The Credit Crunch of 2007-08: Lessons Private and Public
Poole, William, Business Economics
The current financial crisis has much in common with past crises. Poor investment strategies with respect to risk as well as poor evaluation have contributed to the current crisis. This paper presents the lessons to be learned by the private and public sectors. Why do crises keep happening? Mismatch of assets--long-term liabilities offset by short-term assets--can be profitable but is risky, and robust strategies must be able to cope with the risk. A number of measures can and should be taken by private financial entities for their own sake as well as that of the entire financial system. With respect to the public sector, one should be wary of expanding the role of regulation. What should be done, however, is to make sure that public policies are pursued through on-budget spending and taxation rather than through off-budget initiatives, such as encouraging government-sponsored enterprises to accumulate subprime debt in order to further public policy objectives. It would also be useful to reduce overall levels of private debt by reducing tax incentives to borrow.
Business Economics (2009) 44, 38-40.
Keywords: credit crunch, financial crisis, credit, subprime
Our topic is "Lessons of the Credit Crunch of 2007-08." Unfortunately, I suspect that in the title we will have to change 2007-08 to 2007-09. This mess is not going to be resolved quickly, and it contains lessons for both the private and public sectors.
1. Lessons for the Private Sector
Anyone familiar with the scholarly literature on financial crises knows that our recent--and unfortunately ongoing--experience has many general characteristics familiar from past crises. How can the private sector make the same mistakes over and over again? The current crisis, in particular, is in some ways a supersized version of what happened to Long-Term Capital Management in 1998, which was not that long ago and certainly familiar to all who were in senior management in major financial firms at the outset of this crisis.
The root of the current problem is poor credit quality. Too many financial institutions loaded up on too much subprime mortgage paper without adequate assessment of the credit risk. But the issue goes beyond poor credit evaluation, because the strategies behind these portfolios were risky from the beginning. Credit evaluation is hard, and we cannot depend only on better credit evaluation in the future to maintain financial stability. The financial system needs to be robust with respect to credit risks.
I reluctantly conclude that the market is all too often shortsighted--not as shortsighted as the public sector typically is but shortsighted nonetheless. The problem is well known in the finance literature. The probability distribution of possible outcomes has fat tails--the probability of extreme events is much higher than managers of financial firms and investors in those firms seem to understand. Financial firms pursue risky strategies that yield apparently high returns year after year, until the crisis hits and the strategies fail catastrophically.
A common feature of financial strategies that fail is a duration mismatch--assets on the balance sheet have longer maturities than liabilities. Financial firms can indeed earn reliable returns from maturity transformation, provided they have robust strategies to deal with the risk. What seems to have happened is that firms have relied on thick asset markets to allow them to borrow short-term by putting up their longer-term assets as collateral. Once lenders come to distrust the value of the collateral and ask for more, the strategy is in great difficulty. Selling the collateral at a price anywhere close to its value on the balance sheet may not be possible when the market comes to distrust the paper.
The possibility that asset markets would close could and should have been foreseen. …