogoff, that bank runs, whether in the proper or in the “shadow” banking system, have real effects that are very difficult to contain.

If you’ve got some free time this weekend, particularly if you’re not a macroeconomist, it’s worth looking through the references in the Lo and Gorton/Metrick papers.

Lo’s “Twenty-One Book Review” (2012) (IDEAS version). Gorton and Metrick’s “Getting Up to Speed” (IDEAS version).

“The Credit Crisis as a Problem in the Sociology of Knowledge,” D. Mackenzie (2011)

(Tip of the hat for pointing out Mackenzie’s article to Dan Hirschman)

The financial crisis, it is quite clear by now, will be the worst worldwide economic catastrophe since the Great Depression. There are many explanations involving mistaken or misused economic theory, rapaciousness, political decisions, ignorance, and many more; two interesting examples here are Alp Simsek’s job market paper from a couple years ago on the impact of overly optimistic potential buyers who need to get loans from sedate lenders (one takeaway for me was that financial problems can’t be driven by the ignorant masses, as they have no money), and Coven, Jurek and Stafford’s brilliant 2009 AER on catastrophe bonds (summary here) which points out how ridiculous it is to legally define risk in terms of default risk, since we have known for decades in theory that Arrow-Debreu securities’ values depend both on the payoffs in future states and on the relative prices in those states. A bond whose default occurs in catastrophic states ought be much more expensive than the same bond whose default is negatively correlated with background risk.

But the catastrophe also involves a sociological component. Markets are made: they don’t arise from thin air. Certain markets don’t exist for reasons of repulsion, as Al Roth has mentioned in the context of organ sales. Other markets don’t exist because the value of the proposed good in that market is not clear. Removing uncertainty and clarifying the nature of a good is a important precondition, and one that economic sociologists, including Donald Mackenzie, have discussed at great length in their work. The evaluation of new products, perhaps not surprisingly, depends both on analogies to forms a firm has seen before, and on the particular parts of the firm who handle the evaluation.

Consider the ABS CDO – a collateralized debt obligation where the underlying debt are securitized assets, most commonly mortgages. The ABS CDO market grew enormously in the 2000s, and was not understood at nearly the same level as traditional CDO or ABS evaluation, topics on which there are hundreds of research papers. ABS and CDO teams tended to be quite separate in investment banks and ratings agencies, with the CDO team generally well trained in derivatives and the highly quantitative evaluation procedures of such products. For ABSs, particularly US mortgages, the implicit government guarantee against default meant that prepayment risk was the most important factor when pricing such securities. CDOs, often based on corporate debt, were used to treating correlation between various corporations in a given CDO as the most important metric.

Mackenzie gives exhaustive individual detail, but roughly, he does not blame the massive default rates on even AAA-rated ABS CDOs on greed or malfeasance. Rather, he describes how evaluation of ABS CDOs by ratings agencies used to dealing with either an ABS or a CDO, but not both, could lead to a utter misunderstanding of risk. While it is perfectly possible to “drill down” a complex derivative into its constituent parts, then subject the individual derivative to a stress test against some macroeconomic hypothetical, this was rarely done, particularly by individual investors. Mackenzie also gives a brief story of why these assets, revealed in 2008 to be superbly high risk, were being held by the banks at all instead of sold off to hedge funds and pensions. Apparently, the assets held were generally ones with very low return and very low perceived risk which were created as a byproduct of the bundling that created the ABS CDOs. That is, arbitrage was created when individual ABSs were bundled into an ABS CDO, the mezzanine and other tranches aside from the most senior AAA tranche were sold off, and the “basically risk-free” senior tranches were held by the bank as they would be difficult to sell directly. The evaluation of the risk, of course, was mistaken.

This is a very interesting descriptive presentation of what happened in 07 and 08. (Final version from the May 2011 American Journal of Sociology)

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