Lessons From the 2007-08 Credit Crunch: What Should be Done?

ST. LOUIS, Sept. 2 /PRNewswire/ -- In light of the consequences that
followed the policy responses to the "credit crunch" of 2007-2008, regulators
will need to increase their vigilance to avoid future crises, based on a paper
published by the Federal Reserve Bank of St. Louis.
Paul D. Mizen, professor of monetary economics and director of the Centre
for Finance and Credit Markets at the University of Nottingham, and a visiting
scholar at the St. Louis Fed, looked at the market reactions and policy
responses to the credit crunch for the September/October issue of Review, the
Reserve Bank's bi-monthly journal of economic and business issues. The
publication is also available online at the St. Louis Fed's web site:
http://research.stlouisfed.org/publications/review.
Mizen noted that from 1993 to 2006, a number of macroeconomic conditions
sowed the seeds of the "credit crunch."
"Low interest rates encouraged greater borrowing, low savings ratios and
higher debt to income levels for consumers in industrialized countries," said
Mizen. "With low volatility, steady growth and increasing house prices,
lenders did not perceive great risks. Revolving debt in the form of credit
card borrowing increased significantly and, as prices in housing markets
across the globe increased faster than income, lenders offered mortgages at
ever higher multiples (in relation to income), raising the level of secured
debt to income. Credit and housing bubbles reinforced each other."
The innovation in mortgage-backed securitization to lower quality subprime
mortgage categories created assets with greater risks than the issuers or the
end-investors appreciated. "Sellers of subprime mortgage securities mispriced
risks by using models that assumed house prices would continue to rise while
interest rates would remain low," he said. "This was a false assumption, but
many other practices reinforced the error as buyers and sellers of subprime
mortgage securities and collateralized debt obligations failed to assess risk
characteristics properly. There was a failure in the incentives mechanism to
assess risks carefully because the risk would be held by others."
Mizen said when risks were realized in mid-2007, there was a crisis of
confidence in the financial markets as banks stopped funding short term paper,
MBS and CDO issuance slumped, and banks reduced the lending at more than one
month to maturity as they assessed the implications of the newly perceived
risks.
"While many analysts have stated, rightly, that the root of the problem
lay with the subprime market," said, Mizen, "any number of other high-yield
asset classes could have provided the trigger -- for example, hedge funds,
private equity, or emerging market equity. But, it was house prices rather
than equity or commodity prices that fell first, and therefore the crisis was
triggered by subprime-related assets."
Assessing the overall response by central banks, Mizen said, "Central
banks handled the crisis well from the perspective of providing liquidity to
the markets, but spreads remain larger than before the crunch."
At the same time, however, he believed that the central banks "did less
well in providing funding liquidity for failing institutions" and that the
ultimate consequences to the taxpayer from these actions cannot be known right
now. In the United Kingdom, the Bank of England's rescue of Northern Rock was
not regarded as a success and regulatory reforms will need to be made to avoid
the same problems in the future.
In the United States Mizen said, "The Bear Stearns crisis resolution
process seems to have delivered what the Federal Reserve set out to achieve.
The crisis was dealt with swiftly, and as a result the financial system did
not face a settlements equivalent to a 'payments problem.' The owners and
fund managers of the investment bank were effectively punished for taking
risky strategies." He added, however, that the cost to the taxpayer is yet to
be determined and under the support operation for the GSEs, Fannie Mae and
Freddie Mac, the scale of the lending is much greater, with potentially much
greater cost to the taxpayer.
Mizen believes reforms will need to be made to the regulations imposed on
banks, and he questioned the extent to which banks should be allowed to avoid
regulation by using off-balance-sheet vehicles to conduct business in
structured finance products.
"Questions also need to be asked about the incentive structures facing
originators and investment banks that created the complex products for resale,
the regulation of ratings agencies in rating complex financial products, and
the use of fair value accounting," he said. "Regulators need to ask questions
about an institution's own assessment of the risk being carried, but they also
need to consider the systemic risks that arise when the actions of an
individual bank impinge on other banks or the markets."
Mizen said the Fed's new rules for higher-priced mortgage loans should
improve regulation of the U.S. mortgage market, but he suggested, "the setting
of 'gold standards' for originators to match products (for example,
alternative mortgages) offered by the GSE's or minimum borrower standards
would also help."
He said several lessons from this period that can be applied to potential
future crises, among them:
(1) The need to create incentives that ensure the characteristics of
assets "originated and distributed" (in which financial institutions lend
money and sell the claims to a third party) are fully understood and
communicated to end-investors.
(2) Central banks should review and evaluate the effectiveness of their
procedures to inject liquidity into the markets at the time of crisis and
their response to funding individual institutions.
(3) Regulators will need to consider the capital requirements for banks
and off-balance sheet entities that are sponsored or owned banks, evaluate the
scope of regulation necessary for ratings agencies, and review the usefulness
of stress testing and "fair value" accounting.
With branches in Little Rock, Louisville and Memphis, the Federal Reserve
Bank of St. Louis serves the Eighth Federal Reserve District, which includes
all of Arkansas, eastern Missouri, southern Indiana, southern Illinois,
western Kentucky, western Tennessee and northern Mississippi. The St. Louis
Fed is one of 12 regional Reserve Banks that, along with the Board of
Governors in Washington, D.C., comprise the Federal Reserve System. As the
nation's central bank, the Federal Reserve System formulates U.S. monetary
policy, regulates state-chartered member banks and bank holding companies, and
provides payment services to financial institutions and the U.S. government.
SOURCE Federal Reserve Bank of St. Louis

Charles B. Henderson of Federal Reserve Bank of St. Louis, +1-314-444-8311,
Mobile, +1-314-609-5972, charles.b.henderson@stls.frb.org