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The Credit Crisis

Raghuram Rajan

Chicago Booth School of Business

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Outline

The Crisis: Origins

The Impact

Resolving the crisis?

Regulatory Lessons

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Bad Investments

Child of past crises Emerging markets => Industrial country

corporations => Industrial countryhousehold

Sophisticated Financial Sector Effectively sold mortgages from

Phoenix, Arizona to buyers around theworld

$ 100 sub-prime mortgages generated

$ 80 AAA

Originate to distribute spreads risks but

Quality of originations weakened

Depended on house price rising

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Bad Investments contd.

Banks held on to poor quality assets Poor governance and risk

management

At the top

Through the organization Tail risk

Writing earthquake insurance

Where were the risk managers?

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Financed with short termdebt

Short term debt cheaper because Lenders better protected.

Rolling over financing is easy in goodtimes.

Market requires banks to hold littlecapital because losses remote.

Aided and abetted by Fed policy

Greenspan put

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The Impact: Sequence ofevents

House price stops rising

Mortgage Defaults=> MBS fall in value,become more difficult to price, and pricebecomes more volatile

Market for mortgage backed assets driesup.

Illiquidity

Potential Insolvency

More hits on their way Credit cards Commercial real estate Commercial and industrial loans

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Issuance of ABS

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Jan-00 Oct-00 Jul-01 Apr-02 Jan-03 Oct-03 Jul-04 Apr-05 Jan-06 Oct-06 Jul-07 Apr-08

Student Loans

Other

Non US RMBS

Manufactured Housing

Home Eq (subprime)

Equipment

Credit Cards

Autos

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Credit markets freeze

Banks unwilling to sell impaired assets

Banks unwilling to substitute for shadowfinancial system Worries about borrower credit risk. Worries about own liquidity if lenders want

money back.

Worries about likely fire sales pushing securitiesprices further down common discount rate forrisky assets

Banks unwilling to raise enough equity

Stability is not the major focus of the privatesector in the midst of a crisis!

Institutional overhang not a major problemright now because demand for credit low. Butwill hamper recovery.

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Declining credit asset pricespull equity prices downwards

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1/1/2007 4/1/2007 7/1/2007 10/1/2007 1/1/2008 4/1/2008 7/1/2008 10/1/2008 1/1/2009

BKX (left) ABX.07-1 AAA (right)

source: Bloomberg

ABX.07-1 AAA versus BKX* index prices

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When will credit marketsfind a bottom?

When the risk of large institutions collapsingis small. Guarantee debt Audit institutions (the Stress Test) Clean up bank balance sheets by

isolating/selling problem assets

Good bank/bad bank Recapitalize banks through a mix of privateand public funds

Some actions may have to be mandated

This will allow asset prices to recover and

credit to flow more freely, thus notimpeding recovery.

Will require more public money: politicalsupport weak

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3 Lessons for financialregulation

Regulators and markets are subject tothe same euphoria that bankers are.Over the cycle

the market becomes less risk averse, soregulatory arbitrage increases

enforcement as well as risk managementget weaker.

How do you ensure regulations have bite?

Illiquidity is contagious. Problems canemerge from anywhere and hit

elsewhere.

Stability is a public good in the midst ofa crisis, with limited private incentiveto help create it.

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Implications

Heavy handed, focused, regulationwill most likely to lead to arbitrage,without insulating sensitive areas.

Bright lines? Utilities?

Lighter, across-the-board,regulation with contingentescalation of regulatory powers andactions more useful.

No matter what regulators do,disaster can always strike. Createprivate sector buffers that will notbe eroded in good times.

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A problem

Large complex entities!

Break them up?

Slow their growth (higher capitaland supervision)?

Limit their growth?

Force them to become easier to fail.

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THANK YOU!

T