The Subprime Crisis: Short-Term
and Long-Term Financial Policy
Responses
Charles Calomiris
Columbia University, NBER
World Bank/IMF Conference
May 26, 2009
What We Learned from the Crisis
Origins Reflected Deep Policy Errors
• Loose money, flat yield curve
• Housing subsidies delivered via leverage
(F&F, FHA, FHLBs, risk weights for mortgages,
2006 intervention, CRA). F& F have $1.6 tr
subprime out of $3 tr total subprime.
• Huge buy-side agency problems: two different
versions: banks, institutional investors. Both
reflect regulation of stockholders’ control.
• Regulation Failure: Not mainly a leverage
arbitrage story about mortgages in MBS and IBs,
but a deeper risk mis-measurement story
about commercial bank regs. Also, especially
after March 2008, too-big-to-fail problems.
Real Fed Funds Rate
14
12
Fed Funds Rate Less Core PCE Inflation
10
Fed Funds Rate Less U. Mich. Median 5Yr. Inflation Expectations
8
4
2
0
-2
-4
2008
2005
2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
-6
1960
Percent
6
2002-2005 Taylor Rule
Figure 1: Annual Cash CDO Issuance
500
450
400
350
300
250
200
150
100
50
0
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
14
All Mortgages: Foreclosure Inventory (pre-1998)
All Mortgages: Payments Past Due 90 Days (pre-1998)
All Mortgages: Foreclosures Started (pre-1998)
12
Subprime Mortgages: Foreclosure Inventory (post-1998)
Subprime Mortgages: Payments Past Due 90 Days (post-1998)
Subprime Mortgages: Foreclosures Started (post-1998)
Prime Mortgages: Foreclosure Inventory (post-1998)
Prime Mortgages: Payments Past Due 90 Days (post-1998)
Prime Mortgages: Foreclosures Started (post-1998)
8
6
4
2
2007-Q1
2005-Q1
2003-Q1
2001-Q1
1999-Q1
1997-Q1
1995-Q1
1993-Q1
1991-Q1
1989-Q1
1987-Q1
1985-Q1
1983-Q1
1981-Q1
0
1979-Q1
Percent of Mortgages
10
Credit Crunch Driven by Liquidity Risk
• Protracted uncertainty about size, incidence of
loss (complex financing structure with extreme
dependence on uncertain housing prices).
• Fundamentals were important, but crisis mainly
reflected panic selling of risky assets and
scramble for liquidity (huge spreads for longterm assets and in quantity declines in money
market instruments (ABCP, CP, repos, Libor).
• Schwarz (2009) identifies liquidity risk factor,
and shows most of spread widening is related to
this factor. Adrian and Shin (2009) reach same
conclusion with a different approach.
Credit Crunch Costs
• Subprime losses app. $600 bil, but liquidity
scramble has caused general scarcity of credit.
Banks had raised over $450 bil in equity until
September 2008, but now total shock will be well
above $1 tr., and possibly far above that.
Despite accounting change, banks are averse to
increasing loans.
• Lending on balance sheets appears stable, but
that masks collapse of securitization financing,
and crowding out of new financing from
drawdowns. (Ivashina and Scharfstein 2009)
• Spreads remain high, especially for risky
borrowers who did not already have credit lines.
High-Risk Spreads, 2003- April 8, 2009
Low-Risk Spreads, 2003- April 8, 2009
Short-Term Responses
Crisis Management
• First TARP purchase plan was flawed: Pricing
problem, mgt. problem, little bang for buck. Aggregator
bank unlikely to work much better. Nationalization fraught
with problems.
• Preferred stock injections: Used in 1930s in US, in
Finland in 1990s.
– Seniority protects taxpayers and crowds in private
offerings of common (if implemented properly). It has
not been implemented properly (warrants, common
stock dividends because of stigma nonsense).
Warrants were especially counterproductive to raising
stock. Best used on relatively healthy banks
(incentive problem).
– Shocks now too large to solve with preferred stock.
• Current plan will not work: Private-public partnerships,
with leverage subsidies, will not affect asset prices and
move us to the “good” equilibrium. Participation will not
materialize (especially given new accounting rules).
Short-Term Responses (Cont’d)
• Fed policy: Appropriate breadth of new activities,
involves many new facilities, targeting of money markets,
mortgages, other. Quantitative easing is going too
slowly.
• Foreclosure relief: Makes sense to boost consumption,
relieve housing market, and help limit bank losses and
uncertainty. Extent of mitigation currently unclear. $8
million homes at risk of foreclosure (very imprecise).
Proposed cram down won’t work (364 judges) and will
raise consumer credit costs going forward.
• Targeting mortgage market: For healthy mortgages,
refinancing at low rates, helps house prices.
• Avoiding Mark-to-Market Accounting Implosion:
Accounting rules aggravated market declines, legal
liability allows auditors to run the business,
notwithstanding wiggle room in rules. Change made
sense, but better to deal with problem directly.
Short-Term Responses (Cont’d)
• Tough love fundamentalism is misguided
– Dismantling complex global banks to avoid TBTF is
costly and not necessary for long run incentive
alignment.
– Nationalization would disrupt efficient operation of
banks and efficient increased supply of credit.
– Asset values mainly depressed by panic.
– Why have so many brilliant left-wing theorists (who
love arguments about runs, panics, and multiple
equilibria for financial crises in emerging markets)
become ayatollahs of asset pricing fundamentalism
during a Wall St. panic? Could it have something to
do with a political agenda?
Better Comprehensive Approach
• Downside insurance of toxic asset values:
Good incentives for risk taking for weak banks,
in contrast to preferred. Limiting downside with
out-of-money puts can help raise new private
capital, makes toxic assets more liquid. Given
underpricing of assets unlikely to cost taxpayers
much (may even have negative cost).
• Require privately raised equity as quid pro
quo for downside protection: If I am right that
we are in a bad equilibrium, banks will be able to
raise lots of equity at higher prices once bad
equilibrium is eliminated; if not, then (costly)
downside insurance would not be provided.
Current Political Problem
• Despite some progress (mortgage foreclosure mitigation
loss sharing, but limited impact; Fed purchases now
affecting mortgage rates) we are still in bad equilibrium.
• A misalignment of political will and economic
necessity is blocking rational policy. Recovery will be
weak and protracted.
• AIG bonus hullaballoo is just one recent example.
• Treasury’s current plans for TARP III will probably not
work, and there is no appetite for taking the political risk
to announce a plan that would absorb private sector risk,
which is the sine qua non.
Long-Term Regulatory Reforms
• Micro prudential reform, need to focus on measurement
of risk (missing in discussions). “Capital, capital, capital”
not enough; procyclical bank leveraging does not
happen if risk is measured properly.
• Macro prudential regulation to deal with states of world
where micro is not working, and to vary requirements
over time in a smart way.
• Resolution Policy / TBTF Problems
• Housing subsidy reform
• OTC clearing and disclosure
• Bank corporate governance (desirable, but don’t hold
your breath)
Micro Prudential Discipline
• 1. Use loan interest rates in measuring the risk
weights applied to loans for purposes of setting
minimum capital requirements on those loans.
• 2. Establish a minimum uninsured debt
requirement for large banks (a specially
designed class of sub debt, CDS issues, or
contingent capital).
• 3. Reform the use of credit ratings to either
eliminate their use or require NRSROs to predict
PD and LGD, rather than give letter grades, and
hold them accountable for accuracy.
NYC Banks’ Loans/Cash, Equity,
Dividends
1922
Loans/Cash
2.1
Equity/Assets Dividends
0.18
1929
3.3
0.33
1933
1.0
0.15
1940
0.3
0.10
Source: Calomiris-Wilson JB 2004.
$392m
$162m
Micro-Prudential Regulation (Cont’d)
Argentine Banks in the 1990s
Dependent Variable: Quarterly Deposit Growth
Regressor
Coefficient Stand.Error
Eq Ratio (-1)
Loan Int. Rate
Loans/Cash
0.277
-0.254
-0.0032
Sample period: 1993:3-1999:1
Number of Observations: 1,138
Adjusted R-Squared: 0.31
0.074
0.121
0.0007
Micro Prudential Regs Not Enough
• Because of agency problems, pricing of
risk on buy side is not always accurate.
• The combination of monetary policy
looseness and agency problems can
create incentives to ride a bubble.
• Market discipline is not enough under
these circumstances; there needs to also
be a belt on top of the suspenders,
because of agency problems.
Macro Prudential Rules
• 4. Macro prudential regulation that raises
capital requirements during normal times
in order to lower them during recessions.
• 5. Additional macro prudential regulatory
triggers that increase regulatory
requirements for capital, liquidity, or
provisioning as a function of credit growth,
asset price growth, and possibly other
macroeconomic risk measures.
Case Study: Colombia 2006-2008
• Financial system loans annual growth rose from 10% in December
2005 to 27% by December 2006.
• Core CPI rose gradually relative to credit (from 3.5% in April 2006 to
4.8% in April 2007).
• Real GDP growth in 2007 was 8%.
• Current account deficit rose from 1.8% GDP in second half of 2006
to 3.6% GDP in first half of 2007.
• Monetary authority reacted directly to credit growth in real time:
Interest rates were increased 400 bps from April 2006 to July 2008.
• But central bank saw too small a market response to this, so it
– increased reserve requirements for banks and
– convinced superintendency to raise provisioning for credit,
– imposed measures to raise costs of borrowing short-term from abroad
(deposit requirement reactivated), and
– limited not only currency mismatches of banks and other FX exposure in
the system, but also gross currency positions (to avoid counterparty
risks).
• Credit growth is now “only” 13%; risk-weighted capital ratio for banks
is 13.9%, and first half 2008 is 4.9% above first half of 2007,
expected to fall to about 3.5% for 2008 as a whole.
Fix Too Big To Fail
• 6. A regulatory surcharge (which takes the form of higher
required capital, higher required liquidity, or more
aggressive provisioning) on large, complex banks.
• 7. Detailed regularly updated plans for intervention and
resolution of large, complex institutions prepared by
them, which specify how control the bank’s operations
when transferred to a prepackaged bridge bank if the
bank became severely undercapitalized. Plans specify
formulas for loss sharing among international
subsidiaries, and the formulas specifying losssharing arrangements would be pre-approved by
regulators in the countries where the subsidiaries
are located. This resolves concerns about politicized
discretion or incompetence of resolution authority.
Reform Housing Subsidies
• 8. The winding down of Fannie Mae and
Freddie Mac, and the phasing out of the
FHA and Federal Home Loan Banks, and
the replacement of those leverage
subsidies with downpayment assistance
to low-income first-time homebuyers.
Reform Bank Corporate Governance
• 9. The elimination of bank holding company
restrictions on the accumulation of controlling
interests in banks.
• 10. The relaxation of Williams Act requirements
that require buyers of more than a 5% interest in
a company to announce that they are acquiring
a significant interest in a company, and the
elimination of regulatory limits on the percentage
ownership interests that institutional investors
can own in public companies.
OTC Counterparty Risk
Management and Transparency
• 11. The enactment of regulatory
surcharges (via capital, liquidity, or
provisioning requirements) that encourage
the clearing of OTC transactions through
clearing houses. (Not for all products.)
• 12. Requirements for timely disclosure of
OTC positions to regulators, and lagged
public disclosure of net positions. (Avoid
excessive disclosure => illiquidity.)