Links to some interesting papers that I recently read.
The first comes from a conference on financial markets held at the start of this month at the University of Illinois in Chicago. Last fall, V.V. Chari, Larry Christiano, and Pat Kehoe received a lot of attention (e.g., Tabarrok, Avent, Economist, Kwak, Bonddad, and Thoma , , ,) for noting that aggregate lending by banks was in fact increasing during the period in which many analysts were describing it as sharply curtailed. At the Chicago conference, Federal Reserve Bank of Boston economists Ethan Cohen-Cole, Burcu Duygan-Bump, Jose Fillat, and Judit Montoriol-Garriga argued that those aggregate numbers conceal some very significant compositional trends, namely, previously existing lines of credit were being drawn on by borrowers and a sharply increased fraction of lending was consumed by securities originally intended for securitization but which banks were forced to hold on their own books.
Another interesting conference was held two weeks later at the Federal Reserve Bank of Atlanta, from which I found the paper by Gary Gorton quite interesting. (You can also find it discussed by Falkenblog, Cowen, Kling, and Klein). Gorton views the recent problems as an ongoing banking panic. Here are some excerpts:
A banking panic means that the banking system is insolvent. The banking system cannot honor contractual demands; there are no private agents who can buy the amount of assets necessary to recapitalize the banking system, even if they knew the value of the assets, because of the sheer size of the banking system. When the banking system is insolvent, many markets stop functioning and this leads to very significant effects on the real economy….
The current crisis has its roots in the transformation of the banking system, which involved two important changes. First, derivative securities have grown exponentially in the last twenty-five years, and this has created an enormous demand for collateral, i.e., informationally-insensitive debt. Second, there has been the movement of massive amounts of loans originated by banks into the capital markets in the form of securitization and loan sales. Securitization involves the issuance of bonds (“tranches”) that came to be used extensively as collateral in sale and repurchase transactions (“repo”), freeing other categories of assets, mostly treasuries, for use as collateral for derivatives transactions and for use in settlement systems…. [R]epo is a form of banking in that it involves the “deposit” of money on call (as repo is short-term, e.g., mostly over night) backed by collateral. The current panic centered on the repo market, which suffered a run when “depositors” required increasing haircuts, due to concerns about the value and liquidity of the collateral should the counterparty “bank” fail….
Securitized asset classes, e.g., mortgages, credit card receivables, auto loans, may be examples of relatively informationally-insensitive debt, created by the private sector without government insurance….
A “systemic shock” to the financial system is an event that causes such debt to become informationally-sensitive, that is, subject to adverse selection because the shock creates sufficient uncertainty as to make speculation profitable. The details of how that happens are discussed below, but in summary, fear of the resulting lemons market can cause the (inefficient) collapse of trading in debt and a stoppage of new credit being issued.
Gorton’s paper might offer some support for those who think that we just got stuck on the bad side of a structure with multiple possible equilibria. An alternative and more pessimistic perspective is developed in a recent note by Federal Reserve Bank of San Francisco economists Reuven Glick and Kevin Lansing. Glick and Lansing view the problem as more structural and fundamental, resulting from an unsustainable run-up of household debt. Their analysis was also highlighted by Thoma and Bloomberg.