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

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De-Leveraging and the Financial Accelerator: How Wall Street Can Shock Main Street* by SATYAJIT CHATTERJEE View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by Research Papers in Economics 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 financial crisis 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.
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