Explaining the Credit Crunch

Securitization expanded credit but led to a decline in credit quality; this amplified the strain of declining housing prices and rising mortgage delinquencies that began in 2006.

The current economic downturn - the worst in at least three decades -- began with the bursting of the U.S. housing bubble, when mortgage delinquencies forced banks to write down several hundred billion dollars in bad loans. But those overall mortgage losses, while large on an absolute scale, are modest relative to the $8 trillion lost in U.S. stock market wealth between October 2007 and October 2008. In Deciphering the Liquidity and Credit Crunch 2007-2008 (NBER Working Paper No.14612), Markus Brunnermeier describes how those lesser and larger losses were linked and shows how economic mechanisms amplified losses in the mortgage market into broad dislocation and turmoil in the financial market.

Brunnermeier's study identifies four distinct economic mechanisms that played a role in the liquidity and credit crunch now hobbling the financial system. First, the effects of the hundreds of billions of dollars of bad loan write-downs on borrowers' balance sheets caused two "liquidity spirals." As asset prices dropped, financial institutions not only had less capital but also a harder time borrowing, because of tightened lending standards. The two spirals forced financial institutions to shed assets and reduce their leverage. This led to fire sales, lower prices, and even tighter funding, amplifying the crisis beyond the mortgage market.

Second, lending channels dried up when banks, concerned about their future access to capital markets, hoarded funds from borrowers regardless of credit-worthiness. Third, runs on financial institutions, as occurred at Bear Stearns, Lehman Brothers, and others following the mortgage crisis, can and did suddenly erode bank capital.

Fourth, the mortgage crisis was amplified and became systemic through network effects, which can arise when financial institutions are lenders and borrowers at the same time. Because each party has to hold additional funds out of concern about counterparties' credit, liquidity gridlock can result.

Network credit risk problems can be overcome if a central authority or regulator knows who owes what to whom, Brunnermeier notes. Then the system can stabilize. But the opaque web of obligations in the financial system that is currently characteristic of securitization tends to be destabilizing, leading to heightened liquidity and credit problems.

Brunnermeier's study also traces trends in the banking industry that contributed to the lending boom, the housing frenzy, and the 2007 crisis. One such trend developed as banks off-loaded their risks by moving to an "originate and distribute" model of lending. Rather than hold mortgages and other loans on their own books, they held them just long enough to repackage them and pass them on to other investors, who would trade them in bundles as securities.

In another trend cited in Brunnermeier's paper, investment banks exposed themselves to dry-ups in funding liquidity between 2000 and 2007 by increasingly financing their long-term assets with short-term loans. To manage this "maturity mismatch," they relied for example on overnight "repo" funding, borrowing capital by selling a collateral asset today and promising to repurchase it later. This reliance on short-term financing meant that these banks had to rollover a large part of their funding every day, exposing them to rollover risk with detrimental effects on the financial system.

Commercial banks also relied increasingly on short-term wholesale funding and played a role in building the crisis, too. For example, since they only briefly held loans on their books, these banks had little incentive to monitor individual mortgages. Brunnermeier notes that securitization expanded credit but led to a decline in credit quality; this amplified the strain of declining housing prices and rising mortgage delinquencies that began in 2006.

A full-blown liquidity and credit crunch erupted in 2007 and an end of it is still hard to predict. Yet, Brunnermeier reports a silver lining. The four economic mechanisms that help explain the causes of today's financial turmoil form a natural point from which to envision a new financial architecture, one that might reduce incentives to take on too much leverage, address excessive asset-liability mismatches, and monitor the interconnections among financial institutions.

-- Sarah H. Wright