Home > Economics - General > The credit crunch illusion? Guest post from Rabee Tourky

The credit crunch illusion? Guest post from Rabee Tourky

November 19th, 2008

Here’s a post on the credit crisis from my colleague, Rabee Tourky

In a Minneapolis Fed. research paper Chari, Christiano, and Kehoe
examine
three claims about the way the financial crisis is affecting the economy as a whole and argue using a number of graphs that all three claims are in fact myths.

The claims that they dismiss are that bank lending to non-financial corporations and individuals has declined sharply; that interbank lending is essentially nonexistent; and that commercial paper issuance by non-financial corporations has declined sharply, and rates have risen to unprecedented levels.

They conclude their note with the following sharp message:

Our main point is that policymakers have not done the hard work of convincing the public or even academic economists of the precise nature of the market failure they see, of presenting hard evidence, not speculation, that differentiates their view of the data from other views, and the logic by which the particular intervention they are advocating will fix this market failure. We feel that a trillion dollar intervention warrants a bit more serious analysis than we have seen. Our analysis is based on publicly available data. Policymakers have access to other sources of data as well. Policymakers could well believe that bold action is necessary based on data that are different from that considered here. If so, responsible policymaking requires that they share both the data and the analysis that underlies the need for bold policy…

Of course, they cleverly anticipated Brad Delong’s response to their note by arguing that analysis of the financial crisis focusing on interest rate spread lead to mistaken inferences.

I came across the Chari, Christiano, and Kehoe paper via another
response
to it, which kind-off skirts some of the shaper ends of the Chari, Christiano, and Kehoe mythology.

I wonder how the credit crunch myth sits with the following graph of the M1 multiplier (the ratio of M1 to Base Money)? I generated the graph on the
Federal Reserve Bank of St. Louis site
.

Has the money multiplier really collapsed to almost one? What are banks doing with their deposits? Are they hording new deposits in underground volts?

Will somebody please either tell the Fed. to correct their October-November entries for the M1 multiplier or tell
Chari, Christiano, and Kehoe that there is too a credit crunch?

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  1. Michael of Summer Hill
    November 19th, 2008 at 18:11 | #1

    John, maybe Chari, Christiano, and Kehoe must be hallucinating for General Motors is losing $3 plus million per hour.

  2. Will
    November 19th, 2008 at 18:30 | #2

    Since the failure of Lehmans on 15th September, banks have substantially stopped new syndicated lending, the major source of bank loans for large corporate and project borrowers globally. Anyone in the industry could have told Char et al this. As syndicated lending had annual volumes of three or four trillion dollars at its peak, this seems to qualify as reasonably serious.

    Syndicated lending was still going on in fairly good volume prior to 15th September, and lead banks were then still willing to underwrite new syndicated loans, notwithstanding the sub-prime thing had been going on for more than a year. But after Lehmans, underwriting of new syndicated loans stopped entirely.

    Some syndicated loans, including some sizeable transactions, have been closed since Lehmans, but these are almost all legacy deals that the lead banks were already committed to completing prior to Lehmans, and very few new banks have joined these. The only other deals now being closed are by small clubs of local banks for their major home market relationship clients.

    Corporate and project borrowers are being told by almost all banks, subject to the exception above, that there will definitely be no new lending for the rest of the year, but there is no guarantee that it will return in January.

    I think it is a bit rich that Chari et al accuse others of not undertaking serious analysis. While the effective cessation of lending only occurred in the last month of their analysis period, it was in direct response to the Lehmans default, which was hardly a secret and was well recognized in the industry as the catalyzing event.

  3. rabee
    November 19th, 2008 at 18:57 | #3

    Will,

    Your point is made in the other paper I linked to: Ivashina and Scharfstein (2008).

    Chari et al, address the issue though I don’t fully understand what their point is.

  4. Joseph Clark
    November 19th, 2008 at 19:08 | #4

    Chari et al weren’t saying there was no problem with credit, just that a lot of people had been talking garbage and not looking at the actual numbers. They were and continue to be right.

  5. rabee
    November 19th, 2008 at 19:24 | #5

    Joseph,

    Have a quick glance at the Victoria Ivashin
    and David Scharfstein paper.

    Further going to much more traditional analysis how do we explain the large drop in the money multiplier?

    More seriously, it seems to me that many corporations are scrambling to refinance their operations using equity rather than debt. Why is that? Why the sudden need to shift the debt/equity ratio?

    Chari et al, slap a few graphs on a paper and expect their argument to be compelling.

    At best they setup a straw man argument.

  6. Will
    November 19th, 2008 at 20:13 | #6

    Thanks Rabee, apologies for not reading that link. To answer the question they raise in their conclusion, as to whether the drop is supply or demand driven, I can say that it is supply driven. Banks are not underwriting and are not joining syndicated loans that were already underwritten, even for high quality borrowers and projects.

  7. rabee
    November 19th, 2008 at 20:57 | #7

    Will,

    Do you know how banks price underwriting services?

  8. Joseph Clark
    November 19th, 2008 at 20:59 | #8

    Companies are not issuing because spreads are very wide and it is too expensive.

    I’m not sure why the multiplier moved like that but I think it might just be an increase in capital requirements.

    I think your criticism of Chari et al is a bit unfair. They didn’t say there was no problem and they were very open about spreads, they just pointed out that a lot of popular beliefs are not supported by the data. I’m surprised there is such a rush to attack the paper.

    The Ivashin and Sharfstein paper is good too, but deconstructing total loans to include drawdowns doesn’t change the fact.

  9. Will
    November 19th, 2008 at 21:11 | #9

    Rabee

    Yes, I do it for a living. It’s not scientific, just depends on how competitive the market is. In a really hot market the underwriting bank would expect to skim (i.e. retain from the underwriting fee after paying up-front fees to participating banks) 30bp or even less on the underwritten amount. In the first half of 2007, this rose to maybe 50-75bp. Now there’s basically no price at which we would do it.

    Cheers

  10. Smiley
    November 19th, 2008 at 21:18 | #10

    I’m surprised at how low the multiplier was even before the recent precipitous fall. The Wiki entry on “Money creation” uses the example of 5. Is the multiplier higher for less liquid measures of money supply?

  11. Smiley
    November 19th, 2008 at 21:30 | #11

    Actually that does make a lot of sense, because money sitting in your wallet or a “demand deposit” don’t earn that much interest any way, do they?

  12. rabee
    November 19th, 2008 at 21:35 | #12

    Thanks Will,

    I’m not surprised by this. Do you know if the regulatory authorities and the RBA collects data on levels of underwriting activity by banks? Or if someone has this information in the public domain?

  13. No need to publish
    November 19th, 2008 at 21:37 | #13

    “volts” should be “vaults”

  14. Will
    November 19th, 2008 at 21:40 | #14

    Rabee

    I’ll send you an email.

    Cheers
    Will

  15. Hermit
    November 19th, 2008 at 21:51 | #15

    At least one credentialled economist has suggested the oil price triggered the financial crisis
    http://www.theoildrum.com/node/4727
    So how come low oil prices don’t ‘untrigger’ the crisis?

    I wonder if the real goods economy needs time to catch up with the credit sector. In the US until recently I gather you could drive away in a 5.7 litre V8 pickup at 0% interest on top of your sub-prime home loan.

  16. Will
    November 20th, 2008 at 00:00 | #16

    In post 9 I should have said first half of 2008, not first half of 2007.

  17. Ernestine Gross
    November 20th, 2008 at 08:50 | #17

    Thank you Will, for putting it so clearly:

    “Now there’s basically no price at which we would do it” (Will at #9)

    i.e. the market segment in question does not exist. This is what market failure (as distinct from imperfect markets) is all about. The graph of market failure is a blank page. Such blank pages are missing in all Micro-economic and Finance texts I’ve ever come across.

    Chari, Christiano, and Kehoe do not define ‘market failure’.

    The money multiplier diagram shows a beautiful example of discontinuity in the credit markets.

    Interesting post.

  18. carbonsink
    November 20th, 2008 at 09:33 | #18

    When is everyone going to say sorry to Steve Keen?

    Some personal anecdotes:
    - My sales are down 50% from October to November (I sell software mainly to the US and Europe)
    - Several houses in my town have been “repriced” down by 30% or more since mid year
    - A big house going up across the road from me all year. All work stopped in October. The reason? Margin calls.

    Apologies to Glenn Stevens for not being more positive, but I see what I see.

  19. observa
    November 20th, 2008 at 10:11 | #19

    I don’t see any market failure here Ernestine. Markets are all about working out new and innovative ways of doing things and going down dead ends or off cliffs occasionally. However, just like throwing money at negative real cost at bankers, throwing the keys of a Nissan Exa Turbo to 18 yr olds, rather than letting them cook chook at KFC until they can afford a more modest banger of their own, can produce more cliffic episodes in my experience.

    Syndicated loans to spread risk between lenders is sensible stuff until the agent bank can no longer trust the other lenders to cough up, or the other lenders become wary that the agent is really underwriting the deal in the hope of making their cut and flogging off some collaterilised part of it that they wouldn’t normally lend out themselves. Lehmans was of course the market signal to all that this was more often than not the case and so it’s back to lenders and borrowers getting much closer together. Isn’t that all CCK are pointing out here? If the NAB can raise $2bill oversubscribed in an hour, there’s no shortage of dough looking for a home. It’s just that borrowers have to show wiser lenders they have the wherewithal to pay. Some like Centro, ABC and GM in the US apparently can’t do that. Fine, if they can’t they’ll go broke and someone who can pay will pick up the assets cheap, perhaps with some direct bank borrowings and run with them. Generally, it would be more sensible if some wouldn’t throw the keys to the Eddys in the first place.

  20. rabee
    November 20th, 2008 at 10:43 | #20

    You’re absolutely right Ernestine, there’s been a dramatic collapse in the span of existing assets. Basically, the story is all about market incompleteness so it’s not surprising that when we look at prices in existing markets things seem to be working well with no market failure in that partial market: markets are clearing and people are behaving sensibly.

    Put it all together, however, things don’t work as expected.

  21. observa
    November 20th, 2008 at 10:52 | #21

    ‘Apologies to Glenn Stevens for not being more positive, but I see what I see.’

    Well the fact that a major scrap steel buyer has stopped all further intake for 2 months (and then we’ll let you know) and sent their workers on holidays should tell Glenn something. The really bad news will come with the Xmas pay packets and it could well be double digit unemployment by end Qtr1 2009 after all the holiday and LSL is exhausted. If the Japan/Nikkei experience is anything to go by the ASX will bottom around 1500 as we revisit the 1930s. Cash is king and debt poison now as we enter similar deflationary times. Funny money is evaporating fast and it’s survival of the prudent now. Ah well, it was fun while it lasted eh Glenn and Co?

  22. Michael of Summer Hill
    November 20th, 2008 at 17:28 | #22

    Rabee, if the stock market is sitting on a knife edge are we witnessing the calm before the storm?

  23. rabee
    November 20th, 2008 at 17:40 | #23

    A quick update.

    Take a look at the change in bank reserves.


    Click here for the change in bank reserves form the St. Louis Fed.

  24. Will
    November 20th, 2008 at 19:39 | #24

    Observa, you said in 19 “the other lenders become wary that the agent is really underwriting the deal in the hope of making their cut and flogging off some collaterilised part of it that they wouldn’t normally lend out themselves.”

    That is true of securitization but not syndicated loans, which are pari passu senior loans underwritten by and syndicated to other commercial banks. There is no tranching (except in the LBO market which has now, mercifully, pretty much gone along with the other junk). The syndicated loan underwriters always keep a significant participation in the loan themselves.

    I think Ernestine is right to describe it as a market failure. The reason there is no syndicated loan underwriting is not really to do with the quality of the loans or the borrowers but rather the banks to whom they have to be sold. Instead of the high level of confidence in the success of any syndication that we require to underwrite, we today have very little confidence that other banks will apply their very scarce capital to participate in new loans, irrespective of what those loans are like.

  25. Alanna
    November 20th, 2008 at 21:11 | #25

    Well – I was talking to a real estate agent in Sydeny this week. He claims that a potential sale on a one bedroom unit in Neutral Bay, in the vicinity of 395K ask has fallen over three times. Its not the carrot of the first home buyer grant from the government extended to 21K that is keeping the market for real estate down – r/e agent claims banks wont lend to first home buyers without a substantially higher deposit than was previously required – supports the idea of a credit crunch. More cautious lending isnt such a bad thing. Maybe its just reality (in the form of bad loans) catching up with the delusions that have been present in the market for loan funds.
    Easy lending fine of course when equity is rising but when equity falls – typically we get a credit crunch – its nothing unusual that interest rates can rise in recessions.

    Alanna

  26. Alanna
    November 20th, 2008 at 21:17 | #26

    This is not market failure. This is market correction. Where are the costs extended on to those who were not a buyer or seller. Buyers who couldnt pay back loans because they werent aware the loans would re set? lenders sitting on loans they suspected might be toxic but didnt have time to flick to someone else?

    Come on – this isnt market failure at all. Its a speculative bubble that burst. The only failure was a regulatory failure because Greenspan didnt put the brakes on sooner and try and reign it in and failed to correctly regulate the financial markets to ensure transparency and even Greenspan admits it.

    Market failure here? Nonsense.

    Alanna

  27. Ernestine Gross
    November 20th, 2008 at 22:18 | #27

    Alanna, may I know who teaches the stuff you write in 25 and 26 and where?

  28. Ernestine Gross
    November 20th, 2008 at 22:45 | #28

    Will (#24), if I understand your example correctly, you are saying that as a consequence of xyz events in the financial system, the market for syndicated loans of good quality (ie economically profitable projects, managed by reasonable people) does not exist at present at least in some places. If so, then you have given a nice example of practical relevance to illustrate the meaning of the theoretical result in general equilibrium theory: equilibria of competitive private ownership economies with incomplete markets are generically Pareto inefficient (ie resource misallocation is the norm except perhaps on a sunny, say Wednesday afternoon between now and the end of the world). [The text Quinzii and MaGill, Theory of Incomplete Markets, contains references to the original works. Hope this reference will do for current purposes]

    G.E. theory has its limitations. However, to the best of my knowledge it is the body of literature where a ‘market system’ and hence system failure can be discussed in a coherent fashion.

  29. gerard
    November 20th, 2008 at 23:34 | #29

    Let’s hope housing prices crash and stay deflated for ten years.

  30. rabee
    November 20th, 2008 at 23:35 | #30

    Ernestine,

    Generically in the incomplete market setting equilibrium allocations are not even second best efficient. That is they can be dominated by an allocation of resources that can be achieved without adding new markets. Quinzii and MaGill’s book doesn’t capture this because they don’t cover assets with real returns.

    The principal reference is “An introduction to general equilibrium with incomplete asset markets” Journal of Mathematical Economics, 1990 vol 19.

  31. Ernestine Gross
    November 21st, 2008 at 07:37 | #31

    Rebee,

    True, there is a distinction between spanning a space of security returns (nominal) and spanning a space of real assets. Hence my qualification ‘for current purposes’.

    The situation described by Will is, as you indicated in #20, comparable to a ‘dramatic collapse in the span of existing assets’, ie in financial markets. By contrast, global warming is an example of market failure in ‘real assets’.

  32. rabee
    November 21st, 2008 at 07:49 | #32

    Hi Ernestine,

    Your of course right in what you wrote. I was making the point that with real assets the situation is even worse that Pareto inefficiency.

    Real assets are financial assets whose payoff depend on the prices of more than one future spot market.

    I guess I’m being pedantic because I labored away at this literature for a decade.

    Well here we have it, a collapse in the span of assets resulting in the biggest changes in asset prices in a very long time.

  33. Ernestine Gross
    November 21st, 2008 at 08:31 | #33

    Rabee, I enjoyed this thread very much. I also laboured away at this literatue for decades – and never regretted a minute of it.

  34. Alanna
    December 4th, 2008 at 19:53 | #34

    Ernestine,

    I only said the same thing that McFarlane said today in the newspaper. I dont beleive the financial crisis is a market failure. Its a regulatory failure. We didnt spend decades putting in place regulation to constrain the excesses of the market for nothing. The market needs planning and infrsatructure for it to function satisfactorily. We dont just need regulation to correct market failure – we need (and have always needed) regulation to prevent the markets operating suboptimally.
    The deregualation ethos was taken too far for too long. An ideology had all faith put in it, at the expense of reality.

  35. December 14th, 2008 at 07:05 | #35

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