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De-Leveraging and the Financial Accelerator: How Wall Street Can Shock Main Street* BY SATYAJIT CHATTERJEE

he severity of the recent economic downturn percent within a year and a half. What began as a problem in the subprime raises questions about the role of financial segment of the U.S. mortgage market T markets in modern market economies. Why snowballed into a full-blown and one of the worst recessions of did rising defaults in a relatively small portion the postwar era. of the U.S. housing market cause a financial crisis? The severity of the current downturn raises questions about the Why do financial crises have outsized adverse effects role of financial markets in modern on the rest of the economy? As a general rule, a decline market economies. Why did rising defaults in a relatively small portion in economic activity in the nonfinancial sector, such as of the U.S. housing market cause a occurs during a typical recession, induces greater restraint financial crisis? Why do financial on the part of the financial sector and that restraint — crises have outsized adverse effects on the rest of the economy? manifested usually in a pullback of credit and funding As a general rule, a decline in — in turn causes further setbacks to the nonfinancial economic activity in the nonfinancial sector, such as occurs during a typical sector. In the academic literature, this feedback effect is recession, induces greater restraint on called the financial accelerator. In this article, Satyajit the part of the financial sector and that restraint — manifested usually in Chatterjee looks at what underlay the financial shock a pullback of credit and funding — in that emanated from Wall Street in the fall of 2007. Then turn causes further setbacks to the nonfinancial sector. In the academic he focuses on the channels through which the financial literature, this feedback effect is accelerator works and how the accelerator can turn a called the financial accelerator. The terminology alludes to the fact that financial market disruption into a deep recession. greater financial restraint can cause a downturn to gather additional speed or lesser financial restraint can cause an upturn to do the same. When the In the first quarter of 2006, when first began their sustained rise, the initial shock is a shock to the financial delinquencies on subprime mortgages unemployment rate in the United sector itself, the financial accelerator States stood at 4.75 percent. Under can combine with the shock to the impact of the ensuing financial produce a particularly steep decline in Satyajit crisis, the U.S. economy fell into economic activity. Chatterjee is a recession in December 2007, and the First we’ll look at what underlay senior economic advisor and unemployment rate shot up to 9.5 the financial shock that emanated economist in from Wall Street in the fall of the Research 2007, and then we’ll focus on the Department of channels through which the financial the Philadelphia Fed. This article *The views expressed here are those of the accelerator works and how the is available free of author and do not necessarily represent accelerator can turn a financial market the views of the Federal Reserve Bank of charge at www.philadelphiafed.org/research- Philadelphia or the Federal Reserve System. disruption into a deep recession. and-data/publications/.

www.philadelphiafed.org Business Review Q2 2010 1 SOME BACKGROUND ON THE the investment was insufficient to pay same time, it becomes impossible for FINANCIAL CRISIS off the maturing debt. The financial the bank to meet its obligations. The financial crisis that erupted firms made up the shortfall by issuing Rising defaults on subprime in the fall of 2007 has its origins in new short-term debt. In most cases, mortgages in 2006 led investors to subprime mortgages, that is, loans the new debt was absorbed by existing reassess the risks inherent in assets made to risky borrowers for the investors. In other words, the financial based on subprime mortgages. As the purposes of buying a house. The firms were relying on their investors market value of these assets declined, subprime segment of the U.S. housing to “roll over” their loans as the loans investors became worried that future market is relatively small, so it is matured. The mode of operation of investors might refuse to issue new puzzling that default on these loans financial firms was to fund purchases loans against these suspect assets. could become the source of a major financial crisis. One reason is leverage. The Leverage alone can hardly be the financial firms (commercial banks, investment banks, and hedge funds) that bought the risky mortgages funded these purchases by borrowing from other financial market participants. Thus, when these mortgages began failing, it was not just the financial firms that had bought the mortgages that got into trouble, so of long-term assets (risky mortgages) If that happened, the firm would be did the entities that had lent money with a sequence of short-term debt. unable to pay off the new loan it was to the financial firms. These entities, That is, they engaged in maturity issued today. This lack of confidence typically other financial firms, in turn transformation. led to a rollover crisis in which current had borrowed money to fund their While maturity transformation investors refused to renew their loans loans; so the creditors of these other is part of a well-functioning financial to financial firms. Of course, as financial firms also got into trouble. system and financial firms will engage investors refused to renew their loans, Leverage is the reason that a relatively in it (as well as in leverage) to generate financial firms holding suspect assets small pool of failing assets can cause a value for their investors, maturity began to experience great difficulty in systemic problem. Leverage makes the transformation entails some risks. meeting their short-term obligations. insolvency of one financial institution The danger is that if investors become In some cases, the firms simply went a trigger for the insolvency of other nervous about a firm’s solvency, they bankrupt. In other cases, the firms financial institutions. can refuse to renew their loans to suffered huge losses in equity, since But leverage alone can hardly the firm and thereby put the firm in they had used their own funds to be the culprit for the financial crisis. a real bind. This is called a rollover service their short-term obligations. Leverage is at the heart of efficient crisis. Bank runs are a famous example Leverage and maturity financial intermediation and has been of this sort of crisis. In a bank run, transformation were the main a fact of life in industrial economies for depositors rush to withdraw their proximate causes of the financial crisis. centuries. A more important proximate deposits from the bank because they But it is important to understand cause of the crisis was the manner in fear the bank will fail. Banks are that these are proximate causes. The which financial firms leveraged their subject to rollover crises because they reasons why large financial firms purchase of risky mortgages. They engage in maturity transformation. engaged in this type of leveraging funded their purchases by borrowing They borrow very short term (in effect remain a matter of controversy. As short term. They promised their they tell their depositors they can researchers and analysts probe into the investors that they could have their withdraw funds at any time), but they ultimate causes of the crisis, they will funds back within a short period of use the deposits to purchase assets uncover some of the deeper reasons time. Since the mortgages bought that pay off gradually over time. If all as to how and why financial firms got would not mature until many years depositors (or a good many of them) themselves into this bind. Also, it is into the future, the cash flow from attempt to withdraw deposits at the important to remember that leverage

2 Q2 2010 Business Review www.philadelphiafed.org and maturity transformation are not are loans made by the investment in a position to pay off its creditors. problems per se. Perhaps the catalyst bank. Typically, these loans are made The higher the leverage ratio, the that turned these well-known forms of to the nonfinancial sector, which less capacity the investment bank financial intermediation into a recipe includes businesses, households, and has to absorb losses without affecting for financial ruin was the unwelcome the government. In the example, the its creditors.3 It stands to reason concentration of financial risk within a investment bank has bought mortgages that an investment bank’s target handful of very large financial firms. It from households worth $100 and has leverage ratio will ultimately depend appears that the considerable default business-sector loans worth $200. On on investors’ perception of risk in the risk of subprime mortgages was not the liability side of the balance sheet, financial system. During periods of passed on to ultimate investors such the investment bank has debt worth low perceived risk, the target can be as households, corporations, pension $250 in the form of commercial paper expected to rise, and during periods of funds, and insurance companies but and equity worth $300-$250, or $50.2 high perceived risk, the target can be was instead absorbed by a few large What the balance sheet says is that expected to fall. financial firms. Although the subprime the investment bank has invested $50 The important point is that an segment of the U.S. housing market is of its own money and $250 worth of adverse shock to the market value relatively small, the concentration of borrowed money to purchase $300 of assets causes the leverage ratio to the default risk of subprime mortgages worth of assets. rise above its target. To understand in a few large financial firms ended An important aspect of the why, suppose the market value of the up causing a problem for the entire balance sheet is the leverage ratio, mortgages held by the bank declines financial system. defined as the ratio of the value of by 20 percent. In dollar terms, this Now let’s turn to a discussion of assets to equity; in the example, the is a loss of $20. Generally accepted the main channels through which leverage ratio is 6 (300÷50). An accounting principles (GAAP) require a loss in equity in the financial investment bank likes to maintain a the investment bank to record the sector retards economic activity in target leverage ratio that is low enough value of mortgages on its books at the nonfinancial sector. The goal is so as to assure investors who lend it current market value. Thus, the bank to provide some perspective on the money that there is a high probability is required to mark down the value severity of the downturn that followed their loans will be repaid. In the of mortgages on its books from $100 in the wake of the financial crisis. example, the investment bank can to $80. This means that the bank’s sustain losses of up to $50, or one-sixth equity (which is simply the difference DE-LEVERAGING AND THE of the value of its assets, and still be CREDIT CRUNCH

There are several channels 3 A target leverage ratio is not directly observ- through which a loss in equity of able (since financial firms do not announce it), financial firms has adverse effects on 2 Commercial paper is an unsecured promissory but its value can be inferred from the observed note issued by large banks or corporations with behavior of financial firms. See the article by the nonfinancial sector. Some of these a maturity date of less than one year. Since the Allen Berger, Robert DeYoung, Ozde Oztekin, channels involve direct effects and loan is not backed by collateral, only highly and David Lee for evidence in support of target reputable firms can issue commercial paper. leverage ratios. others, indirect effects. Among the direct effects is a pullback in the supply of credit that results from de-leveraging by financial firms.1 To understand the role of de- TABLE 1 leveraging, we need to understand the balance sheet of a financial firm. Assets Liabilities Table 1 gives a simple example of an investment bank’s balance sheet. On Mortgages $100 Commercial Paper $250 the asset side of the balance sheet Business Loans $200 Equity $50

1 The role of de-leveraging in the pullback of credit is discussed at length in the article by Total $300 Total $300 Adrian Tobias and Hyun Song Shin.

www.philadelphiafed.org Business Review Q2 2010 3 between the value of its assets and the in commercial paper (from $250 to Two additional points are worth value of its liabilities) drops from $50 $150). The bank’s balance sheet after making. First, how much assets have to $30 ($280-$250) and its leverage this adjustment will be as shown in to fall because of de-leveraging also ratio rises to 8¹/³. If the bank’s target Table 2. depends on what happens to the target leverage ratio was 6 to begin with, The amount by which the leverage ratio following the initial the loss in the market value of assets investment bank must reduce its assets shock to equity. At the start of the results in a leverage ratio higher than is closely related to the leverage ratio current crisis, the rise in uncertainty the target. it would like to maintain, in this case caused investors to look for lower An increase in the leverage ratio 6. For every dollar decline in equity, leverage ratios than was customary above its target value makes investors the bank must reduce assets by $6. in the recent past. This, in turn, led less eager to lend to the investment Therefore, a $20 decline in equity investment banks to lower their target bank. Investors will demand a higher requires the bank to shrink its assets leverage ratio and that became an interest rate on any new commercial by $120. Taking into account the fact additional factor in the de-leveraging paper issued by the investment bank that the $20 decline in equity was engaged in by financial firms. To (to compensate for the higher risk triggered by a $20 decline in the value continue with our example, suppose of loss) or stop buying the bank’s of mortgages, the bank must reduce its that the new target leverage ratio is commercial paper altogether. Thus, assets by an additional $100 ($120- 4 instead of 6. Then, starting from market forces make it hard for the $20). the position shown in Table 2, the bank to maintain the same level of This process of reducing the new balance-sheet position might short-maturity debt as before.4 At this leverage ratio by reducing assets in look like the one in Table 3. To get its point, the investment bank must either the wake of a loss in equity is called leverage ratio down to 4, given equity raise more equity or reduce its assets de-leveraging. The important point to of $30, the firm must reduce its asset (both of which will lower its leverage note is that since the leverage ratio holdings to $120 ($30 times 4). Thus, it ratio). Raising equity is usually not is a number quite a bit greater than must reduce its assets by $60 ($180- much of an option for banks in the one, de-leveraging can convert any $120). In the example in Table 3, the midst of a financial crisis, although given decline in equity into a much reduction is accomplished by reducing some financial firms did raise equity larger decline in investment bank mortgages and business loans by $30 in the early phase of the current crisis assets. Since a bank’s assets are mostly each. On the liability side, the bank’s and have returned to equity markets loans to the nonfinancial sector, commercial paper declines by $60 in recent months. Typically, in a crisis, de-leveraging results in a constriction (from $150 to $90). the adjustment in the leverage ratio is in the flow of credit to nonfinancial Second, a reduction in investment accomplished by reducing assets. For firms. A reduction in the supply of bank debt (in the example, commercial instance, in the example above, the credit, in turn, raises the firm’s cost paper) goes hand-in-hand with the de- bank might bring its leverage ratio of credit, thereby reducing firms’ leveraging. Given this, it is important back to 6 by reducing its loans to the demand for investment goods and to ask: What happens to the funds business sector from $200 to $100, consumer spending by households and, that investors were formerly lending to with a corresponding $100 reduction ultimately, lowers employment. this bank? In a crisis, the funds end

4 It is worth pointing out that the leverage ratio TABLE 2 is closely related to a bank’s capital ratio, a ratio that plays an important role in bank regulation. The capital ratio is simply the ratio of bank eq- uity (capital) to a risk-weighted sum of bank as- Assets Liabilities sets. As such, it is closely related to the inverse of the leverage ratio. A rise in the leverage ratio Mortgages $80 Commercial Paper $150 will be accompanied by a decline in the bank’s capital ratio. If a bank’s capital ratio falls below the level determined by regulation, the bank is Business Loans $100 Equity $30 required by law to take steps to increase its capi- tal ratio. Thus, an increase in a bank’s leverage Total $180 Total $180 ratio resulting from a drop in asset values may force a bank to take steps to lower its leverage ratio for regulatory reasons.

4 Q2 2010 Business Review www.philadelphiafed.org up in the hands of entities that can borrow with very low risk of default. TABLE 3 Economists refer to this re-allocation of funds from risky borrowers to safe Assets Liabilities borrowers as a flight to quality.5 Of course, the safe assets are bought from Mortgages $50 Commercial Paper $90 existing holders of these assets, who are likely to use the proceeds from Business Loans $70 Equity $30 their sale to obtain other safe assets, such as deposits at commercial banks. Total $120 Total $120 So the process of de-leveraging during a crisis is likely to increase deposits at commercial banks, and if commercial banks do not lend out this new inflow of funds, it will also increase the homeowner who wishes to sell his or For instance, a business that wishes to reserves that the banks hold with the her house cannot find many buyers expand its operations could finance Fed. Thus, during a crisis, the process who can get financing (to buy the the expansion by taking out a loan of de-leveraging tends to move funds house), he or she may be tempted to from a bank using its property as out of circulation and into reserves, drop the asking price. The same is true collateral for the loan. What this which also puts downward pressure for commercial properties. means is that if the business cannot on the inflation rate as money in A decline in the value of repay the loan, the bank (the lender) circulation tends to fall (or grow more residential and commercial properties takes ownership of the property offered slowly).6 has further consequences for the as collateral against the loan. Banks level of aggregate spending. The typically only make loans against FALLING PROPERTY VALUES, reason is that a decline in property collateral because doing so makes DEBT CAPACITY, AND THE values reduces the debt capacity of the loans less risky and encourages FINANCIAL ACCELERATOR businesses and households — which borrowers to spend the borrowed funds The decline in the flow of credit is the maximum amount they are wisely (poor use of the funds results in resulting from de-leveraging also has permitted to borrow — and thereby the loss of the collateral). Naturally, adverse consequences for property reduces business investment and there is a close connection between values. The reason is that the value consumer expenditures (and, the value of the collateral and the size of many properties, such as residential ultimately, aggregate output). Thus, of the loan offered against it. Banks homes and office buildings, is sensitive falling property values lead to a are typically willing to lend up to some to the free flow of credit. When credit decrease in credit offered to the fraction of the value of the property is not easily available, people and nonfinancial sector. This effect is offered as collateral. The maximum businesses cannot easily buy houses what economists call the financial amount that banks are willing to lend and commercial property. This causes accelerator. To understand how the against the borrower’s property is the a drop-off in the demand for such financial accelerator works, we need borrower’s debt capacity. When there property and results in a fall in their to understand why there is a debt is a decline in the value of property market price. For instance, when a capacity and why it declines with that can be offered as collateral, there property values.7 is a decline in the debt capacity of the Commercial and residential nonfinancial sector. 5 See the article by Evan Gatev and Philip properties often serve as collateral in The reduction in debt capacity Strahan and the article by William Lang and Leonard Nakamura for evidence on the “flight business and household borrowing. reduces the flow of credit to firms to quality” during earlier contractionary episodes. with productive uses for funds. Even in the midst of a severe downturn, 6 A consequence of de-leveraging is that safe borrowers get to borrow at a lower interest rate. there will be businesses that can put 7 This could potentially mitigate the contractionary This discussion draws upon the ideas in the funds to good use. There will also be effects of de-leveraging except that the primary article by and Mark Gertler beneficiary of the flight to quality tends to be the and the article by and John some financial intermediaries (the government, not the private sector. Moore, especially the latter. ones unscathed by the crisis, perhaps)

www.philadelphiafed.org Business Review Q2 2010 5 that will be eager to lend. But when nonfinancial sector and thereby adds OTHER FACTORS FEEDING the debt capacity of businesses is fuel to the financial accelerator. THE ACCELERATOR lowered by a decline in property prices, The downturn gathers further speed The previous section began with businesses with good uses of funds and feedback effects kick in: As the observation that the credit crunch cannot borrow as much as they would unemployment rises and economic adversely affected property prices like. This financial constraint curtails activity declines, property prices because property prices are sensitive business investment and eventually decline even more, which leads to to the free flow of credit. Given the leads to an output level that is lower further decreases in debt capacity and magnitude of the financial shock and than it would be in the absence of a further decreases in expenditures, the consequent de-leveraging, the decline in debt capacity. output, and employment. credit crunch is probably an important A decline in debt capacity is also Eventually, this downward spiral factor in the decline in property values. the reason a decline in home equity in property prices and economic However, other factors have played a depresses consumer spending. As activity comes to a halt, in part role in the decline in property values has been remarked upon many times because the financial accelerator as well and have therefore fed the during the current crisis, households begins to lose its potency. Recall financial accelerator. We discuss the borrow against their home equity that the accelerator works through more important channels here. to pay for all kinds of consumer a reduction in debt capacity, which As already noted, declines in expenditures. These expenditures is the maximum level of debt the residential house prices result in go well beyond home improvement nonfinancial sector can borrow declines in home equity and therefore projects (which remain a main motivation for home equity loans) and encompass expenditures for which it would be hard to get a loan directly. A decline in residential property prices reduces how much households can borrow because the property (the house in this case) being offered as collateral is worth less.8 Once again, (given existing property prices). But a decline in debt capacity. If the even in the midst of a crisis, there when economic activity is quite low, household already has an existing will be households that would like to debt capacity is not what constrains mortgage, the decline in house values borrow more than their (reduced) debt investment on the part of firms can lead to home equity becoming capacity, and these households will and households. They reduce their negative. That is, the value of the have to reduce their spending. To the investment simply because investment debt owed becomes larger than extent that the decline in household is not remunerative when the general the value of the property. In this debt capacity constrains business level of economic activity is low. When situation the homeowner may choose investments by small businesses that that stage is reached, a further decline to default on his or her mortgage. rely on the owners’ assets to get loans, in property prices and debt capacity In the run-up to the crisis, many the decline will have deleterious effects does not cause additional reductions in families bought homes with very low on future output and employment as expenditure and output because there down payments. Consequently, the well. are very few entities (businesses or decline in house prices has resulted in Every decline in property prices households) that would want to borrow many families having negative home reduces the debt capacity of the more than their debt capacity allows. equity. The result has been a huge The downward spiral is also arrested rise in foreclosures.9 Foreclosures, in in part because of policy actions. turn, depress house prices. Foreclosed Accommodative monetary and fiscal properties are sold at a heavy discount 8 If the household has a mortgage against the policies shore up expenditures and because lenders (banks) that end up property already, only the value of the house in excess of the outstanding mortgage — the therefore offset, to some extent, the owner’s home equity — can be offered as col- decline in expenditures that stems lateral against the new loan. A decline in the 9 For an excellent discussion of the connection value of residential property reduces home from the operation of the financial between negative home equity and mortgage equity dollar for dollar. accelerator. defaults, see the article by Ronel Elul.

6 Q2 2010 Business Review www.philadelphiafed.org owning them find it costly to hold property prices. Greater uncertainty move out of circulation and into bank on to the houses. As the number (higher probability of both good reserves. of foreclosures rises, the increased and bad outcomes) makes firms and In sum, there are a host of factors presence of sellers willing to sell homes households delay decisions that cannot working to reduce property prices in at low prices puts downward pressure be easily reversed. Most investment the wake of the crisis. The severity and on the price of all properties, including decisions fall into this category so that speed of the current downturn reflects, those not in foreclosure. uncertainty reduces expenditures on in part, the operation of the financial In addition, foreclosures reduce business fixed investment.11 Greater accelerator. The good news is that the the demand for housing space because families who lose homes in a foreclosure end up renting less space than they owned. They end up renting because they cannot get a new mortgage after defaulting on the previous one, and they rent less space than they owned because renting does not have the tax advantages that homeownership does. Thus, the overall uncertainty (especially uncertainty financial accelerator works both ways. demand for housing space declines regarding future earnings prospects) As economic activity begins to revive, with foreclosures. This puts further increases a household’s desire for perhaps because of accommodative downward pressure on house prices.10 precautionary savings (a rainy-day government policy or some good shock, The decline in house prices also fund), which reduces aggregate desired investment on the part of reduces the household net worth of consumer spending. Overall, firms begins to rise. At first, firms that families who do not go into foreclosure. uncertainty can be a potent force desire to borrow less than their debt Household net worth is the difference for lowering business and household capacity (unconstrained firms) are the in the value of all household assets and investment and is undoubtedly an ones that can get funding to undertake all household liabilities. It is a measure important factor in the current their investment. But new investment of household wealth. As house prices downturn.12 It should be noted that the (and rising economic activity more decline, the value of household assets increase in the precautionary savings generally) puts upward pressure on declines. But there is no immediate on the part of households and firms property prices. As property prices change in household liabilities (if the (firms that delay investments park begin to recover, constrained firms household does not choose to default their funds in safe financial assets) also (firms that would like to borrow more on the mortgage), and therefore, there means that these entities allocate more than their debt capacity) can borrow is a decline in household wealth. of their funds to safe assets, and this more as well because the increase Lower wealth translates into lower is another factor putting downward in property prices increases their spending because families feel poorer pressure on the yield on safe assets debt capacity. Of course, additional and spend less. Economists refer to and, ultimately, causing funds to investment increases aggregate output this as the wealth effect. The negative in the short run and, eventually, in the wealth effect of a decline in household long run, as well. Thus increases in net worth lowers consumer spending, property prices provide extra impetus which lowers output and employment 11 The role of uncertainty in delaying invest- to the rise in economic activity in the and further depresses property prices. ment is discussed in the article by Ben Bernanke same way that declines in property Increased uncertainty about the and in the book by Avinash Dixit and Robert prices provided extra impetus to the future also plays a role in reducing Pindyck. decline in economic activity at the current output and depressing 12 A discussion of how uncertainty affects consumer spending can be found in my recent start of the downturn. Business Review article. It is worth noting that there has been a sharp increase in the personal CONCLUSION 10 The interaction between the foreclosures, the savings rate in the U.S. since the crisis began. tax code, and the demand for housing space The savings rate averaged less than 2 percent in In the wake of the financial crisis, was investigated in my recent paper with Burcu 2007 but rose to around 4.5 percent in 2009 and the U.S. economy has suffered one Eyigungor. remains elevated.

www.philadelphiafed.org Business Review Q2 2010 7 of the worst recessions of the post- and maturity transformation are the to feed on itself and cause a large World War II era. There is little doubt proximate reasons as to why defaults in — and more or less simultaneous that this episode will be the focus of a relatively small segment of the U.S. — decline in property prices and research and analysis for a long time housing market led to a financial crisis. economic activity. This diagnosis to come and our understanding of the And the severity of the downturn is has implications for the future: If the origins of the crisis and its aftermath most likely the result of an interaction financial accelerator played a role in will evolve over time. At this point, between declining property prices — making the downturn steep and quick, we can only give provisional answers to brought on by de-leveraging in the we may expect it to play a role in the the question: Why did rising defaults financial sector — and the consequent recovery as well. When the recovery in the subprime mortgage market decline in the debt capacity of the takes root, the workings of the cause a financial crisis that led to such nonfinancial sector. This interaction, accelerator will tend to make it sharp a severe downturn? called the financial accelerator in the and rapid. BR This article suggests that leverage academic literature, has the potential

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