Getting to the Root of the Cause
Time Frame
DJIA Change (Real)
Length
1907-08
-40%
13 months
1919-20
-46%
15 months
1929-33
-83%
43 months
1937-38
-49%
15 months
1946-48
-35%
21 months
1973-75
-51%
25 months
1978-82
-37%
48 months
1987-88
-28%
5 months
2000-01
-18%
16 months
2007-09
-53%
16 months…

Cause/Effect

What is the gasoline, what is the match?
 “Point-of-failure” causes versus “root causes”
 Does a fire station contribute to more fires?

Fed/Treasury actions
 Water or gasoline?

Responses
Get rid of gasoline?
 Get rid of matches?
 Store in safer places?


Cochrane: Moral Hazard-“Too Big to Fail”





Hamilton: Above may be true but partial



Point-of-failure: Fed guarantees and uncertainty about them created
collapse
Long run problem: Fed guarantees, separating “systemic” v. nonsystemic problems and some by instruments that veiled genuine risks
Taylor variant: Fed supplied too much money to markets in early 2000s
Variant: point of failure problems enhanced/created by MTM
Point-of-Failure: Oil prices summer of 2008
Long run: huge increases in mortgage debt put system at risk; much
more vulnerable to point-of-failure issues
Goff: Hamilton on track but still partial


Long run: Large increases in total debt (not just mortgages) relative to
income put system at risk to almost disturbance of income
Wide variety of contributors, private and public
 Debt instruments, foreign capital inflows, leverage ratios, Fannie/Freddie,
incentives/mandates for poorly qualified loans,

Cochrane’s Thesis

Long Run: Existence of Fed creates a moral hazard;
greater risk taken
 Cochrane: bank run externality requires something like
Fed, and some moral hazard
 Moral hazard too great because market expects Fed to
cover everything (over given size)
 BG: Agree but isn’t this tradeoff of having a Fed as Lender
of Last Resort (insurer)?
 Bullard (STL Fed): charge insurance fee?

Short Run: policy uncertainty is the match
 In Sept 08, Fed let’s Lehman fail, saves AIG
 Spurs crisis by statements about conditions
 BG: Prisoner’s dilemma for Fed
6
5
4
3
2
1
6
3.5
5
3.0
4
2.5
3
2.0
2
1.5
1
1.0
0
0.5
-1
0.0
-2
-0.5
0
-1
07M01
07M07
08M01
08M07
TED
09M01
09M07
KCFSI
90
92
94
96
98
00
TED (Libor -TB3)
02
04
06
KCFSI
08
4.0
60000
3.5
50000
3.0
40000
2.5
30000
Debt/GDP - left scale
2.0
20000
1.5
10000
U.S. Debt -- right scale
1.0
0
20
30
40
50
60
70
80
90
00
4.0
3.5
Total Debt/GDP
3.0
2.5
2.0
Non-house-govt/gdp
1.5
1.0
0.5
House-debt/gdp
Govt Debt/gdp
0.0
50 55 60 65 70 75 80 85 90 95 00 05

See mortgage debt as leading indicator, not
as only cause


Mortgage debt securitized-tradeable;


Fire analogy: room with fire in it first does not tell
you about the fuel and match
Quickly reflecting change in valuations
Commercial bank loans non-tradeable;

Held at bank estimated values for longer
$11 Billion City Center Project
Las Vegas – MGM Mirage
Bank Loan/Bond Funded
3.8
Actual Debt/GDP
3.6
3.4
3.2
3.0
Forecast Debt/GDP
(Based on 1980-99, AR(4) Model)
2.8
2.6
00
01
02
03
04
05
06
07
08

Infinite Horizon Economy Budget Constraint:
PV Income + PV Debt

= Debt Service + PV Consumption
“NPG” Condition: Over the long run Income funds
consumption (not debt)

Sustainable Long Run Relationship:
Income – Consumption – Debt Service>=0
Long Run
Debt-Income Ratio
Income Growth - Interest Rate
for PV (Y-C-rb)>=0
3.5
3
2.5
Assumptions: 75-year Horizon
APC = 0.80 (NIPA est.)
0.60%
-0.40%
-1.80%
Post WWII
Variable
Income Growth
10-year Treasury
AAA Bond
BBB Bond
Actual Post WWII Values
6.70%
6.45%
6.75%
7.67%
Income Growth - Interest Rate
0.25%
-0.50%
-1.00%
9
8
7
6
5
1990-99
2003-07:7
4
3
2
1
0
Prime
AAA
BBB
Fed Funds
ComPaper
20
16
Inflation Rate & Smoothed (HP Filter)
12
8
4
0
-4
-8
82 84 86 88 90 92 94 96 98 00 02 04 06 08
9000
GSE Assets + Govt-MBS
(in Billions $)
8000
7000
6000
5000
4000
3000
2000
1000
90
92
94
96
98
00
02
04
06
08
4.5
.032
Capital Inflows (Smoothed) and Debt Growth
4.0
.028
3.5
.024
3.0
.020
2.5
.016
Debt/GDP
2.0
.012
1.5
.008
1.0
.004
Foreign Capital Inflow/GDP
0.5
.000
50
55
60
65
70
75
80
CAPINYHP
85
90
95
DEBTY
00
05
.06
Capital Inflows Relative to GDP
.05
.04
U.S.
.03
.02
.01
.00
Euro Area
-.01
97 98 99 00 01 02 03 04 05 06 07 08 09

Securitization, e.g. CDOs


Credit Insurance



Pooling mortgage (other debt) risk (CDOs, SPVs)
Transferring Risk (CDS)
Cochrane: can shuffle risk around, but not
change total amount
Evaluation:

CDOs, CDS actually relatively small versus size of
overall debt growth


How big of an effect is possible from MTM
pricing of banks?
See SEC Dec. 2008 Study
www.sec.gov/news/studies/2008/marktomarket123008.pdf

31% of bank assets MTM
 22% of these impact income statement
 Part of this amount in Treasuries

Differences in MTM and “amortized cost”
If 20% difference, then 4.4% impact on income
 Currently, using “amortized cost” method

 Citi assets increase by apx. $3B (out of $1.2T)
 BoA assets increase by apx. $9B (out of $1.4T)

Cochrane:


Stiglitz, …



Specify systemic risk for Fed, limiting TBTF
Limit financial innovation
More stringent oversight
Poole, Bullard, BG, …


Raise equity standards
Limit financial firm size
 Charge insurance fee based on size
 Explicit size limitations
2.0
Oct 1927-Oct 1931
1.6
1.2
0.8
Nov 2005-Nov 2009
0.4
5
10
15
20
25
30
35
40
45
50
3.6
3.2
Debt-GDP Ratio 2001-09
2.8
2.4
2.0
1.6
Debt-GDP Ratio 1923-1931
1.2
5
10
15
20
25
30
35
40
45
50



JC: “If we tried to hold equity or corporate debt in highly leveraged entities funded by
short-term debt, we would have the same problems. Actually, we did, back in the 1930s.”
“Leverage” often used as synonym for debt, but, equity can be overvalued and lead to
financial pinches when it falls in value by large amounts; regardless of debt v. equity, the
long run value is PV of income from them (Modigliani-Miller)
Consider 2 Scenarios for City Center (at $10T nominal value)





Case 1: $9T in Shareholder Equity with $1T in bank debt;
Case 2: $1T in Shareholder Equity with $9T in bank debt:
Assume “true” PV of future income = $5T
With project default:
Case 1: Bank takes equity worth $1T




Case 2: Bank takes equity worth $1T




Original shareholders lose $9T
New shares issued worth $4T
Loss in balance sheets = $5T
Shareholders lose $1T
Bank loses $8T in value up front; issues new stock and regains $4T
Loss in balance sheets =$5T
Assessing Safety for financial system?



Long run valuation equal
Case 2 involves an immediate loss of $8T and risks of reissuance; but …
What if in Case 1, shareholders losing $9T default on other payments funding other bank debt or make massive withdrawals of
deposits to fund other payment obligations (1920s-30s scenario)

No difference of debt v. equity (ownership
shares) financing of projects if






Asset prices move with statistical independence;
Asset prices are information based without
systematic errors;
Taxes treatment of both sources is the same
Bankruptcy treatment of both is the same
No asymmetry of knowledge among borrowers,
lenders, shareholders
Implies capital structure matters to the
degree that these conditions matter